It's Not Bonus, Stupid (Congress)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Beginning of End for USD The Reserve Currency

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

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

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

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

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

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

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

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

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

Buy, Buy, Buy into This Sucker's Rally

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

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

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

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

So, enjoy the ride.

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

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

Just be ready to jump out of it any moment.

Lock Bumping EVERYBODY PANIC

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

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

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

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

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

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

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

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

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

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

Pick your poison.

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

Re-privatization, Not Nationalization

No, it's a bit more than rhetorics.

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

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

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

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

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

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

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

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

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

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

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

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

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

When Will the USD Carry Trade Finish Unwinding?

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

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

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

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

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

Can We Go Back To The Old Wall Street?

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

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

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

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

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

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

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

Without costing nearly as much taxpayer money.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economist

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

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?

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

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

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

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

More Harmonic Tremors at Yellowstone

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

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.