Citibank Refuses Hand-Drawn Check

Posted on September 11, 2007 by Felix

People don’t pay by check nearly as much as they used to, because checks are

time-consuming, inconvenient, and not in the slightest bit fun or interesting.

But what if that changed? What if checks became time-consuming, inconvenient,

and fun and interesting? After all, when you write a check, it doesn’t

need to come out of one of those official checkbooks. Holden

Lewis reports:

What if you won the lottery and you got one of those giant cardboard checks

— could you deposit it at the bank?

Yes, if the proper information were written on it…

"It has to contain certain features, and it can be written on anything,"

says Brian Black, managing director of operations and technology for the Bank

Administration Institute. "As long as it has the elements, the surface

doesn’t make a difference. A check is an order to pay someone, that’s all

it is."

Recently, my wife, who’s an artist, commissioned an artwork from a fellow artist

here in New York. Rather than simply pay with a boring check, we decided to

pay for the work with something a bit more interesting: a hand-drawn check,

in pen and ink on paper. Larger than normal, to be sure, and missing all the

magnetic ink and whatnot, but a valid check all the same, with all the proper

information on it.

Our friend took the check to her local Citibank to deposit it. And I’m afraid

this story doesn’t end well. The manager was called, no one smiled, they curtly

said that the check simply wasn’t acceptable, and they refused to accept it

as a deposit. The manager even asked why we hadn’t wired the money instead!

And so the check remains, undeposited. We’ll probably just write a normal one

out of a checkbook instead. But it turns out that depositing a non-standard

check in practice is a lot harder than it is in theory.

Posted in banking | Comments Off on Citibank Refuses Hand-Drawn Check

El-Erian Leaves Harvard, Returns to Pimco

Posted on September 11, 2007 by Felix

Mohamed El-Erian is moving

back to Newport

Beach. Here’s my take on the news.

  • This has got to be a serious blow to Harvard, where his work of rebuilding

    the management team in the wake of Jack Meyer’s departure is only, by his

    own admission, part done. ("HMC is still in a transition phase,"

    he wrote in his John

    Harvard letter three weeks ago.)

  • Given that El-Erian was clearly making a long-term commitment when he moved

    to Boston, does this prove that that Harvard is genuinely bad at retaining

    talent?

  • Or is El-Erian just fickle? His tenure at Harvard was short, but not as

    short as his tenure at Salomon Smith Barney. And he allowed himself to be

    nominated to be managing director of the IMF in 2004, as well.

  • So, what were the real drivers of this move? El-Erian emphasizes wanting

    to be closer to his family in California, which has a certain amount of plausibility

    to it if only because he already took a pay cut to move to Harvard, which

    makes it less likely to be about the money.

  • On the other hand, it could still be about the money and the power. The

    $40 billion that El-Erian was running at Harvard is a huge sum, to be sure,

    but it’s dwarfed by Pimco’s $700 billion. When he left Pimco, El-Erian was

    just one of a number of managing directors all jostling for position as Bill

    Gross’s heir apparent. Now, he’s being parachuted in as co-CEO and co-CIO,

    making him if anything senior to Gross, since he will have official managerial

    clout.

  • In terms of El-Erian’s Pimco career, then, leaving the company seems to

    have been the best thing he could have done: I doubt very much he would have

    been granted this position had he stayed. And I’m sure that his new job comes

    with extremely generous remuneration: El-Erian is now on his way

    to becoming dynastically wealthy.

  • What’s more, the international travel which took its toll on El-Erian when

    he was at Pimco the first time round won’t be an issue now that he’s definitively

    graduated from the emerging-markets universe and will be running everything.

  • On the other hand, El-Erian’s new job is definitely more constrained than

    the one he’s leaving. He has to share his CIO title with Bill Gross, and share

    his CEO title with Bill Thompson. He also has to confine his investments to

    the narrow world of fixed income, rather than being able to invest in any

    asset class at all.

  • And does anybody really believe in what Thompson is calling "a powerful

    and experienced leadership triangle" as an efficient way of running anything?

    Bill Gross is the billionaire founder of the company and I’m sure retains

    a de facto veto over all major decisions there, which means that

    there are essentially three people running the company at once. This is not

    exactly a time-tested recipe for success, no matter how friendly and collegial

    the three men are.

This decision by El-Erian, then, is likely to cause no little upheaval at both

HMC and Pimco. Personally, I’m sad that we won’t be able to find out how El-Erian’s

HMC performed over the long term, which was something I had much interest in.

Pimco, by contrast, is enough of a supertanker that El-Erian’s influence there

will be almost impossible to ascertain. But I’m sure that Bill Gross, for one,

is very happy to have his old lieutenant back on the west coast.

Posted in bonds and loans | Comments Off on El-Erian Leaves Harvard, Returns to Pimco

The Most Credible Financial Blogs

Posted on September 11, 2007 by Felix

The credibility of Crain’s web reporter Aaron Siegel is questionable. He wrote

a whole article headlined "Credibility

of financial blogs is questionable," something he deduced from a report

edited by Spectrem Group’s Ed Eusebio. “There seems to be a disconnect

as to what is a blog and what is a legitimate article,” he quoted Eusebio

as saying along with this more cryptic assessment:

Within the past few years, you are seeing much of the mainstream media grabbing

the floor and have created blogs as another tool for content delivery.

I wasn’t entirely clear what "grabbing the floor" was supposed to

mean, so I phoned up Eusebio myself. "Grabbing the floor?" he asked

– "I don’t even know what that means. I’d certainly never say that."

In fact, Eusebio told me, neither he nor the people he surveyed for his report

consider the credibility of financial blogs to be questionable. "I think

that any financial institution or publication or publisher can deliver information

any way they want to their readers," he said.

Eusebio himself subscribes to a handful of financial blogs, mainly from mainstream

outlets like the Wall Street Journal: those are easier to find than self-published

blogs, he told me. "I do tend to lean to the brands when I’m looking for

information. It’s natural. It takes a bit more looking around sometimes to find

legitimate, good blogs that are not large-company sponsored. It takes a lot

to find the real gems that you can rely on." That said, he added: "Is

someone who is blessed by the WSJ more capable than someone on their own, when

it comes to expertise? No."

I am mildly surprised that the most popular blogs in Eusebio’s survey are all

from mainstream publications: no Barry Ritholtz, no Calculated Risk, no Paul

Kedrosky. Instead, the 106 high net worth individuals who read blogs turned

out to read the big, mainstream sites: Yahoo Finance, MSN Money, Motley Fool.

It’s a bit weird, because blogs on those sites almost never get much traction

in the rest of the econoblogosphere: they’re rarely linked to, and I can’t remember

reading a single Yahoo or Motley Fool blog ever. I do vaguely have the impression

that they talk a lot about US stocks, both individually and collectively, and

whether they’re going up or down. Are there any which are more interesting,

and which have a broader remit?

Posted in Media | 1 Comment

ABCP: The Trillion-Dollar Question

Posted on September 11, 2007 by Felix

Gillian Tett has

some numbers on the enormity of the problem in the money markets. The troubled

asset backed commercial paper (ABCP) market is about $1.2 trillion in size –

three times its 2002 level. The biggest investors in ABCP are money-market funds,

which control some $4 trillion in total, and they’re essentially refusing to

invest in ABCP right now.

I have just one question. Let’s say that up until recently, money-market funds

had $1 trillion of their assets in ABCP. As that number starts to fall precipitously,

what are those funds going to invest in instead? It’s not like there’s

suddenly huge amounts of demand for short-term debt from financial institutions,

and I don’t see any massive outflows from money-market funds in general. And

although there has definitely been a flight to the short end of the Treasury

curve, total supply in that market hasn’t gone up either. If the money-market

funds aren’t rolling over their ABCP, what on earth are they buying in its place,

when their ABCP holdings mature?

Posted in bonds and loans | Comments Off on ABCP: The Trillion-Dollar Question

Valuing Suites in Giants-Jets Stadium

Posted on September 11, 2007 by Felix

Allan Kreda has a stunning datapoint today: luxury suites in the new Giants-Jets

stadium in New Jersey are selling for $1

million each. Per season. Now, I know nothing about football, so I’m maybe

not the best person to opine on this. But on its face, that’s a crazy amount

of money: more than $60,000 per regular-season game, although presumably there’s

a good chance that one team or the other will make the playoffs in any given

year.

What explains these eye-popping sums? My best guess is that it comes back to

the age-old question of what to get the man who has everything. Let’s say you’re

a prime broker, and you want to entertain your hedge-fund clients. You can spend

a lot of money on anything from fine food and wine to strip clubs, but ultimately

your clients could and probably do spend their own money on exactly the same

things themselves. You’re just giving them more of what they’ve already got.

Watching a football match from a luxury suite, however, is not something that

a hedge-fund manager can simply buy for cash. The suites are being sold on 10-year

contracts three years in advance, and as I understand it they almost never change

hands once they’ve been sold. So the hotshot hedgie of 2017 has really no opportunity

to sit in one of these suites unless he’s invited to by its owner – by

the time the games are being played, the suite will have become a valuable asset

which money can’t buy. Perfect, for the prime broker which wants to differentiate

itself from the crowd.

And then there’s the Embedded Superbowl Option. If the Superbowl takes place

during the life of the contract, the owner of the suite can basically name his

price. Given what prime brokers do for a living, valuing an option like that

should be child’s play, no?

Posted in sports | Comments Off on Valuing Suites in Giants-Jets Stadium

On Bankruptcy

Posted on September 11, 2007 by Felix

Megan McArdle has a paen

to the US bankruptcy system today:

The current system works pretty well. Recognizing that we don’t have any

very good mechanism for picking out the profligate from the unlucky (most

bankruptcies involve a little from Column A, a little from Column B), we let

people get rid of their debts regardless of how they were incurred. (Except

for special exceptions, most of them involving the government, such as taxes

and student loans). Then, recognizing that it is not a good idea to make it

painless to borrow money you don’t repay, we make life a little bit miserable

for people who declare bankruptcy–though not very miserable; the chief result

is that it’s somewhat harder to get credit. It’s hard to overstate how well

this works. America’s bankruptcy system is the most generous to the debtor,

the least interested in assigning fault, in the entire world. There’s strong

evidence that this is one of the reasons behind our high rates of entrepreneurship;

it makes it easier to take economic risks.

And on the opposite side of the ideological spectrum, Andrew Leonard ends up

agreeing that bankruptcy

doesn’t seem to reduce Americans’ access to credit very much:

According to data compiled and analyzed by Katherine Porter, a law professor

at the University of Iowa, in the superb "Bankrupt

Profits: The Credit Industry’s Business Model for Post-bankruptcy Lending":

…Creditors repeatedly solicit debtors to borrow after bankruptcy. Families

receive dozens of offers for new credit in each month immediately after

their bankruptcy discharge. Some offers specifically target these families

based on their recent financial problems, using bankruptcy as an advertising

lure. Other credit offers emanate from the very same lenders that the families

could not repay before bankruptcy. While not every lender will accept a

"profligate" bankrupt as a customer, debtors report being overwhelmed

after bankruptcy with a variety of credit solicitations from many sources.

Lenders offer families most types of secured and unsecured loans.

It turns out, according to Porter, that a year post-bankruptcy, bankrupts are

receiving more than 14 credit offers per month – more than double the

six offers per month that the average American receives.

Clearly, bankruptcy is not particularly harmful to creditors. Bankrupts are

the kind of people who tend to run large revolving balances at high rates of

interest, so that even if they don’t pay back every penny, the lender can still

end up making a tidy profit. In other words, even if Megan is right that "America’s

bankruptcy system is the most generous to the debtor," the creditors hardly

seem to be hurting either.

Maybe this is the reason that the arguments about the human consequences of

the subprime debacle tend to concentrate on foreclosure, rather than bankruptcy.

Foreclosure is serious; bankruptcy seems like just another dance step in a long

and complex tango between debtors and creditors.

Posted in bonds and loans, personal finance | Comments Off on On Bankruptcy

Bookstaber Looks for a Government Bailout

Posted on September 11, 2007 by Felix

Rick Bookstaber thinks that bailouts – some bailouts, anyway –

can be a

jolly good idea. If Citadel can bail out troubled companies and make money

at it, why can’t the government do so as well?

To be specific, what if the government maintained a pool of capital on the

ready to buy up assets of firms that are failing, much as Citadel did for

Amaranth and Sowood? Of course, if a private entity is willing to step up

to the plate, all the better. But as a last resort, what if the government

took on the role that Citadel did in these instances. There would be no moral

hazard problems, since the firm still fails. But the collateral damage would

be contained; the market would be kept from going into crisis, the dominos

would be kept from falling. And the taxpayer would have good odds of pocketing

some profits.

One precedent which springs to mind came in August 1998, when the Hong Kong

government spent $15 billion buying up stocks in an ultimately successful attempt

to support the Hang Seng index.

When I was in England, an individual investor asked me where and how he could

buy some of these illiquid debt products which are reportedly trading at 35

cents on the dollar or so – a very attractive price for a buy-and-hold

investor who doesn’t mark to market. I said that I had no idea: the financial

markets have been steaming full speed ahead for many years and have basically

left retail investors behind. This is a good thing in that retail stock-heavy

investors really haven’t suffered from the present crisis, but it’s a bad thing

in that all that retail money is essentially unavailable for bailout purposes.

The government, of course, is not a retail investor, and could if it wanted

step in and buy up illiquid debt by the bucketload. I just can’t see it happening

in practice, though: the politics of deciding what to buy and what not to buy

would be so fraught that economic considerations would rapidly go out the window.

While I’m at it, here’s a Special Bonus Link for you: A

great review of Bookstaber’s book.

Posted in hedge funds | Comments Off on Bookstaber Looks for a Government Bailout

FT.com Struggling in the US

Posted on September 11, 2007 by Felix

Paul

Kedrosky has a fascinating list of the most popular business websites in

the US. Yahoo Finance is tops in both visitors and time per visitor, with a

unique audience of almost 17 million, each of whom spends an average of more

than 23 minutes on the site. The Wall Street Journal comes in fourth, with a

healthy 8.5 million visitors and a time per visitor of 22 minutes – impressive,

considering that most of the site is behind a subscription firewall. I’m sure

that if it goes free it could become the number one site quite easily.

Interestingly, the atrociously-designed Bloomberg.com does well, with 3.5 million

visitors. Meanwhile, the biggest flop is surely FT.com, with a mere 1.8 million

visitors spending a bottom-of-the-league-table 3 minutes when they visit the

site. If the FT is genuine about its ambitions to become a global franchise,

the website has to do much better than this. Going free might not be sufficient,

but it certainly seems to be necessary at this point.

Posted in Media | Comments Off on FT.com Struggling in the US

Whither Countrywide?

Posted on September 11, 2007 by Felix

While I’m on the subject of bank valuations, it’s worth revisiting Countrywide,

which is now languishing at about $16.50 per share and looking

for a second white knight to come in and provide much-needed operating

capital. At the beginning of August, I noted

that investor Dave Neubert thought that a price-to-book ratio of about 1 looked

like a great buying opportunity, so he added to his position at $25.96 per share.

That price-to-book ratio is now 0.66. Oops.

The question of how far Countrywide will fall is an interesting one, because

it helps put a real market-clearing price on an enormous portfolio of subprime

loans. Obviously the market no longer has much if any faith in Countrywide’s

own estimation of its book value – the value of all those loans it holds.

But there are clearly also concerns about Countrywide’s solvency: it has $124

billion in debt, and a market cap of less than $10 billion. If this crunch continues,

that last sliver of equity could be wiped out pretty easily. No financial institution

can survive if its lenders don’t have confidence in it, and confidence in Countrywide’s

survival seems to be evaporating rapidly.

Posted in banking, stocks | Comments Off on Whither Countrywide?

Barclays: Going Cheap

Posted on September 11, 2007 by Felix

The market really doesn’t want Barclays to buy ABN Amro. After Barclays president

Bob Diamond all

but threw in the towel yesterday, the bank’s shares

are up 20p, or 3.45%, today. But wait! Isn’t there a catch-22

here? Barclays’ offer for ABN Amro is largely in stock, not cash, so if the

share price is rising, doesn’t that make its offer more attractive, and therefore

more likely to succeed?

Er, no. As Dana Cimilluca notes

today, Barclays’ offer was made when its share price was 735p. It was inadequate

then: the market calculated that the shares would have to rise to 820p before

the offer was competitive with the rival RBS-led proposal. Today, even after

this morning’s jump, the Barclays share price is just 600p – cheap enough

to be a serious takeover candidate of its own. Although I can’t imagine any

large global institution launching a monster takeover bid for Barclays right

now, I must say.

Besides, one fears to think what Barclays’ UK mortgage exposure is like. If

and when the UK housing and credit bubble bursts, the consequences for Barclays’

balance sheet could be nasty indeed – especially if it hasn’t managed

to diversify into the Netherlands, Italy, and Brazil.

Posted in banking, M&A | Comments Off on Barclays: Going Cheap

The Downside of Homeownership

Posted on September 10, 2007 by Felix

Matt Cooper and I agree on many things: we agree that the tax deduction for

mortgage-interest payments should be abolished (although now’s maybe not the

best time to do it), and we agree that the subprime mess is messy. But Matt,

like Ben

Stein and Jack

Flack, is a big proponent of the

virtues of homeownership.

Matt starts with what he calls "the financial benefits of home ownership"

– that one’s easy. Yes, homes today are vastly more valuable than they

have been at any point in the past, if you ignore the very tip of the peak a

year or so ago. As a result, anybody who bought a home a few years ago or more

is now sitting on a very tidy profit. I grew up in London, and friends of mine

who bought London apartments when they graduated from university have now, pretty

much without exception, made more money on their flats than they’ve made inincome

from their jobs. There are now the people who bought before the bubble, and

the people who didn’t, and there’s a vast wealth chasm between them.

But of course past performance is no indication of future returns, as the ads

say. Buying a house today is no guarantee of wealth creation tomorrow, and housing

prices can go down as well as up. What’s more, there are millions of subprime

borrowers who are unlikely to sign on to Matt’s rosy assessment of the financial

benefits of homeownership. If your mortgage payments are higher than prevailing

rents even as your mortgage balance is higher than the value of your home, you’re

not benefiting in the slightest from your decision to buy: quite the opposite.

And it’s not just subprime borrowers, either: here’s

a representative example of prime borrowers going through just as much pain.

A mortgage is a form of financial leverage, and leverage magnifies both upside

and downside; right now, it’s all about the downside.

What’s abundantly clear is that US house prices have stopped rising (outside

Manhattan, anyway). No one knows whether, over the next ten years or so, they’ll

go up or down. But if you take out a fixed-rate mortgage, you know exactly how

much money you’re committing to spend over the next ten years, and you can use

the wonderful NYT

calculator to work out whether or not you’d be better off renting. (Clue:

Yes, you would, and only substantial house-price appreciation can make the math

work in a home owner’s favor.)

At the margin, there are financial reasons to plump for homeownership rather

than renting: back in March, for instance, I noted

that homeownership is a commitment device, which forces people to build

wealth rather than fritter away their income on consumer products. But such

considerations are always marginal, and are generally obliterated by the big

picture. Yes, if things go well then a homeowner ends up with a magnificent

and hugely valuable asset which he owns outright. But if things go badly –

and you only need one round of layoffs, or a single medical emergency –

then the same homeowner can end up in foreclosure and bankruptcy. Those risks

are much more remote for renters without huge debts – and make no mistake,

a mortgage is one enormous debt. If owning a home is nice, then losing it can

be devastating.

Matt also talks about the social benefits of homeownership, citing (but not

linking to, unfortunately) a study dating back to 2000. But surely one key point

there is that the subprime market was to all intents and purposes nonexistent

in 2000. Yes, there might well have been a correlation, in the 1990s, between

people who bought homes, on the one hand, and people whose families suffered

less crime and had better health and had fewer divorces and so on and so forth.

This is understandable: buying a home is entails a huge commitment and obligation,

and the kind of people who willingly shoulder such commitments are more likely

than those who don’t to be fine upstanding members of society.

But then the subprime explosion happened, concurrently with the housing boom,

and suddenly housing was a get-rich-quick scheme, and the people taking out

no-doc no-money-down adjustable-rate mortgages turned out not to be exactly

the same people who took out plain-vanilla conforming mortgages back in the

day.

In other words, the relationship between housing and stability might well have

broken down during the last housing boom. Over the past few years, I’ve spent

enough time in both places to see the huge difference (to take two admittedly

extreme examples) between the feverish property-mania of Orange County, California,

on the one hand, and the long-term stability of families and other renters in

Stuyvesant Town, Manhattan, on the other.

My point is that the kind of people who have stable and successful lives will

have stable and successful lives whether or not they own their own homes. Naturally,

a lot of them will indeed end up owning their homes, but it’s not a necessary

precondition. And if you wanted an example of a place where millions of people

have successfully had stable and successful lives for decades, it would be hard

to come up with a better country than Germany – which has extremely low

levels of homeownership.

So yes, Matt, there are good reasons for homeownership, some of them

financial. There are also good reasons to choose to rent, and a lot of those

are financial too. Ultimately, a mortgage is a financial product, which carries

a certain cost. Depending on the price of that product, it’s sometimes a good

buy and it’s sometimes a bad buy. In the case of adujstable-rate subprime mortgages,

most of them were bad buys, which only made financial sense if you

intended to either flip or refinance during the two-year teaser-rate window

at the beginning of the loan.

The fact is that a culture of homeownership has both upsides and downsides;

one of the downsides is the lot of those who don’t own their homes

in such a society. There are large parts of the US and the UK where the price

of admission, essentially, is a mortgage; people who can’t or won’t get one

end up marginalized and less successful. It’s the flip-side of what Matt calls

"the social benefits of homeownership", and it can be ugly. In rich

societies where homeownership is less ingrained, there’s often a lot less inequality

as well.

So you will forgive me for not getting excited about anything and everything

which raises the rate of homeownership. I do think that in many cases –

including my own – it is a good idea. But I do not think that

generalizing wildly and saying that the greater the rate of homeownership the

better is useful. The realities are more complicated, and the downside can often

outweigh the upside.

Posted in housing | 1 Comment

GM’s Weak Arguments Against Increased Fuel Economy

Posted on September 10, 2007 by Felix

What wonders of disingenuousness the auto industry is capable of! Right now,

the Big Three are worried about proposals to mandate that they increase the

fuel economy of the vehicles they sell, and so they’re wheeling

out economists to say that the proposals don’t make sense. But one would

think they could do better than this.

The economists (Robert Crandall and Hal Singer) start off badly by asserting

that "no one disputes that more stringent CAFE standards would increase

the cost of making a car". CAFE stands for corporate average fuel economy,

and is the mechanism by which the US government regulates automobile mileage.

And I, for one, am far from convinced that higher CAFE standards would increase

the costs of making a car. In fact, insofar as they encouraged auto makers to

make smaller cars and fewer SUVs, higher CAFE standards might even decrease

the costs of making a car. Remember that cheaper cars, as a rule, are actually

more fuel-efficient, not less.

So color me unconvinced that "carmakers would have to employ very expensive

technologies" if this legislation goes through. Every time the US government

wants to regulate Detroit we hear the same thing, and every time the regulation

happens, the costs magically fail to materialize. Besides, regulations in the

US are far less stringent than they are in Europe and Asia. Since the US car

companies compete in those markets already, why can’t they just import their

own technologies from abroad?

Then comes my favorite part of the whole piece:

If there was fuel-saving technology out there that cost $1,000 but generated

$2,500 in the discounted present value of fuel savings over the life of the

vehicle, carmakers would surely voluntarily embrace that technology. The carmaker

could split the net benefits (equal to the difference between the discounted

fuel savings and the cost of the technology) with the car buyer such that

both parties to the transaction would be better off.

No need for regulation there. With large numbers of vehicle producers and

well-informed consumers, the market is so efficient, in fact, that it ensures

that all such transactions will occur, generating the socially optimal level

of fuel economy.

Tell that to Amory Lovins. The US economy is chock-full of areas where an up-front

cost would save money in net present value terms, but isn’t implemented. And

automobiles are one of those areas. The example here implies that consumers

are willing to spend $1,000 more on a new car, if the NPV of their fuel savings

was more than that. Ha! I’m sorry, but I simply don’t believe that, and I defy

Messrs Crandall and Singer to provide any empirical evidence that it’s the case.

If this were true, then no one would pay a premium for a Hummer: they’d all

require a discount, because of the vast NPV of future fuel costs.

Of course, Crandall and Singer are advisers to General Motors, which has made

a great deal of money from selling the Hummer over the years, and would hate

to see such a cash cow regulated out of existence. This is surely the real reason

why Detroit opposes higher CAFE standards: overseas rivals, especially from

Japan, are better at making fuel-efficient cars, while Detroit specializes these

days in thirsty trucks and SUVs. Which only leaves the question:

Why is Toyota opposing CAFE as well?

(Via Mankiw)

Posted in climate change | Comments Off on GM’s Weak Arguments Against Increased Fuel Economy

Australia: Ahead of the Regulatory Curve

Posted on September 10, 2007 by Felix

Which country is most ahead of the regulatory curve these days? A couple of

recent developments suggest that it might be Australia.

Datapoint One: The Australian Competition and Consumer Commission seems

ill-disposed towards Google’s proposed merger with DoubleClick, worrying

that the combined entity will have the power to crush competitors. The news

comes as we learn that Yahoo, the closest thing that Google has to

a competitor, came very close, recently, to unilateral

surrender:

People familiar with the matter say that over the summer, Mr. Yang did actively

assess one major sacred cow: the Web-search-advertising business it built

up at great expense in recent years. Under the scenario discussed by top executives,

Yahoo would have outsourced that search-advertising activity — which places

small text ads next to Web search results — to either Google or Microsoft

Corp., the people say. One of these people says Yahoo raised the idea with

Google.

Datapoint Two: The Australian central bank is doing its best to shore

up the asset-backed commercial paper market, by accepting such paper in

repo transactions:

Australia’s central bank, the Reserve Bank of Australia, has relaxed rules

on collateral it will accept for short-term funding. This would enable banks

to take more time to evaluate which portions of the asset-backed commercial-paper

market are most affected by ailing subprime mortgages.

In doing so the Australians went beyond the Federal Reserve, which doesn’t

accept such paper as collateral in repo operations but did recently clarify

it was willing to accept a wide variety of such paper for its lesser-used,

and costlier, "discount window" loans to banks.

The Reserve Bank of Australia changes will begin Sept. 17 and in October will

include residential mortgage-backed securities and Australian dollar-denominated

asset-backed commercial paper. Bond yields fell sharply on the news.

This is an eminently sensible idea, and one which I hope will be copied by

other central banks around the world: it helps provide liquidity to a newly-illiquid

market without forcing the central bank into inflationary rate cuts.

Posted in fiscal and monetary policy, M&A, regulation | Comments Off on Australia: Ahead of the Regulatory Curve

Bloomberg’s Pastorini Profile Appears

Posted on September 10, 2007 by Felix

Back at the beginning of July, I wondered

where the long-awaited Bloomberg profile of Lawrence Niren (a/k/a Edward Pastorini,

a/k/a Theodore Roxford) might have got to. It was promised

in April – and, finally, it arrived on the last day of August, with a

reasonably bland headline: "Gold

Fields Bidder Takes Twisted Path From Shelter to Argentina".

The best thing about the story is the photo

accompanying it, which comes from a 1995 San Francisco Chronicle piece. Niren

looks utterly bonkers, a cross between Frank Zappa and Bob

Druskin. (Yes, I promised

you another entry in the "facial hair" category: this is it.)

The Bloomberg story is a strange combination of mockery and seriousness: "Niren

says he’s preparing his defense in Argentina, where he has a home, a fiancee

and cats… For at least a decade, Niren, who often wears his hair in a ponytail,

has floated takeover offers that lifted stock prices and then went nowhere."

The story also falls a long way short of constituting any kind of formal correction

to the original

Bloomberg story, which claimed that "U.S. financier Edward Pastorini

may lead a bid for Gold Fields" and which sent Gold Field shares soaring.

Rather than sending reporters to obscure Argentine provinces to interview the

staff of a hotel where Niren once stayed, it might have been easier, quicker,

and a whole lot cheaper to just run a story saying "Edward Pastorini is

a fraud, and we were duped". Which is the subtext of the whole article,

even if nothing quite along those lines ever appears.

Posted in facial hair, Media | Comments Off on Bloomberg’s Pastorini Profile Appears

What is Ben Stein Smoking? (Part 3)

Posted on September 10, 2007 by Felix

One of the great things about being on holiday in Europe is that there’s no

chance of running across a Ben Stein column by mistake. But this morning I made

the mistake of noticing that my new colleague, Mr J. Flack, is applauding

Stein for made "a lonesome point of great relevance" with respect

to subprime loans.

The questions rose, unbidden, in my mind. Had Stein’s brain been invaded by

aliens? Did he manage hit on something germane in much the same manner as a

stopped clock tells the right time twice a day? Thus did I find myself, on my

first day back at the blog, reading

Ben Stein, with predictable results.

For it turns out that Stein is completely wrong, yet again: can anybody

explain to me why this man still has his column?

The point which impressed my pseudonymous colleague seems to be that home ownership

is "the bedrock of the American dream" (Stein), or "the most

personally and financially enabling of endeavors" (Flack). To which I can

only say: Not if you’re a subprime borrower, it ain’t.

I just came back from Germany, where millions of people regularly walk into

their homes and find their own dogs waiting for you there. In Germany, as in

the US, this is a major blessing. But Ben Stein seems to think that this major

blessing is impossible without homeownership, which is ridiculous. A dog neither

knows nor cares whether a home is owned or rented. At the moment, homes still

cost more to buy than to rent. Which means that a renter has more money to spend

on himself, and his dog, than does an owner, even if the owner is a prime borrower.

If the owner is a subprime borrower, the situation is much worse. Subprime

mortgage rates can easily get into the double digits, and homeownership makes

very little sense in that situation. Take a look at the default settings in

the New York Times fantastic buy

vs rent calculator. With a mortgage at 6.25%, buying is better than renting

after 11 years. With a mortgage at 11.5%, buying is never better than

renting.

Stein continues by wheeling out one of the most misleading statistics there

is: "the percentage of those who have defaulted is still fairly small,

possibly 10 percent to 15 percent of subprime loans, and maybe less," he

writes. I would call this disingenuous if I didn’t believe that Stein simply

doesn’t get the truth: that most subprime loans are refinances, and therefore

the percentage of subprime loans in default is much lower than the

percentage of subprime borrowers in default. (A refinanced loan, of

course, is paid off in full, while the borrower remains in debt.) What’s more,

the big problem, everybody agrees, is not now but rather in a few months’ time,

when most of those adjustable-rate loans (and there were precious few fixed-rate

subprime loans) start to adjust upwards from their teaser rates.

Stein thinks, against all the evidence, that "the experiment with granting

loans to less-qualified buyers worked" – clearly, it’s far

to early to say that. And he then disappears off into cloud-cuckoo land, saying

that the cost to everybody else of the subprime debacle "will be whatever

government programs are enacted to bail out borrowers in trouble". Er,

no: the cost will be huge, even if there are no government bailout at all. That’s

the problem with credit crunches: good credits get crunched along with the bad.

And the idea that "those who lent the money get away pretty much scot-free"

– that’s just hilarious. Can Stein point to a single subprime mortgage

lender which is remotely unharmed? Most, it seems to me, are bankrupt.

I pretty much gave up reading the column at that point. But I did skip down

to the end.

If I were the editor of the business section for just one day, I would run

one immense headline: “Everything Is Going to Be Fine. Go Back to Work.”

Yes, Ben, if you’re one of the handful of Americans with a lot of assets and

no debts to speak of, then I’m sure everything is going to be fine. Oh, wait,

you are. Good for you. But for the rest of us, credit matters a very great deal,

and we can’t look with equanimity at a housing collapse and consider it little

more than a buying opportunity. You might be able to afford homes

all over the country; I daresay you’re haggling on one or two right now.

But most of us are struggling to afford just one.

Posted in ben stein watch, housing, Media | Comments Off on What is Ben Stein Smoking? (Part 3)

Labor vs Capital at the WSJ

Posted on September 10, 2007 by Felix

The Wall Street Journal’s reporters want Rupert Murdoch’s money – and

they’re not shy about asking for it. Jeff Bercovici tells

us that they’re going to be "picketing and chanting slogans in front

of their offices at 200 Liberty Street from 11:00 a.m. to 1:00 p.m." today.

Chanting slogans, eh? I’m sure that Murdoch would love his reporters to be

happy – although it’s worth noting that he doesn’t actually own Dow Jones

yet – but I very much doubt that chanted slogans are going to sway him

very much. This is the man, remember, who fired 6,000 newspaper workers in the

UK when they went on

strike in 1986.

On the other hand, the WSJ’s hacks are surely grateful right now that their

new boss is Murdoch rather than Vladimir

Putin. Truly, the sale of Dow Jones to News Corp is looking more than ever

like the least-worst option for the company.

Posted in Media | Comments Off on Labor vs Capital at the WSJ

Citi in Japan

Posted on September 10, 2007 by Felix

An IPO "is

the first sale of stock by a private company to the public". If you already

have shares outstanding, then an offer of further shares is not an IPO. So Citigroup,

pace the

WSJ on Friday, has not really filed for an IPO in Japan: it’s just seeking

a listing there, which is a much smaller deal.

A Japanese listing does make sense for Citi, now that Mrs Watanabe is getting

burned by her carry-trade plays. Japanese retail is a formidable source of liquidity,

and it clearly has a substantial risk appetite. As a result, it’s inevitable

that sooner or later Japanese household savings will make their way into the

stock market, rather than floating around as they do at present mainly in the

bond and FX markets. As a truly global company with a strong presence in Japan

(and, now, a full domestic banking license to boot), Citi is likely to be on

any Japanese investor’s shortlist of stocks to buy.

Besides, Chuck Prince is really

good at looking contrite when he screws up.

Posted in banking, stocks | Comments Off on Citi in Japan

Rescuing Libor

Posted on September 10, 2007 by Felix

The credit crunch started in the subprime market, but it seems that nowadays

it’s most visible, and most problematic, in the money market.

The contagion mechanism is the ABCP market: asset-backed commercial paper.

ABCP came into existence to help quench a global thirst for liquidity; now that

anything asset-backed is looked upon with suspicion, ABCP is untouchable and

can’t be rolled over. As a result, banks have to backstop their CP clients,

which means that they need their money and don’t want to lend it out. And interest

rates in the overnight to one month end of the curve are almost a full percentage

point higher than where one would expect them to be given the Fed funds rate.

Clearly, a large spread between Fed funds and Libor is not normal, and not

in the slightest bit healthy. But is there a good policy response to this nasty

gumming-up of the financial gears, and if so, what is it?

In the blue corner, we have David

Gaffen and Yves

Smith, saying that rate cuts won’t help bring down the spread between Llibor

and Fed funds. In the red corner, we have Brad

DeLong and (strange bedfellow alert!) Larry

Kudlow, saying that rate cuts are the only tool we’ve got right now, so

we might at least try them to see if they work.

I’m generally sympathetic with the red corner: extra liquidity can

breed confidence (although there’s no guarantee it will), and right

now I don’t think that inflation pressures are so great that the Fed can’t afford

a rate cut.

On the other hand, Stein’s Law says that if something cannot go on forever,

it will stop – which means that somehow the financial system

will get to a point where the spread between Fed funds and Libor will come back

down to single digits. If that’s true, then the Fed just decide to let the system

work itself out, so long as credit-sector indigestion isn’t about to devastate

the real economy.

And then there’s the question of how much the Fed should cut rates. DeLong

writes:

We may indeed need a combination of fiscal stimulus and regulatory reform.

But why not first push on the string? Maybe the string is rigid, and pushing

on it will work.

But what happens if pushing on the string doesn’t work? Do you give up, and

decide it just isn’t working, or do you conclude that you haven’t pushed enough?

Kudlow wants Fed funds "around 4 percent," which means that he’ll

continue calling for further cuts even if the Fed slashes by 100bp at the next

meeting (which I very much doubt it’ll do).

Ultimately, I’m on the rate-cutters’ side. While the spread between Fed funds

and Libor is important, the absolute level of Libor is if anything even more

important. And that is certain to come down after a rate cut, even if the spread

doesn’t change at all.

Posted in fiscal and monetary policy | Comments Off on Rescuing Libor

Why Goldman Might Sell its Loans at a Discount

Posted on September 10, 2007 by Felix

The Breaking Views column in today’s WSJ features a column

by Lauren Silva originally published last Thursday. "Can Goldman Win on

Debt?" is the headline on the piece, which asks whether Goldman Sachs is

"about to turn the credit crunch to its advantage".

The problem is that the mechanism Silva’s talking about doesn’t seem to be

any more profitable for Goldman than if the bank simply kept all its unsellable

debt on its balance sheet. Basically, the bank buys debt from itself at 85 cents

on the dollar, recoups "a third of its original loss" if the debt

rises to 90 cents, and "would eliminate its loss" if the debt goes

all the way back to par. Well, yes: if you issue debt at par and it’s worth

par, then there’s no loss.

It seems to me that the Goldman plan, if Silva’s description of it is accurate,

is an attempt not so much to turn the credit crunch to its advantage, so much

as to limit its own downside if things get a lot worse. Goldman’s upside, in

Silva’s plan, is essentially identical to its upside if it kept all its debt

on its balance sheet. But its downside is much smaller: just 17% of face value,

rather than 85%.

Goldman’s share price seems to be stabilizing around a price-to-book ratio

of 2, which is not bad for an investment bank in the midst of a credit crunch.

My guess is that Goldman reckons that its losses on the loans it’s underwritten

are already baked in to its share price, and that taking an up-front charge

to move those loans off balance sheet will actually go down quite well among

its equity investors. The scheme does seem to be a way of moving risk from Goldman’s

shareholders to an as-yet-unspecified group of lenders. Which raises an obvious

question: who are these lenders?

Posted in banking, bonds and loans | Comments Off on Why Goldman Might Sell its Loans at a Discount

Felix Returns

Posted on September 9, 2007 by Felix

I’m back! Didja miss me?

So here’s the thing: I’ve been out of the loop for the past three weeks or

so, and it’s going to take me a little bit of time to get up to speed. If you

would, then, can you tell me in the comments here or by email what if anything

has actually happened in the past three weeks which I really ought to know about

for the purposes of this blog? I know the Fed cut its discount rate, so anything

from then onwards really.

My general impression is that no news is bad news: that the credit crunch hasn’t

really ameliorated visibly, and that there are signs that problems which had

hitherto been confined to the financial and housing markets are now feeding

through into the real economy – a problem which rate cuts may or may not

be able to address. Or, to put it another way, nothing’s really happened.

Many, many thanks to Yves Smith for filling in so magnificently in my absence.

The wonkery level will now go down by about seventeen notches; instead, I promise

a new entry under the "facial hair" category

on Monday. You have been warned.

(And yes, I have a copy of that

CPDO report. Thanks. Also, if you want an idea of what I’ve been up to all

this time, you can check out my

posts on Portfolio’s art blog.)

Posted in Announcements | Comments Off on Felix Returns

Europe vs the USA, Train Station Edition

Posted on September 9, 2007 by Felix

A tourist mother was overheard in the lobby of the MetLife building telling her daughter that it was a train station. This is something which could only happen in America. I love US train stations, especially the grand ones along the Boston-to-Washington corridor: Washington’s Union Station, Philly’s Penn Station, New York’s Grand Central Terminal. But one thing these imposing edifices all have in common is a very un-European habit of hiding the trains.

Europe, of course, has more than its fair share of grand train stations of many different vintages, from Antwerp to Milan. But as a general rule — one which applies equally to the newest and shiniest of them all, in Berlin — they celebrate the trains, rather than hiding them. The centerpiece of any train station is just as much the large steel-and-glass turn-of-the-century sheds over the tracks as it is any imposing facade.

Off the top of my head, I can’t think of any obvious reason why this should be the case. Why should the Europeans be the utilitarians, here? I suspect it might have something to do with the vintage of the stations in the US: maybe they were built a bit later than their European counterparts, in more developed cities, and therefore had less room to play with and more incentive to bury the tracks and the trains. But I doubt that’s the whole story.

Posted in Not economics | 2 Comments

A Call for Central Bankers to Hang Tough

Posted on September 7, 2007 by Felix

Yves Smith at Naked Capitalism submits:

With today’s weak non-farm payrolls report, financial markets participants have turned up the volume on their calls to the Fed to lower interest rates. Even Barney Frank, chairman of the House Financial Services Committee, has weighed in, urging a “meaningful” cut.

So the Financial Times comment today by Raghuram Rajan, professor of finance at the University of Chicago, “Central banks face a liquidity trap,” is particularly well-timed.

Rajan takes up a theme stressed by Nouriel Roubini, namely, that the current crisis is (among other things) a solvency crisis, and providing monetary stimulus won’t make bad credits into good ones.

Rajan points out that the line between a solvency and liquidity crisis isn’t hard and fast. For example, mortgages that looked good in times when there was ample liquidity in the securitized finance markets might not look so hot when things tighten up.

Reading that argument, one anticipates that Rajan is advancing it to press central bankers to make aggressive rate cuts, but it’s a straw man. Rajan states that continuing to meet the market’s expectations for liquidity is ultimately self-defeating. The requirements balloon, becoming so large that central bankers cannot satisfy them. Rajan instead recommends a stringent course of assuring liquidity in “unimpeachable securities,” and “leaning against the wind” when liquidity rises above normal levels.

From the FT:

Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious – much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.

So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value. And cutting rates dramatically, as Alan Greenspan’s US Federal Reserve did after the technology bubble burst in 2000, would be an enormous tax on savers the world over. Better let the market weed out the reckless, unless there is a risk of total market collapse.

But knowing that the political pressure to intervene is asymmetric, asserted far more strongly when markets turn illiquid and asset prices fall than when markets are excessively liquid and asset prices booming, central banks ought also to avoid bringing such situations upon themselves. Better to “lean against the wind” with prudential norms, tightening them as liquidity exceeds historical levels, than to ignore the boom and be faced with the messy political reality of forcibly picking up the pieces after the bust.

Posted in fiscal and monetary policy | 1 Comment

Getting Behind Today’s Employment Report

Posted on September 7, 2007 by Felix

Yves Smith at Naked Capitalism submits:

Those who have been following the job creation story weren’t surprised at the weak BLS employment (the so-called “non-farm payroll”) report today, or by the fact that it revised the results for the last three months downward by 81,000. Various commentators (see here, here, and here) have observed that the rises reported in recent months have been due almost entirely to a “voodoo calculation, the “birth/death model” a plug to allow for business creation and failure (one we’ve commented on before). Note this feature was added in 2001.

And where had these jobs supposedly been created? In construction. Need we say more?

Barry Ritholtz offered his latest observation about the birth/death model before the BLS report was released:

Considering how much softer the economy has been much in 2007 than last year, it is simply unconscionable that the B/D model has actually created more jobs in 2007 than it created at this point in 2006.

Year Jan Feb Mar Apr May Jun Jul

2006 -193 116 135 271 211 175 -57

2007 -175 118 128 317 203 156 26

The Economic Policy Institute has a very good write up:

In an unexpectedly and extremely weak employment report from the Bureau of Labor Statistics, the nation’s payrolls shrunk last month, the first monthly decline since August 2003. Prior months’ job gains were revised down by 81,000….

The reason August’s unemployment rate was unchanged was due to a large monthly fall off–down 340,000–in the labor force…. Had those who left the labor force instead been counted as unemployed, the rate would have jumped to 4.85%…..

Many industries shed jobs or grew slowly in August…. factory employment was down 46,000, the largest monthly loss in that sector since 2003, dispelling hopes that strong exports in the second quarter might help stem these losses. Auto manufacturers made the largest cuts in the factory sector, down 11,000 jobs.

Reflecting the housing market turmoil–including sharply diminished home sales, rising inventories, and falling prices–construction employment fell 22,000, driven largely by a decline in residential contractors….

Local government was also a big job loser last month, driven by a 32,000 loss in public education….

Health care, however, was up 35,000 jobs and continues to buck any negative trends by steadily adding employment. Restaurants and bars also gained 24,000 jobs, and retail trade added 12,500.

These latter gains in retail and food services suggest consumers are still spending freely in some areas….

A central question surrounding today’s report was whether it would provide clear evidence of a contagion effect from financial markets. Are the bursting housing bubble, the credit crunch, and recent financial market turmoil having a negative impact on the job market? The BLS report provides an unequivocal “yes” in response to that question.

Posted in labor | Comments Off on Getting Behind Today’s Employment Report

Nostalgia for Glass Steagall

Posted on September 7, 2007 by Felix

Yves Smith at Naked Capitalism submits:

Boy, is sentiment changing. The latest indicator: an article in MarketWatch bemoaning the demise of Glass Steagall, the law enacted in 1933 that separated commercial banking from investment banking.

The article by Thomas Kostigen gets the history wrong. It makes it sound as if the repeal of Glass Steagall in 1999 was a watershed event. In fact, by then, it was irrelevant. Banks had gotten enough waivers of various sorts to enable them to compete effectively on investment banks’ turf. For example, well before 1999, Swiss Bank Corporation, which was later acquired by UBS in 1998, had purchased derivatives trading firm O’Connor & Associates, UK merchant bank S.G. Warburgs, and US investment bank Dillon Read.

To illustrate, this part of the article is a wee bit scary:

But as banks increasingly encroached upon the securities business by offering discount trades and mutual funds, the securities industry cried foul. So in that telling year of 1999, the prohibition ended and financial giants swooped in. Citigroup led the way and others followed. We saw Smith Barney, Salomon Brothers, PaineWebber and lots of other well-known brokerage brands gobbled up.

This passes for journalism? Travelers Group bought Smith Barney (by acquiring Primerica) in 1993 and Salomon Brothers in 1997. Citigroup and Travelers merged in 1998, the year before Glass Steagall bit the dust.

It gets better:

At brokerage firms there are supposed to be Chinese walls that separate investment banking from trading and research activities. These separations are supposed to prevent dealmakers from pressuring their colleague analysts to give better results to clients, all in the name of increasing their mutual bottom line.

Well, we saw how well these walls held up during the heyday of the dot-com era when ridiculously high estimates were placed on corporations that happened to be underwritten by the same firm that was also trading its securities. When these walls were placed within their new bank homes, cracks appeared and — it looks ever so apparent — ignored.

Umm, there was nothing, nada, in Glass Steagall that said you couldn’t have trading and underwriting under the same roof. That was the norm in the securities industry for the large players from the early-mid 1980s onward.

But despite the lack of industry knowledge, Kostigen isn’t completely off base when he suggests the industry has gotten too cozy and insular:

When banks are being scrutinized and subject to due diligence by third-party securities analysts more questions are raised than when the scrutiny is by people who share the same cafeteria. Besides, fees, deals and the like would all be subject to salesmanship, which means people would be hammering prices and questioning things much more to increase their own profit — not working together to increase their shared bonus pool.

Glass-Steagall would have at least provided what the first of its names portends: transparency. And that is best accomplished when outsiders are peering in. When every one is on the inside looking out, they have the same view. That isn’t good because then you can’t see things coming (or falling) and everyone is subject to the roof caving in.

Congress is now investigating the subprime mortgage debacle. Lawmakers are looking at tightening lending rules, holding secondary debt buyers responsible for abusive practices and, on a positive note, even bailing out some homeowners.

These are Band-Aid measures, however, that won’t patch what’s broken: the system of conflicts that arise when sellers, salesmen and evaluators are all on the same team.

Glass-Steagall forced separation. Something like it, where conflicts and losses can be mitigated, should be considered again.

The romanticizing of regulation is a noteworthy development, a warning that leasing and collaring the securities industry will be popular. Lobbyists take heed.

Posted in banking, Media, regulation | Comments Off on Nostalgia for Glass Steagall

The Journal Tells Us Quants Have Suffered

Posted on September 7, 2007 by Felix

Yves Smith at Naked Capitalism submits:

Readers have probably figured out that I think the reporting in the Wall Street Journal is overrated. We have a prime example on page one today, “How Market Turmoil Waylaid the ‘Quants’.”

My understanding is that newspapers are in the business of providing news. The story that the quants are in trouble is a month old and has gotten considerable coverage in the business press. By definition it is no longer news. For the Wall Street Journal to justify publishing a story about it, particularly a prominent story, it should offer new information, new analysis, or provide a particularly good synthesis (the New York Times often executes that sort of story well).

This piece does none of the above. Admittedly, it isn’t the worst example of a Wall Street Journal article with virtually no redeeming qualities being on page one (my recent top pick is “How Rating Firms’ Calls Fueled Subprime Mess“). But this one is close.

In lieu of providing new information, the story is instead unduly focused on the career of one quant, Peter Mueller of Morgan Stanley. Using him as an organizing device allows the story to mention that Morgan has a largely unknown but large statistical trading unit named PDT, for Process Driven Trading, which contributed $540 million, or about 7.2% of the firm’s earnings in 2006, and lost $500 million from early July through August 9.

Now this angle could have been compelling if the reporters had gotten close enough to their sources to get either a blow by blow of what that nightmarish month-plus felt like (a Peeping Tom’s view of a meltdown is always fascinating) or a sufficiently good understanding of either Morgan’s trading approach or the general issues involved in quantitative investing so as to provide new insight.

But because the writers failed to get the goods, the story, which promises to tell us something new about quants and where they went awry, is instead about one quant, Mueller. In a stereotypic rich man’s odyssey, Mueller goes through the stations of life of a successful young hedgie: makes a lot of money quickly, becomes disillusioned, loses his significant other, drops out, travels the world, takes up kayaking and yoga and returns to playing jazz (both recording his own albums and performing in subways), and competes successfully in the pro poker circuit. But like all prodigal sons, he eventually comes home, which in this case it was to Morgan Stanley, doing pretty much what he did before.

And Mueller’s tale is flabby, and a reference to a short bio of him on a website suggests he didn’t cooperate much, if at all with the authors. Similarly, the information on quant strategies is skimpy and superficial. There’s a brief description of pair trading, a mention of the fact that these traders tend to crib ideas from the same sources and often wind up with very similar strategies. It also regurgitates the traders’ defense for their poor performance: things were anomalous and there was too much capital devoted to their investment style.

John Dizard provided of the Financial Times provided vastly more insight on August 14 in a few incisive paragraphs. Note that the “Gaussian distribution” he mentions is the bell curve; one of the well-known problems with financial models is that many, such as the Black-Scholes options pricing model, assume a normal (bell curve) distribution, which financial markets don’t exhibit (they have “fat tails” and also don’t have a symmetrical distribution of outcomes):

As is customary, the risk managers were well-prepared for the previous war. For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here.

Models based on the Gaussian distribution are a pretty good way of managing day-to-day trading positions since, from one day to the next, risks will tend to be normally distributed. Also, they give a simple, one-number measure of risk, which makes it easier for the traders’ managers to make decisions.

The “tails risk” ….becomes significant over longer periods of time. Traders who maintain good liquidity and fast reaction times can handle tails risk….Everyone has known, or should have known, this for a long time. There are terabytes of professional journal articles on how to measure and deal with tails risk….

A once-in-10-years-comet- wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “resume put”, not a term you will find in offering memoranda, and nine years of bonuses….

All this makes life easy for the financial journalist, since once you’ve been through one cycle, you can just dust off your old commentary.

As I’ve said before, I am mystified at the worry about the coming Murdoch era at the Journal. There really isn’t much there to be lost.

Posted in investing, Media | Comments Off on The Journal Tells Us Quants Have Suffered