The Arrogance of Wall St.

Goldman Sachs is a smart firm...very smart. But their recent position on the re-purchase of warrants from the Treasury has me a little perplexed. Allow me to explain. Goldman took over $10 billion in TARP money from the Treasury to insure against insolvency. In exchange for the $10 billion or so of cash from the Treasury Goldman issued warrants to the Treasury (read: taxpayers). Warrants give one the right, but not the obligation, to purchase shares of a company's stock at a certain price. It's very similar to an "option" with the key difference being the length of time one has to exercise the warrant (the life of a warrant is typically 5-10 years while an option is generally shorter than that, sometimes only months). Here's an example using the Goldman case (I'm too lazy to look up the exact numbers but I think an approximation will suffice).

The treasury receives twelve(12) million warrants that allow them to buy Goldman stock at $122/share. Last I knew, Goldman was trading at $150 (or thereabouts). If the Treasury exercises its right to buy the shares, it would buy them at $122/share and sell them for $150/share, making a tidy profit of $372,000,000. By my rough calculations, that's about a 5% internal rate of return. Not bad for 12 months. But, it's not quite that easy. The contract Goldman signed with the Treasury allowed them to buy these warrants back from the Treasury. But price is negotiable. So what should Goldman pay? Whatever the Treasury wants. I'm guessing the Treasury won't give up their warrants for the $372,000,000 because of the tremendous long-term potential they see in Goldman. Remember, as Goldman's stock increases, so does the Treasury's profit. Since Goldman is one of the first to pay pack their loan, I would bet the treasury is eager to show the taxpayer what a good deal the TARP is for them and is asking for a little premium on their warrants. In other words, more than $372,000,000 and more than Goldman is willing to pay. If I'm the Treasury (and it's a good thing I'm not), then I would NOT let go of those warrants for any less than $750,000,000, yielding an attractive 10% IRR. That's a nice double digit number. It's O.K. for Goldman to 'stick it to the man' as long as the "man" is not the Treasury/tax payer/life saver.

If somebody saves your life, you take what they give you. I'm firmly rooting for the Treasury on this one!

Thoughts on Obama's Plan for Restructuring Financial Services

Last week, Tim Geitner laid out a plan to restructure regulation within the financial services industry. The net result was an additional three government regulatory agencies with clearly defined mandates, which, among other responsibilities include monitoring banks, hedge funds, and consumer protection. One can easily find Mr. Geitner's testimony online (which I will find and post) but, in essence, it boiled down to 1) require banks to hold more reserves and keeping a close eye on banks that are "too big to fail" 2) require certain private investment vehicles to register with the SEC and 3) create a new division whose sole responsibility is to protect consumers. Here are a couple of thoughts. But before I share those, I should disclose (lest there be some agregious misconception that I know what I'm talking about) that I have no idea how to fix the problem. If I did, I would be there...fixing it (and making a lot more money). While I'm generally opposed to creating more governement agencies, I'm sure Mr. Geitner and the entire administration were thoughtful in their proposal, and it is certianly better than anything I would have come up with.

1) I don't think more "regulation" is THE solution, nor was lack of regulation the problem. On the face of it, it would seem Mr. Geitner does think regulation was the problem. I get it, that's what he does, he exchanged a multi-million dollar private contract for a multi-million dollar public contract and his party line is, by necessity, "Re-establish confidence in the banking sector via broader regulation." But this is a faux-solution that is only optical in nature. Nope, more regulators won't work because employees working at Hedge Funds, Investment Banks, and other Financial Institutions are smarter than regulators. These firms made billions of dollars maneuvering through the OTC, FDIC, SEC, Treasury, FED, and the office of Thrift Supervision (just to name a few).

2) I think there is a misalignment of interest between banks that are too big to fail, the shareholders, and the public. If a bank is too big to fail, then the purpose of that bank should NOT be to maximize shareholder wealth. Since maximizing shareholder wealth requires banks (because it is economically rational) to circumvent regulation and shoot for the moon. In other words, pushing the price of the stock higher and higher sometimes means you take more "risks" (that, in theory, you are compensated for). In the end, you have a limited liability since many of your liabilities (deposits) are insured by the state. However, if you are deemed systemically relevant (a very slippery definition) then you should have the public interest as a primary objective with shareholder value subordinate to that of the public. So this position, I think, creates a lot of philisophical problems for capitalism.

Regulation may not be THE solution, but PART of the solution. What I believe we are grappling with are the incentives of capitalism. One tenent of capitalism is constant innovation and efficiency which result from risk taking at some level. Unfortunately, the higher the climb, the steeper the fall.

Investing in the New Economic Paradigm

Image by ocean.flynn via Flickr

I'll continue with the sparse summer posting. It seems these days my time is spent passed out on the couch from overconsumption of otter-pops.

There's little doubt the last two years have changed the rules for investing and managing risk. Constructing your investments based on historical information worked as long as financial markets dealt the same types of risks (though the timing around the manifestations of those risks were completely random). In short, we all learned that when dealing with models, garbage in equals garbage out. Yes, models are helpful and they help crystallize your thinking, but it should not be a substitute for a good deal of independent critical thinking. So with all the uncertainty surrounding where the market is headed over the next 1,3,5, or 10 years I thought I would share a couple of thoughts. Perhaps they will be of some benefit (but probably not).

1) The current recovery may be little more than a "Dead Cat Bounce". Perception is reality. Based solely on the number of editorials, articles, and reports I've seen over the last few weeks, I conclude the majority of US citizens assume the worst is behind us. Which is extremely curious. Based on fundamental information only, there is no justification of a recovery. In fact, less than 15% of all the stimulus has been deployed. Although this is curious, its not surprising. In a previous post I noted Mordecai Kurtz's (Stanford) research on behavioral economics. Kurtz concludes fully four-fifths (80%)of the movement of a stock price is based on behavioral factors, not technical. Markets move up when the majority of investors hold optimistic expectations of the economy and down when the collective view is pessimistic. To me, this conclusion means the American psyche could be in for a huge disappointment. Banks and Insurance companies still have a tremendous amount of exposure to commercial mortgage backed securities, which, by the way, have yet to correct for pricing. If this happens, unemployment could easily reach 15% which, I imagine, will have a devastating affect on investors who assumed the worst was behind us.

2) If traditional asset allocation, modern portfolio theory doesn't work, what does? Perhaps a prudent way to evaluate investments is with three scenarios in mind; growth, depression, inflation. This allows one to be less rigid in their approach and forces investors to consider the macro environment before making a decision, instead of blindly following an allocation model. How much you allocate to each is based on your personal macroeconomic perspective. True diversification is a moving target. Writing in broad generalities, in the growth bucket you would target public stock, high-yield bonds, Real Estate, and avoid T-bills and some commodities. In the Depression bucket you would focus on holding T-bills, Gold, Foreign Reserve Currencies, and short duration government bonds but avoid exposure in US stocks or high-yield bonds. Inflation warrants investment in Commodities, Infrastructure (like toll roads, power, hospitals, etc.)and international markets. You might allocate a third of your resources to each bucket (growth, depression, and inflation) and tilt the allocation one way or the other based on your outlook. One note, exercise prudence when purchasing or selling securities to avoid buying at the height of the market. You could either dollar-cost average (purchase $200 of XYZ security every month/week/etc.) or use some light market timing. An example of "light" market timing would be waiting to buy gold. Gold is trading at historically high levels. Rather than wait for it to return to "normal prices", which may not happen for a few years, you would wait for it to come down, say 10%, and then make your purchase. In other words, you're simply being more opportunistic when you make your purchases. Unless you have a good understanding of a sector, its probably best to dollar-cost average.

Anyway, I'm not providing specific advice, nor am I providing any advice for a fee (now you can't sue me). Rather, I'm simply introducing a couple of ideas that readers might find helpful and would like to study in more detail (on their own).

The New York Common Fund Scandal

Thanks for bearing with me throughout the hiatus. Truthfully, aside from the Chrysler bankruptcy, there wasn't a whole lot going on. However, if you've been reading the financial times or the wall street journal you'll have come across several stories regarding Cuomo's latest smackdown involving one of New York's largest pension plans. Why should you care about this? Because some of the underlying details actually get to the problem with decision making in the institutional world that is equally applicable at the individual level.

Here's what happened. The New York Common Fund is a public pension fund, one of the largest in the world. The fund is being investigated for allocating funds to money managers who made political/personal contributions. That's basically it. Most public pension funds have a Board of Directors acting as a check and balance on what the internal investment team is doing to avoid conflicts such as these. However, at the New York Common fund, they have a sole decision maker, the Comptroller. This Comptroller allegedly allocated money to several external money managers who investigators say also contributed heavily to the local political party. These "contributions", ahem...bribes were made by investment managers directly (think hedge funds and private equity funds) and also by placement agents. Placement agents are basically hired by hedge/private equity funds to help them raise money. They are paid a commission on any money they bring in. Cuomo says these placement agents paid fees to the comptroller, or his party, in exchange for several millions of dollars worth of commitments. Also, the NY Common fund hired consultants that almost had discretionary authority and approved several of these allocations. It's messy. Of course now it's turned into a massive witch hunt that will ripple across the institutional universe. I'm not to naive to think this doesn't go on elsewhere.

There are obvious lessons here, but a couple I think we can apply personally. The first mistake is having a sole decision maker. It's a stupid idea for institutional investors and it's a stupid idea for individuals. You should never make a major money decision without a second opinion. You need someone else to help you think through the idea and help you discover if perhaps you are seeing something that simply isn't there. Second, many pension funds rely on consultants for opinions. This might seem like a good idea. But not taking any action unless a consultant approves such action is essentially giving de facto discretionary authority. This can be equally damaging. So if you don't want to make decisions on your own, and you don't want to rely too heavily on a consultant (or perceived "expert"), what do you do? Something in the middle. Make sure you listen to others but use some good judgment. Ask yourself, why would this individual be considered an expert in a certain field? What are his motives? Are they aware of other opportunities? Are they on the hook for the decision? Do they have money at stake (in other words, if I lose, do they lose?)?

Being honest of ones intellectual and behavioral limitations could save thousands of dollars. It's not enough to be right or wrong, but to be right or wrong for the right reasons (or something like that). Good luck.

Double Standard for Auto Industry

I'm going to field this question as I walk out the door because I don't think it's too difficult. Many are wondering why the Obama administration is taking such a hard line with the auto manufacturers while being so tolerant to the banks. Here are five reasons, in no particular order.

1. Banks pose greater systemic risks than the auto manufacturers. Although the effects of auto manufacturers going bankrupt would be immense, it would be worse to let the banks fail.
2. Banks are operationally solvent. Meaning, they have enough money to pay their bills and have only taken money from the Government to comply with regulation. Auto manufacturers can't even pay their bills, which is mostly due to their high labor costs.
3. Auto makers have been losing market share for the last ten years or so. Up until last year, banks have made money every year.
4. The White House is teaming with former Wall Street executives, which may account for why they understand the wall street funk.
5. The automobile industry has a lot more long-term uncertainty surrounding their business model (i.e. cars that run on alternative fuels, etc.). On the other hand, the low interest rate environment has actually helped banks this year as the spread between what they pay the depositors and what they lend is relatively wide. The majority of banks will be profitable this year (by profitable, I mean in a healthy way).

Insights from PE Conference Part II

More of the same doom and gloom scenarios with some interesting comments from the former head of the EBRD (European Bank for Reconstruction and Development).

-There are major issues with banks in Europe since it is not uncommon for a bank's subsidiary, which functions entirely separately from its parent, to need additional capital to prevent a failure. Here's the problem, the parent bank is located in a different country. So XYZ bank is headquartered in Poland and has an Italian subsidiary that needs additional capital. Taxpayers in Poland have to put up the money to save an ostensibly Italian bank. That's caused some contention.

-Eastern and Central European consumers are more reselient than U.S. consumers because they are not as demanding. Most Europeans in the developing regions are more resourceful and use to living on meager incomes. So it's unlikely the consumer will be as distressed in those areas as they are in other developing regions.

-Lots of talk regarding the deleveraging of the U.S. consumer. That's a fancy way of saying americans are going to save more. According to a brand new study by McKinsey, every percentage point gained in the personal savings rate translates into $100 Billion of decreased spending, which can be a major drag on the economy. This of course, assumes income growth remains stagnate (which it has since 2000). If incomes increase, then spending can increase and savings can grow.

Insights

For the next two days I'll be at the Thunderbird Global Private Equity Conference. The first couple of presentations have been interesting. Here are some tidbits.


Regarding TARP Money. An executive from a large bank that took money from the TARP had to rescind job offers to several candidates because he was informed that banks who recieve money from TARP can't hire non-U.S. citizens. Ouch. Can you say talent flight?

On the Treasury's new plan. Seems like consensus is that the new proposed partnerships (I know, I promised a post on this and will complete it soon) between the governement, banks, and private money, is a logistical nightmare. I can't say I'm surprised. You have three separate parties trying to establish a "fair" price. And everyone has a different agenda.

More shoes to drop. Not to go into detail, but bond spreads are predicting defaults to go from approximately 5% to 15%. That's not great news for employment, and, by extension, GDP.

China's political backlash. Earlier this week China said it was worried about the solvency of the U.S. That should scare most people. China is the largest holder of U.S. treasuries. If China decides to dump them for a safer investment, we would have massive hyperinlation (I know, that's redundant). I don't think that will happen for two reasons. First, there really aren't any other currencies I can think of that are safer and second, they'd be shooting themselves in the foot. China's GDP is like 50% exported and the U.S. is the largest net buyer. Guess what happens if we can't afford their goods due to our hyperinflation?

More to come.

Summing up the AIG bonus debate

Hard to watch/listen to any news without hearing about AIG's $165 million dollar bonus payout. I guess I was a little surprised how quickly the story spiraled out of control. My blood started to boil when I heard a prominent democrat (I won't mention HER name but will only say that it rhymes with "smelosi") illustrate what could generously be referred to as a complete lack of insight, knowledge or even a general awareness of the circumstances and points of debate regarding the bonuses AIG paid out to their employees. I'm not making a political statement. This is not a political blog. Many members of congress, on both sides of the aisle, misunderstand the situation but I only heard her comments due to her public profile.

What Happened
AIG received $170 billion from TARP and posted a 4th quarter loss of ~$60 billion. A week ago AIG announced it was paying out $165 million in bonuses to various employees. Total payouts by AIG could reach over $1.2 billion. The difference accounts for additional performance and retention bonuses. Can't wait for that to happen. And you think $165 million is bad?

So here's a smattering from around the web. I tried to find arguements on both sides, but gave up after discovering there really isn't a logical contra-arguement against the paying of the bonuses, mostly just populist rage. Here what strikes me as funny, everybody hates these guys are getting paid, but no one knows for what or for when and everybody hates the 90% tax. Tell me again why we're having this arguement? Is it even productive?

As you can expect, comments range all over, from very sophisticated "These bonuses are terrible but must be paid as a matter of contract" to "Hey, Pa, come n' see what those @#$%* from AIG that knocked up Jenny done did!" Alas, the apparent risks of a computer in every home.

First....

Rick Newman U.S. News explains why we are so outraged.
Myriad experiments in behavioral economics have found that people are willing to pay to punish members of a group whom they believe to be shirkers or free-riders. In other words, people are willing to make themselves worse off (they have to pay their own money) in order to insure that others don’t get undeserved rewards. But when it comes to the A.I.G. bonuses, the costs of clawing them back are trivial at best, while the public satisfaction at seeing what feels like justice being served will be great. Getting all worked up about this money may not, strictly speaking, be rational, but I think that paradoxically, if some of this money is clawed back, it’ll increase the chances that we’ll be able to keep dealing with the ongoing crisis in a rational way in the future.

On to the rational minds...
Andrew Ross Sorkin (Editor, NY Times).
The fundamental value here is the sanctity of contracts. Imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right. A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it. Let them leave, you say. Where would they go, given the troubles in the financial industry? But the fact is, the real moneymakers in finance always have a place to go. You can bet that someone would scoop up the talent from A.I.G. and, quite possibly, put it to work — against taxpayers’ interests.

SmartMoney
For the stock market, this is a rally-killer. Or worse. No one seems to want to determine whether the people getting this money deserve it or not. Maybe some of them don't—maybe some of them are even the bad people who got AIG into trouble in the first place. But maybe some of them do deserve it. Maybe there's one guy or gal who has just done some brilliant trade that has made taxpayers billions, at least offsetting some of the billions in losses. Should that trader not get a bonus? No one seems to care that the 90% tax will apply to all banks that have accepted federal money, not just to AIG. That includes banks like Wells Fargo, who told Treasury secretary Henry Paulson that they didn't even want the money when the Troubled Asset Relief Program (TARP) was enacted last October. Reluctantly, Wells took the money at Paulson's urging, as did other healthy banks such as JPMorgan. Now virtually every employee of every one of them faces a 90% tax on their bonuses. No one seems to care that the Internal Revenue Code is designed to collect federal revenue, not to punish particular classes of people. These employees will simply leave. Or they will turn their brains off. Either way, the taxpayers whose money is at stake in these companies will be hurt—because these companies will crash and burn.A successful economy depends more than anything else on the rule of law. There has to be a stable set of rules governing the interactions between economic players, and between players and the government.

From the Wall Street Journal
If the A.I.G. bonuses looked were the quintessential example of Wall Street self-dealing, the House’s bill looks like a quintessential example of blunt and ill-considered political policymaking. On top of that, one logical consequence of this bill would be that companies will simply pay people much higher base salaries, which takes us in the wrong direction.

Henry Blogett at Clustershock
Today’s frantic passage of the Populist Rage Tax was a new low in the US government’s response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery — by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what’s left of our economy. If the “TARP bonus” bill the House passed today becomes law, any of the hundreds of thousands of people who work for Citigroup, Bank of America, AIG, and nine other major US corporations will have to fork over 90 cents of every dollar they make that puts their household income over $250,000. That’s household income, not individual income. If you’re married and filing singly, you’ll have to surrender anything over $125,000. Indefinitely.

Eric Etheridge, NYTimes
As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy. But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.

David Harsanyi at DenverPost

Here's an idea: If you stop nationalizing banks, there will be no need to engage in phony-baloney indignation over bonus payments anymore. Don't we want AIG to succeed and get off the government dole? What sort of employee would work for an entity that doesn't honor its contractual obligations? How many valuable employees will walk away from such a company?


Chris Bowers at OpenLeft describes why the tax needs to be broad

1. Passing Constitutional Muster: Lawrence Tribe has written that, in order for a bonus tax to be constitutional, it must be "sufficiently general to avoid classification as a measure targeting solely a closed class of identified and named individuals." The more narrow the bonus tax legislation, the less likely it will be ruled constitutional. As such, making the bonus tax as broad as possible is necessary to the survival of the legislation.

2. Weeding out thieves from the bailout program: The bonus tax must apply to all participants in the bailout program, so as to guarantee that only those firms and people interested in helping the economy participate. Anyone who considers their personal compensation to be more important than helping the economy needs to be kept as far away from the bailout program as possible.

3. Addressing a broad culture of greed and excessive executive compensation: I agree with President Obama that the bonus scandal is a "a symptom of a larger problem," based on a broader "culture of greed.". As such, if the bonus tax that is aimed only at AIG, then it simply is not good enough legislation. The bonus tax has to make a broad dent in broader problem of excessive financial services industry employee compensation, which is directly connected to our ever widening income inequality. This is one of the best opportunities I can ever remember to pass such a law.

Banking Paralysis

Some of you could probably tell I've been intentionally avoiding posting on the economy specifically for a few weeks as I was waiting for the stimulus mess to sort itself out. I hoped to post something about President Obama's stimulus package in more detail, but, after following several publications over the last couple of months on the matter, determined there are enough sites out there to explain what the stimulus means to the "average Joe." But I would like to address a couple of items that have come up in conversations/emails. They are 1) What is taking the Banks so long to get their act together and 2) What does a Bank "Recap" mean?. So there's still lots of discussion around financial services. This discussion however, is different than the commentary six months ago. I'm not going to answer these questions in order, or even in one post, but instead lay out, basically, how banks work. Doing this, I think, will help give perspective to the ongoing financial paralysis. I apologize if this sound condescending, but I have no idea who is reading this blog so I will write to the least common denominator.

How Do Banks Make Money
You open a checking and/or savings account with the Bank and they pay you little to no interest. Then, they take your money and lend it out at say 6%. If the Bank pays you 2% on your savings account, they are making 4% on your money. More specifically, they pay you 2% on your savings account and lend your money to home buyers (in the form of a mortgage) for 6%.

What does it mean to "Securitize" a mortgage?
I wrote about this in an earlier post but will briefly summarize here. Let's say your mortgage is with Bank A for $200,000. You pay the bank say $1,500/mo for 30 years in exchange for the $200,000 up front (you're total payment is $540,000 over 30 years). But perhaps Bank B wants to buy your mortgage from Bank A. So Bank A sells the mortgage, for about $200,000. In this role, Bank A acts as an intermediary and only makes money off of closing fees. Your mortgage is now with Bank B, and they have claim to all future payments. Over the last several years Bank B would typically be an investment bank. Not only would they buy Bank A's mortgages, but they would buy mortgages from thousands of banks. Bank B bundles 1,000 (for example) mortgages together and divvies them out in slices of 10 (each slice has payments from 100 mortgages). This slice can now be called a security, or, a CDO (Collateralized Debt Obligation). The price that another bank would pay for this security is based on the perceived riskiness of the underlying payments, or, the credit worthiness of the borrower. At the time, none of the Banks anticipated the steep decline in housing prices.

Bank Capital
When borrowers began to default because they couldn't refinance their homes the Bank holding the CDO had to write the value of that CDO down accordingly based on mark-to-market (or fair value) accounting. The CDO is an asset to the bank that owns it. Future payment streams from mortgages are assets to banks. However, if the value of the Bank's investment was $10 million a year ago, it's now worth $2 million and they must take a $8 million dollar loss. That's what has been going on over the last year. Let's look at how that affects the Bank by providing an example.

Say you wanted to start a Bank and you were able to come up with $20 million dollars in cash from investors in exchange for equity (i.e. stock) in the bank. Then, you went and borrowed money in the form of Bonds for another $80 million. Now you have $100 million to "invest". Remember, with a bond, you pay the bondholder a set percentage each month, say 4%, of the face value of the bond and at the end of ten years you have to make a lump sum payment to the bondholder for the face amount of the bond (you would have thousands of Bondholders with individual bonds for $1,000 each paying 4%/yr). From the Bank's perspective, Bonds are liabilities. They represent a future obligation the Bank has to someone else. Then, with your $100 million, you go out and buy some CDO's that are paying you 6%. That's a great business model. Your CDO's are paying 2% more than you have to pay your bondholders. But if CDO's fall in value by 80% due to defaulting borrowers in the underlying mortgages, your $100 million of CDO's is now worth $20 million. Keep in mind, you still have to pay your bond holders. Now, your assets are less than your liabilities. Meaning, you don't have enough money coming in from your CDO's to pay your bondholders. The Bank is insolvent. I'm over-simplifying here, but you get the picture. This gets us to about Q3 of last year.

One Thing Exacerbates the Problem
There's a timing issue. You may have noticed at the onset that Banks borrow short and lend long (to use standard industry vernacular). A deposit is a short term liability to the bank, whereas a mortgage is a long term asset. At any point in time a Bank may only have 15-20% of all their deposits on hand in cash. Should depositors want to withdraw all their money at the same time the Bank would not be able to liquidate enough assets to pay their liabilities. This is one sort of "Bank Run." We know from the IndyMac fiasco last year, that all deposits are guaranteed by the FDIC up to $100,000. The problem lies in the fact that most Bank's short-term liabilities are not deposit accounts, and are not insured. To meet these obligations, Banks will typically borrow from other banks. But today, Banks are unwilling to lend to eachother because 1) they are worried the bank won't be solvent based on their exposure to CDO's and 2) they want to hang on to their own cash in case they have the same problem. So banks are just staring at eachother. Finally, a derivative product is to blame for the most recent stagnation--the dreaded Credit Default Swap.

Credit Default Swaps Explained
Back to bonds for a minute. If you want to buy a $100 Bond from JPMorgan you would pay JPM $100 (usually) and they would pay you a set interest rate, say 6% for 10 years, at which point they will pay you $100. You make $6/yr for 10 years and get your $100 dollars back, for a total of $160. Not bad, better than a 2% savings account. But there are two big risks. What if JPMorgan can't pay you back? What if interest rates go up and you're stuck at 6%? You could buy a Credit Default Swap for a few hundredths of a percentage point from an insurer to hedge the default risk (but you can't do much about interest rate risk). The insurer would step in and pay you off in the event the company you bought the bond from defaulted. Simply, they are insurance policies. But, since they're derivatives, the swap itself could be sold for a specific value. Let's make it a little more palpable.

Merrill Lynch owns a bond OR a CDO from Lehman Brothers. They do the sensible thing to protect themselves and buy a CDS to insure against a Lehman default. Since Lehman is a huge company, they go to AIG for the insurance and pay AIG .5%/mo in exchange for the coverage. See the problem? CDO's default, Lehman is insolvent, AIG can't make everyone whole (CDS' aren't regulated so "sellers" of the insurance don't have to have reserves). ML is stuck holding the bag. Whereas ML thought they would be made whole via AIG they are now stuck with major losses on their own assets and are themselves, insolvent Now holders of ML bonds or CDO's must mark down their assets and they are insolvent, triggering another payout by insurers of ML to those that had CDS on ML. And by the way, ML sold their own CDS to other Banks, which they will no longer be able to honor. This massive chain reaction is still playing out across the financial sector. A bank may look healthy but they may be depending on an insurance payment from an insolvent bank.


Hopefully I've been able to elucidate the current financial faceoff in a little more detail. AIG was bailed out because they were the largest sellers of CDS in the world. The government is still trying to figure out ways to either get these toxic CDO's and other mortgage backed securities off the Banks balance sheet, or provide additional capital to "Recap" the bank. Both of which I will treat in the next post.

We interrupt your program to...

Image via Wikipedia

...bring you a message of hope! GEEZE! I have to say it's getting a little annoying how CNN is reporting on the stock market.

"DOW reaches a new twelve year low today. Wait...nope, now is its lowest in twelve years, wait, NOW...now...now...no, NOW."

I get it, it's low. Fortunately, this market has done wonderful things for my popularity at social functions. Although I am getting a little cynical. Conversation:

Partygoer: "What do you do for work?"
Me: "I'm a greedy bonus-mongering private equity investment guy."
PG: Blank stare
PG: "Um, how would YOU fix this mess."
Me: "The way I figure it, the wealthiest people in the world right now are the Somali pirates. I think they should apply for Bank Holding Status and expand operations with money they receive from TARP. Since the government isn't asking any questions, I figure they could get to $20 billion or so with TARP money, plus whatever they get through routine plundering. At traditional 30:1 ratios, they could lend up to $600 billion (USD) to help stimulate the economy. The pirates that get sea-sick can go work on Wall St."
PG: Silence. "Did you see how low the DOW was today?"

On a different matter, I love talking to venture capitalists. They are the only ones that aren't afraid to say they are going to "change the world." I grin like a giddy school boy when they say it and I can never figure out why. Maybe it's because, subconsciously, I know some have actually already done it. Venture capitalists are behind some of the biggest game changing technologies like, Apple, Google, Yahoo, eBay, Amazon, Skype, Twitter, Cisco, MySpace, and Facebook. That's not even including the VC's who are working on advanced biotechnology and Life Science projects that will synthetically replicate human organs without the chance of rejection. I suppose I like talking to them because they're not depressed like the rest of us--they still dream. Here's one of the premier VC's in the world, Steve Jurvetson, of Draper, Fisher, Jurvetson, talking about his love of rockets. Incidentally, my son loves this clip.

http://www.ted.com/index.php/talks/steve_jurvetson_on_model_rocketry.html

A Bong, an IOU, a Favor

While I was stopped unnecessarily on the freeway this morning for President Obama's speech that was less than 15 minutes from my home, I recalled one of my favorite scenes from Dumb and Dumber. It's where the evil kidnapper finally tracks down Lloyd (Jim Carrey), grabs the briefcase and opens it while pointing a gun at Lloyd's head. Instead of finding a suitcase full of ransom money, he finds a bunch of I.O.U's, meticulously accounting for every dollar Harry and Lloyd spent upon learning there was actual money in the briefcase. Lloyd, apparently recognizing the kidnapper's distress, gently picks one of the pieces of paper off the ground and says, in a gentle voice, "Those are I.O.U's, that's a good as money. Look, this one for $250,000 (for a Lambourghini), you might want to hang on to that one..." So classic.

My amusement quickly diminished as I replayed the scene in my head. In the replay, I played the role of Lloyd, my son played the one opening the briefcase (only he wasn't an evil kidnapper), and instead of $250,000 the price tag was $1.5 trillion, and instead of a lambourghini, it was social security. Yep, you can obviously tell that I'm worried about our future generations and the obligations they'll have to face, or not. Todays economic climate is in many ways primal and its given me reason to pause and consider a few random thoughts.

Impact of Today on Future Generations: Economists and politicians have said very little regarding the impact of todays decisions on our children. To what extent are we mortgaging the future? At what point does someone (meaning someone in Washington) stand up and excersise some monetary and fiscal discipline now so that we pay for our decisions, and not our kids? We need to take action and solve the entitlement problem in the U.S., meaning health care and social security. In investing, you are taught to always look at a companys unfunded liabilities (i.e. pensions that are underwater or other obligations they can't meet) and run the other way if they have any. Then that begs the question, why would anyone want to invest in the U.S. with our underfunded pensions, broken social security and medicare programs? Could the U.S. default on its national debt? It's possible, but not probable. I think it would be more politically expedient to pick hyperinflation over default, but I'm not an economist. Time will tell what "kind" of Obama emerges. Will he step up and demand that deficits created from todays debacle be payed back with future suprluses, similar to the EU? Or will he continue to allow politicians make decisions based on the short-term and stick our children with the bill? I'm not saying that's irrational, as the current incentive program enduces such behavior, but we shouldn't expect legislators to act altruistically, better to make it law, which I don't think is probable. But that all leads me to my original soap-box that the problem with politics started when we made it a career.

And another thing. Much has been written about Michael Phelps' bong debacle. Phelps was pictured smoking some herb at the University of South Carolina a week ago. I believe he should definately be more careful as he is a role model but, the amount of outrage over this matter is completely unnecessary. I mean really, even if it is deplorable, is that what we need to be focused on? A swimmer smoking a drug, which to my knowledge, has killed zero people? This seems to be a recent development in America--we're captivated by "breaking" yet useless news which only serves to distract us from other problems we should be dealing with. What's ironic about America's "outrage" is its generally directed toward people engaged in an action that the majority of american's have also participated in, but have not been caught. I love how the news anchors shake their heads in disgust when reporting stories about marijuana use, teen sex, or drunken icons, as if THEY have acted any better (see youtube "newscaster bloopers" if you don't believe me). Anyway, I'm not saying that such actions like those of Michael Phelps or others are acceptable, but I am asking that 1) is that really the most pressing news? Doesn't it just cheapen American intellect? I know that's what sells, but is that the point? To report only what sells? How about what's important? and 2) why should we be accusatory for something the majority of american's have engaged in? C'mon, FOCUS AMERICA! We're too distracted by shiny things--like clearance tags. We love to point the finger and blame other people for their "mistakes". Rhetorical question. Are you saying we are to blame for this mess and not Wall St. executives? I'm choosing not to answer that. But let's scream and throw chairs when discussing their bonuses. Is anyone else concerned that we are outraged at the bonuses of professionals who work in banking (a necessary industry) and not the compensation of professional athletes? Wait, wait, before you respond with "Professioal atheletes haven't caused any harm", I would like you to think about that question (since the two fundamental assumptions can be debated 1) did bankers actually cause today's issues? or did debt hungry Americans and 2) professional atheletes haven't caused any social or economic problems. To which I would say "really?")

A Note About "Interesting Websites"

Some of you may have noticed that I have a list of interesting websites to the right. Every so often I add a site to the list but I have never introduced them as I've posted them. So, since I have some spare time on President's day, I thought I would write a sentence or two on each of them. There is one commonality--all are backed by well known venture capitalists.

1. Zemanta. Contextually relevant pictures, links, and suggestions for email and blogs. Ba

   Image by chucks via Flickr

   sically, you download Zemanta to your browser and while you are typing an email or blog post, Zemanta suggests pictures, links, or tags you may want to add. You can even easily pull a quote from another blog and include it on your blog. Even as I type this, my Zemanta tool bar to the right suggests several pictures for "President's Day" as well as links to useful trivia and blog posts. See the image to the right.
2. BillShrink. Checks credit cards and cell phone offers to ensure you are getting the best deal possible. You enter your balance/monthly fee, your interest rate (for CCd's), zip code, usage, etc. and BillShrink will come back to you with the best result. In the case of cell phones, it list alternatives by signal strength.
3. ScrapBlog. You can create stunning multimedia scrapbooks online for free! Rather than simply send your friends sterile pictures, you can personalize your vacation, first day of school, with one of Scrapblog's templates or create one of your own. It is free to register, create and share your multimedia scrapbook online, but if you want to print it out, that will cost you. Not a bad business model.
4. SearchMe. This is a new way to search the web. SearchMe lets you see what your looking for. Choose your category and you'll see pictures of web pages that contain your answer. This way, you can scan the web page for the necessary information before clicking through. It uses "stacks", which, if you've cycled through the top-movies section on iTunes, it has a similar feel--web pages cycle through your view as you move the toolbar from left to right, or right to left.
5. Yelp. No rocket science here. Yelp is an easy way to find what's good, or not so good, in your area. You type what your looking for in the search bar and then your zip code and a list will populate with user reviews.
6. Wetpaint. A Wetpaint website is built on the power of collaborative thinking. Here, you can create websites that mix all the best features of wikis, blogs, forums and social networks into a rich, user-generated community based around the whatever-it-is that rocks your socks. A social website that’s so easy to use, anyone can participate.
7. Widgenie. If you're one to include polls or other types of tables in your blogs or just want a sharp looking graphic then Widgenie is for you. You can register for free, customize data and create a graphic to post to your blog, facebook, or igoogle account.
8. Prosper. Looking for extra money? Prosper creates an online meeting place for those seeking money and those that have money but want a higher yield on their investment. It's a social lending site. You can apply for a loan or make a loan. Only there aren't any banks involved directly here. If you're looking for a loan, then you enter your information and those willing to make loans, will bid on your loan. Prosper asks for a lot of information on the borrower and will pull a credit score to show to potential lenders. Lenders can slice the data any way they want and bid for high or low-risk loans. What if you don't want to expose all your money to one person? You can spread your money around. If you have $1,000 to lend, you can parcel that out between different borrowers.

There you have it. Some creative sites all aimed at making the universe more efficient. Also, since these are all venture backed companies they are all in the early stages of creation and I know CEO's are open and anxiously awaiting feedback from interested users. So take a look and don't be afraid to drop them a note via their "feedback" links if you don't like something. They will welcome your input with open arms.

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Why Not Give Bailout Money to Taxpayers?

In keeping with the theme of shedding a little light on financial topics you may be forced to discuss or have an opinion on at parties, funerals and baptisms, I would like to highlight a common question. It generally sounds something like this...

"Why not give the bailout money to the taxpayers? We'll spend it. If they want to help us, just give us the money? How come the government is still giving it to irresponsible Wall St. companies? Bailing out Wall St. creates a moral hazard."

Those who hold this view are assuming that 1) all bailouts create a moral hazard, 2) giving money to taxpayers in lump sums is preferred and 3) taxpayers will spend the "stimulus" money. I'd like to present a few alternatives to each of the three basic assumptions. And since the party you are speaking with will probably hold the "pro" side, it will be your job to introduce an alternate view (unless you don't care for confrontation, in which case you can smile and nod, or make a trip to the bathroom).

1) Moral Hazards. This is the idea that if people are insulated from their bad decisions, they are more likely to act irresponsibly. Therefore, if Wall St. knows it's going to get bailed out in a pinch it will continue to act recklessly, or so the argument goes. If I have fire insurance then, according to the argument, I would be less vigilant about having fires in my home. But let me assure you, I would be equally concerned about a fire in my home with or without insurance. Likewise, we would expect banks that have received bailout money to continue in rash behavior. But we haven't seen that. In fact, they've pulled back too much and no lending is going on. Perhaps one solution to the moral hazard issue lies in the perceived outcome. For example, most people are ambivalent towards which banks hold their deposits because of FDIC insurance. That's because FDIC insurance offers a quantifiable solution, a known outcome. But a bailout or a house fire creates uncertainty and potentially complex and messy situations. I think the less certain the outcome, the less impact the moral hazard argument holds. As I stated in an earlier post, I don't think shareholders in Bear Stearns, who lost 100% of the value of their shares, or unemployed CEO's, are still running around like druken frat boys looking for more mischief.

2) Giving money to taxpayers in lump sums. I've heard ridiculous numbers running around the internet about how much we'd all get if the government were to cut us a check. I think CNN ran an article today or yesterday showing the number to only be $9,500 (far below some claims of $100k). There is a psychological difference between a windfall (such as a stimulus check) and increased monthly wealth. Americans tend to save windfalls and spend when long-term prospects for personal wealth increase. Which is why...

3) I don't think consumers will spend like we say we will. I'm not going to spend anything extra this month if I think my income will be zero next month. I believe the issue here is perceived job security. Stimulus from 2002 wasn't very helpful, nor was the stimulus from last year (so far). In environments of financial turmoil and uncertainty Americans save bonus money. However, this is why I think President Obama's taxpayer stimulus might actually work. His idea is to give taxpayers a credit by decreasing the withholding amount. Pretty clever. For most, it will amount to an extra $50/mo. in our paychecks for one year. Some economists think that this will help Americans spend money because we see a long term, fixed increase in our take home pay.

To conclude, I'm saying the moral hazard argument should not be overstated, that if the governemenet wants us to spend, then they should attack the heart of the uncertainty--the job market, and that Pres. Obama's proposed stimulus is fairly astute.

No, wait, DON'T GO!

This is still the blog for the infamous Toad Musings. Only, I think I've grown out of my wife's pet nickname for me. I also thought Adverse Selection was more appropriate. In economics, adverse selection is what you call it when you do business with someone/thing that you should not have only because the other party had information you didn't (what many call informational asymmetry). Confused about the parallels? Excellent. Feel free to tell me if you don't like the new layout.

This will be a big week for the markets. There are a lot of earnings reports coming out this week and if the DOW can stay above its psychological floor of 8,000 that will be a good sign that maybe we've reached the bottom. Notables announcing earnings this week include McDonalds and Wells Fargo. Both may act as the proverbial canary-in-the-cole-mine. McDonalds historically has done very well in recessionary environments and Wells Fargo will provide a proxy for financial services in general. My prediction is that it will not be pretty. I think most firms announcing are going to take a big bath in order to lower expectations going in to the next quarter. Losses will be greater than what most analysts predict and I think its highly probable the DOW will slip below 8,000.

Oh yeah, I haven't said happy New Year yet.

A Laughable Year

So I've been patiently waiting for an interesting financial news story to write about, although I have no idea how any could top what we saw in '08. 2008 was the year we saw the average Joe become a genius. Any schmuck could complain about any industry/politician/policy and be right. It was all a mess. From a rogue trader taking Societe Generale (a HUGE French bank) for $7 Billion, to bank runs, bailouts, and oil frenzies. Whew! What a year. It had all the hallmarks of a good action movie--non-stop explosions, car chases, and blatant disregard for extras. And like a good action flick, just when you think the action is over there is a dramatic outburst of unexpected last-minute action. Like last December where we were supposed to all hold hands and sing like the Who's in Whoville (much to the chagrin of the Grinch) on Christmas Eve--BAM! The grand finale featured Bernie Madoff wowing the audience by taking $50 Billion from savvy investors. In the words of Syndrome (from the Incredibles), "I'm still geekin' out about that!" I got back to my office after the holidays, sat back in my chair, took a deep breath and thought, "What next?" That's when my eyes wandered through the days headlines and saw.....

A Porn industry BAILOUT? Excuse me? Yep, turns out the CEO of Hustler and the CEO of Girls Gone Wild paid a visit (no pun intended) to capital hill for a piece of the stimulus action (no pun intended), approximately $5 Billion. Where did THEIR money go?! America wastes money on boos, cigarettes, gambling, and porn. What's Hustler's excuse? They don't get any love from Jenga (and if the CEO of Hustler is reading, "Jenga" is just my stage name). Hilarious.

Changing gears, my vote for "Best Decision nobody knows/cares about": How about the GAO (government accountability office) refusing to opine on the Governments financial statements for the 11th consecutive year. They claim the government misdirected $55 billion, meaning, it went missing, in 2007. That's up from $41 billion the year before. How about Obama focuses on mowing his own lawn first this year. I'd start with the Defense department, where the GAO sites "accounting chaos." Good call GAO for not putting your name on THAT.

I got a good chuckle out of these cheeky headlines from 2008 from about.com


1. Iraq War Ends; Bush Indicted For Treason (NY Times Spoof Edition)
2. Obama's Use of Complete Sentences Stirs Controversy (Borowitz Report)
3. Black Man Given Nation's Worst Job (The Onion)
4. Failure to Blow Election Stuns Democrats (Borowitz Report)
5. America to World: "We're Not Retarded!" (23/6)
6. Bush in Race Against Time to Wreck Country (Borowitz Report)
7. McCain To Suspend Campaign In Order to Rescue Campaign (Opinions You Should Have)
8. Bill Clinton Sadly Folds First Lady Dress Back Into Box (The Onion)
9. Nation Finally Sh*tty Enough To Make Social Progress (The Onion)
10. Bush To Put FEMA in Charge of Wall Street Rescue (Opinions You Should Have)

Honorable Mention:

11. McCain Replaces Palin with Startled Deer
12. Ponzi Estate Sues Madoff Federal Prosecutors For Slander

2008 set the bar pretty high.