What are the armed forces for, exactly?

Yesterday's news from the National Archive that Britain's ability to defend itself against an attack from the Soviet Union was so diminished in the late 1970s that the prime minister exclaimed: "Heaven help us if there is a war!" spurs me to write a post I've been mulling for a while on the armed forces.

The first thing to say is that we should be grateful to those who risk their lives for all our sakes; we should equip them properly; and we should grant them generous rights after their service is complete. The saga of the gurkhas does us no credit at all, for instance: no service person should have to live in penury after a career in the military.

Let us be clear, though, about what the armed forces are for. If necessary, they kill people. Of course we hope that the ability to do it makes actually doing it unnecessary. But sometimes those fond hopes are unjustified. So no one should join without an absolute unquestioning willingness to kill if ordered to do so. That is what the armed forces are for.

All power structures generate their own dynamics, their own justifications. Ones with a long history carry a lot of baggage, too. Thus we have the fiction that the armed forces are commanded by the Queen, when in fact they do the bidding of the government. We have traditions -- many Victorian inventions -- designed to emphasise the importance of the military. Good tourist-attracting heritage though some of these may be, but they also support some convenient myths. Perhaps if we remembered that the military are funded by taxes we might be a little less tolerant of their parades, their lavish messes, their Saville Row tailored uniforms, and their expeditions. State school teachers don't get junkets to the Antarctic: why do the Army?

It is the toys that really bother me though. The boats and the planes, the missiles and (especially) the nukes. Just as Wall Street had a whole industry dedicated to justifying unjustifiable executive compensation, so the `defence' (by which we often of course mean `attack') sector has a whole industry devoted to persuading governments to buy weapon systems they do not need. Admirals like shiny new boats, nukes enhance the virility of defence ministers. So we spend tens of billions without effective scrutiny yet keep universities in poverty, schools with leaky roofs, and nurses on indefensibly low salaries.

We can't afford to go on this way, especially in the present climate. Let's cancel the Trident replacement now. Let's stop spending money on high tech goodies for the top brass, and equip the men on the front line with the armour they need instead.

We also need to eliminate the culture that allowed bullying at Deepcut and Catterick. The armed forces are civil servants too. Let's treat them as what they are: valued public sector workers who are not above scrutiny. A pound spent on subsidising the port in the officer's mess is a pound not spent on education or health. Battle honours dating back hundreds of years are no excuse for a culture that destroys some people today. As Rahm Emanuel says, You never want a serious crisis to go to waste. Perhaps with shrinking tax revenues and an end to our presence in Iraq we can try to produce a military that is efficient, appropriately funded, fit for purpose and fit to be part of a modern democracy.

Making money from the TALF

Accrued Interest has a great post on the newly expanded TALF. An edited version follows:

Fed will loan funds for purchase of recently issued ABS. This [means] ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

Loans will be non-recourse and not marked-to-market.

The loan term will be up to 3-years.

The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil."

So, buy some ABS, repo it to term with the FED. Sit back and enjoy positive carry, no margin calls, and, err, that's it. Gentlemen, start your engines.

Accounting for bullies

The Washington Post has a nice article on the European Commission's bullying of the IASB.

In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.

The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit.

We already know that David Tweedie, chairman of the IASB wasn't happy about this and reportedly threatened to resign. But what is new is that the Americans are waking up to the implications of this bullying.

"Right now, there is no credibility," said Robert Denham, chairman of the Financial Accounting Foundation, which oversees the FASB. "If we are going to have global accounting standards, my view is that is not going to work if the IASB is going to be jerked around by the European Commission.

Over lunch on the 24th a leading member of the IASB suggested to be that the FASB was irrelevant and that IAS would soon rule the world. Perhaps the Americans won't go gentle into that good night.

Holidays in Financial Capitals

With apologies to the Dead Kennedys:

So you been at the bank
For a year or two
And you know you've seen it all
In a company car
Thinkin' you'll go far
Back east your type don't crawl

Play ethnicky jazz
To parade your snazz
On your five grand stereo
Braggin' that you know
How the niggers feel cold
And the slums got so much soul

It's time to taste what you most fear
Right Guard will not help you here
Brace yourself, my dear:

It's crunch time in London
It's tough, kid, but it's life
It's crunch time in London
Don't forget crime is rife

You're a star-belly sneech
You suck like a leach
You want everyone to act like you
Kiss ass while you bitch
So you can get rich
But your boss gets richer off you

Well you'll work harder
When your group is downsized
For a hundred a day
Slave for bankers
Till you go mad
Then your head is skewered on a stake

Now you can go where people are one
Now you can go where they get things done
What you need, my son:

It's crunch time in London
Money the banks do lack
It's crunch time in London
Where you'll kiss ass or crack

Gor-don Gor-don Gor-don

And it's crunch time in London
Where you'll do what you're told
It's crunch time in London
Where the dole's got so much soul

Christmas Post

I shall be away for a few days from today, so this is the last post for a little while. And, perhaps aptly, it is about the Royal Mail.

I have to say first that I cordially loathe the Royal Mail. Deliveries in my area have one of the highest loss rates in the country, and they are among the least timely. Post offices in central London are almost always horribly crowded, Christmas or not. As an organisation, at least as I experience it, the Royal Mail is broken.

However I don't think the answer is to part privatise it or shut it down. And I recognise that Post Offices outside London often offer services that are important to communities, services that it is hard to put a profit or loss figure on, but which we would miss if they were gone. The arguments in favour of privatisation too often measure what is easy to measure and ignore everything else. (Jackie Ashley makes a version of this argument in the Guardian here.) And if we can spare tens of billions for the systemically important banking system in the UK, surely we can spare a billion or two for the socially important postal system. Let's admit that we need the Royal Mail and see what good we can do with it. (Jon Crudas has an idea here.) But above all let's not use biased analysis based on discredited economics to destroy a national institution that is useful and valuable and could be quite a lot better.

A new tool

There has been a lot of comment over John Gieve's comments to the BBC. The programme has not been broadcast yet, so let me confine myself to one point. Gieve apparently says

Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument - you set one interest rate for the whole economy - with something which is more financial-sector specific."

I would suggest we have at least two such things already. One is capital requirements. The other is monetary policy, specifically the implementation of policy via the money supply, which collateral qualifies at the window and the exact rules concerning bank reserve balances.

Update. I have now seen the program: it is mostly a Robert Peston hagiography, which I had hoped was beneath the BBC. Still I suppose if Jonathan Ross can't get fired for what he did it is too much to expect the Corporation not to laud Peston's rumour mongering.

The most interesting remark in the program for me came from John Varley. Asked if banks had taken too much risk before the Crunch, he said that they did. But he then went on to say that regulators and politicians `acquiesced in this extraordinary boom'. As a judgement that struck me as very much on the money.

Warning signs

From Long or Short Capital, apropos Madoff:

If your investment manager is not charging fees, and is “making it up on volume” (more or less), step back and think about that for a second. If you were in Brazil and a whore said she wanted to give you a free sex because she was making it up on volume, what she really means is that you will wake up down a kidney or two. No different with an investment manager.

Private banker

With apologies to Tina Turner and Mark Knopfler...

All the men come in these places
And the men are all the same
You don't look at their faces
And you don't ask their names
You don't think of them as human
You don't think of them at all
You keep your mind on the money
Keeping your eyes on the hall

I'm your private banker, a banker for money
I'll do what you want me to do
I'm your private banker, a banker for money
And any old assets will do

I want to make a billion dollars
I wanna live out by the sea
Have a Porsche and some paintings
Yeah, I guess I want a mansion
All the men come in these places
And the men are all the same
You don't look at their faces
And you don't ask their names

I'm your private banker, a banker for money
I'll do what you want me to do
I'm your private banker, a banker for money
And any old assets will do

Euros, yen or dollars
American Express will do nicely, thank you
Let me loosen up your regulations
Tell me, do you wanna see me do the tax arb again?

Compensating controls

I almost fell off my chair laughing when I read this. Which is not a very sober response to a very sensible proposal: Credit Suisse is going to use $5 Billion of Illiquid Assets to pay Bonuses. As Bloomberg reports:

The bank will use leveraged loans and commercial mortgage- backed debt, ... to fund executive compensation packages.

Assets in the facility will remain on Credit Suisse's balance sheet and will be held in the company's fund management division, the people familiar with the plan said. The new structure will mean that any mark-to-market losses or gains on the assets will be offset by identical gains, or losses, on the bank's liability to employees.

Employees will receive semi-annual coupon payments on their investment in the Partner Asset Facility at the London Interbank Offered Rate plus 2.50 percentage points. The ultimate value of the facility will be determined over the next eight years as the loans and securities mature or default, the people said.

This is a really really good idea in fact. If bankers know that this can happen, they will be strongly incentivised not to originate illiquid assets. But you can just imagine the looks on the faces around the CS trading floors...

MTM

MTM means for course `mark to me'. It appears that AIG has determined the most reliable source of fair values for some transactions is -- itself. Think of a number. Wow, the number I just thought of was ... the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe...
[These swaps] are different because they didn’t insure against losses... they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG's auditors in this, if it's true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I'll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn't Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG's accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn't AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

The dollar

A 4% return in 5 days? That will do me. The short dollar position is off. I still think it is a great long term trade idea and it will go a lot further, eventually, but I don't want to push my luck.

Hug rationing

FT alphaville suggests hugging a hedgie. I beg to disagree with most of their reasons. Let's go one by one.

1) They provide liquidity. More liquidity equals less market volatility.

Nope. The hedgies are often close to one way. They provide liquidity when we don't need it, as bubbles inflate, but they all rush for the exit when the bubble bursts, making the fall worse and exascerbating downside illiquidity.

2) They help burst bubbles. Short selling is as popular as a cold sore under the mistletoe. But who can now say the shorts were wrong about the banks?

Case unproven. Some funds were short; others were long. Shorting is a good thing, but the hedgies are not necessary for it to persist as a mechanism for enhancing market discipline.

3) They help restore confidence. It’s hard to invest when credit is in short supply, but hedge funds naturally play host to the kind of inspired risk-takers who will spot likely gems in the rubble and pull them - and us - out of the downturn.

Possibly true, but their business model relies on leverage, and that is in short supply. There is no reason non hedgie investors cannot play the same role.

4) They innovate. Innovation is a dirty word. Combined with excessive leverage, it has proved a dangerous concept, but properly applied, it will provide creative fuel for recovery.

Nonsense. Most product development is done in banks. Hedge funds are typically too small and too profit focussed to innovate. I can't think of a single product they invented rather than simply bought.

5) The survivors will be better people.

So clearly nonsense I won't dignify it with any further comment.

6) The survivors will cost less to employ. The industry’s mid-2007 fee structure looks as outdated as a 1929-vintage stock ticker machine.

That's like saying a Bentley at £200K is a bargain because it used to be 300. It's still a very expensive way of getting about, and damaging to the environment to boot. Talking of boots, how about kicking hedgies? It could be more fun than hugging them.

7) They help prop up the economy. Do you really want to witch-hunt all that wealth out of Mayfair?

Err, do I have to answer that? But the concept of stalking Mayfair with a matched pair of Purdey's taking out Porsche drivers is quite attractive for, say, a video game...

Seriously, though, I'm not anti-hedgie. But I do think that their leverage is dangerous and that the one way nature of their liquidity provision is not helpful to financial stability.

About the best one slide summary I've seen

Jeff Frankels has a nice picture on his blog. I like it a lot, but I think it is slightly at error, so here's my version, a slight modification of Jeff's original:
(Click for a larger version.)

Thank you, competition commission

From the FT:

BAA, the airports operator, should be broken up and forced to sell three of its seven UK airports, Gatwick, Stansted and Edinburgh, the competition watchdog said on Wednesday.

God knows the lot of the blase international traveller is a hard one these days, so any smidgeon of comfort is welcome.

The shocking non-call

A deeply scary event for the capital instrument market occurred today. Deutsche did not exercise a call on a lower Tier 2 instrument, the 3.875% sub notes of 2004/2014. From their press release:

Deutsche Bank has decided not to exercise its early redemption option to call the Notes at par because replacement costs would be more expensive than the existing EURIBOR +88 bps step-up coupon. Accordingly, the Notes' early redemption provision at the option of the issuer is not in-the-money.

The entire capital instrument market is based on the principle that banks will call their sub notes at the earliest opportunity - most investors calculate duration on that basis, and few people calculate an option adjusted spread, viewing the option not to call as reputationally too dangerous to exercise. The world has changed: expect the prices of these things to plummet. It will also become significantly more expensive for banks or insurers to issue hybrid capital instruments. This is really really not good.

Thank you Collin Peterson and Tom Harkin

Bloomberg reports:

Credit-default swap clearing would become mandatory under legislation slated to be introduced next month by House of Representatives Agriculture Committee Chairman Collin Peterson.

Not to be outdone,

Peterson’s counterpart in Congress, Senate Agriculture Committee Chairman Tom Harkin, a Democrat from Iowa, last month introduced legislation that would force all over-the-counter trades including credit-default swaps to be traded on an exchange and processed by a clearinghouse.

If this happens, it would be tremendous for London. We will consolidate our lead in credit derivatives, and attract a lot of OTC equity and interest rate derivatives currently traded in the US too. That should cushion Crunch-related job losses a little, at least.

Best explanation for an unusual name

BBC Radio 4's Milton Jones maintains that famous chef Heston Blumenthal is actually one of a band of brothers, all chefs, and all named after motorway service stations. If you like Heston's smoked bacon-and-egg ice cream, you should try South Mimms' kedgeree sorbet. The most talented brother is in fact Burton-in-Kendal Blumenthal, but little has been heard of him recently. Thus far rumours that Ferran Adrià is simply an alias for Ferrybridge Blumenthal have not been verified.

Stores of value

I was pondering stores of value the other day. Like many, I am more worried about deflation than inflation, and that make identification of stores of value more difficult.

Let's start with what does not work. Property, clearly, isn't a good idea. (I might make an exception for agricultural land in an unfashionable part of the country with legal restrictions which make it impossible to develop - and hence make it cheap.) I won't consider anything in dollars or yen, as the former is likely to plunge, and I have been consistently wrong about the latter. Commodities are falling, art is worse, and most of the hedge funds will be gone by tea time.

So, we are left with Euro or Sterling bonds and precious metals. I can see the case for gold, but I'm not a gold bug, and given the run up since 2002, it feels expensive. Euro assets do too, for a sterling investor. Perhaps short dated genuinely AAA credits (IBRD, for instance, or KFW) in EUR are worth considering for a really safe haven, but I wouldn't go out long term. That leaves GBP bonds as a store of value.

The sterling curve is reasonably steep out to 4 years, and flatter after that. That suggests keeping your duration short, especially as rate rises might be only a year or 18m away. Or perhaps sticking with good quality Libor floaters for the moment. So that was my depressing conclusion. Buy AAA Libor floaters in sterling, with a side order of agricultural land and a small allocation to short dated supranationals in Euros, with the FX at least partially hedged.

Risky assets are a lot easier. A first to default note on national champion banks should give some extra juice, and a short on life insurers with significant exposure to guaranteed annuities is an interesting token equity play. But it is the `preserve value' part of the strategy that's difficult, not the `take risk' part.
For that latter I might even throw in a short USD position too. But with a tight stop-loss. But for the former, I'm really struggling.

Epicurean Dice

The Epicurean Dealmaker has a post about risk and uncertainty. He makes some good points, and I want to expand on one of them, that is the respect we should have for the random nature of the markets.

Think about it like this. Mostly in finance we assume that we have the equivalent of a standard dice. That is, while we assume we don't know what number will come up next, we think that we know the distribution of numbers perfectly. In fact the real situation is much more akin to throwing a dice where we have imperfect knowledge of what numbers are on the faces. They might be 1 to 6; but they also might be 1 to 5 with the 1 repeated; or 2 to 7; or something else entirely. Worse, the numbers are changed by the malevolent hand of chance on a regular basis. Not so often that we know nothing about the distribution, but often enough that we cannot be sure that the current market will be like the past.

Thus our risk estimates are potentially wrong for at least two reasons. We might have been wrong about the past distribution. And even if we got that right, it might be different in the future. In other words, you can't manage risk effectively by assuming you know the distribution - to be effective, you really must assume that you don't. Thus you don't just want your risk to be low enough based on one model: you want it to be low enough based on all (or at least all likely) models.

EXceLent Failure

From Bloomberg:

XL Capital Ltd., the biggest Bermuda- based insurer by assets, is seeking a buyer after reporting investment losses larger than its market value, four people with knowledge of the matter said.

Big oops. I could be mean about actuaries. I could be mean about monoline-type business models. But for now I just want to raise a glass to a company that was mostly a sophisticated risk taker. Sadly `mostly' and `not enormously hugely massively well-capitalised - more capital than you can shake a stick at' can be a toxic mixture.

How leveraged is whole business securitisation?

FT alphaville answers very. This graphic (from Deutsche Bank) depicts two of the first WBS deals in the UK, both on pubs. The red shows the total debt of the companies; the grey, the business value. Can't see the grey? That's because the red is almost exactly the same size...

Hedging procyclicality

It suddenly occurred to me this morning that you can, theoretically, hedge the cost of procyclicality.

Suppose your credit risk capital requirements in good times are EUR 10B, and they rise to EUR 13B in a crisis. This is roughly right for a large bank: a Deutsche bank study showed between 30 and 80% increases in capital for their investment grade corporate book, while the Bank of England found 15-40%.

The cost of equity capital is somewhere around 12% for a large bank. Let's go with 10%, assuming that you can meet some of it from cheaper Tier 2 capital. That means you need to make EUR 300M a year to be hedged. Hence you want some position that makes money in a recession. Considering the iTraxx, we see that a 150 b.p. credit spread change is perfectly possible: this has actually gone from 25 to over 200 in the recent events. Unfortunately to make 300M from a 150 b.p. change, you would need to buy a notional of 20B. That's quite a bit of iTraxx.

How about equity indices? Clearly the business cycle is quite long: five years peak to trough would be reasonable. So how about buying an ATM five year put on the S&P? Assuming a 20% fall from the high - it has gone down more recently, but 20% is more typical of an average recession - you would need a notional of EUR 1.5B. That's perfectly possible. But the premium for a five year ATM S&P put using pre-Crunch vols is very roughly 20% of notional, and you need to earn that premium back too. Hmmm. You can do better by buying away from the money, longer dated options and profiting from the move in implied vol too, but the notional will be even larger. Also if the recession lasts longer than a year, you need more puts.

So perhaps practically it is not so easy. But the *idea* of hedging increases in capital requirements is interesting...

What I don't understand about the DMO

FT alphaville has a post on the DMO at the tail end of last week, setting out the auction catalogue for the next quarter and setting out progress to date. It includes this summary of the year so far:This squares with my understanding that the DMO has a policy to keep index linked issuance at less than 20% of the total. My question is why. There is massive demand for long-dated linkers from pension funds and life insurers. Given the need to sell a lot - really a lot - of gilts next year, why is the DMO not giving the market what it actually wants to buy?

The dangers of code

A moment searching reveals numerous companies who will help you with a persistent technology problem - accessing data written using technology that is now out-of-date or hard to find. A great example of this was the BBC Doomsday project - unlike the paper (well, vellum) based original, this was difficult to read a mere 19 years later as it was based on the by-the-outdated BBC micro. See here for more details.

The LRB has an unusual example of this phenomenon this week - shorthand. You see, there isn't a single shorthand. Most people these days learn Pitman, but the modern version of this is a simplification of the Victorian original. And then there are the now-dying if not dead historical systems due to Gurney, Tailor, Byrom and so on. (The picture is from an article in Wikibooks - it shows the Lord's prayer in some common shorthand systems.)

Different systems are often mutually incomprehensible: an expert in one cannot read any of the others, especially if the writer is an advanced shorthandist. There is also the issue that many of these systems evolved significantly over time, so an expert in modern Pitman can't even necessarily read something from a hundred years ago. Thus a diary, say, written in 1895 Universal Stenography is about as difficult to decode as a message in 512 byte RSA. Both are breakable (even without any hardware, user, trust model or failure recovery based attacks), but both require quite a bit of effort. Perhaps the military should take up obscure shorthand systems before quantum computing blows RSA completely out of the water?

More to the point, never underestimate the difficult of decoding a lot of stuff. The problem isn't the decoding: it is reading the decrypt and figuring out what is valuable. That's why those Victorian diaries are still lying around unread: the combination of a really small signal to noise ratio and moderately difficult cryptanalysis is a killer.

Why I support the BA/Iberia merger

Because then I will have one fewer dreadful, customer-unfriendly, delay-ridden airline to ignore when booking travel. The rational for loathing British Iberian is easy: it saves time.

The humbling of the actuaries, part 357,121

Bloomberg has a nice article on one of my favourite pieces of actuarial insanity, guaranteed annuity contracts. The basic story is that life insurance companies wrote long-dated equity index and basket puts in size and didn't price them properly, because their actuaries didn't understand derivatives. With the recent market falls, they are beginning to see just quite how stupid an idea this was.

It’s ending in tears. In September, the insurance raters A.M. Best and Fitch moved the life-insurance industry into its negative-outlook column. In October, Moody’s, and Standard & Poor’s did the same. A.M. Best has downgraded 30 life and annuity companies so far this year.

Of course, because all of this is in an insurance wrapper, there is no requirement to mark to market, so investors cannot see the size of the problem.

In the meantime, the industry is proposing to handle its problems the good, old-fashioned, American way: by putting lipstick on its books.

As the value of GMWB [guaranteed minimum withdrawal benefit] annuities tumbles, the carriers are required to raise the reserves they hold against these products, as a way of assuring that consumers will be paid. Raising reserves, however, could starve their working capital at a time when they’re also writing down toxic mortgage assets. The companies say they’re already holding plenty of reserves, so they’re asking the states, which regulate the industry, to loosen the rules.

Astonishingly, some of the state regulators seem sympathetic:

The National Association of Insurance Commissioners will discuss the proposed changes this month. Iowa insurance Commissioner Susan Voss calls some of the reserves “redundant” and suggests that NAIC will go along.

Short now, short in size. It is a very cheap way to get protection on an extended period of low equity markets.

Arguments against the conservation of cake

Or, why you can't have it and eat it. Information Arbitrage is wonderfully splenetic about bailouts:

The U.S. taxpayers saved Citigroup's life, and for that we may get up to 8% of the company. THAT is called a "punitive program" in Hank's parlance - punitive for the U.S. taxpayer. In my world when you save a company you own ALL the equity, not 1/12th of the equity. The fact that the taxpayer gets up to 80% of AIG - now that starts to make sense.

Quite right. To do anything else involves moral hazard. By all means bail out a systemically important player if you judge it necessary. But be sure to crush the equity holder.

A short note on the yield of inflation-linked bonds

Some people recently seem confused by the yield of some inflation linked bonds. Here's the scoop.

1. Some, but not all, inflation linked bonds are floored at zero inflation on principal. That is, you cannot get less than the face value back. TIPS, for instance, have this feature.

(2. There is a more extreme form of flooring where the coupon is floored at the stated real yield on the face, so for instance if you hold a 2.5% real yield bond where the face has accrued to $1M, then you will always get a coupon of at least $25,000. This form of floor is rare, so I will ignore it.)

3. This means that in effect these floored bonds are a pure inflation-linked bond together with a floor. The strike of the floor depends on inflation to date. To see this, suppose we have an old TIPS. Experienced inflation over its life will have inflated its market price way above par. Thus inflation has to be highly negative for the floor to be worth anything. For a newly issued TIPS, on the other hand, the floor is much closer to the money.

4. When inflation was expected to be 3 or 4% a year, this didn't really matter much. But with deflation expected in 2009 by some, you really need to adjust the yield of short dated newly issued floored bonds by the value of the embedded inflation floor, as this floor is now quite valuable.

5. This is in theory a simple option adjusted spread problem. I say in theory because in some markets - the UK is a good example - there is an oversupply of inflation caps which means that market quoted inflation volatilities are not reliable. But this isn't an issue for TIPS. Simply [;-)] go to your friendly broker, get a quote for the correct strike inflation floor, back out the vol, then use this to option adjust the spread of your bond.

Meredith turns Japanese

A more or less parenthetical remark by Meredith Whitney (quoted in the FT) resonated with me. The note from Oppenheimer included a number of recommendations: here is the third:

Delay the introduction of accounting rule FAS 140 until 2011 or 2012. These moves to bring off-balance-sheet assets back on balance sheet for the sake of transparency are a mirage. The primary assets that will come back on to balance sheets are credit card loans. Frankly, there is more transparency in off-balance-sheet master trust data than in on-balance-sheet accrual accounting.

What struck me was how true this is. The buyers of credit card backed securities won't put up with accrual: they know it hides all sorts of issues they need to see and is usually used to smooth earnings. So why should we put up with it for on balance sheet assets?

This in turn brought to mind a section from a nice short summary on the Japanese crisis I have been reading. From The Japanese banking crisis in the 1990s by Kazuo Ueda:

Large Japanese banks had capital ratios of barely above 8% at the start of the 1990s, with about half of the 8% accounted for by unrealised capital gains on their equity positions. Since then, banks have been
writing off bad loans by basically using operating profits and realising latent gains on equity positions.

Unrecognised losses in accrual accounted loans only being taken when enough earnings materialise to absorb them. Does that sound familiar? You can't fix the problem until you can see the problem. At least a diligent attempt at establishing fair value helps you to see the problem.

Prediction of the week

From Long or Short Capital:

We are at, or past, Peak Roubini

Go and read the whole post: it's funny.

Make a leftie your leader

Bloomberg has an interesting argument. They suggest that the right wing media are reluctant to criticise companies in general. And the left wing media are reluctant to criticise companies headed by prominent lefties. So, for an easy ride, make the most visible symbol of the company a figure from the centre left. I'm available if Jon Crudas's rates are too steep for you.

Keynesian economics in one sentence

From Paul Krugman, offered as a public service post:

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.