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...