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...