Deus Ex Macchiato

Moving on

2009-09-28T16:40:00.003+01:00

This blog should be redirected automatically to the new location, blog.rivast.com. If you are not sent there automatically, please click the link to get to the new stuff.

Bring a problem parties - speed therapy

2009-09-21T12:10:00.003+01:00

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

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

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

A manifesto

2009-09-19T09:08:00.003+01:00

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

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

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

Keynesian traps and flooding the building

2009-09-17T13:58:00.004+01:00

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

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

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

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

One of the many reasons I am depressed

2009-09-10T10:43:00.004+01:00

Barry Ritholtz writes:

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

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

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

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

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

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

Adair dares, and other unlikely tales, updated

2009-09-07T21:44:00.003+01:00

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

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

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

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

HRbots and the false comfort of quantification

2009-09-03T16:35:00.005+01:00

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

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

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

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

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

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

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

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

Oh I do love to be beside the sea side

2009-08-31T07:44:00.004+01:00

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

This collateral smells a bit off

2009-08-13T09:56:00.002+01:00

From Bloomberg:

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

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

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

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

Excess Liquidity

2009-08-12T06:25:00.000+01:00

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

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

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

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

Monoline Death Watch

2009-08-11T19:42:00.004+01:00

Felix Salmon discusses some recent JPM research on MBIA:

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

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

Reasons to stay flat?

2009-08-10T16:35:00.002+01:00

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

Controlling complex systems

2009-08-07T11:40:00.001+01:00

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

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

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

Inefficient Units of Currency

2009-08-07T06:41:00.000+01:00

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

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

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

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

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

2009-08-06T11:04:00.000+01:00

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

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

Creativity

2009-08-05T06:42:00.000+01:00

A lovely rant from Jenny Diski on the LRB blog:

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

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

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

Deprogramming Obama

2009-08-04T08:30:00.001+01:00

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

Don't judge me

2009-08-04T06:05:00.000+01:00

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

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

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

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

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

Come backs

2009-08-03T11:37:00.003+01:00

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

Discrete, discreet trading

2009-08-01T12:27:00.003+01:00

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

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

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

Fact as fiction, and other storytelling techiques

2009-07-31T07:03:00.001+01:00

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

2009-07-30T06:48:00.002+01:00

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

2009-07-29T08:33:00.002+01:00

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

2009-07-28T08:39:00.000+01:00

The details are below: click for a larger picture.

Instability and the cover rule

2009-07-27T10:35:00.003+01:00

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.