Lies, Damn Lies, and Tourism Statistics

In 1995, the owner of the Great Smoky Mountain Railroad sued Warner Brothers. The movie studio had used the railroad as a location for the train crash scene in The Fugitive, and the railroad had asked in return for an end-credit. For some reason the end-credit never appeared in the final film; the owner was convinced that if it had done, visits to his attraction would have been much higher. And to try to prove his point, he commissioned an academic paper from a group of three expert witnesses.

The expert witnesses did what they were paid to do. They took a list of very successful films set in easily-identifiable locations, such as Devils Tower National Monument (Close Encounters) or the baseball field from Field of Dreams. They then looked at the visitor numbers at those locations, and concluded that

When the median increases of the aggregated data were graphed, the span of movie inducement lasted for at least four years and increased between 40 and 50%. Data not presented in this paper would suggest that the induced effect could be longer at some sites and not exist in other cases where locations were not identifiable or accessible…

Additional research is important to document this largely unexplored phenomenon… As yet, no studies have documented the economic impact of one movie on a location or community.

The paper’s not exactly iron-clad. It never gives us any actual datasets, instead just reproducing charts; and the data it does give imply that the margins of error are pretty enormous. To take one example: the 12 locations were split: six were public parks, and six were private attractions. Three years after a film came out, the median public park saw its attendance rise by 33%; the median rise for all 12 public parks and private attractions combined was 34%. And yet the median rise for the private attractions was 67%.

In other words, numbers are certainly possible, but they range around so much that I wouldn’t want to extrapolate them at all.

In any case, the fact that the research was commissioned by someone who knew very clearly what result he wanted should make anybody consider the paper essentially worthless. Ex post, it’s easy to find film locations which benefitted from a certain movie coming out. But that just means there was acres of room for the researchers to cherry-pick the best results. And they never give absolute visitor numbers, just percentage increases, which will skew things even further when even they admit that the field in Field of Dreams had "zero visitors before the release of the movie". (Yes, this really is a research paper where the authors divide by zero and come up with a supposedly useful result.)

But that’s not the only reason to treat any results from this paper with extreme prejudice. There’s also the fact that the paper’s lead author, Roger Riley, said in an email to me that if the results ever were true, they’re probably not any more:

This data was collected in the early to mid 1990’s. Things have change a lot today. Movie companies release to DVD and television much sooner than they once did, thereby reducing the amount of time that a movie is in the public eye. I would be surprised if that could be proven in today’s world.

You know where I’m going with this one, don’t you. This paper, which even its lead author doesn’t consider remotely useful, has become a standard reference point in movie-industry journalism. For instance:

According to the Annals of Tourism Research, locations featured in a successful film can expect to see visitors increase by an average of 54 percent over the four years following the film’s release.

I don’t quite know how the 54% figure became the standard one cited (I would have expected people to say that visitors increased 77% over five years instead), but somehow it did. Thus does Dan Glickman, CEO of the Motion Picture Association of America, say things like this:

Take The Dark Knight for example. It was filmed in Chicago last summer. Over the course of the 65-day shoot, Warner Bros. created more than 1,000 local jobs which generated $13.5 million in wages. They also spent more than $3 million on hotels, $1 million on catering, and $900,000 on lumber and other set materials. In total, The Dark Knight injected more than $35 million into the Chicago economy in two months. Another bonus? On-location filming is terrific marketing. It’s estimated to boost tourism by up to 54 percent.

Never mind the fact that it’s really hard to see how you can get to $35 million once all the big line-items add up only to $18.4 million. The key thing to note here is how a virtually value-free statistic becomes an Impressive Number with which to blind credulous journalists, readers, and interlocutors. No one ever bothers to look the number up and ask if it’s true (present company excepted).

There are a couple of lessons to learn here. The first is that when a statistic fails the smell test, there’s a good chance it isn’t true. But there’s a broader implication: that there’s a good chance that any given statistic isn’t true, whether it fails the smell test or not. And you certainly can’t trust the Fourth Estate to do your fact-checking for you.

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What Just Happened to Google?

If you’re a fund manager, you’re long Google, and you need to report the value of your position as of the end of the quarter, what on earth are you going to say?

Google traded in a surprisingly narrow band for most of today, between $405 and $415 per share. Then, in the final three minutes of the day, everything went batshit. Volume spiked sharply, and the stock gyrated insanely, first spiking up to $489 and then spiking down to just $200 or so before officially closing at $349. In the sanity of the aftermarket, it’s now back to about $405, where you’d expect it to be.

Following its investigation, the Nasdaq is probably going to void all GOOG trades in the final few minutes — something which has one trader, at least, mildly miffed. But just look at the official datapoints: share volume of 12 million shares (that’s about $5 billion), more than double the normal amount; an intraday high of $489, and — most improbable of all — an intraday low of just 1 cent per share. The poor MarketWatch website can’t cope at all, and now says that Google’s close of $341 represents a drop of $171 per share. (No, it didn’t close yesterday at $512.)

The weirdness in Google stock reminds me of what happened to BB&T bank yesterday: it never traded below $36 per share until the final minutes of trading, when suddenly it spiked down to a close of $31, only to jump straight back up to the mid-30s again as soon as the market opened this morning.

Will the BB&T trades be voided too? These things matter, and not just for people holding knock-out options and similar exotica, but also in the real world — quite a few executive compensation packages are tied to things like the lowest level the share price closes at during a certain period.

In a market with volatility through the roof and thousands of stocks trading, a few crazy closing prices are only to be expected. I expect the Nasdaq and NYSE will do their best to void them, even if that does annoy a handful of day-traders.

Update: Nasdaq has acted:

Pursuant to Rule 11890(b) NASDAQ, on its own motion, has determined to cancel all trades in security Google Inc Cl – A "GOOG" at or above $425.29 and at or below $400.52 that were executed in NASDAQ between 15:57:00 and 16:02:00 ET. In addition, NASDAQ will be adjusting the NASDAQ Official Closing Cross (NOCP)and all trades executed in the cross to $400.52.

Update 2: According to Yahoo today (Wednesday), Google closed yesterday at $1,594.63 per share. Clearly things are still extremely skewy.

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Hedge Funds: The Next Shoe to Drop

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You think things are bad now? Just you wait: the chart above gives you a very good indication of what Christine Williamson calls the "bloodbath ahead" in the hedge-fund industry.

No one wants to be invested in an underperforming hedge fund right now — and half of the hedge funds in America are underperforming. What happens when investors decide to take their money out tomorrow, as they’re generally allowed to do on the first day of any quarter?

Sources said they expect the body count to total as many as 2,000 hedge funds and 500 hedge funds of funds between now and the end of March…

Most hedge funds operate on an end-of-quarter deadline for requests from clients to have their money returned. If experts’ predictions of very large collective redemptions come true, managers will have to liquidate their holdings en masse, pushing down prices and forcing many smaller hedge funds or those with poor returns out of business. The wave of closures could span six months, likely beginning in earnest in November and December at the end of the typical 45- or 65-day waiting period when fund managers have to return investor cash.

What you see in the chart is the enormous range of returns between the best-performing and wosrt-performing hedge funds — a range which has never been wider. Ironically, it’s the result of the fact that hedge-fund returns during the Great Moderation of 2002-7 were very closely grouped together — something which prompted funds to take on extra leverage to boost their returns. In turn, all that extra leverage helps explain why the top 10% of funds is up more than 50% over the past 12 months, while the bottom 50% is down more than 25%.

It’s not just redemptions which underperforming hedge funds have to worry about, either: it’s also employees, who are going to have a much smaller performance-related bonus pot to split between them this year.

These problems are propping up elsewhere on the buy-side, too: according to the WSJ, the reason that Lehman Brothers ended up selling Neuberger Berman for $2.15 billion rather than somewhere between $7 billion and $13 billion was that

the deal was held up in recent weeks due in part to protracted contract negotiations with the Neuberger money managers. People involved the discussions have described the process of persuading them to sign on to the deal as something akin to "herding cats."

Could it be that all these fund managers were simply paid far too much money over the past few years? After all, they can’t all find well-remunerated work elsewhere. But for many of them, that probably doesn’t matter: they can live quite comfortably off what they’ve earned already, and if they feel like making more they can just start investing their own funds, without having to worry about office politics or the trader sitting next to them blowing up the entire firm.

In any event, the hedge-fund shakeout over the coming months could be brutal, and have nasty systemic consequences if hundreds or thousands of hedge funds are all trying to unwind their positions at the same time. In the worst-case scenario, a fund which wrote a lot of credit protection could go bust, leaving its investors with nothing and its counterparties with very little. If the counterparty dominoes then started to fall, the financial system could end up in much worse shape than anything we’ve seen so far.

(HT: Gumby)

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The Dysfunctional Credit Market

One of the problems with a credit crisis is that it’s much harder to track fixed-income markets than it is stock markets. Name a stock or a stock index, and it’s easy to see how prices reacted to every minute of the big vote yesterday. Try to find an intraday chart of T-bills, however, or credit spreads, and it’s much harder. And Libor is fixed only once a day, which is about a week in market time.

Given the paucity of credit information online, John Jansen’s blog is invaluable these days. Here he was yesterday afternoon:

The yield on the 2 year note rotated through a mini interest rate cycle as its yield tumbled 37 basis points to 1.73 percent.

It’s a powerful point: the movements on Treasury bonds yesterday were larger than the average rate cut. This morning, the yield on the 2-year had "climbed 13 basis points to 1.79 percent", implying that at the official close yesterday was even lower than Jansen had indicated, at 1.66%.

Later this morning, Jansen dropped an even more eye-popping datapoint: the Fed funds rate, which is targeted at 2%, opened "at 6 ßΩ to 7 percent" before starting to move downwards — something Jansen’s "money market mole" calls "the most dysfunctional market that he has witnessed in 20 years".

And this is even scarier:

Trading today has been limited to overnights with virtually no term trades.

Some small part of that might be due to the fact that today’s the last day of the quarter; things might pick up a little tomorrow. Or, on the other hand, they might not.

So I’m glad that broad stock-market indices are up 4% today. But looking at the credit markets, things are still very bad indeed. Remember, the equity markets have been overoptimistic during the entire history of this crisis. They’re not really to be trusted.

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The Quantum Physics of the Bailout

Right now I feel as though we’re all, collectively, like Schrödinger’s cat before the box is opened, except that instead of two different outcomes there are dozens. Will we revert to ad-hoc, case-by-case responses requiring no legislative approval? Will the Democrats come up with a more left-wing plan they can push through on their own? Might such a plan include outright bank nationalizations? Contrariwise, is the ball in the House Republicans’ court, to come up with a plan that they can vote for? Will something like Plan A still get pushed through, as people seem to hope right now? Or will we end up in utter chaos?

And while I’m on the quantum-physics metaphors, the uncertainty principle fits in here quite nicely as well. If you want to find out the position or velocity of a particle, the very act of observing it can make an enormous difference. Similarly, when the markets observe goings-on in Washington and plunge as a result, that plunge feeds back into the legislative process, making some kind of a deal more likely. I do think that the 777-point drop in the Dow yesterday was a bucket of cold water in many Republicans’ faces: yesterday morning, their greatest fear was being blamed for voting for the bailout, while today, they’re even more scared of being blamed for voting against it.

The reason is that individual voters don’t care about abstractions like "the economy"; they care about their own personal circumstances. And right now, anybody with retirement funds or any kind of stock-market savings is worried. They see their net worth plunge as a result of legislative incompetence, and they rightly blame their elected representative. No, they don’t like the idea of a Wall Street bailout for the fat cats who caused the problem to begin with. But they like the idea of losing a substantial portion of their life savings even less.

I think we can date to September 2008 the point at which serious negative wealth effects started feeding through from the stock market into consumer behavior. Up until now, the US consumer has been astonishingly resilient. But anecdotally, a lot of people are cutting back right now, worried that they’ve lost a lot of money in the markets. Even if they still have credit, people aren’t inclined to use it, because they’ve lost that all-American confidence in their future income.

Does the House of Representatives, collectively, grok this? If yesterday’s stock-market plunge did cause a change in national sentiment, away from anti-bailout and towards get-this-fixed, do the lawmakers in DC have the ability to notice and to change their behavior accordingly? We’ll find out, I guess, when the box is opened. Whenever that might be.

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When the CDX Rolls

I spoke this morning to Marc Barrachin of Markit, the company which owns and runs most of the benchmark CDS indices. Markit recently delayed, for a second time, the biannual "roll" where the components of its indices are updated to reflect changes in the markets. So I was very interested to ask Marc what was going on.

We talked mainly about Markit’s flagship product, the investment-grade CDX index. But when that rolls, lots of other indices roll as well, including the emerging-markets and high-yield indices. The IG index is now entering its eleventh incarnation: IG 11 will be the new on-the-run benchmark, taking over from the current bechmark, which is IG 10.

"The new on-the-run series tends to represent more accurately what the investment-grade corporate CDS landscape is," says Barrachin. "It’s a better hedge, a better representation, and liquidity concentrates in the new on-the-run."

Having said that, IG 10 is hardly the same now than it was at inception. When it was created, six months ago, it included Fannie Mae, Freddie Mac, and Washington Mutual. All three of those credits have now had "credit events": their CDS have been triggered, and those names are now awaiting an auction to determine the recovery rates and how much sellers of protection will have to pay out. Needless to say, it’s extremely rare, if not unprecedented, for three investment-grade credits to suffer a credit event in the space of six months.

When the index rolls, any components of IG 10 which lost their investment-grade credit rating are taken out of the index, and replaced with new investment-grade credits. So apart from Frannie and WaMu, other credits such as Liz Claiborne, Sprint Nextel, and Brunswick are no longer in IG 11. In their place are new credits such as Xerox, Staples, Time Warner Cable, and UPS. The new constituents were set a couple of weeks ago; that hasn’t changed.

Given that the old index includes non-investment-grade names while the new index is all-investment-grade, there’s likely to be some spread tightening when the benchmark CDX index rolls from IG 10 into IG 11. But remember to look at the spread and not the price of the index: the prices aren’t going to be comparable, since the coupon on which the price is based is increasing, to a spread of 170bp from a spread of 150bp. So if IG 10 was trading at 100, that would imply a spread of 150bp; if IG 11 trades at 100, that implies a spread of 170bp. That coupon, too, has already been set and won’t change.

Why has the roll from IG 10 into IG 11 been delayed? The first time round it was because of uncertainty surrounding the aftermath of Lehman’s collapse, and questions over AIG. (AIG is a component of both IG 10 and IG 11; it still has an investment-grade credit rating.) The second time, there were worries about what might happen to Wachovia, not to mention the bailout plan and the credit event at WaMu.

"Rolling on a Monday when you have a high level of uncertainty is not ideal," says Barrachin, since traders want to be comfortable with the index that they’re trading and be able to roll quite smoothly out of the old index and into the new one. When there’s a lot of volatility in the market, that’s more difficult. The decision to delay the roll is taken by a vote of CDS market makers: there are 12 now eligible to vote.

If things go according to plan and there isn’t a third delay, then the roll is now scheduled to take place this Thursday, rather than on a Monday. Mondays are just too risky, these days: you never really know what’s going to happen over the course of a weekend.

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How Bad Could Things Get?

Your cheery upbeat forecast, on a day when stocks are up 3%, comes from Willem Buiter:

If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:

* The US stock market tanks. Bank shares collapse…

* CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers…

* No US bank will lend to any other US bank…

* Assets not viewed as toxic before will become unsaleable at any price…

* Banks will stop providing credit to households and to non-financial enterprises.

* Banks will collapse… No bank will be safe, not even the household names…

* Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.

* Consumer demand and investment demand collapse. Unemployment shoots up.

* The government suspends all trading in financial stocks until further notice.

* The government nationalises all US banks and other highly leveraged financial institutions…

* We have the Great Depression of the 2010s.

And that assumes, of course, that the clearing and settlement system suffers no major blows, and that the US government retains its triple-A credit rating and can borrow from abroad at will.

Maybe we should send Buiter to Capitol Hill to put the fear of God into lawmakers. Bush’s "this sucker could go down" doesn’t seem to cut it.

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When Regulation Works

It’s rapidly become a cliché to describe the current crisis as one of a lack of regulatory oversight. But amidst all the recriminations about how the financial sector should have had much tougher regulation, there’s been precious little evidence that regulators are remotely capable of staying one step ahead of the banks they’re supposed to regulate, or that hard-nosed regulation really can prevent a crisis.

So we all owe Gillian Tett for providing just such an example today: the Spanish central bank.

One key factor protecting Santander from some of the global woes is the tough approach that the Spanish central bank has taken towards regulating its banks in recent years.

Earlier this decade the central bank in essence decided it disliked the idea of banks keeping vast quantities of credit assets off their balance sheets. It also quietly demanded that banks hold higher levels of reserves than international accounting laws required.

Consequently, it furtively "gold plated" – or rewrote – European Union rules to discourage Spanish banks from creating entities such as structured investment vehicles (SIVs). And when banks such as Santander embarked on an acquisition spree in Mexico, the central bank reined them back.

Time to stop being furtive, Banco de España! You’re the closest thing this crisis comes to having a hero. And I can think of quite a few people in Washington who might benefit greatly from a trip to Madrid around now.

Tett ascribes the Spaniards’ position to the fact that the country had a nasty banking crisis of its own a couple of decades ago, very much within the working lifetime of today’s technocrats. But there might be something else to it, too: could they have been so assiduous about regulation precisely because they were emasculated by EMU and the Euro and therefore lost their former primary role as the setter of monetary policy?

Incidentally, the governor of the Spanish central bank is Miguel Fernández Ordóñez. You knew that, right?

Update: Mark Stein made the same point yesterday.

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Libor: 6.88%

Are you in any way reassured by the dead cat bouce in various global stock markets? Don’t be. This is a credit crisis, remember, not a stock-market crisis: the impact on stocks is just collateral damage. And this morning, overnight Libor was fixed at 6.88%, up from just 2.57% on Monday.

OK, that’s the most dramatic datapoint. Three-month Libor rose much less, to 4.05% from 3.88%. But it’s still ultra-high. And TED? 351bp. The credit markets are not happy, no matter what might be going on with stocks.

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Extra Credit, Monday Edition

Burn, baby, burn! Dow down 748: "The question we are facing right now is whether it is better to let an unstable edifice implode, and then attempt to build a new and better structure out of the rubble, or whether there is still a way to shore up the creaky old barn while simultaneously replacing the foundation. The House of Representatives today said: Let it burn."

Nothing to Fear but Irresponsible Words: Jeff Matthews blames Bush.

House Votes Down Bailout Bill; Dow Down 716: "ITS A SHAME THERE ARE NO SHORTS WHO WOULD OTHERWISE BE COMING IN ABOUT NOW TO COVER."

Politics of crisis: "Paulson’s decision to let Lehman fail, on Sept. 14, may have delivered the White House to Obama."

Understanding the TED spread

MoMA Chief Made $1.7 Million in 2007, Tops for Arts Executives

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How Risk Aversion is Evolving

The good news: you just managed to sell your house, you got a decent price for it, and you’re sensibly renting for the time being. The bad news: so now what are you meant to do with your money? It’s over the $100,000 FDIC limit — so do you divvy it up among different banks, or buy a product like CDARS to make sure it’s all insured?

Maybe you open a brokerage account and invest it all in government debt: that’s safe. But what if your broker goes bust? You’d probably be OK, but can you be completely sure? These are your life savings, after all. And although you could survive a small drop in their value, you would be devastated if they were to be wiped out.

What we’re seeing here is a change in risk-aversion. A year ago, a risk-averse investor was one who wanted no risk of any downside, and was willing to trade higher returns to get that safety. Today, a risk-averse investor wants no risk of wipeout, and is incredibly aware of counterparty risk.

To put it another way: a year ago, risk-averse investors would have been very attracted to principal protected notes, where you pay a bank an insurance fee for guaranteeing that your investment won’t fall in value. Today, risk-averse investors wouldn’t trust such a product with a bargepole, since in the event the bank were to fail, they could be wiped out. Indeed, they’d probably be happier simply buying an index fund: yes, it can fall in value, but stock indices don’t go to zero.

Many investors have lost so much money right now that losing a little more is no longer their biggest fear. What we need now, I think, is some way of transforming financial-sector securities so that they go from carrying a small risk of a large loss to carrying a larger risk of a small loss. If that were possible, they’re looking cheap enough right now — especially the debt instruments — that we might actually see some substantial inflows into the sector.

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Stock Indices: The 10-Year View

How have various stock indices done over the past ten years? The Brazilian Bovespa might have fallen by 10% today, but you’d still have been much better off there than here in the US. On the other hand, if you did invest here in the US, you would have done well to invest in the Dow, rather than the S&P 500.

Index

Sep 29, 1998

Sep 29, 2008

Change

S&P 500

1,049

1,119

+7%

Dow

8,081

10,454

+29%

Nasdaq

1,734

1,984

+14%

Brazilian Bovespa

6,869

45,834

+

567%

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Let the Flowers Bloom

When the bailout as originally conceived was first announced, Pimco’s Bill Gross lost no time in putting himself forward as a steward of the $700 billion bailout fund.

Assuming that no second vote succeeds and that the bailout in its present form is toast, the obvious next step is for the government to do something on its own — something which doesn’t require legislative approval. My best guess is that Treasury and the Fed are now going to try to come up with some kind of debt-for-equity swap: a recapitalization proposal which can be implemented through the Fed’s existing powers.

In other words, move over Bill Gross; welcome, Chris Flowers. It’s your expertise we need now.

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Looking for Hope

Is democracy the winner here? Clearly, the people have spoken, through their elected representatives, and they’ve said no to the Paulson bailout plan. If that means a market crash, so be it. At 1,145, the S&P is now 27% off its highs, and 5.5% off where it closed on Friday — bad, but not the end of the world. But it wasn’t a stock-market crash which Paulson was trying to prevent. Rather, it was a complete seizing-up of the credit markets.

Bank of America is leading the financials down, falling 15%: the no-shorting rule can’t prevent this kind of price action. And Morgan Stanley, which was rescued last time only by the promise of a bailout, is down 19% today. But many of the other big banks seem to be holding on OK, and even Morgan Stanley, at $20 a share, is still almost double the price it was trading at a couple of weeks ago.

With any luck, what we’re seeing here is the market doing its worst. If we can get through this and the sun rises tomorrow morning, then maybe a more deliberately-designed and less panicked Congress will be able to agree on a fiscal stimulus bill which could prevent a really nasty recession without being seen as bailing out Wall Street’s millionaires.

But if a vicious spiral in the credit markets takes hold without any hope for hundreds of billions of dollars of US government money to come in and stabilize things, that could spell disaster for an economy which needs credit to grow.

There is one other option. The Scandinavian solution, which involves nationalizing banks rather than simply buying up their assets, could conceivably be implemented without legislative approval — after all, it’s already happened, to some extent, with Frannie and AIG. Since the likes of Paul Krugman and Brad DeLong think the Scandinavian solution is a better one anyway, maybe this will all work out OK in the end.

We can but hope. Or, as one reader just emailed me:

What we all ned to do is Pray to our Lord because he is in charge anyway.

I don’t think he’s talking about anybody in Washington.

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Oh Shit

The bailout act has just failed to pass the House, getting only 202 of the required 218 votes.

This is what happens when you have a free-rider problem: it’s in Congress’s collective interest to pass the unpopular act. But if the act is going to pass, then it’s in any individual’s interest to vote against it, thereby looking noble and on the side of his consituents.

The result? Stocks are down well over 5% as I write this. And it could get much worse.

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Where Will Treasury Find Its Model?

Steve Hsu has some ideas on how Treasury’s reverse auction might work; a new paper from NERA also considers the practicalities. The big question, of course, is how on earth one goes about valuing unique and hard-to-understand MBSs, CDOs, CDOs of CDSs, CDO-squareds, and other such exotica.

The NERA paper gives an idea of how it might be done, if it can be done at all. You start by finding relatively simple pass-through securities which are amenable to a standard reverse auction. Then you extrapolate:

Holding an auction may not be feasible if ownership

of a distinctive and therefore unbundleable asset is too concentrated. For these non-auctioned

assets, financial or statistical analysis may be used to estimate the value. This would involve

calibrating pricing models to the newly available market data generated by auctions, to estimate

the contribution to value of the various asset characteristics. Applying the estimated models to the

non-auctioned assets would then yield a predicted price for each asset.

Is this realistic? I asked Marcia Mayer, one of the authors of the NERA paper, and she responded:

Indeed, pricing of multi-sector CDOs (which contain tranches of other CDOs) and CDO2s poses difficult modeling challenges. Prices for these securities have historically been model-based, but those model-generated results were benchmarked against recent transactions in similar securities. Since the summer of 2007, model-based values, even using assumptions adjusted for rising delinquencies and defaults, became increasingly difficult to validate in the face of the drying up of the liquidity in CDOs and other component securities. The auctions would generate publicly-reported transactions in component securities, which would greatly facilitate the pricing process. We recommend that the auctions begin with simpler products and move toward more complex products. For assets that are narrowly held and too idiosyncratic to bundle, prices obtained at auction for simpler assets–and their implications for discount rates, default rates, prepayment rates, etc.–could be used to estimate fair values.

In other words, if you have prices for simpler assets, and you have a workable model, then you can end up with decent prices for more complex assets. And the auction should generate nice transparent prices for the simpler assets.

But where is the workable model going to come from? One of the defining characteristics of this financial crisis has been the collapse of models which worked up until 2007 or so, and then failed, with devastating effects.

There are couple of people who seem to have built models which worked quite well: John Paulson and Andrew Lahde, for starters. Do you think they might be persuaded to give those models to Treasury, now that they don’t need them any more?

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Charlotte’s Web

Did Vikram Pandit really just say what Heidi Moore says he said, on this morning’s conference call?

The plan is to fold the U.S. retail bank into the Wachovia team.

If I have this right, Citigroup might have bought Wachovia, but in effect, as part of the same deal, Wachovia has taken over Citibank. Which means that two of the three largest retail banks in America are now based in Charlotte, North Carolina.

Clearly this deal was done very quickly, and things might change. But if the retail bank is now to be run by the Charlotte-based Wachovia team, that’s a really good move by Pandit, who has no real ability or credentials in that area. Wachovia, by contrast, knows retail banking very well, and is extremely good at it.

Maybe this helps explain why Citi shares are trading higher on a day when the rest of the stock market is sharply down, and despite the fact that Citi’s going to have to dilute its present stockholders even further in order to make this deal work.

Or it could just be that Citigroup now boasts a deposit base of $1.3 trillion. With that sort of might, even barely-competent managers can make huge amounts of money.

Update: Heidi emails me the transcript. Pandit did indeed say it:

“Our plan is to fold our US retail bank, which is about a third the size of Wachovia’s retail bank, into the Wachovia platform and the team is extremely strong — the Wachovia team, Terri Dial, Marty Lippert.”

Wachovia is three times the size of Citibank’s retail operations?! I had no idea.

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China’s Wen: “Cooperation is Everything”

Chinese prime minister Wen Jiabao spoke to CNN’s Fareed Zakaria while he was in New York for the UN General Assembly last week. He very rarely gives interviews, and this was possibly his most open interview ever.

From a financial-markets point of view, the interview is very good news. Wen made it very clear that China is willing and able to help get through this present crisis — something which is absolutely necessary, given its enormous stock of US debt. A couple of excerpts:

ZAKARIA: What do you think of the current financial crisis affecting the United States?

WEN: This time, we should join hands and meet the crisis together. If the financial and economic systems in the United States go wrong, then the impact will be felt not only in this country, but also in China, in Asia and in the world at large.

I have noted the host of policies and measures adopted by the U.S. government to prevent an isolated crisis from becoming a systematic one. And I hope that measures and steps that they have adopted will pay off.

ZAKARIA: There is another sense in which we are interdependent. China is the largest holder of U.S. Treasury bills. By some accounts, you hold almost $1 trillion of it. It makes Americans – some Americans – uneasy. Can you reassure them that China would never use this status as a weapon in some form?

WEN: Something has gone wrong in the virtual economy. But if this problem is properly addressed, then it is still possible to stabilize the economy in this country.

Of course, we are concerned about the safety and security of Chinese money here. But we believe that the United States is a credible country, and particularly at such difficult times, China has reached out to the United States.

And actually, we believe such a helping hand will help stabilize the entire global economy and finance, and to prevent major chaos from occurring in the global economic and financial system. I believe now, cooperation is everything.

So there you have it: the US and China are allies in the Global War on Systemic Risk. Although I’m not sure you’d find many Americans willing to agree that the present crisis is an "isolated" one.

(HT: Fallows)

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Measuring the Credit Crisis in Markit Press Releases

Markit’s CDX credit-derivative index was meant to "roll" — be updated with the most up-to-date set of credits — on September 22. The roll was first delayed by one week, and then, in a vote on Saturday, was delayed another week. Here are the releases, I’ll have more tomorrow when I talk to a Markit exec.

September 15:

Following a majority dealer vote, the forthcoming Markit CDX index rolls will be delayed by one week.

The Markit CDX North America Investment Grade index and its related sub-indices will roll on September 29, 2008 instead of September 22, 2008 as initially planned.

The Markit CDX North America Crossover, Markit CDX Emerging Markets and Markit CDX Emerging Markets Diversified indices will roll on September 29, 2008 instead of September 22, 2008 as initially planned.

September 26:

Markit, a financial information services company and owner of the Markit CDX indices, today announced that the Markit CDX North America Investment Grade, Markit CDX North America High Volatility and Markit CDX North America Crossover indices will roll into their eleventh series on 29 September 2008. The Markit CDX Emerging Markets index will roll into its tenth series and the Markit CDX Emerging Markets Diversified index will roll into its eighth series on 29 September 2008.

September 29:

Markit, a financial information services company and owner of the Markit CDX indices, today announced that it has postponed the rolls of the Markit CDX North America Investment Grade, Markit CDX North America Investment Grade High Volatility, Markit CDX North America Crossover, Markit CDX Emerging Markets and Markit CDX Emerging Markets Diversified indices.

This decision was taken after Markit CDX index dealers voted to postpone the rolls due to market conditions and requests from their clients.

The aforementioned indices will roll into new versions on 2 October 2008 instead of on 29 September 2008 as previously announced. The indices will have an annex date of 2 October 2008 and an effective date of 21 September 2008.

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TED: 348bp

There are some great comments on my blog entry from Friday about whether the TED spread really matters right now. With TED up to a whopping 348bp today, it’s worth addressing them.

One thing which comes up repeatedly in the comments is the fact that trillions of dollars of debt instruments are tied to Libor — which means that even if the interbank market is very illiquid and not used in practice, it can have enormous effects on real-world interest payments.

This is true, but it’s entirely a function of Libor, rather than the TED spread. Libor was fixed higher today, at 3.88%, and yes, that’s vastly more than investors are willing to receive from Treasury over the same timeframe. But the fact is that 3.88% is not a particularly high nominal interest rate, not when the year-on-year rate of increase in consumer prices has hit 5.4%.

So by all means get exercised about Libor; just don’t use the TED spread as a proxy for Libor.

Ben makes a similar, but separate point: 28-day funding at the Fed can be even more expensive than Libor. But once again, we’re looking at an unnatractive funding source for banks, in the light of all the overnight liquidity which has recently been injected into the banking system, and then worrying probably a little too much that it’s quite high.

It’s quite obvious that interest rates are rising right now: for banks, for companies, for consumers, for pretty much everybody, really, except the government. That’s what happens in a credit crunch, and it’s not pretty. I do think though that the best indicator of how high interest rates have risen is, well, how high interest rates have risen. Libor now is about a percentage point higher than it was through most of the summer, and that’s worrying. But let’s concentrate on that, rather than looking at the TED spread.

Posted in banking, bonds and loans | Comments Off on TED: 348bp

How to Rescue a Bank

What’s the best way to rescue a failing bank? Bear Stearns got bought by JP Morgan with the help of a $29 billion Treasury backstop. Northern Rock was nationalized. Lehman Brothers was allowed to fail outright, enter bankruptcy, and eventually have its operations sold off to Barclays and Nomura. WaMu too was allowed to fail, but only after the OTS had pre-orchestrated a sale of its operations to JP Morgan. Merrill Lynch and HBOS were acquired with the help of regulators happy to waive anti-trust requirements. Fortis is being recapitalized with $16 billion of Benelux government cash. And now there’s Wachovia, which is a new model again: it’s being acquired by Citigroup, with the FDIC providing a monster $270 billion guarantee that no more than $42 billion of the bank’s loans will sour. In return, the FDIC is receiving $12 billion of Citigroup preferred stock and warrants.

Of all these models, the WSJ makes a compelling case this morning that the Lehman one is the worst. Tim Geithner, especially, knew that the consequences of allowing Lehman to fail would be gruesome — but he did it anyway, and things got much worse than he imagined much faster than he feared.

With hindsight, it would have been a less bad idea to spend $30 billion bailing out at least the senior bondholders of Lehman Brothers: such an action might well have prevented the need for the current $700 billion financial bailout.

I, for one, was a big supporter of the no-bailout-for-Lehman option. But it turns out that Lehman really was too big to fail, or too interconnected to fail, or maybe it was just that the markets were too fragile for any bank to fail.

There are three silver linings to the Lehman failure, though.

Firstly, things are so chaotic right now that a huge bank like WaMu can also fail, leaving its senior bondholders with pennies on the dollar, and the markets barely blink. If Lehman hadn’t already failed, it’s entirely conceivable that the WaMu collapse could have had much the same repercussions — but since the repercussions had already happened, it seems that there was a limit to how much worse things could get, at least in the short term. (For a pessimistic view of what the WaMu deal means in the longer term, see John Hempton.)

Second, the consequences of the Lehman failure have forced the US government to implement a massive all-things-for-all-banks rescue plan, rather than continuing to bumble down its erstwhile ad hoc road. Up until now, regulators have been so reactive rather than proactive that there hasn’t been a hint of strategy: now, the new Bailout Office Office of Financial Stability actually has the luxury of being able to think things through before it does them.

And finally, the Lehman failure, in forcing Morgan Stanley and Goldman Sachs to accept Federal Reserve regulation, has removed a large potential source of systemic risk going forwards. Goldman has been for many years the largest hedge fund in the world, and for all its vaunted risk-management skills, it could in theory have blown up at any time. Now, that eventuality is less likely, and if it does still happen it will be less harmful.

What’s quite clear is that regulators around the world have learned a great deal over the past year. Let’s hope they don’t again find themselves in the position of having to put those lessons to practical use.

Posted in bailouts, banking, regulation | Comments Off on How to Rescue a Bank

Extra Credit, Sunday Edition

A BILL: "To provide authority for the Federal Government to purchase

certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers, and

for other purposes. "

The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC: John Hempton is great when he’s angry.

Warren’s World: My take on the big new biography — or at least its first 174 pages.

Passports Denied: Mexican Americans Can’t Travel: Because they weren’t born in a hospital.

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Should the Bailout Reduce Other Government Spending?

The most annoying part of the first presidential debate, for me, was when the moderator, Jim Lehrer, asked the same question three times. Basically, he said that if you’re spending $700 billion on a financial bailout, then you’re going to have to cut back somewhere else:

And what — and the first answer is to you, Senator Obama. As president, as a result of whatever financial rescue plan comes about and the billion, $700 billion, whatever it is it’s going to cost, what are you going to have to give up, in terms of the priorities that you would bring as president of the United States, as a result of having to pay for the financial rescue plan? …

Are you — what priorities would you adjust, as president, Senator McCain, because of the — because of the financial bailout cost?

But if I hear the two of you correctly neither one of you is suggesting any major changes in what you want to do as president as a result of the financial bailout? Is that what you’re saying?

Before we go to another lead question. Let me figure out a way to ask the same question in a slightly different way here. Are you — are you willing to acknowledge both of you that this financial crisis is going to affect the way you rule the country as president of the United States beyond the kinds of things that you have already — I mean, is it a major move? Is it going to have a major affect?

Larry Summers, today, gives the answer I would have given:

The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less…

A family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays…

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers.

I’m not sure if it would have been politically feasible for Obama to have given this answer: no one running for president wants to sound cavalier about the fiscal consequences of spending $700 billion. But the fact is that those consequences are pretty small, or at least they might well be, if the government buys up the toxic assets at near-market prices. The key task is to structure the bailout legislation in such a way as to minimize the chances of it losing lots of money for the government. If you do that, then you don’t need to cut back on much in the way of other proposed programes.

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Ben Stein Watch: September 28, 2008

Faced with Hank Paulson’s request for $700 billion to bail out troubled banks, everybody has their own idea which they think will work better. Including, heaven help us, Ben Stein:

If we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay some of the price?

We have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them.

Where to start. First, annulling CDS contracts would constitute a massive and completely unanticipated flow of hundreds of billions of dollars away from people who had hedged their credit exposure and towards whiz-bang financial rocket scientists who created synthetic CDOs and other such exotica. Anybody holding a synthetic bond rather than the real thing would get a completely undeserved windfall. And any bank which had hedged its bond and loan exposure would probably go bust overnight.

Second, "the incomprehensibly large liability of the banks" would not cease. Remember that the Treasury plan is to buy up mortgage-backed assets, not credit default swaps. The liability of the banks comes from the fact that they’re holding huge amounts of super-senior CDO tranches and the like on their balance sheets. It does not come from the fact that they wrote, on net, a lot of default protection. That was a problem for AIG and other insurers; as far as we know, it has not been a problem for banks.

Third, the present financial crisis is not the fault of speculators who happened to be right that mortgage-backed bonds were massively overvalued. Making people pay for being right? Seems like a bad idea to me. Especially since the biggest speculators of all — people like John Paulson and Andrew Lahde — have already unwound their positions and taken their profits.

Fourth, we have not survived a house-price "correction" of this magnitude before. The last time that national house prices dropped this much was during the Great Depression. OK, in a sense you can say we survived the Great Depression. But only with a lot more anguish than is currently being felt.

Fifth, the CDS market does not multiply the effect of the housing downturn. As Stein does, to his credit, understand, a derivatives market such as that in credit default swaps is a zero-sum game. All it can do is transfer risk from one part of the global financial system to another. There’s no magnification going on. AIG was not involved in writing or securitizing mortgages, but it was ultimately brought to its knees by the mortgage market, because it used the CDS market to insure them.

There are well over $10 trillion of residential mortgages in the US. That’s more than enough money right there to cause massive chaos in the financial system if a large proportion of those mortgages all go sour at the same time. By Occam’s Razor, you don’t need to blame the CDS market for this one.

But Ben’s angry — and when he’s angry, he seems to lose the ability to think coherently. A bit like when he’s calm, really.

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Bloomberg Thumbs its Nose at FDIC

On Thursday, I criticized a Bloomberg story by David Evans which seemed to be unnecessarily alarmist about the FDIC’s finances. Later that day, Jeff Bercovici ran a letter from the FDIC to Bloomberg, complaining that the story "does a serious disservice to your organization and your readers by painting a skewed picture of the FDIC insurance fund".

How did Bloomberg respond to this criticism? Not by addressing it directly. Instead, their PR agency, Rooney & Associates, sent out an incendiary email to journalists on Friday, which kicked off with this highly misleading line:

The Federal Deposit Insurance Corp. (FDIC), the largely unseen government agency that backs the deposits in banks that earn their keep by writing mortgages, will likely run out of cash.

Has Bloomberg not heard of the maxim that when you’re in a hole, it’s a good idea to stop digging? Evidently not: and maybe the reasons is that Evans’s story is actually a 14-page article in the November issue of Bloomberg Markets magazine, which Rooney & Associates represents. Clearly a huge amount of time and effort has gone in to this story, and Bloomberg will be reluctant to accept much if any criticism.

Even so, you’d think that they would tone down their rhetoric a little in the wake of the FDIC letter, instead of ratcheting it up.

I called Terry Rooney, of Rooney & Associates, and asked him whether he had any response to the criticisms of the article which were made by the FDIC (and me, and Chris Whalen, who’s quoted in the article). He was not willing to say anything substantive — weirdly, given that he’d engaged me in the first place — and instead said that I should talk to Evans directly. Predictably, I never heard back from Evans or anybody else at Bloomberg.

Of all the news organizations covering the present crisis, I think that Bloomberg has been one of the very best: it has remained sober throughout, it has avoided publishing unconfirmed rumors, and it has generally been extremely reliable.

On the other hand, Bloomberg is dreadful when it comes to correcting errors or responding to criticism. They can’t even seem to correct erroneous headlines: they’re still running that story from February saying "Hirst Cabinet Fetches $6.2 Million for Bono AIDS Sale", when the actual hammer price was $6.5 million and the actual total price was $7.15 million.

In the case of the Evans story, I suspect that what’s really going on here is that Bloomberg Markets, the magazine, is operating at a far remove from the wire. The magazine is focused on its own business, and its PR agency might well have been utterly unaware of the response to the wire story. Back in June, Terry Rooney sent me a similar pitch, about another David Evans articlethree weeks after I’d originally blogged it. Clearly, the monthly Markets magazine is having difficulty keeping up with the speed at which news moves these days.

Maybe Evans didn’t call me back on Friday because he was still smarting from my criticisms of his article back in May. It’s possible: reporters have notoriously thin skins. But one word of advice to the team at Markets: don’t let your PR people start pitching magazine articles until they’ve digested the response to the story when it first appears on the wire. Otherwise you risk exacerbating existing problems.

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