Category: Structured Products and Derivatives

At the Fordham Conference: Time for a New Antitrust? False Assumptions

At the Fordham Conference: Time for a New Antitrust? False Assumptions

Posted on by David Merkel

Carl Felsenfeld: Do we know what the problem is?? What are we trying to solve?? Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.? But it didn’t deal with those bank acquisitions.? The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.? (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.? The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.? Perhaps a more rigorous application of the Sherman Act would be more effective.? Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.? Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.? RBC as well.? Difficult to detect Control Fraud.? Originating bad loans allows a bank to grow rapidly.? Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.? – Worked ten years at a major bank that went through? a ton of mergers.? The self-regulations with each bank having its own risk model doesn’t work.? The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.? Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.? Bonuses to executives skew incentives.? (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.? Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).? (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?? The market is good at absorbing single failures.? (DM: but not multiple failures.)? b) who should do the regulation?? Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.? No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.? Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.? Analyze management culture for short-termism.? Remember you can never get pricing, volume and quality at the same time.? Financial companies are in a mature industry, so beware sompanies that grow fast.? Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.? I’ll write more about that tonight in a piece that articulates my views on banking reform.

At the Fordham Conference: Creative Ideas for Limiting Bank Risk 2

At the Fordham Conference: Creative Ideas for Limiting Bank Risk 2

Posted on by David Merkel

Simon Johnson’s lunch talk was pretty standard: there is no social benefit to banks being larger than $100 billion in assets.? Major banks are too politically powerful, but they should be fought the same way Teddy Roosevelt did with JP Morgan and trustbusting.? Simon thinks that political opinion is shifting on this issue.? He calls for a size cap based off of a 4% percent of GDP for commercial bank assets, and 2% for investment banks.? This would only affect 6 banks, and would put the banking system sizewise where it was in 1990.

A frequent comment is that Canadian banking is concentrated, and they haven’t been hurt.? But other nations have concentrated banking and have gotten into trouble, notably Switzerland and the UK.

One commenter noted that reliance on wholesale funding drove much more of the panic than deposit funding.

Now the third panel starts:

Rob Johnson spoke about creating a credible resolution authority.? He asked why we can’t send Large Complex Financial Institutions [LFCI] through Chapter 11?? Derivatives must be simplified and brought into clarity.? Contagion, complexity, etc.? No real solution offered.

Jane D’Arista — Financials cannot insure other financials.? Leverage must be scaled back.? Various types of short term funding must be scaled back.? Margin standards must be extended to all financial instruments.

Richard Neiman — Banks are risk-takers, that provide a social service, thus taxpayer guarantees via the FDIC.? Volcker rule may not have prevented the last crisis, but it might prevent the next.? Need a group to try to be proactive on future risks — war-gaming.? Attempt to predict black swans.

(DM: most of this can be done by following increases in leverage.)

Arthur Wilmart: no magic bullet.? Fed overstimulated housing market after dot-com crash.? Reduce implied subsidy to banks.? How to internalize the costs?? Three problems on deposit limits: failing banks, intra-state acquisitions and thrifts aren’t counted.? Narrow banking would contain the subsidy.? Systemic risk insurance fund — at least $300 billion, pre-funded.? FDIC would manage it — most competent of the regulators.

Frank Pasquale — Talks about information asymmetries, need more disclosure.? Financial privacy — banks that are big would have to reveal a lot more.? Records of everything would have to be kept for a long time 10-15 years.

A discussant: choosing the lax regulator (DM solution: government assigns the regulator)

DM: banks should not lend to or own other financial firms.? That would end contagion.? At least that should be limited to a percentage of assets, or through the RBC formula.

One panelist suggests that all financial instruments be traded on exchanges.? (Ridiculous, because only common instruments can can trade on exchanges.? Unique things don’t trade on exchanges.? That’s why IBM equity trades on an exchange, but most IBM bonds don’t.)

Discussant: banks cannot self regulate, not even as a group.

Cheapest source of funds are FDIC-backed deposits.? That’s the big subsidy.? (DM: Charge a much larger FDIC fee.)

Discussant: won’t narrow banking create more risk outside the banks?? Where things are less regulated?? Those losing money outside of the banks would end up taking a haircut.

Discussant: GS or MS failing would still shake the system.

Discussant: a new insurance fund would be difficult to make work.? Also,a new regulator might not be better than existing regulators

Discussant: Regulating money market funds as banks.? (DM:? money market funds lost so little, and banks lost so much… why is this an issue.)

The Rules, Part III

The Rules, Part III

Posted on by David Merkel

Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.? The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.? It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.? All we need to know is the mean and the variance, which are very simple to calculate.? And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.? I would guess that it is wrong more often than it is right.? Academics continue to drag out studies assuming normality because it allows them to publish.? academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.? Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.? Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.? Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.? Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.? The company couldn’t earn an adequate return on capital at such low levels of leverage.? Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.? So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.? But that stopped when the Fed could not drop rates below zero.? Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.? It does not work in finance and economics.? When looking at loss statistics, don’t look at the mean or the variance.? Instead look at the maximum 3-year loss, and gross it up by 20%.? The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.? I use this as an example rule; tailor it to your needs as you see best.? I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.? Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.? Very unlikely.”? Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.? Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.? A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.? When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.? Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.? The regulations have been too loose for too long.

The Rules, Part II

The Rules, Part II

Posted on by David Merkel

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.? I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.? I?m still working with it.? Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.? If Greece defaulted, Greece would lose the low cost funding of the Euro.? The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.? Tough love is the best policy; don?t bail others out if you care about the union as a whole.

On to tonight?s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.? If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.? There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.? In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.? There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can?t make good on his obligations.? As with many speculators, he overcommits.? He is short of funds because many trades are going against him at the same time.? It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.? The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.? After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.? They were one of the main classes of marginal borrowers.

-=-=-==-=-=?==-

Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.? There are trades that no one wants to take at any price that a seller could live with.? There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.??? Complexity is a minus.? We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.? It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.? We see it in corporate bond spreads.? High quality borrowers borrow cheaply.? Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.? This one could go either way; spreads are wide against history, but might be narrow against current difficulties.? The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

The Rules, Part I

The Rules, Part I

Posted on by David Merkel

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.? Not so humbly, I called it “The Rules.”?? This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”? Please understand that I don’t want to make grandiose claims here.? After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.? There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.? For a while, the quant models were poison.? Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.? To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.? You have the upper hand.? But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.? Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.? It is a zero-sum game.? Yes, as crises arise there are always those that look for a way to make money off of the crisis.? And there are some parties willing to risk that the crisis will not be so bad, at a price.? Derivatives don’t exist in a vacuum.? Same thing for shorting — there is a party that wins, and a party that loses.? So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.? You can’t cheat an honest man (or country).? You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.? Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.? If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.? It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.? CIT did die.? Mexico in 1994.? When you can’t roll over your short term debts, it gets really ugly, and fast.? Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.? Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.? “The phrase, “You can always refinance,” is a lie.? There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).? I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.? I know why it happened this way.? A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.? Voila, 5-year mortgage loans with a balloon payment.? For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.? After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.? The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.? But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.? That way the deals would closer at the end of ten years.? Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.? Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.? Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.? Don’t cheat and finance shorter than the life of the assets involved.? There is never an assurance that you will be able to get financing on terms that you will like later.

Notes and Comments

Notes and Comments

Posted on by David Merkel

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.? Ready for how much they made?? Ta-da!? They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.? I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.? But Paul Kedrosky crystallized it for me when he posted this.? And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.? What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas ? Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back ?scaredy cat? regulators who don?t let banks deal in anything they don?t understand, which isn?t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing ? that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and ?scaredy cat? state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS ? if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?? Probably, but consider this article here.? I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody?s Baa series ? because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I?ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment ? few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don?t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.? Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream ? ?Ratings are supposed to be good over a full market cycle!? When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can?t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)? Barry comments on how Goldman Sachs bags clients.? Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.? My comment:

I always advise retail investors not to buy structured notes ? Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn?t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than ?buyer beware,? and ?Don?t buy what someone else wants to sell you. Buy what you want to buy.?

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.? It was featured by Barron’s and picked up in a piece by Barry.? Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.? My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.? My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.? They recently did a piece on whether it is better to buy a home now or wait a while.? My comment:

Anytime you have an artificial deadline for losing a benefit, as the deadline draws near, behavior can become more uneconomic ? ?gotta buy before the credit expires.? Since one can?t see what the price of the house would be in absence of the credit, the higher price doesn?t get factored in. People think, ?If I want it, can I afford the monthly payment and make the down payment??

I suspect that if/when the credit expires, prices will sag on the low end by more than the amount of the credit. We?ll have to look at Zillow to get some hint on that if/when it happens.

11) An interesting piece from the WSJ regarding the fight between wind power providers and natural gas power providers in Texas.? Wind is inherently variable, and so can’t offer guarantees, which other power providers have to. My comment:

The logical way to end this is to align interests — have the wind power producers own some natural gas peakers to offset their variability, and then compete by offering a base load type of power more cheaply.

Or, let them enter joint ventures together, and split the profits. If natural gas and wind can work together they can offer cheap clean power.

12) Another post in the WSJ, asking whether Economics deserves the title “Science” or not?? My answer today is different than if you had asked me 25-30 years ago, when I was a student.? My answer today would be “no.”? Mathematics has added a gloss of seeming science to economics, but the models do not work.? Macroeconomic models don’t forecast well.? Microeconomic models do not explain human behavior well, let alone forecast.? And, models of development economics common when I was a student actually retarded development of countries.? And don’t get me going on Modern Portfolio Theory.? Anyway, my comment:

More to the point, until the economics profession abandons their macroeconomic models, and moves to something closer to ecological models, they won’t have a shot at understanding how things work. Economics has physics envy when it should have ecology envy.

And then, they will realize that you can’t come up with good mathematical models there either, at least not those that allow for prediction and control. Then we can bring economics back to what it should be, a non-mathematical discipline that attempts to explain how men act to gain/create resources to pursue goals.

13) Felix had a good piece on Buffett’s recent shareholder letter.? My comments, edited, because they did not post right:

Felix, for what it is worth, if Berky wanted to issue debt today, they would have to issue at around 0.75% +/- 0.15% over agency yields. More around 5 years, less around 30.

While I?m here, here are 2 curiosities ? Bloomberg?s DLIS function doesn?t work with Berky, which gives a list of maturities, probably because of all the nonguaranteed debt, and EETCs [enhanced equipment trust certificates] from BNSF.

But, using a download feature on Bloomberg off of [BRK Corp] a list is easily available. Sorting it by size of issue outstanding, what is fascinating is that most of the holding company debt has a short tenor. My estimate is an average maturity of 4.4 years and an effective duration of 2.8 years. 90% of it comes due by 2015.

Now, Berky doesn?t have that much debt at the holding company level, but it is remarkable that they are financing so much short. It is a negative arb, because he has a little more cash on hand than holding company debt.

It is a fascinating side of Berky.? Buffett could pay off all of his holding company debt with cash on hand but does not.? He pays a small price to stay flexible, in case he wants to make a big investment.
14) Finally, I’m going to be on the Ron Smith show today, talking about my recent piece on the finances of our Federal Government.? If you are not in the Baltimore area, you can listen here.? I will be on at 5PM Eastern.
A Question of Cultural Failure

A Question of Cultural Failure

Posted on by David Merkel

I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”? The reasoning is simple:

  • Governments can only control a fraction of what an economy or culture does.? Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.? More of the economy or culture goes into hiding, away from the prying eyes of the government.
  • Markets only express a fraction of what mankind does.? They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.? Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.? So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.? The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.? The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.? They act as an internal European IMF, insisting on reductions in the Greek budget deficit.? Greece does its part by saying it hasn’t asked for aid, which is unlikely.? At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.? Protests!? Strikes!? There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.? In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.? Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.? A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.? If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.? I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.? Anything indeed, but who pays the bills?? Dubai is a place of big ideas and little responsibility. ?? It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.? That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.? Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”? Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

A Pox on Liquidity Derivatives

A Pox on Liquidity Derivatives

Posted on by David Merkel

I know I have written about ideas like this before, but I cannot remember where.? Let me start with a story.? I was at a Society of Actuaries conference in 2001 when I bumped into an actuary who was well-known to most before a meeting.? She recognized me, and I asked her what she was seeing that was new.? She told me, “Liquidity Derivatives.”

I shook my head for a moment and said, “Wait a minute, you mean getting a counterparty to pay cash at a time when liquidity is scarce?”? She giggled and said “Yes.”? I continued, “But wait, who would offer to pay at a time when liquidity is scarce?? She said, “That’s the problem.”? The speaker started to talk, so our conversation ended.

That is why I am skeptical about crisis derivatives.? Felix has commented on this, and he is worth a read here.? Unlike many, I do not think that all events in life can be hedged or insured.? In major disaster situations, no one can marshal the resources to make up for the disaster.? No one can insure against property damage in a war.

Citi has its own index of financial stress.? Here it is over the last 13 years:

Surprisingly, Aleph Blog has its own proprietary index for the same thing.

The graphs go the opposite way, but the correlations are over 80% in absolute value terms, and I can tell you that my measure more directly covers what Citi is going for, because it is the difference between the yield on the two-year Treasury and an index of A2/P2 commercial paper.

So, do you want to be able to fund yourself in a crisis?? Do the following: buy two-year Treasuries, and sell short A2/P2 commercial paper.? Most of the time this is a costly trade, if you can get it done at all.? But access to financing during a crisis is valuable, and should require compensation in advance to obtain it.

As for the Citi product, they should ask the question, “who would be willing to part with liquidity during a liquidity crisis?” and ask the question “Are they unquestionably solvent?”? Insurance is no good if the insurer is insolvent.? If Citi is the counterparty, I for one would not be comfortable.

Let me summarize.? Liquidity derivatives are not a reasonable product.? You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.

What is Liquidity? (IV)

What is Liquidity? (IV)

Posted on by David Merkel

When I was a corporate bond manager, I often dealt in less liquid bonds.? Why?? They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.? I had the option of holding those bonds, but not the obligation of holding those bonds.? As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.? I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”? She gave me that usual sweet smile and said, “Okay, David.”? I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.? To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”? I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.? I ended up selling 2/3rds of my holdings, and made significant gains for my client.? The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.? Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.? Then he would let them sit, while they gained in value on average.? Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.? Most things in an average person’s life will not be liquid.? Your house and car are not liquid.? It will take a lot of effort to sell them and buy a different house and car.? So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.? Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.? In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.? Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?? In one sense, yes.? During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.? But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.? The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.? The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.? The private company could act quietly and think longer term, subject to the constraints of their loan agreements.? The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.? For the public and private companies alike, liquidity for any large amount of the shares would be an event.? And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.? My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.? Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?? Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.? The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.? If enough do that, short term yields get really low.? They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.? He told me I was nuts, people would sit on cash.? I replied, “what if you can’t keep the cash safe?”? Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?? There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.? They can’t move to cash.? Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.? Is there really a lot of liquidity out there?? Or, is it being used primarily by the US Government and its affiliates while the economy is weak?? I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.? During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.? It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.? In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.? My contentions are:

  • Securitization does not create liquidity, it only redirects it.
  • The Fed does not create liquidity, it only redirects it.
  • The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.? We all have to work and trade to survive.? Liquidity is where people are transacting at any given moment toward that end.? Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

Too Much Leverage Precedes Many Disasters

Too Much Leverage Precedes Many Disasters

Posted on by David Merkel

There seems to be some confusion over what threatened to cause major banks to fail.? Let me go over my list of the risks:

  • Many relied on AIG to insure their subprime and other structured lending risks.? Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”? After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!? Alas for risk control, and the illusion of the strength of companies merely because they are big.
  • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.? Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.? When the tide goes out — oh well,? GE Capital might not have survived without the TLGP program.? Another reason why I sold all my GE Capital debt when I was a bond manager.? Big companies can make big mistakes.? Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
  • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.
  • Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
  • In general, banks ran with leverage ratios that were too high.? Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.? Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
  • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.? The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.? Guess who survived?
  • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
  • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
  • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
  • State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading.? These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.? By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened.? I don’t care if it means that lending diminishes for a few years.? Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.? (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains.? In the long run, what makes economic sense will prevail, not what scores political points.

Theme: Overlay by Kaira.