Derive This

Annihilate the Perverse Effect of CDS

2009-04-30T19:26:00.002-04:00

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.

USD Can and Will Drop

2009-04-29T01:44:00.000-04:00

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.

Random Musings from Dixie Country

2009-04-19T01:09:00.005-04:00

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."

"Absolutely."

The Legal Scam of FASB Statement 159

2009-04-19T01:07:00.001-04:00

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.

Too-Freemarket Has Become Anti-Free-Market

2009-04-08T07:14:00.001-04:00

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.

China's Bilateral Currency Swaps: First Step

2009-04-01T18:45:00.001-04:00

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.

It's Not Bonus, Stupid (Congress)

2009-03-19T23:33:00.002-04:00

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

2009-03-19T01:58:00.001-04:00

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.

Buy, Buy, Buy into This Sucker's Rally

2009-03-16T22:51:00.001-04:00

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.

Lock Bumping EVERYBODY PANIC

2009-03-15T16:17:00.002-04:00

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.
http://www.youtube.com/watch?v=hr23tpWX8lM&feature=related

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.
http://www.youtube.com/watch?v=glYC53qWsJw

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.

Bailouts Forcing Surge in Systemic Risk

2009-03-08T13:42:00.001-04:00

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.

The Biggest Source for Risk: Government

2009-03-07T14:10:00.001-05:00

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?

China Will Likely Escape Recession

2009-03-02T01:59:00.001-05:00

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.

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

2009-02-21T02:07:00.000-05:00

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

2009-02-21T01:31:00.000-05:00

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?

When Will the USD Carry Trade Finish Unwinding?

2009-02-10T23:55:00.000-05:00

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.

Can We Go Back To The Old Wall Street?

2009-02-09T23:40:00.001-05:00

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.

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

2009-02-01T15:40:00.006-05:00

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?

Economist

2009-01-20T22:54:00.001-05:00

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.

Careful Playing with Black Swan

2009-01-19T22:45:00.002-05:00

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.

Crisis? What Crisis?

2009-01-18T12:35:00.003-05:00

The near-term crisis is over.

Libor is coming down. Mortgage rates are coming down. Bond market of all maturities and for all stripes of borrowers has thawed. Prime consumer credit is moving. CDS spreads have come down from hysterical/historical levels, although it's likely never to come back to pre-crisis levels -- before it disappears. There're still a few anomalies remaining in the market, most notably the spread between nominal and inflation-indexed treasuries. But these anomalies are generally understandable and temporary.

This is not to say all problems are over. Employment and housing will lag at least a few months. The on-going earnings season will be ugly. The tsunami may very well reverberate around the globe back and forth another round, or two. But, barring human stupidity (which can never be barred), these are problems, not crisis.

Oh, another powerful socio-psychological support: the society so much wants Obama to succeed that Citi, BofA, and JP Morgan all decided to move their bad earnings up to Friday, before the inauguration. Wow, that's powerful, meticulous command and control from Obama's still-shadow government, as well as incredible cooperation from our good corporate citizens. Can we assume the remaining bank earnings (Goldman, Wells Fargo) will be good?

On the other hand, the long-term crisis remains healthy and strong, completely unharmed. In fact, I'd say it's been strengthened tremendously by all the scrambling trying to avert the short-term one.

1. Corporate governance.
Lack of shareholder visibility and control, loss of board independence, de-coupling of risk-taker and reward-taker, maturity mismatch between (shareholders and debt-holders) risk and (decision-makers) reward, grossly inadequate risk management systems and techniques, massive built-in systemic chain reaction mechanism...do you see any improvement? Me, neither.

2. Government debt.
Yes, somebody has to pay. That somebody is most likely our later selves and our children and grandchildren, in the form of massively diminished purchasing power and high inflation.

3. Inflation.
Yes, right now it's deflation. And expanded M0 money base alone doesn't cause inflation; more important factors in modern economy include leverage and velocity of money. But greed will drive us to leverage up and churn money as soon as the economy seems to show the first sign of life. And this inflation will be particularly punishing to the poor and polarizing to the society because it will be first and foremost driven by commodities. Will the Fed have enough foresight and political will to jack up interest rates soon enough and fast enough? No chance. In fact, inflation is the path of least resistance to eliminate the massive internal debt. In order to do this, the real interest rate needs to remain negative for a long time. It needs to be an integral part of fiscal policy. I'm not saying it's the right thing to do. It's just the thing people will do.

4. Devaluing dollar.
Yes, right now the dollar is strong for lack of alternatives and unwinding of USD carry trades. But this is bad for US economy and the unsustainable global imbalance. Service economy is a mirage. It's simply impossible to sustain an economy the size of US with lawyers, management consultants, middlemen, and McDonalds and Walmarts. We have to make some stuff, from iPhones to good cars to, yes, steel and toys. To do that we need a significantly devalued dollar to kick start it. Furthermore, there's no easier way to eliminate the massive external debt than devaluing dollar. Yes, it's a scam and everybody knows it but what can they do about it hehehehe...

5. Savings deficit.
No, we refuse to learn to save. It's unamerican. If the government let the crisis blow up, allowed the market to work through its wrongs, and gave people the chance to learn from pain, maybe we would've learned to save. But no, we the people will not allow the government to give us that chance. We are a democracy damnit. The society at large will continue to borrow until the government bails them out, again and again. And the government will continue to bailout the irresponsible until nobody is willing to lend us anymore. And Asia will stop lending, some day.

6. Democracy.
Our democracy failed. It failed when it allowed Bush to invade Iraq and erect Patriotic Act. It failed epically when it re-elected Bush after the disastrous first term. If Bush had just given up in face of pathetic ratings and done nothing about the crisis, instead just followed his inborn, legendary apathy and ignorance, he would've done one virtuous service to the country by giving the capitalist system a chance to work its way through. But hell no, he had to mess up our long-term prospect one last time with the massive, rapid-fire, headless-chicken bailouts. And our elected Congress laid down, spread their collective legs, and let Paulson have his way, any which way he wished. And we had a collective orgasm watching it on TV. Ultimate political porn.

But mostly I'm upset that all the government interventions screwed up the system and made it even more irrational in the long-term. Capitalism requires a minimum degree of rationalism. Arbitrariness increases risk. Arbitrariness from world governments is the ultimate systemic risk. Excessive regulation increases societal cost of doing business. Without all the political headless chickens mucking around, it would've been very painful in the short-term for sure, but the long-term future would've been much clearer and more stable.

Interesting Shakes at Lake Station, Yellowstone

2009-01-18T12:24:00.002-05:00

The Lake, which is the location of last earthquake swarm and an underwater bulge atop the caldera, has been doing this for a few days now -- intermittent, abrupt shakes. Notice that the seismometer's sensitivity is set at 500 microvolts, as opposed to 50~125 at most other stations in the park. So the shakes would max out at 100 microvolt sensivity.

These shakes are local to the station, and obviously not seismic. My (amateur) guess is there've been quasi-periodic magma movements or water sprouts at the lake bottom. Notice that Old Faithful sprouts don't register anything at the YFT station set at 125 microvolts. So these bursts are likely at least a hundred times stronger than Old Faithful.

Most Interesting Seismogram at Yellowstone

2009-01-15T03:11:00.001-05:00

My obsession with Yellowstone quakes continues...

Below is a most interesting seismogram for 1/14/09 -- harmonic tremor with a periodically varying frequency:

Harmonic Tremors Continue at Yellowstome 1/10/09

2009-01-10T13:44:00.001-05:00

At 7:40 and 11:10, Old Faithful:

More Harmonic Tremors at Yellowstone

2009-01-10T04:10:00.004-05:00

More harmonic tremors at Yellowstone:

1/8/09, at around 7:30, 9:00, and 12:50

1/9/09, at around 8:00 and 13:10:

And, what the fuck is this around midnight?

I didn't realize the Upper Falls station is set at a much lower sensitivity than others, 1428 microvolt vs 50-125 at most other stations. Here's the one on 1/3:

The Lake station has been offline for 1/9/09.

To put it in perspective, the frequency of harmonic tremors range from 3-8/min. Wave your hand up and down once every 10 seconds. Imagine the ground goes like that. You'll see how liquid-like it is, almost soothing.

Harmonic Tremors at Yellowstone on 1/3/09

2009-01-05T22:15:00.009-05:00

Since the earthquake swarm at Yellowstone started on 12/27, I've been following it with modest amusement. The idea of a super-eruption (VEI8, or even if just 7) of a supervolcano is mind-boggling, thus fascinating -- certainly would make the man-made financial crisis infinitesimally, pathetically trivial.

BBC did a very good drama on supervolcano -- watch all 12 of the two-part series:

It's drama, but fairly correct scientifically except, of course, the part about timing. Although the timing is intentionally ambiguous, it implies it's sometime in the near future of human civilization. This is pure speculation. To quote an old SNL bit: it's possible...but it's unlikely...but it's possible...but it's unlikely...

However, my passing interest peaked when I checked the U of Utah realtime webicorder in the park (http://www.quake.utah.edu/helicorder/yell_webi.htm).

Look at about 14:00 and 17:00. See something?

Yes, familiar nice sine wave patterns. It's called harmonic tremor. It means the magma was on the move. It has two possible outcomes: either stop and disappear, or the shit blows up.

If you check the other stations in the park for the same time segment, you'll see the same harmonic tremor pattern almost all over the park.

We dodged a potentially huge fucking bullet, this time.

BTW, according to USGS, the water output from Yellowstone River has been steadily increasing since 12/27 while it "should" be decreasing based on historical averages:

It's known that there's a dome at the bottom of Yellowstone Lake, where virtually all of the quakes of this swarm have taken place, that's been rising in recent years. It doesn't take a very imaginative mind to link the two.

What'll happen next? From all I can gather, seismo-vulcanologists say it could happen before I finish this sentence or it could be a million years from now. In other words, they're as clueless as Paulson/Bernanke on CDS, or Bush on the joy of intellectual stimulation, or Obama on unrealistic expectations.

Nothing to worry about, though. If it's a global extinction event, then there's no pain -- who's gonna be around to witness and record all the fantastic screaming and scrambling around and unfulfilled love and unfinished blog posts? The topology of the pain space is circular, infinity = 0. Just as globalization of the financial crisis, through Lehman bankruptcy, made crisis management that much easier and less painful.

Future rat archeologists will no doubt puzzle over their findings a great deal. Poor little fuckers.

PS: As the massive molten mass of magma was sloshing around under Yellowstone, I was enjoying GREAT food and decent wine at a newly discovered Hunan restaurant, the discovery of which was as accidental and meaningless as Yellowstone decided not to blow up at just about the same time, in Flushing with a bunch of friends celebrating my birthday. I thought I had a great birthday party going. But little did I know how great it was.

PPS: If you have to know, it's called 湘水山庄, about 100 yards east of Northern Blvd and Main St, on Northern Blvd. The best, most authentic Hunan food I've found on this continent, before it's covered in three feet of volcano ash anyway. It's so authentic they don't even bother with an English menu. Setting and service are quite decent, and the price is CHEAP.

Lehman Bankruptcy: Crisis Management Through Crisis Export?

2008-12-29T01:59:00.000-05:00

Although Lehman bankruptcy has long past us (feels like an era way for many of us if only for the fact that so very much has happened since, doesn't it?), I think it's nevertheless valuable on many levels to understand it in the correct context. For those of you who'd like to retrospect, CNN Money has an excellent in-depth review of the Three Days That Shook The World.

There's one unmistakable take-away from the analysis: US government definitely, specifically wanted Lehman to go down. They couldn't prevent the BoA and Barclay's talks of a buy-out, of course. But whenever parties involved in the rescue effort went to them for help, you could almost see the glee in their collective eyes when they said "no". Why is that?

In retrospect, FSA's refusal to approve the Barclay's deal was a devastating, decisive event. Why did they? The official explanation is that Barclay's was not strong enough to take over all of Lehman. But they surely could've asked the US government for some assistance and, between US and UK government backing, there surely must've been a way to make the deal happen. We don't know whether UK government did ask US for some corporative effort. Nor do we know whether FSA acted on request from the US government. But we do know for a fact that US didn't do anything.

But even then, all hope was not lost:

But Lehman's ordeal that Sunday night was far from over. First came a tantalizing ray of hope with the word that the Federal Reserve Board agreed to expand the collateral that investment banks could pledge to the Fed as part of both the Primary Dealer Credit Facility - the name given to the historic measure that allowed investment banks to borrow directly from the Fed window after the demise of Bear Stearns on March 16 - and the Term Securities Lending Facility, a $70 billion "collateralized borrowing facility" created on Sunday by banks to enhance liquidity in the marketplace.

When the Lehman executives started to hear on Sunday afternoon that these windows of emergency financing were opening up, they called the New York Fed to see if it were true. If the Fed allowed Lehman to pledge its shaky collateral to the discount window "we might get a reprieve," one Lehman banker said. But the Fed told Lehman, according to this Lehman banker, "'Yeah, we're doing that for everybody else but you. We're going to let you guys go.'"

Now let's take a look at what Lehman bankruptcy has changed.

Since the subprime crisis first broke out in August 07, it had been a US crisis. Everybody else was still looking pretty, especially the Old Europe. But after Lehman bankruptcy, it became a global crisis within a week. All of a sudden, we learned that European banks were in even deeper trouble than their US counterparts. The invincible Euro and GBP started tumbling, along with Ruble and Won and whatnot. Iceland went bankrupt. Basel II became the Biggest Joke in Financial Regulation...well, you know the rest.

Lehman bankruptcy marked the globalizaiton of the crisis.

But, as I said before, the beauty of this crisis is that it's global. If it had been a US crisis, any single one of the subsequent bailouts -- the AIG bailout, the $700B bailout and the Citi baliout -- would've been devastating to the USD and treausires. Another beauty is that everybody has fiat money. The two combined means that everybody can print as much money as she needs without worrying about currency exchange or inflation -- not until the economy revives.

I'm usually not the one who starts conspiracy theories. But the links here are too strong to deny.

Here's another passage from the CNN Money article to finish this off:

McDade and Lowitt, on Lehman's behalf, made one last-ditch effort to convince Paulson that taxpayers should bail out Lehman. They went back down to the Fed and walked the Treasury secretary through a doomsday presentation that Lehman had put together foretelling the likely global consequences in various markets - foreign exchange, swaps and derivatives, among others - if Lehman were allowed to fail. After McDade finished, Paulson told him, "You're talking your own book. We've thought this over."

"That's exactly the point you idiots", Paulson silently laughed to himself.

I'll Sell You All the CDS on Citi, Suckers

2008-11-23T22:05:00.003-05:00

CDS spread has gotten an undeserved attention as some sort of prophetic leading indicator during this crisis. Is there something special about CDS buyers and sellers that make CDS spreads more insightful than anything else? NO, of course not.

If you think the 40 bps CDS premium on US is ridiculous (for up to 5 years anyway), then I have a surprise for you. Citi CDS was going for 470 bps last Friday. This is close to imminent default range. It's much worse than the usual junk credit.

All the bad news and gloomy speculations about Citi notwithstanding, the simple fact is that

1. Citi deposits will not be endangered. This is hugely political. Governments around the world cannot afford to let it happen, or else they'd be stoned to death by the revolution.

2. Citi bonds will not default. Although Paulson maintains that he didn't think the decision to let Lehman go down was a mistake, everybody knows (Paulson included) it was a critical mistake in transforming a financial crisis into a full-blown global, economic crisis. I think we've learned the lesson by now. The world cannot deal with another CDS settlement of a big company. Not Citi, not GM.

Beyond the above two points, everything else is in play, including wiping out equity.

But, before you get too excited about the parallel between Citi and Bear/Lehamn/AIG, think about the following:

1. Unlike the situation weeks before Bear/Lehman, even for weeks for Morgan Stanley, no bank is stopping trading with Citi. Remember, some banks stopped trading with each of them WEEKS before the trouble became public. It's a very easy decision for them to make, with negligible downside compared to the risk IF they seriously think there's a real risk. But no, nobody stopped trading with Citi, as of the past Friday.

2. Unlike Bear/Lehman/MS, Citi is a real bank with real deposit base. I don't know about the off-balance sheet toxic asset in Citi that everybody suddenly seems to know. But the crucial difference is that Citi is not an investment bank. As long as you believe humanity is not quite stupid enough to march off the cliff, Citi will survive - with pain, maybe, but they will survive.

I think it's quite clear by now that the emerging market crisis of last month is mostly aritificial and technical. They are vulnerable for sure. But there's no structural deficiency in BRIC world in the same order of magnitude as in the developed world. China will be hurt by decrease in demand in goods. India will be hurt by decreasing demand in offshoring. Russia will be hurt by slumping oil price. Brazil will be hurt by slumping oil price (ethenol) and FDI. But none of them is nearly as severe as the chronical, structural deficiencies of future-mortgaging and over-consumption in the developed world. As demonstrated by the 4 trillion Yuan plan announced by Beijing, they are at a point where they CAN create enough demand domestically to get through a temporary glut.

What does this have to do with Citi? My point is the world, not just the US government, will not allow Citi to go down. The US government may not have enough credibility, with Paulson changing his mind every week. But the world ganged up together is a credible threat to the shorts.

And, dare I say, with its truly global franchise, Citi is in a better position to benifit from emerging markets while most other banks, much more concentrated in US and Europe, are exposed to the long struggle ahead of us in the develped world.

If you want to say Citi is too big to manage, that's fine. But it still does not negate the fact that Citi is truly too big to fail -- not just to US, but to the world.

I don't know what will happen to Citi stock. But if you want to buy Citi CDS, I can sell you as much as you want.

Public Ownership Is A Fraud

2008-11-19T00:58:00.005-05:00

Michale Lewis' epic piece "The End" makes a great read, even if you don't agree with all of his points or accounts. To me, the central theme is that the beginning of the end of Wall Street was Salomon going public. By going public, the wealth of investment banks is transferred from the public to the previous private partners, while the risk goes the opposite way. This is indeed the single most critical, systemic discourse between risk and reward in our financial system.

I'll take that one step further and say the very notion of "public ownership" has become a farce in modern economy.

1. First of all, few shareholders nowadays intend to "own" it for a long time to begin with -- holding a stock for over a few years is considered an indication of old age, I guess.

2. Secondly, for the few old-fashioned shareholders with the real ownership mentality, they have very limited visibility to what's going on in "their" company. Quarterly report is a mockery of transparency for all modern companies large enough to cross the IPO threshold. This is especially true for financial companies, considering the notion of "off balance sheet", the myriad of derivatives, and the increasingly nonsensical accounting rules (I'm surprised few have criticized FASB in this mess yet).

3. Thirdly, even if transparency becomes real and meaningful via some drastic change in law and regulation, shareholders have little use of it. You can vote once a year in shareholders' meeting and hope the board would exercise oversight for you, just like what you do with politicians. Well, you know how well that's been working out. If you think I'm being cynical, just look at the trend in executive compensation over the last few decades.

4. Even if shareholders care, can get visibility, and have an effective board, the obscenely high executive compensation, and especially the most insane, illogical, anti-owner notion of golden parachute, still provide enough cushion for irresponsible and incompetent behavior for at least some executives. Heads you win, tails you don't lose. Risk-reward breakage. Disaster is guaranteed.

We've seen this farcical notion of public ownership blowing up on our collective face in steel, air carrier, banking, telecom, insurance, auto, technology, air carrier, banking, insurance, auto... Now even GE is in trouble. Every time we find a few culprits, scapegoats to satisfy our frustration, then carry on the same fraud, only to see it blowing up somewhere else a few years down the road.

Time to take a step back and survey the history, folks. Do we want to continue this fraudulous public ownership or go straight to state ownership? Most of our mortgages and banks, some insurance, and autos it looks like, are already state-owned. Or worse yet, tax payers just pay and don't own anything.

Public ownership was once a great idea. And it worked when life was simple and scale was manageable. But today's world is different. We need to either drastically rethink corporate governance model in public ownership or revert back to private ownership. The other alternatives are state ownership or even worse, like what we're heading into now, fantom public ownership with tax payers taking on the ultimate risk without any reward.

I don't think Wall Street is dead. There'll be smart and hardworking people setting up private-ownership investment banks soon, because the future state-owned banks cannot possibly compete and be financially viable without constant stimulus, bailout, and suffocating regulation.

Out of the ash, an Old Wall Street will re-emerge.

Supply and Demand Have Little Relevance to Commodities Price

2008-10-30T00:44:00.003-04:00

Commodities price is driven by supply and demand. This is as true as the law of risk and reward.

Except the law of risk and reward hardly applies for the last few years. As such, so does the law of supply and demand since the commodities bubble started last year (arguably earlier) and ended a few months ago. If you need any proof, here're two pieces of news, randomly selected sources from a blind google search (not intending to target the sources in any way), to illustrate my point:

1. On 04/29/2008, disruption in Nigeria causes oil price to surge $1.50 to a then-record of $119.93. Hmmm...how interesting.

2. On 07/18/2008, disruption in Nigeria causes oil price to drop $5.31 to $129.29. Hmmm...how interesting...wait, WHAT?

The oil run-up of last year bothered me a great deal. So I decided to make an effort in making sense of it. Back then everybody was talking about supply and demand, peak-oil production, Saudi's exaggerated oil reserve, etc. etc. But I couldn't understand how these slow-moving variables could possibly cause the insanely fast-moving price. Then I read about how a new breed of speculators have joined the market and driven up price. That makes perfect sense, just as explaining why water boils by saying the temperature is 100C -- it provides absolutely 0 information. Why did all those speculators all of a sudden swamp into commodities?

Then somewhere along it hit me. Real negative interest rate. When the real interest rate is negative, it doesn't make economic sense to hold cash. Real assets that people need have a much better chance of holding value through inflation. (I know, I can't be even the millionth one realizing this.) With real estate out of question last year, commodities was a logical place to park your money. And it's a self-fulfilling proposition and yet another positive feedback -- the higher the commodities price, the higher the inflation pressure, and therefore the higher the commodities price...ad nauseam.

Did supply and demand have anything to do with the equally dramatic burst of the commodities bubble since July? No more than the run-up. I have a theory on why but it's off-topic so I'll leave it out. And the last leg of plunge was no doubt a part of the Great Unwind by hedge funds and banks, primarily triggered by Lehman CDS settlement.

It's primarily inflation, both real and expected (but probably not the nominal, systematically understated CPI), in relation to interest rate. Similar commodities bubbles driven by negative real interest rate have happened before. But this time it's amplified by the massive amount of concentrated capital, from individuals, corporations, and governments, created through years of internationalization, as well as the dramatic increase in capital flow and leverage through fantastic progress in capital markets and regulations such as securitization and Basel II.

Over the longer term, years and decades, there's no reason to believe the law of supply and demand will break down. But in the shorter term, in a market swamped by speculators who never intend to take delivery, supply and demand have little relevance.

In the very short term, minute-to-minute and day-to-day, supply and demand will have relevance, but only in a nominal and deceiving way. Imagine a fallen autumn leaf in water, a very smart one with a PhD in fluid dynamics, with access to a massive cloud of blades running Linux and models coded in A+. She can explain every minute movement from the molecular level up. Supply and demand. But there's a problem. When demand goes up 1%, sometimes the price goes up 0.1%, sometimes 10%, and sometimes even -1%. She doesn't understand. But Reuters reporters call her anyway and dutifully report on how supply and demand drove the price in their obligotary end-of-day headline.

Enough with cynicism. What will happen to commodities?

On 10/3, right after the passage of the Bailout Pork package, I said commodities would have another long-term run-up. On 10/13, I said the market would have an intermediate-term bottom "before or around 10/21". In retrospect, I was a bit early on both accounts, as I am usually. I didn't see the delay effect of the Great Unwind of forced hedge fund liquidation and bank deleveraging. But I wasn't too far off.

I still stand by them today, only with more conviction. Bernanke's Fed has totally lost its mandated independence from politics. He'll be bullied by Washington and Wall Street into keeping the interest rate below real inflation. The next President, no matter who, will probably not have the political will to call Uncle Ben to tackle inflation until it's too late (this is a change from what I said in my 10/3 article), unless the economic appearance improves drastically in the next few months (unlikely). So we'll have yet another asset bubble, in commodities, and commodities-driven inflation, starting from somewhere between yesterday and mid-2009.

The inflation driven by housing bubble in the last few years was stealth. Those who hitched a ride, the homeowners, didn't complain. Those who missed out, the homeless and the renters, complained but were completely drawn out by the party noise. But commodities-driven inflation will be direct and apparent. So my hope is it wouldn't last too long. And that would be a good thing for society.

Until the good thing happens, enjoy your ride on commodities.

Stop The US vs China Nonsense

2008-10-28T22:41:00.004-04:00

People love enemies. Enemy gives us a sense of purpose, a uniting force. Just look back at the cold war era. Did we obsess endlessly about politician's extra-marital affairs or bicker bitterly about a few billion dollars' pork barrel in spending bills? No, of course not. Let's kill the enemy first. Politicians and media know this very well. Every President must fight at least one war. This is Politics 101. If oil price stays high and Putin stays in power forever, it'd make the job so much easier for US politicians.

Unfortunately, oil has crashed (for now) and Russia looks shaky (for now). China will have to do. It's not ideal, but not bad, either. For one, it's big, unlike Venezuela or North Korea (and Iran somehow just doesn't have the credibility). Even though it's still weak, it's been growing fast. Menacing enough. Secondly, the "communist" label is perpetually handy. Never mind the fact that true Marxists/Maoists/Communists have long been completely pushed out of the political spectrum and exist only at the fringes of common society in China, and many aspects of rule-of-the-jungle capitalism there make most of the self-proclaimed "capitalists" in this country look like socialists. Ignore all that, preface "China" with "communist" and you're done.

The current crisis, of course, makes finding an enemy all the more urgent. China presented itself at the perfect time. First of all, China looks like the only country relatively unscathed by this mess. Even better, their newspapers started calling for abandoning USD as the hard currency. There, done, crisis is over (in the sense that the 300 point drop on the Dow last Friday was a huge relief).

This stupidity must end. US and China need to work together even more closely, at least in economy and finance, to face the numerous post-crisis challenges. Yes, I think the crisis is over and the short-term bottom is behind us. Now we have to solve the difficult problems of global recession, long-term inflation, and structural flaws of international financial system.

First of all, China will not be greatly damaged by this crisis and it's good news for everybody, just as it was when China effectively stopped the contagion of Asian financial crisis in 1997. There are several reasons for my assertion:

1. China's financial system remains relatively arcane and closed to the rest of the world, which turned out to be their biggest blessing this time.

2. Chinese government and central bank have very strong balance sheets as cushion and ammunition against shocks.

3. High savings rate provides cushion. Low leverage lessens the shock.

4. It's true that housing bubble is bursting in China, banks have (potentially significant amount of) bad assets, and some companies do have exposure to the international financial market. But none of these comes even close in relative magnitude to those in developed world. The housing bubble is fundamentally different from those in US and Europe in that the chain-reaction multipliers of subprime and structured finance are completely absent. By all measures, the bad asset problem in Chinese banks in 1999 was much bigger. Yet they got through it fine.

5. It's true that Chinese economy will suffer if the demand for export decreases, especially if it's prolonged. But the domestic market has expanded greatly in recent years with the emerging middle class. There's still ample need for infrastructural improvement to create demand, and the government has the firepower to finance it. Furthermore, China has been diversifying their export destinations in recent years with some success. As long as world demand stabilizes in no more than a year, they'll probably be ok.

6. Contrary to the common misconception, Chinese economy is NOT an export economy. It's much more appropriate to call it a value-added import-export economy. This is a key difference between the Chinese economy and Japanese. Since Japan migrated towards the higher end of value chain in the 70's and 80's, their export relies less and less on importing raw materials (with the notable exception of oil). China, on the other hand, still heavily relies on imported raw materials and components. In my opinion, this is the most important reason why China got through the 1997 Asian financial crisis fine while the currencies of virtually all their competitors' were massively devalued overnight. Chinese economy is much more exchange-rate neutral, except RMD-USD, than most of the world thinks.

And it's a good thing that China doesn't get pulled under by this mess. The economic inter-dependency between US and China is even greater in the post-crisis world. It is to China's self-interest to prevent turmoil in world economy, and to keep the status quo in international trading and USD's position in many more aspects than changing it. Here's why:

1. China has been arguably the biggest beneficiary of the status quo in international trade over the last twenty years or so. Any significant change would take them a long time to adjust and pose challenges and uncertainties.

2. USD's fall from international hard currency would be devastating for China, almost as much as for the US. It'd take them at least a decade to make the transition. This may be the long-term hope for China, France, Germany, Russia, Japan, or Iran. But none of them is ready for it, and will remain unready for years. Yes, there was an article in the English edition of China Daily on "US plundering the wealth of the world". But I find the ensuing hysteria here, excuse my blunt choice of words, laughable. If you actually read the English edition of China Daily regularly, as opposed to occasional glance over second-hand digests and commentaries, you'd find quite a bit of views and opinions not reflecting the government official view or policy. I know this is a surprise to some in the western world but the limit on dissenting views in China has been slowly creeping outward since the 80's. Perhaps more relevant to this case, the Chinese government has been slowly learning the art of public opinion manipulation in the international arena. My reading is this article is more of their gesture to Sarkozy and, indeed, much of the rest of the world. It's the Chinese government's version (in the international arena) of US presidential candidates' "I feel your pain and frustration." No, they don't, in both cases.

3. A devalued dollar (against other major currencies) is bad for China as it almost certainly translates into higher commodity prices, besides the direct impact on their foreign exchange reserve. The dynamic here is quite different from the relative exchange-rate neutrality against other currencies I mentioned above.

On both sides of the (other) pond, there're persistent political forces trying to make an enemy out of the other side. And the leader-wannabes in both countries invariably put up the hawkish face during campaign (internal campaign among power brokers and political elites in China's case). But, also invariably, they come to recognize the interdependency between the two countries soon after coming to power, despite real and important issues and differences. It's a pathetic political circus.

Politicians need enemies to make their lives easier and get them more power. Do we?

USD Carry Trades?

2008-10-26T17:00:00.001-04:00

Yen is the carry trade currency. You know, you borrow Yen, pay next-to-nothing interest, swap it for Australian dollar, get high interest return on AUD. You own the license to print money, unless and until Yen goes up in value. Then you may need/want to unwind -- sell AUD, buy JPY, which drives up JPY, which makes more people need/want to unwind. It's a positive feedback which, despite of the word "positive", means it's destabilizing. Bad. Dangerous. Crash. Crisis. Bad bad bad.

Another possibility you may need/want to unwind the carry trade is increase of risk aversion -- people want to hoard cash. Again, destabilizing positive feedback.

Our financial system is full of positive feedbacks. It's so full of inherent instability it's a wonder it hasn't blown up completely ten years ago. Until we redesign it to eliminate such instabilities, it will blow up again. I believe it's possible to eliminate such instabilities; the key is to eliminate windfalls (spread it out), encourage long-term behavior and discourage short-term speculative behavior. But human society will not have enough political will to make such drastic corrections, not until we suffer greatly. The current crisis does not inflict enough pain.

Let's get back to carry trades.

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help them achieving this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. USD is about the only other currency that strengthened across the board. Why is that? People think US economy will bounce back fast? USD is once again gold? Or even though USD is not gold but everything else stinks even more? If you believe any of that, I have some wonder organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut the rate, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euro, Canadian dollar, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economy beyond hot, suck the lifeblood out of them, then leave them withering in rubles.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken.A system of traders and speculators but no investors is destined to be traded into oblivion.

Perpetual Mortgage: A Better Way Out

2008-10-24T00:38:00.003-04:00

Unless and until the housing market stabilizes, which is a less stringent test than bottoming out, pressure on economy and especially financial market will not subside. This seems a fairly broad consensus now. So there're many answers offered. Presidential candidates and Congress are busy in a race to the bottom, dreaming up all kinds of economically nonsensical, legally borderline or even outright unconstitutional, socialist and/or totalitarianistic ways of "helping homeowners".

As far as I'm concerned, we're selling our collective soul to the devil by embracing government bailout and intervention in panic, without questioning or thinking it through.

I have a better idea than forcing/coercing banks to "modify" mortgages: offer homeowners the option of converting existing mortgage into perpetual mortgage.

Here's how it works.

Say you bought a house on $200K mortgage and are now in danger of default and the house is worth only $150K. You can convert into a perpetual mortgage with a principal of the original amount, $200K. You're still the homeowner, enjoying the tax deduction and all. The lender is still the lien holder. The differences with traditional mortgage are

1. You pay only interest. Assuming the same interest rate , your monthly payment drops by about 15% depending on the rate.
2. Your equity on the property remains 0 as long as you don't sell it.
3. If you sell it at a profit, you don't get an immediate windfall. Instead, you get a reverse mortgage from your original lender on the profit. This reverse mortgage can be sold in case you want to cash out.
4. If you sell it at a loss, you don't take an immediate hit. Instead, you carry a loan on the difference.

The idea is to soften the blow to homeowners when the market goes down, and to give people the option of forfeiting wealth accumulation for maximum lifestyle. The choice is yours to make.

Allow me to remind you of three simple facts about traditional mortgage model:

1. Many people are not ready to deal with the 50%, 100% leverage from housing price on their down payment. As a result, when housing goes up, people make unrealistic assumptions about their networth and financial future; when housing goes down, people go panic and/or desperate. Forcing such huge leverage on unsuspecting, unprepared public ultimately forces the risk on the society as a whole -- it becomes a political/social problem, exactly as we're witnessing now.

2. Such leverage is inherently destablizing at the macroscopic level. When economy runs into headwind, the housing market is likely to go down. But homeowners are also likely to lose their jobs. Positive feedback, exactly as we're witnessing now. Perpetual mortgage spreads out the profit/loss on the house so that both homeowners and lenders have more buffer to cope with it.

3. Most mortgages are never paid off. They either get prepaid (sold or refinanced) or foreclosed. Both are among the biggest risks to lenders, thus adding to the interest rate. Perpetual mortage largely eliminates the delusional assumption that it will be paid off on schedule. It also reduces both by A) discouraging flipping, and B) easing foreclosure danger.

It's not a cure-all. But it should make it less painful for many homeowners and lenders while limiting governmental intrusion on capitalism.

Note that this is very different from renting from the bank. You own the house, participate in its appreciation as well as depreciation, enjoy the tax benefit etc. Banks can also impose the same down-payment requirement, although this is impossible when converting existing mortgages. It also differs from "interest-only" mortgages in that, in case of a downturn, homeowner pays the depreciation over a period of, say, 10 years. The original lender is obliged to offer this loan.

CDS Exchange = Assured Systemic Shock

2008-10-19T15:47:00.002-04:00

Friday I submitted a Proposal on Transforming CDS. I encourage you to read it if you hold just a passing interest in the current financial crisis. But the talk of moving CDS to exchanges has been gaining momentum, touted as the cure by SEC Chairman Chrisopher Cox.

If the man who advocated for deregulation of all things financial, and who was appointed to head SEC for the purpose of making it irrelevant, touts The Cure for the crisis that his agency helped create, we need to be automatically suspicious.

But let's go beyond philosophy, go into details and make a concrete case.

Exchanges reduce counterparty risk by being the sole counterparty; in turn, they protect themselves by imposing margin requirements on their client accounts. So far, in almost everything exchange-traded, this mechanism has succeeded. But this does not make it a fit for CDS due to its inherent high leverage on the seller side.

Say I sell on the exchange $1B CDS on XYZ, which is a decent credit and premium is $10M per year (100 bps). The exchange finds you as the buyer. Since you're liable for the $10M annual premium payment, it requires you to put up collateral of $10M. No problem.

But how much collateral does the exchange require me to post? Obviously the amount should be tied to the notional, NOT PREMIUM, since my liability is tied to the notional -- a fraction of it, but the fraction could range from 0.1% to 91%, as illustrated by recent Fannie and Lehman CDS auctions. 100% of notional? There's no way any seller could afford to sell under such collateral requirements, not at a price buyers would buy. Remember, my collateral would be 100 times of my annual proceeds from this transaction. Even 10 times premium would be too high for the seller. Even at 2 times sellers would cry for pain.

But 2 times premium is 2% of notional, and assuming recovery of 40% (another laughable character of CDS standard models), 1/30 of the seller's liability in case of default.

There may be some remedial measures, such as increasing collateral ratio as the credit deteriorates. But, unlike naked equity options, the payout for CDS is by nature sudden-death, a jump event. The day before Lehman bankruptcy, Lehman CDS was trading at 20% upfront. The next day, you're looking at 80% payout.

Convergence between collateral and potential liability on CDS sellers is not possible. Recovery rate upon default is an unsolved problem. Putting CDS on exchange forces the exchange to take the recovery risk.

Who fills the hole? The Exchange. What happens if The Exchange fails? Complete, certain failure of CDS market. In contrast, the fallout from Lehman bankruptcy we've seen so far is less than 100% in both probability and scale.

If we let the old players and the old guards design the new system, the exchange would be guaranteed by the government, with the exchange taking the profit in good times and the government taking unknown, undetermined risk of recovery rate for no return when disaster strikes. And the collateral requirement of sellers would be pathetically inadequate. Future systemic failure is assured.

Will the society allow this travesty to repeat itself?

Proposal on Transforming CDS: Credit Insurance Trust

2008-10-17T23:02:00.004-04:00

The latest round of eruption of year-long financial volcano has thrust CDS into almost bar-conversation vocabulary. The common sentiment seems to be total hatred or disgust. Eulogies for CDS have already been published. Others are calling for change in how CDS is traded and/or treated in accounting. Common proposals include

1. Regulate CDS as what it is, insurance.
2. Trade CDS on exchanges so as to minimize counterparty (seller) risk.
3. Move CDS on balance sheet.

But the cost to the seller -- capital reserve in 1 and 3, margin collateral in 2 -- would be prohibitively high if the capital/collateral cushion is to be enough to meaningfully reduce counterparty risk. Such high cost to the seller translates to high premium for the buyer. Result: dramatically reduced market size. In other words, CDS is still dead.

Few people would shed a basis point of a tear on such news today, I suspect. But let's not forget CDS can serve a legitimate and important function: hedge. Yes, there are real, meaningful hedges using CDS. If you hold a bond or otherwise are exposed to credit risk of somebody, there's nothing like CDS that can provide direct, fast, efficient, and clean hedge in time of need.

Credit derivatives are NOT financial weapons of mass destruction. They merely have the capacity of being such powerful tools. But whether it serves good or evil depends on people. Blaming financial products strikes me as profoundly misguided and ignorant, even dishonest.

No, credit derivatives didn't cause this crisis. WE -- the government, some market players, some mortgage lenders, and some home buyers -- caused this crisis. We didn't use the powerful tool of credit derivatives properly.

And while we're on it, let's make one point very clear. The reason why we failed to use it properly is not due to lack of understanding of the risks; rather, it's because the system -- regulators, laws, and corporate governance -- has incentivized decision makers at all levels to ignore the risks and focus on short-term gain. Calling regulators and Wall Street executives stupid or incompetent might feel good. But it wouldn't be correct at the overall level.

It's the system that's skewed and flawed. The magnitude and duration of decision makers' risk and reward are misaligned; sometimes even the sign is wrong. If we only focus on a few individuals' misjudgment or unethical/criminal behavior, we run the risk of missing the deeper, greater cause -- the systemic flaws. In doing so, we only set ourselves up for a repeat in the future.

So I'd like to focus on addressing the systemic flaws here, and only on CDS. Let's first take a look at what makes CDS unique -- forget about the standard pricing model or how it's been treated so far, focus on the economic idea behind it.

1. CDS by nature is an insurance.

2. However, there is one important distinction between CDS and traditional insurance products. The latter can be "hedged" via diversification. It's very difficult to hedge CDS this way because, by definition, it deals with low-probability, high-weight events among a small population. This is the most fundamental flaw of CDS as we know it today. It goes right into the well-known fact that statistical applications (not the theory) loses relevance as you migrate towards the distribution tails. No company is big enough to provide meaningful insurance of such risks on a meaningful scale, especially since the company is a credit risk itself. As to governments playing any role, I hope the governments' involvement in this crisis has thoroughly disgusted everyone so let's not even go there.

3. CDS differs from most of other derivatives in that it is inherently highly leveraged. This makes CDS the key ingredient of the chain reaction.

If you understand the above three fundamental characters of credit default protection, you'd realize regulation or accounting gimmicks could not possibly address the real cause of the problem, short of killing the market altogether. The real solution must address all of the three fundamental characters while avoiding throwing the baby out with bathwater.

In addition, just as nobody should, in the legal sense, moral sense, or from societal considerations, reap a windfall from tragedies, as is the case for all traditional insurance, nobody should reap a windfall from default through CDS. The social utility of insurance is to lessen the impact of tragedies as opposed to encourage speculative or reckless behavior. You may be tempted to ban naked CDS based on this consideration. But naked CDS has its legitimate use, since all exposed to a credit risk do not hold the bond.

More importantly, since CDS settlement is by definition a zero-sum game, there is absolutely no reason the society as a whole should be greatly damaged by it aside from the fact that the reference entity has just defaulted. If we cannot find a way out of this PURELY artificial problem without sacrificing its beneficial functions (or going into state capitalism as we are), then I don't know how we deserve the top spot on the food chain.

My proposal is to set up a private, non-profit Credit Insurance Trust (CIT). To begin with, let's call it what it is, Credit Insurance (CI).

1. Those who want to sell CI must contribute capital, the amount of which is tied to the total amount of notional they can sell. The relationship between contribution and allowable notional is determined by auction, e.g., $1 contribution gives you a permanent, revocable, transferable license to sell up to $1000 notional CI (hold you protest on such outrageous leverage -- read on). Licensees are subject to trustee approval. Licensees are seller agents for CIT, which is the legal seller of all CI. Licensees can buy additional licensed amount at prevailing auction price, subject to the total cap set by the Board of Trustees.

2. Board of Trustees is elected annually by CI buyers. The vote is weighted by notional outstanding bought.

3. CIT invests the fund in long-dated treasuries (or other "riskless" securities the BOT deems appropriate).

4. CI premium goes to the Trust. Licensees take a haircut, ranging from 0 to 5 bps. The better the credit, the bigger the haircut. This discourages speculative selling on poor credits. The returned premium goes into a separate fund -- let's call it CITIF -- which also invests in "riskless" securities, but with maturity no longer than one year. Furthermore, CI on a credit cannot be sold once the credit quality deteriorates beyond certain level. This prevents agents from selling garbage while making fees via private arrangements. Existing CI contracts can always be transferred, however, with registration to CIT.

5. Returns on CIT and CITIF investment pay for the administrative cost first. Excess goes into CITIF; deficit comes from CITIF. It's to the BOT's interest not to let CITIF run dry.

6. CI buyers must invest all of the settlement windfall into CIT, which is done automatically as part of the settlement process. In return, they become holders of CIT's interest-only, non-compounding, annual coupon, 10Y bond. In other words, each settlement is automatically a CIT bond issuance. Coupon payments of such bonds come from the accumulated funds in CITIF, set in arrears and capped at 20%, after administrative expenses. CIT bonds can be auctioned at issuance (buyer cash out) or traded on secondary market.

This may seem a bit complicated, and will get more so when put in the international context. Price of CI depends on the valuation of CIT bonds, the pricing of which would be quite interesting. But it has numerous advantages:

1. While credit default risk may have proven too high-weight for any particular company to bear, by definition such risks can be handled, and statistically "hedged" in the same sense of traditional insurance, at the macroeconomic level. This setup solves the fundamental flaw pointed above.

2. There's no economic incentive for speculative selling by the agents. Speculative selling of CDS is the biggest systemic flaw currently. This setup cuts off the chain reaction mechanism from the root.

3. Contrary to the destabilizing effect of CDS, this setup serves to stabilize the system and benefits everyone involved, therefore by extension the society in general. It will also lower the systemic correlation, which is extremely beneficial to many other credit derivatives, e.g., certain types of CDO.

4. Speculative buying is also greatly discouraged. As a credit worsens, the haircut by seller-agents decreases, discouraging them to sell protection on the credit. Also, buyers' payout is directly tied to the future health of CIT; it's to their interest to keep it well.

5. It aligns risk and reward perfectly. In essence, the insurance is backed by the pool of premiums, not by the promise of any single entity. Licensees make the fee for their service and providing the initial funding to the Trust.

6. CIT's fund is guaranteed to be perpetual. The only way it goes bankrupt is for its "riskless" investment to go sour. In such worst-case scenario, the government would have defaulted. The biggest risks cannot be hedged, period (one example is Earth being demolished by Vogons).

7. Buyers can remain anonymous until settlement. This is important to protecting their interest. But anonymity in this framework will not have the side effect of its current form because the net position on each credit can be easily calculated on the seller side, which is completely public.

8. Last but not the least, this setup is in fact extremely simple. It heavily relies on the market, minimizing reliance on government intervention or artificial, arbitrarily set rules and prices.

Let's run some numbers. Say CIT total fund is $1B. Based on auction price of license amounts, $1T notional can be sold. Average premium is 100 bps (1%), or $10B, per year going into CITIF. Average haircut by licensees is 2 bps, or $200M per year. In an EXTREMELY bad year, 10% of covered credits (by notional sold) default. That's $100B. Buyers still get 10% coupon for the first year. Since in such dreadful times people would want to buy more protection, and premium would have increased, future coupon on CIT bonds will likely increase. (I've omitted investment income and expense for simplicity.)

Everybody wins.

Resession Will Not Be Deep

2008-10-16T02:14:00.000-04:00

In Aladin, Lago, Jaffar's sidekick parrot, has one of my favorite cartoon slapstick bits: Why am I not surprised? I think I'll have a heartattack from not being surprised!

News came out today that Bernanke thinks there'll be a recession. And it's supported by retail sales number. The market had a heartattack from not being surprised.

I mean, is it news to anyone that we'll have a recession? We've been in one for a year. And we surely haven't seen its end yet.

But all this talk of DEEP, WIDE recession is nonsense. Human intuition is based on linear extrapolation. Gloom and panic are always at the height just before the bottom. But in the height of panic people have forgotten one key difference: the government finally got it this time.

Bloomberg had an interview saying "Bailout Is Big, Bad, Ugly, the Only Answer: Jane Bryant Quinn". I agree with Jane on everything except the "only" part. NONE of the government rescue efforts since last August was the only choice, especially the massive liquidity injection of the past few weeks, the $700B bailout and the latest comedy of banks being forced to accept government money for peanuts in return. But, be it as may, this latest mafia drama will break the logjam because it finally stumbled on one of the root problems. It will take some time for the massive liquidity and capital to flow down the money supply chain. But it will. It must. Banks need to make money, even if they're not allowed to fail.

The other root problem, housing price, has been helped by several give-away legislations, and will no doubt continue being helped by the new president and congress. These bailouts are equally morally suspicious and objectionable as the bank bailouts. But, again, they will work. As a result, housing price may still go down somewhat, but much slower than withoutthe help.

Government supported housing price plus government supported banks. Everybody is riskfree! It's a riskfree world! How can banks not lend and buy risky assets as long as there's no chain reaction on 10/21? In a few months, as the money flows down the pipe and banks begging everybody to borrow (they would do a Paulson if they could), how can companies not hire and expand?

And, remember the $400B write-downs by US banks and $300B by European banks? They're write-downs, paper loss. As soon as the housing price stabilizes and CDO market volume recovers, $350B of it will become write-ups. Bank quarterly numbers will go up so fast and furious, it'll feel like the good'ol times again.

This recession will be anything but deep.

So will we get out of this mess without paying any price? Of course there's a price. The price is prolonged inflation and massive debt for future generations.

Inflation will be mostly driven by commodities bubble, credit bubble, and housing bubble. Yes, we may very well have yet another housing bubble in front of us.

But what's the problem if we can keep the bubble going in perpetuity?

The only problem is we can't. At some point people will stop buying our debt and stop using our currency to settle trades. Sure, Saddam threatened to settle his oil in Euro and look where he is now. But unfortunately we got in so much trouble in Iraq, the lesson we intended to teach others has turned into encouragement, for Chavez at least. Yes, people have no alternatives since Euro is in even worse shape now. But desperate people find desperate solutions. Just as we've been doing unimaginable, desperate things to avoid the crisis, the world will find unimaginable, desperate alternatives if necessary. You can only count on others being suckers for so long.

The fantastically flawed and effective bailouts we've seen in the last few weeks have hastened the day of reckoning, or at least made it much harder to avoid or delay.

But that's our children's problems. For now, enjoy the new, riskfree world. Be bubbly.

Can I Buy My Own Bond? CDS?

2008-10-15T22:11:00.008-04:00

I wonder if it's legal for companies to buy their own debt on the secondary market or CDS on themselves from another party. If it is, I have some fantastic business models to sell to VCs.

1. You sell $1B bond, then proceed to wreck havoc of the company, for example by taking ridiculous amount of bad risk. Rumors start flying around. Stock plummets. CDS spread shoots up. Your bond plummets. You use $700M of the $1B proceeds of prior bond issurance to buy back all your debt from the secondary market, even though it's not callable. You keep the $300M cash.

2. You buy naked CDS on yourself from somebody, with notional say twice as much as all your outstanding debt. If you ever go down, you'll get such a windfall that you'll snap right back out of Chapter 11 looking prettier than before you went in. In other words, you cannot fail. Technically, you could still fail after the CDS sellers fail to pay you. But we all know now that big CDS sellers are not allowed to fail; our government would call their CEOs into a room and hold guns to their heads and ask them to accept huge sums of money for peanuts in return and the CEOs, after reading the fine print in big bold fonts, would try their personal best to fein indiginity while signing and to hold their laughter long enough to get back into their limos. Therefore you cannot fail, no matter how badly you screw up.

So let's do circle time. I buy CDS on me from you, you buy CDS on you from her, she buys CDS on her from me. As Borat would say, NIIIIICE!

But these are brutes. There're more subtle varieties.

1. You buy CDS on yourself, then casually give out some hints of pending trouble -- insider selling, unintended leak to a reporter while drinking, etc. CDS spread shoots up. You sell or unwind your existing CDS for a 100% profit. Insiders buy low. Company turns out fine. CDS spread goes back down. Repeat as necessary.

2. You're a holding company. One of your subsidiaries is in trouble. Or maybe you decide it's in a dead-end market but can't find a good price to sell. You buy CDS on the sub. You force it down. You get paid, wealth transfer from bankrupt sub to parent.

When Senior Bond Is Very Junior

2008-10-13T22:37:00.000-04:00

Many people are baffled by how Lehman senior debt has been trading after they filed for Chapter 11 protection, as I illustrated in a previous article. Turns out Robert Waldmann at AngryBear has an excellent analysis on the same topic, only earlier.

But, after some more research, I realized it's more general than Lehman selling CDS protection on itself, although the irony makes it more interesting. Generally speaking, in bankruptcy code, derivatives counterparty claim can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to SeekingAlpha reader emrald@aol.com) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

So, what does it mean? If you buy senior debt from a company with significant activity in the derivatives business, your senior bond is in fact subordinate to all such counterparty claims. In case of Lehman, it's not hard to imagine how counterparty claims could easily eat up all that's left. I'm just surprised the market thinks there would still be around 10 cents on the dollar left when all counterparty claims are settled.

If you think only financials are involved in significant derivatives trading, you'd be wrong. Virtually all big companies today are neck deep in this business.

This is arguably one of the biggest stealth dilutions (to bond/eqquity holders) in today's capital markets. The other one would be off-balance-sheet but that belongs to another day.

Market CDS spreads often imply significantly higher default probability than historical data suggest. There're a plural of potential justifications for this apparent "discrepancy". But I tend to think a big part of it is not that market is implying higher default probability. It's lower recovery that market has been trying to say all along.

So, how did such bonds ever get the "senior" label? Did the rating agencies take this into account when rating them?

These are $700B questions, in court. (Not that I'm trying to be dramatic, it's just that anything less than $700B doesn't carry any weight nowadays...)

Lehman CDS Net Settlement Only $6B -- REALLY?

2008-10-13T22:01:00.000-04:00

The whole world financial market has been in cryogenesis for weeks due to the known unknown of Lehman (LEHMQ.PK) CDS settlement on 10/21. But Saturday DTCC came out with a bombshell revelation: The settlement will net to a measly $6B.

Well, according to "calculations so far performed by the DTCC", that is. Anybody care to hint how far this "so far" is? 10%? 50%? 90%?

Secondly, the overall net is meaingless. Let's say A owes B $600B and B owes C $594B. The total net payment is $6B. A still fails, which may trigger another round of CDS settlement. Let's say that one nets to precisely $0. Are we supposed to be suckers again and take comfort in that?

Thirdly, the settlement on 10/21 includes virtually all credit derivatives involving Lehman -- CMCDS, fixed recovery CDS, Nth to Default, CDX, CDO.

There're many other reasons why the DTCC announcement cannot be taken at the face value. But the above are the most important ones and I'll stop here.

The important thing is for the government and the market not to be fooled into a false sense of complacency by this press release. The logjam in worldwide financial markets for the past few weeks is because of the Lehman CDS settlement. Banks know how much they're liable for. But they don't know how much others are, including their hedge fund clients.

Unless government forces disclosure on Lehman settlement exposure, we can only assume the worst -- another bank or two going down and propagating the chain reaction. The opacity has been the single most important reason why the inter-bank market has seized up and hedge funds have been forced to liquidate by the double whammy of prime brokerage margin calls and investor withdrawal.

Government must take the pending storm seriously and force all financial institutes to disclose their net liability or windfall on 10/21. For those with huge liability and whose failures are likely to cause chain reaction, the government must provide immediate backing -- buy preferred stock or force debt-to-equity conversion -- so that it's clear to everyone that the chain reaction will be stopped.

The CDS settlement is a zero-sum game. However big the total payout may be, somebody else will get exactly equally big windfall. So there's no reason for the world to go down on 10/21. However, if left unforced, narrow self-interest, greed, and distrust will make people choose certain demise. We need full disclosure, now.

At a time opacity is causing and fanning panic and distrust, the DTCC press release is not helpful. It merely adds smoke to the scene.

10/21: The Bottom

2008-10-13T01:43:00.000-04:00

Let's cut to the chase. On Oct 21, somebody A will have to pay somebody B $C in cash to settle CDS on Lehman. Estimates on C range from 100 billion to 600 billion (a recent DTCC press release claims that the total net payment on Lehamn CDS is only $6B but I'll write about how misleading that is later). Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in it will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much tax-payer's money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at today's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they could collect, that is.

Back to the more immediate concern. Who is A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs clients. More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Today's auction had $5.7B sell orders. Cash settlement will most likely be at least 10, maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position on CDS, with the possible exception being their proprietary desks and funds. Again, most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for, the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to hedge funds. They knew how much they would need to pay since Lehman bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion that a big part of their requests are on behalf of their clients. Some hedge funds are forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday 3PM in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settles on Nov 7. Its impact is expected to be much smaller, although nobody can be sure, as for all CDS. We may get some rough idea on its auction date, 10/23. If there're high-profile bankruptcies on 10/21 (banks, AIG), then market would be spooked and all eyes would turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. Fed window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250B runs out that day, they can let foreign sovereign funds to buy perferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). Two days ago I wondered if the bottom is near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.

The Wonderful World of Self-Insurance

2008-10-11T02:14:00.000-04:00

I came across this gem, written by Oussama A. Nasr way back in 2003 (oh the good ol' times), on self-referencing derivatives, part 1 and part 2। Be sure to read both. Thank me later. You're welcome.

I assume by now everybody in the trade knows about the trick of shorting the stock while buying CDS. Much more effevtive and capital-efficient than just shorting the stock. But that's child's play. Any self-respecting player would short the stock, buy the bond to hedge himself, and buy CDS -- not from anybody, but from the reference entity itself. This way, if the company goes down, you come out ahead with your shorts and CDS while your bond gets 100% recovery (or more); if it doesn't go down, you unwind short and CDS, and make your money on the bond (not nearly as fun as when the company goes down, for sure).
Does it make sense to buy insurance from the guy whose life is insured on it? No, you say? But no to that, sucker। In the wonderful world of bankruptcy court, it does make sense. Because CDS counterparty claim is above senior debt. You get your claim even under Chapter 11, when senior debt holders cannot cash out.

Lehman senior debt is trading at 15 cents on the dollar। Why is that? Presumably, when Lehman exits Chapter 11 in a year, housing markets will have stabilized somewhat, 20% will have defaulted -- ok, 40%, which is NOT going to happen even in the worst form of subprime, but you still get 60% recovery. Lehman may be holding some equity tranches of mortgage CDOs, which is worth precisely 0 unless Paulson buys it with tax-payer money, and some mezzanines, which is worth precisely 0 unless Paulson buys it with tax-payer money. But these CANNOT be the bulk of their asset. So why 15% today?

My guess is that Lehman has sold a lot of CDS on Lehman over the years। As buyers of such CDS claim their payout, recovery for senior debt holders will be diluted.

Just my wild guess। Don't bet your money on it.

Oh, BTW, in case you haven't read the articles I mentioned at the beginning (yes, read them both), companies can jack up their balance sheet and capital adequacy without getting a penny। They borrow $100M from you, give it right back plus interest minus some. But they look very strong as far as regulators and accountants are concerned -- $100M more tier-2 capital.

I'm not saying this is what's happened. Again, just my wild guess and don't bet your money on it.

The End Is Near! The Bottom Is Near!

2008-10-08T23:00:00.000-04:00

The past two days in stock market have been interesting, revealing, and puzzling.

What happened was no panic selling. Two Friday's ago, after House rejected the Bailout Pork Package, was panic selling. Prices drop like crazy, indiscriminately across the board, then rebound. But what happened in the past two days was steady, guided, sustained downward pressure. I'm sure all chartists have noticed it. And, in the closing minutes, you could almost see two forces fighting, Monday around Dow 10,000, Tuesday around S&P500 1,000. Both times the seller side won at the finish line.

Some big money is exiting the stock market in an organized, well planned, and determined fashion. This is not panic nor desperation. I don't know who the big money is, hedge funds, mutual funds, pension funds. For some reason some people somewhere need a big pile of cash. Not immediately, but in some near future.

When they're done, we'll have a bottom. It could be tomorrow or next week. But it won't be two months away.

Last April/May, I saw the subprime blow-up coming in August, no later than Sept. This April, when the market rallied after Bear Stearns bailout, I called it a sucker's rally and said the bottom would be after Sept at the earliest. Admittedly, I didn't see the full scale of chain reaction from mortgage to CDS to monolines to ARS to CP to Libor to money market funds to bankruns to disappearance of stand-alone investment banking to worldwide seizure. My crystal ball was foggy beyond CDO.

But now, I don't see any crisis ahead of us in the foreseeable future. There may be another bank or two failing. There will be many hedge funds closing -- perhaps the peculiar pattern in the last two days was a prelude to it. There will be long-term inflation.

But all the risks I mentioned above have been priced in. We have thought of all the terrible scenarios. (Heck, even CDS on US is selling at around 40 bps -- to put it in perspective, CITIC CDS spread is around 30 bps, meaning CITIC is considered a safer credit than US sovereign debt.) We're hopeless. We're ready to take the loss and move on. This means the bottom is near. I'm not sure about the prospect of strong economic recovery or bull market. If there is a recovery ahead of us, which is questionable after inflation adjustment, most likely it'll be slow -- let's hope it won't come in the form of yet another asset/credit bubble. I'm too young for death from heart-attack.

Despite all the gloom and doom, the world is not coming to an end. Factories are still churning. Trucks are still moving. Girls are still walking around in their pretty dresses. Funny thing about financial crisis is that, when it REALLY hurts, people will wake up and fix it. And it's much easier to fix than a real crisis, e.g., mass-scale drought. Even Europeans will come together and fix it. All the cash in exile will not be parked in gold-pressed platinum bars. And let's not forget the imminent surge in capital worldwide arising from lowered capital requirements, lowered interest rates, and massive, multi-national capital injection.

Yes, there will be inflation, maybe worldwide. But this is the biggest reason for people not to sit on cash. For many people, I suspect the stock market in the next year or so is their best and last chance to beat or barely keep up with the inflation over many years.

It's Capital, Not Liquidity, Stupid

2008-10-07T23:16:00.000-04:00

I wrote an article over the weekend on how all the massive, desperate liquidity injections by the Fed have failed, and indeed created a short-term liquidity cash burden at the top of money supply chain, banks. Today, I'm seeing a lot of the old, predictable battle cry: "Lower rates! Inject more liquidity!"

I feel compelled to repeat myself.

While liquidity has been a persistent symptom since the start of the crisis last August, it was never the cause. The cause has always been the Incredible Shrinking Captial caused by a combination of:

deteriorating housing market;
over-leveraging while ignoring systemic risk such as counterparty risk in CDS and elevated correlation in CDO;
and positive feedback loop between declining price and loss of capital base created by mark-to-market accounting.

Take a look around. US banks are buried with short-term liquidity cash, so much so that NY close overnight repo rate is almost zero. Does this mean US banks value each other's credit risk as equivalent to treasuries? Of course not. They just know their counterparts will have unlimited supply of short-term liquidity cash tomorrow and that's enough. Why don't they use the cash to start lending to people who need it, such as municipalities, companies, homeowners, and consumers? They can't. The cash is short-term liquidity supply, not their capital. If they use it to expand the asset side of the balance sheet, they run into two big, familiar problems that have burned them, their counterparts, and a few former counterparts:

capital requirements, which everyone has already been struggling to meet, and
risk of inability to roll the short-term debt to finance the long-term asset.

Sure, the Fed is their personal Santa now. But everyone knows at some point it has to suck out this massive excess liquidity. How do you roll the debt then? When will it happen? With every government agency changing rules of the game everyday for the last several weeks, often without any rationale except just for the heck of scaring people (as one official said of the short ban), nobody is willing to take the risk this close to Christmas and bonus time.

Hence the irony: on one hand we have a bunch of sickly banks sitting on an unlimited supply of liquidity, choking the money supply chain from the very top; on the other hand we have the rest of money supply chain dying for liquidity.

Now the Fed is considering buying commercial papers directly. What a concept. Why don't we just get rid of banks altogether and go to the Fed for a mortgage?

The Bailout Pork Package, for all its ills, at least has the diagnosis right: banks need capital injection. But the mechanics of it is too complicated -- what to buy, whom to buy from, at what price, how to set the price, who to manage it. By the time the doctor cuts to the tumor, some patients may have died from an overdose of pain killers.

We need to inject capital, not liquidity, into the banking system FAST. Once banks have enough cushion on top of the minimal capital requirements, they'll start opening up the money supply chain. After all, it's not like banks hate profit.

There are many ways to inject capital fast. Buffett's Goldman Sachs model is one. Immediate shift to capital ratio based on mark-to-history is another. Even emergency lowering of capital requirements is much better than this madness of blind liquidity injection.

It doesn't take a rocket scientist to figure out these solutions and at least give them a serious thought. Why haven't we seen any sincere push for any of them?

Buffett's GS model dilutes equity and may hurt executives' pay this year, nothing like the instant gratification of the Bailout Pork Package.

Amending rules involves no money flow, thus no direct, immediate profit.

I hate to be a cynic, at least when writing here. If there's a better explanation, I'm open.

Liquidity Part of the Problem, Not the Solution

2008-10-06T23:21:00.000-04:00

This is mostly the result of my efforts trying to make sense in my own head of what has been happening for the past few dizzying weeks. Some parts are nothing more than my own guesswork. All are based on public info I've been reading. I decided to share it here hoping readers could help put together a better picture. Critiques and alternate explanations are sincerely welcome.

1. First of all, it's clear that the latest round of the crisis, starting with the Fannie (FNM) bailout and Lehman bankruptcy, is different from the Bear Stearns crisis in March. Bear's was first and foremost a liquidity crisis (there was a serious capital issue behind it but that was not the direct trigger). Fannie and Lehman failed not for lack of liquidity, but due to capital insolvency. Fed data show that Lehman never went to the discount window to get liquidity. Fannie, Freddie (FRE), and Lehman fell because the market had decided they were insolvent, thus refusing to extend any credit or do any business with them.

This is a subtle but important distinction. The fact that Fannie, Freddie, and Lehman failed despite plenty of available liquidity from the Fed proves beyond doubt that all the liquidity-based emergency measures by the Fed and other central banks, including the $630B from the Fed last Monday, were wrong-headed. Besides not solving the problem, in fact they created a false sense of security. In retrospect, if the Fed didn't open up the discount window to investment banks and bail out Bear Stearns, maybe Lehman would've been scared into de-levering much more aggressively.

2. The underlying trigger this time is not subprime. Subprime and Alt-A mortgages are to a significant degree known problems, thus not capable of triggering another round of panic and crisis. The current trigger is the prime mortgage market. This is evidenced by the sudden collapse of Fannie and Freddie. They had little exposure to subprime or Alt-A. Yet their delinquency rates shot up in August. This forced the market to reevaluate its assumptions about prime. If you've experienced an earthquake, you know how it feels when the assumption that the ground beneath your feet is solid and stable is no longer valid. You stop taking anything for granted. You re-examine everything. You panic.

3. The report of interbank lending seizing up has been greatly exaggerated. Libor rates, as quoted in London, have indeed been very high for the past two weeks. So have interbank rates in New York at 11a.m. But the New York overnight repo rate has been very close to 0 for the last week. What does this mean? It's the European banks that have been in trouble lately. US banks, buried to the eyeballs with the massive liquidity injection from Fed and knowing their counterparts in the US are in the same ironic dilemma, are quite willing to lend out the cash for some return, no matter how small.

This ironic dilemma faced by US banks, even before the Bailout Pork Package, is yet another proof of the ills of the Fed's wrong-headed rescue.

Does this present arbitrage opportunities? Surely it does, and with it comes the danger of contagion, this time from Europe. We shall see this week how it plays out. For now, the Libor has become little more than a symbolic benchmark (well, except for those paying for debt indexed off Libor). Interbank lending in Europe has seized up and become irrelevant since banks could go to their central banks, or to the Fed, through some arbitrage channel.

By blindly providing liquidity (as opposed to capital), central banks of the developed world have made credit risk irrelevant. It's a panic response to the panic. Whereas the original panic valued credit risk at infinity, the panic response made (temporarily) credit risk 0 -- but only for banks, the privileged few direct recipients of liquidity injections.

Will this massive pile of short-term liquidity cash trickle down the money supply chain?

Not a chance until the banks have capital relief, which is the real problem. They cannot use the short-term cash to expand the asset side of the balance sheet. Would they trust each other any better? No, they know all this impressive-sounding short-term cash doesn't solve the problem for their counterparts, just as it doesn't for themselves.

But I say this hold-up of cash at the top-end of the money supply chain is actually a good thing. Some people are suggesting lowering capital requirements, as opposed to temporary relief from mark-to-market and some sensible form of capital injections (of which the Bailout Pork Package is not), should be the fix.

Couple that with the massive liquidity now available and guess what will happen? Banks would be out on a shopping spree for all kinds of junk. It'd be Credit Crisis 2.0 before you know it.

The Fed must suck out the senseless excess liquidity, and fast, before Paulson starts using his infinite power and swapping cash (capital cash, that is) for junk.

Mark-to-Market vs Mark-to-History

2008-10-05T23:26:00.000-04:00

By now it should be no question that the Fair Value Accounting rule has driven some firms into a death spiral, and been an important amplifier in the financial nuclear chain reaction we've been witnessing.

To illustrate the point, as if it needs more illustration, let's consider a sudden cut-off of gasoline supply. The cause of the cut-off is such that we can be reasonably sure of its revival, but can't be sure when. The Lambo you just bought last year is worth little on the spot market.

"That's fine," you say to yourself, "I'll just park it for now."

Unfortunately, it's not fine. You used it as part of the collateral on your new Starbucks shop. WaMu texts you at 4pm asking for more collateral. "Or else c u in court," it says, "Sorry, must do MTM." But you happen to be tight on cash. You look around the house and come to the conclusion that the only option is to give up. You let your 10 Starbucks employees go. The next month five of them go delinquent on their mortgages. And these happen to be the last straw that pushes WaMu under the 6% capital ratio stop.

WaMu's insistance on Fair Value Accounting ultimately caused its own demise in this fictional scenario. It's stupid. It's unfair to everybody involved. It's self-inflicted damage, mutually-ensured destruction.

However, supporters of Fair Value Accounting also have a point. Imagine the same scenario above, with one of the following variations:

The cause of the gasoline cut-off is such that we can't be sure it could ever revive.
WaMu thinks that you will default soon regardless because it knows your Starbucks is in trouble. It'd have to sell the Lambo on the market afterwards since it doesn't intend to park it at its own expense and take the risk on it.

It's simply not the regulators' job to judge the market outlook or intention of the company. And, if the company management, when given the option of suspending mark-to-market accounting, comes out saying "we don't intend to sell these mortgages anyway", how can anybody trust them? This is not even a swipe at honesty of corporate manangement. Unexpected events may force companies to change strategy with little warning.

But the solution is so simple it's puzzling why it hasn't been discussed widely and considered sincerely. Just ask companies to report both mark-to-market and mark-to-X on financial assets. The market will have to decide how much of which to use to evaluate the company, and price its stock, bonds, CDS, etc accordingly.

Take Lehman as an example. Its rapid collapse caught most people by surprise, at least before 9/11, the Thursday before its demise. While some hedge funds had been shorting Lehman for months, I'm not sure even they believed Lehman would go down so quickly, especially after the Fed window opened up after the Bear Stearns bailout. If Lehman had the option of dual reporting, people would've valued it somewhere between the two numbers, perhaps even closer to the mark-to-X number.

Trust and confidence can be a self-fulfilling prophecy. If people hadn't been afraid of Lehman's capital solvency, to a large degree due to artificial, nominal paper losses imposed by Fair Value Accounting, they would have continued doing business with it, albeit with somewhat heightened prudence. And Lehman could've survived -- if it had survived till the credit market stabilizes, it would've survived, looking pretty sitting on massive gains as most of the previous Fair Value Accouting write-downs are eventually recouped. The AIG (AIG) bailout may not have been necessary as a result. And tax-payers could've saved a cool $700B (probably more).

The X in mark-to-X could be the moving average market price of the asset, or assets of similar nature, over the last, say, one year after forward discounting. Many details must be carefully considered, of course. But I'll not dwell in them here.

This dual reporting approach has an interesting self-correcting effect if capital requirement is based on mark-to-history. In a bull market, the effectively higher capital requirement, due to time lag and lower-than-market price basis, limits the risk growth while in a bear market, effectively lower capital requirement offers relief and time to adjust. The latter is especially critical in a disaster scenario.

This dampening effect contrasts with the destabilizing effect of positive feedback of mark-to-market: companies are allowed to take on more risk based on paper gains in a bull market, reaching the height of risk just as correction is due, and forced to delever in a bear market, just when they can least afford to do so.

Even the most fervent defenders of mark-to-market admit its destabilizing effect under severely adverse market conditions. Mark-to-history capital requirement coupled with dual reporting can substantially eliminate the negative effects while retaining the positive ones.

Bailout Pork Effect: Short-Term Rally, Long-Term Disaster

2008-10-03T23:28:00.000-04:00

Defeat of the Paulson bailout plan in the house last week was nothing short of a remarkable victory of democracy. All of our political leaders were for it, future ones included, showing more unity than the Chinese Communist Party. The mainstream media were so politically aligned with the Government, they put Xinhua to shame. Yet individual voter-tax-payers, with hardly any meaningful organizing effort, fought for their self-interest and won against all odds. Wow.

If only we had done it five years ago on Iraq war and the Patriot Act, today's American citizens would be hailed as a shining example of independent citizenry of a strong democracy for centuries to come.

Unfortunately, we hardly had time to throw a party before the Senate pulled an old political trick and forced the hands of the House and the voter-tax-payers on the same plan. Only with $170 billion added pork to punish the rebelion act. That ought to teach the citizenry a lesson about respecting the Leaders.

There's no doubt SOMETHING must be done, and quickly, to stop this financial crisis from spreading to the wider world and becoming an economic crisis. The question is what that SOMETHING is. There've been many ingenious ideas floating around the internet. The Leaders have supposedly even considered some of these alternatives. Yet they chose the most costly (to tax payers) possibility and gave us two choices: are you for action or gridlock?

It's the same false choice as the one five years ago: are you for freedom or terrorism?

I used to pull this trick on my kids sometimes: who would you like to wash your hands, mom or dad? They started realizing the Possibility Universe is far larger than what I presented, somewhere around six years old. And I actually felt a bit guilty.

The Leaders have been doing this to us. And we never have the intellectual and/or political capacity to see through the same old trick. And they never have any guilt, I'm afraid.

But, we have to face reality at the end of the day -- would that be Friday?

If the Bailout Pork Package is passed, I'm willing to go with the conventional wisdom that the markets (stocks, bonds, derivatives, USD, commodities, gold) would have a broad rally, with the only exception being the treasuries as money exits the bunker and goes to work. Not too shabby huh?

Well, with $700B you'd expect more. Much more, and much more long term. But long term will be ugly.

First of all, the government has totally abandoned fiscal discipline. Well, it's abandoned it for a long time but now the world cannot pretend it didn't know any more. Foreign investors will have to stop playing suckers and buying the treasuries. They wanted to sustain the pretend game as much as we do. But now we finally killed the chance. Even a pretend game has a limit, beyond which the players simply cannot pretend any more. With the double whammy of hugely increased debt and higher interest, maybe CDS on US is not such a dumb idea (nah, it's still a dumb idea for, if...when US defaults, whoever sold you the CDS will not be around to pay).

Secondly, whereas inflation was a strong possibility in summer 07, now it's a certainty. Excess liquidity (credit) is easy to suck out as long as the Fed is determined to (which they weren't when they had a chance to deflate the housing bubble). But what the Bailout Pork Package puts into the economy is not just liquidity, but a massive amount of capital. Excess capital will stay around in the system for much longer. Capital chases return. Excessive capital chases excessive return. Excessive return at the macroscopic level can come from only two sources: asset bubble or inflation. In this case, it will be both.

Which leads to the third long-term effect: commodities bubble (yes, again, the real one) driven by negative real interest rate. The only reason that can explain the commodities bubble until a couple months ago is negative real interest rate. Supply and demand may have the right sign during some periods, but cannot possibly account for the magnitude of the surge. Amount of speculative money is an ontologically flawed argument since it by definition cannot explain why there were so much of it. When the real interest is negative, it does not make sense to hold cash (and cash there will be a lot of it now).

Real assets is one of the best places to park this massive amount of capital windfall, especially through continuously rolled futures since you don't pay the storage cost. What kind of real asset? Housing (mortgage) was the obvious choice when real interest rate became negative during Greenspan years, and especially after the massive rate cuts in 01. But now people will be careful touching mortgages for at least a few years. The only outlet left is commodities -- gold, oil, metals, rice, corn, who cares what it is. Never mind that there will only be so many taking actual delivery, demand will only increase so much and supply will only decrease so much by the mot exaggerated estimates. The $1T+ excess cash must be parked somewhere and earn some return.

While the effect of the housing bubble on inflation could be indirect and delayed, the impact of commodities is direct and immediate, as we learned with pain earlier this year. As I mentioned above, it will be commodities bubble and inflation.

Early in the year I expected the first thing the new president, whoever it may be, will do is to call up Uncle Ben and tell him to raise rates and kill off inflation. Yes, there will be short-term pain. But he could always blame that on his predecessor, however well deserved it may be, and take credit for the long-term benefits to the economy. I believe this is the main reason why the bubble contracted in the last two months.

Now, however, no matter how much the new president wants to play the game and Uncle Ben wants to be a good political lapdog, they cannot possibly do enough to kill the pending inflation without causing another crisis.

Yes, taxpayers may make money when the $1T+ toxic asset the Leaders will be buying for us matures or gets sold. But only before inflation adjustment.

Five years ago, the Leaders of both parties committed this once-great country to the Iraq war, with unspecified amount of lives and money for unspecifiedlength of time. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

Now, the same Leaders will commit this country to years of inflation and generations of massive debt. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

I'm still holding out hope that this Bailout Pork Package will somehow miraculously be defeated and some better alternatives will be considered with sincerity.

Nah, we don't have time for that. Let's just trust the Leaders. It's not like we have any other choice.

Don't we?

Bailout Should Have No Strings Attached

2008-09-28T23:29:00.000-04:00

Bailout or not, the devil is, of course, in the details. Details like, at what price?

Jake at EconomPic offered an excellent insight on how the bailout plan may result in banks waiting for others to sell to the government first, thus exacerbating the logjam. It goes like this: whoever sells to the government first establishes a price, then others are better off selling at the price in the open market, avoiding penalties such as regulation, compensation cap, and equity dilution.

I'd like to expand on this arbitrage argument, but from another angle. The above analysis means there'll be a premium for selling to the government as opposed to the open market. Based on this argument, one could argue that, the fewer strings attached to the bailout, the smaller the taxpayer premium. I assume this is the argument behind Paulson's objection to any and all costs to the banks opting in the bailout.

As much I resent the bailout idea, this is a valid argument.

But another factor makes the argument even stronger: cost of carry. Whoever decides not to sell to the government or buy from the open market will have to pay cost of carry and take the risk. Risk is obviously very high, even after the bailout provides a backstop, but it's equal for everyone. The cost of carry to a large degree depends on the financial health of the bank. The more desperate the bank, the higher the cost of carry.

Therefore, shaky banks are more incentivized to sell to the government, while healthy ones could afford to hold out more and/or longer in order to avoid the bailout penalty. In other words, many strings attached to the bailout would only result in the taxpayer bailing out the the most shaky banks. This is exactly the opposite of what it should achieve: save the healthy and let a few sick ones perish.

Now this sounds really bad. The bailout idea itself is bad enough to begin with. Now it should not have any strings attached?!

Yes, I mean, no, no strings attached. Just with a bit of the usual bureaucratic delay. But since it's such unnerving times, I say we should specify the delay -- say, one week?

But it doesn't mean taxpayers must be suckers. This is how I would design it: I buy from banks at market price (e.g., average price of the day) plus some nominal premium, say, one week Libor plus 10 bps.

How would this help? The moment the government announces this execution plan, the market will thaw, because there will be people able to buy from the market, pay the cost of carry for a week, and then sell to the government. Who can afford to take advantage of the 10 bps premium? Those with enough liquidity and healthy balance sheet. The desperate ones could sell to the government and/or the market. The only difference is that government is slower. If you can afford the delay, you get to make the extra 10 bps.

The result is the best of the bunch will join the rescue, while the worst ones will provide liquidity and upside pricing pressure to the market, depending on their desperation.

If we have to do a bailout, this is the least costly, most sensible way of pricing it.