Answers to Four Questions About Financial Journalism

Posted on March 30, 2009 by Felix

Will Ortel, a journalism student at the College of Idaho in Caldwell, Idaho, sent me a few questions about financial literacy for a project he’s doing. They’re good questions, so I’m blogging the answers:

Financial education for the layman is a shambles normally organized towards paying bills on time and managing credit cards. This prompts most Idahoans to think "who is this guy" when I explain what a CDS contract is or how short selling works. Is detailed financial knowledge something that most Americans should have? What is it about financial understanding that makes it distinct from engineering or psychological understanding?

I’m very happy that someone who knows what a CDS contract is or how short selling works is attending journalism school — the world of journalism desperately needs financially-literate reporters. On the other hand, there’s absolutely no need for most Americans to understand these things — any more than they need to understand what makes an airplane fly, or how beta blockers work.

Some people are interested in the world of finance, especially now, when troubles on Wall Street seem to be the proximate cause of the worst macroeconomic recession in living memory. So journalists who can clearly and accurately explain such things are to be treasured. But it’s no weakness not to understand how banks’ balance sheets are constructed, or even what a balance sheet is. People need a certain level of psychological understanding to perform their daily duties, which is why life with autism can be so very hard. And some basic personal-finance literacy is a good thing too. But beyond that, there’s no reason people should be expected to understand the mechanics of Wall Street unless they particularly want to. In that sense, yes, it’s much like engineering.

Coming from the standpoint of protecting small investors from hazy information that they might receive, could you support conceptually the establishment of a test to see who was capable of trading individual stocks and bonds (as distinct from vanilla mutual funds)? Can you think of anything that you would want to put on such a test?

It’s true that individual stocks are incredibly risky things which most people should avoid — much riskier than most hedge funds, which most individuals are not allowed to invest in. But I don’t think there’s much evidence that financially-sophisticated individuals make for better investors. If anything, they suffer from overconfidence bias, think that they have some kind of an edge, and make even bigger bets as a result. Giving people a financial-sophistication test might even be counterproductive in that sense: Americans would barge into the markets armed with their "qualification" to trade stocks, and then proceed to lose a fortune.

The much-heralded blog era has begotten the rise of personal financial journalism, perhaps typified by yourself. To what extent do you think that econobloggers parsing news for lay readers will catch on? Do you see yourself as parsing news for lay readers or providing insightful (and occasionally hilarious) commentary to moderately informed dorks (like me) around the country?

I like the idea of "personal financial journalism" meaning "financial journalism written with a personality" rather than "journalism about personal finance". Econoblogging is exploding right now: when I started the Economonitor blog at RGEmonitor.com in September 2006, one person could pretty much keep on top of most of it. Today, that’s unthinkable, I discover great new blogs constantly, and the best of them can become extremely popular and influential very quickly indeed.

That said, I don’t think that most of them are necessarily aiming at what you call "lay readers": a blog is naturally very conversational, and one tends to like to converse the most with people at more or less one’s own level. So you won’t find too many blogs spelling out what a basis point is, or explaining that bond prices move in the opposite direction to yields. So count most of us in with the "commentary for moderately informed dorks" crowd, I think. For lay readers, sites like The Big Money might be a better bet.

If the audience of a news organization with high overhead demands a Jim Cramer or Ben Stein figure, how can that organization deliver a more responsible figure instead and stay solvent? How would you characterize my optimism that the nature of financial journalism might improve?

Well, I’m on the record as liking Suze Orman: just because you’re a financial celebrity doesn’t mean you’re as idiotic as Ben Stein. And I’m not sure how hiring Ben Stein is likely to improve any news organization’s solvency — he doesn’t come cheap.

But one good thing about the internet is that people can become brands without having to be on the television. And since appearing on TV is a great way of becoming incredibly stupid, then with any luck the age of the internet will usher in a new generation of finance pundits who have made their name by the quality of their ideas rather than the recognizability of their faces.

The much-maligned Gawker Media, it’s worth noting, dispenses a pretty large amount of generally-excellent financial advice on such sites as Consumerist*, Lifehacker, and Jezebel. All of it is vastly more useful than anything you’ll get from Cramer or Stein. So the trend is in the right direction. Stein adds no value for the New York Times, so eventually he’ll be dropped. It’s just sad that it has taken so long.

*Update: As Gari points out in the comments, Consumerist is now part of Consumer Reports, not Gawker Media. I should know.

Posted in journalism | 9 Comments

Why Healthy Banks Shouldn’t Repay TARP Funds

Posted on March 30, 2009 by Felix

I got an interesting response from one reader to my post on whether healthy banks should be able to give back TARP funds. Here it is, with permission; the short version is basically "no".

The TARP preferred shares were extended to the major banks last year with a 5% dividend for the first 3 years, stepping up to 9% after the third anniversary. As orginially written, TARP preferred could only be repaid with the proceeds of equity issuances during the first 3 years. Apparently a clause slipped into the stimulus package gives the Treasury Secretary the option to waive that requirement. I think that TARP money should only be allowed to be repaid if fresh equity is raised from the market, and preferably in the form of common stock.

Let’s look at Goldman as an example of a bank that has expressed a desire to repay TARP funding. A few relevant facts:

1) At $100, Goldman has a $46 billion market cap. Assuming no placement discount, Goldman would have to issue 22% of new common shares to repay TARP, effectively telling the market that GS common shares at $100 are a cheaper form of capital than a preferred yielding 5%.

2) Use of proceeds of the equity deal should be properly disclosed as allowing insiders to enrich themselves with higher compensation without government scrutiny. Beyond that, there is no reason to accelerate repayment within the initial 3 years.

3) Based on the terms Buffett extracted on his preferred, GS could not issue 5% prefs today. Again, how could you justfiy paying a higher dividend on a new pref? Other than to facilitate executive looting, I cannot think of a reason.

4) If Geithner waives the equity issuance, where will the money have come from? According to Bloomberg, Goldman has issued about $22 billion of government-guaranteed debt this year. Given the fungibility of money, couldn’t one argue that the government has allowed Goldman to issue debt so that it could buy back its equity and weaken its balance sheet during a crisis? If markets dip again and Goldman needs help, what would we do?

5) Alternatively, one could argue that Goldman is taking its AIG proceeds to buy back TARP preferreds. I know that their CFO said they didn’t need the AIG bailout given their hedges. At the risk of sounding like Maxine Waters, Blankfein (current CEO) reportedly advised Paulson (prior CEO) during the AIG bailout process. To avoid the appearance of a conflict of interest, perhaps Goldman should voluntarily disgorge its AIG hedge profits since the government made them whole on their contracts (based on Blankfein’s counsel).

6) If Goldman escapes the TARP program’s scrutiny after a waiver, they will have a competitive advantage in recruiting, and other, potentially weaker banks would seek the same waiver. It would set off an arms race to repay TARP preferreds, weakening the balance sheets of large banks. And the primary reason would be to allow executive looting to resume without scrutiny. Again, if we dip again what does Treasury do?

7) Goldman is now a bank holding company but I see little evidence of a stable deposit base or other implementation of a bank holding company business plan. Shouldn’t we evaluate that before we allow them to weaken their equity base?

8) Shouldn’t we have a regulatory structure in place before we allow banks to reduce their capital cushion?

I am a portfolio manager following emerging markets stocks. I have no dog in this fight other than being a participant in equity markets and an American taxpayer.

This all makes perfect sense to me, and can be applied mutatis mutandis to any other bank thinking of paying back its TARP funds too. The government recapitalized the banks with TARP funds because the equity markets were closed. The equity markets are still closed. So for the time being, any talk of paying back TARP funds is surely premature.

Posted in bailouts, banking | 7 Comments

OpenTable, Closed Minds

Posted on March 30, 2009 by Felix

I’m a huge fan of OpenTable, and I’ve always imagined that restaurants are, too. They don’t need to spend hours on the phone telling people what’s free and what’s not, special instructions don’t get garbled, and it’s very easy to cross-reference the diner to previous visits. But apparently Raoul’s didn’t get the memo:

I can no longercontinue putting off talking about the back room. I’d prefer it didn’t exist, since I love the rest of Raoul’s. Actually, I’d prefer the maitre d’ didn’t exist, either.

On my second visit, with tables empty everywhere in the front and middle rooms, he instructed the hostess to take us to the garden. I begged him: Please don’t.

He looked down at us in the French style, and said, “You made your reservation online.” Indeed, my friend had used OpenTable, listed on the restaurant’s website. The maitre d’ informed us that OpenTable had assigned us to the back room, and that was that. As we were led away, no happier than prisoners in leg irons, he sneered, “Next time you should call.”

Raoul’s is an old-fashioned restaurant — that’s a large part of its charm. But if it doesn’t want diners to use OpenTable, it shouldn’t offer them the option.

I do occasionally wonder, though, what to do with my Dining Rewards Points. I somehow can’t see myself redeeming them on the website, waiting up to six weeks for delivery, taking a Dining Cheque to a restaurant, and then using it to pay for (some of) my meal. It would be great if I could somehow donate them to charity — help treat some non-profit workers to a very nice lunch every so often. But then I suppose more people would redeem them, and the business model might not work any more.

Posted in food | 4 Comments

Why Big Banks Should be Smaller

Posted on March 30, 2009 by Felix

James Kwak wants to make US financial institutions smaller:

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities…

Size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities).

Kevin Drum is not convinced:

It still has the flavor of a solution that’s clear, simple, and wrong. After all, Bear Stearns was a quarter the size of Citigroup, and it was considered too big to fail. So just what would the limit be on bank size? $500 billion in assets? $200 billion? Can a country the size of the United States even have nationwide banks with limits like that? And what happens the next time around, when all these smallish banks overleverage themselves and collapse en masse? Are we any better off than we are with a few big banks failing?

I’m with James on this one. Two things are worth noting about Bear Stearns: first, it might have been small by Citigroup standards, but its balance sheet was still enormous. And secondly, it wasn’t considered too big to fail, it was considered too interconnected to fail, largely as a result of its role as a major CDS broker.

To get specific, I think that maybe $300 billion in assets would be a reasonable cap on bank size — there’s very little evidence that banks get any economies of scale beyond that in any case. If they want to be part of a global or even a national network that would be fine — I’m sure such networks would spring up quite naturally, much as they have in the airline industry. After all, the United States managed to go 200 years without any nationwide banks, it’s unclear why it desperately needs them now.

At the same time, the cap on the balance sheet of broker-dealers should be smaller still: the more interconnected you are, the lower the cap, to the point at which companies like the CME, which are far too interconnected to fail no matter how small their balance sheet, should be barred from issuing any liabilities at all.

As for what happens when lots of smallish banks overleverage themselves and collapse en masse, well, you get an S&L crisis. Which is fiscally painful, to be sure, but which can largely be avoided through good regulation and which more importantly doesn’t have anything like the systemic implications of the current meltdown. So yes, we’re better off with one of those than we would be with Citi and BofA both failing.

The problem is a practical one: how do we get there from here. There are no good and politically-feasible answers to that question. So in the real world, TBTF banks are here to stay. But that doesn’t mean we have to like it.

Posted in banking, regulation | 5 Comments

Great Moments in Political Rhetoric: Hannan vs Brown

Posted on March 30, 2009 by Felix

From the European parliament, of all places:

(Via MAI, although I’m late to this, it’s been viewed almost 2 million times on YouTube already.)

Posted in Politics | 6 Comments

One Easy CDS Fix

Posted on March 30, 2009 by Felix

I’ve had my share of disagreements with Arnold Kling on the subject of credit default swaps in the past, but he has a good idea today:

Regulators and accountants could require firms that are net sellers of credit default swaps to translate those positions into bond holdings and put these synthetic bonds on their balance sheets. My guess is that had such a policy been in place in 2000, the CDS market would not have taken off.

My guess is that Kling’s guess is wrong: there were actually very few net sellers of CDS, and in any case for most of this decade the stock market seemed to think that ever-expanding financial balance sheets were a good thing, not a bad thing. But yes, definitely: if you’re a net seller of protection, then the notional amount of credit that you’re exposed to should be considered an asset on your balance sheet, just as it would be if you owned that credit in bond form.

It is conceivable that the the monolines — which were by far the largest publicly-listed net sellers of protection — might have thought twice about continuing their escapades in the CDS market if there would have been such an enormous effect on their balance sheet. Doing so would have brought them more into line with the buyers of synthetic CDOs, who were the other large net sellers of protection, and who invested up front all the money that they could possibly lose.

Kling’s other point is that it’s hard to buy long-dated derivatives on the big exchanges in Chicago: if you want something with a maturity of three years or longer, you need to buy it in the OTC markets. That’s true, but he’s wrong that "it is quite difficult to take a position of any size" in long-dated options: those OTC markets are huge, and in many cases substantially larger than the exchange-traded markets. And they seem to work pretty well, in the absence of massive players like AIG taking large net positions (on the order of hundreds of billions of dollars) in the market.

Posted in derivatives | 7 Comments

Why is the NYT Breaking the Web?

Posted on March 30, 2009 by Felix

Websites get old, and need to be redesigned occasionally. That we understand. But the first rule of designing a website is that you make sure you can redesign it without breaking all the incoming links. And the first rule of redesigning a website is don’t break all the incoming links.

The Obama administration broke that rule on January 20, when all links to whitehouse.gov broke at the stroke of noon. And now the New York Times has broken that rule as well, with all links to iht.com now redirecting to a marketing stunt for what the NYT is rebranding as its "global edition".

So for instance if you’re reading my blog entry from May 2007 linking to an IHT op-ed by Ngozi Okonjo-Iweala, you won’t be able to follow that link and read the op-ed. What’s more, that op-ed doesn’t exist on nytimes.com, in any form. The NYT essentially did its best to erase it from the internet, for no good reason.

How did the NYT manage to perpetrate something so utterly boneheaded? And does this mean that those of us who care a lot about our links not dying should start linking instead to organizations which are less idiotic, like the Guardian and the BBC? I hope that the NYT rectifies this error sharpish. Because it’s losing a lot of webby goodwill by the hour.

Posted in Media, technology | 2 Comments

Extra Credit, Sunday Edition

Posted on March 30, 2009 by Felix

My Manhattan Project: The first-person story of Mike Osinski, whose software fuelled the mortgage-securitization boom.

TR thoughts on ticket re-sellers / scalping: Trent Reznor of Nine Inch Nails explains the economics of concert tickets.

Huffington Post launches journalism venture: Arianna and her friends are putting $1.75 million into investigative reporting. It’s unclear whether the operation expects any revenues, or if it does where they’re going to come from.

Hedge Fund Regulation Doesn’t Matter:

An Artificial Operational Due Diligence Floor: It’s important that hedge-fund regulation not give investors a false sense of security. Its main purpose is to look out for systemic risk, not ponzis.

More Evidence of Volcker Being Marginalized

South Park – Stan Marsh takes us through the mortgage crisis: Very well done.

Posted in remainders | 3 Comments

How the CDS Market is Going to Improve

Posted on March 29, 2009 by Felix

A Credit Trader has a great post on what he calls "risky annuity risk", an artifact of the CDS market which will go away when all credit default swaps start trading on a fixed coupon. If you like to geek out with the arcana of the CDS market, you’ll love this.

Let’s say you’re a CDS trader who buys $50 million of 5-year default protection on General Motors at 100bp. That means you pay 100bp per year — $500,000 — in return for getting a big payout should GM default at any point in the next five years. Six months later, GM is looking much riskier, is trading at 300bp. You decide to take your profits, so you sell $50 million of 4.5-year default protection at 300bp. You’re now receiving $1.5 million a year, and paying out $500,000 a year, for a net profit of $1 million a year over the next four and a half years. Which adds up to $4.5 million. Well done! You book your $4.5 million profit, and celebrate with some fine Champagne.

But then GM defaults. This is not good for you. Yes, you’re perfectly hedged when it comes to default risk: the amount you owe to the person who bought protection at 300bp is exactly the same as the amount that the person who sold you protection at 100bp owes you. Assuming no counterparty risk, you’re flat, and there’s no problem there. The problem is that your $1 million-a-year income stream has suddenly gone dry. The CDS have all been wound up: you’re not paying $500,000 a year any more, and you’re not receiving $1.5 million a year any more, either. And your $4.5 million profit has disappeared.

This is what ACT calls "essentially unhedgeable jump-to-default risk" — you bet on a credit souring, the credit sours, you make lots of money, but then you hope desperately that the credit doesn’t sour all the way to a credit event, because then you lose most of the money you thought you’d made.

The solution to this problem is to set the coupon on all CDSs at, say, 100bp. In that case, the first deal is exactly the same: you’re the protection on $50 million notional of GM debt at a spread of 100bp, and you pay out your $500,000 per year. But when you come to close out the deal, instead of selling protection at 300bp, you sell protection at the same fixed spread of 100bp. Since GM credit default swaps are trading at a spread of 300bp, however, you’re essentially selling the exact same contract that you entered into six months previously — you’re selling the privilege of being able to pay just $500,000 a year in return for that big payout if GM goes bust. How much is that privilege worth? $4.5 million.

The CDS has become a tradeable instrument, which goes up in price when spreads widen, and which goes down in price when spreads narrow. The buyer of protection always pays the seller $100,000 a year for every $10 million nominal amount, and the seller of protection pays the buyer an up-front sum if the spread is below 100bp. Conversely, if the spread is above 100bp, then the buyer of protection pays the seller an up-front sum.

By moving to this system, CDS traders manage to get rid of that pesky jump-to-default risky annuity risk, and can cash in their gains as soon as they close out their positions. Liquidity in the CDS market should improve, bid-offer spreads should narrow, and volumes should rise. Of course, that’s exactly what all those people who want to move to exchange-traded CDSs want, right?

Update: Alea, in the comments, corrects my misconceptions about how the new system will work: apparently the annual premium will be a thing of the past, and the whole premium will be payable upfront. Which means that the buyer of protection always pays an up-front sum, no matter what the spread.

Update 2: Wait, no, that’s not it, either, the buyer of protection still pays an annual premium, and then there’s an upfront payment as well. Isn’t that what I said the first time? Look, here you go, Markit explains it all in great detail. Look at pages 15-16.

Posted in derivatives | 2 Comments

Bonuses are Large Because They’re Unpredictable

Posted on March 29, 2009 by Felix

Mike at Rortybomb explains that the whole reason why Wall Street bonuses are so big is that there’s a non-zero chance that they won’t be paid:

I’ve heard it from several people that the argument for the bonus is “we deserve our bonus because we don’t really get paid a big salary and expect to live on our large bonus.” I retort “Well it is so large because you need to be compensated for the employer counterparty risk; you run the risk your employer will be gone, and the next one, be it a new bank or the USA, won’t want to honor it.”

There are other risks, too, with the end-of-year bonus system: maybe your employer will fire you just before you’re due your bonus. Or maybe they’ll simply decide that you don’t deserve one this year, or that you deserve only a very small one.

The point is that there’s so much uncertainty built in to the bonus system that the expected bonus has to be enormous in order to make up for it. Suppose I give you a choice between a base salary of $75,000 a year and an expected bonus of $1 million, or a base salary of $350,000 a year. If you’re anything like me, you’d take the smaller amount with the higher predictability.

Now in the case of guaranteed bonuses, the calculus does change somewhat — in that case, you might well opt for the $1 million. But the guarantee doesn’t mean that you’re certain to get that seven-figure payday; it just means that the degree of uncertainty has fallen substantially. And as Mike points out, you’re still very much running the risk that your entire company goes bust, or that its new owners decide to abrogate those guarantees.

Not getting your bonus is a bit like those bad beats in poker. There’s no point railing against them, they’re bound to happen some of the time, and indeed if they never happened then the game wouldn’t be structured that way in the first place. So accept it and move on with equanimity. Otherwise you just come across like a petulant child.

Posted in pay | 4 Comments

Ben Stein Watch: March 29, 2009

Posted on March 29, 2009 by Felix

Ben Stein counts Jim Cramer as a friend. And millions of people watched the showdown between Jon Stewart and Jim Cramer on The Daily Show. But judging by his column this week, Cramer’s friend Mr Stein wasn’t one of them:

As you may know, Mr. Cramer appeared earlier this month on “The Daily Show,” where Mr. Stewart yelled and cursed at him.

No, Ben, Jon Stewart does not yell at his guests. Cramer is the yeller, not Stewart. And in fact there was surprisingly little cursing, by Daily Show standards, on either side.

This was a substantive exchange — yet Stein still insists on characterizing Stewart as "a comedy guy from Comedy Central". And he also seems to think that Stewart’s only criticism of Cramer is that Cramer’s predictions were wrong. And so he launches into a long explanation of how "we as humans cannot tell the future"; in fact, in the space of four paragraphs, Stein manages to use the word "human" or "humans" no fewer than six times (and "mortals" once), each time making the same point about fallibility.

Defensive much? Well, yes:

I would be remiss if I did not add that I have succumbed to this temptation to speak as if I could tell what the future holds…

The most that economic seers can do is apply broad, generally acceptable principles to current situations and try to go from there. When I stray far from that, I hope that thoughtful readers will call me to account.

Ben, you’re a Hollywood hack, not an "economic seer". But in any case, if you’re genuinely interested in people calling you to account, feel free to browse through the archives here. You’re welcome.

And of course you don’t disappoint in this column when it comes to hackery:

Just two years ago, how many people would have confidently predicted that we would elect our first African-American president in 2008? Who would have imagined that Citigroup would trade for a time under $1 or that General Electric would trade for a time under $6 or that Bear Stearns and Lehman Brothers would virtually vanish, or that a graduating class of law students would be unable to get jobs or that high-end M.B.A.’s would be unemployable?

And who would have guessed that we would have a fall of more than 50 percent in the broad stock indexes or that oil would triple in price and then fall by more than $100 a barrel? Some people might have seen parts of this pattern, but all of it? Again, life is far too complex to be predicted with any consistency.

Let me see: you’re pointing out that no one predicted, two years ago, that Obama would be elected president and where Citigroup would trade and where GE would trade, and that Bear would vanish and that Lehman would vanish and that law students would find job hunting difficult and that MBAs would too and that stocks would fall more than 50% and that oil would go up a lot and that oil would then go down a lot. And you conclude that since no one managed to get all of that right, then hey, that just shows that life is terribly complex.

If all of these things had a 50% chance of happening, the chances of them all happening would be less than one in a thousand. Stein might as well have thrown in a few real outliers too: who on earth would have predicted that Natasha Richardson would die after a skiing accident? No one’s asking for all predictions to be right. They’re just asking that people like Ben Stein quit with the brainless boosterism and pay attention to reality once in a while.

Alternatively, Ben, you could simply quit with the punditry: all those TV appearances and books and newspaper columns which are predicated on the idea that you do know what’s what. It’s much easier to simply keep quiet than it is to be wrong the whole time. And then you won’t have me or anybody else calling you to account any more.

Posted in ben stein watch | 3 Comments

Who’s Gaining from the AIG Unwinds?

Posted on March 29, 2009 by Felix

Tyler Durden has a scary post up, connecting banks’ profitability in January and February to the fact that those were the months when AIG Financial Products was unwinding an enormous number of its contracts en masse. These trades, initiated by AIGFP, were allegedly enormously profitable for the biggest banks in the CDS market:

The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades – ever"…

I can only guess/extrapolate what sort of PnL this put into the major global banks… I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

If this is true, then (a) the banks still aren’t anywhere near sustainable profitability, and (b) those AIG retention bonuses — paid on the grounds that only the people who got AIG into this mess could get it out — are even more egregiously untenable than we had suspected.

The whole point of having the government take over AIG was that it wouldn’t need to enter into panicked unwinds. If it went ahead and did that anyway, the levels of competence and oversight at AIG are even lower than most of us had thought. Which is quite an achievement.

Posted in bailouts, derivatives | 5 Comments

Newsweek’s Fearful Krugman Profile

Posted on March 29, 2009 by Felix

Evan Thomas has a profile of Paul Krugman on the cover of Newsweek. The 2,825-word article has six on-the-record quotes about Krugman; none of them — not even the one from his mother — are particularly flattering. No one is quoted saying a single nice thing about Krugman’s economics or his opinions.

When it comes to the substance of what Krugman produces, rather than his personality, the only two quotes come from Daniel Klein of George Mason ("a lot of what he says is wrong") and Dan Okrent, the former NYT ombudsman with whom Krugman had a bruising encounter. ("When someone challenged Krugman on the facts, he tended to question the motivation and ignore the substance.")

The other on-the-record quotes in the article are hardly any nicer: Sean Wilentz says that Krugman "doesn’t like to be f–ked with"; Gene Grossman says that Krugman’s academic career is over. Meanwhile, Thomas himself speculates that Krugman is "a little wounded" by the fact that the White House isn’t showering him with attention; says that Krugman "sometimes gets his facts wrong" when he writes about subjects other than economics; and asserts that Krugman was so keen to win the Nobel Prize that he almost turned down his position at the NYT for fear of becoming "a mere popularizer".

All in all, the story is not exactly what you’d expect from a cover emblazoned with the words "Obama is Wrong" and the caption "The Loyal Opposition of Paul Krugman". Newsweek’s editor, Jon Meacham, has an interesting take on the article:

Is Krugman right? Is the Obama administration too beholden to Wall Street and to the status quo, trying to save a system that is beyond salvation? Does Obama have–despite the brayings of the right–too much faith in the markets at a time when prudence suggests that they cannot rescue themselves? We do not know yet, and will not for a while to come. But as Evan–hardly a rabble-rousing lefty–writes, a lot of people have a "creeping feeling" that the Cassandra from Princeton may just be right. After all, the original Cassandra was.

I suspect that the final product is the result of overcompensating for the fact that Thomas and Meacham have just such a feeling: they’re fearful that Krugman might be right, and have therefore come up with a list of reasons why it might be reasonable to ignore him.

And this, at heart, is why I think we haven’t yet seen the worst of this crisis, neither in terms of the financial markets nor of the broader economy. There’s still a sense of denial in the air — a feeling that if you’re going to devote an entire cover story to someone like Krugman, then the story should bend over backwards to showcase people saying that he’s wrong, while it need make no such effort to quote anybody saying that he’s right.

Or, to put it another way, the question posed by the article isn’t whether Krugman is right or wrong — it’s whether he’s worth listening to or not. And the answer posed by the article is "we fear he might be, but we hope he isn’t". The problem — which the article doesn’t mention — is that the history of this economic crisis to date is a history of fear being right and hope being wrong.

Posted in economics, Media | 3 Comments

What they Used to Teach You at Stanford Business School

Posted on March 29, 2009 by Felix

Chris Wyser-Pratte, who got his MBA from Stanford in 1972 and then spent the next 23 years as an investment banker, sent me the following note last night. I’m reprinting it here with his permission:

I learned exactly seven things at Stanford Graduate School of Business getting an MBA degree in 1972. I always used them and never wavered. They were principles that enabled me to put the cookbook formulas that everyone revered in context and in perspective. I think they served my clients (and perhaps me) rather well. Here are those seven principles, and who taught them to me:

  1. Don’t use many financial ratios or formulas, and when you’ve picked the few that will actually tell you what you want to know, don’t believe them very much (Prof. James T.S. Porterfield);
  2. Remember that any damn fool can compute an IRR or DCF. The trick is to find a business that can return 20% after tax, understand its critical indigenous and exogenous variables, and then run it so it meets its return target. (Prof. Alexander Robichek.)
  3. Always ask what can go wrong (Porterfield);
  4. Never extrapolate beyond the observed points of a distribution, you have absolutely no information outside the observed range (Prof. J. Michael Harrison);
  5. Remember that you can always break the bank at Monte Carlo by doubling your bet on red at the roulette table every time you lose. The problem is it will break you first; It’s called "the takeout." Therefore, always manage your financial structure so that takeout is not an issue. (Porterfield.)
  6. Big M (today Nassim Taleb’s Black Swan) is never a part of the optimal solution. If it shows up in the answer with any coefficient greater than zero, you have the wrong answer and have to continue to do program iterations. (Harrison.)
  7. There is never any excuse for looking through the substance of an economic transaction, whatever the accounting, and if the accounting permits you to do so, it’s wrong (Prof. Charles T. Horngren.)

Conspicuously absent from this list are Prof. Jack McDonald and his Efficient Market Theory and Random Walk, Prof. William Sharpe, Nobel Prize winning author of the Capital Asset Pricing Model (which he later acknowledged didn’t work because his data were wrong, but it’s still used everywhere and they didn’t take away his prize) and Prof. James Van Horne, who believed that the Fed actually controlled the economy through its monetary policy actions. Gene Webb — who at least tried to improve my people skills — and Ezra Solomon in International Finance deserve honorable mention.

The conclusion I derive from your interesting article is that the reason the economy was destroyed by Wall Street, which died in the fire it created, was that they violated, ignored and were probably ignorant of all seven principles listed above. They not only couldn’t do the math, they were mesmerized by its precision because they used a black box and believed in its oracular power even though they didn’t understand how it worked, believed what occurred before could be expected to occur again, hadn’t a clue about what risks were indigenous and exogenous to their own business (or which were which), how probable those risks were and what the consequences were of ignoring the takeout risk, in particular. They also thought financial sleight of hand had meaning. In short, they had their head stuck where the sun don’t shine and deserved what they got. We, the world, didn’t.

What Wyser-Pratt doesn’t mention is that in 1972, business school students largely expected to go into business, as opposed to finance. And insofar as banks hired MBAs, it was because they wanted employees who understood business. Over the following decades, MBAs, and the bankers they turned into, became increasingly expert in finance, while knowing less and less about business. Eventually we ended up living in a world where a major retail operation like Sears could be owned and run by a financial engineer who thought that the answer to any question was simply to spend yet more of the company’s precious cashflow on stock buybacks.

Essentially, we moved from a world where banks were run by businessmen, to a world where businesses were run by financiers. Let’s hope that the pendulum will now swing back (only with more women in charge this time around), and that business schools will start de-emphasizing finance in their curricula. But that might be too much to hope for. Even in 1972 students were being taught CAPM. And the vast majority of them failed to ignore it.

Posted in banking, education, investing | 3 Comments

Whining Executive of the Day, AIG Financial Products Edition

Posted on March 29, 2009 by Felix

Executives at AIG Financial Products are not happy bunnies these days, and they’re starting to make their views public. Jake DeSantis, for instance, published his resignation letter as a NYT op-ed. But Paul Harriman and his wife, Jan Ellen Harriman, clearly don’t have that kind of access. So they’re blogging at Livejournal instead.

John Carney at Clusterstock found Jan Ellen’s blog on Friday and her husband’s on Saturday. Today he reprints Paul’s latest blog entry, since Paul has now put it behind a firewall. It echoes his wife’s in all its main points: he worked very hard, and London is very expensive (he’s paying rent of $10,000 a month and school fees of $30,000 a year) and he needs that bonus to cover his annual expenses.

There’s also this:

We’ve been forbidden to speak to the press, by a company that obviously hates us and spreads false and misleading "information" about us, when they can be arsed to respond at all.

I think it’s fair to say that morale at AIG Financial Products is low — but not quite as low as the self-awareness of an executive who genuinely thinks that if you live in London you need to pay $10,000 a month in rent, and who also seems to think that joining his wife in ranting on Livejournal is in any sense a good idea.

So a word of advice for any other AIGFP executive who’s tempted to go public bemoaning the loss of his bonus and his livelihood: don’t. You are hated already, and this kind of display, with ten parts self-pity to zero parts contrition, doesn’t help you out in the slightest.

Posted in pay | 3 Comments

Long-Term Stock Market Volatility Datapoint of the Day

Posted on March 29, 2009 by Felix

Warren Buffett, take note:

Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance.

The subject is the stock market, and the paper in question, which Mark Hulbert writes about in the NYT today, could well give the Sage of Omaha some sleepless nights, since Buffett famously accepted a $4.5 billion bet, very near the top of the market, that stocks would go up in the long run and not down.

There’s been a lot of debate surrounding the bset way to mark Buffett’s losses on that bet: while the base case is to use Black-Scholes, a vocal contingent of Buffett supporters has said that it’s silly to use today’s elevated volatility to price long-dated European-style options which can only be exercised on one specific date. Over the long term, they say, stock-market volatility is much lower than we’re seeing right now.

Well, it has been in the past. But how much reason do we really have to believe that the future of the US stock market is going to resemble the past of the US stock market, rather than simply wending its way, in a necessarily volatile fashion, towards zero? Empires do fall, after all, and one of the co-authors of the paper, Robert Stambaugh, points out that the probability of global warming proving catastrophic for the stock market, while it can’t be calculated with any specificity, is surely non-zero. Stambaugh’s co-author, Lubos Pastor, generalizes:

Professor Pastor emphasized that the last two centuries could easily have been less hospitable to the United States, most likely lowering the stock market’s returns. An investor couldn’t have known in advance that the United States would win two world wars, for example, or emerge victorious from the cold war. In any case, he said, there is no guarantee that the next two centuries will be as kind to the domestic equity market as the last two.

This is exactly why an unknown set of counterparties paid Warren Buffett $4.5 billion: for his triple-A-rated guarantee that over a very long time horizon, something catastrophic and unexpected wouldn’t happen to US equities. If you couple that guarantee with some credit protection written on Berkshire Hathaway, you come close to having a very powerful insurance policy against black swans. You can’t clip tails outright. But clearly there are some people trying their hardest to minimize their tail risk. Maybe they put more stock in Bayesian analysis than Buffett does.

Posted in stocks | 3 Comments

CDS: The No-Natural-Seller Meme

Posted on March 27, 2009 by Felix

I was on a panel last night with Simon Constable of Dow Jones Newswires, and I’m sure that to our lay audience a peculiar exchange in the middle of the conversation must have sounded a bit like dolphin squeaks. He was trying to demonize credit default swaps, and said with great finality and self-assuredness that if you wanted proof positive that they were the spawn of the devil, all you needed to do was examine them objectively, as he had done, and you’d see that they had no natural seller.

I then interjected that of course credit default swaps have natural sellers: any bond investor is a natural seller of CDS protection. We started going around in ever-decreasing circles of mutual incomprehension, until the moderator happily put an end to that particular discussion and moved us on to the next topic. But now Arnold Kling has resuscitated the meme:

There is no institution which, in the ordinary course of its business, takes a position for which selling credit default swaps is a natural hedge…

Credit default swaps allow companies to trade the default risk on, say, a mortgage-backed security. The holders of that security have a natural interest in buying protection. But nobody has a natural interest in selling protection.

I thought I’d dealt with this back in December, but evidently not, so let me try again, this time quoting a little of my Wired article on the Gaussian copula function:

If you’re an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream–interest payments or insurance payments–and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn’t constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.

The point is that there are a lot of very sophisticated bond investors out there, and much of the time they could replicate the risk and return of buying a bond by putting together certain trades in the CDS market — and get much better liquidity that way. It’s not easy to find bonds from certain issuers, but you can always find a broker willing to buy credit protection on any given name.

A bond investor isn’t really hedging anything, so it’s true that if and when a bond investor starts selling default protection, then he isn’t offsetting some opposing risk. But it’s simply not true that in order to make a derivatives market work, both sides have to be hedging something. In the CDS market, you can simply have one person, who doesn’t want risk, selling that risk to another person, who does want it.

Generally speaking, it’s a good thing for banks to sell down their risk, even as it’s also a good thing for institutional fixed-income investors to buy risk: that is, after all, their job. Part of the problem in this financial crisis, as I was talking about earlier, is that banks started persuading themselves that they’d sold so much risk that there wasn’t any left, even as the amount of risk they had on their balance sheets continued to balloon. That was a serious failure of risk management: they didn’t sell enough risk, largely because they couldn’t find any buyers (except for AIG, sometimes) for the super-senior risk tranches that they were prone to keeping on their books.

But those buyers weren’t absent because there were no natural sellers of CDS; they were absent because the yields on offer on those super-senior tranches were so ridiculously low that no one in their right mind wanted to buy them. So long as there are bond buyers, there are natural sellers of default protection. They might not be hedging anything, in a narrow sense, but they are large, and numerous, and extremely useful when it comes to providing liquidity and price discovery. By all means regulate the CDS market; by all means move CDS trading onto an exchange. (Although that might not make as much of a difference as many people hope.) But let’s not kid ourselves into believing that there was no reason for the CDS market to exist in the first place.

Posted in derivatives | 2 Comments

Miami Beach Datapoint of the Day

Posted on March 27, 2009 by Felix

Josh Giersch finds a Zillow map of the SoFi district of Miami Beach – a five-by-five block are south of Fifth Street which has 317 properties for sale, including 21 in just one building.

The problem is that with that kind of oversupply, prices are sure to continue to fall, which means that no one’s going to buy at these levels, which means the oversupply will only get bigger, and so on and so forth. I have no idea what can turn this around, but for the time being, always remember: things will get worse before they get worse.

Posted in housing | 2 Comments

Obama’s Housing Plan Unveiled

Posted on February 18, 2009 by Felix

I have to say I like the look of Obama’s housing-bailout plan. It’s quite elegant, and makes full use of the fact that Fannie and Freddie are now owned by the US government — which means they can be forced to offer 105% loan-to-value mortgages even when the borrower isn’t creditworthy at all.

Obviously, all of this comes at a cost to the US government: the figures being bandied around today range from $75 billion in the NYT to $275 billion at Bloomberg. But really nobody has a clue how much it will cost: that’s entirely dependent on whether or not the plan succeeds in arresting the fall of house prices.

I especially like the idea of offering loan servicers $500 if they modify a loan before it becomes delinquent, especially if it’s accompanied by an easy and streamlined mechanism for getting such modification requests into the Fannie and Freddie systems.

This plan isn’t designed to directly help borrowers who are massively underwater: if your first mortgage is more than 105% of the value of your house, you’re ineligible. That will help reduce some of the costs to the government, and move them over to the lenders, who now look as though they will be bailed in to bankruptcy proceedings — a long-overdue development.

Incidentally, this plan is certain to increase the astonishingly high delinquency rates on non-agency mortgages, since it’s basically designed to take most of the remotely viable non-agency mortgages and refinance them into agency mortgages, leaving only the complete and utter nuclear waste behind.

So far, there’s not even a glimmer of a plan for how to get private-sector lenders back into the mortgage market in any significant quantity — and that’s going to hurt markets like Manhattan, where most mortgages are non-conforming. But Manhattan property owners are rich enough to look after themselves. This plan aims straight at the heartland, where it really matters. It’s a good start, but it might well yet prove to be insufficient. We’ll see.

Posted in housing | 3 Comments

Did the Feds Kill the SEC’s Stanford Investigation?

Posted on February 18, 2009 by Felix

There’s a tantalizing tidbit at the end of the NYT’s Stanford report today:

The current S.E.C. charges stem from an inquiry opened in October 2006 after a routine exam of Stanford Group, according to Stephen J. Korotash, an associate regional director of enforcement with the agency’s Fort Worth office.

He said the S.E.C. “stood down” on its investigation at the time at the request of another federal agency, which he declined to name, but resumed the inquiry in December 2008.

How many federal agencies have the ability to kill an SEC investigation? This sounds very much as though it’s either the FBI or the CIA. Either way, there might be all manner of drug connections we haven’t yet heard about — after all, Caribbean banks have long been used as centers for laundering drug money.

And what prompted the resumption of the inquiry in December? The exit of Thomas Sjoblom as Stanford’s lawyer didn’t happen until February, according to Bloomberg. Did the un-named federal agency decide to give the SEC the all-clear to restart its investigation at that point? All very odd.

Incidentally, I don’t believe the CNBC report that Stanford was in the US on Tuesday, trying to book a private jet to fly him to Antigua. Stanford’s a tax exile: he doesn’t spend more than 90 days a year in the US at the best of times. And he has his own fleet of private jets. So the chances that he would find himself on US soil, and in need of a jet, just as the SEC filed the case against him would seem to be slim indeed. If the SEC doesn’t know where he is, I reckon there’s really no chance he’s in the US.

Posted in fraud | 4 Comments

Stanford: Criminal Charges Almost Certain

Posted on February 18, 2009 by Felix

The SEC case against Allen Stanford comprises little more, right now, than a civil complaint; more private cases are now being filed. What does this mean for Stanford himself? Is he subject to arrest anywhere in the world? I asked Michael Gurland, a former federal prosecutor who’s now at Neal Gerber Eisenberg, about what happens now.

Gurland told me that criminial charges are probably on their way: "The allegations on their face support criminal mail and wire fraud charges. I would assume there’s an ongoing FBI investigation. The likelihood that he’s going to be indicted are extraordinarily high." But that indictment doesn’t need to be made public unless and until he’s found and the US authorities start trying to extradite him from wherever he’s turned up.

Given that there’s still no indication of Stanford’s whereabouts, the presumption is now that he’s a fugitive, and that he’s trying to place himself in a country which doesn’t have good extradition relations with the US. Meanwhile, all of Stanford’s creditors and investors, and certainly anybody who bought a CD from Stanford International Bank in Antigua, are going to have to look to the court in Texas if they want to get any of their money bank. Going to a branch in Antigua or Venezuela or Mexico — or any branch at all, really — isn’t going to do them any good.

Gurland also explained to me that SIB’s location in Antigua would have hugely complicated the SEC investigation: a large part of Stanford’s operations were simply outside the SEC’s jurisdiction. Maybe that explains why the investigation went on so long.

Meanwhile, Bloomberg’s Alison Fitzgerald is reporting that the SEC investigation really went into full overdrive only last week, when Stanford’s lawyer, Thomas Sjoblom of Proskauer Rose, suddenly "stepped down" from his role. Details are sparse, but Sjoblom’s decision to stop representing Stanford would seem to have coincided with the release of press reports that SIB looked like a Ponzi scheme; presumably, up until that point, Sjoblom had been cooperating with the SEC and other authorities.

In any case, Stanford doesn’t need a civil lawyer right now, he needs a criminal defense lawyer. Or, more to the point, he just needs someone who can help set up a new life for him as far removed as possible from any extradition threats. I suspect he’s found such a person already.

Posted in fraud | 4 Comments

MBIA’s New Structure

Posted on February 18, 2009 by Felix

It’s taken rather longer than anybody exepected, but MBIA has finally put in place its long-promised plan to split up the company into its component parts, with the relatively strong public finance insurer getting a new name — National Public Finance Guarantee Corporation — and being insulated from any of the structured-finance liabilities which have devastated the company’s credit rating and share price.

I spoke to Jay Brown, MBIA’s CEO, this morning, and asked him a few of the obvious questions.

The first one was whether this corporate restructuring is going to do any good: will National actually write any business in practice?

Brown said that realistically not much is going to happen in terms of writing new business until MBIA files standalone financial statements at the end of the first quarter: "that will provide a lot of clarity", he said. He did add, however, that if you’re holding municipal bonds which were wrapped by MBIA in the past, the new structure should be a relief to you pretty much immediately, since MBIA is making every effort to make National as bankruptcy-remote as possible.

From the point of view of the holding company, less has changed: it still owns the same mix of businesses it had before. But now they’re more clearly delineated, which means they’re easier to deal with separately, which might help increase value; MBIA’s shares are up 17% in early trade, but still near their all-time lows below $5.

As for the people who hold structured products guaranteed by MBIA, they’re not substantially worse off than they were before, just because they’ve already marked down their MBIA wraps to almost worthless.

Going forwards, of course, the big task facing Brown is to persuade the markets that National’s guarantee is really worth something. To that end, he’s taking a page out of Barack Obama’s book:

It’s an uncertain world out there. We’re going to be pushing a very transparent company. Starting today we’re putting up on our website every policy the company insures, with transparent financials.

But do investors really have the time or the inclination to go through all that information and judge for themselves how creditworthy National is? Isn’t the whole point of a bond insurer that investors are lazy and don’t want to do that kind of work and are much happier just relying on a triple-A rating? And isn’t that now a thing of the past, never to be repeated?

On the other hand, municipalities, especially small ones, and especially the ones with a lot of auction-rate securities still outstanding, are desperate to refinance their debt and are finding the markets essentially closed right now. If National can help them at all, it might be able to make the difference between getting a bond away and not being able to issue anything.

Brown knows it’s going to be slow going: "We started 35 years ago," he says, "and took the better part of a year to sell the first policy." But at least now there isn’t any uncertainty about MBIA’s structure going forwards.

And he also cleared up a bit of confusion I had about the regulatory status of National: although right now it’s an Illinois company — it’s being created out of an insurer MBIA bought in 1989 — the regulators in both Illinois and New York have agreed that MBIA can move it to New York. So New York State will still be MBIA’s regulator, not Illinois: there’s no forum-shopping or regulatory arbitrage going on here.

There’s still going to be lazy investors out there, people didn’t do much work at all on anything. We’re going to have to see how this market develops over the next few years. There were $400B in bonds issued last year.

I’m still far from convinced that the bond-insurer business model really works any more, or, for that matter, any business model which was or is reliant on a triple-A credit rating. And National might be asked to start paying out on its insurance policies pretty soon, if municipal finances continue to deteriorate. But if it can do that happily and still retain its financial strength, there might conceivably be a future for it yet.

Posted in insurance | 3 Comments

Extra Credit, Tuesday Edition

Posted on February 17, 2009 by Felix

Automakers Seek $14 Billion More in Aid: And will surely seek more still, in a couple more months, if they get this now.

Bill Moyers interviews Simon Johnson: Video here.

Investors caught as regulators swoop on Stanford: The game was up last week already: "A client whose $250,000 CD matured on Feb. 9 could not get the money out."

College crush: "90 percent of high-school students are told by their high-school counselors that they ought to go to college." For a huge number of them, this is a lie.

What I learned listening to Larry Kudlow: Krugman becomes a fully-paid-up member of the CNBC-haters-on-CNBC club.

Recovery.gov: Is live.

On moving Valentine’s Day to stimulate the economy: If it were on the second Wednesday of every February, then restaurant revenues would rise. Even at PF Chang’s, the least romantic restaurant in the world.

Opinion Laundering: A phrase which should enter the general demotic, and a phenomenon for which everybody should be on the lookout.

The Case for Free Transit: From Yglesias. Avent glosses.

NY Times article skimmer: A great way to rediscover the serendipity of the newspaper.

Posted in remainders | 1 Comment

Adventures in Flackery, Private Jet Edition

Posted on February 17, 2009 by Felix

Two high-profile financial columnists filed two strikingly similar opinions on corporate jets today:

  1. A private plane is really a flying office. It is a way for a busy executive to get from one place to another as efficiently as possible, to get as much work done as possible on the way, and to avoid down time.

    The executive of an important company has immense responsibilities. His or her time is precious. To waste that time in an airport security line or dealing with flight delays is, quite frankly, a sin against the stockholders. Flying on a private plane is not a decadent act — it is just a way to move a very valuable asset around to maximize its productivity. To keep executives from using these planes is as foolish as not allowing them to use cell phones or computers.

  2. I have some sympathy for the industry. There is actually some point to executives of big companies with plants or facilities spread across the US, and indeed around the world, flying point-to-point by corporate jet to visit them.

    As a shareholder, I would prefer senior executives to save time in this way rather than having to queue at airports to get through security check points.

Is there some kind of PR push going on? As it happens, yes there is! And it was announced today! Well done, PR people!

Posted in ben stein watch, Media | 2 Comments

Allen Stanford, Ponzi Operator

Posted on February 17, 2009 by Felix

Patrick Kidd says that Allen Stanford is "another victim of the biggest economic crisis since the 1930s"; Joe Wiesenthal says that nobody is accusing Stanford of being another Ponzi scheme. So before this meme takes root, let’s be clear about this: Stanford is not a victim, he’s a crook, just like Madoff. And yes he was running a Ponzi scheme. Just like Madoff. The only real difference was that Madoff’s returns were variable, while Stanford’s were fixed.

I’m not sure why Joe is so convinced that Stanford had a genuine investment operation:

Even the SEC concedes that the money was actually invested. What’s more, it’s not clear that the truth is that different from what the company was advertising.

They always admitted on their website that client investments went towards alternative investments. So it’s very possible that assets they thought were completely liquid have now become frozen…

It’s easy to imagine that Stanford’s returns exceeded what they’ve paid out over the past several years, during which private equity and real estate vastly outperformed the market…

Bottom line is that the company’s fraud doesn’t appear to be nearly as baldfaced as Madoff’s and Stanford’s clients may end up with more than pennies on the dollar, assuming any of it can be found.

A couple of factual points here: firstly, the SEC is "conceding" nothing. All they’re saying is that the overwhelming majority of Stanford’s funds disappeared into a "black box" controlled by Stanford and his CFO, James Davis. Now, given that it’s hard to simply obliterate $8 billion, that money had to go somewhere, and I daresay some of it wound up being "invested" in some form or another. But there’s absolutely no evidence to suggest that Stanford’s assets ever exceeded its liabilities.

What’s more, there’s quite a lot of evidence to suggest that a lot of Stanford’s "investments" were in the kind of micro-cap stocks beloved of pump-and-dump operators. That’s not investing in something liquid and then seeing it freeze up, it’s gambling, and it’s often illegal.

And while it’s possible to imagine that Stanford’s returns exceeded what they paid out, that’s largely a function of the fact that they weren’t paying out much if anything. Once you’ve invested in Stanford, you’re very unlikely to redeem your CD unless you really need the money: after all, you trust the bank (otherwise you wouldn’t have invested there in the first place), and you can get much higher interest there than you can anywhere else.

Meanwhile, it’s impossible to imagine that Stanford’s returns exceeded what Stanford claimed those returns to be. As the sole shareholder of Stanford International Bank, Stanford had every incentive to maximize, rather than downplay, his reported returns: it was those returns which gave his investors confidence that he could pay them back.

So right now I have no reason to believe that Stanford wasn’t just as baldfaced a liar as Madoff. And I frankly don’t have much hope that the money in Stanford’s "black box" is going to be found — not unless Stanford himself gives it up. A Ponzi scheme is any scheme where you promise high returns which are actually fictional. Ponzi schemes work so long as there are net inflows, and they fail as soon as you get net outflows. That description fits Stanford to a T.

Posted in fraud | 5 Comments