Skin in the game

The most important factor in determining whether a residential mortgage will default is whether the home owner has skin in the game, according to the WSJ:

The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected...

51% of all foreclosed homes had prime loans, not subprime, and the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures.

This isn't exactly news, but it is further confirmation of a fact that has been clear since 2007 - alignment of interests is key in the credit markets.

Shotguns and blowups

From Mark Gilbert on Bloomberg:

If the aftermath of the credit crunch is a financial landscape featuring fewer banks, each even bigger than before because of government-engineered mergers and opportunistic takeovers of weaker brethren, then we should all be very afraid. That, though, is exactly where we are headed.

The whole article is spot on: I recommend it.

Reality and perception in equity markets

The hard part about making market calls is not coming to a view on fundamental value. While that's difficult, it is still easier than the other part of making a trading decision, which is estimating current and future sentiment. It's particularly tricky at the moment: fundamentals suggest to me that most developed equity markets are over-valued. But sentiment is positive, and there is a wall of money still sitting nervously on the sidelines. If even a small fraction of that comes to the market, we could go significantly higher. The greater fool trade is always risky, so I'm flat equity at the moment and likely to remain so at least until either fundamentals improve or sentiment (and prices) turn down. Just my two cents: I wouldn't pay any attention if I were you.

The Axiom of Choice and Other Fallacies

The full Axiom of Choice states that given any set of mutually disjoint nonempty sets, there exists at least one set that contains exactly one element in common with each of the nonempty sets. One easy (and not quite right) way of thinking of it is that given a set, you can always pick an element of it. Sound obvious, huh?

Well... not quite. The problem comes when the set becomes infinite. Then how you tell me what you have picked becomes an issue. If the set is only countably big, so that you can number the elements 1, 2, 3 and so on, it isn't an issue - you say `I pick element 14,784,...' or whatever. But if the set is bigger than that, for instance it has the same cardinality as the real line, then specifying what you have picked gets harder.

In particular, set theorists have proved adept at constructing very large sets indeed - the boundary of `stupidly big' starts somewhere around the totally ineffable cardinals. For these babies, specifying the choice that you have made requires so much information that some mathematicians reject the axiom of choice as not effective. Basically they think that if you can't say what you have chosen without ridiculous amounts of information, then you can't choose. It also turned out that full AOC was equivalent to other principles that people found troubling, such as the law of the excluded middle. Some mathematicians therefore rejected full AOC, accepting only the axiom of choice when applied to `reasonable small' sets. (Thus we get for instance realizable versions of AOC, where you can apply AOC to `nice' sets.)

So what, economics lovers? Well, it turns out if Chris Ayers is to be believed that lots of economics relies on AOC

All current solution concepts in game theory also require the theorems implied by AC. In particular, lexicographic utility, lexicographic probability, the real line being well-ordered, and the existence of a universal space are all equivalent to AC; therefore any argument to disprove their existence must be false. Any proofs using properties that fail under AC must be redone. The concept of Nash Equilibrium becomes either a tautology (in the absence of AC) or violates rationality (in the presence of AC); we provide an example demonstrating this.

My strong suspicion is that this is a storm in a teacup and that even if Ayers' result is true (which it may well not be - caveat lector), you can get by with a weaker `effective' version of AC by considering suitable realizable outcomes. You'd end up with a smaller collection of games, but this would probably include realizable versions of all of the interesting ones. Still, even if this is nonsense, the idea of setting up game theory in a more effective setting is interesting.

Update. A cursory search doesn't reveal any academic association for Mr. Ayers. And the proof of the first theorem is wrong. That's not a proof that Ayers is a charlatan, of course, but should make one more sensitive to the possibility.

Fixing monopolies

The monopolies and mergers commission has proved utterly ineffective in dealing with the large supermarkets. Tesco, in particular, plays far too large a part in the total UK shopping spend. They are a malign influence. So what can we do? With a bit of luck, we can get two birds with one stone, and cripple them by making them over pay for Northern Rock. If they can somehow me coerced into taking a few toxic bits of Lloyds too perhaps that will shut Neelie Kroes up too...

20%

No, not my standard broker's commission, but the average level of credit enhancement in CMBS before 2003. FT alphaville, commenting on the forthcoming tsunami of CMBS downgrades, reprints this enlightening table from S&P:This very clearly shows how investors let their standards slip in the hurt for yield during the Boom years. Not everyone was convinced though: from 2004 the practice of splitting the AAA into two or more tranches became commonplace. The top tranche, amusingly, is called super duper AAA.

S&P want at least 19% credit enhancement for AAA going forward. At least this is generating a nice repack business as banks take junior AAAs and resecuritise to keep most of the notional at AAA. The Americans call this a Re-Remic* -- which isn't nearly as cool sounding as super duper AAA.

* Real estate mortgage investment conduit, or CDO-squared to its friends.

Physics envy, History envy

Physics is in some ways the geekiest science. It's fundamental, it has hard maths in it, and it has had enormous success at explaining the phenomena it tries to study. What other subject can successfully predict something to twelve decimal places?

As a result, some practioners in other fields have physics envy. This is a notable problem for finance quants, many of whom didn't make it as academic physicists (or did make but didn't like the salaries). Indeed in retrospect one can make a case that one of the causes of the Credit Crunch was the collapse of the Soviet Union - the argument would go that the collapse freed up lots of highly trained mathematians and physicists, some of whom came to work for investment banks - no bulge bracket firm was without its Academy of Sciences prize winner; the geeks used used the maths that they knew, which was mostly stochastic calculus, to model things; these models were dangerous but not easy to falsify (because they were only really wrong in a crisis); so the industry used them and was subsequently screwed. In one way at least communism brought capitalism down with it.

Anyway, the desire to build highly mathematical models has in practice lead finance down a dangerous path. Perhaps the aspiration was good, but the implementation has been deeply flawed.

Let me instead propose a different aspiration. History envy. History is a lovely subject. There are lots of facts, but most historians ignore many of the relevant ones. They are interested in motivations, in causes, in the evolution of ideas. They want to understand the why as well as the what. A good history text is carefully argued and insightful. It provokes discussion, and casts fresh light on the present. It's not clearly wrong, given the evidence, but it can never be said to be right, either.

How much better would finance be if it took these desiderata? Abandon the spurious and misleading quest for quantification. Just try to make an interesting argument about why things happen.

Most expensive cities for residential property

Via Infectious Greed, an interesting list of the top 10 cities globally by average residential sale price:
Hong Kong is a special case, being an island where much of the undeveloped land is owned by the government, but the others do certainly look like short candidates. Chinese property derivatives anyone?

Restructuring and bankruptcy

The Economics of Contempt has a nice historical summary:

the first major restructuring that I can remember being significantly hindered by CDS was Marconi, and that was back in 2001-2002. Marconi was negotiating a restructuring with a bank syndicate, but for a long time certain syndicate participants (cough, UBS, cough cough) refused to agree to any restructuring that didn't constitute a "credit event" under the 1999 ISDA Credit Derivatives Definitions. The holdout banks had purchased CDS on Marconi to hedge their exposure, and if they were going to agree to a pretty drastic restructuring, they wanted to make sure they got the benefit of their hedges. After more than a year of restructuring negotiations, the banks agreed to a debt-for-equity swap that qualified as a credit event under most of the CDS contracts, but also pretty much wiped out shareholders.

Mirant Corp.'s 2003 bankruptcy was also largely a result of CDS. Several creditors had purchased CDS protection on Mirant, and one major creditor in particular, which rhymes with Pitigroup, was relatively open about the fact that it didn't agree to a restructuring because it needed a bankruptcy filing to trigger its CDS contracts referencing Mirant. The bank that rhymes with Pitigroup's refusal to agree to a restructuring (which came at the last minute and was a big surprise, if I remember correctly) effectively torpedoed any chance Mirant had of avoiding bankruptcy.

I'm not personally familiar with Mirant, but the Marconi example is certainly a good one. There is a definitely a good case that rights to sit at the creditors table should sit with the risk holder, not the bond holder.

Seriously antiquated

FED, OCC, OTS, FHFA, CFTC, SEC, FDIC, NAIC, ...

It seems that Obama and co. do not have the balls to sort out the alphabetic mess that is US supervision. Even the obvious targets - the OTS, who supervised AIG (yes, technically AIG was a Thrift), the SEC's regulatory capital regime, which did such a good job there are zero out of five large firms left on it - may be left to waddle on. Antiques may have an attractive patina, but sometimes you need something that is fit for the modern age. We won't get it, though. I am very tempted, like .the Epicuran Dealmaker, to give up on this crap

The types of instability

Money market funds were one of the more minor vectors of the crunch. Since they did not want to break the buck, and as they had rather limited loss absorption capability (thanks to the lack of anything akin to equity), they were sellers of the debt of any institution rumoured to be in trouble. In other words, they exacerbated funding liquidity risk but helping to turn a rumour into reality.

Belated the SEC has proposed revisions to the regulatory framework for funds: see here for a prospectus.

What these proposals will do is turn a nasty dynamic destabiliser into a static one. Since funds will be unable to invest in low quality instruments, they will not be able to fund lower quality firms at all. In effect the barrier to entry for the big boys club will get higher.

Timing

Is it a good time to start an old-fashioned bank?

Honour

Martin Wolf, quoting Mervyn King, writes in the FT:

'My word is my bond' are old words: 'My word is my CDO-squared' will never catch on.

He's right, but it is a shame. After all, we need a convenient shorthand for 'My word is badly structured and likely to lead you into trouble'.

The loneliness of the long distance regulator

Lord Turner, a decent, thoughtful regulator, told the Treasury select committee yesterday that

there should instead be a "tax on size" by requiring the big banks to set aside more capital when they expanded beyond a certain size.

Quite right too, and nice to see an idea I championed being mentioned in such august circles. The bad news is that

Turner also warned the MPs that the radical changes to regulations needed in the wake of the banking crisis may not take place because of the emergence of green shoots of recovery and "exhaustion".

Regulatory reform is a marathon not a sprint and I share Turner's doubts that we have the stamina to do a good job at it.

Post of the day

How can you not like something that begins 'Emerging Markets and derivatives are like alcohol and barbiturates: each on its own has attractions but create a recipe for choking on one's own vomit when combined'? It's about nefarious doings in the CDS market on the Kazakh bank BTA, and it is here.

Before the bust: AIG's early collateral postings

AIG's collateral postings after the rescue are well known - essentially the firm was saved so that it could continue to fulfil its obligations to the banking system, notably under the CDS it had written. AIG before the fall has received less attention. But now Bloomberg has done some digging, and the story of the collateral calls that brought AIG down is emerging.

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, ... “It was precisely that drain of liquidity to Goldman and SocGen that put AIG in a position of illiquidity and ultimately threw them into the government’s arms,” said Charles Calomiris, a finance professor.

Including collateral from before and after the rescue and payments made by Maiden Lane III, a vehicle created by the Fed to retire the swaps, Goldman Sachs received about $14 billion from AIG, Societe Generale got $16.5 billion, and Deutsche Bank AG received $8.5 billion.

Cash up front please

The Telegraph reports an idea of Paul Tucker's: making the banks pay to clean up their own mess:

The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated - and then collected from the industry via a levy.

This isn't a bad idea. But there is a better one. Make them pay before the crisis.

There are various ways to do this. One is to take cash from the banks, via a beefed up version of the way the FDIC works. In order to be a financial institution, you need an annually renewable license, and the license should be expensive.

A more intriguing one, though, is to make the banks hand over each year not cash, but one year call options on their stock. The regulator would then hedge these options. The bank's shareholders would only be diluted if the stock went up, sugaring the pill for them, while the hedging process would ensure the regulator made money whether the stock went up or down. Indeed, as the position is long gamma, a big fall would be particularly profitable to the hedging strategy.

Each way bet

One of the nice things about Foyle bookshop - despite its Waterstoneisation - is that the staff selections are still charmingly eclectic. Leonardo Sciascia's Equal Danger was one a few weeks ago. Sciascia is an oddity, a novelist who write political polemic disguised as detective stories, a stylist rather than a plotter.

Here's a nice little section. The speaker is talking about Pascal's wager. He generalises:

Today the possibility of making the wager has shifted from metaphysics to history... I would risk losing everything were I to bet against the revolution. But if I bet on it, I lose nothing if it doesn't take place. I win everything if it does.

I feel the same way about regulatory reform. If it isn't necessary and we do it properly, we lose very little. But if it is -- if failure to reform just bakes more systemic risk into the financial system - then failing to reform properly means that we lose a great deal. In this context the gutless Obama plan is worse than thin: it is a bet that may ruin us.

Chop the tail off a 911 or something...

Please accept my apologies for the scarcity of postings - I have been in Berlin. There will be more soon but meanwhile, here's a tip from the locals. Short Porsche. Porsche's short options position on VW expired on Friday, and it is thought that they escaped by the skin of their teeth, but the firm's debt burden is a serious problem.

A nice graphic on large bankruptcies

(Click for a larger version.)

5% is not much

The Obama administration is proposing that originators should retain a 5% stake in securitisations. This is not enough. 20% or 25% would achieve the desired alignment of interests. 5% gives 20:1 leverage. Yet another missed opportunity.

The Amherst Trade

This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a 'daring' CDS trade by Amherst Holdings. I didn't comment on it at first as I didn't understand the trade from the initial news items, but I now think it is possible to work out what's going on.

Let's start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let's say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let's suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst's trade work*.

Now, here's the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds - $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It's just that this time, that party wasn't an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection -- and in particular naked shorts -- should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst's long vs. the cash would have been obvious thanks to trade reporting. Personally I don't particularly feel the need to help the CDS trading desks of investment banks, mind you.

Wasted opportunities

As weeks have dragged into months, my frustration at the lack of real financial reform has hardened into anger edged with ennui. I don't expect much to happen now, and it irritates me. Ruth Sutherland sums up the situation quite well in the Guardian:

the Obama administration in the US, which still has plenty of wind in its sails, stepped back from radical moves to downsize pay packages on Wall Street, opting instead for modest improvements to corporate governance... The credit crunch led to a recognition of the need for a deep rethink of the Anglo-Saxon capitalist model. We are, however, in danger of missing the moment as the City takes advantage of political disarray to regroup. The belief of the resurgent financial sector, as another FT headline puts it, is that the market is confounding the left. Tentative suggestions that the recession is already over only strengthen the currents pulling us back towards business as usual.

Every 'House prices rise' or even 'House prices fall less fast' headline is ammunition for people like Angela Knight, who has suggested that even FSA's current modest proposals for improving banks' liquidity do not strike the right balance.

Instead of trumpeting any green shoots, however implausible, we need a wide discussion of the issues, and we need the willingness to be bold. Back to Ruth:

There should be a proper debate about a form of Glass-Steagall Act to separate "casino banks", which would have no recourse to the public purse if they run into trouble, from financial utilities, which would continue to be backed by taxpayers.

I personally don't think that this is possible, as all systemically important financial institutions have (whether we like it or not) an implicit recourse to the lender of last resort, but Ruth is right - we should talk about it.

There should be dynamic provisioning, so that banks are compelled to build capital cushions in the good times. Another idea is a levy on the sector to cover taxpayers against the risk they will have to bail out banks in the future.

But the point is less about the specific measures than about the need to change the culture.

That is absolutely on point. This crisis has already been a tragedy for many people - people who have lost homes and jobs. It would be really tragic if we learned absolutely nothing from it, if the net result was just to carry on, with exactly the same rules and the same mindset, to the next financial meltdown.

Update. As Barry Ritholtz points out, the gap between the US administration's rhetoric and its actions is huge. Here are the principles Larry Summers laid out for reregulating the markets:

1. The government must have the authority to take over and liquidate failing nonbanking financial institutions.
2. Regulators must be able to make certain that financial institutions have enough capital to weather crises.
3. Regulated entities must not be able to choose their regulators,
4. Regulators should not have to fight each other for jurisdiction.
5. The interests of consumers must trump the interests of regulated companies.

Good foundations, those. It's a shame the Obama administration have erected a makeshift shack on them. They are poodles when we need heros.

Sunday foreclosure datapoint

Courtesy of Realtytrac:

What we need now

Less regulation of financial institutions. More leverage. After all, look how well that worked the last time... No? No. So it is rather a surprise that there is even any discussion of Goldman Sachs moving back from being a commercial bank to being an investment bank. The Reuters story is here. The regulatory regime Goldman used to operate under before the change - in the days after the collapse of Lehman - was so flawed that the SEC ended it. Given that it is not possible to be a CSE any more, if Goldman wanted to shed its bank holding company status and the regulation that goes with it, what exactly would they do?

MAC make believe

From Ken Lewis' testimony to the House:

In mid December... I became aware of significant, accelerating losses at Merrill Lynch, and we contacted officials at the Treasury and Federal Reserve to inform them that we had concerns about closing the transaction. At that time, we considered declaring a 'material adverse change'... Treasury and Federal Reserve representatives asked us to delay any such action, and expressed significant concerns about the systemic consequences and risk to Bank of America of pursuing such a course.

No one would expect a CEO to tell less than the full truth in a setting like this. But this must surely add fuel to the fire of shareholder litigation burning under BofA.

Update. More (unhelpful to Ken) docs here.

Financial stability vs. cost of debt

Ten year government bonds are hitting highs in the UK and the US - strangely enough, 4% is the magic number in both countries.

Is this good? Clearly increasing yields make it more expensive to raise debt, and both governments have big deficits to service. So rising yields is a bad thing.

But... bank net interest income depends quite sensitively on the shape of the yield curve. If the curve is sharply upward pointing, as it is at the moment, then banks who borrow short and lend long make more money. Profitable banks rebuild capital fast. So rising ten year yields are actually good for financial stability at the moment.

The time for the curve steepeners may well be ending, though. This trade has given most of the juice it has, in my judgement. It might even be time to go short credit for the first time this year...

Stiglitz on Corporate welfarism

Joseph Stiglitz has a great piece on state capitalism. I'm sure the original is in a mainstream US publication, but the syndication I picked up via Naked Capitalism was in the Jakata Post. The whole thing is worth reading: here are some excerpts:

With all the talk of "green shoots" of economic recovery, America's banks are pushing back on efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent a recurrence of the crisis, this is one area where the devil really is in the details - and the banks will muster what muscle they have left to ensure that they have ample room to continue as they have in the past...

It has long been recognized that those America's banks that are too big to fail are also too big to be managed. That is one reason that the performance of several of them has been so dismal. When they fail, the government engineers a financial restructuring and provides deposit insurance, gaining a stake in their future. Officials know that if they wait too long, zombie or near zombie banks - with little or no net worth, but treated as if they were viable institutions - are likely to "gamble on resurrection." If they take big bets and win, they walk away with the proceeds, if they fail, the government picks up the tab.

The Obama administration has, however, introduced a new concept: "too big to be financially restructured"... Restructuring gives banks a chance for a new start: new potential investors (whether holders of equity or debt instruments) will have more confidence, other banks will be more willing to lend to them, and they will be more willing to lend to others. The bondholders will gain from an orderly restructuring, and if the value of the assets is truly greater than the market (and outside analysts) believe, they will eventually reap the gains.

The Obama administration has not restructured the banks. Instead, partly swayed by intense lobbying from the banks, they have rescued bondholders and even protected equity holders, at great cost to the taxpayer. As Stiglitz says

Most Americans view [this] as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending to payments of outsized bonuses and dividends. Tearing up the social contract is something that should not be done lightly.

But this new form of ersatz capitalism, in which losses are socialized and profits privatized, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity - and, with the Federal Reserve making funds available at near-zero interest rates, there are ample funds to do so.

Some have called this new economic regime "socialism with American characteristics." But socialism is concerned about ordinary individuals. By contrast, the United States has provided little help for the millions of Americans who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most lose their health insurance, too.

America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to automobiles, with no end in sight. In truth, this is not socialism, but an extension of long standing corporate welfarism. The rich and powerful turn to the government to help them whenever they can, while needy individuals get little social protection.

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don't break them up, then we have to severely limit what they do. They can't be allowed to do what they did in the past - gamble at others' expenses.

Stiglitz is angry about this, and you should be too.

Being bitchy

Sometimes, when you have written about a topic, you pick up something someone else has written and are just blown away by the author's understanding and insight. Let's just say that this did not happen to me with Gillian Tett's book on credit derivatives and the credit crunch.

The book is out

My book on the credit crunch is, according to my publisher at least, out today. Amazon.com link here, amazon.co.uk link here.


Update. In response to Phobos' comment, please be assured that the book is intended for the general reader - there are no equations, and a background in mathematical finance is definitely not assumed.

Information based finance

Without good data, it is rather hard to do good analysis. Therefore if accounting standards are sensible, they become invisible: investors use the data, and take it for granted. But if accounting standards are bad - if they allow reporting companies to conceal material facts - then the users of financial statements are put at a huge disadvantage. Credit rating and securities analysis becomes a lot more difficult. This is why the basic test for accounts is still 'are they true and fair?'

I think the major accounting standards setters, the FASB and the IASB, have a very difficult job to do. They are subject to intense, well resourced lobbying from the financial services industry. Moreover, being accountants, they are not experts in all of the products they have to write rules for.

The recent news here is deeply depressing. On Sunday, the observer reported that the IASB may lose the power to make accounting standards in Europe. This is pure politics: the banks have lent on the European commission, and the commission is leaning on the IASB. The IASB is trying to hold the line, but the pressure to allow banks to lie about the value of their balance sheets is considerable.

In the US, things are just as bad. Today FT alphaville picks up a story from the WSJ that the FASB is coming under huge pressure to relent on the reclassification of off balance sheet vehicles. This comes after the shameful capitulation of the FASB on fair value.

The problem here is that one side - the issuers of financial statements - is well organised and the other - the readers - isn't. It would be a great shame if the result of the asymmetry was a permanent degradation in the quality of financial information. But right now, 'true and fair' seems further away than ever.

Update. Floyd Norris has an excellent post on the flexibility that the current loosened US rules give in the NYT. The key point is that if a sale is 'distressed', it can be ignored for the purposes of fair value. One fund bought more of a security that they already owned, and were marking at $98.93, for $9.50. They then

contacted the selling broker-dealer to determine whether the sale was “distressed” (and thus could potentially be disregarded for purposes of determining the fair value of the security). On May 28, 2008, the broker-dealer responded that the security was “not coming from a distressed seller, just one that wanted to get out.” Notwithstanding this response, the Ultra Fund’s portfolio management team informed the Valuation Committee that they believed the sale was distressed

(Quote from SEC litigation against the fund.)

Now, admittedly this is illegal and I am not claiming that the large banks would go this far. But it does illustrate how valuations can be manipulated once you are allowed to ignore current transactions.

Wot no TALF?

I have been surprised at the slow takeup of the TALF. It looked to me like a license to print money. As Zero Hedge points out, less than $30B has been allocated to a program with a trillion dollar capacity.

Part of my surprise is that to be eligible for the TALF (at the moment at least - this will probably change) a security needs to be AAA rated. And S&P are on the downgrade war path. As Calculated Risk reports, quoting S&P, approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages [of CMBS}, respectively, may be downgraded. So you would have thought that people would have rushed to throw things into the TALF before they became ineligible.

Bloomberg suggests that the TALF, and its brother the PPIP, is stalling. They seem to have a point.

How big? The answer is 24 (or 42 backwards...)

(You really can ignore this if you have no interest in digital photography...)

I went to a lecture last night on digital camera sensors. As you probably know, each pixel in a digital camera is composed of at least one photosite (sometimes as many as 4, but ignore that for this discussion). Each photosite is basically a switchable photoelectric capacitor: light comes in, some of it is converted to electrons by the photoelectric effect, and the resulting electrons are stored.

Now, here's the kicker. Each photosite can only store tens of thousands of electrons. How many exactly depends on the size, but it's a number like 50,000.

This is really a problem. Why? Well, for two reasons. First the resolution of the camera depends on the signal to noise ratio of the photosite. Quantum effects (in particular shot noise) limit the resolution - and short of increasing the size of the photosite, there is absolutely nothing you can do about this. Second, to read the data out, you need to be able to move and then measure those 50,000 electrons accurately. And that isn't easy either.

Now there are various smart things you can do, including putting in on board noise reduction in the sensor and doing your A2D conversion as near to the photosite as possible. But at the end of the day, noise reduction just amounts to guessing what the signal should have been. The fundamental camera resolution is limited by the number of photosites you can cram on the chip, and the more you cram on, the smaller they get, the fewer electrons they can hold, and the worse your noise problems get.

What's the limit? Well, it turns out that for really high performance sensors, 35 square micrometers is about as small as you want a photosite to be, or roughly 6 micrometers on a side. 35mm is 24mm x 36mm, which translates to 4000x6000 or 24 megapixels. This is more or less exactly where the best full frame sensor DSLRs are already.

In other words, the resolution wars are over. New digital cameras will either cap out around 24 megapixels, have high noise and/or very aggressive and intrusive noise reduction, need bigger than full frame sensors, or use a wholly different light sensing technology from the one we have been using for the last 20 years. High noise is intolerable, bigger than full frame sensors are very expensive because they require huge pieces of silicon, and a new photosite technology does not appear to be around the corner.

Now, 24 Mp is enough for very nearly all applications, and most of the people who need more will move to medium format digital. But still it is sobering to think that a technology that we have been used to delivering seemingly effortless performance increases every two or three years is close to the quantum limit already.

OK, that's enough of that. Back to the economics.

Entrepreneurship

From Alain de Botton’s The Pleasures and Sorrows of Work, via the LRB blog.

These individuals were writing their stories in a subgenre of contemporary fiction, the business plan, and populating them with characters endowed with deeply implausible personalities, an oversight which would eventually be punished not by a scathing review by some bright young person from the London Review of Books but by a lack of custom and a prompt foreclosure.

I have no comment, really, I just like his turn of phrase.

Too many big ones

I'm away from the office at the moment so posting will be a little light, but I do want to pick up an interesting graph from Dick Bove at Rochdale Securities via the Big Picture. It shows the total number of US banks reporting (to the FED? to the OCC?). This is not a helpful trend if you don't want banks to become too big to fail...

CDO waterfall errors

CDOs are complicated. In particular, many of them have waterfall structures that include diversion tests - if x then tranche y gets some money, otherwise it goes to tranche z. Unsurprisingly, trustees sometimes get these tests wrong. Expected loss has found an example: I do encourage you to read it if you have an interest in either structured finance or operational risk.

Long or short Buiter - the origins of the Crunch

This is a rather long post on some aspects of the origins of the Crunch. It is definitely work in progress, so please bear with me, or skip on to something shorter and less drafty.

Let's begin with Long or Short Capital, one of my favourite places to go for financial sarcasm. Commenting on the recent falls in the US treasury market, they say:

Apparently, there is a finite limit to increasing the supply of something such that it will begin to become less dear. Some refer to this reversionary force as part of the unproven theory “supply and demand” wherein the basic concept is that if there is demand X for some thing and there is supply Y then there will be price Z. If Y is decreased, then a new equilibrium price will be attained that will be higher than Z. If Y is increased, then a new equilibrium price will be attained that is lower than Z...

Some people, and most politicians, insist that such forces and theories are not only unproven but are unlikely to exist. If they were to allow that “supply and demand” may exist, they would stress that it’s important that we do what we can to obviate our need for such burdensome natural laws. Is that not the mission statement of Government?

Now of course this is true in the large rather than the small. If you have a trillion of debt out there and you want to blow out another ten billion, it probably won't move the yield. But if you want to double your debt, then expect to pay more. The stickiness of price under changing supply make it easier to deny that eventually too much supply meeting too little demand will move prices.

Now to Willem Buiter, one of the most serious economists of his generation. In a recent blog post (reprinting parts of a longer paper) he discusses the causes of the crunch. I will quote selectively as the post is quite long. Buiter identifies five causes to the Crunch, of which the following are important for my purposes:

1. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels.

2. The extraordinary preference among the nouveaux-riches countries (BRICs and GCC countries) for building up huge foreign exchange reserves (overwhelmingly in US dollars) and for allocating their financial portfolios overwhelmingly towards the safest financial securities, especially US Treasury bonds. This increase in the demand for high-grade, safe financial assets was not met by a matching increase in the supply of safe financial assets. This further depressed long-term risk-free interest rates. Western banks and investors of all kinds who had target or hurdle rates of return that were no longer achievable by investing in conventional safe instruments, began to scout around for alternative, higher-yielding financial investment opportunities - the search for yield or for ‘pure alpha’, which, as everyone knows, is doomed to failure in the aggregate.

3. Following the entry of China, India, Vietnam and other labour-rich but capital-scarce countries into the global economy, the return to physical capital formation everywhere was lifted significantly. The share of profits rose almost everywhere.

4. Following the collapse of the tech bubble in late 2000 - early 2001, monetary policy in the US and, to a lesser extent also in the Euro Area, was too expansionary for too long starting around 2003, flooding the world with excess liquidity... this excess liquidity went primarily into credit growth and asset price booms and bubbles

Let's pick this apart a little. First we have a wall of money from newly cash rich countries. Combine this with the retirement savings of the baby boomers, and you have an awful lot of cash looking for a home. The mistaken policy of keeping short rates too low was amplified by this, as the new money bought bonds, leaving the back end of the yield curve low too. (Contrast this with the current environment where the short rate is zero but the back end is much higher.)

There were not enough safe homes for the cash, and the banks soaked up the excess demand by creating new AAA instruments - CDOs and ABS and such like. Investors who wanted a bit of yield but still the security of a AAA rating bought these in droves. This further loosened the credit channel as lending decisions became disintermediated from risk taking.

What is interesting about this account - which I buy as at least one of the major mechanisms which caused the crisis - is that it focusses on the excess supply of investable funds, something that even today central banks do not monitor. Even if they did, the only monetary tools available are the price and availability of short term money. What Buiter's account implies is that central banks also need to control the ease of distribution of longer term funds into credit, something that would require a much more dynamic view of bank regulation. If everyone wants to buy five year AAA-rated bonds, then the existing ones are going to get more expensive, AAA borrowers will be able to raise funds more cheaply, and banks will find a way to create more AAA bonds. A large drop in the cost of credit is bad for financial stability. Moreover you cannot necessarily fix the problem by raising the short rate: what the central bank needs to do is intervene in the credit market. Hmmm...

Arbitrary conviscation is a good thing

OK, maybe that is a little provocative. But here's the reasoning. Any effective special resolution regime for banks has to intervene early. That means sometimes seizing banks (particularly too big to fail banks) which are well capitalised and liquid because the supervisor thinks that it is better for the system to act now than to wait. They need to have the power to do that.

How would such a regime work? Broadly the regulator would monitor signs of stress: capital ratios, ease and cost of funding, stress tests, loan performance and so on. The range of indicators should be broad, and over time more can be developed. If one or more of these gauges suggest a looming problem, or just because the regulator thinks it wise, the bank would be seized. Either it would be sold to a stronger, well capitalised peer or a good bank/bad bank split would be made, with shareholders ending up with a stake in the bad bank. (I prefer the latter as the former tends make big banks bigger, something I think is a bad thing.)

The result of this kind of power is events like the takeover of WaMu. Some people claim that this was unfair and unwarranted. (See here for John Hempton's take on the FDIC's action here. I don't know enough of the details to know if John's account is fair, but he certainly makes some interesting points.) But even if a seizure is arbitrary, I still think that the supervisor needs to have the power to do this kind of thing, and that that power should be exercised if there is a reasonable suspicion - no more - that the bank is in trouble.

Why? Well because if banks thought that this really was likely, they would take more care to stay safe. Conviscation is an effective moral hazard prevention mechanism. Providing that shareholders know that their rights can be voided by the regulator more or less whenever they like, they will demand that banks are run in a demonstrably prudent fashion. What's not to like about arbitrary conviscation?

Is it a bird? Is it a plane?

A frequent correspondant pointed me in the direction of the recent IATA air passenger and freight statistics. They give a useful counterpoint to the Baltic Dry Index. Freight first:
You can probably guess what Passenger looks like, given BA's results:

My guess is that the freight index is a more useful guide to global trade than Baltic dry, simply because it reacts faster, and is not as badly distorted by the lag of fresh capacity coming on line.

Tucking in

Bank of England’s Deputy Governor Paul Tucker gave a speech yesterday which FT alphaville picked up. He is surprised by something that doesn't shock me in the least:

...it would be good if regulators, internationally, required all banks regularly to turn over a meaningful share of their ’stock liquidity’ in the market on a reasonably regular basis. That would also help to put banks in a position to reap the benefits of the Bank’s Discount Window Facility, through which, as I have described, sound banks can borrow gilts. Frankly, it has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or, if they did, how many did not have a regular presence in the gilt repo market or even had no capacity to repo at all. Turning up in the core secured-funding markets for the first time for years is an absolute give away of distress. All that has to change.

Gilts trade well under Libor. The gilt repo market is sleepy and sometimes not particularly efficient. Is the Deputy Governor really that surprised that that smaller banks choose not to dabble in a market that will likely lose them money, and which has been something of an insider's club? I know the Bank believes that gilts are the cornerstone of the market, but from the late 90s to 2007 it was the Libor market, not the Gilt market, that was by far the most important source of interbank funding for most players. The only way that the Bank is going to change that is by getting FSA to require banks to buy gilts - which is exactly what they are doing.

Too big to succeed

As I write this, Manchester United are on the verge of their champion's league final with Barcelona. I'm cheering for Barca, but I have to admit that Man U are a success. They are one of Europe's great teams, for now at least.

Let's compare them with RBS. If Man U screw up - say Ronaldo goes to Real Madrid, they overpay for Tevez who then breaks a leg, and Rooney gets even fatter and loses it - then Man U's bond holders will probably suffer. Another team - the far more worthy Liverpool for instance - will win the Championship. There will be gnashing of teeth. But the fall of this particular champion won't cause much more than a surge in beer sales as fans drown their sorrows. The problems at RBS, on the other hand, left the UK tax payer with a lot of risk, cost them a lot of money and severely restricted the supply of credit to the UK economy, with hideous economic consequences. We simply could not afford to let RBS fail.

In other words, then, some firms' size is a problem for the economy, and some aren't. (Man U's size and spending power might be a problem for football, but that is a different story.) If you have firms whose size and market position makes them effectively too big to fail, then you already have a problem. Superivising them isn't the issue: stopping them getting that big is.

John Kay takes up the next part of the story in the FT. If large, systemic providers are inevitable, or at least if we have them at the moment, we need to ensure that their functions survive their failure, whatever the cost to shareholders and the restriction on companies' freedom of action.

There should be a clear distinction in public policy between the requirement for essential activities to survive and the continued existence of particular companies engaged in their provision. There are many services we cannot do without – the electricity grid and the water supply, the transport system and the telecommunications network. These activities are every bit as necessary to our personal and business lives as the banking sector and at least as interconnected. Even a brief hiatus in their supply is intolerable.

But the need to keep the water flowing does not establish a need to keep the water company in business. We do not mind if one chain of high street shops closes its doors, because there are many other places to buy our clothes and groceries. Other industries are different. We cannot contemplate keeping aircraft circling over London while the liquidator of Heathrow Airport Ltd finds the way to his office.

In all industries where there is or might be a dominant position in the supply of essential public services, there needs to be a special resolution regime. The key requirement is that assets that are needed for the continued provision of these services can be quickly separated from the organisations engaged in their supply. The businesses involved must be required to operate in such a way that such a separation is possible.

This implies of course that there is a big difference between the big boys and the rest. The state promises to intervene in their affairs and seize their assets far sooner than it would for a less important player. If this threat is credible, not only would it be good for the economy, it also might encourage firms not to get too large. Lots of small, competitive firms are good.

Update. 2-0. Thank you Barca. The look on Ronaldo's face is priceless.

Let's get all of those worries about inflation in perspective

Hat tip the Guardian data blog.

Update. Krugman's take is here. The one line summary: does the big inflation scare make any sense? Basically, no.

The real expenses scandal

I get the sense that if I ever met George Monbiot, I'd dislike him. He often comes over as ignorant and opinionated. He's angry a lot of the time too. But none of this makes him wrong. And in yesterday's Guardian he was spectacularly right about PFI.

PFI allows consortiums of banks, construction and service companies to build and run our public infrastructure. Though the government maintains that this offers better value than using public money, in reality the numbers behind all PFI projects are rigged. While the government retains much of the risk, the investors keep the profits, which often run to many times the value of the schemes.

The public liability incurred so far by the private finance initiative is £215bn...

One of the consistent features of PFI is that the projects are reverse-engineered to meet the demands of corporate investors. This, for example, is how the £30m public scheme to refurbish Coventry's two hospitals became a £410m private scheme to knock them both down and rebuild one of them – containing fewer beds and fewer doctors and nurses. The old scheme was too cheap to attract private money.

We should all be incensed by this. Yes, MP's expenses are scandalous and symptomatic of a wider dishonesty. But if you want a case of public money being used for private gain, PFI is the biggest, most glaring example. How Gordon Brown ever got a reputation for prudence after promulgating PFI is beyond me. We should not let our anger at his other failings to distract ourselves from the failings of this rotten, shameful system. PFI encapsulates the worst of free market dogmatism without any compensating controls. There is no price discovery and little competition. Instead we have a simple transfer of public funds to private companies. PFI brings crony capitalism to the heart of public procurement, and anyone who cares that their taxes are spent efficiently should be vehmently opposed to it.

The psychogeography of investment banking

I will ignore for a moment the fact that Epicurian Dealmaker does not make very accurate use of the term `psychogeography' (see Mind Invaders for a reasonable if amusingly partial introduction), and answer his question. First he quotes Tolstoy, the important part being

A Russian is self-assured just because he knows nothing and does not want to know anything, since he does not believe that anything can be known.

The question is then

Naturally, I exclude the Russians from my analysis, because I am completely unaware of anyone currently operating in the financial sector who will admit to knowing nothing, much less take pride in it.

Your thoughts?

My thoughts are that many of the MDs I have ever met in M&A fit Tolstoy's description admirably.

The flight to simplicity

Rick Bookstaber has an interesting if flawed post on the neue sachlickeit in derivatives:

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

That would all be true if the list of standardised products stays short. But I am willing to bet quite a bit of money that more and more products will be exchange traded and cleared rather quickly. The sales people - who get paid more for exotic structures - will push hard for this. Soon range accruals and power inverse floaters will go through exactly the same infrastructure as plain vanilla swaps.

Where Bookstaber goes really wrong, though, is a mythologising of the early days of derivatives:

If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line... [things went bad].

Oh grow up. I mean, really. Derivatives were always about tax arb and regulatory arb and ratings agency arb and accounting arb/earnings smoothing. There never was a golden age when derivatives were used just to meet risk management needs, and where unicorns lay down with virgins after the market closed. Swaps grew because they allowed the derivatives desk to lend without the credit department finding out. Credit derivatives grew thanks to a massive regulatory arbitrage. It has always been a client facilitiation business, and what the client wanted, the client generally got (albeit at a price).

Pounds per pixel

I had cause recently to muse on the rather variable cost of a pixel. It's like this.

Pentax has a new digital camera out. It's called the K-7, it is apparently quite nice, and the body will cost roughly £1,200. It will produce images with 15 million pixels. This is fairly typical for a good quality digital SLR.

Now consider the large format camera I bought the other day. It cost £200, and it will take 5x4 film. Even a medium quality flat bed scanner can produce a three hundred million pixel scan from a 5x4 negative. Lenses for the LF camera are roughly the same price as high end digital lenses - a Rodenstock Apo Sironar S 150mm is comparable in price to the Pentax 31mm limited. So I am getting a pixel for 0.000067p, vs. 0.008p for the digital photographer, a factor of over 100 better.

Now of course digital is free once you have the camera, and large format isn't. But the £1,000 I have saved will buy quite a big pile of Fuji Velvia 5x4. Sometimes old technology is cheaper and better than new...

Rebuilding

There is a lot of comment around at the moment about how broken finance is: here, for instance, is a piece by Pablo Triana. And certainly there are many, many issues that we have no idea how to deal with in practice, including fat tails, autocorrelation, correlation smiles, and hidden systematic risks. These phenomena challenge option pricing models, CDO pricing, basket option pricing, ABS pricing and all sorts of quantitative risk management model.

But, but, but. There are some things that work. The huge push in the 1990s on the behaviour of the yield curve has at least left us with a good idea how to manage single currency swaps books. Vanilla puts and calls can mostly be hedged effectively. Credit derivatives - despite stident claims otherwise - have not caused the end of the world as we know it.

We need then to return to the things we do actually know, and to be very critical about what has worked well, what has worked acceptably, and what has turned out to be unhelpful. Saying the whole edifice of mathematical finance is rotten is just as counterproductive as saying that none of it is. For once, finance theorists need to be disinterested and critical observers of reality rather than cheerleaders (or hooligans). Let's see what we need to tear down and what is still standing now that the tumult is dying down.

Anish Does Brighton

A few shots of the Anish Kapoor installations at the Brighton Festival.

Data audialisation

Via Alea, ten years worth of stock price as an audio file. Isn't that nice? More details here.

Goat backed securities

And other goat derivatives. I'm not joking. The BBC is, though. (This link may not work if you are outside the UK - I'm not entirely sure, but my apologies if it doesn't.)

Homonym corner

Many years ago, my research work was in concurrency theory. Therefore it was a bit of a surprise to find the Guardian asking Is concurrency to blame for spread of HIV in Africa? Fortunately it turns out to be a different sort of concurrency. It was a nasty moment, though. Any donations of strong spirits will be gratefully received. Well, apart from the ghost of Hamlet's father.

Hoicked from the comments

In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the "worst-case scenario" that is important. If regulators had used the great depression as the worst case scenario, they wouldn't have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. 'Plausible' worst cases have a nasty habit of turning out to be too optimistic: wasn't it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can't see how systemic risk regulation would cause bankers to take greater risks. So, I don't see where moral hazard fits in.

Fair enough - bankers are not people riding bikes. (Quite literally, usually - Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a "moral" position on systemic risk? I don't think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism - that the first and only duty of a firm is to its shareholders - is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I'd like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that "countercylical measures in a boom dampen economic growth". Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

80/20 derivatives

In the FT, Aline van Duyn comments on the Geithner derivatives reforms:

In Mr Geithner’s vision, banks, investors and companies that use derivatives will have to register their activity. In this way, regulators will be able to see the whole picture of risk that has been built up in the financial system. These players in derivatives will all have to put some money aside in case their bets go sour. The amount of bets will therefore be limited. Large parts of the markets will be cleared centrally, which means that the default of a big bank at the centre of the market will not set off a daisy chain of defaults. Regulators will finally have specific jurisdiction over these financial instruments...

First, what is a “standardised” derivative? Is the cut-off size or simplicity?

That is relatively easy. Most banks' derivatives book - and certainly all the big players' books - are mostly vanilla. If you called 'standardised' a plain vanilla interest rate or cross currency swap, forwards, FRAs, caps and floors, plain vanilla swaptions into plain vanilla swaps, and plain vanilla options on single FX rates, equities, equity indices and commodities, (plus the already-DTCC cleared credit derivatives) you would have not just 80% of the industry, but probably more like 90%. Just centralising the clearing of these simple instruments would dramatically reduce counterparty risk and improve market transparency. If you added in basket options, asians and barriers, you would certainly have more than 95% of the industry.

Second, will plans to shift to centralised clearing include derivatives contracts that already exist, or just new ones? This is a vital issue: the risk in the financial system is largely the result of existing contracts. And, as the people still employed at AIG are realising, you cannot just throw these contracts into the river.

There is no reason not to novate old contracts into the new system. It will take time, but you can do it, especially for the inter-dealer business.

Third, who is subject to the regulations? Banks, certainly; large hedge funds, probably. What about smaller investors or companies such as airlines that use derivatives to hedge oil and currency positions?

Regulated banks and hedge funds, plus anyone else with more than a 1% market share, say, in a given market, or anyone the market regulator tells to use the system. The advantages to the banks of central clearing would be large enough that they will pressure big clients to move onto the system anyway.

Aline raises some reasonable objections, but in this case I do think that you can remove 80% of the risk for 20% of the effort.

The pain in Spain...

...as the FT says, will be felt mostly by the banksWhat is interesting about this is how vintage insensitive it is. In the US, there is a world of difference between the 2005s and the 2007s: in Spain, not so much.

Update. Downgrades loom for the Spanish banks as an interest diversion test is tripped on a Caja Madrid RMBS.

Sound words on defence spending

Lewis Page writes sharply and well on defence procurement. He's a sample:

defence manufacture brings us a measly billion or two in exports each year – and our arms industry requires the great bulk of the £15Bn defence materiel budget in spending to win us this rather paltry amount of trade.

Put that way, the claim that we need our massive - per capita larger than any other EU state - defence budget to support exports is clearly ridiculous. Does this spending provide credible independent capability? Page says no, and gives detailed examples:

the Prime Minister can fire his American-made Trident missiles without asking Washington frst. But he cannot expect his supposedly ‘Britsh’ or ‘European’ systems to keep operatng through a normal-length war if US support is cut of. No, seriously. The Eurofghter contains so much US equipment that American consent is required for us to export it to Saudi Arabia, for goodness’ sake. EADS tells us openly that “the A400M will beneft from use of American content”. The command system for the Nimrod is being made by Boeing. The Future Lynx uses American engines.

On a day when the shameful truth of defence procurment - that British soldiers are dying because we can't get them the kit they need - is once more emphasised, it is time to face the truth. Defence spending isn't just absurdly high in the UK: despite that, it does not give the ordinary soldier, sailor and flyer what they need and deserve.

If you want to subsidise exports, then support the most efficient exporters. They are not defence companies. If you want capable weapons systems, then buy the best ones that you can afford*. And if you want to send men out to fight, then you have a moral obligation to kit them out properly: that imperitive over-rides any possible national interest in a particular manufacturer or procurement process. We don't just need to cut defence spending: we need to spend smarter and more ethically.

*Subject of course to acceptable 'will they support it' risk. One might like to consider for a moment in this context whether the Sukhoi-30 is a better bet for the RAF than the Eurofighter...

Update. A correspondant with considerable knowledge of the defence industry points out that even when UK defence companies can meet a procurement objective, they are more expensive than their civil equivalents because they cannot meet the same timescales and margins. A combination of the shelter provided by captive defence spending and the overhead (both in cost and in putting off some staff) of security means that they simply are not lean and mean enough. If you want a van, go to Ford or Toyota or Renault - don't go to someone who makes tanks.

Non-classical Cost Benefit Analysis

Remember Schroedinger's cat? Poor moggy is trapped in a box with a radio active isotope. The isotope decays randomly. Let's say that there is half a chance of detecting a beta particle using a detector inside the box during some time interval. If the particle is detected, then poison gas is released and the cat dies. If not, it lives.

This setup is usually used to explain superposition of states: basically until you open the box, the cat is in the superposed state 'dead and alive'. You force it to be one or the other by observing it.

I want to use it to talk about something else, though - cost/benefit analysis. If you like cats, then you will want to save moggy. But there is a cost to opening the box early, a pound say. If you judge the worth of a cat as more than two pounds, then you'd spend the pound and guarantee that the cat is safe. In general, 'classical' cost benefit analysis says that if a bad event has cost x and probability p, then it is worth spending px to prevent the bad thing.

Concretely this is usually expressed with less likely events: a certain kind of brake failure on your car is a one in a million event, and the average cost of an accident if your brakes fail is ten thousand pounds, so it is only worth spending a penny to prevent the problem.

This classical cost benefit analysis makes two big assumptions. First it assumes that the bad events are independent and identically distributed. In many applications, this is not true: making the system safer sometimes encourages people to take more risk (and not fixing an obvious safety issue makes them more careful). There is good evidence for this from the development of ABS brakes, amongst other things: they didn't make cars nearly as much safer as the developers hoped, since drivers absorbed the safety margin by driving more aggressively.

In the cat experiment, you can think of this as moggy learning (perhaps by cat telepathy) that if it gets between the isotope and the detector, the particle is less likely to be detected, and hence it is more likely to live. This changes p from 1/2 to 1/3, say, and now your pound is only worth spending if you think a cat's life is worth three pounds.

The second major problem is that your estimate of the probability of failure for small p, is likely to be wrong. Your estimate of the cost, x, might be wrong too. As James Kwak says:

imagine that the government had considered the idea of systemic risk regulation five years ago. It would have cost money; it would have created new disclosure requirements for banks and possibly hedge funds; it would have required countercyclical measures in a boom that would dampen economic growth. Those are the costs of regulation. And how would anyone have estimated the benefits? No one would have estimated the scenario we face today – trillions of dollars of asset writedowns, 3.3% contraction in the U.S. economy and counting, even more severe damage elsewhere in the world economy. And as a result, the regulation would have died.

... it’s a mistake to think that all policies can be boiled down to cost-benefit calculations when one side of the equation is difficult or impossible to measure accurately, and the last thing we need today is more economics-based overconfidence.

In other words, cost benefit analysis is all very well if you can measure the costs, the benefits, and their probability distribution accurately. But if you can't, as in the costs of financial regulation vs. its benefits, then you shouldn't use spurious theory to try to justify the decision you wanted anyway. If you don't know the probability of the particle being detected, you simply have to fall back on an ethical judgement: killing cats is wrong.

Monoline death watch, day 1000

(The fate of the monolines was sealed by the risk they wrote in 2005-2007, so day 1000 is if anything conservative - it takes insurers a long time to die thanks to their accounting and the pay as you go nature of the claims against them.)

In a move so predictable it hardly raises a yawn, Bank of America, Citigroup, JPMorgan and 15 other large financial institutions filed suit on Wednesday against MBIA, claiming the bond insurer reduced its ability to pay policyholders by splitting its business in two.

It is difficult to think of how a monoline could split without generating lawsuits. If x of capital and y of investments support z of risk, and you split z into to pieces, how do you divide x and y? There is not widely agreed answer, so someone is going to think that the credit quality of the piece they end up with a claim against is lower that it should be - and they will sue. Moreover since there are clearly diversification benefits between risks, even if the split is entirely fair, the capital needed for the two pieces is larger than that for the original whole.

The lesson? Agree collateral upfront, based on your marks.

When you want to come bottom of the list

Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages... In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman -- but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Trigger convertibles

This is an idea of Steve Randy Waldman's, and I like it.

The basic idea is that you have a deferrable CB. That is, a fixed rate bond which pays coupons, but where the issuer can defer the coupon without it being a default event. Many preference shares are like this, for instance.

The bond is also convertible into shares. Unlike a normal CB, though, the bond is convertible after deferral at a fixed discount to the then current stock price. Thus it is a trigger CB - the trigger being the deferral. (One could have other triggers too, such as quarterly net earnings being sufficiently negative, or Tier 1 capital ratios falling too far. You could also have conventional conversion features too.)

The attractive part, akin to contingent capital, is that the holder is incentivised to fund fresh equity issuance just when the issuer needs it. The issuer pays something for the option to raise equity, but not nearly as much as it would have to pay for real equity capital. If the issuer wants to be sure of the capital, conversion after the trigger is hit would be mandatory: if they thought that the discount was incentive enough, it would be optional, with a correspondingly lower coupon on the bond.

Who's right?

Krugman fears lost decade for US due to half-steps reports Reuters.

Elsewhere, George Soros leads growing chorus of 'green shoots' optimists.

I don't know who is right. I can't even make a good guess. But it is an interesting question. Opinions seem more divided now than at any time in the last six months - and divided opinions make for interesting markets.

Road deaths and other acceptable casualties

An article by David Mitchell from Sunday's Observer is so full of sense, and so nicely written that I want to quote quite of lot of it. It concerns the pathetic whingeing of the car lobby that they are sometimes caught breaking the law and even *gasp* punished for it (although not very much).

Apparently, the criminals who break the speed limit don't like the punishments they receive. Then again, the criminals who break the murder laws don't particularly like the punishments they receive either, but they don't form quite such a strident lobby...

The fact that many more people speed than murder does not make it any less a crime, even though it is a lesser crime. And the difference in the magnitude of the offences is reflected by the huge difference in their punishments. So that doesn't excuse the grumbling letters to Top Gear magazine either...

Almost everyone knows when they're speeding and almost everyone speeds. Maybe this massed recalcitrance means we should change the law, allow people to drive as fast as they like and accept a few thousand more road deaths? ...

Some drivers seem to have a gut feeling that racing around attached to a big internal combustion engine, going wherever they want, as quickly as they deem convenient, is some of sort of natural right or ancient British liberty. Well it's not. It may feel natural but so does smoking or an expensive boob job. It's recent, unnatural and unhealthy and the world would probably be a better place if no one had ever done it. Soon they may have to stop.

Then in today's paper, in a nice segue, we find:

Thousands of taxis, buses and council vehicles could be fitted with devices that prevent them from exceeding the speed limit.

Given that a driver's willingness to obey the law seems in inverse proportion to the cost of their car, I would suggest phasing in speed limiters immediately on all cars selling for more than £20,000. Sports cars, the worst offenders, would have to have speed limiters fitted at their MOTs. I am sure that this would do more to reduce road deaths than any amount of traffic calming or improvements in crumple zones. Add in genuine enforcement of the Highway Code by real policeman on the road, and we would have a revolution in road safety.

Student loans

Are student loans a good idea?

Certainly as they are implemented in the UK, they serve no one well. The level of tuition fees is set too low to fund Universities properly. (The under funding of higher education gives the lie to Blair's 'Education, Education, Education'. Schools might have done well under Labour, but Universities have not.) Yet they are set high enough to discourage some students from applying to University, particularly those who have a higher aversion to taking on debt or less experience at doing multi-year cost/benefit analysis - and that is primarily the children of the less well off.

In short, we have a classic Nu-Labour half a hard on situation (as in there is nothing worse than...) Either fees need to raised very substantially, so that at least Universities are not losing money on every undergraduate educated. Or England needs to follow Scotland in ending the experiment with loans, with a more-than-matching increase in government spending on Universities.

The quality of teaching in English higher education is falling; contact hours are declining; and equipment is often laughably bad. The only thing that will fix these issues is money. If we want as many students in University as we have at the moment, someone is going to have to spend more. And even if we don't, accepting that the Blairite push to higher numbers was overdone, then the spend per student needs to increase. If it doesn't, the English University system will keep getting worse.

Control theory and capital

The beginnings of control theory can be summarised as 'nail it in the right place'. Suppose there's a plank over a barrel. You can keep the plank level by putting a weight in just the right place, so that it balances.

The problem with this is that any perturbation will cause the plank to swing away from the level. A gust of wind might even do it: the equilibrium is unstable. Therefore control theory 101 would suggest that you move the weight dynamically to keep the plank balanced. If one end swings up, move the weight slightly that way until it swings back.

Over the years, a lot has been discovered about how to control unstable objects moving in unpredictable environments. Modern fighter aircrafts are in some ways a triumph of control theory: without the computers which control their flight surfaces, they would fall out of the sky. And what the computers do is determined by control theory.

One of the many reasons that the current regulatory capital regime is pants (not to put too fine a point on it) is that it is stuck with static control. That is, think of a number, and that's the amount of capital that you need. In reality, the regime needs to be dynamic: the anticyclical capital of earlier discussions is one piece of this puzzle. What struck me as I walking home from a lecture last night (one which touched in passing on control theory) is that we do not even have the right inputs to develop a control theory of bank capital. That is, we don't really know what the equivalent of the angle of the plank (or the speed, pitch, yaw and so on of the fighter) is. One can think of some things that it might make sense to monitor, like credit spreads or the availability of interbank liquidity, but so far as I am aware, there has been no systematic study which discusses the indicators of health of the banking system, let alone identifies how they respond to changes in regulation. That would be the basis of a serious control theory of banking.

On the curve

Bloomberg says Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings.

For that bet to come off, US banks have to earn lots of money.

What's the major determinant of bank earnings that Geithner can control? The shape of the curve. Banks make money if their short term cost of funds is lower than the longer term rates that the loans they make price from.

So... pay 1m USD Libor, receive constant maturity 3 year swaps. Trade of the month.

Scoring the SEC

The WSJ reminds us that despite the SEC's lamentable record, US regulatory reforms seems as far off as ever. How badly did they do? Here's my assessment.

• Supervisor of investment banks: 0/5. There are none left. That really does tell you all you need to know.
  
• Market supervisor: 2/5. Rule SHO didn't stop naked shorts, and the SEC's record dealing with market abuse and insider trading is not wonderful. Nevertheless, they have sometimes acted prudently in the equity markets in the past.
  
• Information gatherer: 4/5. Edgar is very useful, and Idea seems like it will be even better.
  
• Hedge fund regulator: 1/5. They could have found Madoff in 2002.

It seems to me, then, that the SEC is a great website with a deeply flawed supervisor bolted on the side. So why hasn't Geithner done anything?

Keep your enemies close?

The news that Obama has recently had a meeting with two of his fiercest critics, Krugman and Stiglitz, does him credit. I think there is more to it than the title of the post: it suggests maturity that Obama is willing to listen to different views. One can't imagine Gordon Brown, for instance, being so open minded. Leaders who encourage diversity of opinion are likely to end up better informed than ones that don't, and to make better decisions as a result. I'd like Krugman and Geithner to do a job swap, of course, but at least Krugman isn't crying unheeded in the wilderness.

Years and years - a riff continued

Charles Butler, looking at the same Jonathan Hopkin post I talked about earlier, comments:

We may find the right wing to be insufferably and unacceptably stupid since the time that the same Ronald Reagan took office, but the left has descended into the ethical black hole of defending only a restricted number of vested interests.

Would that he were wrong. But he's not. For me, one of the reasons that Thatcher got and kept power was that she challenged the entrenched interests that the left was in thrall to in the 1970s, notably the unions. (The unions of closed shops and entrenched employment rights for the few, that is.) If the general perception is that the Left is pandering to this kind of selfishness again, then it will be out of power in the UK for as long as it was in the Thatcher years.

The triumph of the system

Over the last few days I have cycled over sixty miles (for pleasure - business is not going that badly). Somewhere around mile 50, it occurred to me just how amazing public transport is. I can get further in an hour by train than I can cycle comfortably in a day under my own steam, and it costs me much less than I can earn in an hour. Imagine what getting around would be like without the kind of multiplication of effort that railways provide - if we all had to provide our own private infrastructure. The state really did do some things well, and even now, in these denuded times, those advantages have not entirely disappeared.

The failure of the left

Jonathan Hopkin makes a good point:

Almost as distressing as the collapse of the free market model of free-wheeling finance is the failure of the Left in the West to say anything very much about it.

So far so obvious, and so depressing. But Hopkin insightfully contrasts this failure to an earlier triumph.

Karl Polanyi's masterpiece 'The Great Transformation' interprets the rise of Nazism and Fascism as a response to the threats free markets posed to the livelihoods of the masses. Only after the catastrophe of war did Western governments discover a way of providing protection without foreign aggression or the scapegoating of ethnic minorities. 'Embedded liberalism' (as John Ruggie defined it) involved liberal trade between nations under stable exchange rates and capital controls, with welfare provision inside the nation state to insure workers against social risks. This model was a triumph, delivering growing living standards and social equality for the best part of half a century. But the moment it ran into trouble the assault began, and the various components of embedded liberalism have been steadily dismantled over the past couple of decades.

We need to put embedded liberalism back again

Now this is interesting. First is embedded liberalism the only solution? It seems rather overweaning to me to suggest that it is. But is it one solution? Well, it certainly worked before, if that is any guide. This kind of macro-political debate is exactly what we need: so why are parties of both the Right and Left so anxious to avoid it?

Setting budgets

I went to a big science talk this week. The details aren't particularly important, but the discussion of the budget process was. The speaker contrasted an earlier regime, where he had had a budget that was deliberately set lower than the expected cost of his projects, with an over-run expected, with the current system he had to operate under, whereby budgets were set higher, but he was not permitted to exceed the stated sum.

It made me wonder which resulted in the lowest expenditure for a given project, and what the risk implications of budgeting were. Clearly if you say 'don't spend more than $10M', then there is a huge temptation to spend $9.95M regardless of what it actually costs to get the job done. And if you say 'I think it will cost you more than $8M to get this done - see how much more' then some project managers will take perverse pride in trying to prove you wrong and do it for $7.9M. So I am rather inclined to recommend the deliberately low model of bidgeting. However, it is important in this setting that there isn't an incentive for cutting corners that should not be cut. Sometimes it really does cost $8.5M to do it right.

On transaction liquidity

Naked Capitalism has a typically engaging post on transaction liquidity.

One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.

Fair enough. A priori it is not clear if having transaction liquidity is a good or a bad thing.

One of the comments I have heard from debt market participants in the bubble era was that they were faced with a 'wall of liquidity", tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk.

Let us look at these one by one.

• Capital. That was the regulator's fault and not the banks'. And it had little to do with liquidity. So yes, it was a bad thing, but it has nothing to do with either CDS per se or with transaction liquidity.
  
• Profits. There are arguments in both directions for fair value vs. accrual, but again this has nothing to do with either CDS or liquidity.
  
• Hedging. Here's the nub. A lower cost of capital is good for the economy when it is growing. But if it is created by over-leveraging the financial system, then clearly it is dangerous.

Let us turn back to NC:

Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to... Higher frictional costs lead investors to think twice about adding and exiting positions.

This is also a good point. Transaction liquidity supports the development of crowded trades, but often there is not enough to support their closing. I wonder if we should consider some form of frequency based regulation, whereby more frequent traders require more capital.

Personally, then, I think the case remains tantalisingly unproven. In traditional equity markets, abundant liquidity supports price discovery, permits speedy asset reallocation, and lowers everyone's cost of capital. But patchy liquidity, whereby there are periods of liquidity which can suddenly disappear, as in the ABS market and some other areas of credit, is deeply unhelpful. What we really need is more constant liquidity, so that liquidity assessment is possible for the life of a trade. Perhaps market maker requirements have a place here: obliging firms to provide liquidity in good times and bad - a feature of the equity but the credit markets - could help to even things out. And certainly if we are going to intervene to improve liquidity (as in the TALF), then we need to consider the possible negative effects of too much liquidity.

Monoline death watch, continued

Watching the monolines die is a bit like listening to Fidelio. Intellectually you know that it going to end, but there are times when it feels like it cannot happen fast enough. Now we seem to have moved past the Komm, Hoffnung of Act 1 - there is no hope - and the protagonists are in chains. Specifically Syncora (which used to be called SCA - the name swapping in monoline land is as bad as that in a Shakespearean comedy, and a lot less funny) has stopped paying claims. This is of course a default event for CDS written on it. The FT story is here.

Don't say he did not warn you

David Davis, writing in the FT, sets out Tory policy:

The first stages of an austerity regime, involving pay and recruitment freezes for the entire public sector, will be controversial and uncomfortable.

It is likely that this will be policy for the next government, and it scares me rigid.

Two thirds of a fine horse?

Not really. But the assets in Whistlejacket, the defaulted SIV sponsored by Standard Chartered, were liquidated yesterday, and reached an average price of 67.1 cents on the dollar according to Bloomberg. That means that anything more than 2 to 1 leverage in an off balance sheet funding vehicle is too much...

How much capital does a bank need?

Probably the best answer is the least amount that gives comfort and confidence to debt holders, regulators, and other stake holders. But that is a moving target.

Over the last twenty years people like me have spent a lot of time trying to construct and improve capital models. At its simplest, a capital model uses some measure of risk to deduce how much capital is required for some portfolio. The problem is that many of these measures of risk have proved highly fallible, and thus capital has been systematically understated. Moreover, thanks (1) to leverage and (2) to the fact that losses are a deduction from capital, even small capital mis-estimates can emperil a bank in a crisis like the current one.

These chickens (or in Citigroup and Bank of America's case, flocks of giant mutant turkeys) are coming home to roost. Six of the largest nineteen US banks require more capital, according to the FED: and you can be sure other banks around the world do too.

What you can be sure of in these discussions is that the numbers are essentially arbitrary. No one really knows how much capital a bank needs at any given point, not least because risk based capital models have lost their credibility. Capital is adequate if and only if it keeps the relevant stakeholders happy: and risk based estimates no longer keep people happy. So don't expect the negotiations of the coming weeks necessarily to make sense. It will all be about the deal that can be done when everyone gets around the table.

Update. Matthew Yglesias, via Gary Becker, has a nice characterisation of what we can expect from capital, and indeed regulation in general:

The best you can hope from a regulatory regime is ... [a] fairly crude rule will improve on the outcomes generated by the unfettered market... when we're looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there's no danger there we should be very suspicious. We shouldn't count on being to fine-tune our results to perfection

Two down, one to go

Jacqui Smith, possibly the least competent Home Secretary since Henry Brooke (although there in Blunkett to consider for that title too, and that is pretty tough competition), has already announced that she will not be going ahead with a massive snoop project (although she wants the same functionality provided privately). The cancellation of the id card project is apparently being actively considered, and anyway the Tories have said that they will cancel them. And the Trident replacement may be on the block, along with a number of other large defense projects. This is all good.

It's just a shame we are still stuck with this:

Yes, the grandiose, ultimately useless (or at least currently without a use) and hideously expensive Olympic building projects sail on regardless. Our shameless pandering to the IOC continues. As Simon Jenkins says, while the ­citizens starve, the precious ones are fed. Still, at least some of these cuts are better than none.

Copula counterfactual

How different would the world be if David Li had written about a variety of different copulas rather than just the Gaussian one? (Do read the excellent Sam Jones piece that the link points to.)

Positions

A recent Bloomberg story reminded me that it has been months since I discussed the markets with a view to position taking. Sorry.

So... It seems obvious that high quality corporate credit (ex Financials) is a good place to be, especially with the decline of the Libor/govy spread. I tend to view medium durations, around 5 to 7 years, as attractive at the moment not least because they will profit from eventual curve flattening when things (finally, possibly after some years) get better. Fund short term if you can and you have a very high risk tolerance and _great_ liquidity risk management.

I'm not convinced equity markets offer anything at the moment. My gut is to be short, but there is a huge weight of money waiting to get into equity - goodness only knows why - and you could get crushed on a relief rally. So stay away.

In the ABS space, collateral is key. If you can do loan level analysis, then there are some serious bargains to be had, particularly at the top of the securitisation waterfall. The discriminating buyer, especially the discriminating buyer who uses the TALF, should make money.

In FX, I am still inclined towards short USD, despite the flight to quality risk. FX vol seems expensive: consider selling short dated vol.

That was your stupidly infrequent global macro update. Cheques behind the usual stone in Bishopsgate.

Competence and the consumer

I had a nasty shock the other day. There is a snake's head fritillary on my balcony that was looking rather nice, and I took a picture of it. The image was out of focus. Now, my digital camera is both sophisticated and perfectly capable of handling the conditions, so I wasn't pleased. But I forgot about it until I saw this post on DIY auto focus adjustment.

It looks a bit tricky, but actually it isn't. After an hour, I had recalibrated my Pentax's AF, and it is now much sharper. But what shook me - almost stunned me - was how far out the camera was. 260 microns. That's like trying to get to the Tower of London and ending up in Milton Keynes. My naive assumption that a piece of high end consumer electronics would be properly calibrated out of the box was obviously very foolish.

Of course, by the time I had got this done, the fritillary flower had fallen, but here's a 100% crop from an image of some blossom, taken with the newly calibrated AF:
I wouldn't say the focus is absolutely perfect, but it is an awful lot better than it was, and close to the best that is achievable without lab equipment.

It is interesting that things like my camera are limited not by their maximum performance, but by the competence of the factory and distribution system. Given that these problems get much harder for higher resolution cameras - see here for an extended discussion of calibrating medium format digital backs - you might want to pause before buying a camera with more than 10M pixels. It might be fine out the box, but it might well not be, and if it isn't, extracting the performance that the camera is capable of can be a tedious business.

Protect the worker, not the job

Jonathan Hopkin has a couple of good posts on job security, welfare, and the labour market here and here. He discusses the Danish solution to the problem that:

• Countries with flexible labour markets tend to grow faster, but
  
• Flexible labour markets produce large amounts of individual unhappiness when jobs are lost. They also tend to result in discrimination against some classes of worker, such as the over 50s.

The slogan of the Danish solution is the title of this post: protect the worker, not the job. That is, Denmark combines labour market flexibility - easy hiring and firing, with relatively little job protection - with relatively lavish welfare systems, education opportunities, and state pensions. It sounds like the best of both worlds - Italian fashion and Swiss trains in the terms of yesterday's post - but as Hopkin points out (and I elaborate) there are some things that you need to make it work. These include:

• An open, meritocractic job market, supported by strong anti-discrimination legislation (rather than in Hopkin's delightful jargon, the political-clientelistic system of much of Southern Europe);
  
• An extensive network of out-placement and other job seeker's services, and in particular a good adult education and retraining system;
  
• Generous unemployment benefits;
  
• Portable pensions and other work benefits which encourage a portfolio approach to careers rather than a job for life culture;
  
• Infrastructure which supports workers, like a good transport system, readily available child care, and good public health care;
  
• High levels of social trust so that the unemployed are genuinely job seekers.

In other words, you can't just say let's be like Denmark without doing a lot of politico-social systems engineering to make that possible. I very much doubt that however much Italy, say, wanted to emulate Danish success, they could (and of course the success of the ultimate political-clientelist, Berlusconi, suggests strongly that Italy does not want to do that).
Thinking that you can just change employment conditions and automatically get a Danish style success is the same class of error as the UK made in imposing student loans, or many countries are making with self select pensions. Even if rationally the policy solution makes sense, without education, culture and support systems around it to explain how to use it, the policy may well fail. Thus borrowing on a student loan may well be rational, but in the context of a (prudent) culture of avoiding debt, and perhaps a sense that university is not for the likes of us, the imposition of loans leads to higher education becoming a middle class ghetto. Similarly making people responsible for their retirement might be good classical economics, but how many of them have the financial education to make sensible choices?

Becoming French

Matthew Lynn, in a typically opinionated and wrong-headed piece on Bloomberg, thinks

The British economy is becoming increasingly French.

Why which he means

It will have a huge tax burden to carry, a state that is the dominant actor in the economy, and a system whose resources are managed more by some kind of national plan than the free hand of the market. The government is now explicitly emulating France, with its national champions.

Sadly this leaves out the good parts about the French economy: the generous welfare system; good education and health care; job security (at least for some); rational working hours for many. No, the UK isn't becoming French. It is becoming much worse: French for big companies, but American for ordinary workers. That's like having Italian railways and Swiss fashion.

Darling, darling man

He's actually done it. Top rate tax to rise to 50%. Well done Alistair.

Update. OK, the continuation of any tax relief at all for pension contributions from higher earners is a disappointment, as is the pale green nature of what little he did do for the environment. Still, the budget is more bold than I expected. If Darling is rediscovering his balls, this can only be a good thing. Of course, it could just be a leadership bid post Gordon, but that's politics.

More on models

From Daniel Kahneman, via portfolio.com:

A group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

Quant funds and the field approximation

It has come to general attention recently that many quant funds have had a terrible few months: see here for more details. Specifically the momentum following funds have suffered badly from the crap rally of the last little while.

What is going wrong?

One way to see the issue is to consider a technique that sometimes works well in statistical physics. Don't panic, I promise there will be no hard maths. It's like this. Sometimes, you want to know how a given something behaves inside a solid. Let's make the something an atom (although it doesn't have to be). Say this is an atom of impurity in an otherwise pure crystal. How will this impurity affect things?

One could attempt to model the interaction of the atom of impurity with its neighbours, and their neighbours, and so on. If you could do those calculations, the results would be precise. But often you can't, because there are too many effects to consider, and too many other atoms which can exert an effect. So a good short cut is to first calculate the properties of a perfectly pure crystal, and then consider the impurity like a boat in the sea with these properties. You don't model each neighbour separately, in other words: you model the combination of their effects as one thing. This is sometimes called the field approximation, as you are calculating the field of the pure crystal, and then looking about how the impurity behaves in that field.

This works pretty well for one impurity, and it isn't too bad when there are many, providing the percentage of impurity atoms is low enough. But once the percentage of impurities starts rising to the point where one impurity interacts with another, the approximation starts to fail rather badly. Furthermore if the impurities change the way the crystal interacts with itself, then this also means that a new approach is needed.

And so it is with hedge funds. When there were few quant hedge funds interacting with a market that was mostly driven by real money, then the fund's model of market behaviour was reasonable. But as the percentage of trading activity that was hedge fund originated increases, that model becomes less and less tractable. I suspect that phase transitions are possible, whereby the market dynamics suddenly change for only a small increase in the percentage of fund activity. What's happening, then, is that we have too many hedge funds chasing too few arbs. Things won't get better until the capital allocated to quant funds declines significantly.

Payment for failure, German edition

From Bloomberg:

Dresdner Bank AG, the unprofitable lender acquired by Commerzbank AG, was sued by the former head of capital markets at its investment banking unit over his severance pay... Dresdner in-house lawyer Matthias Woldter told the Labor Court that Neumann can’t seek the severance payment because his unit contributed 5.7 billion euros to the investment bank’s record 6.3-billion-euro loss last year.

“The losses were incurred especially at the unit Mr. Neumann headed,” Woldter said. “His duty was to care for its short-, medium- and long-term profitability. He significantly failed in bringing that about.”

Tanja Karhausen, Neumann’s lawyer, said that the payments were due independently of the 2008 results.

Bankers wonder why they are so widely disrespected. Law suits like this are part of the reason. Individually it may make sense for this guy to sue. But collectively he is just helping to put another nail in the coffin of the reputation of banking.

Nuclear No Nos

Nuclear Power is not the answer. Two stories explain why.

First, there is the waste. We simply do not know how to deal with it, how expensive that will be, or even if we will ultimately be successful. This story in the Guardian provides some more context: I was interested to learn that the most hazardous industrial building in western Europe is at Sellafield, an English nuclear power plant. The second most hazardous one is there too. The estimate for the cost of cleaning this up is £50B - and we all know how accurate estimates like that tend to be (or those of us who are paying for the London Olympics in our taxes do anyway). I very much doubt Sellafield generated fifty billion worth of electricity in its whole life.

Second, there is the lag. The UK will need lots more energy generation by around 2015. That's when the crunch comes. Even if nuclear is a good idea - which it clearly isn't - it can't be ready in time. Notice that if we have an election in 2010, 2015 might be only one parliament away. That should focus minds a little...

Regulating small firms

The current furore over FSA regulation of building societies is interesting. A whistle-blower alleges that

A culture of apathy and complacency marked the FSA in the period of its nadir, with anyone standing up against light-touch official policy criticised for rocking the boat and branded a troublemaker.

I have no idea of the truth of this, but three points are worth making.

• In a regulator, the status of staff depends to some extent on who they regulate. The big swinging dicks are the ones who regulate the biggest banks. Building societies are not glamourous, and hence the quality of regulator here may well have been lower than elsewhere.
  
• Many regulators are really quite bureaucratic. The scope for individual staff, especially line staff, to make decisions is limited. Anything of substance is likely to go up the chain of command. Therefore if there have been failures, it is the senior people who are likely to have been responsible.
  
• Building society supervisors are likely to be a conservative lot - even more conservative than bank supervisors. What they think is dangerous may be a rather large class - and one that includes some reasonable innovations.

Population and the future

Population is a hugely emotive topic. It seems that few people want to be told that they should not have many children as they wish. And certainly the history of population control is littered with oppression. But, as David Attenborough points out

The growth in human numbers is frightening. I've seen wildlife under mounting human ­pressure all over the world, and it's not just from human economy or technology. Behind every threat is the frightening ­explosion in ­human numbers. I've never seen a problem that wouldn't be easier to solve with fewer people

The mid point estimate for the Earth's population in 2050 is over 9 billion. To meet our climate change targets at 9 billion, we will have to cut average emissions per person by 72%. Put simply, the planet cannot stand the weight of our numbers. It is time to acknowledge this hard, horrible fact and start a debate about what to do about it.

The downside of decreasing population is that it will have a large impact on several key parts of the financial system. In particular, as Zoe Williams discusses, pensions policy is based on the possibility of intergenerational subsidies. Current workers pay for current pensioners, at least much of the time in some countries. It will not be politically acceptable for this to continue, especially when fewer current workers have to pay for more pensioners. Again, this is political dynamite and given the entrenched interests, it is hard to discuss the issue. Problems this hard tend to inspire little more than depression in me. Still, at least the depressed don't tend to breed.

Reading Wells' disclosures

Jonathan Weil has been over them carefully. Frankly, reading his article, one wonders (a) why the accounts were signed off and, (b) why anyone would want to buy any of the bank's securities given these tricks.

Systems thinking in the Crunch

Edmund Phelps has a very good article in the FT which harmonises with many of the preoccupations of this blog.

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards... Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud.

In order to understand a system, you need to understand its behaviour, and how changing the rules which constrain that behaviour constrain the dynamics. There is no more a 'right' set of rules for something as complicated as a market as a 'right' set for a mobile telephony or a ball game. Some rules produce more efficient or interesting behaviours: some suffer significant disadvantages.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge.

Growth in infrastructure too: roads and factories and such like. The knowledge moreover is encapsulated in conventions, or rules of the system: a mobile phone is useless without a network of towers that it can communicate with. Capitalism attempts to solve a massive collection of coordination problems - and often (as with the worldwide phone system), it succeeds.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? ... [Hayek] felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism.

This is of course an important (and well understood) point. However most wealth, in the general sense, is created not by true blue skies innovation, but by inside-the-system thinking. 3G phones are possible because we already have second generation infrastructure: ABS only makes sense under some assumptions about road surfaces and driving conditions and so on. Thus the role of capitalism is not just to act as an evolutionary force allowing great new ideas to generate wealth. It must also provide infrastructure - pensions, banking, law, transport, health care and the rest - within which incremental development can take place. There are many non-optimal local maxima here: the US healthcare system is a good example. Phelps makes this point less forcefully:

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place.

Note however that there is an inherent volatility in capitalism.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment.

You can have slow wealth creation with little variation, or faster wealth creation with significant setbacks. But we do not know how to generate fast low volatility wealth creation, even assuming that this was generally considered to be desirable. Moreover there has never been a broad discussion of how much volatility is tolerable. Is an economy that grows at 4% on average over the long run but suffers vicious multi-year recessions occasionally better or worse than one that grows at 3% with much shallower pullbacks?

Investors have proved terrible at addressing these issues not least because they were reluctant to admit to the possibility of setback which was baked into the dynamics of the system.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down.

We urgently need to develop a sense not just of the likely near term path of the economy, but also the possible paths - the kind of thing that it might do. If, as I suspect, highly undesirable paths are still somewhat likely, we need to rewrite the rules to make them much less probable.

Being Boring

I saw the Severn Bore over the Bank Holiday. It wasn't a particularly big bore, as these things go, but it was still impressive. The oddest thing of all, though, was that the cows in the field we were in all lined up to look at it.

Strained, but not entirely silly banking system metaphor no. 152

Happy Easter to all. Deus Ex will return on Monday or thereabouts.

Taleb - 3/10 (and that is being generous)

Let's score Nassim Taleb's latest set of ex cathedra pronouncements:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

Fair point. Score one.

2. No socialisation of losses and privatisation of gains.

Exactly. Otherwise moral hazard is enormous and banking is profitable with little risk. Score one.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

No. Firstly nearly everyone who knows enough to be helpful was driving (or at least helping to navigate) the bus. And secondly most people even if they did not like the driving, weren't in a position to do anything about it. We cannot afford to get rid of all of our experts, even if they have been wrong in the past. Score zero.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It depends on the bonus. One year bonuses with no clawback based on mark to market profits clearly provide bad incentives. But multiyear bonuses with clawbacks based on realised gains may provide a good incentive. Score half.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.

No. Balance complexity with appropriate technology. Complex products can be appropriate, simple products can be inappropriate. It depends. Score zero.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.

No. It is enough to ensure that risk takers genuinely bear the consequences of their actions and that there is sufficient capital in the system for the risks being taken. If you ban dynamite, tunneling gets much more expensive. You just want to be sure it is civil engineers not terrorists who have the dynamite. Score zero.

7. Only Ponzi schemes should depend on confidence.

Nonsense. No one knows what a financial system that is not confidence sensitive might be like. That is an unsolved problem in finance. Score zero (with the judge contemplating taking away a mark for idiocy).

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.

It depends. Allowing firms to increase leverage is insane, and no regulator I know is permitting that (unless you could accounting games which result in over-stating capital). But governments can and should increase their borrowing at times like these. Score half.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.

So what, prey, do you suggest people use to save for retirement? Given I know of no asset whatsoever that does not fluctuate in value, this is a real question. Score zero.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

The sheer cliche density of that paragraph alone deserve a minus five.

Filling the hole

Alistair Darling faces a £39B in the budget. How can we fill it?

£14B from legalising drugs.

£20B from cancelling the Trident replacement that we don't need.

£5B from taxing non-doms and those earning over £100K.

Easy. My consultancy fee, if you are reading this Alistair, is a positively miserly 1%.

Entirely expected lawsuit of the day

From Bloomberg:

MBIA Inc. was sued by Third Avenue Management LLC... over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business...

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in its statement.

Strained, but not entirely silly banking system metaphor no. 151

Something for you to do

Willem Buiter, reneging on his earlier negativity on the IASB, quotes from a statement made on April 2, 2009 by the Trustees of the International Accounting Standards Committee Foundation:

Sir David Tweedie, Chairman of the IASB, reported to the Trustees that at their joint meeting last week the IASB and FASB agreed to undertake an accelerated project to replace their existing financial instruments standards (IAS 39 Financial Instruments, in the case of the IASB) with a common standard that would address issues arising from the financial crisis in a comprehensive manner. Though the IASB is consulting on FASB amendments related to impairments and fair value measurement, the Trustees supported the IASB’s desire to prioritise the comprehensive project rather than making further piecemeal adjustments.

This is good. They are not being rushed into anything, and they are not following the FASB in giving in to the banks. However it does make it vital that the IASB gets sufficient informed comment on fair value during its consultative process. I would encourage anyone who cares about these issues to visit the IASB page here, download the consultative document, and comment on it.

Finite reinsurance: a strange and sometimes manipulative thing

Thanks to AIG, the weird and wonderful world of finite reinsurance has come under broader scrutiny recently. (You may recall that a finite reinsurance policy between AIG and Gen Re was the method used to inflate AIG's earnings in the case that came to the courts in 2008.)

Now, thanks to the Big Picture, further amusing documents have achieved more general publication. I don't agree with much of the thrust of the post - which frankly contains altogether too much credit derivatives related hysteria. But the extra light on finite reinsurance is welcome.

When is finite reinsurance a valid business tool, and when does it verge on fraud? This is difficult to answer because finite reinsurance is a very sophisticated tool that can be used in myriad ways. But let me illustrate a good and a bad situation.

Good finite reinsurance. Suppose a company has a liability with a known size but uncertain timing. Asbestos-related claims are a commonly cited example: the firms knows it will have to pay workers for past exposure to asbestos, and it can estimate the size of those claims reasonably well, but it does not know when the claims will be presented as the sickness has a long and uncertain gestation period. The uncertainy thus created weighs on the share price, even though the company has every intention of paying and the resources to do so. Therefore it purchases a finite reinsurance policy whereby it pays a premium equal to (roughly) the present value of the expected claims to a large, well capitalised reinsurer. The reinsurer takes two risks: one small (that the claims will be larger than expected: this is unlikely as typically the risks insured under finite schemes have rather little uncertainty in claims); and one larger (that the claims will be presented earlier than expected, and hence the invested premium will not have grown sufficiently for them to make a profit). From this we see that finite schemes are often about transferring timing or investment risk rather than the risk of uncertainty in claims.

Bad finite reinsurance. Consider the effect of the scheme above though. Before the reinsurance, the firm had a known hit to earnings in the future but with uncertain timing. Afterwards, it has a stream of expenses - the premium payment or payments on the policy - but no uncertainty. Earnings have been smoothed. Clearly we can extend that effect more broadly via policies which pay out money in the future for an appearance of risk reduction today (buying surplus for an insurer, i.e. flattering their capital position) but where all of the risk comes back in later years, or via policies which move current profits into later years, smoothing earnings. Accounting rules do not permit you to arbitrarily reserve whatever amount of current earnings you like against some future risk, especially a very unlikely and hard to quantify one, but finite reinsurance policies achieve the same effect.

Finite reinsurance can therefore be used, quasi-legally, to manipulate earnings for many companies. It can also be used to manipulate insurance companies' capital position. If ever there was an area of finance crying out for better regulation, I'd say it was insurance.

The continuing equity/credit disconnect

I have written several times before about the equity credit disconnect of the last few years and its implication for capital structure arbitrage models. Recently, the disconnect has reappeared, as this chart of the day from Bloomberg illustrates:If there are any CSA funds left after the earlier dislocation, this would theoretically be a great time to go short equity long credit. The trouble is we now know that these dislocation can last for considerable periods, and reversion to anything close to the theoretical relationship is not guaranteed. Does this sound the death knell for capital structure models?

Correlation is not causality

From the social science statistics blog via Naked Capitalism, an amusing illustration of this truth:

The FASB buckles

Narrowly winning the award for most depressing news of the week (the runner up being Gillian Tett getting an award - and not one for most ignorant commentator on credit derivatives in a mainstream newspaper), Bloomberg announces:

The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules... The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities.

This is just terrible news for readers of financial statements, investors, and financial stability.

Update. You have to love Willem Buiter sometimes. His latest is entitled How the FASB aids and abets obfuscation by wonky zombie banks. Zombies are scary enough. But wonky zombies? Are they going to explain the dynamics of the money supply to you before they eat you? Or would that be wonkish zombies? Seriously, though, it is a good post: I recommend it. My only remark is that Willem is not sanguine about the IASB, whereas I am slightly more hopeful that they will not fall further into sin.

If you go down to the Bank today, part 2

Again, my favourite first:

If you go down to the Bank today, part 1

My favourite first:

Another failure to call

From the FT:

Mizuho Financial, Japan’s second largest bank, has opted not to repay a $1.5bn junior security at the first opportunity, adding to the list of [4] institutions globally that have not repaid similar debt and potentially aggravating some of its investors.

The instruments are perpetual subordinated bonds with calls and no-steps, paying 8.375%. This will further spook Tier 2 and hybrid Tier 1 investors.

Merkel, Sarkozy join protesters

In a sensational development, Angela Merkel and Nicolas Sarkozy have stormed out of the G20 summit meeting and joined protesters demonstrating in front of the Bank of England. Coverage from the Guardian's new Twitter service is here, and further background is here. This follows earlier threats by Sarkozy that he would leave the summit if he doesn't feel members are seriously addressing business regulation, and Merkel's NYT interview on Monday in which she stressed her opposition to the American stimulus package. Rumours that statues of Merkel and Sarkozy surrounded by demonstrators will feature in the planned Economist theme park are currently unconfirmed.

I want a new Porsche

No, not that car. I think they look horrible, and they seem to be driven entirely by idiots. The company. The following should be illegal. I guess that it isn't. But note that I have no idea if the sequence of actions discussed actually happened.

From the comments section of this post at FT alphaville, mildly edited for readability:

Porsche bought cash-settled call options from a number of investment banks.

The banks bought shares to cover their positions - thus reducing the free float.

The banks then lent shares to various hedge funds who were shorting the stock, apparently (rumour) with the encouragement of Porsche.

Porsche then bought the shares that the hedge funds were selling, thus completing the circle (but not falling foul of their claim that they hadn't sold [lent?] directly to short-sellers).

Porsche then announced their massively increased position and the stock price rose. The short squeeze was exacerbated by the fact that Porsche now had more of the stock than anyone thought and the majority of the rest was held by index funds who couldn't / wouldn't sell.

Remember, we don't know this was what happened. But if it did, it feels a lot like market abuse to me. So how come Porsche have been cleared? Ah, wait, could it be something to do with being a German hedge fund (that also makes ugly cars), rather than an American or British one (that doesn't)?

Bigger is worse

There is a meme going around at the moment concerning size in banking. The basic idea is that too big to fail banks are a bad idea. Various people have various ideas of what 'too big' is, with numbers like 300B total assets (a number floated in a nice post at Dealbreaker) being discussed. Interfluidity also has a good discussion here.

My own take is that limits - whether $100B, $300B or some other number - are hard to impose and liable to manipulation, e.g. through off B/S financing. Rather I would make regulatory capital a function of equity. The more Tier 1 you have, the less you can leverage it. At $1B of Tier 1 or below, say, you are allowed a Tier 1 leverage ratio of 25. At $17B, it would be 12, so the formula would be something like

permitted leverage = 20 - 0.5 x [max($1B, Tier 1) - $1B]
total permitted assets = permitted leverage x Tier 1

This formula has a maximum at Tier 1 = $20B, where it permits total assets of $200B (and of course total assets would be defined to include off B/S assets as well as on B/S ones).

Support the government

While we cannot of course in any way support Jacqui Smith in the current expenses row, honestly if you were married to the Home Secretary, wouldn't you need a lot more than a few minutes watching Jodie Marsh, or whoever, to get you through the day?

Change that revolts us

Interfluidity has a nice hypothetical:

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss... These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

I agree, with one exception. PIMROCK doesn't need to buy the whole $10B. It just needs to buy enough that the bank can mark the rest at 82. So probably it only puts in $1B rather than 10. The taxpayer loses less on the subsidy, but more via having to recapitalise JP Citi of America in due course, while PIMROCK loses much less yet still has protection on its bond holdings.

Gearing up for trouble

Even by the intolerably low standards of this blog, this one is going to be obscure...

I want to talk about gears. Bicycle gears. For ordinary people, rather than, say, drug crazed Americans who have recently broken their collar bones. So, what does a reasonable rider want from his or her gears?

• A bottom gear that is low enough to get up most hills. In practice unless you are really fit that means a gear of 42* or lower.
  
• A top gear that is high enough that you can pedal going down moderate hills. 100 is plenty.
  
• A fine spacing of gears in between.
  
• And in particular a relatively gentle change from the little to the big ring at the front.

It doesn't sound like much, does it? Yet pretty much all standard gear set-ups from the large manufacturers fail on one or more of these criteria. 39/53 or 39/52 at the front gives far too big a change. You want at most a difference of ten cogs, I would suggest, or the change up is too jarring.

To get a bottom gear of 40 with a front ring of 42, you need a big cog on the back of more than 27. You can't buy one. So that means that 42/52 at the front doesn't work either.

By this point we have eliminated all of the standard front gears available. What does work is 38/48 on the front, and 13/25 or 13/27 at the back. This gives a top gear of a shade under 100, a bottom gear around 40, and a relatively gentle change between rings. But that requires custom front rings. Why does it have to be so hard?

* The gear in inches is given by dividing the number of teeth at the front by the number at the back and multiplying by the wheel size (usually 27) in inches. The biggest gear is therefore the largest ring at the front through the smallest at the back: the lowest is the small ring at the front through the big ring at the back.

Transatlantic Coup

Simon Johnson has an excellent article in the current issue of The Atlantic magazine. His basic premise, as an ex-IMF chief economist, is that crony capitalism is a fundamental part of many emerging market crises, and it is only when the cronies are forced to take some pain that the crisis can be resolved. Furthermore he argues that this kind of coup, whereby power has been seized by a small group who manipulate the economy for personal profit, took place in the US during the Clinton and Bush years. Thus the Quiet Coup of the article's title. Go and read the whole thing: it is quite persuasive.

Strained, but not entirely silly banking system metaphor no. 150

Political Futures

I don't always agree with Michael Meacher, but this letter in the Guardian is so good, and hits the tone which is lacking in both the government and the official opposition so well, that I am going to quote it nearly in full:

We urgently need ... an alternative to the prevailing Tory-New Labour orthodoxy. I would propose three central strands. It should seek to restore a social democracy which has been ripped apart by greed and an out-of-control inequality epitomised by the banks' bonus culture. We need a solidarity tax levied on the top 5% of incomes and on the so-called non-domiciled super-rich - who use Britain but don't pay into it - with the proceeds hypothecated to end child and pensioner poverty.

We need to redraw the boundaries between the state and the market. The market fundamentalism of the last 30 years is well and truly busted. But ending privatisation, deregulation and PFI is not enough. We need a new perspective for the state, not - as now - passive facilitator and rescuer of last resort, but actively interventionist where the public interest requires it, and strong promoter of the key social values of accountability, equity and real equality of opportunity. A robust market has an essential role, but so does the state, not only in health and education (where private markets do not belong), but in energy (a key to national security), housing (neglect of which is the biggest repository of social misery), transport (for a fully co-ordinated system), and banking (to prevent another collapse and provide reliable housing for low-income households).

We need a state which is less an intrusive snooper and more the guardian of our civil liberties. And we need a major redistribution of power: away from a top-down state to disenfranchised citizens; away from top-down industrial relations to a fair and constructive role for trade unions: and away from a top-down politics to a much more genuinely participative system of governing.

Strained, but not entirely silly banking system metaphor no. 149