Moving on

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Bring a problem parties - speed therapy

Sometimes, when you are talking to someone, you come on an idea that makes so much sense you are surprised that it has not been thought of before. Often these ideas are not anyone's in particular: they emerge somehow in the conversation. Bring a problem parties are an idea like that.

To begin with, three observations. First, a pint is about the right length to talk over many problems. A pint shared lasts half an hour. With a good interlocutor, there is not much that you can't get some helpful insight on in half an hour. Second, independent advice on problems - be they emotional, practical or technical - is often useful. OK, I wouldn't ask the check out person in my local supermarket for advice on solving a high dimensional PDE, but often a random stranger can be helpful. Third, speed dating proves that if an experience is potentially interesting and short enough that a bad encounter is soon forgotten, then (some) people will sign up.

So, bring a problem parties. A selection of people, each with a problem. They are randomly matched into pairs, with one person selected as the solver, the other as the questioner. The questioner buys the drinks and presents his or her problem. The solver tries to help. After half an hour, a bell rings, and another round begins, with solvers as questioners and vice versa. Four rounds would be two hours, and you would be guaranteed two perspectives on your problem. It would also make for a more interesting evening than most. If you franchise it, cut me in please.

A manifesto

I suspect that some, perhaps a preponderance, of my readers are not of my political persuasion. So you might well disagree with the following. But with an election less than a year away, I wanted to write down the core of the manifesto I would propose if I had a big say in a political party. I don't, thankfully, and this is nothing like the platform any of the parties will contest the election on. But I still think the exercise is interesting.

The rules I set were to write down no more than two sentences in ten different areas. In no particular order:

• Education. Abolish the charitable status of private schools, and fold academies back into the ordinary state school system. Abolish student grants and increase university funding, including research funding, very substantially.
• Transport. Abolish road tax, increase petrol duties significantly, and eliminate the special treatment of airlines, including VAT on airline fuel. Invest substantially in carbon efficient transportation infrastructure including trains, buses and cycle networks.
• Taxation. Simplify the personal and corporate tax system, impose draconian penalties on any form of avoidance, and remove the non-dom status completely. Eliminate UK-linked tax havens such as Cayman, Jersey and Bermuda by forcing them either to join the UK tax code or removing their protection.
• Energy. It is too late for fission, so invest heavily in renewables and in energy saving. Push hard for fusion because if we can crack that one, energy becomes a non-issue.
• Defence. Cancel the expensive toys like the Trident replacement. Provide the ordinary soldier with the resources they need, like body armour and IED-proof vehicles.
• Foreign Affairs. Engage more positively with the EU. Revive Robin Cook's ethical foreign policy.
• Constitutional Reform. Introduce proportional representation and a fully elected House of Lords. Disestablish the Church of England and secularise the state, recognising the rights of believers and non-believers equally.
• Finance. Break up the majority state owned megabanks, Lloyds and RBS. Make capital requirement proportional to size to encourage a diverse system of banks that are not too big to fail.
• Liberty. Cancel the id cards project and other big database projects. Enact legislation to protect our historic liberties and roll back both state and private surveillance and data gathering.
• Industrial Policy. Develop a comprehensive policy across education, development aid and innovation support to encourage manufacturing and export-based industries, especially outside the South East. Reduce financial and other services as a percentage of the total economy.

Keynesian traps and flooding the building

A frequent correspondent sent me a link to Phillip's Economic Computer, a wonderful analogue device designed to illustrate the flow of money within the economy. And that got me thinking...

A very rough and brutal sketch of Keynes' classical account of the savings trap is that if people save too much, rather than consume, then the velocity of money drops, inventory builds up, growth falls (and even goes negative) as businesses cut back on production. A standard account of the liquidity trap by Krugman is here.

How does the Phillip's device help? Well, it points out a truth that is often hard to see, namely that money can only be created or destroyed by the central bank. Credit cannot be 'created' without funding; money cannot disappear. These days, rather little money is stored in mattresses or bank vaults: most of it is in the form of bank deposits, securities, or other investments. And of course those assets are someone else's liabilities, i.e. funding for them. Thus these days your choice is not between putting your cash under the bed and spending it: it is between putting it in a bank - which will lend it to someone else - and spending it. In this sense saving is not quite as bad as in the classical Keynesian account, as it provides funding for corporations and individuals who do want to engage in economic activity. Even buying government bonds is not useless as the government spends the money on something.

Now of course the increase in economic activity provided by a dollar of spending on goods may be rather more than that provided by a dollar of bank deposits. But it is worth noting that the dollar of bank deposits are not useless: the bank has to do something with your money, and that something probably has positive economic value. Anything else would cause funds to build up rather too fast at the bank - something the Phillip's computer would model as water flooding out...

One of the many reasons I am depressed

Barry Ritholtz writes:

I believe the brain trust behind the Obama White House has made a huge tactical error.

As Rahm Emmanuel likes to say, one should “never waste a crisis” — and the White House has done just that...

There was widespread popular support for a full reform of finance. What the White House should have pursued was: 1) Reinstatement of Glass Steagall; 2) Repeal the Commodity Futures Modernization Act; 3) Overturning SEC Bear Stearn exemption allowing 5 biggest firms to leverage up far beyond 12 to one; 4) Regulating the non bank sub-prime lenders; 5) Continuing high risk trades to be compensated regardless of profitibility; 6) Mandating (and enforcing) lending standards, etc...

Instead, we have a White House that appears adrift, and the most importantly, may very well have missed the best chance to clean up Wall Street in five generations.

I agree with the conclusion: and it is deeply depressing for those of us who have devoted a lot of energy to arguing for reform.

Ritholtz's prescription isn't quite mine: I am less convinced about the benefits of a Glass-Steagall style split, not least because many European banks managed to be universal without being dangerous; rather I would prefer to see action to split up too big to fail institutions, combined with increased regulatory capital requirements that really constrain leverage for all systemically important risk takers. But the details don't really matter: doing something does.

Adair dares, and other unlikely tales, updated

The headline, of course, should have been British bank watchdog states the blatantly bleeding obvious, but I suppose that is a little more sensational than Financial Services Authority chairman backs tax on 'socially useless' banks. Still, most observers would agree with Lord Turner that much financial activity is socially useless; that the banking sector is too big for the good of the economy; and that Tobin taxes would provide useful revenue while slimming down the bloated banks.

(Update: I should really say something about why Tobin taxes are good from a financial stability perspective. The point is that they introduce more friction into the financial system. Even a small absolute increase in bid/offer spread, when spreads are low, dramatically reduces arbitrage opportunities, and thus 'useless' financial activity. A real money transaction - driven by global trade for instance - would not notice an extra 0.05% on their FX rate; but a program trading volatility would. The same applies in the equity markets: one way to reduce the impact of high frequency trading is simply to make it (marginally) more expensive.

It is interesting to see Lloyd Blankfein, Goldman Sachs' CEO, agreeing with Turner that some of finance had become socially useless. There were always useless parts, of course, but the fraction has grown significantly over the last 20 years.)

So how would we make this work? Well, how about this for a Europe-wide proposal. Transactions physically done in Europe are taxed. In order to (a) sell securities to a European domiciled investor, (b) take deposits in Europe or (c) trade derivatives, FX or repo with a European counterparty, you have to demonstrate that you pay the tax on your global business too (although not necessarily to a European government: any old government will do). OK, some banks would decide to leave Europe entirely. But most wouldn't if the level of the tax was sufficiently low...

HRbots and the false comfort of quantification

One of my favourite cartoon characters is the evil HR director Catbert, from the Dilbert series. Catbert epitomises the Machiavellian intrigues and Catch 22s that epitomise the HRarchy. The character would be funny if she wasn't so accurate.

Catbert immediately to mind when I read a Netflix presentation on their corporate values (hat tip Felix Salmon - who seems to have subsequently deleted the longer laudatory post about these slides). To precis hugely, Netflix say that they want the best people, they reward them at the top of the market so that they don't want to leave, and they get rid of the merely mediocre.

A moment's inspection of course reveals this to be an utter crock, in best Catbert tradition. First, it assumes that the firm's internal mechanisms can tell if a person is any good or not. Second it assumes that being good is invariant over time: if you are good today, you'll be good tomorrow; and if not, not. And third it assumes that a company full of good people is somehow a good thing. All of these are false.

Appraisal mechanisms, 360 feedback (or 720 or whatever) and the like are fascinating and important (from a financial standpoint) games. But I have never come across ones that do not simply validate manager's prejudices. They often bear essentially no relationship to job performance.

The second point is even more important. An employee can be useful in some situations and less so in others. They can sit around for ten years doing nothing much useful, then save the firm. Or they can make a reasonable contribution every year without ever being a star. They can (and in the case of star executives often do) perform wonderfully for years then suddenly screw up massively.

The most pervasive HR lie of all, though, is that somehow it is in the company's interests to have 'the best' employees. Have you ever tried managing a team of star performers? It makes herding cats look easy. They get bored; they all want to know what their career progression is; they fight. I'd much rather have one or two good people and a leavening of average performers. More will get done.

Furthermore, firms need diversity. They need it for the simple business reason that conditions change. If you staff up to optimise for environment X, and then suddenly find you are operating in environment Y, then you are likely to fail. But if you have a bunch of reasonably OK people who are willing to put in a decent day's work for a decent day's pay, then they will probably change what they do to help you out. Their self worth is not tied up with being the best person in the world at their job, and so they will probably not get depressed and sulky when it turns out that they aren't any more.

No, meritocracy is a very dangerous concept. It assumes you can identify the meritorious, and that it is in the firm's interests to have more of them. The more I see of firms, the more convinced I am that neither of those two things is true. Hire some reasonable people. Pay them reasonably. But don't whatever you do ever make the mistake of believing anything someone from HR tells you.

Oh I do love to be beside the sea side

Willem Buiter took a month off from his FT blog, and I think I am going to follow that lead, so expect something in September. Meanwhile, here's some coastline.

This collateral smells a bit off

From Bloomberg:

The vaults of Credito Emiliano SpA hold the pungent gold prized by gourmands around the world -- 17,000 tons of parmesan cheese.

The regional bank accepts parmesan as collateral for loans... [its] two climate-controlled warehouses hold about 440,000 wheels worth 132M Euros...

The bank offers loans for as long as 24 months, equal to the time it takes the parmesan to age, at the euro interbank offered rate, plus 0.75-2%.

I love commodities finance. Particularly when you can eat the collateral if the loan goes bad.

Excess Liquidity

Ian Campbell, on breakingviews.com, has a nice statement of a view I have had for a while.

in their anti-deflationary fervour, central banks may be creating more money than depressed economies require. The surplus creates "excess liquidity" - which may be feeding a new series of stock, commodity, property and bond bubbles...

Sebastian Becker, an economist with Deutsche Bank in Frankfurt, defines excess liquidity as money supply that is surplus to the needs of real economic activity, and therefore free to be invested in financial assets. Becker combines monetary growth figures for the US, Japan, the eurozone, the UK and Canada and finds excess liquidity - measured as a rising stock of money to GDP - in these economies is now being created more rapidly than in the late 1990s stock-market bubble, or during the subsequent house price boom.

Excess liquidity is a really hard thing to estimate, as it is the difference between two really big numbers: the supply of money, and the economy's demand for money. But this really is a Goldilocks situation: you want the money supply to be just right for economic needs. If, perhaps because you are worried about the banking system's access to liquidity, you supply too much, then it is just going to be invested in financial assets, creating a bubble. Are we, I wonder, in the early phases of the first post Crunch bubble?

Monoline Death Watch

Felix Salmon discusses some recent JPM research on MBIA:

in a note issued this morning they said that MBIA’s tangible book value is actually negative, to the tune of about -$40 per share.

OK, the full article has some caveats. But the mere fact that a reputable investment bank (if that is not an oxymoron) can suggest that MBIA is insolvent should raise some warning signs about the extended historical fiction that is insurance accounting.

Reasons to stay flat?

From Morgan Stanley. I find this a reasonable one slide account of where the equity markets are, but that's just a personal take.

Controlling complex systems

From an entirely different context, a rather useful metaphor for what happens when you get the rules of the system right:

attempts at self-control result in a competition between independent processes and that the amount of top-down control biases the competition appropriately

I am increasingly of the view that neuroscience has more useful things to say to finance than conventional economics does.

Inefficient Units of Currency

By Joseph Streckert, from the Canadian literary magazine McSweeney's:

• Children
  
• Millstones
  
• Imaginary euros*
  
• Copies of Now That's What I Call Music! Vol. 7**
  
• Pieces of long-grain rice that are not actually very long
  
• Unicorn heads
  
• Canadian dollars

*Arguably, the ECU (which worked perfectly well as a currency) was imaginary.

**Vol. 7 is I suspect now a collector's item. The current volume is 73.

The notable glibness with which the writer throws off chains of causation

I have nothing to say, really, I just wanted to repeat a lovely phrase from the comments to the post before last.

Things here will be slow and less finance-oriented here for a little while for two reasons: firstly, I have been intending to move this blog away from blogger for some time, and I really want time to look into that. Secondly, the spectacle of the utter failure of reform is depressing me slightly, if not causing a Touretteish Torrent.

Creativity

A lovely rant from Jenny Diski on the LRB blog:

... I’m left wondering what the word ‘creative’ means to people who can overcome difficulty by just being creative. It seems to be like an ingredient that’s available down the shops. If it’s necessary, you’ll get some and use it. Need to produce something? ‘Oh, just think creatively.’ I want to say, how do you think creatively? What is thinking creatively? But I don’t want to let on that I’m ignorant of a process everyone else seems to understand perfectly.

It’s a word I’ve never been able to use because I don’t know what it means really. Creative writing? As opposed to? Does it mean imaginative? OK, now imagination is called for. Right, there you go. How confident everyone seems to be about having the ability to be creative, and knowing what to do with it, and how very little effect it seems to have on the vast majority of products it is sprinkled on.

I especially like `Creative writing? As opposed to?'

Deprogramming Obama

A nice slant from Salon: the president is a prisoner of the cult of neoliberalism.

Don't judge me

Paul Krugman has a post entitled Rewarding bad actors. He takes the view that two situations - the profits from high frequency trading at Goldman (and presumably elsewhere) and the payout to Andrew Hall at Citi's Philbro arm - are undesireable. The common thread, he says, is

in both cases we’re looking at huge payouts by firms that were major recipients of federal aid... What are taxpayers supposed to think when these welfare cases cut nine-figure paychecks

Now, I happen to agree with Krugman that both of these situations suck. However, I think his characterisation of the problem is wrong. He says.

we’ve become a society in which the big bucks go to bad actors, a society that lavishly rewards those who make us poorer

In other words, the problem is bad people. That's too easy. It allows us to point out fingers and take no responsibility. No, the problem isn't evil people. The problem is that we have created a system where unhelpful actions are rewarded. It is the system that is at fault, not the actors. This means that many people are responsible: everyone who failed to promote or support change, and all of those who shaped and defended the current system. Yes, that does include me. But at least I am trying to promote a debate about what rules we need for the future.

Come backs

Just don't do it. That's surely the lesson we learn from sporting comebacks. Lance could only manage third in the TdF - a creditable showing, but hardly the position he was used to. With luck, Michael Schumacher will be similarly unable to reprise his form of years gone bye. As Kevin Mitchell wrote in Sunday's Observer, come backs make for a compelling spectacle, albeit one that is often not to the credit of the protagonist. Perhaps Damon Hill, who Schumacher pushed off the track in one of the worst display's of unsportmanlike behaviour I have ever seen, will enjoy next weekend's schadenfreude. The rest of us should just contemplate a modern memento mori. When it's time to go, just go.

Discrete, discreet trading

One of the things I was concerned with many moons ago is the difference between the types of behaviours you can get in discrete and continuous time. Continuous functions are funky beyond belief, and the less you have to reason about them, generally the better. (For a sample of some of the pathologies, see this book.) Therefore I was particularly interested to read a suggestion by Michael Wellman on making equity trading safer (and, by disallowing order sniffing robots, more discreet) by making it, well, more discrete. Here's the idea: Wellman suggests

a discrete-time market mechanism (technically, a call market), where orders are received continuously but clear only at periodic intervals. The interval could be quite short--say, one second--or aggregate over longer times--five or ten seconds, or a minute. Orders accumulate over the interval, with no information about the order book available to any trading party. At the end of the period, the market clears at a uniform price, traders are notified, and the clearing price becomes public knowledge. Unmatched orders may expire or be retained at the discretion of the submitting traders.

This is really a nice idea. Real users would notice no difference between a market discretised in ten second blocks and a continuous one, but at a stroke bad high frequency trading would be eliminated. Add in a minimum (but low) bid/offer spread too, and the system becomes significantly more robust. The high frequency traders can no longer take your money off the table.

Fact as fiction, and other storytelling techiques

One good way of telling the truth obliquely is to pretend that it is fiction. This was an established technique for ex-spys to spill the beans; and it works for bankers too. Humour is good here - it makes it clear that the author has enhanced the story for comic effect. Except that often they haven't. The Epicurean Dealmaker is a master at this style: often he sounds as if he's relaying a shaggy dog story over a martini in the Library Bar at the Laneborough, when he's actually just giving you the inside track. This passage, though, is uncharacteristically straight. He's talking about the perceived (and actual) success of Goldie:

360-Degree review systems, 24-hour response voice mail, and rotation of bankers through different departments only work when senior managers refuse to make exceptions to the rules. There are a nauseating number of investment banks which profess an undying commitment to teamwork and a dedicated focus on cultivating client relationships rather than chasing transactions. But these banks fall short time and time again because they do not enforce these principles. If Mr. Big Swinging Dick Managing Director who brings in a billion dollar IPO or a ten billion dollar merger throws a hissy fit and threatens to stomp out the door if he has to share credit, or a successful M&A banker refuses to manage a group in Capital Markets, or a Group Head inflates the review scores of all his subordinates to boost their pay and his power, senior management can either hold firm and preserve the culture, or they can cave. If they hold firm, everyone else at the bank hears about it, and they learn that the rules and the culture will be enforced. If they cave, everyone knows that too, and it's off to the bad old races of "what's in it for me." Sadly, most investment bank executive teams cave.

Michael Lewis would have illustrated this story with a mildly amusing tale of bankerly bad behaviour. Other journalists would perhaps have tried to garner outrage before they had even finished making the point. But, being an insider, ED is smart enough to know that the sex, drugs and science fiction work best as garnishes for the real erudition.

Sovereign credit quality and foreign currency borrowing

Ambrose Evans-Pritchard in the Telegraph has an article about Iceland. He notes that the Icelandic krona has fallen by half against the euro since the dark days of 2008, and as a result there has been something of a recovery in Iceland. Unemployment is high, at 9.1%, but still below the Eurozone average. The head of the central bank is quoted as saying: "If you lean back and look you can see that fall of the krona accentuated the shock at first, but it is also now working as a turbocharger for recovery.

So, when can countries devalue their way out of trouble?

One important factor is the currency of debt. If most of a countries' debt is in local currency, then devaluation is more likely to be effective. Clearly you can use a combination of inflation and devaluation to reduce the real value of your debts. If you have a significant amount of debt - government or otherwise - in foreign currency, then things are a lot more difficult. This is partly why I am sceptical about buying the Icelandic recovery hook, line and sinker. (They are, after all, reliant on ever decreasing fish stocks too.) A lot of retail borrowing in Iceland was in Euros. The same applies to the Baltics and the Eastern rim of the Eurozone. Ambrose-Pierce admits this is a problem, noting that `Some 13% of households in Iceland hold mortgages in euros, Swiss francs, or God forbid, yen [and] some 70% of corporate loans are in foreign currencies.' That strikes me as a fact pattern that justifies Iceland's foreign currency debt rating. Clearly Iceland is on the up, but it is not out of the woods yet, and it won't be until investors are confident that it can pay its debt in their currency of denomination.

Moooo

In an article reminiscent of Cows accused of spending a lot of time in fields, Floyd Norris writes in the NYT:

Politicians Accused of Meddling in Bank Rules

He continues with more sound (if rather obvious) comment:

Accounting rules did not cause the financial crisis, and they still allow banks to overstate the value of their assets, an international group composed of current and former regulators and corporate officials said in a report to be released Tuesday.

The report, from the Financial Crisis Advisory Group, also deplored successful efforts by politicians to force changes in accounting rules and said that accounting standards should be kept separate from regulatory standards, contrary to the desire of large banks.

The report is here.

Corporate default rates by year and industry

The details are below: click for a larger picture.

Instability and the cover rule

In the old days of equity derivatives, one of the main instruments was the covered warrant. This was a call option (usually - put warrants are uncommon) issued by a bank and traded as a security: it gave the holder the right but not the obligation to buy some number of underlying shares at a fixed price. This market still exists, and is reasonably active in some countries.

The term 'covered' come from the early regulatory framework. In order to prove to the exchange that the issuer of the warrant could meet their obligations, they had to keep some or all of the underlying. This position in the underlying was known as the cover: it ensured that if the warrant ended up in the money, the issuer could deliver shares to the warrant holders. (Obviously if a corporate issues warrants on itself, then there is no problem: an entity can always print more of its own shares. The issue arises when a bank issues warrants referencing shares in another corporation, often without that corporation's permission or support.)

The cover requirements were supposed to ensure that squeezes did not happen whereby the issuer was forced to pay higher and higher prices to buy shares against the warrants that they hold. This is an issue with less liquid underlyings, especially ones where most of the liquidity is controlled by a small number of parties. By forcing banks to buy the underlying before issueing the warrant, exchanges made market disruption much less likely.

There is definitely something that we can learn from this piece of market history. When derivatives traders are forced by regulation to have a matching position in the underlying, then:

• There is a natural limit on the size of the market;
  
• Both derivatives and underlying markets are more orderly; and
  
• The issuer's risk is automatically limited.

When that is not the case, things can get a little crazy. Let's look at two examples.

The first is the CDS market. I am a supporter of this market, and I view many of those who wish to limit CDS trading as uninformed, hysterical or both. (People called Gillian who have a book to plug may well fall into this category.) However, there is one reasonable objection to CDS, and that is that it sometimes allows the tail (the derivatives market) to wag the dog (the underlying bond or loan market). I have no objection to letting people short credits, but doing so by CDS can provide more protection sellers than there are bonds, creating exactly the sort of squeeze post default that the cover requirements eliminated for warrants. The lack of a borrow market for corporate bonds is the real culprit here. Perhaps one solution would be to keep the CDS market as is, but to require that naked shorts pay a credit borrow fee to a holder of a deliverable instrument. This fee would be in exchange for the bond or loan holder agreeing not to buy protection on it or lend it to anyone else: the fee would automatically ensure that no more CDS protection was sold than there were bonds (or loans) extant which would at least make it more likely that the CDS settlement was orderly.

Second, the commodities market, specifically oil. This post was inspired by a fascinating article on the oil market from the Oil Drum (via FT alphaville). One part of the author's arguments is that the existence of an enormous market in financial contracts on oil has resulted in considerable price volatility - perhaps even price manipulation - which is in the interests neither of producers nor consumers of physical oil, but which benefits intermediaries such as the investment banks considerably. Certainly if one believed that this is true - and the evidence is impressive - then again the solution is obvious: require all derivatives positions to have a physical hedge. If you are short, then you have to own the underlying. If you are long, then you have to borrow the underlying. A given barrel of oil can act as the hedge for just one contract. And you can only use deliverable oil - stuff in tanks - not oil that is still in the ground.

This cancer

For once not the banks. Rather I am picking up an interesting article via Infectious Greed on properties of the Honda Accord through time. Who would have guessed that it was most economical in 1985? Or that it has increased in weight by nearly 50% since 1980?There are too many cars, they use too many resources, and there are too few credible alternatives to them. The Accord's trajectory is just a minor illustration of quite how screwed up we have allowed transport to become.

Introducing Algo

Given that I used to be a computer scientist, my knowledge of algorithmic trading, aka high frequency trading, is shamefully slight. Partly it's because the technology has improved vastly over the last five years: the algo guys used to be three or four nerds in the corner of a vast equity trading floor; now, everyone else is a small corner of their trading arena. If you are as behind on this story as me, you might find this article in the NYT helpful. It does at least make it clearer where the money comes from.

Cry havoc and let slip the dogs of war accounting

OK, the revised version is perhaps a touch less catchy. Bloomberg reports:

The FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

So the Americans are showing some guts. Good on them. This will be an interesting showdown. The FASB, in white hats, are holed up in a one horse town with the evil banker boys coming after them; their old allies, the IASB gang, have abandoned them, and they only have unarmed readers of financial statements supporting them.

Robust finance

John Kay in the FT comments on a theme that is central to this blog:

Any engineer will tell you of the importance of making complex systems robust. You need inspections to prevent failure, to be sure: but since failures are inevitable it is equally important to try to ensure that the consequences of such failure are contained.

This observation is as relevant to economic and financial systems as to technological ones. Designing them with components too important to fail is a prelude to disaster, as we know. In the financial sector, the problem of disruptive linkages between components has become known as the problem of systemic risk... the main source of systemic risk is within large financial conglomerates themselves.

Kay gets the solution wrong though. He suggests that the risky component as he sees it - investment banking - should be isolated from the rest. That's foolhardy on two grounds. First, it wasn't investment banking that caused the crisis. Derivatives weren't the problem, after all: it was mortgage lending. The lesson here is that the risk often isn't where you think it is, and so isolating the risky part of the business is not straightforward.

Instead we should accept that any component might fail, and thus to keep the linkages between all components sufficiently loose that no failure can bring the whole system down. That involves increasing capital and liquidity requirements, decreasing counterparty exposure, and taking a particularly conservative view of systemically important institutions.

72%?

From Bloomberg:

Morgan Stanley set aside 72 percent of its second-quarter revenue for compensation and benefits, more than Goldman Sachs Group Inc. or JPMorgan Chase & Co.

Why on earth do the shareholders tolerate this? That's nearly three quarters of their money, money that they as owners of the firm deserve, that is going out the doors again to employees. If I owned Morgan Stanley stock I would be outraged. Instead probably most of them have so little sense that they are probably buying wrapping paper for really large piles of money as you read this.

39 Steps

No, not a (really rather good) novel by the 1st Baron Tweedsmuir, but rather the steps to revise IAS 39. For those of you who have not been following this slightly less gripping drama, this is the international accounting standard relating to the valuation of financial instruments.

The IAS 39 replacement project is proceeding in three phases:

1. Classification and measurement
   
2. Impairment methodology
   
3. Hedge accounting

We are at phase 1, but this is in many ways the most important one as it relates to the fundamental question what is a financial instrument worth?

The current proposals are a bit of a curate's egg. The good parts first.

• The available for sale category is eliminated. All instruments are either held at fair value or amortised cost.
  
• The treatment of embedded derivatives is simplified.
  
• There will be only one approach to impairment, and it will be used for all instruments in the amortised cost category.
  
• Only loan-like instruments can valued using amortised cost.

Much of the complexity of IAS 39 is eliminated, and the resulting accounting standard should be easier to apply.

The big problem, though, is the availability of amortised cost for some assets. Provided a financial asset is debt like, managed on a yield basis, and the institution's strategy is to hold it to maturity, then they will be able to use amortised cost accounting. This means that the ability to lie about what your assets are worth is preserved. It means that the same bond can be held at two different values by different institutions as one could use fair value and the other amortised cost. If a very firm approach is taken to impairment, and this approach is actually implemented by the audit firms, then perhaps this will not be a total disaster. But I still worry that the basic principle of true and fair has been obscured by the banks' desire to smooth earnings.

In their podcast -- even accountant standards setters make podcasts, -- the IASB say:

While fair value could provide useful additional information [for investors], the board believes that the cost of providing that information likely outweighs the benefits [in some cases].

I have to say that I don't share this belief. I think that the benefits of trying to estimate fair value are great both for the reader of financial statement and for the preparer. Of course, finding fair value can be as hard as finding an allicorn, and there can be considerable subjectivity in the process. But I still want to know what an institution estimates its assets are worth now, not what they might be worth if their strategy is successful.

The modifier on innovation

There has been a fair amount of discussion recently about financial innovation. Willem Buiter has suggested that new financial products should have a licensing regime akin to drugs, and Felix Salmon has written provocatively on the link (or lack thereof) betweeen innovation and economic growth. This should be read in the context of David Warsh's work on Knowledge and the Wealth of Nations, a work that this post from Science Blogs reminded me of.

So, what do we know? First that certain infrastructures help innovations generate wealth. The ability to profit from a good idea helps, as does the ability to finance development. Hence patents and joint stock companies. Education is necessary, and law which gives certainty of ownership is also helpful.

Next, we know that most innovation does not produce growth. A lot of it isn't harmful, but there are many, many dead ends. Markets are sometimes (but not always) good at sorting out which ideas are useful.

Now to specifically financial innovation. The point of financial innovation is to produce products which meet specific needs better (more cheaply, more accurately), and thus often to lower the cost of finance. Some innovations have worked out: a good example would be the convertible bond, which allows companies to monetise the volatility in their stock price. Others have been more or less useless but benign. Credit spread options are a good example here: in the early days of credit derivatives, these were a competitor with CDS as standard credit risk transfer products. CDS turned out to work rather better, and so credit spread options faded into illiquidity without doing anyone any harm.

Are there genuinely harmful wholesale financial products? I am still not sure that there are. I certainly can't think of one*. If firms are required to keep enough capital against the risk of a product; to value it properly; and to document it carefully, then why should trading be constrained? Isn't product licensing just a route to a less efficient economy?

*Tradable emissions permits come pretty close though.

Update. There is a nice rebuttal of the `innovation causes crises' meme from the Economics of Contempt here.

A small town in Switzerland, part 3

Glorious, glorious, glorious is the day: yet more Basel. Here's a key passage from BCBS158:

Factors that are deemed relevant for pricing should be included as risk factors in the value-at-risk model.

If you took the committee at its word, here, no one would have a VAR model. Just consider an equity derivatives book on underlyings in the Eurostoxx. There are 50 underlyings, 50 dividend yields (more if you consider the term structure of dividend yields), at least 20 interest rates in Euros, and as many implied volatilities as you have (strike, maturity) pairs for your options. A decent sized book will have many hundreds, perhaps many thousands, of risk factors. No one has a VAR model with all of those factors in it. So, what is a bank to do? Let's turn back to the committee:

Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the bank must justify this omission to the satisfaction of its supervisor.

Ah lovely. So if you have a tolerant supervisor, perhaps because you are in a small country, or because you are a national champion bank, all is well. If not, you will have some hoops to jump. This provision in short is a charter for regulatory arbitrage. The next part is even worse:

In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage-backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the supervisor has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).

If this doesn't make players with big trading books redomicile to somewhere small, low tax and friendly, I don't know what will.

When a technology dies...

...you sometimes get a decent monument. Here are the sound mirrors at Denge, Dungeness.

Well that went well I think

From Wells Fargo via Creditflux:

In their latest research report, Wells Fargo (formerly Wachovia) analysts calculate that 360 CDO of ABS have now triggered an event of default – up from 343 last month. At $351.6 billion, the notional value of these deals accounts for just over half of all CDOs of ABS.

A small town in Switzerland, part 2

The review of the changes to Basel 2 now moves to the credit risk rules. There isn't much that is new here either: some tweaking of the credit conversion factors for liqudity facilities, and a new, seemingly penal treatment of CDO squared positions (which the committee in keeping with its mission to call everything by a different name to everyone else, call resecuritisations). Here are the risk weights:
Two things spring to mind at once. The classifying criteria is rating. That's right - the ratings agencies, who did such a sterling job at rating ABS that they are facing multiple lawsuits and much approbrium, are still at the heart of regulatory capital. And given that, 20% is hardly penal for a AAA CDO squared tranche. Roll on re REMIC.

Is Goldman just a credit punt?

The Big Picture suggests that it might be, and provides this initially compelling illustration (which I have edited slightly to make it less confusing). However, I think that what we are really seeing is that both overall credit spreads and Goldman's stock price are driven by confidence. The more economic activity there is, the more money Goldman can make from the flow. A similar phenomenon was observable with the Merrill stock price in the 90s -- it acted like a call on the S&P, for similar reasons.

Update. Given ...the furore about Goldman's continued use of a SEC rather than FED VAR calculation, despite being a bank holding company, I am driven to wonder how big Goldie's IRC is. If it is just a giant credit punt, one might expect it to be enormous...

A small town in Switzerland, part 1

First the simple part. The new revisions to the Basel capital accord include Incremental Risk in the Trading Book. I have already commented on these proposals before, and there is nothing really new in the final version. In particular, there is still no clarity over what specific risk might be for, exactly, if you have incremental risk charges as well. My inference is that the IRC proposals are for those who are using a VAR modelling approach, and that the ordinary specific risk haircuts apply to everyone else. But (so far as I can see) the modellers have to calculate both a specific risk VAR and the IRC.

[My interpretation of the scope of the IRC is based on the following text from BCBS159: 'the IRC encompasses all positions subject to a capital charge for specific interest rate risk according to the internal models approach to specific market risk but not subject to the treatment outlined in paragraphs 712(iii) to 712(vii) of the Basel II Framework', 712(iii) to (vii) being the standard rules approaches for specific risk. Caveat lector.]

The world's least favourite airline

I'm still digesting the proposed changes to IAS 39 and to Basel 2 (you wait two years for major accounting and regulatory change then two of them come along at one), so for now I'll just quote a delightful Luke Johnson column in the FT. I read it on a plane, and I agree with this wholeheartedly:

BA has become an institution run not for the benefit of its customers – who provide its revenue – but for its staff and pensioners. Its shareholders, meanwhile, have long been forgotten.

If a firm like BA isn't a conviction short, I don't know what is.

Goldman humour

From John Kemp via Felix Salmon:

Taking out the leverage

The FT has an article today on re-equitisation. The basic idea is that some assets can be structured in such a way as to generate a bond-like series of cashflows, but rather than tranching them into a true bond plus a residual, it can make sense to treat the whole investment as an equity. The key advantage is flexibility: you don't have to worry about bond defaults if things go badly, giving you more freedom to wait out problems.

The private equity industry has known this for a long time. By structuring an investment as unlisted equity, they have been able to take advantage of good opportunities with uncertain payback horizons. The example the FT cites is a real estate investment, an area which has not historically been favoured by private equity, but these are new times. (Another area where equity like financing is preferred is of course sharia-compliant finance, but that is another story.)

Reequitisation, then, is a logical trend. After the recent turmoil, many investors would be happy with boring, safe investments that beat cash. If zero or low leverage equity investments in cash cow assets provide that, then for a while at least, investors will be buying them with alacrity.

Update. There is an article with a similar theme, albeit dressed up in rather grandiose language, in the FT.

Do loan mods reduce delinquency rates?

If you get into trouble on a mortgage, and you are American, and you are offered a loan modification, it is unlikely to help much. The following data is from the Big Picture. Barry explains:

On the left we see the re-default rates of homeowners who were current on their loans when they first defaulted (sounds odd, I know, but these tend to be people who can afford their homes but who subsequently ran into economic problems). The data tells us how many of them have defaulted again 10 months after their loans were modified.

The adjacent table (at right) shows the same thing, only this time with homeowers who were seriously delinquent prior to loan mods. As you would imagine, their re-default rates 10 months after their loans were modified are considerably higher. These are often the people who could barely afford their home (or not at all).

Shape of regulation summary

Understanding ABS

The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:

It's important for people to realize that the credit crunch was not caused by securitization -- it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.

It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.

Another key issue is that people didn't - and to some extent still don't - understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.

AAA to A3 check, 2/3 A3 to AAA mate

Sorry, I couldn't resist the bastard cross of chess and bond ratings. Let me explain. Once upon a time there was a leveraged loan CDO arranged by Goldman called Greywolf. Greywolf, which sounds like a monster who wants to gobble up your money, was in fact a monster who wanted to gobble up your money. In the fullness of time, the AAA tranche was downgraded to A-, or A3 in Moody's speak. Now, according to Bloomberg, Morgan Stanley is doing the Re-REMIC (aka CDO-squared) trick on the Greywolf AAAs. That is, they are buying the AAAs into a SPV and issuing two tranches of notes on the other side, a CDO-squared structure. Bloomberg suggests the tranching is roughly two of AAA to one of Baa2.

My only question, really, is if these new bonds are downgraded too, will someone else step in and ReRe-Remic them?

Growth vs. Stability

I have a conjecture. Like most conjectures in finance, it isn't susceptible to proof. Indeed, were people to act as if it were true, it might well change the system enough that it was no longer the case. Anyway, here it is:

There is a tradeoff between growth and financial instability. The system can be worse than the limit - more unstable or slower growing - but it cannot be better.

One of the reasons I think that something like this might be true is that a supply of cheap credit allows faster growth, but at the cost of instability when there is a downturn. A recent article in the FT supports this. As you might expect, securitisation - the primary cheap credit channel - has come to a grindng halt in many areas.As the FT says:

...the freeze in securitisation markets has led to a dramatic shortage of lending power – a “credit crunch”. Thus the policy question now is whether there is any way to restart or replace this securitisation “motor” to stop the economy slowing further.

This implies of course that faster growth is necessarily a good thing. If the conjecture is correct, then shouldn't we have a discussion about its consequences rather than going broke for growth again?

FSA gets medium rare

Medium rare being of course far from tough. From the Times:

The City regulator said some fines could treble in size as it seeks to address concerns that penalties thus far have not proved much of a deterrent in improving company behaviour.

It also announced proposals for a minimum fine of £100,000 for individuals found guilty of market abuse offences such as insider dealing. Up to 40 per cent of an individual's salary and benefits could be taken, it said.

Why not 100%? Why not 'all their assets'? Drug dealers have all of their assets seized - are we really saying that selling grass to make thousands is completely evil, but insider trading for millions is only 40% evil?

Titled Coffee

This blog was named partly in honour of a system that does actually work well, coffee in Italy. It's good, it's cheap, it enhances many people's lives, and there is a modest living to be made in it. Given my proclivities, I should probably have used Deus ex presso instead, but I liked the partial homophony of macchiato better. Anyway, here's your link of the morning -- high does of coffee have some preventative effect against Alzheimer's. Apparently. Of course like most people I prefer to pay attention to those articles which laud the benefits of things I like (red wine, coffee, ...) and ignore those that mention how harmful they are.

Counter-cyclical capital

I flatter myself that I was one of the first bloggers (although far from the first academic) to comment on the need for anti-cyclical capital rules. Three years later, this is becoming accepted wisdom. People still seem to think that identifying the cycle is difficult. I'm sure it is not, and I identified a number of indicators that could be used to set capital levels in my book. Now the BIS annual report has reviewed several possible indicators: credit spreads, changes in real credit provision, and a composite indicator that combines the credit/GDP ratio and real asset prices. And, rather unsurprisingly, they all work to a reasonable degree.

Meritocractic mistakes

Paul Kedrosky has a fascinating post on Infectious Greed about the Peter Principle.

The principle says, of course, that people climb in an organization until they reach their level of maximum incompetence...

Kedrosky discusses a simulation of organisational behaviour with meritocratic promotions and where competence in a new job has low correlation with competence at a prior level.

The authors simulated the preceding in a pyramidal organizational form using a mathematical agent model. Here is the outcome...

not only the "Peter principle" is unavoidable, but it yields in turn a significant reduction of the global efficiency of the organization.

And, of course, random promotions are better for the organisation than meritocratic ones. The source material is here. Now just try telling that to the HR bots...

Just privatise them?

Ken's right. Can we now, please, at least five years too late, renationalise the railways. After the National Express disaster, it is time to acknowledge that PFI is bollocks and that private franchisees for public infrastructure amounts to nothing more than a grant from the state to shareholders in the good times and socialised loss in the bad ones. Sorry to the crude language and bald assertions, but this waste of money by the ideologically challenged really annoys me.

Update. Felix Salmon has a fascinating piece on the costs of driving in cities here, and how sensible congestion charging combined with fare revisions can make everyone's travel more efficient. While I am not convinced that fixed pricing is the right approach - letting investment bankers who can afford it drive while less highly waged workers are forced onto the subway - there are clearly some very interesting results in the work Felix describes. The right approach would be a variable tarif based on income, so that the congestion charge depends on how much grief you cause other people, how much carbon you emit, and how much you earn, but that is politically impossible.

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.