Sunday, November 30, 2008

Depression Economics

A spectre is haunting the world - the spectre of Depression.  With it depression economics is at hand, as economists dust off their textbooks and look for lessons from the Great Depression.  And what is depressing, is how little economics know, and how little economists are willing to admit it.

It would seem that every Anglo-American economist believes that a big stimulus is needed, to get the economy moving.   In America we are to spend upwards of 1 trillion dollars -  a huge sum.

Now when you are about to spend a truly important amount - money which the American nation does not have - it would seem that there should be some evidence that it will do what one wants.  Is there any evidence that stimulus really gets a nation out of depression?  That is, economists have a model which shows that it does.  Is there evidence from the real world that shows this model is valid?

Paul Krugman writes:  
"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.  

Well, didn't at least the Great Depression prove that Keynesian stimulus worked?   Let's quote Krugman again:

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.
Now there are many things I would call World War II, but one of them would not be a "public works project".   In World War II, we weren't building bridges; we were building weapons  and bombs to blow up other peoples' bridges.  But with World War II, the U.S. got lucky; it won the war, and ended up with half of the world's productive capacity.  People often say military spending is non-productive.  But World War II was an exception, at least for America.  All that military spending turned out to be productive, indeed exceptionally productive, a truly wonderful investment on the dollar - for America at least -, because it was used to wipe out the competition.  

So, if World War II is the example in the real world that Krugman thinks corroborates the model of Keynesian stimulus, then it would seem that it was a very particular case, and that other, unique factors could have played a role.  England, for instance, had the same war stimulus, but endured rationing until 1954.

But let's quote Krugman a fourth time
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.

I'm not opposed to all economic ideas.  Just the dumb ones.

Wednesday, November 26, 2008

Note to Obama: Make this Illegal

This is how it begins (from Bloomberg):
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.)    

Since no public official is likely to heed such advice, here's some more, to some other public officials:  if you are able to legislate or prevent state or town or county officers from entering into such contracts, then do so.  Public officials should be limited to borrowing money with fixed interest rates.  Bonds or loans.  It's not sexy, but it will prevent government agencies from losing the taxpayer's money at the dog races where the betting is run by the mob.

Tuesday, November 25, 2008

Rogue Trader

What does a nation do when the head of its central bank becomes a rogue trader? From Wikipedia:

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

More on Buffet Puts

The SEC exchanged letters with Berkshire Hathaway in July of this year. Interesting. Berkshire wrote:

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

First Reaction - Cititgroup Rescue

From Reuters:

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.

Times are Changing

Private jets are out (or at least two of them), and so are expensive rings (you can wear them, but your media friends will try to airbrush them out).

Friday, November 21, 2008

Bonuses vs Dividend

BNP, the leading French bank, announced to employees at its investment-banking division that bonuses would be down around 75% this year.  Meanwhile, the CEO of cross-town rival Societe Generale, of Jerome Kerviel fame, said that the dividend next year might be cut.  Guess which stock fell by almost 15% today?  

Wednesday, November 19, 2008

Buffet's Weapon of Self-Destruction

Almost everyone remembers famed investor Warren Buffet's remark that derivatives were "financial weapons of mass destruction."  Fewer people remember that Mr. Buffet's Berkshire Hathaway has made probably the biggest equity derivative's bets in history.  They are mentioned in its annual report here (page 47):

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. 

Financial weapons of mass self-destruction, indeed.

Tuesday, November 18, 2008

Heard on the Street article on bonuses

I might as well keep on the bonus beat - somebody's got to do it.  Here's an article from the Heard on the Street section of the WSJ:

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.

Against the backdrop of a financial crisis and intense public scrutiny --particularly after government capital injections -- they had little choice. And, from a purely self-interested perspective, executives have more to gain from getting their share prices up again.  [a here -- Or from keeping the government at bay, so the pigs can return to the trough next year]

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]  

Those will be way down anyway because of weaker revenues.

But the firms also need to show restraint on the percentage of those revenues they pay out.

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%...]

Adopting some of the new ideas on pay pioneered by UBS to avoid excessive risk-taking would be another. For example, the Swiss bank is to keep a portion of cash bonuses in escrow -- with a provision for some to be deducted if the bank generates losses in the future.  [So, you give the bankers a bonus the year they lose lots of money, but you don't give it to them right away, just in case they lose lots of money again.]

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.

This year the pair should surprise investors, who have lost their shirts in
recent months, by being tough.

Weak revenues will ensure lower bonuses anyway. But the firms should make a point by also paying out a lower-than-usual percentage of that shrunken revenue number in compensation.

If investors are to commit new capital in the future, management needs to demonstrate a willingness to put profitability first.

This is the ideal time. With all of Wall Street under extreme pressure, the risk of losing staff is much reduced.  [So remind me, why are the banks paying bonuses at all?]

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

Bonuses : UBS Apes GS

The NYT reports that UBS will, like Goldman, not pay its executives any bonus this year.   The NYT apparently wants to say, Hurrah!  But it looks more like a concerted publicity campaign, to deflect attention from the fact that both are still planning on paying out huge sums this year to everyone else.  And make no mistake about it - executive bonuses are only a fraction of the pool;  most of the money goes to those below.  Inquiring minds want to know why any IB worker should get a bonus, when IBs are receiving taxpayer money to stay afloat.  Unhappily, it looks like the IB model of pigs-at-the-trough will be left in tact; and these same UBS and Goldman executives are undoubtedly planning to make up for this year's sacrifice with even more loot the next time around.

More on Bonuses

Bloomberg had up today a story on attempts by British regulators to rein in bank bonuses, which - unfortunately - meandered a bit.  The article started by saying that "employment contracts [may] hinder efforts to make changes this year". Why? Because some bonuses are guaranteed - when a person is hired, a certain pay-out is written into his contract (for instance) for the first two years. 

It is only at the end of the story that it is acknowledged that it's just a few lucky ducks (usually, those who recently changed jobs) who have guarantees; most do not. So at the least, most bank workers' bonuses can be reduced to zero with no problem. Perhaps those who end up with nothing will cry about the unfairness of the situation, as those with guarantees receive a huge sum for equivalent work, while their team members get nothing. But that's a bit like a model claiming she's being discriminated against because her hair is black rather than blonde. The bonuses that financial-services workers receive are patently unfair compared to the compensation of everyone else in the world; so if fairness is what they want, then the best way to achieve it is by getting no bonus at all.

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

IB Compensation: The Fix is In

Goldman Sachs has announced that it won't give bonuses to its top seven executives. NY Attorney General Cuomo, one of the leading public figures involved in the bonus question, sounds satisfied:
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.

Czar Bernanke

David Brooks writes against a bailout for American automobile companies, by asking "Are we really to believe there exists a czar omniscient, omnipotent and beneficent enough to know how to fix the Big Three? Who is this deity?"

I wonder what he thinks of Bernanke...

Great Depression II

Roubini argues that the U.S. is facing the worst recession in decades (via Naked Capitalism). Roubini seems to be getting behind the curve, as even the normally staid Brad DeLong has proclaimed we are facing the worst recession since the second world war. And former Goldman Sachs chairman John Whitehead has been the first notable to raise the specter of a contraction worse than the Great Depression.

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

Financial Bonuses

Bloomberg news, bless its soul, has had a couple of good articles this past week on bonuses by investment bankers.

This was followed by a commentary by Joe Mysak, where he asks the right question,

``Have you no sense of decency, sir?''

Covering your bases rather than sticking out your neck

Brad de Long writes (9:11 14 Nov 2008) on his blog, "I am now going to stick my neck out and say it will probably be the worst downturn since the Great Depression."  Is this a case of his sticking out his neck or just covering his bases?

Only last July BDL wrote, "If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism [lowering interest rates to prevent an economic slump] was a mistake."  

Since unemployment hit 10.5% per cent in the 1980-1982 recession, it would seem that BDL is now saying that unemployment will "kiss" higher than 10%.   Will he concede that Greenspanism was a mistake?   Or is he just trying to have it both ways - predicting a 10% unemployment rate in the one case, pretending it's not going to happen in the other?

Why oh why can't we have better economists?