The Legal Scam of FASB Statement 159

1. Set up Company, go IPO.

2. Sell $1B bond.

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

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

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

6. Retire as a rich hero.

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

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

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

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

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

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

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

Too-Freemarket Has Become Anti-Free-Market

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

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

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

Free market has committed suicide.

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

No, that last part was me.

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

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

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

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

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

Kill Freemarket. Long live the free market.

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.

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.

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?

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.

Lehman Bankruptcy: Crisis Management Through Crisis Export?

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

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.

Stop The US vs China Nonsense

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?

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

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

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

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

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.

When Senior Bond Is Very Junior

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...)