Sunday, December 28, 2008
Friday, December 19, 2008
The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions.
I have nothing against hedge funds per se, but this is sure to raise flags for members of Congress, as well as the public, especially after the Madoff fraud. Why then is the Fed so keen on doing it? Because it is now in exactly the same situation with credit-card debt, as it was with housing debt a year ago. It failed with housing debt, and it will fail with credit-card debt. The latter has reached unsustainable levels, it can't go on. But the Fed refuses to accept this fact, because it needs and wants to keep the American consumer spending. The Fed simply doesn't understand what "unsustainable" means and hopes that by mere force of will (Bernanke's "We will not stand down") it can keep the waves from crashing or force the horse to drink. While Krugman has compared Wall Street to a Madoff-like Ponzi Scheme, the real Ponzi Scheme is now being run by the Fed.
So how will it end? By a classic rush-to-the-exits, in a crowded theater where someone has yelled "fire". The Fed is putting lots of illiquid assets on its balance sheet, which it won't easily be able to get rid of, should the original owners default. It is effectively borrowing short - massively - and lending long - massively. This works until it doesn't. It works, as long as there is confidence that it work. There is confidence that it will work, so long as the participants think everyone else has confidence that it will work. It stops working when enough people decide they don't want to lend short any more. The confidence evaporates, the Ponzi scheme gets blown, and the exits are swamped.
Thursday, December 18, 2008
The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.
Well, bravo to the one at Credit Suisse who thought of this one. I just hope that, when used as a bonus, the waste is valued at the level Credit Suisse is carrying it on its books - no discounts permitted (although, of course, this can just be finagled by giving out more toxic waste).
Wednesday, December 17, 2008
First of all, I know that we all consider economics a science, but as sub-fields go, macroeconomics is one of the least science-y. Among the reasons—too many variables, too small samples, no repeatable experiments, and so on. ...
Which is why it's important to have a good, qualitative model of the mechanisms involved to supplement the data analysis.
If I had been eating Corn Flakes, they would have been coming up my nose. Fortunately, not. So, after admitting there's no there for macroeconomics considered as a science, Free Exchange still thinks it's important to have a model. I don't think so. Models should help to make useful predictions; so models are relevant only in subjects which are scientific. Otherwise, they are simply a special type of crossword puzzle - perhaps useful for reflection, but irrelevant to the real world. Sure, economists like them, because they constitute a sort of private language which take time to learn and evaluate, and create a barrier-to-entry to non-economists. And so in a tawdry sense of "useful" - in the sense of keeping the riff-raff out - models may be useful in a non-scientific subject. But they don't improve our knowledge of the real world - because a subject which is not a science cannot.
Tuesday, December 16, 2008
The Americans are at it again. They are trying to badger foreign governments into stimulating their economy through massive deficit spending because - well, because they can't think of anything else to do, and they imagine that it is better to keep pedaling and risk hitting a wall than fall off straightaway. It's part of the short-term philosophy of life that has sent Americans to the mall and living off their credit cards. The threat of government default doesn't worry them, not because it shouldn't, but because it seems to far-off in the future, and one more trip to the casino beforehand, after all, might save them.
When the Iraq War was being discussed, there was much talk of American "hard power" versus European "soft power." I was always a bit skeptical about this as a distinction, because the Americans are just as expert at soft power as the Europeans, if they only put their mind to it. Case in point, would be the determined Anglo-Saxon media campaign against the Germans, who are resisting going off the deep end and spending money for the sake of stimulus. This is from a Bloomberg article entitled Merkel’s Popularity Sinks on Handling of Crisis, Poll Shows":
Chancellor Angela Merkel’s popularity slumped last week amid criticism that the leader of Europe’s biggest economy is doing too little to stem the country’s slide into recession, a poll showed.
Asked whom they would vote for if the chancellor could be elected directly, 47 percent named Christian Democrat Merkel, compared with 51 percent a week ago, according to a Forsa poll for Stern magazine and RTL television.
That’s still 22 percentage points ahead of Social Democrat Vice Chancellor Frank-Walter Steinmeier, who garnered 25 percent support, 2 percentage points more than a week earlier, Stern said in an e-mailed statement.
Merkel’s declining popularity may reflect criticism that the chancellor is lacking determination to fight the economic downturn. Nobel Prize-winning economist Paul Krugman told Spiegel magazine that Merkel is “misjudging the severity” of the crisis and “wasting precious time.”
Merkel’s declining support may be rubbing off on her party. The Christian Democrats fell 1 percentage point to 37 percent and the pro-business Free Democratic Party, her preferred ally, rose 1 point to 13 percent.
The combined total of 50 percent, maintained for a third week, would still allow the CDU and FDP to form a coalition government if replicated in national elections in September 2009.
So Merkel lost 4 percentages in a week, her party lost 1 point, and her coalition stayed steady - and Bloomberg ties it to her resistance to a stimulus package because at the same time, Herr Krugman told Spiegel he wasn't happy with her. On the contrary, I would say that Merkel understands much better than Krugman the severity of the crisis, and how important it is to keep some money in the till to help people when they need it, two or three years down the road, rather than frittering it away in a go-for-broke strategy based on a failed economic ideology.
What, may I ask, is Krugman's exit strategy?
Saturday, December 13, 2008
Surely the U.S. can do what Zimbabwe is doing - and Zimbabwe is not encouraging domestic and foreign creditors and investors? So deflation is not inevitable; it depends on choices that the U.S. government and federal reserve make, from hereon in. Maybe we'll get deflation; maybe we'll get deflation then inflation; maybe we'll get inflation then deflation. But I don't think any is inevitable, at least not yet.
Tuesday, December 9, 2008
Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:
(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.
Wow! A halving of housing prices! That's some foresight. Only, if you check previous posts, Brad DeLong sang a different tune. In December 2007, in reply to a Krugman blog entry which said housing prices had "a long, long way down" to go, he wrote:
"A long, long way down" means, I think, "a fifty percent fall along the coasts."
I would cut that in half for two reasons: not 50% but 25% along the coasts, and much less in the interior. First, the likelihood that savings interested in being invested in the secure-property U.S. will be ample over the next generation is high: we will sell political risk insurance to foreign individuals and governments for quite a while yet. So real interest rates are likely to be lower in the past. Second, the zoned zone is not growing--and America's population still is. The gap between heartland and coastal values is likely to grow over time, and that anticipated capital gain should push up prices now.
Perhaps that was a slip of the tongue? No. Here is he again in April 2008:
That [a decline in home prices, back to more or less their pre-bubble inflation-adjusted levels] strikes me as too pessimistic. The rise of Asia and the resulting demand by the rich and by governments for U.S. assets to hedge political risk is likely to keep savings glutting for decades. We aren't buiding more superhighways, there are no major transportation improvements on the horizon, America is filling up, and so land-value gradients are on the rise. If the income distribution continues to erode, we will wind up with higher prices for scarce positional goods--chief among which is location, location, location.
My guess is that we will ultimately give back half of the doubling...
Half of the doubling means, yep, -25% off the peak.
Am I being too hard on Professor DeLong? Almost surely. He did, after all, qualify his "halfway" remarks by saying he thought it was something that needed to be anticipated, not something he thought was going to happen. And he did, as I said, answer Calculated Risk's challenge; kudos to him for at least realizing the question was important. It is not really him, but the others who are silent, for whom we should ask, "Why oh why can't we have better economists?"
Saturday, December 6, 2008
"The lawyer [at the party] even asserted that all bankers should be shot."
We are truly in uncharted territory when a lawyer can take the moral high road and ask that members of another profession be shot.
Thursday, December 4, 2008
Tuesday, December 2, 2008
About half of Icelanders aged between 18 and 24 are considering leaving the country, Reykjavik-based newspaper Morgunbladid said, citing a survey of 1,117 people between Oct. 27 and Oct. 29.Since the population is only 300 000, that's a pretty big percentage leaving. And since it's the Iceland nation which now owes 4.6 billion dollars to the IMF, that's even more that each man, woman, and child left behind will have to pay.
“Tens of thousands” will depart, estimated Jesper Christensen, chief analyst at Danske Bank A/S, the biggest lender in neighboring Denmark.
Sunday, November 30, 2008
"Some readers may object that providing a fiscal stimulus through public works spending is what Japan did in the 1990s—and it is. Even in Japan, however, public spending probably prevented a weak economy from plunging into an actual depression."So, apparently the real world did not do what the models said stimulus should have done. And Krugman's answer is: but our models show that things would have been even worse. Of course they would - if your models tell you to do something, and you do it, then no matter what really happens, your models will tell you that things would have been worse had you not done what you did. That's what models do. But what is still lacking is confirmation of the model by reality.
Now, you might say that the incomplete recovery [of the American economy in the late 1930s] shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump.
Okay, fair enough, but then why do we know that Keynesian fiscal stimulus works? Again Krugman:
What saved the economy, and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.
We can argue about whether that's always true, but in times like these, it definitely is. The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work.
Yes, mass unemployment defines a depression, and it would be better for the unemployed to be doing something productive, rather than nothing. But surely the devil is in the details: "if we can only figure out how to get our hands on it." Krugman doesn't explain how we are to get our hands on it. He doesn't even consider the ontological question: can we get our hands on it? All we get is hope. Hope that stimulus will work. But hope is crappy policy.
Wednesday, November 26, 2008
The three-member county commission [of Dauphin County, Pennsylvania] voted in August to approve two “range accrual swaps” with Deutsche Bank AG, according to minutes of the meeting. The interest-rate swaps, which involve $42 million of fixed-rate debt, guarantees Dauphin County $816,000 the first year and then wagers taxpayers’ money that short-term interest rates beginning in September 2009 won’t exceed 7 percent. Those rates are 2.2 percent now.
“It’s a way for us to raise revenue for the county,” said Chad Saylor, chief of staff to the county commission. “The only source of revenue we have, much like the school districts here, is the property tax.”
And this is how it ends (today from the WSJ):
Looming large among the reasons the [Massachusetts Turnpike] authority needs the cash are three "interest rate swap" contracts related to the Big Dig that were sealed with UBS AG, Lehman Brothers Holdings Inc. and J.P. Morgan Chase & Co. The deals have gone wrong for the state, adding to its interest burden and confronting it with up to $467 million in potential fees if the firms opt to pull the plug on the
"Did anyone know what they were doing?" asks Alan LeBovidge, who walked into the mess a year ago when he became the Turnpike Authority's executive director. Maybe, he says, his predecessors "should have been nice and conservative. It's like going to Las Vegas."
Note to any public official: do not do interest rate "swaps" which have options or knock-ins or knock-outs embedded in them. If you think you're "raising revenue", think again. At best you will lose money. And on average you will lose a lot of money. You don't know how to evaluate the value of the embedding, and, even if you did know how, you don't have access to the parameters you need in order to be able to do it. Investment banks have access because they spend time and resources to follow the market and know what volatilities and correlations are actually worth. And they know what looks good to you, like a fish eying a worm, and how much commission they can hide in their structure. (Hint: it's more than you can imagine.)
Tuesday, November 25, 2008
A rogue trader is an authorised employee making unauthorised trades on behalf of their employer. It is most often applicable to financial trading, and as such is a term used to describe persons - professional traders - making unapproved financial transactions. This activity is in the grey area between civil and criminal illegality for the reason that the perpetrator is a legitimate employee of a company or institution, yet enters into transactions on behalf of their employer without permission.
Bernanke is out of control.
Monday, November 24, 2008
In addition, the Black-Scholes calculations incorporate volatility inputs which are generally not observable. At March 31, 2008, the estimated fair value of these contracts was $6,171 million and the weighted average volatility was 22.8%. The impact on fair value from changes to volatility is summarized below. The values of contracts in an actual exchange are affected by market conditions and perceptions of the buyers and sellers. Actual values in an exchange may differ significantly from the values produced by any mathematical model. Dollars are in millions.
Hypothetical change in volatility (percentage points) Hypothetical fair value
Increase 2 percentage points $ 6,777
Increase 4 percentage points $ 7,379
Decrease 2 percentage points $ 5,563
Decrease 4 percentage points $ 4,956
Let's assume, as I think is the case, that the four indices which are underlying the puts are: SP500, Nikkei, Ftse, and Eurostoxx50. I'm pretty sure that the puts at initiation were 100% (or less) of the spot on the strike date, i.e. the inception date. And for the sake of simplicity, suppose the duration remaining on the options is 15 years. If these assumptions are correct, then it looks like Berkshire was undervaluing the puts by using a too-low volatility on March 31.
Why do I say this? There are two possible kinds of volatility to use when marking options: historical and implicit volatility. To make things simple (for me anyway), use the formula p = f(v) to represent the relationship between the option price p and the volatility v. f is an increasing function; when v1 > v2, then f(v1) >= f(v2), and equality holds only in trivial cases. If p is the market price of an option, then there will exist a unique v such that p = f(v). v is called the implicit volatility. If you trade an option and mark it implicitly, then your profit and loss on the day of trade should be close to 0.
Historic volatility is calculated by looking at the day-to-day variation on the index, over some pre-determined time period. Only institutions who want to die early deaths mark with historical volatility. The old UBS tried it before being taken over by SBC, and one of the reasons they had to be taken over by SBC was because they were marking some or all of their books with historical volatility. They exploded once historical volatility started trending sharply higher, but they couldn't buy back their position, except at a huge loss, because implicit vol was even higher.
I can imagine Berkshire actually using historic volatility; it's what people who are external to option trading would think you're supposed to do. It's what an insurer would think you're supposed to do. If it does, then I understand how they got into this extraordinary position of selling all those puts. Historical vol is at 15, but these idiot traders are pricing it at 24! What a great opportunity to make 9 points! Meanwhile, the option traders are selling the volatility they bought from Berkshire at 25 (or higher...), and they return to Berkshire to get some more. Rinse and repeat. Eventually Berkshire has to stop selling. When it does, implicit volatility explodes - the greatest fool is done, and there's no one left to sell. Berkshire can't buy back its position, except at a huge loss, so it has to sit on it, and pray the market goes its way. Praying, though, is a lousy trading strategy.
I've been sidetracked. The essential point is: if you want to get the market price of the option - what it's really worth - you need to use implicit vol. For the rest of the post, "volatility" will mean "implicit volatility".
Volatility depends on strike; the higher the strike, the lower the volatility. To have got a 22.8 volatility on the 15-year SP500 on March 31st you'd have to go almost to a 200% strike. On the Nikkei the lowest volatility on any reasonable strike was more than 3 points higher than 22.8. On the FTSE you'd have needed a 150% strike. And on the Eurostoxx you'd have needed a 130% strike. It looks best on the Eurostoxx, but the all-time high of the index was 4558, which is only 125% of the index value on 31 March.
So, even if Berkshire sold all its puts only on the Eurostoxx and only at the all-time high of the index, you can't justify a 22.8% volatility. It's at least a point off. And if you assume any kind of reasonable weighting on the indices and strike prices that are sometimes below the all-time highs on the index, you end up concluding that the volatility is undervalued by 2 to 4 points.
In any case, that was then. Volatility has exploded since March 31, up say 6 to 7 points on the same strike. So my best guess is that, volatility has gone up by 8 to 11 points compared to Berkshire's markings. Using its handy table, that turns out to be a loss of around 3 billion Usd since 31st March only on the volatility marking. It took a bath as well on the lower spot.
So Berkshire is under serious water here. Its position is too big; it won't be able to buy it back, at any price. If I were a better man, I'd feel sorry for it.
ADDITIONAL THOUGHT: A Bloomberg article tells us that Berkshire's maximum exposure has decreased recently to 35.5 billion Usd. This must be because of the rise of the dollar. So, inversely, if the dollar were to fall, Berkshire's exposure in terms of dollars would increase - and is theoretically unlimited.
Sunday, November 23, 2008
Citigroup agreed to absorb the first $29 billion of losses on the $306 billion portfolio, plus 10 percent of additional losses, for a maximum total exposure of $56.7 billion. The Treasury Department could end up absorbing $5 billion, the Federal Deposit Insurance Corp $10 billion, and the Federal Reserve the rest.
It's getting a bit tiresome that the Federal Reserve is taking on more and more potentially huge losses, yet no external body or individual is allowed to doublecheck the portfolios involved or the current markings being used. If it's anything like AIG, the markings are fantasy, and Citibank will in short order have to absorb 29 billion of losses, putting the U.S. government at risk.
Friday, November 21, 2008
Wednesday, November 19, 2008
Berkshire is also subject to equity price risk with respect to certain long duration equity index option contracts. Berkshire's maximum exposure with respect to such contracts was approximately $35 billion and $21 billion at December 31, 2007 and 2006, respectively. These contracts generally expire 15 to 20 years from inception and they may not be settled before their respective expiration dates. The contracts have been written on four major equity indexes including three that are based on foreign markets. While Berkshire's ultimate potential loss with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration, the change in fair value from current changes in the indexes do not produce a proportional change in the estimated fair value of the contracts. Other factors (such as interest rates, expected dividend rates and the remaining duration of the contract as well as general market assumptions) affect the estimates of fair value reflected in the financial statements. The carrying amount of these liabilities was $4.6 billion at December 31, 2007 and $2.4 billion at December 31, 2006. If the underlying indexes declined 30% immediately, and absent changes in other factors required to estimate fair value, Berkshire estimates that it could incur a non-cash pre-tax loss of approximately $2.3 billion."
I believe the options are, or at least mostly are, "plain vanilla" puts (on the Nikkei, SP500, Eurostoxx50, and the FTSE), meaning they have a strike price K, and Berkshire has to pay Q * (K - S) should the index finish at S (and below K) on the maturity day, where Q is the quantity of the contracts. Since S cannot go lower than 0, this would imply that the sum of Q * K, for all the contracts, equals 35 billion as of Dec 31, 2007. That's a huge number, by any standard. Notice that the total exposure has almost doubled from the end of 2006 to the end of 2007. Unless I'm missing something, that's an awful lot of new contracts in the year 2007.
It should come as no surprise that credit protection costs on Bershire have tripled in a couple of months. The collapse of equity markets has made these puts much more valuable, and if you're a holder of some of these puts, the only thing between you and relief is Berkshire Hathaway going belly up. So you do what you can - and buy protection.
Now I know, folksy Warren is considered to be a great investor. But, given any trend, there will always be one philosophy which fits the trend. Such is Buffet's "Buy and hold;" it works really well when you are living through the greatest bull market the world has ever known, which is pretty much what we've seen since the end of World War II. It doesn't work so well in a depression environment. So is Buffet a genius? Or has he just believed in the right philosophy at the right time? Or at least the right time through 2007, because times seem to have changed.
Nor should the similarity with AIG be overlooked. Sure, plain-vanilla puts don't suffer from some of the problems of the products which caused AIG to hit the wall, but the enormity of the nominal of Berkshire's bet makes the same result a possibility. Berkshire will need to keep lots of cash on hand in case it needs to make some big pay-outs. Its cash mountain is looking less a luxury and more of a necessity.
Tuesday, November 18, 2008
Heard on the Street: For Wall Street, Less is More
Bring out the hair shirts? The decision by top executives at Goldman Sachs to join peers at Deutsche Bank and UBS in forgoing bonuses for the year is asensible act of contrition. But it is hardly radical.
Now that Goldman has made its move, Morgan Stanley will surely follow --something potentially painful for its chief executive, John Mack, who made the same gesture last year.
Cutting the pay of a handful of top executives is window dressing, of course. What matters is the size of broader bonus pools. [emphasis added]
One part is political. The government and regulators probably don't want to get intimately involved in setting Wall Street pay. [no, of course not, they just want to shovel money into them] Goldman and Morgan Stanley --the two remaining independent firms and the two banks that report first --shouldn't give them a reason to do so.
Keeping the ratio of compensation to net revenues well below the usual target of about 50% is one vital element. [so guess they'll make it 49%...]
More important than politics, however, Wall Street firms need to show their investors they will share the pain in tough times. Morgan Stanley failed last year. It raised the overall compensation ratio to 59%, after taking a big hit to net revenues from a bad mortgage-related trade. Goldman took its ratio down to 44% because it had a very strong year.
recent months, by being tough.
The fourth quarter is likely to be grim. But with Wall Street still fighting
to prove that its business model can get through the crisis, this is no time to
go soft on pay.
-- Thorold Barker
Monday, November 17, 2008
Indeed the very end of the article makes it sound - and here I myself fell off my chair, because I thought the sanctity of a written and signed paper could not be challenged - that contracts could just be put aside. "The banks may have precedent and sentiment on their side if they choose to cut guaranteed payments. English courts have been reluctant to intervene in disputes over bonuses." So, apparently, it's not the law or contracts which may hinder efforts. If there's a will, there's a way. The question is, Will there be the will?
Sunday, November 16, 2008
In a statement Sunday, Mr. Cuomo said, “This gesture by Goldman Sachs is appropriate and prudent and hopefully will help bring Wall Street to its senses. We strongly encourage other banks to follow Goldman Sachs’s step.”
This is most unfortunate. The top seven get only a fraction of what is paid out in bonuses. The goal should be: no bonuses for anyone. As the NYT says in the same article,
There is a widespread belief that the way Wall Street awarded bonuses in recent years helped feed the risky behavior that eventually created big losses on exotic debt securities and helped create the current crisis.
By and large executives at financial firms don't know about the risk their firms are taking. If you want inappropriate risk to be cut, you need to cut the bonuses of the underlings as well.
The IB model needs to end. By the IB model, I mean: paying a lot of money to people in order for them to overcome their natural sense of morality and be willing to do bad things to lots of people. For instance, without the huge pay-out at the end of the year, salespeople in IBs wouldn't be willing to stuff school districts and pension funds with products they knew were toxic waste, as they have most willingly over the past couple of years. They do so, not because they like to naturally, but because they can count the dollars that it brings them; it overcomes their resistance.
So executives don't get any money this year. That's like Steve Jobs accepting, for one year, one dollar as his compensation. It's a fake. They know, as long as the model stays in tact, that they will get more than enough in the future to compensate for their seeming virtue this time.
Bloomberg had an excellent article, which I linked to a few posts ago, saying that Americans wanted the bonuses of financial workers - all financial workers - to be zero this year. Cuomo is selling them out. Let's hope that Congress, at least, is paying enough attention, and cares enough, to raise a howl.
I wonder what he thinks of Bernanke...
I'm not sure about the latter, but Americans do seem to be doing everything in their power to make the current downturn as bad as possible. They are well on their way to blowing 700 billion Usd - an enormous number, pretty much equal to two year's of the worst deficits in America's history (378 and 413 billion, in 2003 and 2004) - without getting much in return, except - maybe - some happy stockholders and traders. To repeat, every American - every man, woman, and child - has just forked over 2000 dollars. If the quasi-science of economics has any truth to it, it is surely that wasting resources has consequences. America has just wasted an unfathomable amount; the dire consequences must be waiting around the corner.
Saturday, November 15, 2008
``Have you no sense of decency, sir?''