Thursday, April 30, 2009

Annihilate the Perverse Effect of CDS

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivize stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

However, CDS changed the game dynamics (to be exact, the change is a compound effect of bankruptcy code change of 2005, which is disastrous in retrospect, and CDS). If you own bond and buy corresponding amount of CDS with physical delivery, you'd want the company to go bankrupt as soon as it shows the first sign of trouble and the bond devalues. You get 100% back on CDS settlement. It's much sooner than the end of Chapter 11, and you get back not only much more than at the end of Chapter 11 but even much more than if you unload the bond right now.

Before you cry "head off CDS", however, please realize it's not necessary to dump the baby with the bath water. As I said many times here before, CDS is just a tool. If it's caused bad effects, blame the people who use the tool or how its use is regulated, not the tool itself.

Here's how to save the baby while dumping the bath water.

If a bond holder also owns CDS, then her economic interest in the debtor is reduced by the protected amount. In bankruptcy court, her say should be reduced accordingly. The hedged interest is transferred to the CDS seller, who could/should replace the hedged bond holder in bankruptcy court.

Simple as that. I'd also argue that a shareholder with option protection should be pro-rated in a similar fashion on shareholder meetings.

There're always complications. For example, a shareholder with CDS protection could be incentivized to drive down the company. Bankruptcy code reform alone will not be sufficient to cover all bases, nor should it be the only tool. But at least it's a good start.

Wednesday, April 29, 2009

USD Can and Will Drop

Recently there's been a wave of blogosphere opinion that USD is a win-win bet. It goes like this: if the world economy gets worse or stays in the dumps, then USD will remain strong, as demonstrated by its performance since Sept 08; if the world economy rebounds, then USD will of course be strong.

It is the "of course" part that I have a problem with. There're two scenarios under which USD will drop, and only one under which USD will remain strong in the intermediate term (a year or two). But even under the last scenario, USD is likely to drop in the longer term.

1. The world economy stabilizes. Make no mistake, we're not there yet. It won't happen until at least the clouds of CEE debt/currency crisis, US/European banking and credit crisis, housing price, unemployment, and consumer demand start to dissipate. But when that happens, the world will be shifting away from USD assets. Furthermore, it is very unlikely that the Fed has enough political will to siphon the massive amount of USD cash it will have printed off the system early enough and fast enough to pre-empt the surge of inflation once the economy stablizes and credit starts to flow again.

2. The world economy stays sickly for years. Under this scenario, the Fed would likely continue printing massive amount of moneyfor awhile. This would put other countries at a disadvantage since nobody else has this kind of monetary leverage. Therefore, they would be increasingly determined to seek alternative reserve currencies. True, right now there is no alternative. But I don't think it's wise to misunderestimate the world's determination and creativity when defending their own economic and strategic interests. When such alternatives emerge, a big part of the world would not feel sorry to abandon USD, a once safe asset abused and discredited by the Fed and US government.

3. As I mentioned above, there're still numerous cloud overhangs. We are quite likely yet to encounter a few more trigger events. Under this scenario, USD would strengthen. But there's a limit to how long the perception of USD being the safe harbor can last. If the crisis mode continues for another year or two, the world would increasingly re-examine the assumption and seek alternatives.

In particular, I find the assumption that China will remain contend sitting in the USD trap laughably arrogant, short-sighted, and lacking imagination. It may happen in the end. But don't take it for granted.It'd take a fundamental shift in US' China policy for China to stop trying getting out of the trap. So far they've talked about SDR, arranged a sleuth of bilateral currency swaps, and piled up on gold. None of the approaches is the end solution. But it'd be foolish not to take their effort seriously.

I've been long USD (against EUR and JPY), gold and TIPS since the beginning of the year. I remain comfortable with all three right now. I trade the intermediate time horizon, from weeks to months. But I'll be ready to flip USD in short order going forward. Against what I don't know yet. We'll find out. But with the wave of opinion of USD win-win bet, I suspect we'll find out soon.

Sunday, April 19, 2009

Random Musings from Dixie Country

It was shortly after midnight. I was sitting in a local 24-hr diner nearby my hotel, ordering my late-night breakfast. I was vacationing in Pigeon Forge, TN, just outside of Smoky Mountains. Dark and quiet outside, a few customers inside, local twang and country music lightly sprinkle the air. It felt like a scene from Sweet Dreams.

And the sausage gravy was awesome.

It brought back memories of my time in West Virginia and Michigan, the small-town USA. And I suddenly realized something odd: where is the recession?

I've been following the recession since before it blew up, circa 4/07. And there's no doubt in my mind that the current stock market rally is a sucker's rally, with a few more time-bombs and either a painfully slow recovery or a bubble/hyper-inflation ahead. But now, out of New York and away from blogosphere and numbers, life around me is as normal as it gets.

Pigeon Forge is a poorman's Disney. Lots of shows and amusement parks, some of which are not bad and many have distinct southern character. Kids love it, therefore I'm happy; besides, I actually enjoyed a few shows. Everywhere is crowded even though it's still far from peak season. Nothing fancy here, but it's solid, good stuff -- food, lodging, convenience, service, entertainment. Not to mention MUCH cleaner than New York city, which is a given everywhere except maybe Detroit. There'll be a car show Thursday. All hotels are sold out for Thursday night. Parkway (yup, just Parkway) is lined up with all kinds of old cars, quite a few American classics such as Camaro Z28 and Corvette Stingray.

I landed in this country in small-town USA. And this is where I first fell in love with this country. There's a charming, romantic deception to the honest, down-to-the-earth quality of small-town USA, I'm aware of it. But I can't help wondering which version of USA is more real, which is more of the root of livelihood and strength of this country.

New York sits on top of the food/value chain of the economy. It's the equities (or junk) tranche of a CDO called US economy. As such, it reaps huge returns in good times and suffers huge loss in bad. Everything about New York is exaggerated, amplified, blown out of proportion -- rich and poor, civility and barbarics, honesty and deception, geniuses and idiots, over-achievers and lazy bums, harmony and conflicts, awareness and apathy, inclusiveness and segregation.

But out here in small-town USA, even I feel safe and relaxed.

The South, however, shows the other schizophrenic nature of this country.

Dolly Parton flaunts patriotism (everywhere in Dollywood and her separate Dixie Stampede show) and internationalism (Festival of Nations) like her left and right tits. But my distinct take-away is that the former is the real theme while the latter is an overture, an effort at best. The deeply rooted contradiction between the two isms was not much of a problem during the good'ol days of American Empire. But as the world changes, the shallow, self-centered and arrogant nature of popular patriotism, or nationalism everywhere else as Americans call it, will become more and more apparent and difficult to reconcile.

Perhaps the most striking demonstration of this contradiction is Le Grand Cirque show in Dollywood. The only whites are girls walking the stage and one male performer; the rest are all Chinese (and although the white performer was nothing spectacular, he was given the center spot during curtsys nevertheless). Is this a symbol of what America has come to, I wondered, whites doing managing and marketing at the top of the value chain while foreigners (mostly Asians and Latinos) do the hard work? (This is not racial, Good Lord knows, but merely an observation of reality, albeit definitely incomplete and anecdotal. Come on, no observation on human society is ever 100% correct. I'm tired of putting up the standard disclaimer on statistics.) It's only a matter of time before others learn how to do management and marketing. Then what do we do? Should I teach my kids to do actual work damnit?

Speaking of Good Lord, the South feels no need for apology when flaunting religion, no more than Dolly flaunting her tits. During the Magic Beyond Belief show, which is very good, the magician spoke during recess, promising not to preach but went ahead and preached about God and all. The audience applauded and amened. One man stood up and walked out with his little girl in arms; I don't know for a fact whether it was a protest but the timing was certainly conspicuous. I didn't mind it. Besides, the show was actually good. But that was about as in-your-face as I could take it before getting annoyed. I suspect many of my Catholic, Jewish, and Muslim friends would feel the same, if not stronger.

So here it is, my first experience in Dixie Country. Very enjoyable, relaxed, romantic, and peaceful as long as I manage not to over-think and poke the hymen of my shallow being.

I'll be back.

As we walked out the magic show to the car, my 7-year-old declared thoughtfully, after a minute of silence: "Dad, I think I have my mind made up."

"About what?" I asked.

"I think we should make this our next vacation place."


The Legal Scam of FASB Statement 159

1. Set up Company, go IPO.

2. Sell $1B bond.

3. Spread rumor of Company's demise. Or better yet, actually run Company almost into ground. Quickly.

4. Buy Company's bond at $40 on $100 par.

5. Book $600M profit, and pocket the $600M extra cash from bond issuance.

6. Retire as a rich hero.

BTW, you don't even need to actually buy the bond in order to book the profit, thanks to the infinite wisdom of FASB (aka FASB Statement 159). Yes, the $600M profit will disappear into thin air by bond maturity, if Company survives, that is. But who cares about next quarter, not to mention 10 quarters later. In any case, the extra cash is real if you manage to drive Company almost into ground faster than spending the bond issuance proceeds.

And if you can recycle these paper as cash through the Fed, you don't even have to worry about financing. Spend the bond proceeds, buy back paper, give it to Fed as collateral for cash, buy back more paper. Zero cost, zero risk, much reward.

This applies to loans just as well, as long as it's securitized and traded on secondary market.

In reality, it takes good research to locate current bond holders and may take some persuasion to buy it from them. But if the gloom looks real enough and you're crafty enough (e.g., gradually over a period of time, through a third-party broker), it can be done without raising too much suspicion.

It gets better. Once you have bought back almost all of your bond, you can set up a phony market price whereever you want.

Companies have actually bought back their bonds on the secondary market. I'm not saying any of them did it intentionally, as outlined above. But this doesn't change the fact that such scams are legal and plausible.

Unless the bond is callable, the issuer should be forbidden to purchase it on the secondary market, be it at discount or premium, and such accounting games cannot be played.In terms of interest rate risk, buying one's own bond from the secondary market is equivalent to having an embedded call option, which otherwise would result in a higher coupon. In terms of credit risk, it is equivalent to selling one's own CDS or life insurance (not considering differences in financing), it doesn't make sense, nor should it be legal, except in the wonderland of modern financial accounting and regulation.

Wednesday, April 8, 2009

Too-Freemarket Has Become Anti-Free-Market

I mean, our financial industry has so overgrown that it has taken over iconic manufacturers such as GM, GE, and Boeing and become their main profit center for years, even decades. It has hired so many traders who don't even understand their own trades, risk managers who blindly throw VAR at everything like snakeoil (or Gaussian distribution, or mean reversion, or my personal favorite, 40% recovery assumption), executives who don't know or even care about what their companies have been doing, programmers who don't understand anything about programming beyond the syntax, and a vast army of middle-management whose only job it is to foward emails and track status. It has hijacked world governments and public policy to such an extend thatthe society has no choice but to bail it out, because it is too big to fail.

But here's the rub: we're making it even more too-big-to-fail.

There is no stronger an advocate of free market and presumed righteousness of market pricing than Wall Street. But when Wall Street's puppet government, across two supposedly ideological opposites no less, insists on using public money to create an artifical market, you know it has gone too far.It has gone straight around the circle of Yinyang and become its own moral enemy, its own Judas.

Free market has committed suicide.

But it gets worse. The Unholy Ghost of Anti-Freemarket is still walking the Earth, preaching the same words to the Great Unwashed Public, who nod and chant in unison: Yeah! Thou shalt not nationalize! Amen! WTF?!

No, that last part was me.

Free market is inherently unstable due to built-in positive feedback, which is in turn due to human greed and fear among other behavioral patterns. This is the source for fat tail or Black Swan. We may never be able to eliminate the instability short of killing free market altogether.But pretending we're still a Freemarket while using public money to create an artificial market is sheer lunacy.

I'm still against government regulation. And what we have now is regulation to the extreme. Instead, we should let banks fail as they may, re-enact Glass-Steagall, and let free market return to Wall Street in the form of private partnership investment banks.

Derivatives is not the problem. The problem is people playing derivatives with other people's money.

Bonus is not the problem. The problem is maturity mismatch between bonus and risk, or letting incompetent managers allocate bonus based not on merit but on personal politics.

Even bubble is not the problem. It's inevitable (instability, positive feedback). The problem is denying the possibility of bubble in the name of omnipotent Freemarket.

Kill Freemarket. Long live the free market.

Wednesday, April 1, 2009

China's Bilateral Currency Swaps: First Step

Before the proposal of replacing USD with IMF's SDR as the world reserve currency, made by Zhou Xiaochuan, China's central banker, China had already made a series of bilateral currency swaps with some neighboring countries, with maturities of up to three years. Now they're extending the arrangement to LatAm.

Here's the list (in Billion Yuan, recent CNYUSD exchange rate 6.835):

Hongkong: 200

South Korea: 180

Indonesia: 100

Malaysia: 80

Argentina: 70

Belarus: 20

According to a prominant economist in Beijing, these swaps serve dfferent purposes for each counter[arty country: for Hongkong, it's to prepare for the pending sale of Chinese T-bills there; for South Korea, it's for helping Korean companies raising capital in China; for Belarus, it's because Belarus wants to take CNY as their foreign reserve; for the rest, it's for settling bilateral trades (companies pay in the trading partner's local currency).

The implications are very intriguing:

1. The official line on the rationale behind these swaps is to reduce forex risk and trading cost. This is a valid point.

2. It offers support for currencies under downside risk. This applies to all except HKD.

3. It serves to diversify China's foreign reserve, albeit only a small percentage (5%) so far, away from USD and to align the composition better with trading partners.

4. Perhaps most importantly, the real meaning is that these are the first concrete step toward a post-USD world. The world trade cannot be based on bilateral currency swaps, to be sure. And CNY has a long way to go before it can become a world reserve currency. But as a transition, this certainly beats bartering, which has been remerging among countries and individuals.

Whether this will be brought up in the G20 summit remains an interesting question.

Thursday, March 19, 2009

It's Not Bonus, Stupid (Congress)

I'll probably get stoned for this post. But somebody has to tell the truth to the great unwashed American public. You see, it's not that the great unwashed American public can't afford hot water, but rather some politicians would rather keep them unwashed. It makes their lives so much easier. Dealing with truth is hard.

Bonus, as applied to the financial sector, is a gross misnomer. It has nothing to do with your performance or the firm's. It's strictly related to how strongly your boss wants to keep you around for awhile, which may range from a month to as long as a year. Therefore, "retention payment" is a much more accurate term, despite the spin-doctor overtone after AIG.

OK, you say, give'em nothing and see where they're gonna go!

Plenty of places to go, in fact -- how about another bank?

Wall Street, or financial service sector in much of the developed world in general, has grown very bloated through rapid expansion that had lasted for decades when the crisis started. Most financial service firms have accumulated a lot of, well, less-than-qualified and less-than-essential staff, at all levels and in every department. Yes, most have gone through countless rounds of lay-off since 07. But lay-offs are inherently arbitrary and prone to non-meritocratic factors such as personal politics. It's not the most reliable or fair selection mechanism. In fact, I personally know a few absolutely top-tier people who got laid off over the past year, or indeed all the years. In comparison, worker mobility is much more consistently fair and efficient, even though the hiring process is far from perfect.

The world still needs financial services, in fact more so than ever -- just the "right kind". There're still a lot of Wall Street businesses making money, some quite handsomely and honestly. As such, there's still demand for talent, experience, relationship, and professional devotion. Even winding down a portfolio requires all these qualities; otherwise you end up amplifying the disaster (yes, this is what happened at AIG last quarter, despite the "bonus", but this is a general view, not a defense for any particular company or instance). It's a highly specialized field with a limited supply of well-qualified labor.

I've long argued here that the government should let bad banks fail, let the market force select surviving banks and employees. We would be back in a short time with functional market, effective corporate governance model, sensible compensation structure, and strong and nimble banks. Government could've paid 10 times the amount of "bonus" to every former Wall Street employee and still saved 99.9% of the taxpayers' money that they've wasted and funneled through various bailouts so far.

The amount of "bonus" is so infinitesimally inconsequential in this mess, compared to the real issues such as compensation structure, corporate governance, procyclic systemic risk, and regulatory oversight as well as enforcement. Yet this is the singular focus of the bill passed by the House yesterday. Don't they, paid by taxpayers' money no less, have better things to do?

Apparently not. Here's a quote from a CQPolitics report:

"You disgust us," (House Ways and Means member Earl Pomeroy , D-N.D.) said, “By any measure, you are disgraced professional losers. And, by the way, give us our money back.”

Do political grandstanding and popularist democracy get any cheaper and more pathetic than this?

This bill is so wrong in so many ways it's unquestionably the height of bad legislation.

1. What about consultants working at banks? There's a natural leveling mechanism in compensation between consultants and employees. Now employees get punished, in addition to their past stock options and restricted stocks and 401k's being wiped out, but her consultant colleague walks away scratch free?

2. What about Morgan Stanley who paid their "bonus" before year-end?

3. If Paulson forced TARP on the CEOs mafia style, or even if the CEOs asked for it, why should the employees doing the actual work get punished because of the decision they never had even the slightest possibility of influence in?

4. What about the European banks lucky enough to escape Paulson's mandatory bailout? Is the House trying to push top talents out of US banks?

5. If anything even remotely ressembling this bill passes the Senate and the Supreme Court, the damage to US as a country, an investment and business destiny, a global leader would be broad, permanent, and irreversible. I don't believe it will. But I'm afraid some damage has already been done.

This goes to show that undue government mettling in private business can be more damaging than the worst nightmare of free-market advocates.

No, dear Congress, you disgust me. It was you who sold out to lobbyists and dismantled Glass-Steagall. It was you who set up the fundamentally flawed, schizophrenic GSEs. It was you who set up the greatest Ponzi schemes in human history called Social Security, Medicare and guaranteed pension. It was you who sit idly by throughout the bubble years without exercising your oversight power. It was you who bankrupted American public. You're as guilty in negligence and failing your fudicial duty as the lying Wall Stret CEOs and rogue traders. And now you're feigning outrage, putting up cheap political show after cheap political show of bellowing inconsequential, irrelevant, ignorant questions down on the CEOs?

It's time for the banks to return taxpayers' money and go bankrupt if they must. This political show has lost its purpose. It's become its own purpose and thus a distraction. Let's work on finding the real solutions.

The Beginning of End for USD The Reserve Currency

I still can't believe it happened just like that. It's so unceremonial, it's a huge anticlimax.

I'm talking about the Fed announcement of the plan to purchase up to $1.5T debt. That's the last bullet in their clip. Lowering the rates further would be like firing from an empty gun, mathematically sound but a bit tricky technically. So the dollar tanked (makes sense), gold shot up (makes sense), treasuries shot up (what?), and stock market shot up (WHAT? Oh, ok, shot-term).

I suspect that, looking back 10 years from now, we'll realize this is the beginning of the end of USD's reserve currency status. Yes, people have been talking about the demise of the dollar for years. But so far everything else -- budget deficit, total debt, trade deficit -- has been gradual, and reversible at least in theory. This is the ominous turn of events that pushes it beyond the point of no return. Even if Fed miraculously manages to shrink its balance sheet back down in the future, which would require just too much political will and independence short of a Second Coming of Volcker++, the cherry is already popped. The confidence in US monetary restraint is gone. So much of what defines US and the world order hinges on the dollar's reserve currency status, I don't even want to speculate what'd happen when it changes.

But the announcement shouldn't be a surprise, though. The downside I mentioned above is long-term. Humans, indeed most animals, are evolutionarily conditioned to consistently overweigh short-term risk and underweigh long-term risk. Yes, the short-term risk is grave. But the short-term risk the government sees is not the real risk, but rather the pain it'd take to fix the real problem. So they did exactly the things they lectured, with condescension and moral superiority, Japan and IMF rescuees on not doing.

Ever seen a kid kicking and screaming, refusing to go to the doctor and go under the needle? That's what the government has been doing throughout the crisis.

But even for the short-term, I doubt the benefit will last. EUR and GBP are up, along with most other currencies. But hey, naughty girls need inflation, too. Chances are that Fed has more than just popped their own monetary cherry, they've started a new lifestyle of monetary promiscuity with abandon. Everybody goes monetizing their own debt, lending from the right hand to the left hand and, whoala, currency stops going up and wonderful, wonderful inflation everywhere.

But is this the real solution, I mean, even in the sense of superficial, short-term fix of symptoms? It is most certainly not. It's inflation for inflation's sake, which achieves nothing except stealing from the future generations. It's a race to the cliff.

I still can't believe it happened just like that.

It's time to buy gold and TIPS, maybe commodities, too.

Monday, March 16, 2009

Buy, Buy, Buy into This Sucker's Rally

The market has turned around. No doubt about it. Here's my rule of thumb: if bad news is good news, or no news is good news, and the market goes up, it's a bull market; on the other hand, if good news is bad news or no/neutral news is bad news and the market goes down, it's bear market.

So Citi came out with some non-news about what their revenue was, for the first 2/3 of the quarter, not considering potential write-downs. The market went on for a 10% surge. It's a bull market.

People are hopeful, by our genetic, evolutionary bias. We want to believe. Now that the earnings season is over, we want to believe the next quarter will be better. We look for evidence supporting the belief. We found one. We latch on to it. Then greed urges us to get in before the crowd. Plus the short squeeze. Plus early tax returns who by definition overpaid.

Oh, G20 meeting produced nothing besides some empty words, which is entirely as expected. But Asia markets rallied overnight anyway. Yup, it's a bull market.

So, enjoy the ride.

How long will it last? Could be as short as yesterday, or it could last until the next earnings season, but no more. There is no reason to believe 09Q1's earnings will show any sign of revival in any particular sector (look at housing, retail, and unemployment). CDS levels on financials (1 year -- all financials are inverted, implying the primary concern is short-term survival) remain at highly stressed levels (300~3000 bps range, meaning highly stressed to imminent default). Even CDS on 5Y US credit has been hovering around 100 bps, although it did come down to the 80's by Friday. Oh, did I mention the ticking time bomb of Central Eastern Europe double wammy of currency crisis and debt crisis that will make the 1998 Asian crisis look like a playground boo-boo? No? Glad I didn't. Why rain on your parade when you could google "Hungary inflaction protest" yourself?

Such sucker's rallies have occurred more than once throughout this crisis. I don't advocate fighting the market, even if it's a sucker's market. A freight train full of suckers carries the same weight as one full of geniuses.

Just be ready to jump out of it any moment.

Sunday, March 15, 2009


Excuse the hyperbole, my friends. This is one of the few more serious threats I've seen. You may have seen me sending alarmist rants before. Most of them are jokes or half-jokes -- you know I'm not a worrier. This is not.

I must be among the last living persons hearing about this, because if you search for "lock bumping" on YouTube you'll find tons of tutorial on how to make a few bump keys that enable you to open all tumbler locks in the world -- the only variations are: number of pins and length/width of the key shaft.

If you didn't know, please, do yourself a favor and learn what the whole world already knows, including the no-good teenage brat down the street. What if he sneaks in your house with a $1 key? What if he has already?

And the below piece of news really cracks me up. Near the end the anchor said, with a straight face, that "a few people wrote to us worried that criminals may learn how to do it from our program but you'll notice that we didn't show that." You sneaky, clever devil you.

Now I have to believe it. The government and media really consider the public to be that stupid. Can't blame them, though, because we are that stupid.

Why are we still selling and buying those locks?

In case you have any doubt, here's a 5 y.o. girl demonstrating.

Of course, if you google "anti-bumping locks" you'll see loads of'em promising to protect your honor. Before you decide to buy a chastity belt, search for "anti-bumping locks" on YouTube and watch how they crack them open like cheap whores.

Unfortunately, I haven't found any effective solutions, nothing except the trusty ol' shotgun.

Sunday, March 8, 2009

Bailouts Forcing Surge in Systemic Risk

Imagine you're a bank. What do you at this juncture, wind down and go conservative or ramp up and take as much counterparty risk as you could get your hands on?

If you chose the former, you may be doing the responsible thing. But it would also the stupid thing. Here're the smart things you can do to ensure your prosperity, or survival at the very worst, in this wonderfully morally hazardous world:

1. Get your tentacles reached as far as possible, and as deeply as possible, into other banks, preferrably the biggest ones. Encourage your counterparties to do the same, but not directly. Rather, make long-winded chains so as to get around netting. Counterparty risk is your best insurance. The more counterparty risk others take on you, the safer you are.

2. With the counterparty web in place, take as big bets as you can get away with. If you win, you get rich, look smart, and get hailed as hero. If you lose, no worries. Government will bail you out.

This is exactly what many banks have done since the first AIG bailout. The world before Lehman bankruptcy may have been pretty screwed up in retrospect, but it was decidedly more sane than today in one aspect: risk carried at least theorectical downside. Back then, everybody would've stopped trading with AIG, C, and BAC if they had been in situations they're in today. Who in their right mind would trade with somebody who has a stock price of $0.35, with a market cap of less than $1B, and lost $60B in one quarter?

But that was stupid, of course; look what happened to Bear and Lehman. Now people have learned the lesson; let's continue trading. If you can't post collateral, no problem. Government will give you more cash or at least swap your ABCDO Squared Mezzanine into treasuries. Even if they don't, they'll give me more cash or at least swap my ABCDO Squared Equity into Fanny paper, which is about the same thing but worth a lot more.

Can you blame the banks?

Of course not. They're merely acting on their self-interest, which is exactly what they're supposed to do. It's the government's implicit guarantee of all companies that are mysteriously deemed too big to fail. All big banks have already been nationalized, except taxpayers pay all the price and get no control.

I know this question is vein but still, I can't help asking: why is AIG still allowed to trade, and by the same people? Just shut down everything except their insurance business, pay everyone $1M and ask them to please stay away from the office, go to Caribbeans or go fishing, just go. Taxpayers would've saved a LOT of money. And it would've been much more fair, sensible, and with much lessmoral hazard than what the government has done.

Saturday, March 7, 2009

The Biggest Source for Risk: Government

The perpetual bailouts are wrong on many levels. Today I'll focus on just one. The government has become the single biggest risk in financial markets.

What will the next bailout do? Is it going to wipe out common equity? Preferreds? If so, will it be the C-series? S-series? Or will they screw the junior debt? Senior? Or are they going to let it fail? Or maybe they'll just keep on pumping money in?

With the perpetual, arbitrary, ever-shifting bailouts and interference in the market, the government has paralyzed the already-disfunctional financial market machinery. Regulatory and policy risks are scaring a lot of players to the sidelines, and at the same time creating huge arbitrage opportunities that could turn out to be equally lethal traps.

Take Citi for example. One possible explanation for C's precipitous fall last week is the perceived arbitrage between preferred and common shares, which called for longing preferreds and shorting common. But is it an arbitrage or a trap? The answer depends on how each series of the preferreds will be converted, which was very unclear when the bailout was first announced. It's an arbitrage if you assume all preferreds get the same treatment; otherwise it depends on the conversion formula, which preferred you bought and at what price (you can only buy the publically traded preferreds, not those held by Uncle Sam, Prince Talal, or Sanford Weill), and at what price you shorted the common stock. The latest report, last updated on 3/3, was that the discrimination against publically traded preferreds would not be "so bad". But still, the language is vague and non-commital.

Such confusion is much more common, and deeper, in fixed income and other areas of capital market. Which JPM bond is backed by the government? How strongly? But really? I mean, are you sure? Will Uncle Sam really tear through the veil of secrecy of Swiss banking or is it just a show? Who gets paid through the conduit called Assured Income from Government? What will happen when AIG loses another $100B next quarter? Will GS still get it or will the conduit be shut down finally? Will somebody high in Washington say/do something that pushes the Chinese over the edge and pricks the treasuries bubble? Who will take how much loss in forced mortgage mod? Or could it be a windfall in disguise in the fantacy land of modern accounting? Will they help European banks when the Eastern Europe Crisis of 2009 hits, or will there be another round of global meltdown?

It's uncertain enough without the government messing around. But if they have to mess around, can't they at least make up their mind and show some consistency?

Monday, March 2, 2009

China Will Likely Escape Recession

There've been quite a few China experts predicting doomsday for China, therefore eliminating the last best hope for the world economy, recently. I have to beg to differ.

Yes, China is anything but detached from the rest of the world and indeed has all the major symptoms has the developed world: housing bubble, bank bad assets, demand destruction, unemployment. But the degree of suffering for China is much less severe in every one of the problems.

Residential mortage market in China is still in its infant stage. Securitization is non-existent. Down payment routinely goes to 40%, even 50%, in most of the localities except for the few big cities like Beijing and Shanghai. Therefore, for the same 20% drop in housing prices, the impact on homeowners and lenders is much less in China. In addition, the percentage of commercial homeowner in China is still tiny in comparison. Most city dwellers live in government and/or employer subsidized housing and owe little to nothing on them. Virtually all country folks live in houses they built with cash.

Financial reform in China had been widely critized, both domestically and internationally, for being too conservative, even paranoid. Of course, now in retrospect, the conservatism/paranoia shielded them from disaster. Except for a few companies going through Hong Kong, there's virtually no exposure to derivatives of any kind except commodities futures, which is tiny on the macroscopic level. Bank leverage remains very low. Commercial banks and investment banks are still strictly segregated. It's hard to make any credible estimate on the scope ofbad assets in Chinese banks. But even if it turns out to be as bad as the most perssimistic estimates say, at least we can be sure there's no chain-reaction mechanism in the system.

China The Export Country is perhaps the biggest myth in modern economy. Yes, they do export a lot. But unlike Japan or Korea, China's exports for the most part are more accurately classified as re-export. Export is to buy iron ore or steel and sell $50k cars. To buy wool and sell sweaters is hardly export from macroeconomics perspective because the value-added is so small. As a result, what happens to Chinese economy in a demand destruction scenario is that both import, a big part of which is the raw materials and components for its re-export industry, and export fall more or less in tandem. This has been shown by the relatively small drop in Chinese GDP as well as overal trade balance in Q4 08 vs the dramatic drop in Japan and Korea. In fact, such a proof already presented itself in 1997. Almost all of China's export competitors had their currencies devalued up to 80% while the Yuan stayed almost constant. There was tremendous domestic pressure to devlue the Yuan, and deafening cry of Chinese export collapse from international experts. Yet nothing happened. Export tax rebate cannot possibly explain for more than 10% of the cost savings. The reason is simple: Chinese economy was mostly re-export driven. As their cost of buying raw materials and components dropped for a large portion, their cost also went down. Yet the world continues to blindly call China The Export Country.

Domestically, anecdotal evidence I've heard shows what the governments, both central and local ones, have been doing to stimulate consumption make Helicopter Ben look like a timid amateur. They hand out cash and/or shopping certificates to whole cities of people. They order all shops to have 30% sales. Is it over-reaction? Sign of desperation? Will such draconian measures bring dire consequences later on? These are all legitmate questions. But at least you can't blame them for not trying. And the shock-and-awe Yuan carpet bombing apparently has been making some impact so far. It's much harder to make Chinese people spend than most westerners imagine.

Finally, unemployment. Numbers like 20M have been thrown around in the western China expert circle like asteroids heading to Earth. I'm sorry, this is just plain ignorance to the vast difference in lifestyle between Chinese peasants and westerners. An average US homeowner may lose her home within months of unemployment. But a Chinese migrant worker from countryside can easily go back to her old lifestyle and live for years, purely on her savings from the few years' city jobs, without as much a psychological trauma as losing one-night's sleep. Metropolitan life in China is still largely based on cash and savings. Rural life in China is still mostly self-sufficient on top of cash and savings -- you don't need much cash and savings at all.

More likely than not, China will escape any severe downturn and remain one of the few growth spots throughout this global recession. And it would not be any miracle, just a combination of fundamental factors, as well as a bit of luck.

What does it mean?

1. China region will probably be one of the better equities markets for 09, possibly beyond.

2. Chinese bonds, if you can get your hands on some, are probably cheap. CDS on Chinese sovereign is going for ~250 bps. It may come down a lot once the world realizes the above.

3. Commodities fall may not last as long or severe as doomsday sayers predict.

4. Upside pressure on Yuan will probably resume as soon as the world economy stabilizes somewhat and the USD carry trade unwind stops.

Saturday, February 21, 2009

You Can Give Me Money, But You Can't Make Me Lend It

I understand it's hard to argue for bank's case on anything nowadays. But I believe the old motto of "easy things are not worth trying" so I'll take a shot here.

(Speaking in evil bank's voice) Uncle Sam, do you want me to be a for-profit entity or a social service? Make up your schizophrenic mind quick because every hour in self-debate will put both of us, along with the society as collateral, in further limbo.

Even though I'm fundamentally a libertarian, I'm far from a fundamentalist libertarian. I readily concur some social services are necessary. I think forcing banks and investors to make mortgage mods is morally wrong nor will it work but I'll not argue it here. Let's assume for the moment we will make homeownership our social goal and banks will be the conduit. Fine. Then take over banks like Fannie and Freddie.

But if you don't have the stomach for it, then let banks be banks. Give banks a chance to do the right (economic) thing for a change. If they decide a credit is worth the risk, they will take it. If they refuse, generally speaking there's a good reason for it.They don't like anyone or hate anyone. They're for profit, remember?

If you force banks to lend to risky credit in this dismal climate, then you're forcing them to repeat the same mistakes that got us into this mess. Only this time you can't blame the banks. And you'd better be ready to keep pumping money into the system. Lots of it. For a long time.

And if you don't want to keep pumping in money, that's fine, too. Let'em fail. There'll be capable and hard-working people starting from scratch in no time. The market and the society will be much healthier and sustainable after rising from the ash.

Pick your poison.

Anything but what the government has been doing so far, which is absolutely the most convenient, irresponsible, morally bankrupt (there! I said bankrupt!), schizophrenic approach.

Re-privatization, Not Nationalization

No, it's a bit more than rhetorics.

Those who're opposed to government intervention in the banking industry, or anything beyond no-string-attached handouts anyway, wisely choose the word "nationalization" to describe it. The neutrals go along. But I don't understand why those who are for it fall for such an obvious rhetorical trap.

As far as I can tell, no self-respecting mouthpiece is calling for nationalization of any banks. Notionalization is not the goal, but rather a temporary measure, a transient point leading to a better, healthier, and more sustainable form of private banking. The Whitehouse declaration today about how they've been supporting a private banking sector "for quite some time" would be comical if it weren't so sad. Really, only for "quite some time", as opposed to since day 0? Does that imply state-owned banking was on their mind some time ago? Now that's worrisome.

No, I don't seriously believe Team Obama has ever entertained the idea of making banks nationalized as an end-point. I bring it up here only to highlight the sad rhetorical mess we've gotten ourselves in on this critical issue. Messages in the public arena as well as from the government have been drowning in mind-boggling confusion. Real issues such as corporate governance, entitlement society, structural corruption of government regulators, chronical decline of savings and manufacturing are pushed aside by relatively trivial, shallow soundbytes such as office furniture and corporate jet. Congress would've appeared only clueless, no worse than the two executive teams so far, if they hadn't put up pathetic political show after pathetic political show bellowing down shallow, tedious indignation on bank CEOs.

Can we at least get one tiny technicality clarified so as to avoid another sad day like Friday? Namely, are we talking about nationalization or re-privatization?

That's a rhetorical question, as I made clear at the beginning of this post. Of course we're talking about re-privatization, aren't we?

I can't speak for others but here's what I mean by re-privatization.

1. Let insolvent banks fail. Throwing money into insolvent banks in a bad, global, likely prolonged recession/depression will not work. Reasons for why this will not work and examples of how this has not worked have been cited ad nauseum in media and blogosphere so I'll not repeat them here. But some people get a mental blackout right here. But if we could peek beyond the mental block just for sport, perhaps the Great Beyond is not so scary after all.

2. Government immediately puts failed bank(s) into conservatorship. Here's the scary N word but hang on with me for a moment. Guarantee deposits as usual. Restructure outstanding debt. Let CDS settle and common/preferred equity do whatever the market fancies to do. Hang on.

3. Segregate the deposits and traditional commercial banking part, re-IPO it, and regulate them as good'ol commercial banks. Re-enact Glass-Steagall and make it a requirement for any foreign banks wanting to do business here. Push for an international standard along the same line later.

4. Set up an RTC as custodian for "bad assets", classified by a one-time sweep. Minimal administrative cost, no trading. The government has incentive to minimize potentially good assets in this pool so as to faciliate the IPO and sale (see below) process and maximize return.

5. Sell the remaining investment banking and capital markets part to private investors ASAP. Make a law forbidding them to go IPO. As I argued before, private partnership is probably the only sustainable governance model for investment banking and capital markets, and public ownership is most certainly not. Extend the safetyguard to all foreign banks doing business here.

Of course, there're a lot of details that need to be worked out. A critical factor is the international aspect. If Uncle Sam unilaterally takes over a multi-national bank, guarantees deposit accounts in US branches but without regard to those in other countries, it could get very ugly very fast. International coordination and cooperation is pivotal. But if there's ever a time for true American leadership, or true American bullying if you prefer, this is it. Get Cheney to chair the G20 meeting with his loose shotgun on the table if necessary. I'm not saying we could force US interest on everyone. But let's face it, it requires power politics, in addition to masterful diplomacy, to get the global villagers to agree on anything without getting hopelessly boggled down on each one's petty issues and historical grudges.

True leadership, both domestically and internationally. Do we have it?

Tuesday, February 10, 2009

When Will the USD Carry Trade Finish Unwinding?

Back in Oct 08, I speculated that USD had become a major carry-trade currency, along with JPY. Bad news for US economy made USD stronger, much like what had been happening to JPY for the past few years. That was a dramatic reversal against the usual carry-trade target currencies such as AUD and CHF (Swiss Franc), and to a somewhat lesser degree EUR and GBP, since early 06. FX rates are one of the most complex dynamics in the complex dynamics of financial world. But when bad news is good news for a currency, it's a sure sign of it being a pivotal carry-trade currency.

Recently, and especially today, we're seeing another proof of USD and JPY being the carry-trade currencies. It's implausible to argue the recent USD strength has anything to do with safety or even risk aversion, the latter being the usual explanation for carry-trade currency strength. It's more like forced, maybe even panicking, unwind of existing carry trades.

Hence lies the surprise to me as a casual observer of the FX market: what, there's still a massive amount of carry trades open, a year and half after the crisis blew up in the US and half a year after the crisis became an exported, global one?

But the more interesting question is this: when will this unwinding finish and bad news for US economy becomes bad news for USD? That would mark the next turning point in the dynamics for USD and JPY.

I would appreciate readers' enlightenment as to how to find data, or even if just a guesstimate, on the scope of carry trades.

Monday, February 9, 2009

Can We Go Back To The Old Wall Street?

Michael Lewis hit it on the head when he called the IPO of Salomon Brothers the "beginning of the end of Wall St". Goldman CEO Blankfein almost suggested we go back to the old Wall Street of private partnership in an FT article yesterday.

Let's face it. We screwed up by dismantling Glass-Steagall, a lesson learned the hard way during the Great Depression but thrown away when complacency and greed got the better of us. Basel II is a joke. The European model of combined commercial and investment banks creates way too much systemic risk. Heck, people on the two sides don't even like each other. Commercial banks serve too much social function (taking deposits and making loans) to be aggressive profit seekers. They must be closely and prudently managed and regulated. Investment banks (including capital markets), on the other hand, must be aggressive profit seekers and risk takers in order to serve their social function, which is to keep the capital markets somewhat efficient and fair. But institutions playing such a pivotal social role cannot be public.

Why? Because public ownership is a farce. The concept of "ownership" is a mirage for most modern companies big enough to pass the IPO threshold. But it's like a CDO Squared backed by mirages when it comes to investment banks. I've written specifically about this before so I'll not repeat it here.

But I'd like to stress another point here: regulation alone cannot possibly be adequate for a beast like investment banking. Two reasons:

1. Regulation by definition is rigid and static, while investment banking by nature must be nimble, innovative, and flexible. The result is you end up with either too little regulation, too much, or the wrong kind. Most likely you end up with D) All of the above.
2. Regulators cannot possibly understand the going-ons at investment banks even if they are honest, earnest, and have the authority. There's just too much going on, too fast, that is too complex. There's no way the regulatory bodies can compete with investment banks for high-quality talent without severely corrupting the process, thus defeating its purpose.

While some regulation on investment banking is necessary, it takes the watchful eyes of private partners to keep the beast from hurting itself and taking the society with it. Only private partners have the power, the incentive, and the capability to do so.

So separate commercial banks from investment banks, nationalize the latter, set up RTC for the latter, and then auction off investment banks to private partners. Out of the ashes of the Wall Street everyone loves to hate today, we'll have a lean and nimble Old Wall Street back in no time.

Without costing nearly as much taxpayer money.

Furthermore, not only should we re-enact Glass-Steagall, we should insist on making it an international standard to level the playing field and avoid future contagion. If someone refuses to adopt the standard, they would not be allowed to compete in the member markets.

Sunday, February 1, 2009

Whatcha Gonna Do When 1+1 No Longer Equals 2?

Several widely respected experts have recently said the same thing: all US/European banks are insolvent if they mark everything to market.

How could this be, after so much write-downs and bailouts? I have no evidence to support or refute them. So my only logical choice is to join them.

My guess is, forget about CDS/CDOs. They're past problems, known problems. The hidden toxic dump remaining, the next bomb that keeps blowing up, may be the highly customized, highly complex structured deals they've been accumulating over the years. There's no wholesale market for any of them. Decomposing them carries substantial risk of mismatching due to the various disparities in the market today. Hedging? If Merrill got into a $15B trap doing the simplest CDS/bond basis trade, how can you have any confidence of any hedge/arbitrage/trade working as expected?

Here lies the biggest surprise to the financial world so far throughout this crisis. 1+1 no longer equals to 2.

If the industry is still struggling to explain the CDS/bond basis and determine whether and how to trade it, then good luck with the structured deals. I've seen some of them. It could easily take a highly specialized expert days to digest it, break it down to pieces, figure out how it'd behave under different scenarios, and calculate risk based on existing standard models. Except, of course, the assumptions made by many standard models have been proven way off-base by the market over the past year. Now, on top of this, take away 1+1=2.

Portfolio decomposition is THE foundation for synthetics and much of structured finance. If you take this away, you take away a big part of the foundation of financial pricing. But the world should not be surprised. It happened before for Long Term Capital. Calling the market stupid is as productive as calling reality stupid, even though you could very well be correct. The market is just pricing in some factors omitted by standard models. I have a model that can explain and quantify these factors but it's beyond this article and beside my point.

My point is,
1. it's futile to expect anybody to price/hedge lots of the structured trades meaningfully, even with the best/purest intentions, and
2. even if there is a liquid market, the pricing mechanism is so different now that many tried-and-true, fundamental assumptions in finance are no longer valid.

It's a wild new world. It may be rational still, we have to assume it so. But it's so fundamentally different that it'd take some time (at least months, quite possibly years) for the industry to make sense of it. If you think I'm exaggerating, think about the impact of abandoning Libor and the US treasury curve having a credit spread of 50 bps embedded.

What we're going through is wholesale, across-the-board, fundamental repricing of every financial instrument in existence.

So why are we still debating about which banks are good and which are bad, what their valuation should be, whether to take away bad asset and how to value them, etc etc?

Forget about valuation and risk management! It's not possible! It's a new world that we don't understand!

There, feels better already. Now we can calm down and think rationally.

Now that we admit we don't know how to price them and cannot possibly know for a long time, the solution becomes apparent: don't price them.

1. Ask banks to do a one-time categorization of assets they deem "hard to price". This hard-to-price pool cannot change in the future.
2. Sweep these hard-to-price assets aside. Get rid of all hedging and stop all trading of this pool. It will be held to maturity except, for perpetuals (e.g., real estate), the bank can decide when to sell (but never buy back into the pool) subject to some hard deadline (e.g. 30 years).
3. Provide a total cost, not including operational/financing costs/hedging costs so far since initial trade, future collateral/margin costs, and any realized P&L due to position changes so far since initial trade.
4. The total cost becomes a nominal addition to the bank's Tier-2 capital base for regulatory and accounting purposes.
5. As assets in the frozen pool mature, the realized P&L with respect to the reported cost is accounted for in Tier-2 capital.
6. The frozen asset can be used as collateral, at reported cost, at the Fed window prior to maturity.
7. Everything else will be marked to market.

The final settlement at maturity is the only sure answer to the perennial question of "what's its worth".

Currently banks do have some flexibility in which assets to mark to cost. But there're too many restrictions in some regards while too much flexibility in others. By doing it across the board (regardless of whether the asset is owned by the mortgage division, a trading desk, or the financing department) and at the same time, one time only, we eliminate the regulatory arbitrage and uncertainty.

Under this system, banks will have to prove some illiquidity threshold for assets they put in the pool. Such threshold will be determined by expert panels set up by the government. Other than the illiquidity criterion, banks are free to choose which ones to keep frozen. If they choose assets already marked down, they'd get a one-time boost, which they must disclose in the quarterly report.

The merit of this approach is to provide capital relief to the banks without government subsidy, government guarantee, or some other artificial price intervention. Banks would not be forced to sell assets and/or raise capital in the worst moment. It's the ultimate bailout without spending a penny.

The hope is that, when held to maturity, the macro-economy will recover and most assets will pay off. Nobody is seriously predicting Armageddon after all. In fact, China used essentially the same approach circa 1998 and it worked out beautifully.

This is not the best solution, of course. The best solution is to let all banks fail, use a small fraction of the trillions of bailout money to support deposits and the massive ensuing unemployment, let the good and capable to restart from scratch. We'd have a lean and healthy private partnership Wall Street in no time, in which risk and reward are matched in magnitude and duration, owners actually have control, and stupidity/mediocrity has nowhere to hide.

But that's no going to happen, is it?

Tuesday, January 20, 2009


Economist is someone who, upon hearing something works in practice, snaps "Ah! But does it work in theory?"

Risk manager is someone who, upon hearing something doesn't work in practice, assures "Ah! But it works in theory!"

Executive is someone who, upon hearing something doesn't work, mumbles "But but but my risk manager assured me it works!"

Trader is someone who, upon hearing something doesn't work, inquires "What's the spread?"

Quant is someone who, upon hearing something doesn't work, proposes "It'd work if we assume 1+1=2.429583478, instead of -1.239843924 -- that's where the standard model is wrong!"

IT manager is someone who, upon hearing something doesn't work, yells at her programmers "Why doesn't it work?"

Programmer is someone who, upon hearing something doesn't work, calls her headhunter.

Headhunter has found herself a new job as a bank teller.

Bank asks gubbermen for bailout, again.

Gubbermen asks economist for ideas.

Monday, January 19, 2009

Careful Playing with Black Swan

Now that everybody and their stock broker have bought Taleb's book, everyone knows about black swan. A good number of people may have played with it, I fear.

If you bought deep-out-of-money long-term puts any time after last September, good luck, you probably won't get back to the waterline even if the market goes down 20% from here. Aside from time-decay, the implied vol (VIX) was so hysterically high last October that you have a good chance to lose money even if the market goes your direction.

As usual throughout our evolutionary history, most people follow and lose. Only a select few have what it takes to do the Black Swan Trade.

I'm not talking about the math behind options. Black and Scholes Themselves may not have what it takes to do the Black Swan Trade. I'll use a little anecdote to make my point.

A friend of mine bought some deep-out-of-money LEAPS puts on SPY back in April, 08, when market started rallying on Bear Stearns' bailout. He said "shit is gonna blow up again in September". Pretty succinct, don't you think? But market kept going up, VIX kept going down, as a result he was bleeding a little every day. But early September brought rumors about Lehman. He was almost back above the water! Here's what happened as he told me later (I'm paraphrasing):

There's a good chance that the government will bailout Lehman in the end. So I'll close this one and roll it forward. Then, after I sold the puts, I thought "VIX just shot up and, if the gov bails Lehman out this weekend, I'd be killed by the double whammy of market going up and VIX going down -- look what happened after Bear...just too much risk opening a position now. I'll sit the weekend out."

The rest, of course, is history. With hindsight, he could've opened another Black Swan trade right after the Lehman weekend anyway and made some money. But the risk of doing that back then was also high. Regardless, the point is that the satisfaction was gone. The glory was tarnished. Once you get that close to a ten-bagger, a two-bagger is hardly enticing.

Here's a guy who understands the math, the pitfalls, all the greeks. He saw it coming while the herd was cheering. He just left his would-be-perfect Black Swan Trade open for one weekend.

The Black Swan Trade requires extraordinary courage, persistence, and patience. The herd says you're wrong. The market proves you're wrong day after day for months or even years. Wife complains. Peers jab at you at the bar. Yet if you slack for one day, you may miss the single day you've been suffering months/years for.

It's a miserable way to make money.

No wonder Taleb quit his fund. No wonder he has such a strong urge to brag and show he's right. Now that he's totally famous and proven right, I'm still not sure he's satisfied or that he can ever be. (I'm not trying to psychoanalyze him per se. This is just a generalized observation.)

Maybe it's time to take another look at the Black Swan Trade you did.