Art: Kravis Sells to Japan

Posted on November 4, 2008 by Felix

There’s a lot of interesting stuff packed into this one paragraph from Carol Vogel’s auction report today:

A Degas gouache, “Dancer in Repose,” that was being sold by the financier Henry Kravis and his wife, Marie-Josée Kravis, was sought by two telephone bidders. From around 1879, it depicts a dancer sitting on a bench massaging her foot. The Kravises bought the work at Sotheby’s in London in 1999 for $27.9 million, and in the summer the auction house gave the Kravises a guarantee that experts said was more than $40 million. On Monday Yasuaki Ishizaka, head of Sotheby’s Tokyo, took the winning bid by phone: $33 million, or $37 million including Sotheby’s fees.

First, why are the Kravises selling — and selling such a key piece from their collection, to boot? When Kravis bought the work it was the most expensive Degas ever sold at auction, and that record stood until yesterday, when it broke its own record. That’s not the kind of work you sell just because your "taste has moved toward 20th-century modern works", as Bloomberg speculates. Could it be that Kravis needs the money? It seems improbable, but you never know.

Second, Sotheby’s is so worried that it’s willing to sell works for amounts well below the guarantee, thereby locking in a loss. That’s not a healthy sign at all, as far as the market is concerned. Normally, when an auction house guarantees a work, it takes possession itself, and then tries to sell it privately for a higher sum. But Sotheby’s clearly didn’t want to take that risk.

Third, it looks like the Degas is going to Japan — which has not been a source of much art-world bidding of late. But the Japanese still like their Impressionists, and this one looks like something of a bargain, from a Japanese point of view. Nine years ago, the painting sold for ¥3 billion; yesterday, it sold for ¥3.66 billion. That’s an annualized growth rate of just 2.2%, which includes what by all accounts was the biggest rise in art prices the world has ever seen. Maybe with the crazy strength of the yen these days, the Japanese will become important buyers again. Although there’s no indication they’re particularly interested in the likes of Damien Hirst or Jean-Michel Basquiat.

Overall, the Sotheby’s auction was weak, especially when you consider that it had much bluer-chip artists than next week’s contemporary auctions. Those will give us a much better indication of whether the art bubble has finally burst.

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Inequality in New York

Posted on November 4, 2008 by Felix

Ed Glaeser, Matt Resseger, and Kristina Tobio have a new paper out on urban inequality (ungated version here), which declares Manhattan (New York County) to be the most unequal county in the US:

While Manhattan is the physical embodiment of big-city inequality and has a Gini coefficient of .6, the Gini coefficient of Kendall County, Illinois is only about one-half that amount.  Kendall is a small but rapidly growing county on the outskirts of the Chicago area that combines agriculture with a growing presence of middle-income suburbanites.  In Kendall, 9.2 percent of households earned more than 150,000 dollars in 2006, and 9.3 percent of households earned less than 25,000 dollars.  In contrast, 20.4 percent of households in New York County earned more than 150,000 dollars, and 26.5 percent earned less than 25,000.

If you read the comments on this blog, you’ll be told with great vehemence that it’s really hard to live on $200,000 a year in Manhattan. If that’s true, how on earth is more than a quarter of Manhattan’s population managing to live on less than $25,000 a year? The paper addresses that question:

Prices differ across metropolitan areas, but if prices were the same for every type of person in every area, then prices should not impact inequality, at least as measured by the coefficient of variation or the Gini coefficient.  However, as suggested by Black, Kolesnikova and Taylor (2007), prices may be quite different for people at different places in the income distribution.  New York may be much more expensive for a relatively rich person than it is for a relatively poor person.  Indeed, the very fact that poor people continue to live in New York suggests that the area may not be as expensive for them as average prices would indicate. 

I think there’s a lot of truth to this. Childcare, for instance, is expensive in Manhattan — but if you don’t pay for childcare, then it doesn’t really matter how much it costs. The same can be said for just about any services (massages, psychotherapy, taxis), as well as things like brand-new children’s clothes and toys.

Meanwhile, the poor get enormous benefit from the quality of public services in Manhattan, from the police and fire departments to the public libraries — which are basically paid for by the rich. They also live in housing which is priced well below market rate: if you added the implicit housing subsidy onto cash income, there would be barely anybody in Manhattan living on less than $25,000 a year.

What interests me is the way in which the poorest quarter of Manhattan’s population has become increasingly invisible even as inequality has grown substantially over the past 25 years. My own neighborhood of the East Village (f/k/a Alphabet City) is a prime example of an area where there’s still a very large poor population, but where visible life only ever seems to get more and more expensive, with retail-level stores catering to poorer people closing down and being replaced by those catering to yuppies.

That kind of change breeds resentment, of course, and the paper shows a correlation between inequality and not only the crime rate but even the murder rate. "People are less happy when they live around richer people," say the authors; I wonder whether the destruction of personal wealth which is going on in the Financial District might make poor New Yorkers happier. I hope so.

(Via Avent)

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Can Gross World Product Shrink?

Posted on November 4, 2008 by Felix

Mish casts his mind back to April, when I declared with great confidence that "it’s pretty much impossible for the entire world to register negative growth in any given quarter".

Let me change that a little: I still think the world won’t see negative GWP growth in any given quarter. But I no longer think that it can’t. Fitch now sees GWP growing by just 1% in 2009, dragged down by a -0.8% contraction in the developed economies of the US, UK, Euro area and Japan. And so it’s maybe not surprising that Mish, who’s more bearish than most, thinks that we will see "an outright contraction" in the next few quarters.

This, more than anything else, brings home to me the severity of the current crisis.

A negative print for gross world product would be all but unprecedented: this is a number which has been growing slowly but steadily for millenia. According to The World Economy, a truly invaluable reference work, GWP grew by 0.15% a year between 1000 and 1500; by 0.32% a year between 1500 and 1820; by 0.93% a year between 1820 and 1870; by 2.11% a year between 1870 and 1913; by 1.85% a year between 1913 and 1950; by 4.91% a year between 1950 and 1973; and by 3.01% a year between 1973 and 1998, just when China really started taking off.

At this point, the IMF defines a global recession to be any year with less than 3% GWP growth, so a drop to 1% is brutal indeed. A fall into negative territory would be shocking in the extreme — the kind of thing one would expect to see only in the event of a major global upheaval such as world war or climatic catastrophe. This is really nothing to do with subprime mortgages any more: it’s a worldwide deleveraging the likes of which we’ve never seen before. And where it will lead, nobody knows.

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Why Bank of America has to Re-Hire Merrill’s Brokers

Posted on November 4, 2008 by Felix

I just had a very interesting conversation with a Merrill Lynch type who filled me in with much more information on the subject of those retention bonuses.

The numbers: Bank of America wants Merrill’s most profitable brokers. Most brokers earn about 40% of their total commissions, with the other 60% going to the firm. And if you bring in more than $1.75 million a year in total commissions, Bank of America is offering a retention bonus of 100% of your total commission. If you bring in between $1 million and $1.75 million, then you can get something very close to that in retention bonus. But if you’re only bringing in say $500,000 a year in commissions, then Bank of America is less interested in keeping you, and you’ll be lucky to get any retention bonus at all.

Why does Bank of America need to pay Merrill’s employees to stay? It’s because the clients of a good stockbroker — and when you’re bringing in a seven-figure sum in annual commissions, you’re a good stockbroker — are loyal to the individual, rather than the firm. If the broker moves, chances are that most of his clients will move with him. And right now the broker is, effectively, moving: to Bank of America — a firm with a stingier corporate culture which might well be less assiduous when it comes to coddling high-producing divas.

What’s more, the takeover by Bank of America provides a perfect one-time-only opportunity for a Merrill stockbroker to phone up his clients and tell them that Merrill’s acquirer is not where they want to be, and that they’d be much better off following the broker to his new home. (Of course, he’s unlikely to mention the fact that his new employer has just given him a seven-figure signing bonus.)

Stockbrokers are a bit like lawyers: they get called by headhunters the whole time. Because they get paid on a commission basis (although these days the commissions are normally a percentage of total assets rather than a commission per trade), they’re profitable for whoever their employer might be, and there’s constant demand for them. Many move every five to seven years, when their lock-up period ends, taking a nice signing bonus each time.

So Bank of America has essentially found itself having to re-hire all of Merrill’s brokers. It doesn’t care all that much about the small fry, but it is offering the bigger producers retention bonuses on a par with the signing bonuses available elsewhere. Given the hassle involved in moving from one shop to another, that’s nearly always enough to persuade a broker to stay.

One open question is what is going to happen to Bank of America’s private banking operation, including US Trust. Chances are it will eventually be folded into Merrill Lynch, but not for a while. A private banker, from Merrill’s point of view, is essentially a glorified stockbroker, who works with richer clients and spends a bit more time talking about things like estate planning and art collections, and maybe less time talking about asset allocation and investment strategies. There might also be a bit more access to hedge funds and private-equity funds.

But for the time being, the different franchises are likely to remain separate: there’s just too much chaos involved in the merger to try to make things needlessly complicated by throwing US Trust into the mix as well. When dealing with rich clients, as all these people do, it’s important not to be too hasty. After all, as the entire industry knows, the rich can be very loyal — but they can also be fickle.

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Landsbanki Debt Settles at 1 Cent on the Dollar

Posted on November 4, 2008 by Felix

What happens to unsecured bondholders when a financial institution goes bust? A good place to start is to look at the settlement price in CDS auctions. Fannie and Freddie settled in the high 90s: yes, there was a credit event, but from a bondholder perspective there were few if any losses. WaMu settled at 57%: a much more painful outcome for fixed-income investors. Lehman, of course, settled at a gruesome 8.6%, leaving unsecured bondholders pretty much wiped out. But even that seems like a wonderful outcome compared to the result of today’s Landsbanki Islands auction: the final settlement price was just 1.25%.

A few years ago I took a freelance job writing a last-minute advertorial for Landsbanki. I flew out to Keflavik, took a $140 cab ride into Reykjavik, and met with a couple of friendly, sober, and smart senior Landsbanki executives in their unimposing and even borderline-shabby headquarters. It was clear that Landsbanki was the big-and-boring bank in Iceland, compared to the acquisitive, high-paced, highly-levered, engineered-to-the-hilt Kaupthing. But it was also clear, even then, that Iceland’s reliance on its own tiny currency placed it at the mercy of international capital flows to a very unhealthy degree. When the money fled Iceland all at once, there was nothing its banks or its government could do.

I’ll be very interested, now, to see what happens to Ireland, which is a country quite similar to Iceland if you just look at its banking system. But as part of the euro zone, it’s much safer. And I just can’t imagine ever reading this kind of thing about Ireland:

Mr. Danielsson, the economist, visited the country recently and found the situation grave.

“Salaries are frozen, food prices are shooting up and they are laying off people left, right and center,” he said. “Companies are going bankrupt all over the place. It’s unimaginable how bad it is.”

Ms. Gisladottir said Britain’s decision had sent Iceland back some 30 or 40 years, to a time when it was an isolated, poor country, dependent mostly on its fishing trade.

“This is a major crisis,” she said. “We haven’t been in this situation for, probably, ever. We cannot solve it alone. We need solidarity from partners, from friendly countries, and we thought the U.K. was one of them.”

If Ireland ever got into serious trouble — if its CDS spreads started gapping out to distressed levels — then I’m pretty sure the UK would be part of the solution, not part of the problem. But then again, the UK and Ireland have never had a serious fight over cod.

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Extra Credit, Monday Edition

Posted on November 4, 2008 by Felix

Itau to Buy Unibanco in $12.5 Billion Agreed Takeover: For anybody like me who’s been following Brazilian banking for years, this is huge.

Hedge Funds: The Future: As seen by Paul Wilmott.

The Mythology Of Credit Default Swaps

Crisis management: A Q&A I had with Bill Rhodes of Citibank. "There were lessons learned in both the Latin American debt crisis and the Asian financial crisis. Why didn’t policymakers think to look at these, instead of relearning everything again? Why didn’t anyone bother looking at some of our experiences? That’s part of the problem."

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Exchange-Traded Derivatives: Why Stop at CDS?

Posted on November 3, 2008 by Felix

Donna Block has an overview of all the different groups jockeying to set up a CDS exchange:

Businesses trying to establish the new market include CME Group Inc.; NYSE Euronext Inc.; IntercontinentalExchange Inc. or ICE; Eurex, the derivatives arm of Deutsche Börse AG; and Knight Capital Group Inc.

But are all these people essentially fighting the last war? Why should CDS, of all non-exchange-traded derivatives, be the ones which are the most dangerous in the future? Neil Roland reports:

“Who’s to say the next big crisis won’t involve commodity or currency swaps?” said Texas University law professor Henry Hu, who testifies regularly before Congress about derivatives. “If we really care about transparency, we ought to care about all over-the-counter derivatives.” …

University of Houston finance professor Craig Pirrong said a single clearinghouse for the entire $600 trillion derivatives market would do more to address risk and inefficiencies than a guarantor for just one of its sectors.

I do wonder at the way in which credit default swaps, more than any other financial instrument, have become demonized to the point at which people genuinely think that a more-regulated CDS market will pose substantially less systemic risk. But of course the amount of non-CDS OTC derivatives, with all their counterparty risk, dwarfs the CDS market. Which makes me think that all of this is really gesture politics more than it is a serious attempt to reform the financial architecture.

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Art: The Last-Chance Argument

Posted on November 3, 2008 by Felix

I have little time, in general, for optimistic arguments saying that art will continue to do well as an asset class. But Marion Maneker has an interesting idea about why the upcoming fall sales might not be quite the disaster that many fear:

For passionate collectors, turning off the supply of great art is worse than the financial sector’s threat to their ability to pay for it. There’s much talk of serious collectors who had been sidelined by the free-for-all market being tempted back in with the dual prospect of once-in-a-generation buying opportunities and the promise that reckless money will be staying home.

High prices for art do have a way of pulling sellers out of the woodwork: it’s easy to say that you’ll never sell your Warhol, but it’s much harder to turn down $30 million for it. As a result, the big evening sales have been full of very good works in recent years, often consigned by people who didn’t need to sell.

There’s a good chance that for the foreseeable future, those discretionary sellers will be much less tempted to put their work up for auction. After all, they’ve all been contacted by the auction houses in the past, and if you said no to an auctioneer telling you that your painting could go for $30 million, it becomes incredibly easy to continue to say no when the top price mentioned is only $20 million.

From a buyers’ perspective, then, this month’s sales might well be the last with lots of very desirable works. Going forwards there will always be the estates of deceased collectors, and other forced sales. But now could be the last great smorgasbord of art for a while, and it might be irresistible to serious collectors with lots of cash. If such people still exist.

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Driven to Bankruptcy

Posted on November 3, 2008 by Felix

Do you know anybody who bought a new car in October? Most of the country was a little bit preoccupied, I think, for that kind of activity. But even so, the news that GM sold just 168,719 cars last month — down from 307,408 in October 2007, and possibly the first time it sold fewer than 200,000 cars in a month since the 1940s — is sobering.

Part of the problem, of course, is that GM isn’t very good at making the kind of cars that people want to buy. But there’s also the fact that if you want a car loan from GMAC, you now need a credit rating of at least 700. Plus, of course, GM no longer owns GMAC, which can’t help.

New cars, like houses, are leveraged assets: you buy them on credit. As demand for all leveraged assets falls, it stands to reason that new-car sales, as well as financed used-car sales, are going to fall commensurately.

Now this doesn’t need to be the end of Detroit. But it does imply that the equity in the big three carmakers is going to zero. As Justin Fox notes, bankruptcy is pretty much exactly what all of them need right now.

As the carmakers come out of bankrupcy, it’ll be interesting to see the degree to which they continue to cling to a business model which involves selling the cars at a loss and trying to make up the profits on the financing. It seems to me that the most successful brands have for decades been the ones with the least reliance on their retail leasing arms. And in any case I don’t see much of an appetite for car-lease receivables over the next few years.

What this says to me is that Americans will be buying cheaper cars, just because they won’t be able to get financing for the more expensive ones. And since cheaper generally means smaller and more fuel-efficient, that’s got to be a good thing for the country.

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Will Retail Investors Continue to Buy and Hold Stocks?

Posted on November 3, 2008 by Felix

It’s still too early to tell whether the stock-market crash of the past couple of months has done any lasting damage to the conventional wisdom that a buy-and-hold strategy applied to a diversified stock portfolio is generally a very good idea. But it is worth pointing out that a couple of the names one might associate with the idea, when you look a bit more closely, aren’t nearly that simplistic.

For instance, consider Henry Blodget, who wrote The Complete Guide to Wall Street Self-Defense for Slate back in 2004 — something full of common-sense advice for long-term investors. He recently posted a blog entry headlined "Time To Abandon Buy And Hold? No: Time To Buy", in which he seems to advocate at least some attempt at market timing:

The Japan news is profound and disturbing, but it does not change the basic equation: price matters. Buy stocks when they are cheap, sell them when they are expensive.

How does a normal retail investor know to sell stocks when they’re expensive? Through rebalancing: once a year or so, look at your portfolio and, so long as you can do so without too much in the way of adverse tax consequences, bring it back to whatever kind of big-picture asset-allocation setup you wanted all along. If your stocks have gone up a lot, you might sell some, or at least invest no more money in stocks; if your stocks have gone down a lot, you’ll buy more. So that’s a good way of buying low and selling high within a basically buy-and-hold framework.

Jason Zweig, on Saturday, had another interesting datapoint, this one relating to Warren Buffett:

As recently as 1995, 73.5% of Berkshire’s total assets consisted of a portfolio of publicly traded stocks that (at least in theory) any investor could have replicated. As of June 30, though, Berkshire’s stockholdings made up just 25% of its total assets.

Again, Buffett might not have been selling stocks, exactly, but he certainly hasn’t been buying them with anything near the alacrity with which he’s been buying less marketable assests. The net effect is similar: he was quite low on stocks when the crash came.

In a world where many retail investors have unthinkingly bought stock-market funds just because they’re meant to be the best long-term investment, it’s sobering to realize that it’s more complicated than that — but then again, right now it’s pretty obvious to everybody that buying stocks isn’t always a great investment. And right now we’re in a pretty unprecedented situation where millions of people are buying stocks within their defined-contribution pension plans, in the hope and expectation that those stocks will rise so much over time that their savings will grow into enough money to live on in retirement. That’s a very big, very crowded trade — and one which is pretty much unprecedented, since until quite recently most pensions were defined-benefit, not defined-contribution.

The fact is that no one has a clue what stocks are going to do over the next decade or two. We could be entering another bull market; we could just be at the beginning of a huge bear market. What’s clear is that buying stocks is a risky way to invest your life savings, and that a lot of people who took on that risk were not really clear on exactly how much their savings could fall.

But the good news is that, at least if I can rely on a few conversations here and there over the past weeks, most retail investors are reacting to the stock-market crash in exactly the right way: by not even opening their brokerage statements. Right now, knowing the mark-to-market valuation of your stock portfolio is not a useful piece of information to have; it’s much more likely to drive you to do something silly than it is to help you do something prescient.

And looking forwards, it’s clear that the US savings rate is going to start rising in the coming years. That, too, is good news, in a world where there’s no such thing as a free lunch. If you want to save money, save money. Don’t place too much trust in the market to make your money grow, since there’s a good chance the market will end up moving in entirely the wrong direction.

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Which Markets are the Hardest to Move?

Posted on November 3, 2008 by Felix

Jim Surowiecki this week looks at what he calls "ancillary markets" — things like futures, the VIX, or credit-default swaps — and the effect they have on the stock market:

Even if these ancillary markets aren’t being gamed, the attention paid to them is out of all proportion to their informational worth. Because they are small relative to the elephantine U.S. stock and bond markets, it doesn’t take a lot of money to move them significantly, and since they have low margin requirements, speculators can have a big impact on prices while putting up only a little cash. Credit-default-swap contracts, similarly, are generally not that expensive, so fairly small investments can move prices noticeably. When U.S. stock-market investors take their cues from these other markets, the tail is wagging the elephant.

I think this is probably true, but I’d love to see some hard facts on this. Is there any quantitative data about how much money it takes to move different markets an equivalent amount? How much money would it take to send a CDS spread gapping out, and how much money would it take to that stock’s price up or down? And how big is the difference between those two numbers? Has anybody done any research on this?

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Financial Crisis: Not Hitting Brokers

Posted on November 3, 2008 by Felix

Just how parlous a state is Wall Street in right now? In one of the more encouraging signs I’ve seen of late, a fight is brewing at Merrill Lynch — over the size of the "retention bonuses" that Bank of America is going to have to pay Merrill brokers in order to persuade them not to leave their own firm.

Officials declined to comment on criticisms of its bonus pool, but a person close to the situation told The Post the bulk of the bitterness is coming from the lowest-producing advisers – a group Merrill is looking to shed.

Indeed, some brokers have been offered zilch to stay on board the combined team, while those who have been offered bonuses – just 50 percent of the work force – represent nearly 80 percent of Merrill’s broker business, this person said.

Remember, these are one-off retention bonuses we’re talking about here, not the annual bonuses which Wall Street spends so much time obsessing about. Getting fired is very bad. Seeing your annual bonus reduced is bad. But not getting a retention bonus on top of your annual bonus? When that’s the worst thing that brokers have to complain about, I can’t figure that Wall Street is in particularly dire straits.

The lesson here is that good old-fashioned stockbroking has managed to survive the financial crisis pretty well. Investment bankers have seen their business dry up entirely in many cases, but stockbrokers still have their clients, and those clients are even more concerned about the market than they have been in the past. And in general, the more focused that clients are on the market, the more money the brokers make. So while institutional Wall Street is doing badly, retail-facing Wall Street still seems to be doing OK.

Update: I’m told that I’ve got this wrong, and that stockbrokers don’t get an annual bonus, instead working on an "eat what you kill" basis. But the bigger point remains: annual compensation, going forwards at Bank of America, will be if anything higher than it was at Merrill Lynch, given that a chunk of it is paid in stock and anybody paid in Merrill Lynch stock is pretty unhappy right now. So why would you need a retention bonus on top of that?

Update 2: John Carney claims the problem is that the BofA compensation scheme might create more of a conflict of interest for brokers than existed at Merrill, with brokers incentivized to make money for the firm rather than for their clients. But how a retention bonus is supposed to fix that problem I have no idea.

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How AIG Failed

Posted on November 3, 2008 by Felix

The WSJ shines a bit more light on what went wrong at AIG today, with a story centering on the chap who designed its risk models, Gary Gorton. In a nutshell, anybody writing credit protection runs two risks: the default risk of the underlying security, on the one hand, and market risk, on the other. It seems that AIG only ever asked Gorton to worry about default risk; no one ever bothered to calculate the risk that CDS spreads would gap out, forcing AIG to take billions of dollars in mark-to-market losses and post many billions of dollars more in collateral.

Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances…

AIG began selling credit-default swaps around 1998. Mr. Gorton’s work "helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money" because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton’s work didn’t address the potential write-downs or collateral payments to trading partners.

Incidentally, AIG Financial Product’s Joseph Cassano was kept on as a consultant after he retired in February — at a rate of $1 million per month.

The WSJ also reports, without citing even anonymous sources, on the subject of Goldman’s exposure to AIG, and the amount of AIG collateral that Goldman now holds:

Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG — most of it before the U.S. stepped in.

Goldman protected itself in other ways, too, since it’s not easy getting that collateral:

Late last October, Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and it ultimately posted $1.5 billion. Goldman hedged its exposure by making a bearish bet on AIG, buying credit-default swaps on AIG’s own debt, according to one person knowledgeable about this move…

Mr. Gorton attended the Federal Reserve Bank of Kansas City’s annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, "The Panic of 2007," which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. "It is difficult to convey," he wrote, "the ferocity of the fights over collateral."

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let’s say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you’re happy, and making money. But let’s say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

As far as AIG was concerned, it was one of the biggest companies in the world, more than capable of weathering any mark-to-market storm — and therefore all it cared about was default risk, not market risk. But as a result, it took on much more market risk than it was really aware of — and that market risk ended up forcing the entire company into the arms of the US government.

The lesson, of course, is simple, but hard to learn: it’s not the risks you measure which bring you down, it’s the risks you don’t measure. But protecting against those risks is very, very hard.

Posted in derivatives, insurance | Comments Off on How AIG Failed

Extra Credit, Sunday Edition

Posted on November 3, 2008 by Felix

Iceland, Mired in Debt, Blames Britain for Woes

If we only had a financial system: And how the lack thereof caused the present crisis.

GM needs bankruptcy, not a bailout

ICE to Buy Clearing Corp. as Big Banks Support Plan: Strong competition for the CME plan, which is probably a good thing.

The Financial Aid Test for Banks: If you want a Treasury recapitalization, you’d better make sure your Community Reinvestment Act rating is solid.

Pr(Sarah Palin=President)>Pr(John McCain=President)?

And finally, the story of the carbon weevils:

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When Wall Street Takes Advantage of the Public Sector

Posted on November 3, 2008 by Felix

Andrew Clavell called it, back in February:

Let’s assume you work at a Pennsylvania school board… The more complex the structured product, the more opportunity for agents to extract fees at your expense… If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t.

OK, so he got the state wrong. But the NYT has an astonishing tale today of what happened to a school board in Whitefish Bay, Wisconsin. They were persuaded by an investment banker, who hailed from a local shop called Stifel Nicolaus, to invest in a leveraged synthetic CDO. It was a high-risk, low-return instrument:

If just 6 percent of the bonds insured went bad, the Wisconsin educators could lose all their money. If none of the bonds defaulted, the schools would receive about $1.8 million a year after paying off their own debt. By comparison, the C.D.O.’s offered only a modestly better return than a $35 million investment in ultra-safe Treasury bonds, which would have paid about $1.5 million a year, with virtually no risk.

Why on earth would they take such a deal? Well, the investment banker, for one, was highly incentivized: his firm made about $1.2 million on the deal.

In the same story, we learn about a peculiar debt instrument issued by New York’s own Metropolitan Transportation Authority, which seems to be some kind of floating-rate note with an embedded put option, not to the MTA, but to the underwriter:

Variable-rate bonds had a hitch: many investors would purchase them only if a bank like Depfa was hired as a buyer of last resort, ready to acquire bonds from investors who could find no other buyers. Depfa collected fees for serving that role, but expected it would rarely have to honor such pledges…

When the bank was downgraded, investors dumped those transportation bonds, because of worries they would get stuck with them if Depfa’s problems worsened. Depfa was forced to buy $150 million of them, and bonds worth billions of dollars issued by other municipalities.

Then came the twist: Depfa’s contracts said that if it bought back bonds, the municipalities had to pay a higher-than-average interest rate. The New York transportation authority’s repayment obligation could eventually balloon by about $12 million a year on the Depfa loans alone.

This is a crazy premium. There was a total of $200 million of the bonds in question; if the debt service on those bonds rose by $12 million a year, that would mean Depfa was charging a whopping 600 basis points extra in interest payments when it took possession of the bonds. Again, what bond issuer would ever agree to such a thing?

The NYT story never says what these bonds were called, or exactly how the "buyer of last resort" facility was structured, so any more information on that front would be very welcome. But what’s very clear is that public-sector issuers and investors were taken for a ride by Wall Street. Which I guess is nothing new, but it’s not going to help the banks one bit now that they’re turning to the public fisc for bailouts.

Posted in banking, bonds and loans | Comments Off on When Wall Street Takes Advantage of the Public Sector

Liaquat Ahamed’s Lehman Question

Posted on November 2, 2008 by Felix

Add economic historian Liaquat Ahamed to the ranks of those, like Paul Krugman, who think that monetary policy has at this point done all that it can do, and that the next important step will have to be fiscal. I was privileged to have lunch with Liaquat on Friday, and was the recipient of a fascinating disquisition on the kinds of global contagion which caused the Great Depression.

One of the things which interested me most was how incredibly global the causes of the Depression were; among them were the massive inflows of US funds into Germany between 1924 and 1928, followed by a sudden stop in 1929 and the collapse of Germany’s banking system in 1931, with its attendant and enormous knock-on effects in the UK and US. If you think that the downside of globalization is a new thing, be sure to read Liaquat’s book when it comes out in a couple of months: it will show you that history repeats itself much more often and more closely than you might think.

Liaquat also put his finger on a question which I have to admit has been troubling me as well.

According to its official balance sheet, Lehman Brothers had total stockholder equity, when it went bust, of about $26 billion: assets of about $639 billion minus liabilities of about $613 billion.

Lehman’s shareholders have, of course, been wiped out; its assets, once they’re liquidated and worked out, will go to its bondholders. Those bonds are trading at no more than about 10 cents on the dollar, which implies that the assets, far from being worth $639 billion, are in fact worth only about $60 billion.

Now I understand that things go at a discount when they’re liquidated. But a $580 billion discount? That’s beyond sense. There’s something weird going on here, which I hope someone in the blogosphere will be able to explain to me.

Did Barclays and Nomura somehow snatch up the asset side of Lehman’s balance sheet for pennies on the dollar, while leaving the liabilities behind? If not, what happened to that $639 billion in assets? Was it really worth only a tenth of that, implying fraud on an unprecedented level by Lehman’s senior management? Is the market massively underpricing Lehman debt? Or is there something obvious which I’m missing here? Any answers would be gratefully received not only by me but also by Liaquat.

Update: We have some of the answer. A lot of Lehman’s liabilities were secured, primarily in the form of repos and reverse repos. The unsecured liabilities were closer to $100 billion than to $600 billion. So if the unsecured liabilities are only worth 10 cents on the dollar, then that implies Lehman’s assets were worth only $100 billion less than we thought, rather than $580 billion less than we thought. In a fire sale situation, that’s conceivable.

I also spoke to a Wall Street analyst today, who told me about one phenomenon which helps explain the Lehman insolvency hole. Let’s say that Lehman brothers was writing and buying credit protection on lots of credits such as, say, Ford. At any given point in time, its exposure to Ford defaulting was minimal, since every CDS that it had sold on such an event was offset by a CDS that it had bought.

But then Lehman defaulted — and all the CDS that Lehman had sold on Ford were cancelled. The counterparties went out into the market, the Monday after Lehman’s collapse, and got three quotes for what it would cost to replicate the credit protection that they had bought from Lehman. Under the terms of their CDS contract, the counterparties then became unsecured creditors (to the degree to which Lehman hadn’t already put up collateral) for the lowest sum quoted — a sum which, given what the markets were like that Monday, was incredibly high.

On the other hand, where Lehman had bought credit protection on Ford, nothing was cancelled: that CDS continued to sit on Lehman’s balance sheet without anything special happening. So Lehman’s liabilities exploded, since the bank now owed billions of dollars to counterparties where it had written credit protection. But nothing similar happened on the asset side of the balance sheet. Which would help explain why Lehman’s debt is so cheap.

Posted in banking, bonds and loans, economics | Comments Off on Liaquat Ahamed’s Lehman Question

Art: Signs of Desperation

Posted on November 2, 2008 by Felix

The front page of the NYT’s arts section today is dominated by a 2,000-word auction preview by Carol Vogel. The headline is "Tapped Out?" and the article continues on all of page 16, under the hed "Auction Houses Brace for Fall". Vogel’s tone is highly pessimistic: "anxiety is the dominant mood," she writes, adding that Sotheby’s and Christie’s are "whistling in the dark" in their search for buyers.

Directly opposite Vogel’s article, on page 17, is a full-page ad from Sanford Smith, who runs the ART20 fair which is at the Park Avenue Armory this weekend. He writes:

In the 40 years I have been in the art business as a collector, dealer and show producer I have never seen the value of quality merchandise do anything but increase…

Now is the time to buy… Your purchase of art will not only increase in value but will also bring beauty and pleasure into your life — unlike your portfolio.

Smith is not alone in pushing this line. In recent weeks I’ve received a steady stream of emails from dealers and art consultants, all of them variations on the theme that art is a good investment at a time when more mainstream asset classes are plunging in value. Funnily enough, I never got these emails during the boom years, when art really was getting more and more expensive.

There’s a definite whiff of desperation in the air, and I can advise anybody that if they’re talking to a dealer who’s saying that his wares are a good investment, they should run very fast in the opposite direction. Here’s an exercise for anybody who’s not convinced: have a look at the art which has increased the most in value over the past decade, and ask yourself if any of it was sold as a good investment.

Incidentally, this downturn is already presenting nice opportunities to anybody still in the market for major works. Sotheby’s, for instance, has a very important 1916 Malevich, onto which it has slapped an eye-popping $60 million estimate. But it knows for a fact there’s at least one buyer out there:

Determined to offset some of the risk, Sotheby’s has lined up what it calls an irrevocable bid on the painting. That means the auction house has a buyer who has contractually agreed to purchase the painting for an undisclosed sum.

If someone else is willing to pay more, the original bidder will get a share of what is called the upside: the difference between what he was willing to pay and the higher price.

This is a no-lose proposition for the buyer. If there aren’t any other bids, he gets the Malevich at what he clearly considers a good price. If there are other bids, he gets paid in cash for losing the auction.

The lesson here is that if you definitely want any major painting that is coming up for auction, talk to the auction house in advance. You might well be able to work out a deal, and there’s a very good chance you’ll be able to persuade them to waive a large chunk of their commission if you submit an "irrevocable bid".

Posted in art | Comments Off on Art: Signs of Desperation

Lehman Europe and Prime Brokerage Counterparty Risk

Posted on October 31, 2008 by Felix

Euromoney has allowed free access to its November cover story on Lehman Brothers Europe for this weekend only, so go there now and read it while you can. It starts off at much the same place as John Hempton’s blog entry from a couple of weeks ago, about the critical importance of the US Securities Exchange Act of 1934. Here’s Hempton, on the consequences of the act:

The result. Whilst Lehman brothers went bust, Lehman’s US broker dealer did not. This pretty well saved the US hedge fund industry.

Europe however was a different story. Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman. Many funds have folded. Far more have been nicked. Whilst the US hedge fund business is currently looking dazed, confused and a little problematic, the UK business is on life support.

In some sense this is the end of the City of London.

Euromoney’s Helen Avery gives some real-world examples, foremost among them Oak Group’s John James, who has seen substantially all of his assets disappear into the maw of his prime broker, Lehman Brothers International Europe. And the losses were human, too: after hedge fund Olivant found itself unable to vote its stake in UBS because it was held by LBIE, its CFO threw himself in front of an 100mph train at Taplow station in England during rush hour.

The numbers involved are huge: Avery says that more than $22 billion of its clients’ securities were "rehypotehcated" by LBIE, thereby essentially turning those clients into unsecured creditors of LBIE when it went bust.

Avery does add a layer of complexity to Hempton’s take on things: while the US legal regime is certainly friendlier to prime-brokerage clients than London law, a lot of the problems ultimately stem from the fact that Lehman Brothers in the US took all of LBIE’s money out of the UK just before it folded. In other words, if LBIE hadn’t had a rapacious parent which stripped LBIE of all its assets in its final hours, none of this might have happened.

What’s more, although UK prime brokers regularly allow themselves to rehypothecate (ie, onlend) their clients’ securities, US prime brokers also do exactly the same thing, after first asking their clients’ permission. Their clients often say yes, because they can essentially make free money on their long positions by allowing their prime broker to lend them out to short-sellers.

As a result, even US hedge funds are more alert than ever to the issue of their prime brokers’ counterparty risk. That means a move away from broker-dealers like Morgan Stanley and towards large commercial banks with a big deposit base, like JP Morgan Chase. Morgan Stanley probably isn’t crying too much over the loss of its prime-brokerage clients, since it wanted to derisk anyway. But it’s yet another big change in the international financial architecture: prime brokers always used to be investment banks; now those banks are either history or being sidelined, while players such as Credit Suisse, UBS, Deutsche Bank, and BNP Paribas are seeing their prime-brokerage operations grow.

What will ultimately happen to the securities onlent multiple times by LBIE? Will they ever find their way back to their original owners? It’s possible, but the best case scenario is that it will take many years. The worst-case scenario is that the money is gone forever, into the $100 billion black hole of insolvency which suddenly opened up when Lehman went bust. If that much money is being lost, it stands to reason that Lehman’s hedge fund clients will count themselves among the losers.

Posted in hedge funds | 1 Comment

Unsympathetic Demographic of the Day: HENRYs

Posted on October 31, 2008 by Felix

Do you pity the HENRYs ("high earners, not rich yet")? If you’re Shawn Tully you do. In an astonishing feat of reporting, he’s discovered that if you ask people whether they feel rich, especially if they work hard and have children, they’re liable to say no, even if they’re earning very large amounts of money:

Our cover subjects, Lindsay Mayer and her husband, Zach, a Dallas attorney, feel stretched on $500,000 a year. Lindsay, a senior manager at telecom provider Avaya, has also started her own small business on the side, investing $60,000 to launch a company called Maelee Baby that markets stylish diaper totes. Once again, their biggest expense outside of taxes and their mortgage is the children. The Mayers pay $2,200 a month for child care for their two kids. "Child care is the real killer," says Lindsay. "We’ve achieved so much. We can’t understand why we’re still worrying about money." The last ten days of each month, she and her husband invariably remind each other to watch expenses. "It baffles us that we have to say that to each other," she says.

I just can’t make this add up. Assume a 40% tax rate, between the feds and Texas, and they’re making $25,000 a month after tax. Their house cost $350,000 in 2005 — which implies roughly $2,000 a month in mortgage payments. They’re also "pouring money into their 401(k) accounts for retirement," we’re told — so let’s assume that they’re both making the maximum contribution this year of $15,500 each. That’s another $2,500 a month or so between them. Let’s also assume that Lindsay’s took her entire business investment out of this year’s salary, and budget another $5,000 a month for that.

Between mortgage, childcare, 401(k) contributions, and Maelee Baby, then, we’re up to $11,700 a month in expenses — that’s about $140,000 a year, less than half their take-home income. The Mayers make $500,000 a year, and claim to be "not spending a lot of money on extra stuff". So how come they’re "still worrying about money"? Simple: worrying about money is a perfectly natural and human thing to do. Everybody does it, regardless of their income. But the idea that the Mayers are "not rich" is laughable.

(Via Fox)

Posted in pay | Comments Off on Unsympathetic Demographic of the Day: HENRYs

The 50bp Lower Bound on Interest Rates

Posted on October 31, 2008 by Felix

There’s been lots of talk in recent days of the "zero bound" on the Fed funds rate — which is exactly where the Taylor Rule would put it. But the real bound might be halfway between here and there, at 50bp. "Beyond that," as Greg Ip says in the Economist this week, "things get tricky" :

If the Fed did target zero, it might encourage banks just to leave their money at the Fed rather than lend it to each other, causing the federal funds market to dry up. It would also make it hard for money market mutual funds to pay a competitive yield and cover their operating expenses. Money would flow out of them and into government-guaranteed bank deposits, straining bank capital ratios.

Tracy Alloway has much more on the money-market issue today: it turns out that 26% of all money-market funds charge more than 50bp in fees alone. Of course, money-market funds should be able to get more than the bare Fed funds rate on their money — but the actual rate has been undershooting the target rate quite consistently of late, and in any case investors expect some non-negligible interest rate on their funds.

Any broad-based move out of money-market funds and into bank deposits wouldn’t just strain bank capital ratios, it would also devastate the CP markets, where such funds are extremely important buyers.

Alloway also mentions that below 50bp we’d be likely to get many more repo fails — which would significantly damage one of the few remaining sources of reliable liquidity. Which implies, given the way in which real-world interest rates have barely budged in the face of Fed easing, that the downside to cutting past 50bp is significantly greater than any upside. There might be another half-point in rate cuts in the offing, but beyond that, the Fed will probably cut no further.

Posted in fiscal and monetary policy | 1 Comment

Extra Credit, Thursday Edition

Posted on October 31, 2008 by Felix

It’s time: "The Economist does not have a vote, but if it did, it would cast it for Mr Obama. We do so wholeheartedly."

The £5,000bn bailout: "£5,000bn has implicitly or explicitly been made available by central banks and governments since April 2008 to support wholesale funding by banks. That is a genuinely big number. It’s equivalent to about a sixth of the total annual economic output of the whole world."

When the Press Wreaks Havoc: How an erroneous Dow Jones report sent the Dow down 400 points.

Gasparino v. Ratigan: Simply bizarre.

Posted in remainders | Comments Off on Extra Credit, Thursday Edition

Blogonomics: The Cost-Benefit of Bloggers

Posted on October 31, 2008 by Felix

Thanks very much to Tyler and Brad for the kind words; I hope to be here for a while yet. But Tyler also makes an interesting point about blogonomics:

Media, like new library books, are being hurt by the downturn and the slowing of advertising dollars. I fear that the non-independent blogosphere may be in for a bit of a financial bloodbath. So often the bloggers were an "investment in long-term name and image" rather than a profit center.

There’s no doubt that ad dollars are going to be harder to come by in the coming quarters. Websites are getting better and more popular, but that also means inventory is rising faster than ad budgets. And with financial-services advertising providing the backbone of many websites, the consolidation and budget cuts in that industry will hit us content providers very hard.

It’s also true that if you put a blogger on payroll, it’s not going to be easy for a startup site to cover that payroll from selling ads against the blogger’s pageviews alone — especially now that bloggers make just as much money as regular journalists, and a good ad sales person costs much more still.

But if you are going to invest in your own editorial content, bloggers are often a very smart way to go. They’re lean, since they need very little editing and often work from home. They build a reliable readership: in a world where loyal readers are defined as those who visit five times a month or more, blogs often get readers coming back more than once a day, especially if and when the comments streams get lively. And, yes, they’re cheap, compared to any other original content. On a dollars-per-word or even on a dollars-per-pageview basis, it’s hard for other forms of editorial content to compete with bloggers.

If you’re a monthly magazine like, say, the Atlantic, and you want people to visit your website, you need something to draw them in. You can buy traffic, of course — but unless those bought visitors come back, that’s going to get very expensive very quickly. It’s generally preferable to build something great instead, so that people want to visit regularly. And one relatively easy way of doing that is to hire some good bloggers. (When I say "relatively easy", I mean that it’s easier than most of the alternatives, not that it’s easy.)

On the other hand, there’s no law which says that every major magazine has to have a hugely popular website if it is to be a success. Yes, you have to have some kind of web presence. But elaborate websites don’t come cheap, and if you’re in a cutting-back mode and websites aren’t your core competency, then those websites — bloggers and all — can quite find themselves on the chopping block much more quickly than they ever anticipated.

Posted in blogonomics | 1 Comment

Chart of the Day: The Russia-Brazil Spread

Posted on October 30, 2008 by Felix

After writing about my BRIC decoupling thesis, I asked the friendly chaps at Markit if they could share with me the 5-year CDS spreads for the four countries in question. It turns out that India isn’t really much of a credit — it doesn’t like to issue foreign debt — and that therefore its CDS are very illiquid. But here’s what the other three have done over the past year:

bricspreads2.jpg

Clearly, while they all tend to move in the same direction, the magnitude of their respective moves is very different. And interestingly, even after the most recent rally, the spread between Russia and Brazil is continuing to gap out, and is now over 500bp:

russia-brazil.jpg

Remember, historically Russia has trade through Brazil, as you can see: it’s only been trading wide of Brazil in the past two months. So the fact that it’s now 500bp wide of Brazil is kinda crazy. After all, they’re both mainly commodity plays, and their stock markets have both been devastated. But the credit markets show a huge distinction between the two countries which isn’t easily visible elsewhere.

This kind of information has never been more important or interesting, and it’s a tragedy that it’s not more easily available. As Andrew Clavell says:

Opacity equals profitability for the sell side, I suppose; it has always puzzled me why the bond market, many multiples the size of the equity market, has transparency a fraction of that of the equity market.

With any luck, one of the consequences of the credit market is that people simply won’t stand any more for not having credit-market information. Even if your only investment is in a S&P 500 index fund, you’re still probably more interested, these days, in where the CDX is trading than you are in where the S&P 500 is trading. After all, the CDX has been a very good leading indicator of what’s about to happen to your stocks.

I know that Markit is interested in getting its information out there; I look forward to the day when it can be found on Yahoo Finance just as easily as any stock price. In the meantime, we’ll just have to make do with blog entries from people with Bloombergs.

Posted in bonds and loans, derivatives, emerging markets | Comments Off on Chart of the Day: The Russia-Brazil Spread

The Homeownership Bubble

Posted on October 30, 2008 by Felix

The US goverment still, it seems, thinks that encouraging homeownership is a very good idea:

Four former secretaries of the Department of Housing and Urban Development told a packed meeting room… that just because the financial system is flawed doesn’t mean the dream should die.
"The American dream is to own a home. I’m not foolish enough to believe that every person ought to own one. But if they aspire to that dream we should do everything we can to help them," said Alphonso Jackson, who stepped down as HUD secretary in April.

This is silly. With millions of Americans entering the ranks of the unemployed, with the broader economy going into a vicious recession, and with homeownership rates already at unsustainably high levels, the last thing the government should be concentrating on is pushing homeownership rates higher. Instead, it should focus on affordable housing for all Americans.

Steve Kerch’s article does have one very odd assertion, though:

The homeownership rate peaked at just under 70% in the late 1990s, but has fallen off since.

If this were true, it would say a great deal about the subprime boom. But it’s not true. Here’s the chart, from the Census Bureau’s data:

ushomeownership.jpg

The peak of the chart, just above 69%, came between Q2 2004 and Q1 2005. In the 1990s, the rate never went higher than 67%. And this is a data series where each percentage point makes a huge difference: in a country of 100 million households, a rise of 1 percentage point means an extra 1 million homes being owned. If those homes are worth an average of $250,000, then that’s $250 billion.

Right now, we’re at 68% homeownership. To get back to the historical mean of 65%, some 3 million homes worth something in the region of $700 billion will have to get bought by landlords. That’s going to take a while, but it’s pointless trying to delay the inevitable. We’re in a homeownership bubble right now, which is bursting. Let’s try and concentrate on the upside — cheaper housing — and not try to keep that bubble artificially inflated.

Posted in housing | Comments Off on The Homeownership Bubble

When Banks Stop Underwriting

Posted on October 30, 2008 by Felix

Citigroup and Credit Suisse are so damaged by the financial crisis, it seems, that they’ve given up underwriting loans to their biggest and most valuable corporate clients, including Nestle and Nokia. Instead, they’re linking those loans to the companies’ CDS spreads. This is not a good idea, as Sam Jones notes:

Banks are supposed to be arbitrary lenders, in the sense that they perform, in-house, the necessary due diligence on on the creditworthiness of a company, and lend to that company accordingly.

Tying rates to CDS, though, is effectively outsourcing opinions of the creditworthiness of a company to the market. Indeed, it’s more of the same “outsourced” due diligence from banks that in part inflated the ’00-’07 debt bubble in the first place.

I’ve never been particularly impressed by arguments which say that indexing is a bad idea because if everybody did it, there wouldn’t be any price-setters. But this is a clear case of where that kind of an argument works. Banks have more and better information about borrowers than anybody else, they should be the price-setters. If they let the market decide, on the basis of worse information than the banks themselves have, they’re making the whole edifice less robust.

Note that the problem here is one of who’s doing the underwriting, and is not anything related to CDS: the banks could easily have used bond spreads instead, if they were liquid enough. Which is why I hate Bloomberg’s lede:

Citigroup Inc. and Credit Suisse Group AG are among banks tying corporate loan rates to credit- default swaps, raising borrowing costs and exposing companies to derivatives accused of crippling the financial system.

Clearly, the "derivatives accused of crippling the financial system" meme is not one which is going to go away. Even when it has very little place in a story such as this.

Posted in banking, bonds and loans, derivatives | Comments Off on When Banks Stop Underwriting