Newspaper Economics

Posted on December 15, 2008 by Felix

Jim Surowiecki’s column on newspapers is a good one, especially when he talks about the drop-off in advertising revenues and newspapers’ failure in the online space. I have to take issue with this, however:

People don’t use the Times less than they did a decade ago. They use it more. The difference is that today they don’t have to pay for it…

For a while now, readers have had the best of both worlds: all the benefits of the old, high-profit regime–intensive reporting, experienced editors, and so on–and the low costs of the new one. But that situation can’t last. Soon enough, we’re going to start getting what we pay for, and we may find out just how little that is.

Ask Sam Zell whether this is true, and he’ll laugh. It turns out that subscribers are more expensive, not less expensive, than online readers. Yes, they pay more — but they’re not paying for intensive reporting, experienced editors, and the like. They’re paying for printing presses, mobbed-up newspaper delivery operations, and the whole enormous physical infrastructure involved in getting thousands of tonnes of newsprint delivered to millions of front doors every morning. It’s a hugely expensive operation, and its costs are nowhere near covered by subscription revenues.

There’s an old saying that you’ll never understand newspaper economics until you understand why newspaper vending machines are designed so that you can take as many papers as you like for your quarter. Newspapers are, first and last, devices for delivering ads to readers. It’s the ads which account for all the profits, not the cash coming from subscribers or people who buy their paper at the newsstand. Yes, news itself is free, nowadays. But it always has been. What we’ve been paying for all these years was never news, it was papers.

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Further Adventures in GM Debt

Posted on December 15, 2008 by Felix

GMAC’s brinkmanship would seem to have worked:

Late Friday, the company received a reprieve from lenders, who agreed to amended terms of a $38 billion restructuring of debt obligations that were threatening to overwhelm the company.

But the 10% (ish) haircut taken by GMAC’s bondholders to help recapitalize GMAC turns out to have been a necessary but not a sufficient condition for GMAC to become a bank holding company. The firm also needs to raise $2 billion in fresh equity capital, of which GMAC’s existing shareholders are "unlikely" to raise more than $750 million.

So, anybody fancy investing $1.25 billion in GMAC? According to the WSJ, the firm is talking to private equity investors, but I can’t imagine they’re falling over each other to get in on this opportunity. Especially, as David Reilly says, when the fundamentals of capital structure are up in the air.

Reilly explains that the government’s loans to the automakers were initially going to be senior even to secured creditors of GM. That didn’t go down well at all, so a compromise was reached whereby government loans would squeeze in to the capital structure between senior and senior secured debt. But there was a twist:

In the case of bankruptcy, the government would be exempt from a legal stay, which freezes creditor claims until the court divides up the assets. It also included language saying the government’s loans couldn’t be haircut, as often happens to debts in bankruptcy.

Reilly is up in arms about this:

In effect, the language creates a new kind of debt and subordinates the senior, secured holders. That is a possible outcome debt investors now have to keep in mind when investing in industries the government may ultimately have to prop up.

The financial crisis already has shaken the confidence of debt investors in everything from ratings to asset values on bank balance sheets. If the government wants to get markets working again, the last thing it needs to do is give these already skittish investors yet another reason to worry.

I have some sympathy for Reilly’s position, but not a lot. It’s not government’s job to bail out bondholders, and in any case I’m sure nearly all of GM’s creditors would much rather the government got its exceptional language than that it didn’t get involved at all.

What’s more, there are lots of other classes who often get paid in full during bankruptcy, including trade lines, payroll, and other operating expenses. Bondholders would simply have to add government loans to that list, rather than add them in as eligible for a haircut.

It’s worth remembering that if and when the government’s loans mature and GM doesn’t have the money to repay them, the government is almost certain to simply roll them over — something bondholders would not do without huge negotiations and concessions. Government loans and private-sector loans are very different animals, and it often makes sense to treat them differently.

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Detroit Bailout: No News is Bad News

Posted on December 15, 2008 by Felix

Shorter WSJ: Will the government use TARP funds to bail out the automakers? Maybe. Will it ask Congress to release the second tranche of TARP funds? Don’t know. If it did, would there be ugly scenes in Congress? Don’t know. Will the government require the automakers to declare bankruptcy? Don’t know. Is there any way to bail in bondholders without forcing the automakers into bankruptcy? Don’t know. How much will all this cost? Don’t know, could be anywhere between $8 billion and $50 billion.

Shorter shorter WSJ: With banks, you need to get things done over the weekend. With automakers, evidently, not so much.

This all bespeaks a lack of leadership, which is the one thing clearly needed to avoid a worst-case liquidation scenario which is looking increasingly likely.

I don’t know if this is still the case, but the WSJ was reporting all last week that one of the big sticking points here is the transition from Bush to Obama. If Treasury’s going to ask for the second tranche of TARP funds, it’s going to have to lay out a plan which of necessity will mostly be implemented by the Obama administration. But the Obama-Biden transition team seems disinclined to cooperate with Treasury in terms of putting together such a plan, and Treasury doesn’t want to try to push something through without clear support from Obama.

Treasury knows that Congressional Republicans will attack it no matter what; it doesn’t want Congressional Democrats attacking it too. Even now that the legislative session is over, House and Senate politicians might well be unable to resist returning to Washington for denunciation practice.

On the other hand, Paulson has very little to lose by asking for the second tranche of funds — he’s out of a job come January 20 anyway, and getting the second tranche would make it much easier to find Detroit bailout funds. There’s no way that Congress is going to manage to pass a resolution blocking the release of funds, and even if it did, Bush could just veto it. So if the White House wants a big automaker rescue package, it has the ability to put one together in the face of Congressional opposition.

Now seems like an odd time for Treasury to suddenly start worrying about the will of the people, but there are both political and practical reasons not to put together a big bailout too. Politically, it flies in the face of everything the Republican party stands for; practically, it probably won’t work anyway. (Few of this administration’s major initiatives ever have done.)

The base-case scenario, then, is probably a mini-bailout, using whatever funds are left over in the first tranche of TARP money. That will either get Detroit to January 20 without anybody declaring bankruptcy, or else it will at least will mange to keep any bankruptcy filing in Chapter 11 going-concern territory rather than Chapter 7 liquidation.

And then, come January 20, the whole highly elaborate dance between the automakers and Congress will start up again, only now there will probably be a car czar in the mix as well, who will intone gravely, regularly, and utterly ineffectually about the need to turn around Detroit’s declining auto sales figures. For by then it’ll probably be too late, if it isn’t already.

This will all all make for great satirical fodder. But I’m very pessimistic when it comes to the economics of all this, both in the Rust Belt and for the nation as a whole: I just can’t see any kind of happy ending to this story at all.

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Madoff: The Tax Implications

Posted on December 14, 2008 by Felix

Let’s say you’re a successful businessman who has managed to earn $10 million this year, but who also had $10 million invested with Bernie Madoff. Obviously, you’re not happy about seeing your savings wiped out — but if I’m reading this WSJ article correctly, since your loss is a "theft loss", the whole thing is deductible, and you basically get to keep all your income tax-free!

And it gets better: because of Madoff’s high-turnover investment strategy, you probably paid as much as $500,000 in taxes in each of the past three years on fictional trading gains. All those can now be refunded as well.

A week ago, then, you reckoned that you were going to have about $11 million in total earnings (counting $1 million in interest from Bernie), on which you’d pay roughly 40% in taxes, leaving you with $6.6 million after tax.

Today, you have $10 million in tax-free earnings, plus $1.5 million in tax refunds, for a total of $11.5 million in post-tax income: roughly $5 million more than you were expecting.

Which doesn’t completely make up for your $10 million investment loss, of course. But it does soften the blow.

On the other side of the ledger, of course, the IRS was expecting $4.4 million from you this year, but now is going to have to pay out $1.5 million to you instead. Which works out at $6 million less money available for the public fisc. I haven’t seen estimates of the total cost of the Madoff fraud to the US government, but it’s surely in the billions, and quite possibly in tens of billions. Which is real money even by government standards.

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The Noble Lie

Posted on December 14, 2008 by Felix

Ever since the Madoff affair became public I’ve been thinking about Harley Granville-Barker’s play The Voysey Inheritance, which has many parallels with Madoff. (A family investment-management firm uses its clients’ money as its own, and uses incoming funds to make interest payments to existing clients, but is finally undone by redemption requests; there’s even an indelible scene where the father confesses all to his son, and explains his secret: his ill-gotten wealth made him trustworthy in the eyes of his clients.)

Wonderfully, the play is out of copyright, which means that you can read the whole thing at Google Books, or download it in PDF form.

The Voysey ineritance, just like Madoff’s money-management operation, was ultimately a confidence game; it’s easy to see why the play was so attractive to David Mamet.

But really all finance is a confidence game, and just as Madoff dwarfs Voysey, so do total stock-market losses (in the tens of trillions of dollars) dwarf Madoff’s. So long as investors had faith in Voysey, or Madoff, or stocks, everything worked fine. It was only when they tried to take their money out in quantity that things imploded.

Edward Hadas calls this "the noble lie":

The noble lie is the foundation on which all banking is built — the ability of a bank’s depositors and borrowers both to consider the same funds as their own. It’s a lie because no bank, no matter how well capitalised, can always let each depositor cash every account…

The fiction of potentially unlimited withdrawal is not limited to bank accounts. Holders of the more advanced financial instruments — bonds, shares and derivatives — cannot all sell at once. If more than a few try, the market price drops sharply. If there is a stampede for the exit, the market disappears entirely.

"Stampede for the exit", of course, is also known under its more wonkish name: "global deleveraging". If everybody’s selling and nobody wants to buy, what you thought of as wealth — that number at the bottom of your brokerage statement, whether you have an honest broker or not — can evaporate with astonishing speed.

Which I think is the answer to Brad DeLong’s question of how on earth $20 trillion of wealth has been lost, when total loan defaults are only on the order of $2 trillion. The defaults sparked a deleveraging, and the deleveraging destroyed the confidence which was keeping asset prices aloft.

For example: if there’s just one person willing to pay $950 for my Google stock, then that’s how much it’s worth. But if that marginal buyer goes away, and there’s a general sentiment that people would rather have cash than Google stock, the price can fall precipitously without much if any news. DeLong tries to model the preference for cash over Google stock as a rise in such things as "liquidity discount" and "risk discount", but that’s not how it works in the real world: few people ever bought Google stock because they did the math and decided that the risk-adjusted present value of future dividends was $950. (Especially since Google doesn’t pay a dividend.)

Sure, DCF jockeys exist, but they don’t tend to be price-setters. Brad DeLong, who’s done a lot of original research on the equity risk premium, is basically in that camp: he buys stocks because he has faith in his own analysis. But most of us aren’t that clever: we just buy stocks out of some combination of greed and fear (that we won’t have enough money to live on, decades hence, if we don’t invest our money in ways which make it grow substantially).

In times of turmoil, we start worrying less about not having enough money in 20 years, and more about not having enough money in 20 weeks. (What if I lose my job? What if my investments fall further?) So we sell our investments.

Can this be modelled as an increase in the liquidity discount? Maybe, but in that case Brad has already answered his own question:

As long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically and organizationally driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically and organizationally driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1.

The intertemporal elasticity of substitution might normally be close to 1, but it sure isn’t there right now — not for those of us without tenure, anyway. It came down a lot in the summer of 2007, when the commercial paper market first started seizing up, and it’s even lower now. Ask any hedge fund manager dealing with massive redemptions — it might not be rational to buy with a long time horizon and then suddenly decide to liquidate, but this is not a rational market, and it hasn’t been for some time.

There’s also a strong feedback loop here. In normal markets, the more that prices fall, the more people want to buy. In financial markets, during a time of crisis, the more that prices fall, the more people want to sell. The intertemporal elasticity of substitution isn’t a constant: it’s a variable, which falls along with the market. And the people who don’t adjust their discount rate fast enough to new realities end up, like Bill Miller, getting crushed.

Especially if you’re buying financials and other confidence stocks, you need a lot of other people to be buying them too, otherwise they have a tendency to go to zero. More generally, whenever lenders lose confidence in a company and refuse to refinance its debt, shareholders are likely to find themselves severely diluted at best, and quite possibly wiped out entirely.

It’s entirely reasonable to draw a distinction between Mr Voysey and Bernie Madoff — the men with the ignoble lies — and the more noble lies underlying the stock market. But deleveraging is no respecter of nobility. Which is why all of us are now suffering, not just those who invested with Bernie.

Posted in economics, fraud | Comments Off on The Noble Lie

Ben Stein Watch: December 14, 2008

Posted on December 14, 2008 by Felix

Are you worried about the state of the economy? Fear not! Ben Stein has a solution: "the federal government," he says, "has to guarantee loans made by lenders".

This looks like English. It has English syntax. But I don’t think it has any actual meaning.

I’m serious: the more you think about what it could possibly mean, the less it makes any sense. The only thing I can come up with is that by "lenders" Stein just means "banks", and that he wants the government to pay the banks in cash whenever a borrower defaults on a loan. So if I use my Citibank Mastercard, say, to buy a new TV, and then I miss my next credit card payment, the taxpayer will just pay Citibank back for me. Does that mean that I now owe the government the cost of a television, plus interest and penalties?

I don’t think Stein actually has a policy in mind when he writes these things; he’s just bullshitting, like he does on television, in the expectation that if he sounds authoritative, no one will notice that his words make no sense at all. The tactic seems to be working, too, at least when it comes to the readers who matter most: his editors at the New York Times.

Maybe they were bludgeoned into insensibility by Stein’s sequence of obnoxious observations:

High-end restaurants, like my favorite, Mr. Chow in Beverly Hills, are still almost impossible to get into…

A friend in real estate in California has written to me that “the recession has destroyed our wealth,” adding: “We are essentially bankrupt.” …

The house across from ours in Beverly Hills was sold two years ago and leveled to build a house twice as big; the lot sits empty and is again for sale…

My Cadillac dealer down here in the desert, near Palm Springs, is constrained by the credit crisis…

There is nothing here — nothing — of the remotest interest to Stein’s readers. This is the business-page equivalent of Larry King’s unlamented column in USA Today: a concatenation of insipid banalities, published for no reason other than the fact that the author has some kind of celebrity status.

Still, Stein does retain the ability to throw the occasional curveball:

Maybe Barack Obama can put some meaningful regulation in place when he becomes president. Maybe he can convince Congress to repeal the Private Securities Litigation Reform Act and get the private bar back in oversight gear.

You thought that blaming the Community Reinvestment Act for the financial crisis was stupid? Well, Ben Stein can outstupid even that: he’s blaming the Private Securities Litigation Reform Act instead, without stopping to notice that big class-action suits tend to happen after there are losses, not before. They don’t prevent bubbles and wrongdoing from happening, they only serve to redistribute wealth after those bubbles have burst.

The headline on this column is "Before the Fear, There Was Foolishness". Which is actually true. But it ignores the fact that the column itself is proof positive that there’s just as much foolishness during the fear, too. Some things are just constants. Like, it seems, Ben Stein and his abysmal column.

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Bernie Madoff Datapoint of the Day, Employment Edition

Posted on December 14, 2008 by Felix

From the WSJ:

People familiar with the firm say Madoff employed 200, with 20 or so in the asset management group that was housed in a separate floor from the trading group.

I think we need to hear a lot more about those 20 people. What did they do? It seems inconceivable that none of them ever saw what was in front of their faces all along, which implies that this fraud wasn’t a one-man operation. But then again, it’s $50 billion, that stands to reason.

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Ecuador’s Small Investors

Posted on December 14, 2008 by Felix

Since I wrote about Ecuador on Friday, there’s been a trickle of emails coming in from individual investors who hold the country’s bonds. These two came in quick succession:

I’m not into locking up on default for months/years while the court battle rages so i’ll just dump the bonds… the big boys can fight the bigboy dances all by themselves.

I would be very happy to act legally against the country – but lack the knowledge and resources.

Both these emails raise the question of whether individual investors can or should attempt to sue Ecuador for the return of their money. My feeling is that the first investor has the right idea: if you’re not an expert in such litigation, with a large budget for it, don’t go there. Yes, it’s possible that small creditors will be able to piggy-back on the heavy spadework done by big vulture funds in the Southern District of New York, so it might be worthwhile joining a class action somewhere, if it doesn’t cost you anything. But anything beyond that is likely to be prohibitively expensive.

On the other hand, small Ecuador bondholders might not have to do anything at all. One of the most important changes which Ecuador made the last time it defaulted, in 2000, was that it switched all of its bonds from an unwieldy fiscal-agent system to a much more bondholder-friendly trustee system. As result, it’s entirely conceivable that the trustee, who acts on behalf of all the bondholders, will end up being the recipient of any money successfully attached by litigious vulture funds — with the result that all such funds will end up being distributed equally among all bondholders rather than going entirely to the "big boys".

Either way, selling the bonds now, when they’re trading for twentysomething cents on the dollar, seems to me like getting out at the bottom. Even if the litigation isn’t successful, there’s a reasonable chance that the next Ecuadorean president, whoever it turns out to be, will end up paying the debt. And given how long Ecuadorean presidents normally stay in power, especially after they default, that day might not be too far off.

Incidentally, I pulled out my old April 2001 Euromoney cover story on Ecuador’s last bond default to see if I’d written anything there about trustees and fiscal agents. And as I was flicking through it, I was tickled to find this:

geithner01.jpg

To be a Treasury official in charge of dealing with an Ecuadorean bond default once is bad enough. But to find yourself in charge of America’s official response to two Ecuadorean bond defaults feels almost unfair. Maybe Geithner will just kick Ecuador down to the undersecretary for international affairs, and pay it as little attention as he can get away with. I, for one, certainly wouldn’t blame him.

Posted in bonds and loans, emerging markets | Comments Off on Ecuador’s Small Investors

Alex Kuczynski’s Moral Blindness

Posted on December 13, 2008 by Felix

How is it possible that Lisa Wilson, in a three-sentence, 58-word letter to the editor, can raise more serious and more interesting moral issues surrounding the institution of surrogacy than Alex Kuczynski did in her entire 7,700-word cover story on the subject? I’m not sure, but that’s exactly what she did:

If prostitution is unethical, immoral and illegal, why is it O.K. for one woman to pay for the use of another woman’s body? If it’s unethical, immoral and illegal to buy and sell body parts for transplantation, why is it O.K. to rent a uterus? Our morality seems so malleable in the hands of those who feel entitled.

LISA WILSON

Yarmouth, Me.

Thank you, Ms Wilson, for nailing the real fault with this story, instead of getting sidetracked by a silly discussion about the semiotics of the accompanying photographs.

Posted in Not economics | 5 Comments

Video of the Day: Bleed the World

Posted on December 13, 2008 by Felix

Pure genius. Especially the Bono bit.

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Extra Credit, Friday Edition

Posted on December 12, 2008 by Felix

The Stock Market Still Hopes For a Bailout: I think Jim’s right and I was wrong on this one: the stock market is pricing in a TARP bailout for Detroit.

Obama’s pick to solve the energy crisis

Magicians And Mathematicians: Quants can be really stupid.

Buffett on 0% interest rates: I hope this is for real. If it is, it’s brilliant.

airtraffic: A masterpiece of infomation visualization. Be sure to click on the "high quality" button.

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Ecuador’s Idiotic Default

Posted on December 12, 2008 by Felix

In the annals of idiotic political decisions, today’s default by Ecuador has to rank pretty high. The country failed to pay a $30.6 million interest payment on its 2012 global bonds, despite the fact that it has $5.65 billion in cash reserves and debt service accounts for less than 1% of Ecuador’s GDP.

As a result, Ecuador’s economy will suffer greatly. The country is a major exporter, not only of oil, but also of such things as shrimp, bananas, and cut flowers; trying to get trade finance for any of that will now be all but impossible.

But those aren’t even the biggest reasons this default is so stupid.

This debt has already been restructured twice, and there’s zero chance that bondholders will agree to it being restructured a third time. They know that Ecuador has the ability to pay, and they don’t like being bullied.

Most importantly, they have leverage. Yesterday, Judge Thomas Griesa, of the Southern District Court in Manhattan, ordered the attachment of Argentine pension fund assets held in New York, on behalf of defaulted Argentine bondholders. It’s the latest move in a long legal game being played out between Argentina and its creditors, and the creditors are scoring a few minor victories these days.

They face, however a formidable adversary: Argentina was careful to repatriate all its attachable assets before it defaulted, and the only reason the pension funds got attached is that they weren’t nationalized at the time. Argentina also has seriously heavyweight legal representation, in the form of Cleary Gottlieb — which used to represent Ecuador, too, until Ecuador fired them earlier this year and denounced them as criminals.

Ecuador’s bonds are all issued under New York law, and the country needs a good New York law firm to defend itself. Unfortunately, it’s having to make do with Foley Hoag in Boston instead.

Even with Cleary, Ecuador would have had a hard time defending itself against well-funded antagonists such as Elliott Associates and Greylock Capital, who are expert at navigating the legal system. With Foley Hoag, it has no chance, for one big reason: Ecuador has dollarized. The dollar is the legal currency of Ecuador; there is no other. As a result, all of Ecuador’s assets, ultimately, are US assets.

Ecuador’s bondholders will vote to accelerate its debt very quickly. As a result, Ecuador won’t have to just pay its $30 million coupon payment any more: it will have to pay the full $510 million principal amount. And the chances are that the 2015s and 2030s will be accelerated too. What’s more, if it doesn’t pay up in full, its creditors will surely find a way to take the money anyway.

The only hope for Ecuador now — and it’s a slim one indeed — is that this whole thing has been engineered by people holding Ecuador’s credit default swaps, and that once they’ve been paid out, the government will quickly act to cure the default. (Incidentally, the single biggest writer of default protection on Ecuador is… Venezuela. You can be quite sure that the leftist solidarity between Rafael Correa and Hugo Chavez is no longer.)

If this default isn’t cured in a matter of days, Ecuador is going to lose billions of dollars it can ill afford to see go. Surely Correa knows this — and surely he knows, too, that whenever Latin American presidents announce a debt default, they rarely last long in office. Which makes this decision even more inexplicable. But there’s Ecuador for you: always bet against the country taking the logical and sensible course of action, and you’re likely to make a lot of money.

Posted in emerging markets | Comments Off on Ecuador’s Idiotic Default

How TARP Funds will be Released

Posted on December 12, 2008 by Felix

I’ve been looking for this all morning; many thanks to the NYT for finally clearing it up for me. How will Congress approve the $350 billion second tranche of TARP money, now that its legislative session is closed for the year? It doesn’t have to:

Under the legislation governing the program, Congress has 15 days to say “no” to the Treasury Department after a request for the money is made, or else the department automatically gets the money. To vote on a Treasury request, House and Senate members would probably have to interrupt their holiday vacations to return to Washington in the waning days of the 110th Congress.

This is good news. So long as Congressional Republicans don’t actually have to vote for the money to be released, they can simply remain in their constituencies and quietly let it happen, claiming that it’s out of their hands. What’s more, I think that an absolute majority in the Senate would be needed to vote this down; given that 52 Senators voted for the bailout bill, the chances of that happening seem slim.

I expect Treasury to make a formal request as soon as today; once that’s happened, and once it’s clear that Congress is not going to schlep back to Washington to try to vote the request down over the holidays, I suspect that any number of banks would be happy to structure a back-to-back loan whereby they extend money to Detroit right now, only to be paid back with TARP funds in a couple of weeks’ time.

This is only a stopgap solution, of course, but right now any solution is so obviously better than the alternative that we can probably all start breathing again, at least for the time being.

All the same, it’s worth pointing out the irony here. If Treasury requested the TARP funds for their original purpose, Congress would be much less happy. But since some small part of those funds is necessary for bailing out Detroit, the full $350 billion is likely to be released in to the largely-unaccountable hands of Paulson and Kashkari. How much of it they’ll manage to spend before January 20 remains to be seen.

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Information Transformation

Posted on December 12, 2008 by Felix

Justin Fox has a great post on

Bengt Holmström’s distinction between low-information and high-information assets:

There are low-information assets–cash, bank deposits, money-market securities–where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets–stocks are the best example–where the value is highly uncertain, and every investor assesses it differently.

Securitization is the process of transforming low-information assets, like corporate debt, into high-information assets, like opaque CDO-squareds. And I think this insight is the best way of answering Richard Wagner’s exam question about securitization:

The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive offenders of lenders to monitor borrowers and thereby weaken overall economic performance?

Classically, the answer to this question — the one which all of Wagner’s students gave — was no. Investors in CDO-squareds, under the kind of assumptions commonly made by economists, have perfect information about all the underlying loans.

In reality, of course, they don’t. But more to the point, it’s orders of magnitude harder to understand a CDO-squared than it is to understand a single loan — and single loans are hard enough to understand themselves. You can start making correlation assumptions and the like in an attempt to simply matters, but that only pushes off the moment of reckoning: you still need to crunch a lot of data to come up with empirically-based correlation assumptions, and no one ever had either the ability or the inclination to do that.

Financial innovation nearly always involves a move towards higher-information assets from lower-information assets. This is not a good thing. It’s easy to say things like "don’t invest in something you don’t understand", but how on earth is anybody meant to understand something as high-information as the stock market, let alone things like CPDOs?

A lot of the boom in debt markets during the Great Moderation, I think, was a result of buy-siders being seduced by instruments which they believed required little if any sleeves-rolled-up credit analysis. Maybe one surprising consequence of the credit crunch will be an increase in demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them.

Posted in bonds and loans, economics | Comments Off on Information Transformation

Free Marketeers for Wage and Price Controls

Posted on December 12, 2008 by Felix

Jim Surowiecki effectively slaps down those — like Henry Blodget — who would blame the UAW for the collapse of the Detroit bailout plan:

There are a couple of things to notice about this story. First, it has almost nothing to do with the core problems faced by G.M., Chrysler, and Ford. The wage gap between U.A.W. workers and workers at other car companies is no longer that big, and labor costs at this point account for only ten per cent of the cost of producing a vehicle…

More important, having the government dictate the wages of employees–which is literally what the G.O.P. was insisting on doing–is precisely the kind of government meddling in the marketplace that Republicans normally abhor… What’s next? Price controls?

Funny you should ask that, Jim. Because Henry actually wants price controls, at least on gasoline:

Specifically, a gas tax that fixes the price of a gallon of gas at $4 a gallon nationwide, with the tax being the difference between the market price and $4. The tax will thus adjust with the market price of oil–less tax when oil is expensive, more when it’s cheap. And the price of gas will stay fixed at $4.

I don’t see how you could conceivably get a "market price" when there’s no market: presumably oil companies and gas stations would simply mark up their prices so that the market price was always at or above $4. But it’s fascinating to me to see free-market types scrambling, when crisis hits, to come up with wage controls, price controls, and generally the whole panoply of failed Socialist policies. So much for ideology, I guess.

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Madoff: Effectively Unaudited

Posted on December 12, 2008 by Felix

Floyd Norris asks, of Bernie Madoff:

I assume his funds’ books claimed to be audited. Who were the auditors? How were they fooled?

It turns out that investor Jim Vos already looked into that:

Madoff’s auditor, Friehling & Horowitz, operated from a 13-by-18-foot office in Rockland County, New York, a small operation for the auditor of such a large firm.

In other words, Madoff might as well have got a chimpanzee to audit the books, for all the checks and balances that Friehling & Horowitz provided. Which, of course, is why he chose them in the first place. I’m sure they were well compensated for not asking too many awkward questions; it would be nice if they, too, go to jail.

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Madoff: The 0-and-0 Hedge Fund Manager

Posted on December 12, 2008 by Felix

Reading Michael Ocrant’s 2001 profile of Bernie Madoff (via Greg Newton), one can see why fund-of-funds loved him so much: they got to keep all the associated fees! Madoff himself charged nothing:

The acknowledged Madoff feeder funds — New York-based Fairfield Sentry and Tremont Advisors’

Broad Market; Kingate, operated by FIM of London; and Swiss-based Thema — derive all the incentive

fees generated by the program’s returns (there are no management fees), provide all the administration

and marketing for them, raise the capital and deal with investors, says Madoff.

Madoff Securities’ role, he says, is to provide the investment strategy and execute the trades, for which

it generates commission revenue.

Of course, "nothing" means "everything" in this case: Madoff might not have charged any management fees — he just stole all the money instead.

And in light of what’s been happening in the S&P of late, this is just hilarious:

The apparent lack of volatility in the performance of the fund, Madoff says, is an illusion based on a

review of the monthly and annual returns. On an intraday, intraweek and intramonth basis, he says, “the

volatility is all over the place,” with the fund down by as much as 1%.

Here’s how the article ends:

Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy

is the strategy and the returns are the returns.” He suggests that those who believe there is something

more to it and are seeking an answer beyond that are wasting their time.

I hope they all lived to see this day.

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Stick a Spork in Him, He’s Done

Posted on December 12, 2008 by Felix

Bernie Madoff: one of the biggest crooks of all time, but a boring name. If only he was called something straight out of a comic book. Something like Otto Spork.

He’s a real person: a man who invested substantially his entire hedge fund in a pair of Icelandic glaciers (you really can’t make this shit up) which were listed on the Luxembourg stock exchange under the ticker symbols IGP and IGW.

Neither IGP or IGW have earned any revenue and there are no indications that they will do so in the in the immediate future. Neither is currently operating … Despite having earned no revenue and having no immediate prospect of doing so, IGP’s shares have purportedly increased in value by 984 per cent since the initial investment by Mr. Spork’s hedge fund started in 2006.

This is mark-to-myth taken to the point of outright fraud. If you’re investing in illiquid securities, you can mark them at pretty much whatever you like; if you keep on marking them higher and higher, you can report stellar returns.

But as Floyd Norris notes, there’s one thing which is guaranteed to reveal all such deceptions: large redemptions. Madoff and Spork both kept on going until the markets turned and increasingly risk-averse investors started asking for their money back. Absent the stock market crash, they’d probably both be happily frauding away today.

As a result, more frauds are likely to appear in coming months. Ponzi schemes can never survive an economic crisis.

(Via Kedrosky)

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Will the White House Bail Out Detroit?

Posted on December 12, 2008 by Felix

The ball’s in the White House’s court; there’s no chance of Congress passing a Detroit bailout bill before it reconvenes next year. The White House has TARP funds, but only $15 billion remains from the first $350 billion tranche; that’s barely enough for Detroit, and in any case it’s needed as to backstop Treasury commitments to the financial sector. So here’s one question:

What does this all mean for the probability that Paulson will get the second $350 billion?

On the one hand, if Congress won’t give Detroit a fraction of that amount, it’s really hard to see why they will be so generous to Wall Street. Clearly any bailout is supremely unpopular among both voters and their representatives, and of all the bailouts to attempt, Wall Street is probably the most unpopular.

At the same time, however, Congress has already passed the $700 billion TARP bill, and clearly something needs to be done: maybe a case can be made that now it’s obvious $700 billion is not nearly enough, it would be silly to block the release of the second tranche. But I’m not hopeful.

I do wonder whether the White House might be able to find Detroit bailout money (or, at the very least, debtor-in-possession financing money) somewhere other than TARP — a bit like Bob Rubin managed to find Mexico’s bailout money in some hidden corner of the Treasury, using a dusty old piece of legislation for a purpose it was never designed for. Paulson’s quite open about the fact that he’s happy to make decisions first and worry about their legality later — can’t he do that now, with Detroit?

The problem is that it might be a stretch even for Paulson to decide that Detroit really falls under his purview. Congress has spoken, unambiguously: it doesn’t want a bailout. (Or, rather, a minority of Senators has managed to block a bailout.)

And while the stock market is down this morning, it isn’t plunging in the way it did after TARP failed the first time around. I don’t believe that the stock market is pricing in some kind of Deus ex Machina from the White House, which would imply that maybe it’s not as worried about the fate of Detroit as many of the rest of us are. And if Wall Street isn’t worried, then the chances are that Paulson isn’t worried, either.

Which is bad news for Detroit, I fear.

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It’s a Mad, Mad, Mad, Madoff World

Posted on December 12, 2008 by Felix

The WSJ fills in more details regarding the Madoff case, and it’s actually more gobsmackingly unbelievable than it was last night.

For one thing, Madoff didn’t invest simply on behalf of a couple of dozen multibillionaires; he had many common-or-garden millionaire clients, many of whom were introduced to him — I’m not making this up — through the Boca Rio Golf Club in Boca Raton and the Palm Beach Country Club in Palm Beach. Apparently the ability to invest with Madoff was sold as a side benefit of joining the clubs — as ever, if you make something seem exclusive, people will clamor to get it.

It gets worse: a chap called Harry Markopolos has been saying that Madoff was a fraud in May 1999 — almost a decade ago. Obviously, nothing happened, but Markopolos didn’t give up: he wrote the SEC in 2005, saying that "Bernie Madoff’s returns aren’t real". But until Bernie Madoff himself admitted that fact, the SEC was nowhere to be seen. Others saw it too: Cassandra did, and, according to Henry Blodget, many of Madoff’s investors reckoned that he must be a crook and that this was a legal way of profiting from fraud.

There was every reason to believe that Madoff was cooking the books. He posted regular small monthly returns, adding up to 10% per year, year in and year out — essentially the Holy Grail of high returns with almost zero volatility. Even in recent months Madoff perpetuated the fiction:

Mr. Madoff’s Fairfield Sentry Ltd., a hedge fund run by Madoff Investment Services to invest in shares in the S&P 100, claimed to be up 5.6% through the end of November, a period when the Standard & Poor’s 500-stock index was down 37.65%. In October, Fairfield Sentry was said to be down 0.06%, a month when the S&P 500 lost 16.8%.

Now those kind of returns are very attractive to country-club millionaires: you can see where that part of the fraud came from. But it turns out that Madoff’s largest investors were fund-of-funds managers, including huge names like Tremont Capital Management.

Such managers do one thing, first and foremost: they exist as an extra pair of eyes to oversee the actual fund managers; they’re a risk control, and they’re sophisticated enough to smell impossible returns like Madoff’s. I simply can’t believe that they funneled billions of dollars of client money to Madoff without ever talking to his chief risk officer (there wasn’t one).

There’s also the question of the $50 billion number, given that Madoff "only" had $17 billion in assets under management, according to his SEC filings. I see three possibilities which might explain the difference:

  • Madoff, falling apart, can’t add up, even after including all the fees he extracted from the funds.
  • The amount of funds that Madoff reported to the SEC was a fraction of the amount of funds that Madoff reported to his investors.
  • Madoff borrowed the extra $33 billion, as Kaja Whitehouse suspects.

I think the second option is the most likely, but insofar as banks lent Madoff anything unsecured, they’re feeling really stupid right now.

The one thing I’m sure of is that Tremont and Fairfield Greenwich are going to face some massive lawsuits over this — and will suffer enormous redemptions. (Does Fairfield Greenwich run non-Madoff money? It’s unclear, but it’s probably moot; if they did yesterday, they won’t tomorrow.) If they’re idiotic enough to place billions with Madoff, they have no business running anybody’s money.

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Extra Credit, Thursday Edition

Posted on December 12, 2008 by Felix

Paul Krugman’s Nobel Prize Lecture: Maybe you can get the video to work, I can’t.

Shareholder Value: US companies, since Q4 2004, have returned more money to shareholders than they’ve actually made.

$73 an Hour: Adding It Up: "Labor costs, for all the attention they have been receiving, make up only about 10 percent of the cost of making a vehicle"

Leaders of the English-speaking world: There must be something in the air.

Somali Pirates to acquire Illinois Senate Seat

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Diamond Datapoint of the Day

Posted on December 12, 2008 by Felix

Bloomberg headline, Dec 9: "Diamond May Fetch 9 Million Pounds at Christie’s, Defying Slump".

Bloomberg headline, Dec 10: "Diamond Sells for Record $24.3 Million, Defying Slump".

Consider the slump defied! But the best line comes from the buyer, Laurence Graff, who’s going to recut the stone to make it flawless.

"We’ll lose a few carats, but nothing too substantial."

There’s a lot of history to this stone — it was given by King Philip to his daughter, the Infanta Margarita Teresa, as part of her dowry when she married Emperor Leopold I of Austria in 1667. So it seems a shame to chip away at it for the sake of flawlessness, which in any event has always been the most overrated of virtues.

Incidentally, the rest of the sale was a bust:

Forty-five percent of the lots were left unsold, including a 4.24-carat pink diamond pendant whose lower estimate had been reduced from 330,000 pounds to 200,000 pounds.

"The market is difficult, but it’s still there for the very best," said Sancroft-Baker.

There’s a lesson here, for any hedge-fund wives having financial strains. If all you’ve got is a 4.24-carat pink diamond pendant, fuhgeddaboudit. Dealers aren’t even getting out of bed these days unless you’ve got a provenance dating back to King Philip and a carat weight in the 30s.

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This is Not Good

Posted on December 11, 2008 by Felix

The WSJ reports that talks to save the automakers have broken down in the Senate, and that there will be no bailout.

Once again, Congressional Republicans have killed an intiative backed by both the White House and the Democrats — and I can’t imagine that the stock market will take any more kindly to this news than it did to the news that the House Republicans had voted down the first attempt at TARP.

The problem here is that there really doesn’t seem to be a Plan B: there isn’t any indication that the government is even willing to provide debtor-in-possession financing within Chapter 11. And if such financing is not forthcoming, the worst-case scenario is looking increasingly probable: an outright Chapter 7 liquidation, which would cost millions of jobs and would probably have a devastating effect — thanks to the inevitable supplier bankrupcies — on the big Japanese automakers with plants in the South. In other words, everybody loses.

Can Congress really be so pig-headed as to let this happen? Evidently, yes. Expect serious excoriation from the media: I think that most journalists have a gut-level understanding that Detroit’s massive adspend was one of the few things keeping them in a job these days. And maybe in coming days some kind of Chapter 11 solution might be cobbled together, or at least a package which helps out the suppliers and the remaining US carmakers (including Toyota, Honda, and other foreign firms with a US presence).

Up until recently, bankers have been Villain Number One in the story of this crisis. But given Washington’s astonishing ability to screw up just about everything it’s attempted to make things better, maybe politicians will find their way back to the top of the list. Certainly, this is not representative democracy’s finest hour.

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Loan Mod Datapoint of the Day

Posted on December 11, 2008 by Felix

From the NYT’s Sheila Bair article:

A $300 billion foreclosure prevention program passed by Congress this summer to help up to 400,000 homeowners wound up larded with requirements, like requiring background checks and restricting eligibility for mortgage relief to people at risk of foreclosure as of March 1.

As a result, fewer than 200 people have applied for the program since it opened in October, according to officials from the Department of Housing and Urban Development, and no loans have been modified.

One does wonder who comes up with these numbers ($300 billion, 400,000) — which are off by $300 billion and 400,000 respectively. Could it be that moral hazard concerns in the loan-mod world really are overblown?

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The World’s Biggest Ever Heist

Posted on December 11, 2008 by Felix

I still can’t quite get my head around the enormity of the numbers in the Madoff case. For one thing,

Madoff’s investment advisory business served between 11 and 25 clients and had a total of about $17.1 billion in assets under management.

Now that’s what I call high net worth individuals! And then you read the indictment, and you think you know what to expect, until:

On Dec. 10, 2008, Madoff informed the Senior Employees, in substance, that his investment advisory business was a fraud. Madoff stated that he was "finished," that he had "absolutely nothing," that "it’s all just one big lie," and that it was "basically, a giant Ponzi scheme. Madoff stated that the business was insolvent, and that it had been for years. Madoff also stated that he estimated the losses from this fraud to be at least approximately $50 billion.

Yep, $50 billion. In other words, that $17.1 billion is only the beginning: presumably Madoff’s clients had invested much more than that, and Madoff was sending statements to them, on the one hand, while reporting different numbers to the SEC, on the other — none of which were true.

If the total losses are really $50 billion, that means that the average loss to Madoff’s clients is a minimum of $2 billion, and perhaps as much as $4.5 billion. After all, in a Ponzi scheme, everybody comes out fine, except the last people out: the 11 to 25 clients still with Madoff to this day.

The one thing this does do is get me a little bit more comfortable with Jeffrey Epstein’s business plan of managing billionaires’ money. Clearly there are actually quite a lot of people with a few billion dollars to invest and who feel perfectly comfortable entrusting it to individuals like Madoff and Epstein. Who knew?

Right now, there are a handful people whose world has suddenly been turned upside-down: who have, overnight, suddenly lost billions of dollars of dynastic wealth to a Wall Street con man. I’m sure that their names will appear sooner or later. But there really is no precedent that I can think of: when has one man ever managed to steal $50 billion dollars? If the $100 million Harry Winston heist in Paris was the "steal of the century", what’s this?.

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