Category Financial Crisis

Entries 25 Total

When you have a hammer, all the world's a nail – network edition

Jul 10, ’09 10:43 AM

I’ve read a few times the editorial by my former colleague Duncan Watts, and despite some interesting discussion, I can’t help thinking that this is a guy who knows a lot about networks and not so much about financial markets.

The article is about the problem of size and complexity in financial services organizations. Watts argues that we ought to pay attention to:

a general trend toward building ever larger and more complex networks. In recent years, hundreds of millions of people have rushed to join online social networks, while billions more rely on e-mail and cellphones to stay connected to friends and coworkers all day, every day. Technologists wax lyrical about “Metcalfe’s Law,” which posits that a network’s “value” increases in proportion to the square of the number of people or devices in it. And system designers revel in the ability of networks to improve a system’s overall efficiency by dynamically distributing computer-processing load, power generation, or financial risk, as the case may be.

And the answer is that we should prevent firms from becoming big and complex enough to be deemed “too big to fail.” For Watts, too big to fail is too complex to exist. Fair enough. But this is suggested in a complete absence of any content of what financial services firms, hedge funds, or other trading organizations actually do. For instance, are we speaking about proprietary trading positions in various markets that tie them together, like multi-strategy hedge funds (.pdf)? Or are we speaking about a firm that acts as a clearing member for a bunch of other firms, as it was the case in 2007 when the top 10 investment banks were counterparties to 90% of all credit market trades? Or are we speaking of firms that are/were wildly leveraged, like Bear Sterns (or its subsidiary, the magical Everquest Financial and its CDO-squared monster Parapet)?

In other words, Watts’ version of systemic risk only makes sense if we just put brackets around a disparate set of practices, encompassed in varied institutions, and call them all “a series of complex, interlocking contingencies.” Well, sure, a complex system of interlocking contingencies does indeed sound like it might create systemic risk. But it doesn’t say much else. And let me be clear that I’m on board with the problem of systemic risk. I just don’t know why it makes sense to think of financial markets as the same as email, and electric grid, or an epidemiological event.

So what instead? First, I think we need people with substantive knowledge of what financial services organizations do. This is not a way of saying that only finance people and economists should be figuring out what to do (these are the people, after all, who made this disaster), but it is a way of saying that abstract knowledge of risk or organizations or networks is insufficient. Securitization is not just an interlocking contingency – or rather, it is, but that’s saying almost nothing. The roots of that contingency, including the measurements of risk in the creation of new assets (as Yuval Millo would suggest) and the institutional and legal conventions of creating a limited liability trust incorporated in the Caribbean to launder asset-backed securities into invest-able shares (as I would suggest) are where the action is.

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Valuation of Warrants

Jun 30, ’09 7:47 AM

From the CBO’s June update on TARP funds (that’s a .pdf):

The market value of outstanding warrants held by the Treasury is around $6 billion, CBO estimates.14 Of the total, about $1 billion is from warrants issued by the 10 banks that recently repaid their TARP funds. However, those calculations are sensitive to the assumptions used in CBO’s models—particularly for treating the volatility of future stock prices (that is, how widely stock prices fluctuate over a given period).

14. CBO uses a Black-Scholes options-pricing model to price TARP warrants that relies on observed stock prices, estimated dividend yields, and historical data on volatility compiled from weekly securities returns for a period of 10 years.

Because what other methods are you gonna use?

Interestingly, the current estimate of the amount of ‘subsidy’ from $700+ billion TARP (that is, the part we’re not going to get back) is $159 Billion. Cost is weird here, since there are three main sources of governmental assistance: 1) asset guarantees; 2) very cheap loans; and 3) payments not going to get paid back.

And in particular (ahem, Goldman Sachs), $35 Billion to AIG in loans and stock purchases, lots of which went directly to pay off GS and others’ credit default swaps. Another $40B lost to the auto industry, and $50B to the as-yet-established mortgage relief plan.

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Goldman Sachs is corrupt

Jun 22, ’09 10:04 AM

Looks like Goldman Sachs is going to be making record bonus payments on the year. Let’s take a stroll, shall we?:

  • Under then-head Jon Corzine (the soon-to-be-ex-governor of NJ), Goldman fucked over LTCM when they were going bankrupt in the late-1990s. From Roger Lowenstein’s When Genius Failed: “In Greenwich, Goldman’s sleuths, who had the run of the office, left no stone unturned…A key member of the Goldman team was Jacob Goldfield…[who] appeared to be downloading Long-Term’s positions, which the fund had so zealously guarded, from Long-Term’s own computers directly into an oversized laptop (a detail that Goldman later denied). Meanwhile, Goldman’s traders in New York sold some of the very same positions. At the end of one day, when the fund’s positions were worth a good deal less, some Goldman traders in Long-Term’s offices sauntered up to the trading desk and offered to buy them. Brazenly playing both sides of the street, Goldman represented investment banking at its mercenary ugliest. To JM and his partners, Goldman was raping Long-Term in front of their very eyes (172-173).
  • They bet against their own positions during the sub-prime collapse As Michael Lewis put it, “Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.”; And instead of telling the rest of as well.
  • They took $12.9 billion government payouts as counter-parties to AIG’s credit default swaps. (the same M.O. they used as counterparty to LTCM, when the Fed bailed them out then as well);

And this is the stuff that comes without even digging any. I used to want to work for GS, and recommended a friend take a position there. Why? Because they’re smart, interesting, the top of their class. And I still appreciate some of the more interesting hedge funds. But honestly, reading this kind of stuff is so so so frustrating. How is this conscionable behavior? Seriously, how? I’m at the point when I just think, Fuck Them. I might as well recommend my students go into the mafia or prostitution before recommending that they go into investment banking these days. There seems to be only nuanced differences.

There was a time in our history when, in exchange for building the infrastructure of the United States, we allowed industrial robber-barons to make massive amounts of money. And in FDR’s famous ‘new deal’ speech, to the San Francisco Commonwealth Club, he called for a New Deal to remedy this.

Maybe there was a time when a similar bargain was made for Wall Street. But what are we as a society getting in return for allowing these new robber-barons? If the answer is, not enough, then where’s our New Deal?

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Shameful administration stance on finance pay

Jun 11, ’09 8:13 AM

This article doesn’t make clear enough the fact that ALL major Wall Street banks continue to have billions of dollars of federal assistance. Set the pay for giving money to AIG but not for Goldman Sachs, despite the fact that the money went directly from AIG to Goldman Sachs. Goldman Sachs books profits because their counterparty is being directly propped up with federal dollars. And it’s obviously not just GS.

That we’re willing to set pay at 7 firms but not others is an absurd Kabuki theater exercise in pretending that the administration gives a damn about it. It is only a way to inoculate the administration against the inevitable public outcry when (still absurd) Wall Street pay gets reported. It is shameful, shameful, shameful.

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Banks, TARP, Treasuries

Jun 10, ’09 9:58 PM

This week, we find out that 10 banks are returning TARP money. Or more specifically, 10 banks are repaying $68.3 billion in federal bailout money. This does not mean that these banks are freeing themselves from the yoke of government (only, says the snark in me, it allows them to pay themselves obscene amounts of money to retain the best and the brightest. Best and the brightest. Just keep clapping!).

On the contrary, their ability to bring in profits over the past quarter are almost certainly the result of near-zero federal funds rates and an alphabet soup of government support programs.

The FDIC has been providing a Temporary Liquidity Guarantee Program (.pdf) since November 2008 (guaranteeing unsecured senior debt of eligible banks); the Federal Reserve’s Commercial Paper Funding Facility (CPFF) purchases three-month unsecured and asset-backed commercial paper from banking institutions; the Fed’s Asset Backed Commercial Paper (ABCP) Money Market Mutual Fund (MMMF) Liquidity Facility and the Money Market Investor Funding Facility (MMIFF) buy asset-backed debt to support money market funds; the Fed’s Term Asset-Backed Securities Loan Facility (TALF) supports “the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).”

There are two effects here, one practical and one theoretical. The practical effect is to make money cheap and relatively risk-free, or at least to transfer the risk to the federal government and the profits to the private sector. So think about what this means, not for the 10 banks whose free money is putting them above the ‘stress test’ line, but the rest of the banks (Citi!!!) whose free money isn’t.

The second effect, which is more interesting from the point of view of economic sociology, is that the federal guarantee of almost any risky asset held by a private financial institution effectively alters the information contained in the market price of these institutions and assets. I would almost but not quite suggest that the state has effectively transformed the toxic assets held by banks into US Treasury bonds, but it’s not not doing that.

More specifically, you might ask: what the price of an asset is that is guaranteed by the federal government? How valuable is it? How much risk does it embody? These questions are unanswerable, and in this sense, the alphabet soup of programs and supports have significantly reduced the signal-to-noise ratio of credit market prices. This is a momentous shift in the financial system.

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The rise of futures trading, part who knows what

May 29, ’09 11:24 AM

The financial crisis has made it appear as though futures markets have been humming along famously and unproblematically until the past few years, when credit default swaps and esoteric derivatives made the otherwise functional system toxic. And this may be. But let’s not pretend that futures markets were always just hedging mechanisms with an added speculative benefit for entrepreneurial risk-takers. They’ve been primarily about speculation for some time.

A couple of interesting data points here. The first is a chart from EHnet (in a well-cited article:

What happened between 1970 and 2002?

What happened between 1970 and 2002?

As you can see, the total amount of produced grain trends upwards, but the amount of speculation trends exponentially. More data points would help, of course. But I can provide an educated guess that in the mid-1970s the modal speculator in futures was a rich, risk-taking individual; by the 1990s it was corporate and financial institutions; and in the 2000s it’s been financial firms big and small.

And why might rich folks have taken note of futures trading through the 1970s and into the 1980s? Taxes, baby.

There are numerous ways that uses of futures markets for tax avoidance purposes are practiced by people who have income from “unrelated sources,” such as real estate, stock transactions, etc. Brokerage houses and advisory services have promoted these tax avoidance ideas among high income persons. And such uses have been growing.

A common method is the “tax straddle” and its many variants. Essentially, these are spread positions in pairs of futures delivery contracts that fluctuate closely together – most commonly in pairs of delivery months for the same commodity – handled in such a way as to create paper losses in the current tax year, with offsetting gains deferred until the next tax year (and repeatable in the following tax year). Also, it enables short-term capital gains to be converted to long-term capital gains.

The precious metals futures markets have become rife with such transactions, as well as other types of tax avoidance maneuvers, but so have interest-rate futures markets and perhaps some agricultural commodity markets, like soybeans. All futures markets are subject to tax avoidance transactions and many have been used for that purpose by traders in such markets.

The Treasury estimates that in 1981, about $1.3 billion will have been lost by taxpayers’ use of futures markets to defer taxes and to convert tax obligations from ordinary income and short-term capital gains rates to long-term capital gains rates. The IRS has been challenging such taxpayer claims in the courts and believes it will win most cases but wants to plug the loopholes now through legislation (see “Statement of the Honorable John E. Chapoton, Assistant Secretary for Tax Policy Before the Committee on Ways and Means, House of Representatives,” U.S. Congress, House, 97 Cong. 1 sess., given 30 April 1981, unpublished transcript).

There seems to be general agreement that futures markets should not exist for tax avoidance purposes but there is apprehension in agricultural circles that the liquidity of agricultural commodity markets would suffer if the successful speculator in futures could no longer count on sheltering income from speculating in futures from high tax rates. They argue for exclusion from any modifications in the tax laws.

- pg. 301, fn 8 in Paul, Allen B. 1982. “The Past and Future of the Commodities Exchanges.” Agricultural History 56(1): 287-305.

Interesting, no?

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A framework for understanding the financial crisis

Feb 18, ’09 1:35 PM

I’m working on a piece that tackles more directly the sociological causes of the financial crisis. Here is a marker in the sand, my overall assessment. Short, probably cryptic, but what I believe is going on. Yes, I think every section needs elaboration. It will eventually be about abstract finance:

The financial crisis was driven by a confluence of 4 factors: 1) a social technology that transformed specific assets into abstracted risk; 2) a communications and computational technology that allowed these new financial instruments to be calculated and traded; 3) an institutional environment that facilitated the creation of unregulated investment vehicles and rated the resulting derivatives that they produced; and 4) a large pool of leveraged, conventionally-allocated investments that exacerbated systemic shocks by translating them into other markets. In this alternative view, the causes of the financial crisis are a social and technical trading technology, a specialized set of investment vehicles, and a conduit between these vehicles and the rest of the world of finance.

When you have (1) abstract risk, you increase the danger that the people who know how to manage the originating risk are not going to be the same people (or even kinds of people) who are actually managing the risk. When that abstract risk is (2) reified by a pricing technology, it lends a kind of stability and confidence in the qualities of risk that are quite likely unwarranted. If, by law and custom, you can then be (3) able to ‘package’ that into a discrete entity like a fund or trust or structured investment vehicle, you make it seem like there is a really big separation between the new, abstracted, measured risk and the originating risk. And when you have organizations and investors who trade these packaged entities alongside other kinds of entities, all now measured in terms of their abstract risk, you create avenues to spread risk systemically from one kind of market to others.

If you think of the financial meltdown as a sub-prime mortgage crisis, or a credit crisis, you are, in my humble opinion, mistaking the catalyst for the cause.

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prediction-o-rama, finance style

Feb 11, ’09 2:22 PM

So here’s my guess as to endgame for the ‘bad bank’ plan:

1. Banks, backed by the federal reserve, will buy some of the crummier so-called toxic assets – CDO’s backed by (worthless) mortgages, (wildly overinflated) lease agreements, (defaulted) credit card debt, and other juicy bits.

2. They’ll pair these assets with something looking a lot more like gold – say, treasuries – and then they’ll put them into a trust corporation.

3. The trust will then be securitized and sold as ‘government-backed high-yield assets’ or somesuch. It’ll look like a combination of gold and government-insured, high-yield assets.

4. Investors (including pension funds, state agencies, as well as more interesting investment companies), tired of losing their pants on the stock market and short on private equity deals, will take a big fat bite at this newly shiny apple.

5. Everyone declares victory and hopes that the ‘real’ economy picks up.

Oh, until the assets are suddenly revealed to be really worthless, and another giant wheelbarrow of public funds will be forced to back them, insurance-style.

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Socialist recruitment

Feb 9, ’09 1:18 PM

This kind of article, a straight-reporting job on how tough it is to live in NYC on half a mill a year, reminds me of why New York sucks. The dirty driving reality of this town is that we are all supposed to be shocked and outraged, but we’re supposed to envy them too. And the frozen hot chocolate is a rip-off and it tastes chalky, icy, crappy.

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Merrill Lynch

Jan 23, ’09 7:29 PM

It goes without saying that we should at minimum subtract $3-4 billion from anything that B of A will receive from TARP.

A 1- or 3-year across-the-board cap on finance salaries wouldn’t be terrible, frankly, and even if it creates hardship for employees, it will be temporary. And it is reasonable. We can argue about what a cap should be.

And for those who say you would lose talent, I say, so what? Talented people in an industry that screwed the rest of us. And who spent a decade making the top .5% of incomes in the US. Those with a 1-year time horizon are doing more harm than good in finance anyhow.

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