Congress is supposed to start its review of the SEC today, January 5.

In the spirit of inquiry, we’re wondering—only half jokingly—had Mr. Madoff admitted only to losing vast sums of money in September, would the government have provided bailout money to him?

Why not? At the point regulators had investigated his firm eight times over 16 years, and presumably found very little that was suspicious.  (Here’s our take on regulators as “wise” monkeys.)

Were the actions of board and senior managers at many of the other firms that sought and received bailouts any less egregious?  Possibly less (allegedly) criminal but less egregious?

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 karaoke, 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 cooperation, we sent this e-mail to Mr. Altmire in early December.  Despite being naive 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.

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.

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 2nd 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.

…(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 a, 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