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.