This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
Let’s start with the more esoteric of the two books, The Complete Guide To Option Pricing Formulas.? Almost every option formula is included there, together with ways of estimating volatility, certain statistical techniques, aspects of compound interest math, etc.? The book is very comprehensive, and for those that need how to estimate the value of standard and non-standard options, it is a good book to keep on hand as a reference, together with the free CD-ROM containing an Excel add-in that allows you to use the formulas inside Excel.? I have used them for some of the insurance companies I have worked for; the software was easy and reliable.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
There are quirky aspects to this book, including cartoons and photos that are somewhat self-aggrandizing to the author, but make the point in a humorous way.? I liked both books, but only a modest fraction of my readers should have any interest here.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? My objective is to aid my readers, and not explicitly take money from them.
Ding!? Round one ends in the legal fight between Bloomberg, LP, and The Federal Reserve.? The Columbia Journalism Review provides a summary, as does Bloomberg itself.
Here’s a redacted version, showing the changes.? (Please note I scanned two bitmap documents, and did OCR on them, and ran a document compare — there may be some errors here, but I did the best that I could.)? The main expansion of the complaint is the inclusion of a request for documents related to the Bear Stearns rescue.? It also clarifies that it is looking for loan records.
Here’s the the Fed’s answer to the amended and expanded complaint.
The Fed’s basic response is that no documents exist for some of the requests, that it has turned over some documents, but is holding onto pages of 231 documents for which they claim to have an exemption under FOIA.? They claim exemptions 4 and 5, which are (from Wikipedia):
4) trade secrets and commercial or financial information obtained from a person and privileged or confidential;
5) inter-agency or intra-agency memoranda or letters which would not be available by law to a party other than an agency in litigation with the agency;
This is just my take, and I could be wrong, but it seems to me that the Fed refuses to disclose on the grounds that the documents are sensitive since they contain confidential financial information, or, they involve inter- or intra-agency communication, such as with the Treasury, or inside the Fed itself.? Point 5 seems to be a pretty broad exemption, but it remains to be proven whether the information is of such a nature that only an inter-agency suit could force divulging the data.
The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn?t lend against.
They are playing favorites with institutions, and don?t want that to be revealed.
The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
Certain banks would be embarrassed by revealing what they own.
It?s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).
As pointed out in the Bloomberg article above, there is a good possibility that they are trying to hide the amount that they have lost already.? Also, as I have pointed out in my last piece on this topic, the insurance industry discloses everything with their assets, and it does not harm them.? It would not hurt banks to do the same, and certainly if it is a matter of this one limited disclosure, the confidentiality of the banks would probably not be materially harmed.
1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.
2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?
4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.
5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.
6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.
7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.
8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.
9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.
11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.
12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.
13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.
14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.
Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.
The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.
An End to Redemption-Related Selling by Hedge and Mutual Funds
Increased Lending
Tax Cuts
I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”
19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.
20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:
Endemic Political Corruption
Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.
21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.
I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.
23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.
24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).
1) What a mess.? I had been lightening up on equity exposure over the last week, but seemingly not enough.? The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months.? Well, at least I admit it when I lose; let’s see if I can’t do better in the future.
2) The rally in long Treasuries is the cousin to the fall in equities.
A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%.? That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run.? The long run is another matter.
3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries.? If I may, what isn’t the Fed going to buy?? Do they really want to flatten the yield curve when the long end is this low already?? Don’t they have enough to do with instruments that have credit risk?? They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.
4) One example of that is the junk bond market, where the average yield is now over 20%.? Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.
6) TIPS, excluding the long end, are trading below par.
Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities.? The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation.? I don’t see that coming over the intermediate-term, but in the short-term we could see that.? Eventually the Fed will have to monetize many of the promises that it is making.
7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP.? That is a true horror.? I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now.? My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.
8 ) It is no surprise here that GM is scrambling, as are the other automakers.? Let them try to get debtors to compromise.?? They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy.? They have refused to accept some liabilities in the past.
9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved.? I guess it took Paulson longer to realize the immensity of setting up those auctions.? It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.
10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan.? (Note the dirty float free market-like movements. 😉 )
Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.
It would be a simple matter of fairness as well.? As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.
11) It’s my view that the economics profession comes out of this crisis with a black eye or two.? There is a lot of room for humility here.? Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.).? That is a strength of the Austrian school, though.
Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller.? The way that assets are financed does make a difference when there is financial stress, and even more in insolvency.? Also, the financing windows are not always open.? Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments are not valid except when the market has “fair weather.”
12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply.? Personally, I don’t think it will work.? It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive.? Three last semi-related articles that I found interesting:
T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them.? There are some dangers though:
a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.
It might be better for the US Government to lock in long funding rates while they are available.? Who thought the 10-year or 30-year could be so low?
I am a skeptic on leveraged ETFs in one way.? My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.
To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index.? There is also slippage from rolling futures from month to month.
Here’s my challenge, and I may do this myself, or, though I encourage others to do it.? Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage.? If there is no friction or fees, they should do as well as T-bills.? My guess is the higher the leverage the lower the aggregate returns.
Let the games begin.? Does anyone want to run this analysis before I do it, say, six months from now?
hmf asks, “David – if possible, whenever you have a chance, could you please explain why there is any spread whatsoever between govt-guaranteed bank-issued debt (e.g., the GS TLGP bonds) and comparable treasuries.? It would seem they’re one and the same – thus no default risk.? Thank you very much!”
I left a comment on this on John Hempton’s blog, who also addressed this question.? The comment is still in moderation, so I will attempt to recreate my argument.
There are many US Government securities, some of which are “Full Faith and Credit” [FFC] that trade with a spread over on-the-run Treasury securities:
Off-the-run Treasuries trade at a discounted price (higher yield) due to illiquidity.? Note: On-the-run securities are the ones that have recently been issued.? They are often used by Wall Street for hedging purposes in other bond issuance, which adds to the liquidity (most of the time).
Title XI shipping bonds (full faith and credit) trade at a spread to a ladder of similar maturity Treasuries.? They are less liquid, but there is usually good demand for this paper.
Aid to Israel and TVA bonds are full faith and credit [FFC] and usually trade at a spread over Treasuries.
Overseas Private Investment Corp bonds (FFC) often trade at a spread over Treasuries.? I once bought some OPIC put bonds where the option adjusted spread was 2% over Treasuries.? I had to buy the whole issue, so, again, it was illiquid, because anyone you would try to sell it to you would have to educate them on the bond.? Not easy, why should the seller trust your explanation, particularly as you no longer want the bond?? (That’s what brokers are for…)
I used to manage a portfolio of Credit Tenant Leases.? Most of my leases were on buildings leased by agencies of the US Government, and the lease payments were not subject to appropriation, so I did not have to worry about the budgeting process of Congress.? These were not FFC, I had a cut-through claim to the lease payments; I had priority over the building owner in getting paid.? If the US were to fail to pay, I had recourse to the building owner (can’t squeeze blood from a stone, though), and failing that, I could take possession of the building.? So with a hard asset behind the loan, I was doing secured lending to the US Government, and getting 1.5-2.0% over Treasuries to boot.? Though the CTLs were fungible, they were definitely illiquid.? But when you think about the extra spread versus the possibility of loss — the property was high quality, the return was disproportionate to the risk.
Another [not FFC] piece of paper was a first mortgage note on a building that served a critical government purpose, where the government could not move because of old computers which they could not move due to fragility and security reasons.? We got roughly 3% over Treasuries in a small deal where I ended up buying 20% of the issue.
Are Fannie and Freddie guaranteed by the government?? They seem to be, but you can pick up an additional 100-140 bps if you lend to them.
So, it’s not unusual for FFC securities to trade at spreads over Treasuries.? And, it is normal for pseudo-government securities to so trade.? But it is weird for the 3+ year Goldman Sachs securities to be issued at 2.2% over the relevant Treasury security.? It’s not an illiquid issue — $5 billion is a big deal.? There is a little structural complexity, but it is in the nature of a financial guarantee from the government.
There is the matter as to whether the Government would ever selectively default on FFC guaranteed issues, but the courts would have something to say on that, unless Congress deleted their authority on the matter.? You can’t fight city hall; you certainly can’t fight the US Government, and it has been behaving erratically of late.
So, if I were managing insurance/bank assets, would I buy these issues with a FFC guarantee from the FDIC.? Yes, all day long unil I was full of them.? The reasons cited for not buying them don’t add up, and they seem really cheap.? I would use them as a substitute for Treasury and Agency securities.
PS — A note to the new administration: want to save money?? Easy.? Create a capital account for the budget, and borrow using Treasuries to buy the buildings that you use.? Don’t do CTLs anymore.
Here’s a bonus idea off of yesterday’s post.? Offer longer-dated floating-rate debt indexed to 3-month T-bills.? It would be a TIPS substitute, and cheaper.
Update: 10/27 10AM: Bond Newbie is correct. TVA securities are not FFC — I slipped on that one because of a project that I worked on long ago, and my knowledge was garbled. Here is an incomplete list of all FFC securities:
Farmers Home Administration Certificates of beneficial ownership
General Services Administration Participation certificates
U.S. Maritime Administration Guaranteed Title XI financing
Small Business Administration Guaranteed participation certificates and Guaranteed pool certificates
Government National Mortgage Association (GNMA) –? GNMA-guaranteed mortgage-backed securities, and GNMA-guaranteed participation certificates
U.S. Department of Housing & Urban Development Local authority bonds
Washington Metropolitan Area Transit Authority Guaranteed transit bonds
If anyone knows where there is a full list, I would be happy to post it.
I’ve been asked by a number of readers for my opinion on the economic team being put together by the incoming Obama administration.? I’m not that excited, but then Bush Junior’s economic team was pretty consistently disappointing.? What we have is a bunch of Clinton-era retreads in Summers, Orszag, and Geithner.? Bob Rubin may not be there, but those that learned from him are there.
And, this is change.? I have sixty cents sitting next to me.? That’s change also.? Moving from Paulson to Rubin’s students is exchanging one part of the intellectual framework of Goldman Sachs for its cousin.? As Ron Smith said to me off the air when I was recently on WBAL, the economic advisors of Bush and Obama are members of the same intellectual country club.? There is little real change there.
But, look at it on the bright side.? The best part of the Clinton administration was the Treasury Department and the affiliated entities.? Perhaps that will be true of the Obama administration as well — pragmatism ruling over dogmatism, and a fear of freaking out the bond market.? Could be worse.? Save us from misguided idealists (perhaps Bernanke — a pity he didn’t pick a different dissertation topic), who think they know how to fight economic depression, but really don’t, and waste a lot of time and money in the process.
As it is we get two new programs this morning that are more of the same😕 Keep expanding the Fed’s balance sheet; don’t think about the eventual unwind.? Create more protected lending programs that encourage lenders to flee unprotected areas of the market for protected areas.? Do anything to shift debt from private to public hands; but don’t do anything that truly reconciles bad debt.
I do have a beef with the selection of Geithner, though.? This Bloomberg piece gives a sympathetic rendering of his attempts to deal with derivatives.? He tried to achieve consensus of all parties.? My view is that the areas where he could achieve compromise were areas that were important but not critical.? He needed to take a bigger view and question the incredible amounts of leverage, both visible and hidden, that we were building up and focus on what regulatory structures could properly contain the increased leverage, lest the gears of finance grind to a halt, as they have done today.
We can be less sympathetic, though.? Chris Whalen’s (Institutional Risk Analytics) opinion of him is quite low, or, as he was quoted in this NYT article:
?We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,? said Christopher Whalen of Institutional Risk Analytics. ?Throw in the Bear Stearns/Maiden Lane fiasco for good measure,? he said.
?All of these ?rescues? are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.?
Ouch.
?He was in the room at every turn of the crisis,? said another executive who participated in several such confidential meetings with Mr. Geithner. ?You can look at that both ways.?
This Wall Street Journal editorial is similarly bearish.? Geithner was in the room on every bad decision, and a few non-decisions.
My view is that he is a bright guy who is out of his league in trying to deal with the aftermath of the buildup in leverage, that has lead to the collapse in leverage that we all face.? Now, I can’t be that critical of him, because he has been cleaning up after the errors of many, a small fraction of which he bears some responsibility for.
No one is equal to solving this crisis.? It is bigger than our government, which made an intellectual mistake in thinking that it could promote prosperity through Greenspan-like monetary policies, which almost everyone lionized while they were going on, except a few worrywarts like me, James Grant, etc., who followed the buildup of leverage in the Brave New World.? Now we face its collapse; let’s just hope and pray? that it doesn’t lead to worse government than what we have now.
PS — If I were offered the opportunity to fix things, I would take it, and:
Create a means of resolving home foreclosure issues in a manner similar to Chapter 11, which would lead to more compromises.
Institute true tax reform that eliminates the sheltering of income, and eliminates all tax preferences.
Wind down the Fed’s current “solutions”
Begin inflating the currency to force up the value of collateral relative to nominal debt levels
The last one I like the least, but I’m afraid it would have to be done.? Phase two would be:
Move to a currency that is gold-backed.
Replace the Fed with a currency board.
Create a new unified regulator of all depositary institutions.
Slowly raise bank capital requirements, and make them countercyclical.
Bring all agreements onto the balance sheet with full disclosure.
Enforce a strict separation between regulated and non-regulated financials.? No cross-ownership, no cross-lending, no derivative agreements between them.
Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
Move back to balanced budgets, and prepare for the pensions/entitlements crisis.
On that last one, there are few good solutions there, but we would have to try anyway.? So it goes.
This book is big, very big at ~700 pages. It is a testimony to the idea that history doesn’t repeat itself, but it often rhymes.
The book is arranged chronologically, and geographically within each time period.? Time is spent on each are roughly in proportion to the amount of unique data that we have from each era.? Thus, the recent past gets more pages per year.? Roughly one-quarter of the book goes from ancient times to 1800, and one quarter to the 19th century.? Half of the book is 1900-2005.
There are several things that the book points out, common to each time and area investigated.
1) It is very difficult to eliminate interest.? Even when governments or religions try to restrict interest, either in rate charged or in entire, systems arise to create promises to pay more in the future that than full payment today.
2) The more technologically advanced economies get, the lower interest rates tend to get.
3) Boom/bust cycles are impossible to avoid.
4) Governments introduce currencies and often cheat on them (debasement, or inflation of a fiat currency).
5) Governments do sometimes fail, whether due to a lost war, civil war, or default, taking their currencies and debt promises with them.
6) The economic cycle across the world is usually more correlated than most people believe at any given point in time, even in ancient times.? (How much more today… decoupling indeed…)
7) Cultures that allowed for a moderate amount of debt financing prospered the most, in general.
Those are my summary points after reading the book.? Homer and Sylla drew some but not all of those conclusions.? It’s an ambitious book and and ambitious read.? Sidney Homer did a lot of significant work researching from the past to the middle of the 20th century, and Richard Sylla did an admirable job giving the grand sweep of the increasing complexity of the bond markets as the 20th century progressed until 2005, which was an interesting point at which to end the fourth edition.? The fifth edition, should there be one, will prove even more interesting as it surveys the end of the housing and credit bubbles, and the shape of the financial system in their aftermath.
This book is a must for those that like economic history.? I really enjoyed it.? For those without such an interest, it’s a big, somewhat-expensive, show-off book that will be occasionally useful as a reference.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I’m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.
What the FDIC did with WaMu affects other banks like Wachovia.? Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.? Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.? If one of them fails, the game is over.? Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.? Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.
What I meant by “the game is over” is that the idea that you can keep laying off risk on increasingly large and complex banks would be over as a strategy.? Also, the ability of the US Government to continue to bail out every decrepit entity would be tested, and possibly found wanting.
There are still more oddities to the current bond market, most of which involve parties that can?t take certain risks any more.? We can expand that to banks, and toss in Citi.? Citi is trading like it is going out of business.? Now, Citi is one of the ?too big to fail? [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.? If they are in trouble, I?m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.? Is there a foreign bank that wants them?? I doubt it.? This would be another area where a new TBTF chapter of the bankruptcy code would be useful.
So now we have a bailout of Citi by the US Treasury and FDIC.? At present the rescue of Citi is a plus to the markets, because it takes a short-term problem off the table, leaving behind a more ill-defined long-term problem: how much can the US Government borrow/guarantee?? Also, what of their derivative exposures, and the state of the other TBTF banks?? It’s difficult to get that big in a credit boom without absorbing the seeds of the credit bust.
So, I am selling a little into the euphoria.? We will see where all of this leads, but my guess is that it is just one more step on the road to credit failure for the US Government.
I’m taking a brief break from “all crisis, all the time” writing.? I’m backlogged on book reviews, and it is time to write some.
When I get a book on asset allocation, I suck in my gut and say, “Oh no, not another book that falls into the common traps of only relying on past history, and doesn’t consider structural factors….”? I was surprised this time, and I have a book on asset allocation that I can wholeheartedly endorse.
Messrs. Swedroe and Kizer have distinguished between asset classes in sophisticated ways.? With annuities they classify immediate annuities as good, variable annuities as bad, and equity indexed annuities as ugly.? I could not have said it better.
They identify real traps for the retail investor: avoiding the structured product that Wall Street tries to feed retail investors.? They always find new ways to cheat you, encouraging you to sell options that seem cheap, but are quite valuable.
They also describe areas of the asset markets that are less correlated with domestic stocks and bonds — Real Estate, TIPS, Stable Value (I would note the over a long period stable value and bonds do equally well), Commodities, International Stocks, and Immediate Annuities.
Assets that are hybrid between equity and debt tend not to offer much diversification to a balanced core portfolio, so junk bonds, convertible bonds, and preferred stock do not offer much of a diversification advantage.? Similarly, Private Equity is highly correlated with public equity returns over a intermediate-to-long time horizon.? (I would note that any of those assets classes may present relative valuation advantages at certain points in time, and that expert managers can add value, if you can find them.? As for now, high yield is attractive, and there is value in busted convertibles trading for their fixed income value only.)
Hedge funds are difficult to consider as an asset class.? Their is much variability across hedge fund types, and within each type of hedge fund.? There are a lot of difficulties with survivorship bias in analyzing the effectiveness of hedge funds as a group.
The book has several strengths:
How do the costs of an asset class affect performance? (e.g. Variable Annuities)
How do taxes affect performance? (e.g. covered calls)
How does complexity affect performance? (e.g. Structured products)
How do personal factors like age and risk averseness affect what products might work well?
How does inflation affect performance?
Now, this is only indirectly a book on asset allocation.? It is not going to give you a set of procedures to tell you how to analyze your personal situation, the relative attractiveness of various classes at present, and the macroeconomic environment, and calculate a reasonable asset allocation for yourself, your DB plan, or endowment.? But it will give you the necessary building blocks to see how each alternative asset class fits into an overall asset allocation.
PS — Remember, I don’t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.? Such a deal if you wanted to get it anyway…
This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
