Negative Convexity at Morgan Stanley

Morgan Stanley was short subprime. Subprime went down. Morgan Stanley lost

$3.7 billion on the trade. How is that possible? Morgan Stanley’s CFO, Colm

Kelleher, explained

it thusly:

“We began with a short position in the subprime asset class, which

went right through to the first quarter; as the structure of this book had

big negative convexity and the markets continued to decline, our risk exposure

swung from short to flat to long.”

So, what is this "negative convexity" of which Kelleher speaks?

Eric Jardine says

that it means that "we started out perfectly hedged but have since gotten

long as markets have deteriorated," but that’s not entirely right: as Kelleher

says, the bank started out short, they were then briefly perfectly hedged, and

then they ended up long. I have a feeling that in fact Morgan Stanley was putting

on a trade which was much more complicated than the simple long-senior short-junior

play that Jardine hypothesizes.

Part of the problem is that "convexity", as a concept is not very

easy to understand. It’s basically about the relationship between price and

yield: as a bond’s price goes up, its yield goes down, and vice versa. But if

you draw a graph with price on one axis and yield on the other, you don’t get

a straight line, you get a curve. Convexity is basically a measure of the shape

of that curve.

With most bonds, there’s something called positive convexity, which is great

for investors. If you buy a Treasury bond at par, say, then your profit in the

event of a 50bp drop in yields is greater than your loss in the event of a 50bp

rise in yields. For any given move in interest rates, your upside is bigger

than your downside. Nice!

But of course in the world of ultra-sophisticated financial engineering, you

can create instruments which have so much negative convexity that the price

might start off moving in one direction as yields start moving, and then eventually

start moving in the other direction.

I have no idea what kind of trade Morgan Stanley got involved in. But essentially

they went short at a point on the price-yield curve which was so very, well,

curvy that their profits from falling prices soon turned into losses

from falling prices.

The people responsible for this trade have, we’re assured, been taken

out and shot. I guess now they understand how convexity can bit

you in the ass.

Posted in bonds and loans | Comments Off on Negative Convexity at Morgan Stanley

CheatNeutral

If carbon offsetting is a joke, you might as well make

it funny.

(Via Tabarrok)

Posted in climate change | Comments Off on CheatNeutral

Rio Tinto Won’t be Independent for Long

When mergers get mooted, the stock-market reaction is generally predictable:

the stock of the target company rises, and the price of the would-be aquirer

falls. In the case of the latest proposed mining

mega-merger, the stocks followed most of the script: Rio Tinto soared 32%

on the news that it was being eyed as a takeover candidate by Australian giant

BHP Billiton. But interestingly, BHP

rose 3% itself. The market has spoken: a merger of these two companies is

a good idea.

Given that Rio’s share price is now all about merger arbitrage, expect some

kind of deal sooner or later, and treat its official

statement as little more than hardball negotiation. As Jason

Singer says,

BHP will need to pay up. How much is the question the two companies —

and the teams of advisers they will no doubt start assembling — will

be working through for weeks to come.

Of course, now that Rio Tinto is in play, other companies might decide to make

a rival bid. I suspect that Brazil’s CVRD might be interested, for starters.

Posted in M&A, stocks | Comments Off on Rio Tinto Won’t be Independent for Long

On Auction Houses’ Estimates and Reserves

There’s something I’ve always wondered about auction-house estimates: are they

estimating the hammer price, or are they estimating the final sale price, including

commission? The auction house press releases, and newspaper reports in the wake

of the auction, always talk about the latter: they’ll compare the price including

commission to the pre-auction estimate. But last night at Sotheby’s, a Van Gogh

with an estimate of $28 million to $35 million was passed, unsold, after bidding

stalled at $25 million.

Now the auction house’s commission is 20% of the first $500,000, plus

12% of the rest. Which on a $25 million hammer price would mean a total of $3.04

million. Add that to the $25 million hammer price, and you get $28.04 million

– which is above the low estimate. And you surely can’t have

a reserve price above the low estimate. Or can you?

Posted in art | Comments Off on On Auction Houses’ Estimates and Reserves

Extra Credit, Thursday Edition

Two

for the pot: Citi needs more new hires than just a CEO.

The

Carbon Calculus: Energy sources which become cost-efficient if you charge

for carbon emissions.

No

government after 149 days and no one notices: [insert obligatory Belgian

joke here]

SIV

Rescue Plan Delayed, May Be in Trouble

Next

Permanent Citigroup CEO: The PaddyPower odds. Gary Crittenden is 4-1; Stan

O’Neal is 50-1.

Hillary’s

climate-change plan

Dirty Money: "influenza

A viruses in respiratory secretions can survive for up to 17 days on banknotes".

I

Write For, Like, The Business Section? Textual analysis of the NYT’s Bizday.

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

Fiji Water goes Carbon Negative

You thought it was cool to be carbon-neutral? Well, Fiji water, one of the

most environmentally

absurd companies on the planet, has now gone carbon-negative!

I’m sure Nigel Tufnel would be proud. Claudia Deutsch reports:

The announcement comes after a summer in which numerous environmental groups

attacked the bottled-water industry for selling an unnecessary product at

great environmental cost. Mr. Mooney insists Fiji’s plans were in the

works long before that, but he conceded that the summer’s “media

environment” prompted Fiji to “rethink the value” of publicizing

its efforts.

“We are a small brand, but we are raising the bar for the entire industry

on how we should operate,” Mr. Mooney said. “If we’d announced

this six months ago, we’d be solving a problem no one in our industry

thought existed.”

Well, some of us have

been banging on about this since February at least, but I guess one shouldn’t

look a gift horse in the mouth. I look forward to seeing Fiji’s annual carbon

reports: announcements are easy, but one often finds much less transparency

on this kind of thing than one might expect. Think of it like stock buy-backs:

trust, but verify.

Posted in climate change | Comments Off on Fiji Water goes Carbon Negative

Japan Datapoint of the Day

And you thought it was bad here, in the US:

Japan’s housing starts dived 44% in September from the year earlier, the

sharpest fall on record, following a 43.3% plunge in August and a 23.4% drop

in July.

As Brad DeLong might say,

gurk!

Posted in economics | Comments Off on Japan Datapoint of the Day

Whole Foods Board Wimps Out, Exonerates Mackey

When the world found out that John Mackey, the CEO of Whole Foods, was a sockpuppet

hyping his own stock on internet message boards under an assumed name, it was

clear that he should resign

immediately. Instead, the Whole Foods board formed

a Special Committee. And now, almost four months later, that Special Committee

has finally acted:

Whole Foods Market Inc.’s board, reacting to Internet postings by its chief

executive, amended the company’s code of business conduct last week to sharply

restrict online activities by the grocer’s officials.

The new code bars top executives and directors from posting messages about

Whole Foods, its competitors or vendors on Internet forums that aren’t sponsored

by the natural-foods chain.

Oh yes they did. They amended the company’s code of business conduct.

It seems that "Rahodeb" isn’t the only puppet here: the entire Whole

Foods board looks as though it’s dancing on the end of strings manipulated by

Mackey. Pathetic.

Posted in stocks | Comments Off on Whole Foods Board Wimps Out, Exonerates Mackey

Toxic Waste Watch: Beware CDO-backed ABCP!

Since when do CDOs borrow money? I’m obviously rather behind the curve here,

since I thought that a CDO was basically an unlevered entity which invested

in debt. When it got income from that debt, the income would go first to people

holding the super-senior tranches, and then waterfall down. If you want extra

risk in CDO form, that’s easy: you just buy the lower-rated tranches. There’s

no need for leverage.

Unless you’re Citigroup, it seems. Sam Jones has done

some close reading of Citi’s

10-Q:

In Citi’s 10-Q filing on Monday, the bank repeated its weekend disclosure

of $43bn in CDO super senior debt “backed primarily by subprime collateral.”

The crucial point being that most of that was made up of:

…approximately $25 billion in commercial paper principally secured

by super senior tranches of high grade ABS CDOs.

You knew that asset-backed commercial paper (ABCP) was having problems. You

knew that CDOs were having problems. What you didn’t know, until now, was that

Citi had managed to combine the two, to create CDO-backed ABCP. Yikes! (Or if

you did know, you didn’t tell me.)

Is anybody else doing this?

(Via Smith)

Posted in banking, bonds and loans | Comments Off on Toxic Waste Watch: Beware CDO-backed ABCP!

How to Address a Goldman Sachs Banker

Goldman Sachs is building a new

headquarters building which will carry the address 200 West Street. It’s

on the west side of the street, on the block between Vesey and Murray. But if

you plug the address into Google Maps, say, you’ll be directed a couple of blocks

north, to the east side of the street at the intersection with Harrison. (One

block further north still, and you’d be at the back door of Citigroup.) It turns

out that "200 West Street" is what’s known as a "vanity

address", a bit like "4 Times Square". So what was the original

address, which Goldman didn’t like?

The most recent application that Borelli approved came from Goldman Sachs,

which is building new headquarters in Battery Park City, across from the World

Trade Center site. “It’s on Route 9A, which is the West Side Highway,

in front of what is technically Marginal Street,” he said, turning to

a giant map of Manhattan that was mounted above his desk. “The everyday

person would never know that Marginal Street exists, because, physically,

it’s a highway.”

Wouldn’t an address on "Marginal Street" be, like, the best address

ever for an investment bank?

Posted in banking | Comments Off on How to Address a Goldman Sachs Banker

Bleg: Looking for a Free-Float League Table

Companies like PetroChina and Google, which have a very small free

float, have been getting a lot of press for their enormous market capitalizations.

Does anybody have a league table of the most valuable companies in the world

by value of free-floating shares?

Posted in stocks | Comments Off on Bleg: Looking for a Free-Float League Table

PageRank: WaPo Up, Forbes Down, Portfolio beats WSJ

Remember the Great

PageRank Massacre, when the Washington Post saw its Google PageRank drop

from 7 to 5 overnight? Well, the good news is that WaPo is back, and stronger

than ever – it now has a PageRank of 8! Weirdly, however, Slate, which

is owned by the Washington Post, still languishes with a PageRank of 5. And

Forbes, which got demoted to 5 during the Massacre, has now fallen even further,

to a truly dismal 4. Meanwhile, I’m glad to see that Portfolio has improved

from 7 to 8 (wsj.com went the other way), while nytimes.com has been bumped

up from 8 to 9. Here’s a handy table so you can see what’s changed:

Site PageRank 10/25 PageRank 11/7
msnbc.com 9 8
nytimes.com 8 9
wsj.com 8 7
ft.com 8 8
portfolio.com 7 8
bloomberg.com 6 6
washingtonpost.com 5 8
forbes.com 5 4

Bonus quote, from News Corp executive Anne

Spackman: "Google now affects everything we do online". Yet another

reason why WSJ.com is bound to go free.

(Bleg: Does anybody know what Slate’s PageRank was on 10/25 and before the

Massacre?)

Posted in Media, technology | Comments Off on PageRank: WaPo Up, Forbes Down, Portfolio beats WSJ

Wall Street Bonus Watch

Jesse Eisinger emails to say that he’s hopeful about winning our

bonus bet, in the wake of stories today in the WSJ

and the NYT.

Both of them report on projections from executive-compensation experts Options

Group and Johnson Associates, and the overall picture is mixed:

Johnson & Associates predicted that bonuses would be down 5 to 15 percent

for fixed-income traders; up 5 and 20 percent, respectively, for equity and

equity derivative traders; and up 10 to 20 percent for investment bankers.

Bonuses for corporate staff members, according to Mr. Johnson, will be flat

to 5 percent up, and asset management will be getting increases of 5 to 10

percent. The Options Group predicted that fixed-income bonuses would fall

15 to 20 percent, and that equity and investment banking bonuses would rise

10 percent.

Note that bonuses in the commodities sector aren’t even mentioned here; those

are going to be up sharply. I’m still confident I’m going to win the bet: if

corporate staff are seeing their bonuses flat to up a little, and if headcount

is higher now than it was last year, then it’s hard to see how bonuses in aggregate

could be down more than 10%.

Now the one big unknown here is whether Wall Street is going to make good on

its implicit promise to its employees. As a rule, financial professionals work

very hard all year, in the hope and expectation that if they make a lot of money

for their firm, a substantial chunk of those profits will be returned to them

in the form of a bonus check. In other words, from an employee’s point of view,

a bonus is a reward for a job well done.

From an employer’s point of view, however, the bonus is a way to retain talent

and to ensure that the top producers remain at the firm for another bumper year.

So if a certain business performed very well in 2007 but looks as though it

will have a dreadful 2008, the firm has no real reason to pay out big bonuses.

The employees who made lots of money for the bank in 2007 will get very annoyed

and leave for greener pastures (ie, hedge funds), but that might be just what

the bank wanted in any case: lower payroll in 2008, and no hit to earnings from

paying out aggressive 2007 bonuses either.

That said, investment banks have reputations to protect, and a bait-and-switch

like that is the kind of thing that Wall Street remembers: anybody trying it

risks having a lot of difficulty attracting talent next time the good times

are rolling.

And there’s one more reason I’m optimistic about winning the bet: it’s denominated

in those increasingly-worthless things called dollars. Investment banks operating

internationally – which is all of them – are going to find that

their bucks don’t have nearly as much bang as they used to. Which means they’ll

need to shell out more of them to keep their international employees happy –

something crucially important, when it’s those international employees who are

probably going to drive growth in 2008.

Posted in banking | Comments Off on Wall Street Bonus Watch

Privatizing the Sidewalk

Matt Cooper says

that he is "not a privatize-the-sidewalks kind of guy". Why not? It

seems to be working

pretty well in New York:

A 150-square-foot sidewalk berth anywhere between 96th Street and Canal Street

costs $4,749.29 annually, about $31 a square foot. (Owners also pay a $510

fee for the two-year license.)

These consent fees, which are the city’s going rate for private businesses

to lease public real estate, were doubled or tripled in 2003, when the regulations

changed. The fees have created a significant revenue stream for the city;

it has taken in $10.7 million in cafe fees this year, according to Jonathan

Mintz, the consumer affairs commissioner…

If a restaurant pays $150 a square foot annually for a 2,500-square-foot space

along, say, Hudson Street in the West Village, the rent would total $375,000

a year.

Posted in cities | Comments Off on Privatizing the Sidewalk

The Best Subprime Reporting and Analysis

Jack

Flack and Jack Shafer look

to the MSM today for help in unscrambling the subprime mess. (Weirdly, however,

Shafer asks journalists to nominate the best journalists on this beat,

rather than asking genuine housing experts.) In the broader media world, however,

by far the broadest, deepest, and smartest coverage of the subprme crisis and

housing meltdown comes not from any newspaper but rather from the blog Calculated

Risk.

CR himself does an amazing job of aggregating housing-related news, and adding

some smart analysis as well; his sidekick Tanta is one of the best financial

writers in the world, and explains complex ideas with wit and great clarity.

The blog is a one-stop shop for all your housing-related news and analysis,

and must be mentioned in any round-up thereof. Now, if only they would

serve a full RSS feed…

Update: That was easy! Calculated Risk now has a full

RSS feed. Thanks!

Posted in housing | Comments Off on The Best Subprime Reporting and Analysis

What is a Deferred Tax Credit Noncash Charge, Anyway?

The NYT is a general-interest newspaper, which should be comprehensible to

a broad reading public. And certainly me. But even the NYT can’t seem to explain

clearly what’s

going on at GM. What does this mean?

DETROIT, Nov. 7 — General Motors reported its largest quarterly loss

ever today after it took a huge noncash charge to write down deferred tax

credits.

The NYT does note that "GM’s $39 billion overall loss equals $68.85

a share, nearly double the company’s closing stock price Monday."

So if it’s just lost $68.85 a share, how come the stock is worth anything at

all?

This is the kind of story which journalists hate. They’re not accountants,

and when they phone up accountants to ask what’s going on, they get the kind

of answer which makes perfect sense to accountants, but which is very hard to

translate into English. And besides, they’re on deadline.

Galloping to the rescue this morning, however, is blogger extraordinaire

Steve Waldman, who does his best to explain

what’s going on. But first he makes sure to let us know that things are

actually even worse than they might seem at first glance:

Check out GM’s top-level balance

sheet last quarter (the quarter ending Jun-07). Look at the line called

"Total stockholder equity". Yes, it really does say negative 3.5

billion dollars…

A $30B net charge would bring GM’s accounting equity down to negative 33 billion

dollars.

Is that a record? What’s the maximum negative accounting equity ever reported

by a going concern? Or, consider this: GM is not a penny stock. The market

imputes a lot of real value to those claims worth negative dollars on its

balance sheet. GM’s market cap as of yesterday was about $20.5B. That’s a

positive number.

Surely there comes a point where stock-market valuations and accounting valuations

have to be on at least speaking terms with each other. But in the case of GM,

at least, it seems, that point is probably a very long ways off.

But anyway, back to those deferred tax credits. Here’s Steve’s explanation

– thanks, Steve!

For those who want to know, "deferred tax assets" arise when firms

recognize expenses before they are allowed to take a tax deduction for those

expenses. Let’s say a large New York bank decides some of its assets are worth

10B less than originally thought, and writes those assets down on its balance

sheet. If the bank pays a 35% tax rate, 3.5B of that "loss" should

eventually be absorbed by the government in the form of reduced tax payments.

But companies don’t get to pay fewer taxes whenever they change their estimate

of the value of an asset. The bank gets a cash write-off on its taxes only

when the assets are actually sold and the firm realizes a loss. In the meantime,

the firm recognizes a 3.5B "tax asset", the value of the future

tax savings it expects. This is all perfectly legitimate — writing down

the assets without recognizing the expected tax-savings would badly overstate

costs. But sometimes a firm’s estimate of future tax savings turns out to

be wrong. Say the bank is forced to sell the impaired assets when it is already

losing money. Then there is no immediate tax savings, because the bank wouldn’t

have paid taxes that year anyway. The firm may still be able to "carryforward"

the loss, and recover some of the tax savings. Or it may not. Tax laws are

complicated.

GM had previously estimated that it had $39B in future tax write-offs coming

to it. Its accountants now think the company might never get the chance to

use them. Though this is not a cash charge, it is not a good omen either.

Firms realize tax assets when they are profitable enough to have a large tax

bill to take deductions from. GM is basically announcing that it’s unsure

it will earn enough money to be able to take advantage of its pent-up tax

offsets before they expire. Tax asset write-offs are insult-to-injury kind

of events. Firms get hit with the accounting charge when, and precisely because,

they can’t make enough money to have a tax liability to escape from.

Tax asset write-offs might also be a signal of distress, indicating that a

firm lacks the flexibility to time its loss realizations advantageously. Tax

laws are complicated, and sometimes tax benefits expire regardless of what

a firm does. One mustn’t draw conclusions. Still, it does make you wonder.

Posted in stocks | Comments Off on What is a Deferred Tax Credit Noncash Charge, Anyway?

Extra Credit, Wednesday Edition

GM

Watch, Again: Foreclosures and Fees: Tanta on Morgenson. "High rates

of foreclosure and bankruptcy are money-losers for mortgage servicers, not profit

centers".

More

Bank, Brokerage Writedowns, Ratings Cuts Inevitable

The

dollar hits an all-time low against the Deutschmark

Price

Discrimination 101: On the economics of rude waiters.

How

Not to Follow the Example of Ocean’s 11: "When the students went

to see “Ocean’s 12,” undercover agents were seated right behind

them in the theater, eavesdropping as the young criminals made comments like

“Oh, this is just like us.” All four were eventually arrested and

are serving seven-year prison sentences."

Impressionist

and Modern paintings fetch $350 million at Christie’s: No sign of auction-market

weakness just yet.

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

Shaukat Aziz as Citigroup CEO!

The Economist places its weight behind Shaukat

Aziz as the ideal CEO of Citigroup:

The 58-year-old joined Citibank in 1969, and worked in various parts of its

global empire—including Britain, Greece and Malaysia—before eventually

becoming global head of Citi’s private bank. So he knows the firm well,

and certainly has good international experience.

He left in 1999 to become the finance minister of Pakistan; he is now prime

minister. Pakistan’s economy has flourished during this time, even as

its politics have deteriorated. Given the country’s current state of

emergency, he may be tempted to find an exit. He would surely be alone amongst

potential recruits in regarding the job as an opportunity for a quieter life.

If it happened, Citi would have former finance ministers as both Chairman (Rubin)

and CEO (Aziz). They say that Citigroup is the size of a small country; maybe

it needs an experienced pol to run it.

Posted in banking | Comments Off on Shaukat Aziz as Citigroup CEO!

The Economics of A-Rod, Part 2

Why is it that the best place to find high-level microeconomic analysis in

the NYT seems to be the sports section? First there was Ed

Wyatt on Tour de France breakaways; now comes Columbia’s Jeffrey

Gordon on the A-Rod opt-out. Gordon transcends Leitch-level

analysis (which I was very

happy with) and takes the game theory of baseball negotiations to a whole

new level, explaining why A-Rod might well end up getting more money out of

the Yankees if they don’t have a $29 million subsidy from the Texas

Rangers. His headline says it all: "By Opting Out, Rodriguez Really Wants

In".

Gordon looks at the $29 million subsidy in an interesting way: as a bargaining

chip being used by the Yankees to keep Rodriguez from defecting elsewhere. By

opting out of his contract, Rodriguez takes that chip away from the Yankees,

and forces them to get serious about retaining him.

In Gordon’s view, Rodriguez opted out of his contract very early on, before

the Yankees made him a serious offer, because he actually wanted to stay

at the Yankees. It sounds weird, but Rodriguez, on this view, opted out

in order to avoid putting the Yankees into an impossible position. If he opted

out after a serious Yankees offer, there would be no way he could return

to pinstripes. And without Rodriguez opting out, the Yankees were very unlikely

to offer the kind of money that Scott Boras thought Rodriguez was worth. So

the only way that Rodriguez could get a fully-valued offer from the Yankees

was to opt out very early on in the negotiation process.

Now Gordon does concede that spiteful and self-defeating behavior by the Steinbrenner

sons could scupper this strategy. And from a public-perception point of view,

Rodriguez has been damaged: this is very important, since in the world of sponsorships

and endorsements, public perception is a valuable, fungible and monetizable

commodity. The amounts of money involved seem to have turned even Portfolio’s

sports blogger into a latter-day

Marxian, asking "how much money does one person need?", with the

implication that it’s somehow déclassé to ask for lots

of money if your team failed to meet expectations.

Interestingly, Gordon’s analysis did seem to move the market, a little. In

the immediate wake of the A-Rod opt-out, the probability of his starting the

2008 season as a Yankee, according to Tradesports, dropped to as low as 2%.

After Gordon’s article appeared, the Tradesports contract rose, and it’s now

up to 10%. It’s still much lower than the 50% or so at which the contract was

trading before the opt-out was triggered, but it’s now clearly non-negligible.

All the same, if you really buy Gordon’s analysis, the contract is a screaming

buy – or would be, if there was any liquidity in it, which there isn’t.

Price for New York Yankees in 2008 at TradeSports.com

Posted in sports | Comments Off on The Economics of A-Rod, Part 2

Australia Datapoint of the Day

John

Quiggin:

On an exchange rate basis, Australia has a higher GDP per person than does

the US.

Currently US GDP per person is around $US44,000. Australia’s is about

$A51,300, which at a market exchange rate of 0.93 converts to about $US47,700.

Posted in economics | Comments Off on Australia Datapoint of the Day

Citi: In Defense of Gary Crittenden

Brad DeLong

takes a cheap shot at Citigroup’s CFO, Gary Crittenden, who on the Citigroup

conference call tried to explain where all those extra write-downs were coming

from. Crittenden explained that much of Citi’s subprime exposure was in so-called

super-senior tranches, which were designed to have no default risk. But in October,

suddenly the cost of insuring AAA-rated MBS tranches against default started

spiking upwards – which means that the implied markt value of those tranches

went down, even if Citi still has every confidence that they won’t default.

Here’s how Brad sees it:

When Crittendon says that "if you look at what the ABX would imply in

terms of real estate price reduction, it starts to imply very, very high numbers…

it’s unlikely that those… will take place" the sentence should

not come to an end. There should be a comma, and after the comma the sentence

should continue "therefore Citigroup is sponsoring and investing in a

new hedge fund to take advantage of the undervaluation of the ABX and similar

market opportunities, and we are now raising capital." If you say:

  • We’re taking a markdown based on the ABX.
  • But we believe the ABX is underpriced.

Shouldn’t the very next sentence be:

  • We are moving to profit from this mispricing?

In fact, it’s not nearly as simple or as easy as that.

The problem is that the

ABX is a very bad indicator of what CDOs might be worth. What happened was

that Citi and other banks issued many billions of dollars’ worth of structured

securities which were rated AAA by the ratings agencies and which were then

sold to highly risk-averse investors, who placed great store in that AAA credit

rating. Of late, the ratings agencies have been going on something of a downgrading

spree, and few if any investors place much faith in a AAA rating on a structured

product any more. Remember, these investors are very risk-averse. But they’re

also holding a large amount of highly illiquid paper, which they can’t sell

easily if at all. So the one option open to them, if they’re worried about credit

risk on that paper, is to buy credit protection on it.

As a result, the cost of insuring AAA-rated paper against default spiked up

– and it’s that insurance cost which is measured by the ABX indices. The

paper itself still doesn’t really trade at all. But here’s the problem: since

the paper isn’t trading, the ABX indices give the closest thing that there is

to a market price for the underlying paper. If Citi wants to mark to market,

then, it has to mark to the ABX market. Crittenden’s point is that those marks

don’t make a lot of sense when it comes to the actual value of the underlying

securities, in terms of the net present value of the cashflows associated with

them. If you wanted to construct a model which would spit out the ABX-implied

valuations, you’d have to assume nationwide housing-price falls which were really

enormous. (It would have been nice for Crittenden to quantify those falls, I

must admit.)

So what’s Citi to do? It constructed these CDOs, and has faith in the cashflows

going to the super-senior tranches which it owns a lot of. It’ll mark those

tranches down, but it’s not going to sell them, partly because it can’t

sell them (there’s no market for them right now), and partly because, pace

DeLong, it thinks that the (implied) market is mispricing them.

But precisely because there is no market in these things, one can’t simply

set up a hedge fund to arbitrage the mispricing, since the mispricing is more

theoretical than actual. You could try going long the ABX, but the ABX doesn’t

have anything to do with cashflows: it has everything to do with the cost of

insuring against default. And it’s entirely possible that a jittery world will

pay more for default protection for some time, even if the cashflows themselves

are rock-solid.

In fact, the only way you can really benefit from the (implied) mispricing

is to mark your assets down today, in line with what the ABX is implying, and

then collect your cashflows as per schedule. And that, it turns out, is exactly

what Citigroup is doing.

Posted in banking, bonds and loans, housing | Comments Off on Citi: In Defense of Gary Crittenden

Lessig at TED

A rare video of one of Larry Lessig’s legendary slide shows on copyright and

creativity, this one from the TED conference in March. And this one comes with

added Jesus! Enjoy.

Posted in intellectual property | Comments Off on Lessig at TED

Electricity: Deregulation Sends Prices Soaring

David Cay Johnston’s headline says it all: "Competitively

Priced Electricity Costs More, Studies Show". When states deregulate

their electricity sectors, the price of electricity goes up, not down –

and the attempts of pro-deregulation advocates to spin the data otherwise are

downright embarrassing.

Dean

Baker notes that the news here is actually even more striking than it looks

at first glance. The studies looked at the market for industrial energy, not

the pricess paid by residential or commercial users. And one of the driving

ideas behind electricity regulation is that there’s a cross-subsidy: industrial

users will pay more so that residential users can pay less. If you get rid of

the regulation, then, industrial users should pay less pretty much automatically,

since they’re no longer subsidizing residential users.

Mark

Thoma picks up on the description of the way that electricity auctions in

deregulated states are designed, and quotes Hal

Varian as saying that differences in auction design can make an enormous

difference. But I don’t think that auction design is at fault here. Rather,

electricity companies in a deregulated market will generally find a way to charge

whatever they can get away with. Sometimes they get slapped down: when Arizona,

Illinois, Ohio, Pennsylvania and Virginia deregulated their markets, it didn’t

take long for them to change their mind and impose rate cuts, freezes or caps.

But that’s OK, because in the really big states like California, Texas, and

New York, the state simply allowed deregulated electricity prices to rise and

rise, to the point at which they’re now 49% higher than electricity prices in

states with price regulation.

What’s more, the difference in prices spiked up during the infamous period

when Enron was manipulating energy prices in California – but it never

really came down thereafter, and is much bigger now than it was then. What we’re

seeing now is actually worse, in aggregate, than what we saw during

the California energy crisis. There’s no way to spin this: electricity price

regulation is good for consumers, and electricity price deregulation is bad

for consumers. End of story.

Posted in regulation | Comments Off on Electricity: Deregulation Sends Prices Soaring

Citi: Is Stuckey Too Constrained?

Jules: You sendin’ The Wolf?

Marsellus: Feel better?

Jules: Shit Negro, that’s all you had to say.

Rick Stuckey is the Winston Wolf of the financial world, screeching into problem

areas and cleaning them up with great professionalism and no panicking. He managed

the LTCM fiasco, and now he’s been put

in charge of Citigroup’s subprime portfolio.

Which is all well and good, but I think that if Bob Rubin and Win Bischoff

were really serious about washing out these stables, they would have given Stuckey

more than just $43

billion in subprime-backed assets. After all, Citi’s mark-to-model portfolio

now totals $135 billion, an increase of $40 billion in just three months, and

I doubt that the problems in it are confined entirely to subprime. Are there

securities in there backed by option-ARM prime mortgages, or commercial real

estate lending? Are there bridge-equity lines, or impossible-to-sell loans to

private-equity shops? Citi isn’t saying, and it seems that they’re discouraging

Stuckey from even asking.

If you’re sending in The Wolf, you want him to deal with everything, not

just the worst of the mess.

Posted in banking | Comments Off on Citi: Is Stuckey Too Constrained?

NYT-Bartiromo: The Comedy of Errors Continues

The NYT has corrected

its Bartiromo

story from yesterday – the one which invented not

only a new Citigroup executive called William Rose, but

also an "international investment firm" with $60 billion called

"Cutter Associates". But they still don’t have it right.

Here’s the way the story now ends:

Having weathered the Citigroup storm, Ms. Bartiromo said, she is free to

pursue the thing she most loves to do: talk to business people about what

is about to move the market.

“I love this thing now called sovereign funds,” she said, meaning

the large pools of capital amassed by governments in Asia and the Middle East,

and managed by groups like Qatar Associates, an international investment firm.

“I had the head of Qatar on and he said: ‘Look, we have $60 billion

we want to put to work.’ I find that kind of stuff so exciting. I find

it so sexy.”

It’s true that there isn’t a firm called Cutter Associates, but there also

isn’t a firm, a group, or anything else called Qatar Associates. There’s a sovereign

wealth fund called the Qatar Investment Authority which is, well, sovereign:

describing it as "an international investment firm" rather misses

the point.

And for all Bartiromo’s preternatural bubbliness, I don’t think she’d say something

like "I love this thing now called sovereign funds," either: she’s

more serious, and more well-informed, than that.

This is more than a storm in a media teacup: it speaks to the shallowness of

the NYT’s bench when it comes to business coverage. Some of the reporters have

no idea what they’re talking about, and the editors don’t seem to be up to speed

enough on business issues to catch mistakes. On any serious financial publication,

substantially everyone should know what a sovereign wealth fund is. As the IMF’s

Simon

Johnson notes, these funds now run some $2-3 trillion, and could reach $10

trillion by 2012. Those are enormous sums of money.

The market in business news has moved online, and is both increasingly competitive

and increasingly lucrative: ads on business news websites are some of the most

expensive on the web. The NYT’s strong online franchise gives it a headstart

in this market, but once the FT and the WSJ go free, it’s going to need more

than that.

Posted in Media | 3 Comments