Friday, 28 November 2008
Thursday, 27 November 2008
Of all the various slips, I thought her claim that syndicated finance was a characteristic of the credit boom the clearest indicator that she was winging it. (Syndicated lending is the oldest and most reliable of all the credit markets, in case you were wondering.)
My assumption is that the BBC’s focus when hiring its financial correspondents (as with all others) is to prioritise generalist story-making skills and presentation manner, rather than technical knowledge such as how to read a balance sheet, or how the credit markets work.
This is understandable but rather worrying, given that for the next few months there will continue to be job cuts, companies collapsing etc and these will frequently lead the evening bulletins. I presume that many of these stories will be reported to the country by yet more enthusiastic but largely ignorant reporters, many of whom will have to perform on the national stage before their limited knowledge on the matter, hastily picked up from Wikipedia and one or two sources, has had time to dry.
I am too cynical now to be frustrated by this, but I do wish that one day standards might rise just a little.
Oh, and the prize for the least mawkish and most informative article on the Woolworths story goes to the FT, for this news article and this comment piece.
Wednesday, 26 November 2008
Here's a good intro to the subject, noting how Obama uses skills the Romans would be likely to recognise and admire.
Tuesday, 25 November 2008
"And the scholarliness of her work is a thing to behold: she produces lengthy documents that have an air of "referenciness", with nice little superscript numbers, which talk about trials, and studies, and research, and papers ... but when you follow the numbers, and check the references, it's shocking how often they aren't what she claimed them to be in the main body of the text. Or they refer to funny little magazines and books, such as Delicious, Creative Living, Healthy Eating, and my favourite, Spiritual Nutrition and the Rainbow Diet, rather than proper academic journals."
This approach is more than a little reminiscent of my bete noire, Naomi Klein, who flies around the world lecturing on the evils of being wealthy enough to fly around the world. She annoys me not because of her personal hypocrisy but because she leads the McCarthyite wing of the global left - charging those that disagree with her as guilty of genocidal thought crime. An odious approach to debate if I ever heard one.
One day I'll probably have a proper rant about that but in this post I wish to only accuse Klein of McKeith-ite referenciness. Her latest book has no less than 60 pages of footnotes. "I expect the release of the book to be a battle. And the endnotes are my body armour," she said on its publication. But an argument is more than about footnotes, it's about sense, logic and fairness.
A read of the very sensible Paul Seabright gives you an idea of how Klein veers off the track of reality.
"Sixty pages of footnotes do not add up to rigorous and careful research. Klein appears to believe that "Chile in the seventies, China in the late eighties, Russia in the nineties and the US after September 11, 2001" all had essentially the same economic policy. She writes that the Southern Cone of Latin America is the place "where contemporary capitalism was born". She thinks that Gorbachev's reforms of the Soviet Union were going swimmingly until he caved in to IMF pressure in 1991, which makes it inexplicable why he should have been vulnerable to IMF pressure in the first place. She ignores the contribution of economic liberalization to China's astonishing growth in the past three decades, contenting herself with a sneer about China's becoming "the sweatshop of the world". The recent experiences of India, a democracy that has moved towards liberalization of its economy without massive crises, are not mentioned. More people have escaped malnutrition through the economic reforms of these two countries in the past couple of decades than through any previous economic programmes in history, which makes the omission a large one.
Cherry-picking the evidence is particularly important for Klein's favoured strategy of guilt by association, when she implies, for instance, that since many torturers have been keen on free markets, free-market ideology leads intrinsically to the use of torture. It is not clear what, on this theory, explains the use of torture by Communist or otherwise anti-capitalist governments. Since she never mentions it, she may not be aware that it has ever happened."
Look at Kemp's graph. Look at the volatility in the first half of the twentieth-century. And then see how much calmer life has been in the last 50 years. Here's a general rule of thumb: in a capitalist economy, the less volatility there is the more wealth is created.
And this graph also suggests a reason why ‘emerging market’ economies (China, Russia etc) may not rapidly overtake the economies of Europe and the US. If you take a look at GDP growth in China then you’ll see similarly large swings in GDP, with a recent, and admittedly long, upswing.
During periods of growth, capitalist economies invest, build and implant physical and institutional structures to support further growth. During a downturn, some of this is destroyed. The bigger the downturn, the less stuff (both tangible and intangible) is carried over to the next growth period from the previous one. Hence, volatility is generally (and I'm being very general here) a long-term economic bad.
I think this is how the UK government is approaching the economy. It knows that pumping some extra cash into the economy (sorry, a ‘fiscal stimulus’) is a risk but better for the government to borrow a more now and people feel there’s an economic security blanket rather than there be a sudden, long-lasting and hugely value-destroying downturn.
As Kemp notes: "What made the Great Depression 1929-33 unusual was not the DEPTH of the contraction (which was not abnormal for period) but its DURATION. Previous business downturns had lasted a few months but this one dragged on for years. Industrial activity peaked in Sep 1929 and did not begin expanding again significantly until H2 1933."
Though it is also here worth noting Matt’s point that downturns in economic cycles are often “symptomatic of some deeper cycle in the way that we organise ourselves” and could be seen as a part of a wider more positive dynamic at work.
Friday, 21 November 2008
men are men and
mountains are mountains.
While studying Zen,
things become confused.
After studying Zen,
men are men
and mountains are mountains.
After telling this,
Dr. Suzuki was
“What is the
difference between before and
only the feet are a
little bit off the ground.”
Properly formatted link.
Thursday, 20 November 2008
One trend of the equity market in recent years has been denial. This denial often took the form that rising share prices (and then commodity prices) were unconnected to high levels of liquidity (credit), and so ignoring the idea that a decline in liquidity would lead to a fall in share prices (for instance: when debt is no longer there for private equity buyouts, there is no ‘bid premium’ for companies that might be bought out).
It is interesting now to see many equity investors waking up to what's happening in the credit markets, and some making very similar mistakes. Now they are mistakenly ascribing powers of foresight onto the credit markets, trying to pin significance onto indicators that have little wider meaning, often so divorced from the real world as to only tell a story about the indicator itself. (But analysts need something to write and theorise about!)
There is only a little truth in the myth that credit markets know more than equity markets (a point debated in the link immediately above). The truth is that credit markets have different sources of information and research to those that focus on shares. Credit market news tends not be mediated through bank analysts and PR-driven national newspaper articles. Instead, it tends to be internal, or provided by specialist news organisations that have two-way information exchanges with market participants. The latter pair of reasons help explain how the credit markets could have deluded themselves so much ahead of the crash.
Overall, I do not think that the credit markets provide 'better' information than the equity markets, or vice versa. It is, however, interesting to see that the equity market, which is deeper and more liquid than the credit market, can be just as wrong as the credit market, but in its own distinctive way.
Wednesday, 19 November 2008
Tuesday, 18 November 2008
Monday, 17 November 2008
Wednesday, 12 November 2008
Tuesday, 11 November 2008
In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ” And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home¬owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.
In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up?
All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
“Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.
“You have to understand this,” he says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”
“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.
Here's a few I've come across recently:
"Customer dwell time" - The amount of time customers stay in restaurants or pubs.
"Fixed-price discount retailer" - Poundshop.
"Wet to dry split" - amounts of drink and food sold by a pub.
"Dark spread" - difference between the coal price/costs and the power price.
Monday, 10 November 2008
The US government’s credit line to AIG, which was effectively taken over the state earlier this year, now totals USD 150bn. Much of this relates to its CDS and CDO exposures, and this is partly because the monolines acted as conventional insurers in the CDS market rather than swap dealers. It said today in a somewhat apocolyptic release that “Approximately 95% of the write-downs AIG Financial Products has taken to date in its CDS portfolio were related to Multi-Sector CDOs.”
The article – in the New York Times – makes a stab of explaining the near impossible, giving a background to one of the most complex financial products around, as well as a human face or two. However, it falls a little short of providing a fuller explanation of the details. (For more on investment banks failing, here's the FT giving a good insight into the PwC team restructuring Lehman.)
“The synthetic CDO grew out of a structure that an elite team of JP Morgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like IBM, General Electric and Procter & Gamble.”
Normal (or cash) CDOs (collateralised debt obligations) are funds that invest in bonds and loans, and then are themselves parcelled and then sliced up and sold onto bond investors. A kind of bond squared, with a dose of leverage (borrowing) at each turn. Meanwhile synthetic CDOs are like normal CDOs but instead of being made up of lots of bonds and loans, they are packed with credit-default swaps, a form of derivative. (For more detail, here's one prescient essay on the subject, and here's another from 2004, but with the usual industry defence of the product.)
According to the NYT's jaundiced post-credit-crunch eye: “Synthetics could be slapped together faster, and they generated fatter fees than regular CDOs, making them especially attractive to Wall Street.”
The originator of the synthetic CDO would usually retain a stake in the product but sell on much of it to other investors, and it was originally used as a mechanism to offsetting the risk of high-grade corporate lending. But from around 2002 there was shift away from insurance (aka 'balance sheet') to speculation (aka 'arbitrage') CDOs, writes the NYT, when investors were looking for yields after they had sold out of equities but could expect little return from bonds. This led to more borrowing (much of which went into the property market) and more appetite for risky investments with ever-increasing complexity.
These developments were supported by the belief that by spreading risks throughout the system, and cutting these risky investments up into small pieces, would mean that a few bad apples would not, and could not, spoil the whole barrel. The above-linked article from Credit magazine notes the following:
"it is broadly accepted that the risk embedded in the super-senior tranche of a synthetic CLO referencing a pool of investment-grade assets is remote in the extreme. This is because even if a super-senior swap accounts for as much as 90% of a CDO’s capital structure (which is not uncommon), more than 10% of the assets within the reference pool would have to default for losses to be sustained by the most senior tranche – an improbably high default rate for investment-grade bonds when the historical norm has been for a default rate of about 0.3%."
The NYT focuses on Merrill Lynch’s land-grab for mortgage lending, explaining that the bank sought to emulate the profits made by Lehman Brothers. “The firm’s goal, according to people who met with Merrill executives about possible deals, was to generate in-house mortgages that it could package into CDOs. This allowed Merrill to avoid relying entirely on other companies for mortgages.” According to executives interviewed by the NYT, Merrill Lynch focused more on profits than evaluating risk.
And unlike the pioneers of synthetic CDOs, Merrill Lynch “seemed unafraid to stockpile CDOs to reap more fees”. By 2006 it was the world’s biggest underwriter of the products. But the risks began to spread after AIG suddenly stopped insuring the highest-quality portion of the company’s CDOs against default. Merrill Lynch couldn’t find a replacement but continued to create new CDOs, and the company’s unhedged exposure to mortgages continued to grow.
“In 2005, firms issued $178 billion in mortgage and other asset-backed CDOs, compared with just $4 billion worth of C.D.O.’s that used safer, high-grade corporate bonds as collateral. In 2006, issuance of mortgage and asset-backed CDOs totaled $316 billion, versus $40 billion backed by corporate bonds.
Firms underwriting the CDOs generated fees of 0.4 percent to 2.5 percent of the amount sold. So the fees generated on the $316 billion worth of mortgage- and asset-backed CDOs issued in 2006 alone, for example, would have been about $1.3 billion to $8 billion.”
But when the market turned, in 2007, “the impact was brutal”. The market collapsed, and Merrill Lynch was forced to take a USD 7.9bn write-down related to its exposure to mortgage CDOs. Chief Executive Stan O’Neal was also forced out, replaced with John Thain.
“None of the trading businesses should be taking risks, either single positions or single trades, that wipe out the entire year’s earnings of their own business,” Mr. Thain said in January. “And they certainly shouldn’t take a risk to wipe out the earnings of the entire firm.”
In August, Thain arranged the sale of the CDO assets for 22 cents on the dollar. For the first nine months of 2008, Merrill recorded a net loss of USD 14.7bn on its CDOs. Shortly afterwards, Merrill was taken over by Bank of America.
Thursday, 6 November 2008
And I’ve found an obvious one, or at least a candidate. Moody’s downgrade of financial insurer Ambac appears significant and deserving of much greater coverage and analysis than I have so far seen. Bloomberg has this brief article, Reuters output was nothing more than an abbreviated version of the Moody’s press release, while the FT ran only half the story – missing the point that Moody’s has downgraded all the bonds covered by Ambac.
The collapse of the monoline’s AAA ratings has been a steady and pretty grim tale, all through the year. It is having some large, and long-term impacts, particularly on US municipal borrowers, who will see their borrowing costs rise.
Wednesday, 5 November 2008
So it was interesting to come across this rather fantastic New Yorker article which manages to also talk about postmodern economics, and has a good stab at applying Jacques Derrida to high finance. It’s great stuff for all you postmodern economics types (ie all of you!).
Meanwhile, the New York Times takes a less theoretical (but just as postmodern) take on mechanics and economics. It echoes some of my own ideas, which one day I'd love to write about in more detail. In a nutshell, my theory is the credit crunch explodes the modernist over-reliance on numbers and rigid models, so opening the way for a postmodernist analysis to emerge. In this, Taleb and Kay are already working out some patterns.
Along the way, I’ve come across a number of introductory pieces on the subject, such as this one, as well as this piece from a new, rather high-minded and ambitious blog, which I hope will continue to de-mystify finance, one area at a time. If you ever wanted to know about CDS, then it has a great intro on an issue that the mainstream press never fails to describe in scary and intimidating terms.
However, for securitisation, I still like one of my very early attempts to tackle the subject!
Meanwhile, here's a story of another gullible investor that shouldn't have been dabbling in finance.
Tuesday, 4 November 2008
However, the style and substance of the article is very different. Rather than taking the approach of educating readers, bringing forward fully-fleshed personalities making real-life decisions, the FT reporter has opted for the more traditional reportage style where details are left to one side, instead focusing on controversy and relying on hyperbolic jargon to get the story across.
So the article writes that a “Leftwing” council representing a poor suburb has “speculated” in “toxic loans”. Political opponents “branded his Communist predecessors stupid” with banks “seeking to exploit local councils”.
Admittedly the story is a short one so there was limited space to write in details. However, the reader of the FT article is left with nothing more than a sense that something went wrong, something to do with complex financial instruments, and what was a Communist council doing investing in these things anyway? To an informed reader, this is nothing different to what one reads in a tabloid.
Monday, 3 November 2008
Here's one, a rather scary one, about a schools administrator, an Irish-German bank and a rather sharp financial advisor, a Mr Noack, who sold a USD 35m CDO investment on the back of two hours training.
"But Mr. Noack’s explanation of a CDO was very wrong. Mr. Noack, who through his lawyer declined to comment, had attended only a two-hour training session on CDOs, he told a friend.
The schools’ $200 million was actually used as collateral for a complicated form of insurance guaranteeing about $20 billion of corporate bonds. That investment — known as a synthetic CDO — committed the boards to paying off other bondholders if corporations failed to honor their debts.
If just 6 percent of the bonds insured went bad, the Wisconsin educators could lose all their money. If none of the bonds defaulted, the schools would receive about $1.8 million a year after paying off their own debt. By comparison, the CDOs offered only a modestly better return than a $35 million investment in ultra-safe Treasury bonds, which would have paid about $1.5 million a year, with virtually no risk."More of this kind of thing, please!
Wall St Journal have a good one on Taleb's fund. Probably the only hedge fund making money at the moment. Likely that if there were more proper contrarians around then the markets might do a little better at expecting the unexpected.
Here's the full text of the WSJ article:
WSJ, 3 November 2008, Scott Patterson
For most of October, it seemed nearly everything that could go wrong with the markets did. But the rout turned into a jackpot for author and investor Nassim Nicholas Taleb.
Mr. Taleb last year published "The Black Swan," a best-selling book about the impact of extreme events on the world and the financial markets. He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.
Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.
A professor of mathematical finance at New York University, Mr. Taleb believes investors often ignore the risk of extreme moves in the market, especially when times are good and volatility is low, as it was for several years leading up to the current turmoil. "Black swan" alludes to the belief, once widespread, that all swans are white -- a notion that was proven false when European explorers discovered black swans in Australia. A black-swan event is something that is highly unexpected.
Assets under management at Universa have neared $2 billion since the fund launched early last year with $300 million under management. While Mr. Taleb frequently consults with Universa's traders, the Santa Monica, Calif., fund is owned and managed by Mark Spitznagel, who worked for several years in the 1990s as a pit trader on the Chicago Board of Trade.
To execute its strategy, Universa buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn. They become extremely valuable in a market decline of 20% or more in a one-month period.
When times are good, such options are cheap and Universa gobbles them up, taking small losses along the way. When the market makes a quick, steep turn south, as it has recently, Universa's positions gain value as investors scramble to protect themselves in the downturn by buying puts. The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility.
Here's an example of a trade the fund made recently. In late September, when the Standard & Poor's 500-stock index was trading around 1200, Universa purchased put options that would pay off if the index fell to 850 by late October. Since such a plunge was considered highly unlikely, such options cost only 90 cents. On Oct. 10, those options cost $60 as the S&P 500 tumbled sharply. Universa sold most of its position in the high-$50 range.
Universa also purchased a number of puts on financial stocks, such as Goldman Sachs Group. In late July, it paid $1.29 apiece for options on American Insurance Group, the insurance giant that by September was on the brink of bankruptcy. The puts were priced to pay off if AIG dipped below $25 a share by September. Universa eventually sold them for about $21 apiece.
The fund has "done what it was supposed to do for us," says John Salib, a partner at Landmark Advisors, a New York fund that invests in other hedge funds and that invested in Universa in July. "We wanted to protect our portfolio against this kind of environment."
Mr. Taleb made his first killing on Black Monday, the crash of Oct. 19, 1987, as a trader with the investment bank First Boston (now a part of Credit Suisse), with a large position in out-of-the-money Eurodollar contracts. Investors fled into the highly liquid contracts as the market crashed, causing their value to surge.
While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil.
The task for the fund's managers is to persuade clients to stick around after their big gains. Historically, such dramatic downturns have been rare events, occurring only once or twice a decade.
Mr. Spitznagel cautions against optimism. "You could say that so much value has been destroyed that there just isn't much left," he said. That is "a dangerous assumption, since things can always get worse."