Economic and Financial Bad News

Posted on October 30, 2008 by Felix

If you’re one of those people who needs a negative GDP number to convince yourself that we’re in a recession, here you go. But the headline -0.3% figure isn’t the worst bit: that would be the 8.7% fall in disposable personal income. If there was any doubt about the outcome of this election, that number alone should put it to rest: there’s no way that the incumbent party can win in that kind of economic environment.

And while the macro picture is bad, the financial picture is just as gnarly. The NYT has had a great pair of back-to-back pieces on important financial stories which people aren’t paying enough attention to: Diana Henriques looked at the The Reserve Fund yesterday, while Mary Williams Walsh, today, turns her attention to AIG.

While both of these entities look like studies in incompetence, The Reserve is clearly the worse of the two. The shock of breaking the buck seems to have been so great that it suffered some kind of institutional cardiac arrest, to the point at which it has become utterly unresponsive:

Initially, the company simply announced that it would delay redemptions from the Primary Fund for up to seven days, as allowed by law. Customers were somewhat reassured, but anyone trying to get additional information was met with busy phone lines and unanswered e-mail.

The news occasionally posted on the fund’s Web site got steadily worse. On Sept. 18, investors in a host of other Reserve money funds learned that their money would be tied up for as long as a week; that delay later became open-ended. On Sept. 19, the fund delayed redemptions from both the Primary Fund and the US Government Fund indefinitely.

Since then, investors have been on a roller coaster of broken promises, with the company repeatedly blaming its record-keeping systems for delays.

Several requests for comment from management of the Reserve Fund have been declined. “I have no confidence at all in what it says,” said Mrs. Dews.

This is incompetence of the highest order, in the context of a world where institutional investors are actually putting money in to money-market funds. A couple of days’ delay in communication is one thing; a month and a half is so far beyond unacceptable as to mean that The Reserve is going to be tied up in litigation for years. Certainly while The Reserve has shut down like this, it won’t be the beneficiary of any inflows. Quite the opposite: all its investors are likely to leave as soon as they can — including, I suspect, the Chinese government, which has as much as $100 billion at least $5.4 billion invested with The Reserve.

As for AIG, the problems there stem from the fact that the financial-products people kept on insisting that their assets were just fine, thank you very much, that marking to market was a silly thing to do, and that their CDS portfolio was worth much more than the market said it was worth.

Of course, they were spectacularly wrong.

I’m reminded of Alea’s "why you should cut your losses quickly" chart from last Friday. You thought it was a bad idea for SocGen to liquidate Jerome Kerviel’s massive stock-futures position on a US holiday? Well, maybe. But in hindsight, if they’d decided to wait for the markets to rebound, they would have lost much more. AIG, in contrast, decided to hold on to its positions for dear life, and pray they’d go up:

After the insurer’s credit rating was downgraded in September, its G.I.C. customers had the right to pull out their proceeds immediately. Regulators say that A.I.G. had to come up with $13 billion, more than half of its total G.I.C. business. Rather than liquidate some investments at losses, it used that much of the Fed loan.

Clearly, liquidating in September would have been a much better idea than holding on through October: I’m sure the losses AIG was worried about have gotten substantially larger over the past month.

And then of course there’s the CDS portfolio, which AIG has been overly optimistic about every step of the way. It could have hedged in 2007 or earlier this year, but passed up all opportunities to do so, and as a result it is now facing hundreds of billions of dollars in unnecessary losses. This is why marking to market is a good thing: it forces companies to realize losses and liquidate early at a survivable loss, rather than adopting the hope-and-pray strategy and seeing losses become so large as to be systemically dangerous.

Finally, in the intersection of the economy and finance, James Hagerty of the WSJ looks at Frannie spreads, which have been widening out steadily for the best part of two months now, despite nationalization. The first thing the new Treasury secretary should do is implement an explicit government guarantee on the senior debt of both companies. It won’t cost anything, since the guarantee is there already, just not explicit. But it might help mortgage rates come down rather than up during a time when the Fed’s rate cuts clearly aren’t doing the job.

Posted in bonds and loans, economics, fiscal and monetary policy, housing, insurance | Comments Off on Economic and Financial Bad News

Extra Credit, Wednesday Edition

Posted on October 29, 2008 by Felix

Treasury, FDIC Crafting Plan to Rework Millions of Mortgages: We need a lot more detail than this before working out what to make of it.

So how many hedgies did Porsche really kill? Not as many as you might think.

IMF ‘has six days to save Pakistan’: And that was two days ago. Here’s some of what the Fund is said to be demanding.

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

Might Blackstone Go Private?

Posted on October 29, 2008 by Felix

At lunch today with Mick Weinstein of Seeking Alpha, I wondered whether Blackstone, which currently has a market capitalization of around $2 billion, might not be a takeover candidate. After all, it would be something of a jewel for many big banks.

Mick made the obvious point that Blackstone isn’t controlled by its public shareholders, it’s controlled by Steve Schwarzman, who would never sell for a single-digits sum. Which is absolutely true. But that doesn’t mean the public shareholders might not get bought out — by Steve Schwarzman.

After all, Schwarzman has said that "this kind of environment is tailor-made for making absolute fortunes in the private-equity business" — even as being a public company is clearly not helping him in the slightest. And Wes Edens, the CEO of Fortress Investment Group is already, um, joking about going private:

He quipped that the market had cheapened the value of Fortress’s portfolio companies so much that he would be willing to buy them all back. He also joked that if Fortress stock fell much further, to $1, he would institute a hostile takeover of his own company.

Schwarzman and Edens certainly have the ability to take their companies private. It’s what they’re used to, and their life was much happier back in those days. So who’s going to stop them?

I ought to mention a couple of other things I talked about with Mick: firstly, that Seeking Alpha entry about Microvision which got pulled following complaints from the company. It turns out, in light of subsequent events, that it was pretty much on the money. But it was never reinstated, because the author wouldn’t return emails or have any real contact with Seeking Alpha. Without any communication with an author, Seeking Alpha won’t publish anything.

Indeed, they need not only communication, but also your real identity: Notable Calls was dropped from Seeking Alpha because the author wouldn’t reveal his identity to Mick. A shame, because it’s an excellent blog.

Mick also talked about ways in which Seeking Alpha might do better by its contributors, without necessarily going down the revenue-share route. There are moves afoot to allow contributors to advertise for free on their own pages; the Seeking Alpha team has also constructed a "top contributors" algorithm which might prove popular. And there’s even noise about moving to Disqus for comments, which would be great, since one of the most annoying things about SA is the fact that you end up with two different comments streams. My suggestion was a financial-services tab, which could be populated with contributors’ firms.

The fact is that most of Seeking Alpha’s contributors are simply not in the kind of financial position where a revenue-share agreement would make any difference to them. But there are other things which they would like, and which Seeking Alpha might be able to provide. The more of them that SA implements, the happier its contributors are likely to be.

Posted in blogonomics, hedge funds, private equity | Comments Off on Might Blackstone Go Private?

Stock Volatility Datapoint of the Day

Posted on October 29, 2008 by Felix

We’re used to big stock-market swings in the last hour or even half-hour of trading. But the last ten minutes? The Dow was at 9,350 at 3:48; ten minutes later, it was at 8,960. That’s a drop of almost 400 points, or 39 points a minute.

At that rate, it would have taken just 230 more minutes — less than four hours — to go all the way to zero. Never have those decimal points in Dow reports seemed so silly: we’re rapidly reaching the point at which all you can do with any meaning is round to the nearest thousand.

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CDS: The Less You Know, The Worse They Look

Posted on October 29, 2008 by Felix

For those of you who like your CDS exposés presented in the mellow tones of Leonard Lopate and Jesse Eisinger over the course of a leisurely half-hour, here you go.

This is a sober public radio progam, not a finger-pointing piece of populism like the awful 60 Minutes piece on the same subject. But it’s worth noting a broader dynamic, wherein the least informed commentators are also the most alarmist.

Think of a spectrum of opinion, with "credit default swaps are the root of all evil" on the left, and "credit default swaps are a brilliant invention which helped spread risk and mitigate the effects of the financial crisis" on the right. I’m a right-winger, on this spectrum, albeit not a rabid one: I think that a large part of the financial crisis was caused by unfunded super-senior CDO tranches, which were made possible only by misusing CDS technology.

Jesse’s to the left of me; I’d say he’s center-left in terms of financial journalists generally. Most market participants are to the right of Jesse, somewhere in my neighborhood. But Lopate is clearly to the left of Jesse: he keeps on wanting to lay enormous amounts of blame on credit derivatives and the people who structured them, drawing unhelpful parallels with Bankers Trust and generally asking leading questions of Jesse who then finds himself having to tell Lopate that it’s really not as egregious as all that.

60 Minutes, of course, went further still, and entitled its segment "Financial Weapons of Mass Destruction", making the now-common claim that Warren Buffett had described credit default swaps thusly. But Buffett wasn’t talking about CDS when he used that famous phrase, he was talking about common-or-garden derivatives which no one seems to be worrying about at all.

Or rather, everybody seems to be using the term "derivatives" interchangeably with "credit default swaps" — which is just plain weird. Are CDS dangerous because they’re derivatives? Well in that case there are much bigger problems than the CDS market, which is a small fraction of the total derivatives market. Are they dangerous because they’re not exchange-traded, instead changing hands in the OTC market? Again, just look at interest-rate derivatives, where the OTC market dwarfs any exchange.

60 Minutes is probably the worst offender here: it claims that the CDS market "blew up Wall Street", for all the world as if we would have been just fine with falling housing prices, just so long as no mortgages were hedged with CDS. But no one ever seems compelled to mention that CDS, like all derivatives, are a zero-sum game with just as many winners as losers — unlike mortgages, where it’s entirely possible for everyone to be a loser. If the losses in the economy are widespread, and they are, then that can’t be due to CDS: if the only winners you can find are a couple of smart-or-lucky hedge fund managers like John Paulson and Andrew Lahde, then total losses on credit default swaps simply can’t have been all that big.

I had lunch yesterday with Shane Akeroyd of Markit, and he had a more sophisticated take on what we’re seeing. The problem isn’t CDS specifically or even derivatives in general, he said: the problem is that the world had an enormous amount of leverage, and all that leverage is now being unwound at once. Do CDS make it easier to firms to lever up? Yes — but if CDS hadn’t been around, some other instrument would have been found which had the same effect. Blaming CDS for the market meltdown is like blaming Microsoft Word for a magazine article you don’t like: it might have made things easier, but it was hardly necessary.

Credit existed as an asset class long before CDS came along. That’s one of the reasons that the Treasury and rates markets are so liquid: anybody wanting to make a pure credit play would take a position in corporate bonds, say, and then hedge their interest-rate exposure. But corporate bonds can be illiquid, and hard to find or short, so the arrival of the CDS market made it much easier to trade credit. That’s a good thing — as I’ve said before, if it weren’t for the CDS market, none of the the credit world would be functioning right now, and we’d be in an even worse situation.

But it’s always easier to look for someone to blame than it is to really try to understand the dynamics of a highly complicated financial crisis. If that blame can be laid at the feet of a market no one’s ever heard of, and especially if you can put huge scary numbers like $58 trillion in headlines, no matter how misleading notional numbers are in the world of derivatives, then few editors are going to complain.

And one final note on big scary numbers: Elisa Parisi-Capone asked last week what happened to all the missing Lehman Brothers CDS. The DTCC saw only $72 billion of the $400 billion in outstanding Lehman CDS, she says: where’s the other $328 billion?

The answer is that there never was $400 billion in outstanding Lehman CDS. That number was a quick-and-dirty Citigroup estimate which became conventional wisdom very quickly, even though it was later revised down substantially. In general, the media loves to latch on to the biggest number it can find, and so the $400 billion gained a lot of currency even though it was pretty much pulled out of thin air.

As a general rule, then, it’s worth taking anything you read or hear about credit default swaps with a very large grain of salt. It’s not an easy subject to understand, and it’s much easier to jump to conclusions than it is to do laborious homework and end up with a nuanced position. Besides, bankers who weren’t involved in the CDS market love it when people start blaming CDS, because doing so implicitly leaves them with less blame for themselves. They should take more responsibility, and journalists shouldn’t be so quick to let them off the hook.

Posted in derivatives | Comments Off on CDS: The Less You Know, The Worse They Look

The Dollar’s Not That Strong

Posted on October 29, 2008 by Felix

While I’m throwing darts at Paul Kedrosky, I ought to mention that I also think he’s quite wrong about the dollar. He has a good line — "think of the dollar as Squealer the Pig collectible Beanie Babies circa Christmas 1996, and you begin to get the picture" — but he’s falling prey to the classic error of looking at where the dollar’s coming from, rather than where it’s actually at.

For the past five years or so, the dollar has been the single largest funding currency in a global carry trade worth untold trillions of dollars. People borrowed and sold dollars, buying all manner of other currencies, from the British pound to the Brazilian real. Now that carry trade is being brutally unwound, and the world’s currencies are snapping back to a much more natural level.

The European tourists in New York and the Latin American tourists in Miami all knew it. Lord knows American travellers in London and Paris knew it. The Canadians knew it, the Russians knew it, and, most of all, the Icelanders knew it, buying up shiny new SUVs at massive discounts thanks to their hugely overvalued currency. They all knew that the dollar was very weak. Now, those days are over.

To put it another way, the effect of the carry-trade unwind has been to bring the world closer to PPP than it has been in years. There’s something which just feels right about emerging-market countries being cheaper than developed countries, which means that the decline in the Russian rouble and the Brazilian real doesn’t shock me, even if they are running trade surpluses. And with a declining oil price bringing down the US trade deficit, a large part of the fundamental reason for dollar weakness is going away.

The go-to guy in the blogosphere when it comes to international capital flows is, always, Brad Setser:

This is much more of an unwinding of carry trades than a flight to quality — though there is an aspect of that too. Some Russians for example, seem to have rediscovered the joy of holdings dollars rather than rubles.

The dollar’s rally has a silver lining. It has pulled the RMB up too — and the RMB needed to appreciate against most European and emerging market currencies.

Brad is no dollar bull, but even he doesn’t buy the idea that the dollar is in any kind of bubble right now. And remember that for all the real economy seems to have overtaken financial-industry chaos as the prime cause of market turmoil, the financial sector is still a very long way from being out of the woods. And European banks, in general, have much more leverage than their US counterparts — a commercial bank like Barclays is levered to the kind of degree which would make Bear Stearns blush. If leverage is the root cause of all the recent chaos, then it stands to reason that the euro would get hurt hard.

Besides, remember that the euro, when it launched* at the beginning of 2002, was worth just 88 cents. Today, it’s worth $1.28. That’s a substantial appreciation of the euro and depreciation of the dollar. We just took a rather circuitous route to get here from there, is all.

*Update: "Launched", here, means "launched in physical currency form". The euro existed for three years before that in electronic form, and before the euro there was the ecu, which was originally set at 1 ecu = $1.

Posted in foreign exchange | Comments Off on The Dollar’s Not That Strong

Why Banks Should Lend Out Treasury’s Funds

Posted on October 29, 2008 by Felix

Paul Kedrosky has a peculiar argument today, saying that banks shouldn’t lend the money they’re getting from Treasury:

Banks are looking at a changed world, one with deleveraging everything, consolidation happening apace, and defaults almost certain to rise rapidly over the next 24 months. Imagine that despite all of this banks began “business as usual” lending. What would happen? Almost certainly the banks would see higher levels of non-performing loans and defaults on these new efforts, perhaps even to the point that they would require more capital to reduce solvency fears. And what would we say then? We’d say, “Idiots, why did you race out and loan the money that we gave you into this weakening economy?”

There are a couple of problems with this argument. The first is the idea that loans made now will have higher default rates than legacy loans: I can’t for a minute see why that should be the case, given that everybody expects underwriting standards to have tighened up. But there’s a big difference between tighter underwriting standards, on the one hand, and a credit freeze, on the other.

The bigger problem is that if the banks don’t lend out this new money, the argument for bailing them out in the first place is severely weakened. The reason to bail out banks is that they’re systemically important and that now more than ever they are crucial intermediaries who keep credit moving in the economy. (Now more than ever because the primary bond markets have completely seized up.)

If banks don’t onlend Treasury’s money into the real economy, then they should have been allowed to fail — with FDIC protection for depositors, of course, and maybe even with the government nationalizing unwanted banks and taking on their senior liabilities. At least that way equity holders and sub debt holders would have chipped in a large part of the cost of the bailout.

As the recession bites, a lot of corporations are going to be looking to Washington for bailouts. The big car companies are there already; I’m sure that airlines and Big Agriculture and steel mills and all manner of other concerns will be making the trek as well. If Paul wants to defend a bank bailout which keeps banks solvent without boosting lending, he’ll have to explain why all these other industries shouldn’t qualify for the same kind of thing. And that’s hard.

Posted in bailouts, banking | Comments Off on Why Banks Should Lend Out Treasury’s Funds

Media Buy Datapoint of the Day

Posted on October 29, 2008 by Felix

How much is Barack Obama paying to blanket the networks with a half-hour TV buy during prime time this evening? Would you believe about the same amount as it costs to buy 30 seconds of airtime during the Superbowl?

According to the AP, Obama’s paying $1 million to each of CBS, NBC, and Fox; the infomercial will also appear on Univision, MSNBC, BET, and TV One. The NYT claims that this "is the ultimate reflection of Mr. Obama’s spending flexibility", but given the fundraising numbers which all of the major campaigns announced this year, $3 million seems like little more than a rounding error to me — and is also the going rate for Superbowl ads.

The big lesson here, I think, is how incredibly narrow and tactical ad buys are during presidential election campaigns. Although this is nominally a national election, and although the Obama campaign has been making consistent noises about fighting in 50 states, the structure of the electoral college forces adspend into swing states. The winners are small local TV stations; the networks see none of the hundreds of millions of dollars spent every four years.

Of course, this is no normal media buy; I can’t imagine that Microsoft, say, would be able to buy half an hour of network time for any amount of money, let alone a paltry $1 million. And even at that rate, it makes a certain amount of sense for the networks: they’ll get a healthy audience with zero production costs, while staying newsworthy.

But I don’t think that this buy really demonstrates the depth of Obama’s pockets. After all, the RNC raised $66 million in September; if they wanted to, they could have followed suit. If they choose to concentrate their dollars where they will make the most difference, that’s up to them.

Posted in Media | Comments Off on Media Buy Datapoint of the Day

Extra Credit, Tuesday Edition

Posted on October 29, 2008 by Felix

VW briefly world top company as shortsellers caught: Is Porsche a car company or a market-manipulating hedge fund?

Mrs Watanabe and the sudden rise of the yen: "It was common for Japanese retail investors to be offered leverage of 20 times or more for their cash".

A few suggestions for journalists and bloggers: Put options are insurance policies. And "if you’ve got a theory of finance which could be used to prove that all insurance everywhere is a mirage, a piece of financial charlatanry which can’t possibly work, then you’re not actually contributing much to the discussion."

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

The Financial Crisis Hits the World’s Hungry

Posted on October 28, 2008 by Felix

The extremely poor can’t catch a break, it seems. A year ago, with food prices through the roof, they were at risk of starving to death as a result of not being able to afford to eat. But now, with food prices falling, things don’t seem to have got much better:

The number of hungry around the world is at risk of increasing as the financial crisis cuts investment in agriculture and crops, said Abdolreza Abbassian, secretary of the Intergovernmental Group on Grains at the United Nations Food and Agriculture Organization in Rome. The total increased by 75 million last year to 923 million, the UN estimates.

"The net effect of the financial crisis may end up being lower planting, lower production," Abbassian said. "More people will go hungry."

Interestingly, this seems not to be a result of lower crop prices per se, so much as less credit:

In Brazil, the world’s third-biggest exporter of corn after the U.S. and Argentina, production may fall more than 20 percent because farmers can’t get loans to buy fertilizer, said Enori Barbieri, a National Corn Producers Association vice president. The nation’s coffee harvest, the world’s largest, may drop 25 percent for the same reason, said Lucio Araujo, commercial director at farmer cooperative Cooxupe, located in Guaxupe…

Minnetonka, Minnesota-based Cargill and Decatur, Illinois- based Archer Daniels, the world’s largest grain processors, are among the crop buyers to halt financing for growers in Brazil, said Eduardo Dahe, who represents the companies as president of the National Association of Fertilizer Distributors.

This seems to me to be a cut-and-dried opportunity for the IFC to step in. Agricultural loans, which get paid off with future crops, are a standard financial instrument, and it shouldn’t be hard to restart them, either with direct bilateral loans or through a system of guarantees. Come on, World Bank Group — show us how fast you can move when you want to!

Posted in food | Comments Off on The Financial Crisis Hits the World’s Hungry

Cognitive Disconnect of the Day

Posted on October 28, 2008 by Felix

nytcover.jpg

This is the front page of nytimes.com earlier this afternoon. It’s a tough time to be a journalist: clearly moves like this are clearly newsworthy, but equally clearly it’s very hard to say anything intelligent about them. Hopes for a rate cut? Bargain hunting? Well, maybe. Nobody really knows.

If a rate cut is capable of moving markets, that’s incredibly good news, since everybody (including me) was convinced that monetary policy was pretty much tapped out at this point, and that a reduction in the Fed funds rate would have very little impact on credit, or, through credit, on equities.

As for the bargain-hunting, I’d be more inclined to believe it if there were some indication of where all the money was coming from, or if volume were higher.

My feeling, for what it’s worth, is simply that no one has a clue what stocks are worth, and that therefore they’re liable to swing around wildly on little or no news. But it’s hard to put that on the front page of nytimes.com.

(HT: Zubin)

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The Income Inequality Game

Posted on October 28, 2008 by Felix

Dan Goldstein, the brother of fashion blogger Lauren, has an interesting web project of his own, trying to work out how well people understand inequality in the US. Go give it a twirl; the more people who take the interactive quiz, the more useful the results will be. Here’s how I did:

household.jpg

I was good on median household income, and I was good on overall income distribution. But I was way off on where the 95th percentile of household income is, because I just plugged in the number I got from Barack Obama. How dare he mislead me like that!

Posted in pay | Comments Off on The Income Inequality Game

Quote of the Day: Rupert’s Surprise

Posted on October 28, 2008 by Felix

Michael Wolff on how Rupert Murdoch discovered there was more to Dow Jones than just the WSJ:

I don’t believe he had any idea there was an enterprise side of the business. I believe I was the one to explain Factiva to him. He wanted the newspaper. The fact that after he bought the newspaper he found himself with these rather successful businesses was I think surprising to him. I think he was pleased.

Posted in Media, publishing | Comments Off on Quote of the Day: Rupert’s Surprise

The Spreading Crisis: Finance to Business to Consumer

Posted on October 28, 2008 by Felix

It’s been clear for a while now that the financial crisis has spread into the real economy. But even with that knowledge, today’s consumer confidence numbers are a shocker:

The Conference Board Consumer Confidence Index, which had improved moderately in September, fell to an all-time low in October. The Index now stands at 38.0 (1985=100), down from 61.4 in September.

I’m not entirely sure what the methodology of this survey is, but at this rate the number is rapidly heading towards negative territory. After all, the component numbers could still get significantly worse:

Consumers’ appraisal of current conditions deteriorated sharply in October. Those saying business conditions are "bad" increased to 38.3 percent from 33.4 percent, while those claiming business conditions are "good" declined to 9.2 percent from 12.8 percent.

Everybody in America is acutely aware of the stock-market crash, which surely was the single largest contributor to the plunge in consumer confidence. But even so, those thinking business conditions are bad are still in a minority. The US consumer is a supertanker, and collectively we take a long time to turn around. So although this number is down dramatically today, I suspect it’s going to continue to fall for a while yet.

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Adventures in Icelandic Monetary Policy

Posted on October 28, 2008 by Felix

What does it mean that Iceland has just raised interest rates by 600bp, after cutting them by 350bp a couple of weeks ago? I’m not talking about monetary policy here, I’m talking about what it means in practice. Central bank interest rates, after all, are the rate at which national banks can borrow overnight funds. So does this mean that Iceland’s big three banks are actually borrowing new money, even though they’re all insolvent?

The decision to raise rates is being painted as an attempt "to return to a market-based floating exchange rate regime". But the reason that regime fell apart was nothing to do with Iceland’s monetary policy. Rather, it was a function of the fact that anybody looking to earn interest on Icelandic krona deposits would have to have that money on deposit with an Icelandic bank. Which, in turn, meant taking bank credit risk on top of FX risk. And if you wanted to take bank credit risk, you could make much more money by selling default protection.

So I suspect that this latest move by the central bank is largely symbolic. No liquid currency market can exist in a country without a functioning banking system. Unless and until Iceland gets solvent banks — either new ones or restructured old ones — the krona will continue to trade largely through newspaper classified ads.

Posted in fiscal and monetary policy, iceland | Comments Off on Adventures in Icelandic Monetary Policy

Where Buyers Should be Looking

Posted on October 28, 2008 by Felix

There was an interesting exchange just now on the deals panel, between Jim Casella, of Case Interactive Media, and Michael Wolff. If you have cash right now, said Casella, it’s a great time to be a buyer. This has been a very common theme of late, especially from private-equity types and value investors: the more that valuations fall, the more attractive they become.

But Wolff responded: if you have cash right now, that’s probably because you’re prudent. And if you’re prudent, there are other things you can do with cash beyond making strategic acquisitions: specifically, you can buy back your own debt, which is probably trading at a 16% yield.

More generally, any decision to buy equity will involve either a majority or a minority stake. If you’re a minority investor, doing something like buying public shares, then to a large degree you’re at the mercy of the market — and the market as a whole doesn’t have cash to spend. That means your company might not be able to refinance its debt, and that it will end up being taken over by its creditors. On the other hand, if you’re interested in buying companies whole, the opportunity space is large, and there’s free money to be made by doing things like buying back your own debt at levels significantly lower than where it was issued.

To put it another way: while equity valuations are cheap right now, debt valuations are cheaper still. And anybody looking at companies has to look all over the capital structure — not only of potential acquisitions but also of their own company.

Posted in investing, M&A | Comments Off on Where Buyers Should be Looking

The WSJ’s Subscription Model

Posted on October 28, 2008 by Felix

I’m at the Future of Business Media conference, where the wifi is painfully slow and where Robert Thomson, the editor of the WSJ, spoke this morning. He spent some time addressing the subject of whether wsj.com should be free, and started off by saying that people like me who think it should be are fuddy-duddies from the dot-com era, who haven’t kept up with how things have changed. He also said that although the debate about going free did happen, "we never seriously considered not charging for specialized content".

But a lot of what Thomson said didn’t quite add up, and I still reckon that wsj.com is going to go free eventually — although not nearly as quickly as I anticipated when Murdoch first bought it.

For instance: Thomson tried to paint a picture of non-subscribing visitors to the WSJ’s website being so attracted by the headlines on premium stories that they end up subscribing. He said that the website is up to 30 million uniques — "a doubling of the audience from last year, and a great free funnel of the readers to premium content". (If you think that number is high, so do I, and so does Thomson: he admitted that web metrics are "problematic".)

Thomson admitted that the website’s ad revenue is growing much more slowly than its visitor count, and he didn’t even mention what the growth rates are in paid subscriptions on the website.

And later on, Thomson talked about "how promiscuous web readers are" — implicitly admitting that just because someone is reading a free story about the yen, to use his example, they’re not going to jump through all the hoops needed to pay money to read a premium story on the recapitalization of Japanese banks.

Thomson also talked about how his decision to allow Dow Jones’s newswire content to appear for free on his Chinese-language website has sparked 400% growth rates there.

Thomson’s most interesting datapoint, for me, was when he was asked about the impact of consolidation in the financial-services industry on subcription revenues. He replied that there’s no doubt that if you’re a Dow Jones sales person phoning up banks and trying to get them to subscribe to products, you’re not in a great place right now. At the same time, he said, people who got fired from a place like Dow Jones haven’t disappeared, and are likely to strike out on their own in one form or another. They won’t necessarily be reached by a human salesperson, but if and when they find their own way to Dow Jones, they will still subscribe to content.

But aren’t individual subscription rates much lower than corporate rates? No, said Thomson, not on a per-person basis. If you can get a company’s worth of people to subscribe at individual rates, you’ll make more money than if you just sell a single corporate subscription. The question, of course, is how many individuals, after being fired from a big bank, will still do that.

My feeling is that Thomson was entirely right when he said that commentary had become commoditized, and that therefore you couldn’t charge for it; he also said the same thing about most news. But what he calls "specialized content" is to a large degree just taking commoditized news, and adding the kind of value that comes from informed commentators. Yes, there are things which Dow Jones the WSJ can do and no one else can do in quite the same way — Thomson was interesting when he started talking about selling content on the subject of India to Japan, for instance. And in a world where Dow Jones is looking to individual subscriptions to make up the losses from corporate subscriptions, it’s going to be very difficult for them to start slashing those individual subscription rates to zero.

But I suspect that eventually the WSJ will do the math and work out that the best way to monetize and grow its large number of unique visitors is to maximize the time they spend on the site. And the best way to do that is to go free.

Posted in Media, publishing | Comments Off on The WSJ’s Subscription Model

Extra Credit, Monday Edition

Posted on October 27, 2008 by Felix

Greasing the Slide: On vicious cycles in the financial markets. More here.

Mark to market for Social Security? Seems reasonable.

Paulson Explains Himself: Calling Frank Drebin! Why didn’t Paulson tell Fuld to sell Lehman?

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

Did the End of the Investment Banks Cause the Latest Sell-Off?

Posted on October 27, 2008 by Felix

Robert Peston thinks that much of the recent sell-off can be attributed to the decision by Goldman Sachs and Morgan Stanley to convert into banks:

It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk…

Morgan Stanley and Goldman are – by far – the biggest prime brokers, with Morgan Stanley the number one.

But as banks, they’re prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

So the US authorities should have known – and presumably did know – that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

I’d love to see some datapoints here. Is it true that the prime-brokerage operations of Goldman Sachs and Morgan Stanley have been shrinking, even as competitors such as Lehman Brothers and Bear Stearns have gone bust? It might be the case that the total amount they’ve lent out to hedge funds has declined, even if their client count is rising. And I’m sure that there’s been a lot of pressure both internally and externally for those shops to derisk and deleverage.

But the fact is that as soon as the investment banks started getting access to the Fed’s money, they were bound to become much more tightly regulated — whether they became banks or not. Has that process been sped up by their move to become banks? Frankly, I doubt it — no one at Treasury or at the SEC is interested in giving Morgan Stanley and Goldman Sachs a hard time right now over the fact that they don’t immediately conform to all the requirements of banks. These things take a certain amount of time, and everybody understands that.

But are hedge funds being forced to sell assets because their prime brokers are derisking? That’s entirely possible. But I’d be more convinced if I was shown an actual instance of it happening.

Posted in banking, regulation | Comments Off on Did the End of the Investment Banks Cause the Latest Sell-Off?

Libor, or the Tango of White-Hot Hate

Posted on October 27, 2008 by Felix

The exegesis on the global financial crisis that you’ve all been waiting for has finally arrived. Ladies and gentlemen, I present to you the incomparable Bernard-Henri Levy:

One recalls "Leviathan," Rousseau’s "Social Contract," de la Boetie’s "Discourse on Voluntary Servitude"…

What is a social bond and how is it broken? Voila. Here we are. This debacle, this shipwreck, is showing us the answer…

Is man a predator of man? Does the fear of this predator slumber within us?

…Consider the tango of white-hot hate that has been discreetly called the "drying up of interbank credit."…

You start off with a financial crisis, then the whole cloth begins to unravel little by little: At the beginning you have a terrified crowd, and at the end, a lynch mob.

I knew BHL was rich, but damn he must have lost a lot of money this month.

Posted in eschatology | Comments Off on Libor, or the Tango of White-Hot Hate

The TED Debate

Posted on October 27, 2008 by Felix

Alex Tabarrok puts up a chart of the TED spread over the past 40 years or so, with the clear implication that it’s not at unprecedented levels right now. Alea responds with a chart of something he calls the "TED ratio", which is at

unprecedented levels but which may or may not be a useful indicator. Both charts are derived from this data, which is probably the best place to look if you want to make your own mind up first.

Looking at that final chart, the thing which jumps out at me is not (only) that the TED spread is very wide right now, but the fact that it has never before gapped out at a time when T-bill rates are falling. For the past 40 years, Eurodollar rates and T-bill rates have moved in the same direction. Now, they’re moving in opposite directions. I don’t know what that says about the credit crunch, but it does seem to say something about how crazy the markets are at the moment.

Incidentally, I’m getting back on a plane Monday morning; don’t expect much if any posting until later in the day.

Posted in bonds and loans | Comments Off on The TED Debate

Ben Stein Watch: October 26, 2008

Posted on October 26, 2008 by Felix

Here’s a quick pop quiz for you, to see how well you understand the credit crisis. There’s only one question:

What makes a bank insolvent?

(a) When it doesn’t have enough money to pay all its obligations, because the loans it made fell in value.

(b) When it builds up ample reserves but dares not lend them out.

(c) When it fails to dissolve upon being dunked into a bath of liquidity.

If you answered (b), then congratulations: you’re Ben Stein! Here he is this week:

Months ago, one of the greatest of American economists, Anna Jacobson Schwartz, who was co-author with the late Milton Friedman of “A Monetary History of the United States,” accurately said that American banks did not face a liquidity crisis, but that they might soon urgently face a solvency crisis. In other words, banks would have ample reserves to lend but might lack assurances that they could meet all their financial obligations if those loans went bad. She was right. In fact, bankers have had so many losses and faced so much uncertainty that they dared not lend, for fear of killing their banks with bad loans — so we have actually had a solvency crisis.

Anna Schwartz, of course, knows exactly what insolvency is. Stein, on the other hand, first tells us that any bank which couldn’t meet its obligations if its loans went bad — which, of course, is all banks — is insolvent. And he then says that a solvency crisis is what you get when banks dare not lend.

There is absolutely zero justification for the NYT printing this claptrap. The name of Stein’s column is "Everybody’s Business": it’s meant to be something a general reader, without specialized financial knowledge, can understand and learn from. So when he gets basic concepts like solvency utterly wrong, he’s causing very real damage. And of course at a stroke he renders pointless much of the rest of his column: one can do no better than hazard a wild guess at what he thinks he’s talking about when Stein says that he wanted the government to "issue blanket solvency guarantees to banks".

One of Stein’s most annoying rhetorical tics is to give the impression that he’s thought about something long and hard, and that he’s doing us all a favor by just presenting his thought-through conclusions rather than actually working through any kind of argument. There’s a prime example this week:

The failure of government to limit the loss possibilities from credit-default swaps has also been a mystery to me.

Anybody who knows anything about credit default swaps, or who read Stein’s Yahoo column on the subject, knows this lies somewhere between meaningless and idiotic. But Stein isn’t writing for readers who know what credit default swaps are: he’s writing for readers who don’t know what credit default swaps are, and who think that he does know. And so thousands of people now think there’s some simple solution to the credit crisis which the government is willfully ignoring, with the result that stocks fall and it’s all Hank Paulson’s fault.

Indeed, Stein goes on to say that "all of the recent misery, including the stock market’s plunge" was caused by people who should face criminal prosecution. It’s a wonderfully deluded view of the world: if you buy stocks and they go up, then you’re clever and admirable, while if you buy stocks and they go down, that’s clearly the fault of nefarious criminals.

Stein’s also more than a little disingenuous here:

I get a certain amount of mail asking why I was unable to spot the stock market crash in advance, sell short and become rich. And why was I unable to foretell the future, so my readers could avoid losses and make money?

Well, I am just a person. I don’t have any magical powers to foresee the future.

This sounds perfectly reasonable until you remember that Stein’s the person who wrote an entire book entitled "Yes, You Can Time the Market!".

Stein uses this week’s column to exhort his readers to "start saving right now, and don’t stop until you die" — I guess that means they should never retire. But he is absolutely to blame for doing his very best to elide the distinction between saving and investing, by doing things like referring to his stock-market investments as his "life savings". If you bet your money, you’re not saving it — and investing in the stock market is always a bet, even when it has a greater-than-even chance of paying off.

Stein ends with a very peculiar argument against windfall taxes on oil companies:

When crude was skyrocketing, the beautiful people wanted to beat Exxon Mobil, Chevron and BP into a pulp. Many people assumed that oil barons controlled prices, made “obscene” profits and made life difficult for ordinary citizens. But the price of oil has fallen by more than half from just a few months ago…

The oil companies are just corks bobbing up and down on the ocean of worldwide demand and supply, exactly as the oil companies said they were. They are not going to be starving, but they are clearly not the invincible demons that their enemies said they were. Now that we see how vulnerable they are, is there any reason to hit them with a surtax?

As is his wont, Stein gets the argument for a windfall tax exactly backwards. The whole point of a windfall tax is that oil-company profits weren’t the result of any particular skill or good management on the part of the companies themselves, and that they were simply windfalls which resulted from a high oil price. The argument had nothing to do with the companies being invincible demons who controlled prices — quite the opposite.

And I’m afraid I don’t see how vulnerable the oil companies are — not at all. A one-time windfall tax on the profits they made when oil was over $100 a barrel wouldn’t change the economics of the oil industry at all. And since tax revenues are going to plunge as the recession bites, it makes sense for the government to raise money where doing so does the least harm. An oil-company windfall tax would do less harm than a lot of other taxes which are being levied right now. I’m not saying I think it’s a great idea, necessarily. But Stein’s argument against it is just silly.

Posted in ben stein watch | Comments Off on Ben Stein Watch: October 26, 2008

Credit Market Datapoint of the Day, AIG Edition

Posted on October 25, 2008 by Felix

What was that about the credit markets improving? Not so fast:

American International Group Inc. has used $90.3 billion of a U.S. government credit line since it was bailed out last month…

AIG’s latest balance was revealed yesterday by the New York Federal Reserve, and is up from $82.9 billion a week ago…

The firm needed cash after credit downgrades forced it to post more than $10 billion in collateral to clients who purchased guarantees on bonds that lost value.

What this means is that over the course of the past week, the value of the default protection written by AIG has gone up so much that the insurer has had to put up an extra $10 billion in collateral. Collateral requirements are a function of secondary-market CDS prices: they go up when CDS spreads go up. And so the spike in collateral means that CDS spreads, at least on the stuff that AIG was insuring, have gone up substantially over the past week.

This doesn’t exactly come as a surprise, of course: all risk assets have been decimated during the latest bout of market carnage. But the sheer magnitude of AIG’s collateral requirements is stunning. Consider this:

AIG sold protection on $441 billion of fixed-income investments, including $57.8 billion in securities tied to subprime mortgages. The swaps plunged in value as the assets they guaranteed declined, forcing $25 billion in writedowns over nine months and leading to three quarterly losses.

Remember that the writedowns took place before AIG was nationalized. And let’s say that the subprime securities have all at this point been marked to zero. Then that would require AIG to put up $33 billion of collateral. And let’s say that AIG has manged to lose $7 billion on its securities-lending business. Then it has still had to put up $50 billion in collateral against $383 billion of non-subprime guarantees. That’s equivalent to non-subprime bonds trading at an average of 87 cents on the dollar. Which might not sound too distressed, until you remember that AIG only guaranteed securities it considered extremely safe.

I don’t know exactly what kind of non-subprime securities AIG was writing protection on. But given the amount of collateral it’s had to put up, one can only conclude that the market is pricing in a wave of defaults the like of which America hasn’t seen in a very long time. And which would easily justify the kind of stock valuations we’re seeing at the moment.

Posted in bonds and loans, derivatives | Comments Off on Credit Market Datapoint of the Day, AIG Edition

Stocks: A Bear Case

Posted on October 24, 2008 by Felix

If stocks fall, that means they’re cheaper than they were. And if they’ve gotten cheaper, they must be a better investment, right? That’s the gist of a blog entry from Jim Surowiecki today.

But that’s not necessarily how this is going to play out. It’s true that stocks have been a good long-term investment in the past, but that doesn’t make them a good long-term investment in the future, even if they are looking cheap(ish) these days. And to understand why, it’s worth looking at a very old-fashioned indicator: the stock market’s dividend yield.

As Steve Waldman rightly points out, the vast majority of investors aren’t speculators trying to maximize their net worth. Instead, they’re trying to maintain their standard of living post-retirement:

Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production).

But for many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream — one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late 70s and early 80s, the S&P 500’s dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price. An entire stock-market sector — tech stocks — was created on the tacit understanding that most of them would pay no dividends at all, most of the time. And the most admired man in the stock market, Warren Buffett, also abjured dividends entirely.

In the mid-1990s, about the time that Alan Greenspan first started warning about "irrational exuberance", dividend yields dropped below 2% for the first time, and they stayed there even through the dot-com bust. People had long since stopped buying stocks for their dividends: now, they were investing in the expectation of future capital gains.

A stock portfolio wasn’t something you could live off, any more: the only way to do that would be to sell it down over time. Equities might still be permanent capital from a corporate-finance point of view, but from the point of view of an individual investor, they were bought only to be sold, at a higher level, in the future, to someone else.

This worked for a long time. As defined-contribution pension plans replaced defined-benefit schemes, and as a generalized unanimity emerged that stocks were the first best place to put retirement savings, the flow of money into the stock market was more than healthy enough to keep prices rising and to justify people’s faith that they would continue to do so indefinitely.

But if stock prices start falling year after year, then it will become increasingly apparent that it’s not reasonable to expect long-term capital gains. Yes, stock prices have generally risen over the long term. But for most of the decades in question, people never really expected them to do so.

There’s a word for an asset class which everybody expects to continue to rise in perpetuity: a bubble. And although stocks are down a long way from their highs, the idea of stocks as something to buy today and sell for more money tomorrow is so deeply ingrained in the national psyche that a few months of market volatility is nowhere near enough to erase it.

So consider this possibility: that stocks will continue to fall until their dividend yield reverts to its long-term historical mean, somewhere around 3.5%. At that point, people will start buying them not for capital gains but for income, and I think it’s reasonable to expect a stock-market floor at roughly that level. From then on in, both prices and dividends would be expected to rise at roughly the same pace as national GDP.

Of course, there would still be volatility. But that doesn’t mean that there’s likely to be "exceptional performance in the future," in Surowiecki’s words. Indeed, stock-market performance might be downright mediocre. Which might not be such a bad thing.

Update: The wittily-named "Modigliani_Miller", in the comments, points out that in a world where investors prefer capital gains to dividend income (which is probably any world where the capital gains tax is lower than the income tax), companies can simply return money to shareholders through share buybacks rather than dividends.

On the other hand, there’s also this, from dWj, which makes my case positively sunny:

There used to be a rule of thumb that stocks were expensive when the dividend yield got down to 3% and cheap when it got to 6%. By this measure, after 12 years, stocks are finally down to "expensive" again — and will be cheap when they lose another half of their value, supposing the dividends aren’t cut too badly. (I’ve been using $25 per S&P 500 lately when doing dividend calculations, which assumes dividends only drop about 15%. We’ll see about that.)

Posted in investing, stocks | Comments Off on Stocks: A Bear Case

How the Lehman Bailout Increased Moral Hazard

Posted on October 24, 2008 by Felix

David Schelicher emails with a provocative question, in the wake of my IM exchange with John Carney yesterday: what if letting Lehman fail actually increased the amount of moral hazard involved in lending to banks? "Moral hazard is based on predicted future government decisions," he notes, adding:

A lack of a Lehman bailout only reduces moral hazard if investors think it is a preview of future actions. But the failure to bail out Lehman has been blamed throughout the world press and by world leaders (see, e.g., Lagarde in France) as the cause of the world-wide credit crisis. The cost of the Lehman failure made clear to world leaders the cost of allowing a major broker-dealer bank to go under. Because it is widely considered a mistake (whether or not it actually was one), the Lehman non-bailout makes a bailout for the next major financial institution more likely. Hence, moral hazard was increased, not decreased by the decision not to bailout Lehman.

I think he’s right: Hank Paulson has pretty much explicitly said that he won’t let any more banks go under (ie default) on his watch, and the WSJ is reporting today that the moral-hazard trade is now being extended to insurers as well.

If Treasury had bailed out Lehman, there would always have been the chance that it wouldn’t bail out the next bank to get into difficulties — just as the bailout of Bear Stearns didn’t mean that Lehman was safe. But after Treasury let Lehman fail, no further failures could be allowed, and indeed one of the main functions of the TARP bill was to make government bailouts much easier.

People like Carney, then, who care deeply about moral hazard, should probably wish that Lehman had been bailed out, rather than be happy that it wasn’t.

Update: In the comments, SteveOh says something very interesting:

I do get the feeling that the Fed has had the banks in their back pocket ever since.

If it were not for the Lehman failure, do you think Merrill would have merged with BoA, or that GS and MS would have become bank holding companies, or that JPM would have accepted their capital injection?

I’m quite sure this isn’t the reason that Lehman was allowed to fail — there’s zero indication that anyone at Treasury or the Fed has been able to look that far ahead. But it is a consequence of letting Lehman fail. In the case of Bear Stearns, Jamie Dimon was to a very large extent calling the shots, and policymakers were doing his bidding. Now, thanks largely to Lehman, the tables have been turned.

Posted in bailouts, banking | 1 Comment