Tuesday, September 30, 2008

Human capital

The Role of Education Quality for Economic Growth
Eric A. Hanushek and Ludger Woessmann (http://ssrn.com/abstract=960379)

The figure shows, by country, the share of students that scored very low (< 400 rough PISA equivalent, "scientifically and mathematically illiterate") or very high (> 600) on cognitive tests administered over the last 40 years. The results give a good indication of the quality of human capital in the country's workforce. Click for larger version.

From the paper:

...To create our measure of quality of education employed in this study, we use a simple average of the transformed mathematics and science scores over all the available international tests in which a country participated, combining data from up to nine international testing occasions and thirty individual test point observations. This procedure of averaging performance over a forty year period is meant to proxy the educational performance of the whole labor force, because the basic objective is not to measure the quality of students but to obtain an index of the quality of the workers in a country.

If the quality of schools and skills of graduates are constant over time, this averaging is appropriate and uses the available information to obtain the most reliable estimate of quality. If on the other hand there is changing performance, this averaging will introduce measurement error of varying degrees. [i.e., younger workers in developing countries probably have better skills than indicated in the data.]

More PISA fun.

Why no bailout?

Representatives in Congress received thousands of phone calls and emails from constituents against the bailout, which some wags have characterized as "no banker left behind" :-)

We can trace this popular reaction against CEOs and Wall St. to growing income and wealth inequality. Ordinary people no longer feel they have a stake in the system. Their reaction may be irrational (even the poorest American has a big stake in the continued functioning of the economy), but it was certainly predictable.

Next spring, unlike last year, less than half of the Harvard graduating class will take jobs in finance. I guess that signals a top in the market 8-/

Related posts:

financier pay

all about the benjamins

a reallocation of human capital

a new class war

non-residential net worth

working class millionaires

Monday, September 29, 2008

Complexity illustrated: Lehman WAS too connected to fail

This WSJ article illustrates what I discussed more abstractly in this earlier post Notional vs net: complexity is our enemy. The story claims that by allowing Lehman to fail, Treasury and the Fed triggered the final stage of the crisis that got us to where we are today. I've included my figures from the earlier post here.

...in an age where markets, banks and investors are linked through a web of complex and opaque financial relationships, the pain of letting a large institution go has proved almost overwhelming.

In hindsight, some critics say the systemic crisis that has emerged since the Lehman collapse could have been avoided if the government had stepped in.

The Fed had been pushing Wall Street firms for months to set up a new clearinghouse for credit-default swaps. The idea was to provide a more orderly settlement of trades in this opaque, diffuse market with a staggering $55 trillion in notional value, and, among other things, make the market less vulnerable if a major dealer failed. But that hadn't gotten off the ground. As a result, nobody knew exactly which firms had made trades with Lehman and for what amounts. On Monday, those trades would be stuck in limbo. In a last-ditch effort to ease the problem, New York Fed staff worked with Lehman officials and the firm's major trading partners to figure out which firms were on opposite sides of trades with Lehman and cancel them out. If, for example, two of Lehman's trading partners had made opposite bets on the debt of General Motors Corp., they could cancel their trades with Lehman and face each other directly instead.

This figure shows three trades which almost cancel. Remove one of the counterparties and you have chaos instead of hedges. In a last ditch effort, after letting Lehman fail, Treasury tried to cancel these trades out manually -- good luck! Why did we not have a central exchange in place earlier?

Oops, there goes AIG! (Big issuer of CDS insurance.)

The reaction was most evident in the massive credit-default-swap market, where the cost of insurance against bond defaults shot up Monday in its largest one-day rise ever. In the U.S., the average cost of five-year insurance on $10 million in debt rose to $194,000 from $152,000 Friday, according to the Markit CDX index.

When the cost of default insurance rises, that generates losses for sellers of insurance, such as banks, hedge funds and insurance companies. At the same time, those sellers must put up extra cash as collateral to guarantee they will be able to make good on their obligations. On Monday alone, sellers of insurance had to find some $140 billion to make such margin calls, estimates asset-management firm Bridgewater Associates. As investors scrambled to get the cash, they were forced to sell whatever they could -- a liquidation that hit financial markets around the world. ...AIG was one of the biggest sellers in the default insurance market, with contracts outstanding on more than $400 billion in bonds.

To make matters worse, actual trading in the CDS market declined to a trickle as players tried to assess how much of their money was tied up in Lehman. The bankruptcy meant that many hedge funds and banks that were on the profitable side of a trade with Lehman were now out of luck because they couldn't collect their money.

...At around 7 a.m. Tuesday in New York, the market got its first jolt of how bad the day was going to be: In London, the British Bankers' Association reported a huge rise in the London interbank offered rate, a benchmark that is supposed to reflect banks' borrowing costs. In its sharpest spike ever, overnight dollar Libor had risen to 6.44% from 3.11%. But even at those rates, banks were balking at lending to one another.

Who was next after AIG? Time for a bailout!

...Goldman, Paulson's former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Saturday, September 27, 2008

Clawbacks, fake alpha and tail risk

Earlier this year I wrote a post Fake alpha, compensation and tail risk in finance:

...current banking and money management compensation schemes create incentives for taking on tail risk... and disguising it as alpha. The proposed solution: holdbacks or clawbacks of bonus money... When will shareholders smarten up and enforce this kind of compensation scheme on management at public firms?

The classic example is writing naked (unhedged) insurance policies covering rare events and pocketing the fees as alpha. You trade tail risk for cash, and hope things don't blow up until you are out the door. It's agency risk on steroids.

This NYTimes article describes, in detail, a perfect example of this phenomenon in the case of AIG. AIG, a global insurance company with over 100k employees, was brought down by a tiny unit in London that traded credit default swaps (CDS).

Once it became clear that AIG was in trouble, Treasury and the Fed had to step in because AIG was too connected to fail. In fact, the article states that Goldman, Paulson's former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Joseph Cassano, the former head of AIG's London credit derivatives unit, is perhaps the first (although probably not the last) poster boy for clawbacks in the credit crisis. Total compensation for his unit of 377 employees averaged over $1 million per employee in recent years. I would guess that means Cassano took home easily in the tens and perhaps over 100 million dollars in the last few years. Will taxpayers get back any of that compensation?

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

NYTimes ...Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

...The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

...These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

Update: from the Pelosi bailout legislation summary -- good luck implementing this!

New restrictions on CEO and executive compensation for participating companies:

* No multi-million dollar golden parachutes
* Limits CEO compensation that encourages unnecessary risk-taking
* Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate

CDOs, auctions and price discovery

How is Treasury going to buy up CDOs and other mortgage backed securities? What is the price discovery mechanism? I've heard discussion of a reverse auction process, in which the government offers a price and owners of the assets decide whether to accept the bid.

But this makes the problem sound much easier than it is. There are no simple or uniform categories for these securities -- no two are exactly alike. I imagine Treasury is going to have to do a lot of homework before each auction, perhaps aided by some sophisticated professionals (Bill Gross of PIMCO recently offered his team's services). Data on each security is available from ratings agencies like S&P and Moody's but presumably one would supplement this with additional information. After some initial analysis Treasury could set a conservative bound (i.e., using pessimistic estimates of future default rates and home prices) on the value of each security in units of the original face value (this one is worth at least 25 cents on the dollar, this is one, 45 cents, etc.). Then, they can publish a list of securities in a particular value category (without, of course, giving out the actual value estimate) and conduct a reverse auction covering all the assets on the list.

If they can get the assets below the value estimate, great for taxpayers like you and me. If banks (hedge funds? pension funds? foreign banks? who is really holding all this stuff?) won't sell at prices below the bound, and the auction heads above that price, Treasury should start demanding warrants or equity stakes on some sliding scale. In other words, the bid keeps getting higher, but at some point Treasury starts asking for not only the particular CDO but some additional warrants or stock. (This could also be done on a sliding scale from the beginning of the auction -- Treasury gets an additional x percent of the bid in warrants, where x increases with price.) The equity stake is compensation for the government for having to having to overpay for the security. At this price there is an (expected) flow of funds from taxpayers to recapitalize the seller, but at least we are getting equity in return. It is claimed that there is a range of values (roughly 20 percent of current market prices) over which the seller would be getting more at auction than the market is currently offering, but the government is still getting a good deal on the asset (expects to make money even under conservative assumptions).

Will it work? Who knows, but at least it may restore some confidence to credit markets.

Here are some old posts that really get into the nitty gritty of what is inside a typical CDO. You'll see that I've been covering credit securities since 2005 :-)

anatomy of a cdo

deep inside the subprime crisis

mackenzie on the credit crisis

gaussian copula and credit derivatives

Here's a recent NYTimes article that gives a peek into the complexity of structured finance.

NYTimes: ...Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here’s how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers’ incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6 percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it’s a toxic portfolio. Of the 2,093 loans that remain, 23 percent are delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most senior of the securities were downgraded to near junk bond status last week. Valuing mortgage bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear Stearns securities are almost certain to lose value as long as home prices keep falling.

“Under the current circumstances it’s likely that you are going to take a loss on these loans,” said Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear Stearns and bundled and rebundled them into even trickier investments known as collateralized debt obligations, or C.D.O.’s

“No two pieces of paper are the same,” said Mr. Feltus of Pioneer Investments.

On Wall Street, many of these C.D.O.’s have been selling for pennies on the dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31 billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar. Citigroup says its C.D.O.’s are relatively high quality because they were created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.

Friday, September 26, 2008

Mortgage securities oversold by 15-25 percent

Below are some quotes which support the view that mortgage assets are currently undervalued by the market. Yes, the market is inefficient -- it overpriced the assets at the peak of the bubble (greed), and is currently underpricing them (fear). Both Buffet and ex-Merrill banker Ricciardi below think the mispricing is about 15-25 percent. That is, the "fear premium" currently demanded by the market is 15-25 percent below a conservative guess as to what the assets are really worth. This is the margin that can be used to recapitalize banks, perhaps without costing the taxpayer any money, simply by providing a rational buyer of last resort and injecting some confidence into the market. Note to traders: yes, this is obvious. Note to academic economists: this is yet another market failure -- but of an unprecedented scale and complexity.

(Actually, 15-25 percent is not bad, and just shows that credit markets are generally more rational and data driven than equities. During the Internet bubble and collapse you had mispricings of hundreds of percent, even an order of magnitude.)

Warren Buffet interview from CNBC:

Government intervention necessary to restore confidence in the market.

If I didn't think the government was going to act, I would not be doing anything this week. I might be trying to undo things this week. I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Mispricing is about 15-20 percent:

...all the major institutions in the world trying to deleverage. And we want them to deleverage, but they're trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that's willing to leverage up. And there's no one that can leverage up except the United States government. And what they're talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that's going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won't do it perfectly right, I think they'll make a lot of money. Because if they don't -- they shouldn't buy these debt instruments at what the institutions paid. They shouldn't buy them at what they're carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.

Christopher Ricciardi, former head of Merrill's structured credit business, in an open letter to Paulson. Note his comments illustrate the role that psychology, or animal spirits (Keynes), plays in the market.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis.

Government purchases of illiquid mortgage assets from the system will cost taxpayers significant sums and expose them to downside risk, without addressing this fundamental issue. Billions of dollars held by all the major institutional bond managers, hedge funds and distressed funds are already available to purchase mortgage assets.

However, in the absence of a way to finance the purchase of these assets, such funds must bid at prices which represent an attractive absolute return acceptable to their investors (15% to 25% typically), resulting in typical transaction terms that have significantly impeded the sale of mortgage securities to these funds. If these funds could finance their purchases, especially under efficient financing terms, they would still require similar returns, but would be able to buy many more assets, and bid higher prices for the assets.

Our financial system needs the capital markets and the natural power of securitization to get a jumpstart from the government. I propose using the powers granted to Treasury to create “vehicles that are authorized…to purchase troubled assets and issue obligations” under currently contemplated legislation to more efficiently address the crisis and establish a program which we might call the Federal Bond Insurance Corporation (”FBIC”), as an alternative to simply having the government directly purchase assets.

Comment re: behavioral economics. The preceding housing bubble and the current crisis are very good examples of why economics is, at a fundamental level, the study of ape psychology. On the planet Vulcan, Mr. Spock and other rational, super-smart traders and investors would have cleared this market already. But we don't live on Vulcan. Anyone who wants to model the economy based on rational agents who can process infinite amounts of information without being subject to fear, bounded cognition, herd mentality, etc. is crazy.

When the conventional wisdom is that house prices never go down (people believed this just a couple years ago), you risk little of your reputation or self-image by investing in housing. When the conventional wisdom is that all mortgage backed securities are toxic, you must be extremely independent and strong willed to risk buying in, even if metrics suggest the market is oversold. This is simple psychology. Very few people can resist conventional wisdom, even when it's wrong.

Wednesday, September 24, 2008

Survivor: theoretical physics

Some very interesting data here on jobs in particle theory, cosmology, string theory and gravity over the last 15 years in the US (1994 -- present).

Based on these numbers and the quality of the talent pool I would guess theoretical physics is the most competitive field in academia, by a large margin. (Your luck will be much, much better in computer science, engineering, biology, ...)

The average number of years between completing the PhD and first faculty job is between 5-6. That would make the typical new assistant professor about 33, and almost 40 by the time they receive tenure.

Here are the top schools for producing professors in these fields:

1. Princeton 23 (string theory rules! or ruled... or something)
2. Harvard 18
3. Berkeley 16

This is over 15 years, so that means even at the top three schools only 1 or at most 2 PhDs from a typical year gets a job in the US. The US is by far the most competitive market. If you follow the link you will see that the list of PhD institutions of US faculty members is truly international, including Tokyo, Berlin, Moscow, etc. (Note I think the jobs data also includes positions at Canadian research universities, so I should have written N. America rather than US.)

The field is very much dominated by the top departments; the next most successful include MIT, Stanford, Caltech, Chicago, etc.

Here are some well-known schools that only produced 1 professor of theoretical physics over 15 years: UCLA, UC Davis, U Illinois, U Virginia, U Arizona, Boston University, U Penn, Northwestern, Moscow State University (top university in USSR), Insitute for Nuclear Research (INR) Moscow

Here are some well-known schools that only produced 2 professors over 15 years: Ohio State, U Minnesota, Michigan State, U Colorado, Brown

Here are some well-known schools that only produced 3 professors over 15 years: Columbia, CERN, Johns Hopkins, U Maryland, Yale, Pisa SNS (Scoula Normale Superiore; the most elite university in Italy), Novisibirsk (giant physics lab in USSR)

You can see that by the time we reach 3 professors produced over 15 years we are talking about very, very good physics departments. Even many of the schools in the 1 and 2 category are extremely good. These schools have all hired multiple professors over 15 years, but the people hired tend to have been produced by the very top departments. The flow is from the top down.

This dataset describes a very big talent pool -- I would guess that a top 50 department (in the world) produces 3-5 PhDs a year in theoretical physics. If most of them only place a student every 5 years or so, that means a huge number (the vast majority) of highly trained, even brilliant, physics students end up doing something else!

How many professors do you think are / were straight with their PhD students about the odds of survival?

I only knew one professor at Berkeley who had kept records and knew the odds. One day in the theory lounge at LBNL Mahiko Suzuki (PhD, University of Tokyo) told me and some other shocked grad students and postdocs that about 1 in 4 theory PhDs from Berkeley would get permanent positions. His estimate was remarkably accurate.

How many professors do you think had / have a serious discussion with their students about alternative career paths?

How many have even a vague understanding of what the vast majority of their former students do in finance, silicon valley, ...?

Related posts: A tale of two geeks , Out on the tail

Tuesday, September 23, 2008

The time to buy is when there is blood in the streets

As I mentioned in my previous post on the mortgage bailout, it seems clear that Bernanke and Paulson both think that mortgage backed securities are undervalued at current market prices (my scenario (1) in the previous post). Bernanke refers to the difference between "hold to maturity" and "fire sale" prices in his congressional testimony.

Many commentators are trying to wrap their heads around this difference. To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

The following false conundrum has been stated recently by numerous analysts, including Paul Krugman: "if Treasury wants to recapitalize banks it has to overpay for toxic assets, to the detriment of taxpayers; if it wants to pay fair prices for the assets then banks won't benefit." There is no conundrum if markets, at this instant in time, are systematically underpricing mortgage assets.

When the Internet bubble burst in the early years of this century, investors were so gun shy and under so much pressure that they would not pay even rationally justifiable prices for stakes in technology companies. Smart investors who were willing to put capital at risk bought assets at fire sale prices and made huge profits. This is nothing more than fear and herd mentality at work. If herd thinking can lead to overpricing of assets, why not underpricing immediately following a collapse?

Markets overshoot on both the up- and the down-side!

These points are obvious to any trader... it's the academics with equilibrium intuitions who are struggling to understand! Note as I mentioned in the earlier post, the "hold to maturity value" can only be modeled using probability distributions for defaults, price movements, interest rates, etc. But I've been told many times by people in the industry that current market prices imply massive default rates which are unrealistically high.

WSJ has the best summary.

Related discussion: Paul Krugman , more Krugman , Economist's View , Brad Setser.

WSJ: ...Uncertainty in housing markets and the economy are forcing financial institutions to mark mortgage securities at fire-sale prices, rather than their value if held to maturity, effectively creating a vicious circle of more write-downs that further depress asset values, Mr. Bernanke explained.

Mr. Bernanke said the Treasury plan should have taxpayers buy the assets and hold them at close to their maturity value. Removing the assets, he said, would bring liquidity back to markets, unfreeze credit markets, reduce uncertainty and allow banks to attract private capital.

...In subsequent questioning, Mr. Bernanke distinguished between, on the one hand, “fire sale prices,” the ones that prevail “when you sell into an illiquid market” and, on the other, the prices that holders think the assets are really worth, sometimes described as “fundamental” values or “hold-to-maturity” value.

“The holders have a view of what they think it’s worth. It’s hard for outsiders to know,” Mr. Bernanke said. The point of an auction is to reveal those prices. “If you have an appropriate auction mechanism… what you’ll do is restart this market,” he added.

Paulson, while seeking maximum flexibility, said the Treasury is considering doing auctions one asset class at a time. He said the aim to bring “bright people” to work on the challenge of designing market mechanisms.

Update: Krugman admits he agrees with me on this point, although he still doesn't like the plan:

Krugman NYT blog: ...Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply.

I don't really like the plan either, but at least the earlier argument based on the pricing conundrum is now understood to be sloppy. I just read that Paulson will cave on the populist CEO compensation limit. As usual, bounded rationality (limited brainpower) is at work here. The taxpayers would be benifited much more by Treasury taking an equity stake or warrants in banks that are being bailed out. They should have made Paulson cave on that -- the compensation issue is just symbolic.

Ask the expert

Several panicked multimillionaires and financiers asked me recently if they should liquidate all their investments and go to cash.

My answer? "Beats me" :-/

Standard questions:

1) are you going to be able to time the bottom? what's your investment timescale?

2) what kind of cash? Treasuries? Swiss Francs? Renminbi?

Generally I'm not a big believer in timing the market. On the other hand, I can think of numerous plausible scenarios for the next couple of years in which (some kind of) cash is by far the best asset. I can't think of very many in which it's not :-(

Academic trends in pictures

From GNXP, some beautiful graphs which depict the rise and fall of certain academic fads. My wife is a professor in the humanities (she did her graduate work at Berkeley in comp lit during the height of "theory"), and she got a big kick out of these!

Judith Butler, your 15 minutes are over :-) (Bad academic writing awards; see below figures for sample.)

Certain higher dimensional theories of fundamental physics might be next ;-)

I searched the archives of JSTOR, which houses a cornucopia of academic journals, for certain keywords that appear in the full text of an article or review (since sometimes the big ideas appear in books rather than journals). This provides an estimate of how popular the idea is -- not only the true believers, but their opponents too, will use the term. Once no one believes it anymore, then the adherents, opponents, and neutral spectators will have less occasion to use the term. I excluded data from 2003 onward because most JSTOR journals don't deposit their articles in JSTOR until 3 to 5 years after the original publication. Still, most of the declines are visible even as of 2002.

No, this is not a joke -- at least as far as I know.

Professor Butler’s first-prize sentence appears in “Further Reflections on the Conversations of Our Time,” an article in the scholarly journal Diacritics (1997):

The move from a structuralist account in which capital is understood to structure social relations in relatively homologous ways to a view of hegemony in which power relations are subject to repetition, convergence, and rearticulation brought the question of temporality into the thinking of structure, and marked a shift from a form of Althusserian theory that takes structural totalities as theoretical objects to one in which the insights into the contingent possibility of structure inaugurate a renewed conception of hegemony as bound up with the contingent sites and strategies of the rearticulation of power.

Sunday, September 21, 2008

The devil in the details

As we all know, the devil is always in the details. The proposed legislation will put $700B in the hands of Treasury to buy distressed assets in an attempt to unfreeze credit markets. This gives the current and future Treasury Secretary incredible financial and discretionary power. Let's put aside issues of corruption and abuse of power and assume a benevolent, public spirited, intelligent person in charge. I make this assumption not because it is realistic, but in order to proceed to the question: How, exactly, will this work?

First, let's differentiate between CDOs and CMOs (Collateralized Debt / Mortgage Obligations), which are securities that entitle the holder to future cash flows from bundles or tranches of mortgages, and CDS (Credit Default Swaps) which are derivative contracts which allow two parties to bet on defaults. CDS can be used for pure speculation, or to spread out the risk associated with CDOs. I will discuss CDOs and CDS separately below, although it should be obvious that both markets are interconnected and, at this time, highly problematic. (In fact there are even synthetic CDOs which are built out of CDS, which make things yet more complicated...)


There are two possible world states that we have to differentiate between. Keep in mind that CDOs are currently highly illiquid, due to seizing up of markets, so in many cases there may not be any market price.

1) CDOs are oversold. In this scenario markets, due to extremely high risk premia and, well, fear, are underpricing CDOs and, effectively, overestimating future default rates on mortgages. To decide whether they believe this, Treasury must use its own models with its own forward looking projections.

IF actual future default rates turn out to be lower than implied values backed out from current market prices, then Treasury (and the US taxpayer) stand to make a lot of money by assuming the role of a rational buyer of last resort. (Which is not to say there won't be losses; there must be as home prices will end lower than in the period when most of these mortgages were written. But how much of this is in previous writedowns?) In this scenario, many banks are challenged by (short term) cash flow issues and mark to market accounting, which forces them to carry their securities on the books at the current (undervalued, oversold) market valuation, but do ultimately have positive net asset value.

(Note: cash flow insolvency is not the same as balance sheet insolvency!)

2) CDO market prices are fair. In this case many institutions will fail without massive infusions to their balance sheet. But Treasury should not buy securities at higher than fair value (if at all possible); instead they should take equity stakes in insolvent companies on behalf of the taxpayer, so that there is some upside participation. In the worst case Treasury should assume control and supervise an orderly liquidation. Note again that an institution can face short term cash flow problems (be unable to service debt) even if the long term value of their net assets is positive.

Even if we start out in case (1) we will end up in case (2) as the situation normalizes and other actors bring capital into play. There is an estimated $500B in distressed assets funds that will participate if valuations are favorable. I just heard on CNBC that Treasury may use a reverse auction model (starting at very low bids), in which case the banks themselves will get to decide whether they are desperate enough to accept a bid. Probably a good strategy.

Deciding between case (1) and (2) (ultimately, on a CDO by CDO basis) is going to depend crucially on models and future forecasts of home prices, interest rates, prepayment rates and foreclosure rates. Geeks rule!

In any event, Treasury will be acting like a giant hedge / private equity fund for the next few years. Do they have the human capital? Hopefully their returns will be good :-)


I'm more at a loss here. Will Treasury get involved with CDS? There are going to be some huge losers (AIG?).

When Treasury tries to evaluate the (balance sheet) solvency of a particular firm, won't they have to price out that firm's entire CDS book?

Will this market automatically function properly if the CDO market becomes liquid again and counterparty confidence is restored?

Miscellaneous questions:

Do we really trust Treasury to do the right thing? Are there any checks and balances? Would those get in the way of decisive action?

What about foreign banks like Deutsche Bank, Credit-Suisse, etc.?

Naked Capitalism has a negative take on the plan. They suggest that Paulson is not being straight with the public and intends to buy assets at a high price, with the only goal of recapitalizing (his friends at big) banks. I don't necessarily agree with the reasoning given below, but it is worth thinking about.

Nakedcapitalism: ...Yet as we discussed, the plan makes no sense unless the Orwellian "fair market prices" means "above market prices." The point is not to free up illiquid assets. Illiquid assets (private equity, even the now derided CDOs were never intended to be traded, but pose no problem if they do not need to be marked at a large loss and/or the institution is not at risk of a run). Confirmation of our view came from a reader by e-mail:

I worked at [Wall Street firm you've heard of], but now I handle financial services for [a Congressman], and I was on the conference call that Paulson, Bernanke and the House Democratic Leadership held for all the members yesterday afternoon. It's supposed to be members only, but there's no way to enforce that if it's a conference call, and you may have already heard from other staff who were listening in.

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

[Paulson's statements are all internally consistent if he believes we are in state (1) described above: current market prices, due to fear and sky high risk premia, are too low and fair prices based on reasonable models of future behavior would be higher --steve]

I don't think that our leadership has been very good during this negotiation (or really, during any showdowns with this administration) at forcing the administration to own their position. If Paulson wants this plan, then he needs to sell it to the public, and if he sells a different plan to the public (the nonsense buying-at-market-price plan) then we should pass that. I'd rather see the government act as a market maker for the assets to get them transferred over to private equity firms and sovereign wealth funds and other willing holders. And if we need to recapitalize these companies, it seems like the cheapest way for the taxpayer is to go in and buy up the distressed debt and then convert that to equity.

On the other hand I've heard in other quarters that the proposed legislation allows Treasury to more or less compel firms to sell distressed assets. Which is it -- they'll have to overpay to pry the assets loose, or they've given themselves draconian powers to seize them?

Saturday, September 20, 2008

The professor called the shot

It has been clear for a while that, unless the home price bubble were to miraculously stabilize in mid collapse, the US government itself would have to socialize the entire problem in order to solve it.

It looks like Ben Bernanke (AB Harvard, PhD MIT, Professor at Princeton) made the call. Paulson is no slouch (AB Dartmouth, MBA Harvard, CEO and Chairman of Goldman Sachs), but when the biggest financial decision of our generation was made, the geeky PhD told the Harvard MBA what to do.

NYTimes: The ad hoc approach Mr. Bernanke and Mr. Paulson had been trying was no longer enough.

Talking into the speaker phone on a coffee table in his office, Mr. Bernanke told Mr. Paulson that it was time to stop treating the symptoms by bailing out distressed companies and instead start attacking the root problem with a comprehensive strategy.

Congress would have to sign off, and it would fall to Mr. Paulson, as the envoy of the executive branch, to take the lead.

Mr. Paulson understood.

...“Going back a long time, maybe a year ago, Ben, as a world-class economist, said to me, when you look at the housing bubble and the correction, if the price decline was significant enough,” the only solution might be a large-scale government intervention, Mr. Paulson said. “He talked about what had happened when there had been other situations historically. And basically he said in his view the time might ultimately come when something like this was necessary.

Mr. Paulson said he agreed but hoped it would not come to that. “I knew he was right theoretically,” he said. “But I also had, and we both did, some hope that, with all the liquidity out there from investors, that after a certain decline that we would reach a bottom.”

Friday, September 19, 2008

Treasury to socialize entire mortgage loss

Complexity has won! More precisely, fear of systemic failure due to overcomplexity has trumped fear of moral hazard.

Is the overcomplexity due to insufficient regulation?

We're going to put the whole mess on the US and taxpayer balance sheet. Paulson estimated hundreds of billions, but it could easily be a trillion. It all depends on home prices.

WSJ has a nice blow by blow account of the last week of crisis, focusing on key players like Paulson, Thain, Fuld, etc. (See also here.)

WSJ: ...In a private meeting with lawmakers, according to a person present, one asked what would happen if the bill failed.

"If it doesn't pass, then heaven help us all," responded Mr. Paulson, according to several people familiar with the matter.

Paulson statement

Thursday, September 18, 2008

Phil Gramm, McCain and the CDS meltdown

In my last post I tried to illustrate why certain entities like AIG might be too connected (not just too BIG) to fail. I didn't mean politically connected -- I meant too connected in the web of unregulated credit default swap contracts. So connected that if, for example, AIG were to fail, the entire financial system would collapse. The now $60 trillion CDS market is a tangle of unknown and unregulated contracts whose value depends sensitively on the behavior of underlying securities such as bundles of mortgages.

The "too connected to fail" problem could have been averted with some simple regulatory steps; ideally in the future we should have a central exchange for these contracts with collateral requirements. I've discussed the incredible growth of the CDS market several times on this blog. But I always wondered why it was't more carefully regulated.

Economist: (2006) OVER a year ago, a whiff of something nasty filled the nostrils of the world's financial regulators. It came, appropriately, from the back end of the credit-derivatives market, an unregulated asset class that was growing so fast that banks and hedge funds that dabbled in it had lost track of their trades.

In other markets where trading is private (rather than on an exchange), the problem might have seemed minor, involving thankless back-office tasks with monotonous names like matching and confirmation. But this time regulators saw a threat to the stability of banks, because of the popularity of credit-default swaps (CDSs), instruments that disperse lending risk around the financial system.

...Last month Alan Greenspan, former chairman of the Federal Reserve, startled bond traders at a dinner in New York with both a friendly pat and a slap on the wrist. Credit derivatives, he gushed, were “becoming the most important instruments I've seen in decades.” But he then went on to say how appalled he was at the “19th-century technology” used to trade credit-default swaps, with deals done over the phone and on scraps of paper.

The answer, apparently, is in a bill sponsored by McCain economic advisor Phil Gramm -- the Commodity Futures Modernization Act, passed in 2000, which exempts swaps from regulation! [Thanks to reader STS for making me aware of this.]

Did McCain know about this earlier in the week when, after first pretending there was no crisis in financial markets, he ranted about the betrayal of the noble American worker by the greed and corruption of Wall Street?

MotherJones: ...But Gramm's most cunning coup on behalf of his friends in the financial services industry—friends who gave him millions over his 24-year congressional career—came on December 15, 2000. It was an especially tense time in Washington. Only two days earlier, the Supreme Court had issued its decision on Bush v. Gore. President Bill Clinton and the Republican-controlled Congress were locked in a budget showdown. It was the perfect moment for a wily senator to game the system. As Congress and the White House were hurriedly hammering out a $384-billion omnibus spending bill, Gramm slipped in a 262-page measure called the Commodity Futures Modernization Act. Written with the help of financial industry lobbyists and cosponsored by Senator Richard Lugar (R-Ind.), the chairman of the agriculture committee, the measure had been considered dead—even by Gramm. Few lawmakers had either the opportunity or inclination to read the version of the bill Gramm inserted. "Nobody in either chamber had any knowledge of what was going on or what was in it," says a congressional aide familiar with the bill's history.

It's not exactly like Gramm hid his handiwork—far from it. The balding and bespectacled Texan strode onto the Senate floor to hail the act's inclusion into the must-pass budget package. But only an expert, or a lobbyist, could have followed what Gramm was saying. The act, he declared, would ensure that neither the SEC nor the Commodity Futures Trading Commission (CFTC) got into the business of regulating newfangled financial products called swaps—and would thus "protect financial institutions from overregulation" and "position our financial services industries to be world leaders into the new century."

...But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.

In essence, Wall Street's biggest players (which, thanks to Gramm's earlier banking deregulation efforts, now incorporated everything from your checking account to your pension fund) ran a secret casino.

Notional vs net: complexity is our enemy

The credit default swap (CDS) market, where AIG played, had notional outstanding value of about $45 trillion at the end of 2007 (about $60 trillion now). Of course many of these contracts are partially canceling, so the net value of contracts in the market is much smaller than the notional value. Unfortunately, the network diagram (network of contracts) probably looks something like this: Imagine removing -- due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. -- one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancellations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail. Systemic risk is all about complexity. Here's a simple example of a network of contracts whose notional value is much larger than its net value. Suppose A = AIG, B = Barclays and C = Citigroup have traded CDS contracts related to a particular pool of mortgages. If defaults in the pool exceed some threshold, A must pay B $1 billion, but will receive $1.1 billion from C. Now suppose there is a third contract in which B pays $1 billion to C if defaults exceed the threshold. The notional value of all contracts is $3.1 billion, but the net value that changes hands is only $.1 billion. So notional value is 31 times net. B's position is completely neutral and A and C only have $.1 billion at risk. This may sound contrived, but it's actually not unrealistic. Everything is fine until, say, A has a problem. Suppose A becomes insolvent and *poof* disappears. B and C are left with naked $1 billion bets on mortgages. Suddenly the notional value, which wasn't previously very representative of the amount at risk, due to the cancellations, isn't far off from the amount at risk ($3.1 vs 1 billion). Now scale this little example up to, say, $45 trillion in notional value, thousands of bets and dozens of firms, and you've got systemic risk!

Wednesday, September 17, 2008

Carly on Palin

I'm not a big fan of Carly Fiorina, but she's at least an experienced CEO who knows what a meritocracy of ability is about. She's also one of McCains key economic advisors. Here's what she said about Palin yesterday during a radio interview:

Do you think she [Palin] has the experience to run a major company like Hewlett-Packard?”

“No, I don’t,” Ms. Fiorina said.

I said there's no way she could run Goldman, and I agree there is no way she could run HP. But apparently she's good enough to run the country.

I can't imagine how McCain, Palin and their economic advisors (among them Fiorina) would fare in dealing with the current mortgage problems. Bush is very lucky his last Treasury Secretary is not a dud like the first two. Thanks, Goldman!

Common incorrect belief: it doesn't matter who the president is, or what his IQ is, he'll just bring in the right advisors. Now replace the word "president" with CEO (or Lab Director or Head Trader or Commander in Chief...) and tell me whether you still believe it. Smart people bring in even smarter advisors, and are better at deciding between conflicting streams of advice. As we say in science: first rate people hire first rate people. Second rate people are in danger of hiring third rate people.

...The Obama campaign could not have been more gleeful: “If John McCain’s top economic adviser doesn’t think he can run a corporation,” said Tommy Vietor, an Obama spokesman, “how on Earth can he run the largest economy in the world in the midst of a financial crisis?”

Let me clarify something: I'm not an IQ fundamentalist. There are many smart people would not make great leaders. They cannot connect with average people, lack common sense, are not pragmatic, etc. To be a great leader, one needs all of those qualities and intelligence.

The very fact that Obama was able to defeat Hilary in the primary implies that he can effectively run a big, complex organization. His silicon valley approach to fund raising was novel and wildly successful. Any of the other candidates (D or R) could have tried it, but no one else did. Does that mean Obama is a technologist? No! But he was smart enough to understand and adopt the proposal when it was brought to him by technologists! That's why I think he has the pragmatic smarts to be a good president.

As of the spring: nearly $200 million raised from over a million donors. In February, the Obama campaign reported that 94 percent of their donations came in increments of $200 or less, versus 26 percent for Clinton and 13 percent for McCain.

To understand how Obama’s war chest has grown so rapidly, it helps to think of his Web site as an extension of the social-networking boom that has consumed Silicon Valley over the past few years. The purpose of social networking is to connect friends and share information... A precursor, Meetup.com, helped supporters of Howard Dean organize gatherings during the last Democratic primary season, but compared with today’s sites, it was a blunt instrument.

Obama’s campaign moved first. Staffers credit the candidate himself with recognizing the importance of this new tool and claim that his years as a community organizer in Chicago allowed him to see its usefulness. Another view is that he benefited greatly from encouraging a culture of innovation and lucked out in the personnel department, with his own pair of 20-something wizards. Joe Rospars, a veteran of Dean’s campaign who had gone on to found an Internet fund-raising company, signed on as Obama’s new-media director. And Chris Hughes, a co-founder of Facebook, took a sabbatical from the company and came to Chicago to work on the campaign full-time.


Here is a NYTimes graphic illustrating the decrease in market capitalization of financial firms. In 2007 they were 20% of the total stock market capitalization of $20 trillion dollars. By today they comprise about 17% of a $15 trillion market. (In other words, financials as a group are down about 15% relative to the market as a whole.) If you mouse over a particular company (on the Times flash version, not here) you can see how much its shares have lost over the last year.

This brings to mind a conversation I had a couple of years ago with hedge fund manager David Kane on whether "financial games" necessarily lead to more efficient allocation of economic assets in our society. I think everybody agrees now that we had (and still have -- 20% to go!) a massive housing bubble in which assets were overallocated to investment in homes. The use of leverage to make these investments is what has led to the destruction of so many major financial firms. Interestingly, many people predicted a few years ago that hedge funds would be a source of systemic risk, but so far in this crisis they haven't played a big role. Perhaps that is yet to come.

On the benevolence of financiers (December 2006)

Money talks (January 2007)

David, if you are still reading this blog, I would love to hear your thoughts on current market events! [David's comments are here -- well worth reading.]

Deep thinker John McCain was very quick to throw Wall St. and the financiers under the bus in his remarks yesterday.

Monday, September 15, 2008

Orders of magnitude and timescales

As a physicist I can't help making some comments about orders of magnitude and timescales :-)

If home prices return to normal (historical) levels, total mortgage debt losses will be about $1 trillion. This is a staggering sum, but won't destroy our economy. After all, our misadventure in Iraq will end up costing us about the same amount. [Insert anti-Bush diatribe here.] If necessary, we could socialize the whole loss like we've done with Iraq -- put it on the nation's and taxpayers' balance sheet.

The problem is that the credit bubble losses are concentrated in financial firms, which are getting hit with a huge shock as their portfolios approach the day of mark to market reckoning. This shock is going to have to be worked through the system over a relatively short timescale if we are to avoid systemic paralysis, or worse. Once a particular entity becomes insolvent, the entire web of counterparty transactions between it and the rest of Wall St. is in jeopardy.

Dealing with that relational web is the real challenge -- can we recognize the losses without impairing the functioning of our financial and banking system?

Sunday, September 14, 2008


Looks like I called it right -- Lehman and Merrill disappeared this weekend. I didn't expect Merrill to go so fast, but apparently the Fed gave them an ultimatum. BofA bought them for $44B. The era of the independent broker-dealer is over: only Morgan and Goldman remain.

AIG is next -- they need to raise $40B or endure a downgrade from credit agencies.

Forget about $200 oil (it's under $100 already) and inflation (for a while)-- we're headed into a recession in the US and a serious slowdown worldwide.

It looks like we'll have a mark to market soon :-) Main Street is going to lag for a while -- the final 20% capitulation in housing prices will still take a year or two.

Stockpile food and convert everything to Swiss Francs...

Georgia and the balance of power

A great piece in the NY Review of Books. History will clearly reveal, even to those who are today still unwilling to acknowledge it, the unprecedented squandering of US power by the Bush administration. Miscalculation after miscalculation after blunder, all caused by stupidity and the triumph of ideology over analysis.

The Russian invasion of Georgia has not changed the balance of power in Eurasia. It has simply announced that the balance of power had already shifted. The United States has been absorbed in its wars in Iraq and Afghanistan, as well as potential conflict with Iran and a destabilizing situation in Pakistan. It has no strategic ground forces in reserve and is in no position to intervene on the Russian periphery. This has opened an opportunity for the Russians to reassert their influence in the former Soviet sphere. Moscow did not have to concern itself with the potential response of the United States or Europe; hence, the balance of power had already shifted, and it was up to the Russians when to make this public. They did that on August 8.

...It is inconceivable that the Americans were unaware of Georgia's mobilization and intentions. It is also inconceivable that the Americans were unaware that the Russians had deployed substantial forces on the South Ossetian border. US technical intelligence, from satellite imagery and signals intelligence to unmanned aerial vehicles, could not miss the fact that thousands of Russian troops were moving to forward positions. The Russians clearly knew that the Georgians were ready to move. How could the United States not be aware of the Russians? Indeed, given the deployments of Russian troops, how could intelligence analysts have missed the possibility that Russia had laid a trap, hoping for a Georgian invasion to justify its own counterattack?

It is difficult to imagine that the Georgians launched their attack against US wishes. The Georgians rely on the United States, and they were in no position to defy it. This leaves two possibilities. The first is a huge breakdown in intelligence, in which the United States either was unaware of the deployments of Russian forces or knew of them but—along with the Georgians—miscalculated Russia's intentions. The second is that the United States, along with other countries, has viewed Russia through the prism of the 1990s, when its military was in shambles and its government was paralyzed. The United States has not seen Russia make a decisive military move beyond its borders since the Afghan war of the 1970s and 1980s. The Russians had systematically avoided such moves for years. The United States had assumed that they would not risk the consequences of an invasion.

If that was the case, then it points to the central reality of this situation: the Russians had changed dramatically, along with the balance of power in the region. They welcomed the opportunity to drive home the new reality, which was that they could invade Georgia, and the United States and Europe could not meaningfully respond. They did not view the invasion as risky. Militarily, there was no force to counter them. Economically, Russia is an energy exporter doing quite well—indeed, the Europeans need Russian energy even more than the Russians need to sell it to them. Politically, as we shall see, the Americans need the Russians more than the Russians need the Americans. Moscow's calculus was that this was the moment to strike. The Russians had been building up to it for months, and they struck. ...

This is why I think McCain and Palin are just as stupid as Bush. By stating that "We are all Georgians" he is simply playing into Russian hands. We are in no position to do anything in Georgia. I prefer Obama over McCain not just because he is smarter, but because he is very likely smarter and more pragmatic. (Remember the ridiculous flare up over lapel flags! That's what red state voters care about... not the more complex reality of deteriorating US power.)

The Russians knew that the United States would denounce their attack. This actually plays into Russian hands. The more vocal senior US leaders are, the greater the contrast with their inaction, and the Russians wanted to drive home the idea that American guarantees are empty talk. The Russians also know something else that is of vital importance. For the United States, the Middle East is far more important than the Caucasus, and Iran is particularly important. The United States wants the Russians to participate in sanctions against Iran. Even more importantly, it does not want the Russians to sell weapons to Iran, particularly the highly effective S-300 air defense system. Georgia is a marginal issue to the United States; Iran is a central issue. The Russians are in a position to pose serious problems for the United States not only in Iran, but also with weapons sales to other countries, like Syria.

Therefore, the United States has a problem—either it must reorient its strategy away from the Middle East and toward the Caucasus, or it has to seriously limit its response to Georgia to avoid a Russian counter in Iran. Even if the United States had an appetite for war in Georgia at this time, it would have to calculate the Russian response in Iran—and possibly in Afghanistan (even though Moscow's interests there are currently aligned with those of Washington).

In other words, the Russians have backed the Americans into a corner. The Europeans, who for the most part lack expeditionary military forces and are dependent upon Russian energy exports, have even fewer options. If nothing else happens, the Russians will have demonstrated that though they are not a global power by any means, they have resumed their role as a significant regional power with lots of nuclear weapons and an economy that is less shabby now than in the past. Russia has also compelled every state on its periphery to reevaluate its position relative to Moscow. That is what the Russians wanted to demonstrate, and they have demonstrated it.

Obama and race

I agree with this. I think political correctness prevented many democrats from thinking clearly about how race would influence the final outcome of the election. Political correctness also prevents us from understanding many other obvious things about society today.

Related discussion here.

WSJ: ...Democrats' fatal blindness to the brute fact of race in America. When, during the primaries, the Clintons seemed to allude to the subject of Sen. Obama's electability in light of his race, they were accused by many of their fellow Democrats of "playing the race card." It is fairly incredible that it was, for the most part, not until this summer that liberals began publicly asking themselves if the country was ready for a black president. That it was not until recently that liberals began wondering with any forcefulness whether people really were telling pollsters the truth about their attitudes toward race. ("Will race influence your vote for president?" "Race?! Me? Are you kidding? Of course not!")

For 18 months, the majority of liberal commentators wrote so rapturously and unskeptically about Sen. Obama's candidacy that you would have thought he was just a white guy with a deep tan. It was as though people were afraid that if they spoke honestly about racism as a stumbling block to his candidacy, they would be taken for racists themselves. Indeed, it was as though by ignoring racist attitudes when writing about Sen. Obama, liberal commentators conferred on themselves the virtuous idealism that they were fantastically attributing to the country as a whole. It is an elementary psychological fact that we sometimes praise to an absurd degree what makes us slightly uncomfortable -- or that we put the source of discomfort in an impossibly ideal light in order to put as much distance as possible between us...and the person we fear we may actually be.

What polls show about racism and voting:

...Some people who are telling pollsters they're for Obama could actually be lying.

Such behavior has been called the "Bradley Effect ," after Tom Bradley, a black mayor of Los Angeles who lost his bid to be California's governor back in 1982. While every poll showed him leading his white opponent, that isn't how the final tally turned out. Things haven't been far different in some other elections involving black candidates. In 1989, David Dinkins was eighteen points ahead in the polls for New York's mayoral election, but ended up winning by only a two-point edge. The same year, Douglas Wilder was projected to win Virginia's governorship by nine points, but squeaked in with one half of one percent of the popular vote. Nor are examples only from the past. In Michigan in 2006, the final polls forecast that the proposal to ban affirmative action would narrowly prevail by 51 percent. In fact, it handily passed with 58 percent. That's a Bradley gap of seven points, which isn't trivial.

Pollsters contend that respondents often change their minds at the last minute, or that conservatives are less willing to cooperate with surveys. Another twist is that more voters are mailing in absentee ballots, and it's not clear how those early decisions are reflected in the polls. Yet the Bradley gap persists after voters have actually cast their ballots. Just out of the booth, we hear them telling white exit pollers that they supported the black candidate, whereas returns from these precincts show far fewer such votes. Thus they lie to interviewers they don't know and will never see again.

Saturday, September 13, 2008

Babbage on economics and innovation

Hmm... might be worth a look sometime, if I can find it in the library. From this talk.

Google books link.

Babbage, who, like Isaac Newton, was Lucasian professor of mathematics at Cambridge, attempted to construct the first computer in the early nineteenth century, more than a century before the first working computer was produced. Of course, Babbage's computer was based on mechanical power rather than electronics, but it still required parts with very precise specifications. In carrying out this project, Babbage had to work with many workshops. In the process Babbage learnt a great deal about modern manufacturing.

Based on his experience, Babbage published an extraordinary book, The Economy of Machinery and Manufactures, which went well beyond any contemporary work of political economy in creating a realistic analysis of modern production. The significance of rapid technical change struck Babbage, who claimed, "... the improvements succeeded each other so rapidly that machines which had never been finished were abandoned in the hands of their makers, because new improvements had superseded their utility" (Babbage 1835, p. 286). Babbage's rule of thumb was that the cost of an original machine was roughly five times the cost of a duplicate (Babbage 1835, p. 266).

More from Wikipedia, on comparative advantage:

In On the Economy of Machine and Manufacture, Babbage described what is now called the Babbage principle, which describes certain advantages with division of labour. Babbage noted that highly skilled - and thus generally highly paid - workers spend parts of their job performing tasks that are 'below' their skill level. If the labour process can be divided among several workers, it is possible to assign only high-skill tasks to high-skill and -cost workers and leave other working tasks to less-skilled and paid workers, thereby cutting labour costs. This principle was criticised by Karl Marx who argued that it caused labour segregation and contributed to alienation. The Babbage principle is an inherent assumption in Frederick Winslow Taylor's scientific management.

My favorite Babbage quote:

On two occasions I have been asked, – "Pray, Mr. Babbage, if you put into the machine wrong figures, will the right answers come out?" In one case a member of the Upper, and in the other a member of the Lower, House put this question. I am not able rightly to apprehend the kind of confusion of ideas that could provoke such a question.

Friday, September 12, 2008

A trillion in the balance

Via Calculated Risk. If house prices return to historical norms, mortgage credit losses will be roughly $1 trillion.

From Jan Hatzius, Goldman Sachs chief US economist, presented at the Brookings conference, Beyond Leveraged Losses: The Balance Sheet Effects of the Home Price Downturn. Here is a short excerpt on estimating mortgage credit losses (note that Goldman is now forecasting prices to decline another 10%):

If nominal home prices remain at their 2008 Q2 level until mid-2009, before reverting to a +3% annualized trend, our model implies that mortgage credit losses realized in the 2007-2012 period will total $473 billion. If nominal home prices fall another 10% through the middle of 2009, the model projects losses of $636 billion. Finally, if prices drop another 20%, predicted losses increase to $868 billion. Moreover, the table suggests that losses peak in the third quarter of 2008 if home prices are flat going forward; in the fourth quarter of 2008 if prices drop another 10%; and in the second quarter of 2009 if prices drop another 20%.

Thursday, September 11, 2008

Credit crisis: half way through?

Case-Shiller is down about 20% since the peak in real terms, and we have another 20% to go before the metrics are back in normal range. This would give back all the housing gains since the late 90s. Commercial real estate and consumer debt crises have yet to materialize but are likely to follow.

10 million Americans are underwater on their mortgages. The UK is in even worse shape, with a 70% drop in mortgage approvals.

Bear is gone.

Paulson and Treasury looked closely at the GSEs and decided it would be better to move now than to pay more later. Was there a trigger event? Were there scared Chinese bankers on the phone with Paulson? (Who do you think are the biggest holders of GSE paper?)

The Korea Development Bank looked closely at Lehman and took a pass. Lehman's stock is now in free fall.

Merrill financed 75% of its recent sale of $30B in mortgage securities at 22 cents on the dollar. The counterparty is a straw man, so Merrill will have to take the securities back if the price falls even further. That means Merrill could still go the way of Bear and Lehman eventually.

No mark to market, no resolution in sight.

Socializing losses after privatizing gains in the fat years.

Of related interest: great podcast interview with Robert Shiller. Act now, because Bloomberg has a tendency to take these down after a while.

Wednesday, September 10, 2008


Neal Stephenson has a new book out. I discussed it briefly with him at Scifoo -- he was remarkably modest in his description, given the ambition and scope of the 900 page novel, which early reviews compare with classics like Dune and the Foundation Trilogy.

Check out this video trailer (complete with jiujitsu-inspired combat sequence :-), and this bibliographic list of influences, which include J.S. Bell, many worlds quantum mechanics and Kurt Godel...

Fraa Erasmas is a young avout living in the Concent of Saunt Edhar, a sanctuary for mathematicians, scientists, and philosophers, protected from the corrupting influences of the outside "saecular" world by ancient stone, honored traditions, and complex rituals. Over the centuries, cities and governments have risen and fallen beyond the concent's walls. Three times during history's darkest epochs violence born of superstition and ignorance has invaded and devastated the cloistered mathic community. Yet the avout have always managed to adapt in the wake of catastrophe, becoming out of necessity even more austere and less dependent on technology and material things. And Erasmas has no fear of the outside—the Extramuros—for the last of the terrible times was long, long ago.

Now, in celebration of the week-long, once-in-a-decade rite of Apert, the fraas and suurs prepare to venture beyond the concent's gates—at the same time opening them wide to welcome the curious "extras" in. During his first Apert as a fraa, Erasmas eagerly anticipates reconnecting with the landmarks and family he hasn't seen since he was "collected." But before the week is out, both the existence he abandoned and the one he embraced will stand poised on the brink of cataclysmic change.

Powerful unforeseen forces jeopardize the peaceful stability of mathic life and the established ennui of the Extramuros—a threat that only an unsteady alliance of saecular and avout can oppose—as, one by one, Erasmas and his colleagues, teachers, and friends are summoned forth from the safety of the concent in hopes of warding off global disaster. Suddenly burdened with a staggering responsibility, Erasmas finds himself a major player in a drama that will determine the future of his world—as he sets out on an extraordinary odyssey that will carry him to the most dangerous, inhospitable corners of the planet . . . and beyond.

I can really grok the appeal of isolation from the booms and busts of the outside "saecular" world, especially as we enter the climax of election season ;-)

Avout = Caltecher!

Tuesday, September 09, 2008

Hank in charge

This Times article details who is running the show when it comes to the Fannie and Freddie bailout.

NYTimes: ...“Bush was in charge when it was cut taxes, deregulate, have free trade, etc.,” said Representative Barney Frank, the Massachusetts Democrat and chairman of the House Financial Services Committee. “But then the old paradigm broke down, and it fell, frankly, to more serious thinkers to figure out how to cope with the current reality.”

...Mr. Paulson, a former chairman of Goldman Sachs, joined the White House in July 2006 after an intense courtship by Mr. Bush’s chief of staff, Joshua B. Bolten. He demanded clout and got it, in part because “Paulson did not need the job; the administration needed Paulson,” said Vincent R. Reinhart, a monetary economist at the American Enterprise Institute in Washington.

Mr. Reinhart says Mr. Paulson, like Mr. Bush, would ordinarily resist government intervention. “I think the economy is taking Bush and Paulson to a place where they wouldn’t go on their own,” he said. “In a crisis, you start bending principles, and Paulson bent principles.”

By relying so heavily on Mr. Paulson, Mr. Bush is doing more than bend conservative principles. He is taking himself out of public view in the one area of policy making that matters most to Americans: the economy. Mr. Wehner, Mr. Bush’s former adviser, does not see that as a problem so long as the markets stabilize. And Mr. Frank, the Democratic congressman, said Mr. Bush’s reliance on the Treasury secretary is “one of those things that, historically, will be to his credit.”

Do the people who think Sarah Palin is up to the job of President of the United States think she could have been CEO of Goldman Sachs as Paulson was? ("After all, Alaska is a lot bigger than Goldman Sachs! And, it's closer to Russia! How much oil does Goldman have, anyway? Hey, she does have a journalism degree from U Idaho!") Anti-elitism can only go so far...

Who has more responsibility, the President or CEO of Goldman?

Sunday, September 07, 2008

Bye bye Fannie and Freddie

On my way back from Europe, I noticed that Fannie and Freddie have been nationalized, with shareholder value going to zero! It's a huge development -- much bigger than Bear earlier in the year. The housing bubble still has further to pop, so stay tuned!

Here's economic guru John McCain on the subject -- his sentiments are right, but the fact that he can't get the exec compensation to within 3 orders of magnitude is a bit worrisome. (I suppose Palin could have nailed it within two orders of magnitude or better ;-)

NYTimes: “It’s hard, it’s tough, but it’s also the classic example of why we need change in Washington. It’s an example of cronyism, special interest, lobbyists. A quasi-governmental organization, where the executives were making hundreds of — hundred some billion dollars a year, while things were going downhill, going to hell in a handbasket,” Mr. McCain said, adding that the two companies need “more regulation, more oversight, more transparency, more of everything, and frankly, a dramatic reduction in what they do.”

But not to worry, McCain / Palin's grasp of economics and finance is every bit as solid as that of our most recent great Republican leader George W. Bush, and look how well he did!

Video: [Bush, blathering off the record on something he doesn't understand -- was that Bush on July 18, or McCain this weekend?] "There's no question about it. Wall Street got drunk ---that's one of the reasons I asked you to turn off the TV cameras -- it got drunk and now it's got a hangover. The question is how long will it sober up and not try to do all these fancy financial instruments."

I'd post the video itself here except it's old news, and, well, nobody wants to talk about GW anymore -- especially not the people (the same ones who are backing McCain and Palin, more or less) who predicted what a great president he'd be. Too bad we don't judge voters on their records like we do traders. I know who I'd fire.

You voted for GW? Twice?!? Your P&L is negative one trillion dollars for the united states. Put your stuff in this box and follow the security guard out the door. No, you don't get to take a position on this election or advise any geneticists on evolution.

Note I'm not trying to blame Bush for the credit disaster -- the trillion dollars is for Iraq alone.

Venice photos

I only spent part of a day in Venice. It's a magnificent relic of a bygone era, but overrun by tourists and the types of businesses that cater to (exploit) them.

Friday, September 05, 2008

Trento photos

If you ever come to this part of Italy try the wonderful gnocchi -- it's apparently a regional specialty. We had several epic dinners compliments of the workshop -- I think the food was actually better than what I had in Paris.

Scientifically the meeting was great for me -- I learned a lot and got to meet a number of people whose papers I've read over the years. I'm not a heavy ion specialist but I got some insight into what the community thinks is going on. On to ALICE and LHC!

Two Italian theoreticians, Francesco Becattini (Florence) and Lorenzo Ferroni (LBNL):

Some pictures of Trento:

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