Spero Consulting

Archive for December, 2008

We’re try­ing to shed our eth­no­cen­trism, and as a nod to our global read­er­ship, we’ve added a trans­la­tion fea­ture to the right.

Let us know how well it works – espe­cially our good friends in Kiev and London.

Not sure if it is as cool as our vis­i­tor map. If not, it is a very close second.

So, in 35 lan­guages, we wish all of our clients and read­ers a happy, healthy, and pros­per­ous 2009.

Approx­i­mately ten days ago, after his release from jail, we caught a brief glimpse of Bernie Mad­off on the tele­vi­sion news. 

He was walk­ing along the side­walks of New York, pre­sum­ably near his apart­ment, and he was sur­rounded by a swarm of news reporters and cameramen.

It seemed that some­one accosted him – pushed him – but the episode didn’t last very long. We didn’t think much of it at the time and fig­ured that it was a dis­grun­tled neigh­bor who was also an investor in Mr. Madoff’s funds who had hap­pened upon him and his entourage, and that was that.

Upon fur­ther reflec­tion, we had our tit­u­lar thought: what a civ­i­lized coun­try we live in! 

Many very rich, clever, and rel­a­tively pow­er­ful peo­ple seem to have lost sub­stan­tial sums of money by invest­ing with Mr. Mad­off. Yet, he was arrested and arraigned and released on bail – all accord­ing to our laws – and upon his release he felt safe enough to ven­ture into public.

To date he has suf­fered noth­ing worse than a push.

Thus, so far, it seems that his investors have been con­tent to let the gov­ern­ment take the lead in pros­e­cut­ing him, and they have not imple­mented or acted on any vendet­tas or thoughts of revenge.

Now, this is the same coun­try that responded quite aggres­sively to 9/​11 – some say too aggres­sively – so, we don’t believe that we live in a sis­si­fied, effete country. (And it’s cer­tainly not that way out­side of the gun-​controlled cities and states where our media tend to reside.) So, we’d argue that it is sim­ply self-​control (of oth­ers) that per­mits Mr. Mad­off to walk the streets.

Of course, the future could prove us wrong and per­haps some folks are patient and want to serve their revenge cold. Until that time, we’ll mar­vel over the fact that West­ern Civ­i­liza­tion seems alive and impulses seem to be well-​controlled.

One of them, at least.

Update: We’ve added an excel­lent line from Peggy Noonan’s Decem­ber 26^th, weekly col­umn, as it fits so per­fectly with our theme.

We spent a recent noon-​time dis­trib­ut­ing year-​end, hol­i­day, bonus checks to a group of care-​givers and their managers. 

It was very grat­i­fy­ing, espe­cially since it wasn’t our money. We’re jok­ing, of course. It would likely have been more grat­i­fy­ing had been our money, but while the lunch was for a small orga­ni­za­tion, it’s not that small.

Now, we know that it is quite easy to go through life ignor­ing not only peo­ple in need but also those who help them on both a vol­un­teer and paid basis. (It’s worth not­ing that those who do get paid usu­ally don’t get paid much for their efforts.) There are a lot of car­ing peo­ple serv­ing a vari­ety of con­stituents, e.g., in fields like men­tal retar­da­tion, men­tal health, the aged, etc.

Those folks spend sub­stan­tial time and energy help­ing oth­ers, includ­ing the less for­tu­nate, to lead more ful­fill­ing lives. For exam­ple, we know good peo­ple who have devoted their entire work­ing careerss to pro­vid­ing such aid, and that often requires fight­ing against an uncar­ing and soul­less gov­ern­ment bureau­cracy (in their attempts to do the right thing.) For another exam­ple, we know of oth­ers who call their work­places on their days off to check on their favorite clients. All of these peo­ple, for at least some por­tion of their daily lives, try to do the right things for oth­ers. (Yeah, some­times it seems weird to us, too.)

In her weekly col­umn, A Year for Books, Peggy Noo­nan men­tions “Mother Teresa’s Secret Fire” by Father Joseph Lang­ford, a friend of Mother Teresa’s. Ms. Noo­nan writes: “…and of the things he learned from her includ­ing, most cen­trally, this: You must find your own Cal­cutta. You don’t have to go to India. Cal­cutta is all around you.”

In that regard, if the reader has access to Touch­stone Mag­a­zine, we encour­age them to read the Anthony Esolen’s excel­lent essay, “Pot­ter­ville Nation,” in the Decem­ber issue. Unfor­tu­nately, it is not avail­able on line.

In the essay, Mr. Esolen writes about the clas­sic movie, It’s a Won­der­ful Life. His point is that it was not nec­es­sary for George Bai­ley to have never been born for Bed­ford Falls turn into Pot­ter­ville. (In the movie it is called Pot­tersville with an “s.”)

Even if George had been born, there were any num­ber of steps along the way when he could have veered slightly (almost imper­cep­ti­bly) away from his con­science and duty, and that would have been to the severe detri­ment of other indi­vid­u­als, his com­mu­nity, and soci­ety. Many of those small turns would have seemed innocu­ous or would have been unob­served by oth­ers. It’s quite pos­si­ble that no one, includ­ing George, would have known the dam­age he caused or did not pre­vent as he chased his dream. (Per St. Fran­cis de Sales, that doesn’t mean that one should over-​analyze or over-​account for ones every actions and deci­sions. We’ll try to pro­vide a link in the near future.)

Mr. Esolen notes that nowa­days much of soci­ety looks more like Pot­ter­ville than Bed­ford Falls, and he attrib­utes that phe­nom­e­non to folks (self­ishly) fol­low­ing their dreams to the exclu­sion of oth­ers. (Per­haps, like Utopia, Bed­ford Falls never existed. In fact, Mr. Esolen men­tions that self-​recognition and feel­ings of guilt may have been the rea­son why the movie was unsuc­cess­ful dur­ing its ini­tial release in 1946.)

Now, one rea­son we par­tic­u­larly like his essay is that it fits quite nicely with a recent con­ver­sa­tion we had with one of the princesses. We were told “When I’m an adult, I’ll do what I want.” Our reply was, “Hmmm, we don’t see any real adults act­ing that way. In fact, it seems to us that ‘I’ll do what­ever I want’ is the antithe­sis of adult­hood, civ­i­liza­tion, moral­ity, ethics, and rea­son. The impul­sive ‘I’ll do what­ever I want’ cer­tainly makes one no bet­ter than ani­mals and not very close to angels.” (Obvi­ously and clearly, we’re not talk­ing about those who are old enough to be adults, but who choose not to be, but that’s a post for another day.)

We told her that being an adult involves doing what oth­ers need you to do. In that sense, adult­hood isn’t lib­er­at­ing, but as George Bai­ley dis­cov­ered, it can be very ful­fill­ing. (Lib­er­a­tion involves liv­ing a coun­try where the gov­ern­ment per­mits cit­i­zens to be adults, but that, too, is post for another day.) 

We’ve won­dered how many times we’ll have to repeat that mes­sage in the com­ing years, and at Christ­mas Eve Mass, we prayed for the strength to be able to do so as often as it is needed to be heard.

We’re also quite thank­ful that her mother, the chair­man, sets such an excel­lent exam­ple of adult behav­ior and respon­si­bil­ity (and com­pen­sates for our many fail­ings and immaturity).

Unlike the folks that we ref­er­enced above, we doubt that we do our fair share, but we pray for those who do. We wish them and you a Blessed and Merry Christ­mas and a Healthy and Happy New Year.

Higher Pay for Con­gress­men and Greatly Reduced Staff Staph Levels

This past week­end – the last before Christ­mas – we saw a few reports crit­i­ciz­ing the upcom­ing Con­gres­sional pay raises, includ­ing this one at FoxNews: Pay Raises for Law­mak­ers Anger Watch­dog Groups.

In that arti­cle, some­one from a watch­dog group noted that “Mem­bers of Con­gress don’t deserve one addi­tional dime of tax­payer money…”

We’ll leave the issue of what Con­gress­folk deserve to oth­ers, includ­ing their maker. Our stan­dard response when folks com­plain about the weather in West­ern PA – we think the sun appeared once in the first 24 days of the month – is to ask, “do you really deserve any bet­ter?” That nor­mally silences the hon­est ones.

As we promised last week in Cas­san­dra, the SEC and Mr. Mad­off, here is our rec­om­men­da­tion as well as our moti­va­tion and ratio­nale to elim­i­nate gov­ern­ment bureau­cracy (via changes in the leg­isla­tive, rather than the exec­u­tive, branch of the fed­eral government).

As reg­u­lar read­ers know, we’ve pro­posed our own solu­tion to the mort­gage cri­sis that is based upon sim­ple changes in tax rules: pro­vide either invest­ment tax cred­its or accel­er­ated amor­ti­za­tion (imme­di­ate write-​offs) of the pur­chase price of mortgage-​related assets: more car­rot than stick for pri­vate investors. We have also pro­posed a solu­tion for the larger crisis-​in-​confidence, which has evap­o­rated liq­uid­ity faster (and drier) than the after­noon sun in Death Val­ley. That one is much more stick than car­rot for cur­rent finan­cial firm shareholders.

We’ve sent our solu­tion to var­i­ous mem­bers of the media, the com­men­tariat, and a few politi­cians. All to no avail. We have been ignored, but, of course, we think that says more about them than it does about us: would you expect us to write any­thing else?

After see­ing her at Mass one Sun­day morn­ing in Octo­ber, we sent our idea to the Melissa Hart, our for­mer U.S. rep­re­sen­ta­tive and this year’s Repub­li­can can­di­date for the same Con­gres­sional seat that she lost two years ago.

She ran this year’s cam­paign as dread­fully as her 2006 effort, and so while she’ll con­tinue her law career in Pitts­burgh while Jason Alt­mire will again rep­re­sent our dis­trict in Washington.

Other than see­ing Ms. Hart at Mass, we’ve had almost no direct per­sonal obser­va­tion of her. One excep­tion was at an August fund-​raiser for a local char­ity. It was at a com­edy club, where politi­cians of both par­ties per­formed stand-​up rou­tines. Note: we’re using those last three or four words very loosely.

Pre­sum­ably watch­ing the likes of David Let­ter­man on tele­vi­sion every late night per­mits many to delude them­selves into believ­ing that they, too, can suc­ceed in telling jokes in front of an audi­ence. (Hey, Mr. Let­ter­man and CBS have suf­fered from a sim­i­lar afflic­tion for many years.) That reverse psy­cho­log­i­cal pro­jec­tion seems anal­o­gous to lis­ten­ing to Madonna or Brit­ney and then try­ing karaōke, because, hey, it really can’t sound any worse, can it? Yeah, actu­ally, with­out clever pro­duc­ers and proper edit­ing devices, it cer­tainly can.

Any­way, most of the politi­cians were as bad as you’d expect. One was truly and painfully hor­ri­ble – quite embar­rass­ing – for a par­ties involved, but a few were very funny.

The most painfully bad was Ms. Hart. Based upon that per­for­mance, we’d guess that prior to law school she earned a degree in account­ing and before that served on the stu­dent coun­cil and glee club in high school and before that won hand-​writing awards in ele­men­tary school and prob­a­bly still has the neatly-​organized papers and cer­tifi­cates to prove it. It was being forced to lis­ten to some drunk guy yell at his kids at a car­ni­val or be party to a con­ver­sa­tion where some­one refers to his wife as “my old lady.” Ick.

As it turns out, Mr. Alt­mire was very funny, acerbic, and jus­ti­fi­ably cruel to Ms. Hart, who had gone first.¹ Based upon view­ing his cam­paign ads, we were quite sur­prised by his wit and humor. We had erro­neously pegged him as a younger, House ver­sion of Penn­syl­va­nia Sen­a­tor Robert Casey, whose recent claim to fame is his dis­gust that his favorite potato chips are no longer served at the Capi­tol cafe­te­ria. No, we’re seri­ous.

Based upon that sin­gu­lar pos­i­tive expe­ri­ence with Mr. Alt­mire and in the spirit of post-​election, bi-​partisan coöper­a­tion, we sent this e-​mail to Mr. Alt­mire in early Decem­ber. Despite being naïve and ide­al­is­tic, we’re quite skep­ti­cal – some might even say cyn­i­cal – so we had extremely low expec­ta­tions, and they were indeed met. Two Fri­days ago, we received this form mes­sage in reply.

Now, please real­ize that we have extremely low expec­ta­tions so we gen­er­ally avoid con­tact­ing our elected rep­re­sen­ta­tives, but to receive such a silly let­ter, which may be an appro­pri­ate response to an 80-​year-​old widow won­der­ing about her grandchildren’s future in an illiq­uid Amer­ica. Well, it is just down­right demean­ing, and it pro­vided us with a rare, per­sonal glimpse into the inner non-​workings of our fed­eral government.

With that obser­va­tion came the real­iza­tion that Con­gres­sional staphs are a major crutch as well as a major rea­son why Con­gress is so dys­func­tional and has approval rat­ings that stand at about half of Pres­i­dent Bush’s. ² We hypoth­e­size that as part of this year’s per­for­mance review, some stapher will sub­mit that e-​mail form as part of a port­fo­lio of out­put to show proof pos­i­tive of their value to Mr. Alt­mire, and that’s both a shame and a national dis­grace. It pro­vides no value to Mr. Alt­mire or his con­stituents. It’s just bor­ing, stu­pid, and bureaucratic.

Our rec­om­men­da­tion: limit Con­gres­sional staffs to three peo­ple. One recep­tion­ist in the home office and two employ­ees in Wash­ing­ton, DC: a recep­tion­ist and an assis­tant. With the cost sav­ings, dou­ble the pay of Rep­re­sen­ta­tives and Senators.

We think it would pro­vide more effec­tive term lim­its than term lim­its, and would focus Con­gres­sional atten­tion on only impor­tant and gen­eral top­ics. In addi­tion, we think that it would focus the atten­tion and speech of indi­vid­ual Rep­re­sen­ta­tives and Sen­a­tors ton top­ics on which they have some per­sonal knowl­edge, rather than the cur­rent sit­u­a­tion where they speak on all top­ics on which their staph may write.

We’ll likely expand this post and write more on the topic, but isn’t the near elim­i­na­tion of Con­gres­sional staphs “change that you can believe in?” Also, isn’t it the best way to fight the staph infec­tions that plague our nation’s Capitol?

We were at Williams-​Sonoma this past week­end and saw a beau­ti­ful cop­per, KitchenAid mixer for $899.95. (Its twin is made of nickel, and we have no idea of how prices of that metal have changed, but we doubt that they have gone up since the summer.)

The nearly $900 seemed a bit expen­sive for a mixer; so, we joked with the clerk that KitchenAid must have bought their cop­per sup­ply much ear­lier in the year when prices were three times as high and that it must be still try­ing to recoup its costs. (Unfor­tu­nately, no one really cares about your cost, only your value, and we doubt that KitchenAid hedged or even “nedged” or “sledged.”) They’re quite beau­ti­ful mix­ers, and if they can sell them at that price, we say, “God Bless ‘em.”

Our clerk didn’t give much of a ver­bal reply to our joke, but had she done so, it would have prob­a­bly been some­thing like: “Yeah, what­ever, please go away if you’re not going to buy it.”

We were reminded of that brief encounter by the Com­modi­ties Report in today’s edi­tion of The Wall Street Jour­nal: Cop­per Is at a Four-​Year Low. This year, prices have decreased from about $4 per pound to about $1.25 per pound.

Now, that report made us pon­der: with the recent dras­tic reduc­tions in such com­mod­ity prices, what will des­per­ate thieves steal? Given the risks, is it still worth­while to strip cop­per down­spouts from churches or remove wiring from con­struc­tion sites or take man­hole cov­ers from roads or siphon gaso­line from stor­age tanks or other cars? 

If such folks were a bit more indus­tri­ous and had a bit of mall space, they might try to sell $300 mix­ers for $900. Merry Christmas.

It Doesn’t Add Up.

Accord­ing to The Wall Street Jour­nal, today S&P Cut Rat­ings on 11 Banks.

Depend­ing upon each institution’s account­ing poli­cies, indi­vid­u­als at those firms may have cheered their firm’s respec­tive down­grade because that action may have reduce the value of the firm’s out­stand­ing debt thereby allow­ing the firm to rec­og­nize an unre­al­ized gain on its income state­ment. (Yeah, it is per­verse and stupid.)

For exam­ple, by com­bin­ing the con­tents of this arti­cle about Mor­gan Stanley’s fourth quar­ter earn­ings and page two of this report, it seems that Mor­gan Stan­ley equity-​holders “gained” about $3.6 bil­lion because the firm’s debt – its promise to meet future long-​term oblig­a­tion – has become worth sub­stan­tially less to cred­i­tors than it was at the end of August. (We cal­cu­late the $3.6 bil­lion as $5.9 bil­lion of com­bined real­ized gains – from the actual repur­chase of its long-​term debt – and unre­al­ized gains – from writ­ing down the book value of debt – which are men­tioned in the arti­cle, minus about $2.3 bil­lion of real­ized gains men­tioned on the income state­ment, but we could be wrong, and its kind of besides the point; so, we don’t mind being wrong.)

Reg­u­lar read­ers will note that for quite some time, we’ve promised a rather long post on the nature of mark-​to-​market account­ing, but we’ve been busy, and it’s not the most excit­ing topic.

Our view is that there is noth­ing inher­ently wrong with mark-​to-​market account­ing for assets when mar­kets exist. 

Unfor­tu­nately, for many asset classes, there aren’t robust, active mar­kets; so, the exer­cise become mark-​to-​model (by def­i­n­i­tion an abstract, sim­pli­fied view of real­ity) or mark-​to-​quote (by def­i­n­i­tion an unful­filled wish or hope if no exchange took place). But we’ll save those issues for a longer and more detailed post when time is less pre­cious, but today we must fin­ish deck­ing the halls.

In our view mark-​to-​market for lia­bil­i­ties makes far less sense and cre­ates a per­verse sit­u­a­tion where a weak­ened firm may the­o­ret­i­cally ben­e­fit from that weak­ness; it’s not the same as loss carry-​forwards.

We’ll try to be clear. Take our esti­mated real­ized gains and unre­al­ized gains for Mor­gan Stan­ley as given, i.e., $2.3 bil­lion real­ized on retired debt and $3.6 bil­lion unre­al­ized on out­stand­ing debt.

Rec­og­niz­ing a real­ized gain on the early pay-​off on debt makes com­plete sense. If Mor­gan Stan­ley was able to repay $2.3 bil­lion less than the book value of its debt, then good for the firm and its own­ers. Note that such a sit­u­a­tion could occur if either base inter­est rates increased sub­stan­tially or credit spreads widened sub­stan­tially. (Those are actu­ally arti­facts, not rea­sons, but that’s how folks talk.)

In our mind, rec­og­niz­ing an unre­al­ized gain of $3.6 bil­lion is prob­lem­atic. Hold­ing base rates con­stant – and they’ve actu­ally decreased this fall – the only way for debt to lose such value is if the firm’s (per­ceived) cred­it­wor­thi­ness has deteriorated.

In that case and at some point, it would seem that the firm would not have the cash bal­ances nor the cash flow to real­ize the reduc­tion in out­stand­ing, con­trac­tual claims against it. To us, that means that the claim against the firm remains at the face value, and the resid­ual claimants – the share­hold­ers – would have to sat­isfy that entire claim (or some nego­ti­ated amount) before they would receive any­thing.

More­over, if the firm is uncred­it­wor­thy and can­not refi­nance the debt, then by the def­i­n­i­tion of a lia­bil­ity – an item of expected future sac­ri­fice from a past trans­ac­tion or event – the firm should record the lia­bil­ity at (1) its approx­i­mate face value (plus or minus any pre­mium or dis­count) or (2) its liq­ui­da­tion value in case of bankruptcy. In that lat­ter case, it is not clear whether the firm remains a going-​concern or not.

There­fore, if it is a going con­cern but it can­not pay-​off – say with cash or via refi­nanc­ing – at the deval­ued mar­ket value of debt, then we say that the expected future sac­ri­fice is not the “mar­ket value,” it is the face value. So, where is the gain? Nowhere; it doesn’t exist.

It seems that knowl­edge and its rarer cousin, wisdom, have no role at the FASB or the SEC. We derived our argu­ment from basi­cally one def­i­n­i­tion – a lia­bil­ity – and one assump­tion: the firm’s a going con­cern. Does it seem that our policy-​makers have lost sight of the prover­bial for­est because of the trees? Or are we wrong? If so, how?

In their attempts to become rel­e­vant, they’ve achieved the opposite.

We have two other posts today, Oil in the 30s: Merry Christ­mas, in which we oppor­tunis­ti­cally crow about our prowess at pre­dict­ing oil prices, and The Harvard-​Yale-​CALPERS Cycling Club, in which we lament the lack of imag­i­na­tion among fund man­agers and the enor­mous harm caused by inex­pe­ri­ence or inep­ti­tude (got to throw-​in the per­sonal and insti­tu­tional greed, too). We do that via an analogy.

Now, this post extends both of those because, here, we make a pre­dic­tion about the effects of the endow­ment losses suf­fered at many uni­ver­si­ties and col­leges. News media reports indi­cate that many schools will face endow­ment losses pro­por­tional to those suf­fered by Har­vard and Yale: 25 — 30%. 

Con­trol­ling for the reduc­tion in dona­tions due to the reces­sion and loss of wealth due to the sub­stan­tial decrease in equity and real estate val­ues, which admit­tedly isn’t easy, we fore­cast that dona­tions will fall even far­ther, par­tic­u­larly among the non-​wealthy, i.e., the middle-​class.

In some sense, dona­tions are a lux­ury good, and one would expect them to be highly sen­si­tive to income lev­els, but that’s not our argument.

Our argu­ment is much sim­pler: we imag­ine that lots of alumni, par­tic­u­larly the small donors, will say (at least to them­selves): “We gave you our hard-​earned money and you did what with it? Don’t you have some fidu­ciary respon­si­bil­ity to be rel­a­tively con­ser­v­a­tive to, at least, say, attempt to pro­tect the prin­ci­pal? And you did what? I’m not giv­ing you my money so you can dab­ble and “uri­nate” it away.”

Then again, maybe we’re just pro­ject­ing – the psy­cho­log­i­cal way – not the guess the future way.

My fickle friend, the sum­mer wind.

A few weeks ago, Har­vard announced that its endow­ment fund lost about $8,000,000,000 (since July 1).

This week, Yale announced that its endow­ment was down about 25% for the year. That’s about $5,900,000,000. (Their fis­cal year started July 1.)

Like­wise, accord­ing to yesterday’s Wall Street Jour­nal, CALPERS, the Cal­i­for­nia Pub­lic Employ­ees’ Retire­ment Sys­tem, has lost about one-​quarter of its assets since July 1. That’s almost $60,000,000,000. Poof! To put it into per­spec­tive; that is A LOT of money.

On their hous­ing investment, CALPERS has been able to lose 103% of their invest­ment due to lev­er­ing it. Before the losses, they were lev­ered about four-​to-​one; so, it is quite pos­si­ble that they could con­tinue to loss.¹

Now, we’re not writ­ing to directly crit­i­cize those fund-​managers’ invest­ment strate­gies. That’s rather mun­dane. We think indi­rect crit­i­cism via an anal­ogy will suf­fice because it doesn’t require any finan­cial train­ing or knowl­edge nor the abil­ity to cal­cu­late nor a host of other “skills” nor­mally cov­ered in MBA programs.

When we were younger and had fewer depen­dents we spent a sub­stan­tial amount of time and energy cycling the nar­row, twist­ing coun­try roads that abruptly climb the steep hills and quickly descend into the the dark val­leys and ravines that form much of South­west­ern Pennsylvania.

We rode good dis­tances in almost all con­di­tions – as long as the tem­per­a­ture was above 5º Fahren­heit. Where we rode, it was nor­mal to pedal for about 60% of the total dis­tance. We’d guess that it equated to about 90% of the time because one was either ped­al­ing uphill slowly or coast­ing down­hill – usu­ally quite rapidly.² As a point of com­par­i­son, in the flat – except around turns – one ped­als almost 100% of the time and distance.

One sum­mer, we decided to take the road bike to the beach. The thought of rid­ing on long, flat sur­faces seemed par­tic­u­larly appeal­ing given the omnipresent effects of grav­ity in our home terrain.

We recall our first ride on that vaca­tion. Ah, to be on a flat, smooth sur­face where every rota­tion pro­pelled one for­ward, rather than up. It was so lib­er­at­ing. We felt pow­er­ful and strong and rode for miles south along the Outer Banks. We were begin­ning to think that train­ing in the hills had made us a for­mi­da­ble coastal plain rider. We were thrilled, and decided to turn around and race home to tell the chair­man – though she wasn’t the chair­man at that time, only the boss, and she didn’t really care.

And that’s when it hit us. As they sing, “The sum­mer wind came blow­ing in from across the sea.” All that con­stancy, con­sis­tency, momen­tum, speed, and power. That feel­ing of invin­ci­bil­ity, youth, and vigor. It was – we can’t resist – it was gone with the wind.

What had been an unno­ticed tail­wind was now a very obvi­ous head­wind. It would have been per­fect if we were try­ing to fly a kite or a plane, and at the moment we under­stood com­pletely why the Wright Broth­ers from Day­ton, OH chose Kitty Hawk, NC to exper­i­ment with flight; wind, nice and strong, anytime you wanted it. We were reminded of it mile-​after-​lung-​bursting, air-​stiffening and resist­ing, lactic-​acid pro­duc­ing mile.³

We had left the hotel a few hours ear­lier as young, fit, ener­getic, twenty-​something, and returned wiz­ened, shriv­eled, aged: like the only liv­ing sur­vivor of the War between the States, which had ended 125 years earlier.

We learned some­thing that day. We sub­se­quently relearned the les­son repeat­edly and ad nau­seum as we rode through the windswept Mid­west in both Mis­souri and later in the same Min­nesota coun­try­side where Greg Lemond trained to be a cham­pion. (Don’t worry, we have no pre­ten­sions. In fact, we had and have no com­pre­hen­sion how men like Mr. Lemond can pedal as fast as they can for as long as they can. Our only con­clu­sion is the self-​comforting ratio­nal­iza­tion of medi­oc­rity: if we can’t do it, they must be freaks!)

Over time easy money poli­cies, for­eigner investors with “excess” cap­i­tal, low base rates, tight­en­ing credit spreads, and the asso­ci­ated low volatil­ity all pro­vide pow­er­ful momen­tum yet are almost imper­cep­ti­ble to the either (1) inex­pe­ri­enced – like we were those many years ago ped­al­ing down NC 12 – or (2) the slow-​witted. (You know, the folks that you joke about when you ask whether they have twenty years of expe­ri­ence or one year of expe­ri­ence twenty times.) Like us in our youth, both seem will­ing to extrap­o­late their per­for­mance from the slight­est bit of evi­dence to items far out­side their rel­e­vant and reli­able ranges and draw far too opti­mistic con­clu­sions about their own abilities.

Yes, every­one is a genius or a star when they’re run­ning or rid­ing with the wind. 

It seems that much of pelo­ton of traders, struc­tur­ers, and fund man­agers, which grew larger and larger on that rel­a­tively flat sur­face between 2001 and 2007, had no appre­ci­a­tion for the fact that some­times it is nec­es­sary to turn-​around and some­times even if you don’t turn, the winds can shift from your back to your front.⁴ 

Yes, folks. There may be wind, invis­i­ble and strong, that is assist­ing you, and that can change faster than you can say, “Where is Lehman trad­ing today?”

It’s not nec­es­sary ride like Greg Lemond into the wind, and it is unre­al­is­tic to expect many to pos­sess that abil­ity to thrive is such con­di­tions, but is it too much to ask fund man­agers to reach a level of knowl­edge and wis­dom pos­sessed by the likes of Bob Seger or Frank Sina­tra or us?

We don’t think so, but despite what appears to be a deep-​seated pessimism, we are eter­nally opti­mistic and hope. It’s why we are often dis­ap­pointed and expect to be in the future.

The reader may think of many other ways to make a sim­i­lar point, and their sto­ries may be more lucid, direct, and par­si­mo­nious, but that just goes to show how truly inept some folks have been with other peo­ples’ money. “Who could have imag­ined?” Well, the answer is, when they’re get­ting paid as much as they were, they should have been able to do so. We wrote about that in The Seventy-​Year-​Old Teenager.

---

Foot­notes:

Back on May Day, when oil was about $120 per bar­rel, we spec­u­lated in Com­mod­ity Bub­bles? Yeah, Prob­a­bly, that the price could be $40 per bar­rel by year end. (We weren’t very spe­cific about which kind of oil and when it was to be deliv­ered, but such is life.)

We don’t keep track of all of our pre­dic­tions – only the ones where we turned out to be right. For those, we con­tinue our streak of being 100% cor­rect, and we’ll con­tinue to occa­sion­ally high­light them in posts.

On Octo­ber 31, in Scary Thoughts on the Lack of Size and Humor, when oil was still a robust $65 per bar­rel, we revised our end-​of-​the-​year esti­mate of $40 down to $25. With the cur­rent price of January-​delivery oil con­tracts at $37 and with those con­tracts clos­ing on Fri­day, we may have to for­get mak­ing that pre­dic­tion, but who knows? Cra­zier things have hap­pened and can happen.

In that Hal­loween post, we also joked that through Con­gres­sional and exec­u­tive efforts, Con­gress­man and women were able to meet their cam­paign promises of lower energy costs. Through con­certed, bi-​partisan effort and quite a bit of sense­less panic (TARP, TARP), they were able to do it even before the election.

We must ask: has any gov­ern­ment in the his­tory of the world ever presided over a larger and faster destruc­tion of wealth? Note that there was not a sin­gle exoge­nous event that caused the mas­sive destruc­tion: no vol­cano, no tsunami, no earth­quake, no inva­sion of body-​snatchers, no forty days of rain and floods; no plague, no war, no comet or meteor col­li­sions, no pesti­lence, no drought: only inep­ti­tude and greed.

Yes, we do have cheaper oil and gas, but accom­pa­ny­ing those declines is the destruc­tion of tril­lions of dol­lars of equity and real estate val­ues. In ret­ro­spect, some of that “value” was clearly fic­tional and over-​stated, but it seems that the losses have gone deeper than to just wipe-​away the market’s froth.¹ In that regard, we can now fill the Suburban’s 44-​gallon tank for about $75, but we’d pre­fer to have the stock mar­ket at Decem­ber, 2007 lev­els or even the lower sum­mer of 2008 levels.

We doubt that all of the neg­a­tive effects of our endogenously-​caused prob­lems have been real­ized. In addi­tion, we note that the (finan­cial) impli­ca­tions of a global or national cat­a­stro­phe is truly hor­ri­fy­ing to con­tem­plate. But we ask: does the reader think that the remain­ing finan­cial firms are devel­op­ing such sce­nario analy­ses and con­tin­gency plans or do you think that as Christ­mas approaches their man­age­ments – and risk man­age­ments, in par­tic­u­lar – have breathed col­lec­tive sighs of relief and gone back to business-​as-​usual (with a myopic focus on day-​to-​day mar­ket movements)?

Despite our pes­simism, we do believe that this is the best time ever to be alive and the best coun­try – the USA – in which to live.² Thus, we do wish the reader a happy, prosperous, healthy, and blessed New Year.

---

Foot­notes:

We very much like the ancient Greek story of Cas­san­dra, and one could well imag­ine that for almost ten years, Harry Markopo­los felt like a modern-​day Cassandra.

We don’t know enough about Mr. Markopolos to know whether he wrote let­ters to the SEC about hun­dreds of other fund man­agers claim­ing that they also ran Ponzi schemes or were part of the con­spir­acy to assas­si­nate Pres­i­dent Kennedy, were adducted by UFOs, or pro­vided FDR with advanced knowl­edge of the bomb­ing of Pearl Har­bor or some com­bi­na­tion of the four. If so, then it is quite pos­si­ble that Mr. Markopo­los is a lucky crank, but we doubt it.

Instead, it seems that Mr. Markopo­los is quite knowl­edge­able and was quite spe­cific in his crit­i­cism of Bernard Mad­off. Moreover, it seems that he was quite will­ing to stake his rep­u­ta­tion and devote his time, energy, and con­sid­er­a­tion to doing the right thing – only to be ignored by an indif­fer­ent bureau­cracy. Now that is a sur­prise, isn’t it.¹

We sym­pa­thize with Mr. Markopo­los. Since late September, we’ve writ­ten to a num­ber of folks in the press and gov­ern­ment about our pro­posed solu­tion to the mort­gage cri­sis only to receive no seri­ous feed­back. We did received one demean­ing form e-​mail mes­sage from our Con­gress­man Jason Alt­mire.²

As The Wall Street Jour­nal reports in Chas­ing Bernard Mad­off, which appears on-​line as Mad­off Mis­led SEC in ’06, Got Off, it seems that Mr. Mad­off may have avoided some scrutiny due to fam­ily and polit­i­cal connections. 

Whether any­one acted overtly to stymie a seri­ous inves­ti­ga­tion into Mr. Madoff’s prac­tices in unclear. The much more com­mon and insid­i­ous prac­tice would be to dis­miss the alle­ga­tions with a know­ing chuckle and pos­si­bly a wink and per­haps a few rhetor­i­cal questions: “Bernard Mad­off? The for­mer chair­man of NASDAQ? Yeah, right.” Or pos­si­bly: “No, we inves­ti­gated that com­plaint. We didn’t find any­thing. I don’t know what that guy’s prob­lem is. What his name Markopolo­po­gos or what? He doesn’t think we take our jobs seri­ously. Who is he to crit­i­cize us? That …off. He should get a life.”

We sus­pect the bureaucracy’s iner­tia was moti­vated in ways sim­i­lar to those that we wrote about last month in Good Luck with that: Get­ting Bank Exam­in­ers to Act. We’d guess that if any SEC employ­ees had an inkling of the truth, they – like Mr. Mad­off – hoped that the prob­lem could be solved with a nice bull mar­ket. (One of the most damn­ing pieces of evi­dence against the SEC deals with the facts that to imple­ment Mr. Madoff’s stated strat­egy, the sizes of cer­tain equity options mar­kets – stated in terms of the num­ber of open posi­tions – would have to be about five times larger than they were/​are.)

Given that col­lec­tive behav­ior, we think that Ronald A. Cass states it best in his WSJ opin­ion col­umn, Mad­off Exploited the Jews: “The vio­la­tion of trust at the heart of that story … It illus­trates the lim­its of law, not the need for more of it.”

Three days ago in a post, Past Per­for­mance Is Not a Guar­an­tee…, we ref­er­enced the strug­gling invest­ment man­ager William H. Miller and wrote:

“We want to under­stand what causes or moti­vates peo­ple to lose their skepticism…and accept some­one as, say, a can’t-lose “genius” investor…rather than view him as a large risk (with, hope­fully, a cor­re­spond­ing large expected return). What hope or psy­cho­log­i­cal need per­mits such credulity?”

There are no alle­ga­tions of wrong-​doing on Mr. Miller’s part. It seems sim­ply that his luck ran out. The unfor­tu­nate aspect of his case as in many oth­ers was/​is the incor­rect attri­bu­tion of suc­cess to his abil­ity rather than his luck or a com­bi­na­tion of the two. (We all fall for that fal­lacy to var­i­ous degrees, espe­cially when it involves our own ability.)

It seems quite easy for folks – who lack the nec­es­sary degree of skep­ti­cal imag­i­na­tion – to err when mak­ing such infer­ences, espe­cially when gains are rel­a­tively steady and losses are rel­a­tively rare but large.

The arrest of Bernard Mad­off a day after that post and the sub­se­quent news reports as investors come for­ward admit­ting to extremely large losses makes us revisit the ques­tion. (Esti­mates of losses range near $50,000,000,000, and pros­e­cu­tors allege that Mr. Mad­off com­mit­ted fraud.)

His case is inter­est­ing because it seems that the reported returns in his invest­ment funds were incred­i­bly steady and sub­stan­tial and there were few, if any, losses until recently. That sequence is what made a few folks sus­pi­cious – some of those folks for quite some time – but, as it turns out, far too few.

Jason Zweig has a nice col­umn in the week­end edi­tion of The Wall Street Jour­nal, enti­tled How Bernie Mad­off Made Smart Folks Look Dumb, which to some degree addresses our ini­tial ques­tion per Mr. Miller.

Not being in their acquain­tance, we’re not sure of the intel­li­gence of the “Smart Folks” mentioned in the article’s title, but we are highly skep­ti­cal of their level of sophis­ti­ca­tion. In fact, when refer­ring to oth­ers, we usu­ally use that term pejo­ra­tively as it seems to related to either some notion of taste (for some­thing “exotic”) or some­thing overly-​complex and detailed (for no reason).

Besides their own greed, which is a nec­es­sary factor, it seems that cre­at­ing an aura (or mirage) of exclu­siv­ity is often a key fac­tor in trick­ing gullible investors.

In Mr. Zweig’s arti­cle, he para­phrases Robert Cial­dini by writ­ing “Mr. Mad­off shifted investors’ fears from the risk that they might lose money to the risk they might lose out on mak­ing money. If you did get invited in, then you were anointed a mem­ber of this par­tic­u­lar club of ‘sophis­ti­cated investors.’” So per­fectly sim­ple. That tech­nique preys on the investors envy and pride, but espe­cially the seem­ingly mas­sive need for accep­tance and affiliation.

It’s not just indi­vid­ual investors who fall for such tactics. As the many reports about Mr. Madoff’s arrest note, many insti­tu­tions invested heav­ily with Mr. Mad­off, too.

We lost count of the times in our career when we heard, “XYZ is doing it, so we should, too.” XYZ was usu­ally a big­ger, “more sophis­ti­cated” firm look­ing for oth­ers to bear its risk. Unfor­tu­nately, many of those XYZs have dis­ap­peared – usu­ally for self-​inflicted rea­sons often because they mis­cal­cu­lated the amount of risk that they had retained.

In the insti­tu­tional set­tings, some­times, the argu­ment was extended to: “if we don’t do this now, we won’t have the oppor­tu­nity to par­tic­i­pate in future deals.” (Many of those were equally as dubi­ous, too.) The jus­ti­fi­ca­tion was rarely eco­nomic but often relied on want­ing to be part of the in-​crowd.

When faced with those sit­u­a­tion, we thought shouldn’t the question(s) be: “Why the sud­den gen­eros­ity? Doesn’t the fact that they’re includ­ing us indi­cate some level of des­per­a­tion on their part?” Of course, we weren’t sophis­ti­cated enough to under­stand the attrac­tion – merely skep­ti­cal and cyn­i­cal. (By the way, this is the same mech­a­nism by which traders and invest­ment man­agers often co-​opt gullible (and needy) risk managers.

We often say – usu­ally to our­selves – never under­es­ti­mate the need for affiliation. 

Look no fur­ther than the stu­pid­ity of haz­ing rit­u­als or the preva­lence of school and team-​related para­pher­na­lia and apparel in our soci­ety. In that regard, one of the princesses likes to count the num­ber of Steeler jer­seys at Sun­day Mass. Our casual empiri­cism sug­gests that it is highly cor­re­lated with the team’s sea­sonal per­for­mance to date, which isn’t that dif­fer­ent than invest­ment per­for­mance; they’re both quite ephemeral.

A friend who has spent his career in cor­po­rate human resources has sug­gested that the need for affil­i­a­tion can over­whelm com­pen­sa­tion con­sid­er­a­tions for many aspir­ing indi­vid­u­als within firms. He wasn’t talk­ing about appren­tice­ships or junior employ­ees at, say, audit­ing firms who need work expe­ri­ence for licens­ing rea­sons. He was dis­cussing quite senior hires.

Our advice is sim­ple: in any situation, force your­self to put some weight – some prob­a­bil­ity – on the hypoth­e­sis that you’re being played, regard­less of your level of intel­li­gence and sophis­ti­ca­tion. Place some weight on the fact that oth­ers may have the audac­ity to try to cheat you.

Hey, every­body likes a win­ner and wants the approval of oth­ers, espe­cially their peers or bet­ters, right? We only give this advice so that you’ll like us. Right? Are you with us? Really? Seriously? Good, good. We feel much bet­ter now.

P.S. After hear­ing one woman on FoxNews this morn­ing we wouldn’t be sur­prised if many of Mr. Madoff’s for­mer investors argue that his anti-​social behav­ior did not begin until after they invested with him because, you know, they would have known if some­thing wasn’t quite right.

Implied Under the Assump­tion of Risk Neutrality

We have sev­eral posts related to the cal­cu­la­tion of price-​implied default rates under the assump­tion of risk neu­tral­ity and sev­eral posts related to sim­ple CDS calculations.

Those posts have involved dis­crete, single-​period prob­lems, where there are only two dates of inter­est: today and a future date where an uncer­tain claim or cash flow will be real­ized, i.e., when bank­ruptcy would occur.

We’ve focused on binary mod­els and will con­tinue to do so here. In fact, to ana­lyze a two-​period prob­lem, we’ll just build upon our lat­est post from Decem­ber 2: Price Implied Default Rates.

We think that need­less detail obfus­cates the cen­tral points while pro­vid­ing no mar­ginal explana­tory power: either in a sta­tis­ti­cal or ped­a­gog­i­cal sense. So, we like to keep things simple.

Note that we’re pro­vid­ing exam­ples of sim­ple, reduced-​form mod­els à la Jar­row and Turn­bull (1995) or Hull and White (2000), not a struc­tural Mer­ton model like KMV. We’ll do that when we have the time.

In our Decem­ber 2^nd post, we con­sid­ered a risky, one-​year, zero-​coupon bond. We assumed a face value of $1,000, a risk-​free rate of 5%, and the risky bond’s yield to be 8%. We could have stated that last assump­tion as the bond has a price of $925.93.

From those assump­tions, and the addi­tional assump­tion that the owner of the bond would recover 60% of the face value, we cal­cu­lated the risk-​neutral-​model-​implied default rate of 6.94%.

Now the cal­cu­la­tion of that default rate depends upon all of the assump­tions, and obvi­ously the answer will vary with changes in any of the assumed vari­ables: the bond’s price or yield, the risk-​free rate, and the loss given default rate.

Obvi­ously, it also depends upon the applic­a­bil­ity of risk-​neutral val­u­a­tion, which allows us to impose two very impor­tant con­sid­er­a­tions (ver­sus real­ity). It allows us to (1) treat the bond’s price as the expected value of its cash flows, which is only valid if the cred­i­tor (in the model, not in real life) is risk-​neutral, and (2) use the risk-​free rate as the proper dis­count rate for a risk-​neutral per­son. Those assump­tions allow us to work with expected cash flows, rather than curvy pref­er­ences. We’ll focus on cal­cu­la­tions in this post and not on applicability.

Finally, the answer also depends upon our choice of prob­a­bil­ity func­tions. Here, the only uncer­tainty involves full pay­ment or not; so, that credit risk is eas­ily mod­eled as a binary func­tion, but it is impor­tant to note that risk-​neutrality does not imply a par­tic­u­lar prob­a­bil­ity func­tion. Once the ana­lyst has cho­sen from a fam­ily of dis­tri­b­u­tion func­tions, the assump­tion of risk neu­tral­ity will deter­mine (imply) par­tic­u­lar para­me­ter val­ues, but that is all. For the more math­e­mat­i­cally inclined, that is the change-​of-​measure that is referred to in the texts. (Prob­a­bil­i­ties are weights. Dif­fer­ent para­me­ter val­ues within a dis­tri­b­u­tion cause pos­si­ble events to be weighed dif­fer­ently; ergo, the mea­sure is changed.)

In this prob­lem, we’ll keep the same assump­tions as in our pre­vi­ous post for the first of our two peri­ods. So, here is the set­ting: We have two zero-​coupon, risky bonds issued by the same firm and each with a face value of $1,000: one matures in one-​year and the other matures in two years. Imag­ine that there are two risk-​free bonds, too.

The one-​year risky bond is described as above; so, it will have a price of $925.93. If that bond were risk-​free, it would have a price of $952.93. In a risk-​neutral model, the dif­fer­ence in prices is the present value of the expected loss (of the risky bond, of course).

The risk-​free rate in the sec­ond period is 7%. Note that there is no mar­ket risk – that is, no inter­est rate risk – so there is no evo­lu­tion of inter­est rates or any type of rate process in our hum­ble, lit­tle exam­ple. (We’re just mak­ing up num­bers to illus­trate a few basic ideas.)

The bond that matures in two years has a yield-​to-​maturity of 9.982%, which for all intents and pur­poses – and for every­one except the truly anal – is 10%.¹

As an aside, with our two sets of inter­est rates, we can cal­cu­late an over­all yield-​to-​maturity from our term struc­ture of for­ward, risk-​free rates, and for risky rates, we can deter­mine the struc­ture of for­ward rates from our risky yield curve.

Risk-​free yield-​to-​maturity: we don’t really need to cal­cu­late this, so you can skip it is you want, but if the risk-​free bonds are priced to earn 5% in the first year, and a two-​year bond is priced to earn 7% in the sec­ond year, then the geo­met­ric aver­age return for the zero-​coupon, risk-​free bond bet­ter be close to the arith­metic mean of 6%. That yield-​to-​maturity is simply:

[(1 + r₁)·(1 + r₂)]^1⁄₂ — 1 = [1.05·1.07]^1⁄₂ — 1 = 5.995%

So, the yield on a two-​year, zero-​coupon, risk­less bond is about 6%: just like we knew before we did the calculation.

Risky for­ward rate: now, given the risky yield-​to-​maturity is about 10% on the two-​year, zero coupon, bond, and given a first-​year risky rate of 8%, then the implied for­ward rate for the sec­ond period must be:

[(1 + 0.08)·(1 + r₂)]^1⁄₂ — 1 ≈ 10% implies r₂ = 1.1² /1.08 - 1 = 12%

So, if (and only if) the two-​year, risky bond yields (about) 10%, then its price is:

$1,000 ÷ 1.1² = $826.45 ≈ $826.72.

By the way, we’re off by 26¢ by using the easy 10% instead of the more pre­cise 9.982%, but the les­son is free; so, the reader really shouldn’t complain.

Notice that credit spread increased from 3% (8% — 5%) in the first year to 5% (12% — 7%) in the sec­ond. All things equal, we should expect that the risk-​neutral, price-​implied, default rate will increase, too. Let’s see if that happens.

Three Prob­a­bil­i­ties of Default (or default rates): when we move to a multi-​period prob­lem, we have to be care­ful to spec­ify the default rate to which we’re refer­ring. There are con­di­tional, mar­ginal, and cumu­la­tive prob­a­bil­i­ties of default, and that is true whether we’re dis­cussing actual (but unknown) prob­a­bil­i­ties of default or risk-​neutral-​implied prob­a­bil­i­ties of default like we’re doing here.

The con­di­tional prob­a­bil­ity of default for a period, t, is the eas­i­est notion to under­stand: given that the firm has sur­vived until the begin­ning of that period, it is the prob­a­bil­ity that the firm can’t pay its bills dur­ing the next inter­val of time; here, we’re using one year as the time inter­val. We’ll denote con­di­tional prob­a­bil­i­ties as p_t for every period t.

The mar­ginal prob­a­bil­ity of default is the prob­a­bil­ity that the firm will default in period t. Now, the firm only has the oppor­tu­nity to default in period t, if it hasn’t already defaulted; so, the mar­ginal prob­a­bil­ity con­sid­ers the prob­a­bil­ity of sur­viv­ing until that point and the con­di­tional prob­a­bil­ity of default. If p₁ is the (mar­ginal) prob­a­bil­ity of default in the first period, the (1 — p₁), then the mar­ginal prob­a­bil­ity of default is:

(1 — p₁)·p₂,

For our lit­tle prob­lem, we won’t intro­duce any spe­cial nota­tion for the mar­ginal prob­a­bil­i­ties of default.

Finally, the cumu­la­tive prob­a­bil­ity of default is the sum of all the mar­gin­als: p₁ + (1 — p₁)·p₂ in a two-​period prob­lem. We wrote about longer term cumu­la­tive prob­a­bil­i­ties of events in this post, Good Col­umn, Bad Math, where we talk about 100-​year floods.

So, let’s find the con­di­tional prob­a­bil­ity of default in the sec­ond period. Given that there was no default at the end of the first period, what is the prob­a­bil­ity of default in the sec­ond period implied by the bond’s price?

Well, with one period remain­ing, the price of the only remain­ing bond is:

$1,000 ÷ 1.12 = $892.86.

So, we can find the con­di­tional prob­a­bil­ity of default in the second-​period, p₂, the same way that we found the prob­a­bil­ity in our one-​period prob­lem.²

price = $892.86= (1 — p₂) × ($1,000 ÷ (1 + 0.07)) + p₂ × (600 ÷ (1 + 0.07))

$892.86= (1 — p₂) × $934.58 + p₂ × 560.75.

So, if the firm sur­vives the first period, there is an 11.16% con­di­tional prob­a­bil­ity of default in the sec­ond period. That means that the mar­ginal prob­a­bil­ity of default for the sec­ond period is the prob­a­bil­ity that the firm sur­vives the first period mul­ti­plied by the con­di­tional prob­a­bil­ity of default in the second:

(1 — p₁) ·p₂ = (1 — 0.0694) · 0.1116 = 10.385%

The cumu­la­tive prob­a­bil­ity of default is the sum of the two mar­gin­als: 6.94% + 10.39 = 17.33%.

Note that at the end of the first period the dif­fer­ence between the risk-​free bond’s price of $934.58 and the risky bond’s price of $892.86 is $41.72. The $41.72 rep­re­sents the risk-​neutral, “present value” at the start of the sec­ond period of the con­di­tional expected loss in the sec­ond period of the two-​period bond. So, the $41.72 is related to the con­di­tional prob­a­bil­ity of loss and the poten­tial loss of $400:

($400 × 11.16%) ÷ 1.07.

But the sec­ond period will be expe­ri­enced only if there was no default in the first period! So, in a risk-​neutral world, a cred­i­tor will only expe­ri­ence the oppor­tu­nity to lose (a dis­counted aver­age) of $41.72 if there is no default in the first period: with prob­a­bil­ity (1 — 6.944%).

And the value of that today – at the start of it all – must be dis­counted by the first period’s risk-​free rate of 5%. So, the present value of that expected loss that

$41.72 × (1 — 0.06944) ÷ 1.05 = $36.97.

Is our analy­sis cor­rect? Let’s see. A two-​year, risk-​free, zero-​coupon bond would have a price of $890.08. Our risky bond has a price of $826.45. That means that in a risk-​neutral world – given all of our assump­tions – the present value of the sum of the expected losses is the dif­fer­ence: $890.08 — $826.45 = $63.63.

In the first year, the present value of the expected loss on debt with a face value of $1,000 is $26.67. That means that the present value of the expected loss in the sec­ond period must be: $63.63 — $26.67 ≈ $36.97. Hey, where did we see that num­ber before? That’s right — a few inches above where we dis­counted the expected present value of the second-​period loss.

What about CDS?

To pro­tect against loss, the CDS should pro­vide $400 in case of default at the end of each period.

If the CDS pol­icy were sold period-​by-​period, i.e., one-​year terms, the first year’s pre­mium would have to be at least $26.67 and the sec­ond year’s if sold today would cost at least $36.97. The actual cost, like every­thing else in the real world, would depend upon how badly cred­i­tors want to pro­tect against loss, but those val­ues are actu­ar­i­ally fair in a risk-​neutral setting.

Also note that if the CDS pol­icy were sold at the start of the sec­ond period, the pre­mium would have be to at least $41.72 to be actu­ar­i­ally fair in a risk-​neutral world. So, if pur­chased con­sec­u­tively, the insur­ance pre­mi­ums would need to $26.67 today and $41.72 next year in our risk-​neutral world.

What if the insur­ance were pur­chased for two peri­ods? What would the con­stant pre­mium be? In that case, there is a chance that one or both pre­mi­ums will be received (or paid). If there is no bank­ruptcy in the first period, then the pre­mium will be paid twice; so, we need:

pre­mium + (1 — 0.06944) pre­mium ÷ 1.05 = $63.63

pre­mium (1.0 +0.93056 ÷ 1.05) = $63.63

pre­mium = $33.74

We assumed that the pre­mium was paid at the begin­ning of each period; so, it is like an “annu­ity due” and actu­ally is like a ran­dom, annu­ity due. It’s ran­dom because it is a con­stant stream of cash flows, but the end­ing date is unknown. In this sim­ple two-​period exam­ple, the “stream” could be one or two payments.

Also remem­ber that risk-​averse cred­i­tors should be will­ing to pay more than that, i.e., a risk pre­mium, too.

And remem­ber, we’ve said absolutely noth­ing about prob­a­bil­i­ties in the real world that our exam­ple rep­re­sents. Risk neu­tral prob­a­bil­i­ties and default rates are derived from a set of assump­tions that per­mits (rel­a­tively) easy cal­cu­la­tion, but those prob­a­bil­i­ties and rates only work in our model, and they do not rep­re­sent real fre­quen­cies. For more on that, please see our other posts on the topic.

As we hope that you can see, CDS is iden­ti­cal to term life insur­ance – except mil­lions and mil­lions of sim­i­lar firms don’t die each year; so, there is lit­tle empir­i­cal evi­dence of var­i­ous fac­tors, includ­ing loss given default rates.

By the way, we’ve ignored counter-​party risk and a host of other com­pli­cat­ing assumptions.

As with many of our longer posts, we’ll likely edit this one in the near future.

Copy­right © 2008 Spero Consulting.

---

Foot­notes:

…(Nor even an Indi­ca­tion) of Future Performance.

Here’s an excel­lent exam­ple: The Stock Picker’s Defeat. The arti­cle is from today’s edi­tion of The Wall Street Jour­nal, and describes William H. Miller’s initial, long-term suc­cess and his sub­se­quent (and recent) extreme lack of suc­cess while invest­ing at Legg Mason.

It seems that for a long time, Mr. Miller had a rep­u­ta­tion as a savvy investor. It seems that time might be past. Our guess is that his com­pe­tency – high or low – hasn’t changed through the years, but it seems that his luck has changed for the worst, and unfor­tu­nately, luck often over­whelms competency.

We hope to some day under­stand how rep­u­ta­tions are made – how peo­ple get to be finan­cial geniuses – at least for a lit­tle while – or pop­u­lar “mod­ern” artists (although we doubt that we’ll ever under­stand that).

We don’t mean that we want to under­stand eco­nomic mod­els of rep­u­ta­tion. We under­stand those now, and we’ve not found them to be very help­ful for our purposes.

We want to under­stand what causes or moti­vates peo­ple to lose their skep­ti­cism – if they had any to start with – and accept some­one as, say, a can’t-lose “genius” investor or what­ever rather than view him as a large risk (with, hope­fully, a cor­re­spond­ing large expected return). What hope or psy­cho­log­i­cal need per­mits such credulity?

Given the obvi­ous roles of luck and good for­tune – how for­tu­nate we are to live now, to be born here, to have food, shelter, lib­erty, a blog, family, health, and on and on – in life and many endeav­ors, what causes folks to for­get that luck and for­tune and see cer­tainty where none exists or where cer­tainty may have existed but can eas­ily dis­ap­pear like a puff of smoke – just like the value of Mr. Miller’s invest­ment funds?

For some rea­son – maybe not a good rea­son – it reminds us of the apoc­ryphal Chester­ton quote, “When a man stops believ­ing in God he doesn’t then believe in noth­ing, he believes any­thing.” Maybe that includes magic invest­ing skills, but we sus­pect that many of the devout are equally gullible.

Who says that mod­ern man is no longer super­sti­tious, espe­cially where the mar­kets are concerned?

The Wall Street Jour­nal has an arti­cle today enti­tled, Mack and Thain Lose ’08 Bonuses.

We’re nei­ther sym­pa­thetic nor antag­o­nis­tic towards Mr. Thain, who has only been in his posi­tion for a year; so, we take no glee in his being shut-​out. Hope­fully, he’ll be able to make-​do with his $750,000 salary, $15-$20 mil­lion sign­ing bonus from late 2007, and his other accu­mu­lated wealth from his past exec­u­tive positions.

What inter­ests us in the arti­cle is the men­tion that Mor­gan Stan­ley plans to imple­ment com­pen­sa­tion schemes that include “claw back” fea­tures. That means that in the future, the firm could recoup ear­lier bonuses if, say, a trader later blows up.

Please note that we are writ­ing in gen­er­al­i­ties and not attempt­ing to con­struct an opti­mal con­tract, but we do see claw-​back fea­tures as mov­ing in the right direc­tion for both firms and employ­ees. (We’ve writ­ten pos­i­tively about sim­i­lar fea­tures before.)

At first glance, such claw­backs may seem to impose more risk on employ­ees, but if they’re struc­tured and used prop­erly, they need not; thus, we’d expect them to be wealth-​maximizing for the firm and expected-​utility max­i­miz­ing for employ­ees. That’s if they are con­structed intel­li­gently.

We’d hope that Morgan’s scheme is so con­structed – to, say, claw back por­tions of a 2008 bonus because trades or invest­ments made in 2008 sub­se­quently go bad.

We hope that the firm does not attempt to claw back a por­tion of say, a 2008 bonus because the trader made a money-​losing trade in 2009. We under­stand the aver­ag­ing effects of long-​term con­tracts, but believe that such rep­ri­mands would likely be per­ceived as being arbi­trary and capri­cious and sub­jec­tive and would likely have two effects: (1) before-​hand, many traders would leave to join hedge funds or to trade for them­selves, and (2) those traders who did stay and win large bonus awards could be expected to become sub­stan­tially more risk-​averse in the future (because both the cur­rent period’s bonus and past bonuses were all still at stake). In gen­eral, it doesn’t seem that most trad­ing and invest­ing firms want to induce traders to min­i­mize risk; instead, it is to man­age risk intel­li­gently or effi­ciently. If the goal were, in fact, to min­i­mize risk, then pay­ing a bonus as a func­tion of prof­its would be a huge mis­take in the first place. There’s much cheaper ways to induce that behavior.

The Good: Besides claw backs, we’d rec­om­mend that firms con­tinue to pay bonuses on earn­ings even after traders have left the firm – solely to induce them to behave and act in the firm’s long-​term inter­ests while they are employed. It is very tempt­ing to want to pun­ish for­mer employ­ees for leav­ing or for a vari­ety of real or per­ceived trans­gres­sions, but it is not nec­es­sar­ily the wis­est pol­icy nor fidu­cia­r­ily responsible.

Unfor­tu­nately, it seems that UBS may have taken that course.

We’re very grate­ful that the WSJ arti­cle men­tions that UBS imple­mented claw­backs in mid-​November because we had pre­vi­ously missed that announce­ment in the press.

The Bad: In August, we com­mented on UBS’s plans to use phan­tom shares in its com­pen­sa­tion schemes in Incen­tives at UBS and in Gen­eral. That plan seemed to impose a sub­stan­tial – we mean exces­sive – amount of risk on its employ­ees. W would strongly encour­age inter­ested par­ties to read that post.

From our read­ing of a few arti­cles more recent arti­cles, espe­cially this Lon­don Times arti­cle, UBS’s plan seems down­right vin­dica­tive. While that may be jus­ti­fied in the cases of for­mer senior exec­u­tives and while it may be sat­is­fy­ing to stiff employ­ees in bad times, it’s gen­er­ally not wealth-maximizing; it seems quite sub-​optimal.

UBS calls a neg­a­tive bonus a “malus.” Get it? It sub­sti­tutes “mal” for “bon” to get the oppo­site. Very clever!

The Ugly: Accord­ing to a Tele­graph arti­cle, UBS will attempt to claw back pre­vi­ously awarded, but not dis­trib­uted bonuses, if the bank under-​performs, and it could recover up to two-​thirds of the cash por­tion, which would be held in escrow for at least a year. So imag­ine that you, Joe Trader, or more pre­cisely Josef Trader, had a par­tic­u­larly good year in 2009, but the firm had com­pletely hor­ri­ble year in 2010; so, not only do you not get a 2010 bonus, but your 2009 bonus is gone, gone, gone. How would you feel? What are the odds that it could occur? Is it worth tak­ing the chance (bear­ing the risk) of such per­sonal losses? If it’s not, you may want to seek employ­ment elsewhere.

The Times arti­cle men­tions that Share-​based bonuses won’t vest for three years and exec­u­tives will be required to retain 75% of those shares for sev­eral more years, and the “malus” sys­tem will apply to shares, too. As we wrote in August and repeated above, such plans impose sub­stan­tial risk on employ­ees. UBS should expect to pay higher com­pen­sa­tion on aver­age and expect an exo­dus of employ­ees. We’d guess that it would lose many of its best, most con­fi­dent employ­ees, and many of its most risk-​averse, and espe­cially the inter­sec­tion of the two. Would you, dear reader, tol­er­ate such a scheme?

By the way, for exit­ing employ­ees, all bonuses paid on depar­ture will be sub­ject to the “malus” sys­tem. What are the chances that will be manip­u­lated against the employee (as, say, a short-​term way to boost current-​period profits).

In that regard, we love this quote from the bank that appeared in the Tele­graph arti­cle: “This should pre­vent any pay­ments that prove to be inap­pro­pri­ate in the near future.” But, when did pre­vent­ing any, which we take to mean “all” inap­pro­pri­ate, pay­ments become the goal?

In eco­nomic mod­els, profit-​maximization in the short-​term or wealth-​maximization in the long-​term do not imply the all costs can be elim­i­nated. We, and every other econ­o­mist that we know, teach that there is an eco­nomic level of costs that max­i­mizes prof­its. Like­wise, in decen­tral­ized orga­ni­za­tions, all dys­func­tional behav­ior can­not be elim­i­nated with­out also elim­i­nat­ing the ben­e­fits of auton­omy; it is throw­ing the prover­bial baby out with the bath-​water or being penny-​wise and pound-​foolish. (See just about any­thing that we’ve writ­ten in our Illus­tra­tions and Fal­lac­ies sec­tions, espe­cially about extrem­ists in Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions.)

We what find to be espe­cially galling is the fact that intelligently-​applied claw­backs are a great idea for both firms and employ­ees, but unfor­tu­nately, if (as an early adopter) UBS botches its imple­men­ta­tion – which given the infor­ma­tion in the press seems highly likely – then other firms will likely be hes­i­tant to use them. That’s a shame.

If large firms want to elim­i­nate risk, then we encour­age to elim­i­nate pro­pri­etary trad­ing and oper­ate rel­a­tively low-​risk, low-​margin businesses. That’s what we’ve rec­om­mended for government-​insured firms in our aptly-​titled post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We’ll likely edit and add to this post in the near future.

Copy­right ©2008, Spero Con­sult­ing Incorporated.

Every­body knows that the short­est day is the first day of win­ter, which is usu­ally Decem­ber 21 in the North­ern Hemi­sphere. (Sorry read­ers from down-​under, but we’re rather geo­cen­tric that way.)

So, does the short­est day have the lat­est sun­rise and the ear­li­est sun­set? Is there a sym­me­try between dawn and dusk?

Per­haps you’ve never con­sid­ered it, but one can find sun­rise and sun­set times for many cities around the world at http://​www​.time​and​date​.com and prob­a­bly other sites, too.

When we have more time, we’ll write about how the earth’s axis, which obvi­ously affects the vari­a­tion in the length of days, is not con­stant. As we recall, the axis varies between 17 and 22 degrees over rather long cycles; so, the earth spins like a top – but not smoothly; instead it “wob­bles.” Does the reader think that the wob­bling might affect tem­per­a­tures and cause some regions to warm and oth­ers to cool as the angle changes through time? Yeah, we do, too.

By the way, did the reader know that sum­mer is a few days longer in the North­ern Hemi­sphere than in the South­ern Hemi­sphere? As it turns out, it is longer, but not as intense. 

While the earth’s orbit around the sun is an ellipse, the sun is not cen­tered in the ellipse. Sum­mer in the South­ern Hemi­sphere (win­ter up here) occurs when the earth is closer to the sun; there­fore, sum­mer down there is more intense but shorter. (We don’t have a short, non-​mathematical expla­na­tion for it. Per­haps that’s why our PhD is in the social sciences.)

Now, get­ting back to our orig­i­nal ques­tion, the lat­est sun­rise and ear­li­est sun­set do not occur on the short­est day of the year. 

The ear­li­est sun­sets in the North­ern Hemi­sphere occur right around this date, Decem­ber 8 (or 7^th or so). While the lat­est sun­rises don’t occur until about a week into the new year: around Jan­u­ary 5 or so. 

For those of us liv­ing at roughly the 40^th par­al­lel, the sun sets 3 – 4 min­utes ear­lier today than on the win­ter sol­stice, and near Jan­u­ary 5, is rises about 3 – 4 min­utes later in the morn­ing than on the solstice.

Some­thing sim­i­lar hap­pens in June, but it is not sym­met­ric with the win­ter. The ear­li­est sun­rise occurs around June 13, which is only about a week before the sum­mer sol­stice, whereas the lat­est sun­set occurs near the end of June, about a week later than it.

And you thought we were just a pretty face who thinks the gov­ern­ment bailout a bad idea.

We were search­ing our hard drive for a paper, and found a very inter­est­ing arti­cle that we had saved about the per­ils of exces­sive lever­age. It is As Funds Lever­age Up, Fears of Reck­on­ing Rise from the April 30, 2007, edi­tion of The Wall Street Jour­nal. It is sub­ti­tled: Fed and SEC Ques­tion Wall Street on Poli­cies; ‘A Mock­ery’ of Mar­gin.

We’re not sure if an arti­cle from the Spring of 2007 is truly an early warn­ing per our title, but “Warn­ings of Exces­sive Lever­age” doesn’t read as nicely.

In light of very recent events and mar­ket events since mid-​2007, it is quite inter­est­ing and dis­cusses or quotes many famil­iar names, includ­ing, John Paul­son (big win­ner); The Penn­syl­va­nia State Employ­ees’ Retire­ment Sys­tem (not a big win­ner); Tim­o­thy Gei­th­ner (next Trea­sury sec­re­tary); War­ren Buf­fett (not Jimmy Buf­fett); Ken­neth Grif­fin and Citadel Invest­ment Group (not big win­ners); Edward Lam­pert (not big win­ner, although we do like Lands End at Sears); and many more.

In the arti­cle, the reporters para­phrase Janet Tavakoli as follows: “the col­lat­eral pro­vided by hedge funds to secure swaps could be dif­fi­cult to trade… In a mar­ket down­turn, attempts to unwind such posi­tions could lead to a vicious cycle of sell­ing that would feed on itself…” Sounds reasonable.

We also par­tic­u­larly like this lit­tle box that doesn’t appear in the on-​line article:

RISK FACTOR

•  The Sit­u­a­tion: Reg­u­la­tors have grown wor­ried about ris­ing lever­age in the U.S. finan­cial sys­tem.
 
•  The Play­ers: Hedge funds and the Wall Street firms that pro­vide them with financ­ing are among the biggest con­trib­u­tors to the rise.
 
•  The Bot­tom Line: No one is sure what will hap­pen with this com­plex web of bor­row­ing and deriv­a­tives in the event of a seri­ous mar­ket downturn.

Wow, who would have thunk that there were peo­ple way back in 2007 warn­ing of such risks as well as the lax­ity of risk man­age­ment. Does this mean that the ongo­ing liq­uid­ity cri­sis need not have occurred? (By 2007, it was already too late to pre­vent the mort­gage cri­sis.) Does that mean the destruc­tion of tril­lions of dol­lars of wealth could have be pre­vented and avoided? So, this sug­gests that it wasn’t (and isn’t) a nat­ural dis­as­ter. Wow! And for what?