How to Survive a Crisis by Wachovia Securities

An ad in the WSJ advertises: Download free report by a 120 year old firm "Six Strategies for Weathering Market Volatility" by Wachovia Securities. You would think they could have forwarded that to HQ last week.

Efforts to Regulate Freddie and Fannie

Katrina Vanden Heuvel, editor of The Nation, and Eric Schlosser, argue in today's WSJ that 'What we really need is a new New Deal: a systematic approach to the financial and economic problems of the U.S.' Crisis and Leviathon. The really bad news of bad news is anticipating more clueless cures from Washington.

Check out this compilation of snippets from people defending Fannie and Freddie when they were sowing the seeds of this current mess, berating the motives of those who were criticizing these institutions, and Franklin Raines' statement about mortgages

"These assets are so riskless, that their capital should be under two percent"

With that kind of mindset from the top, it's obvious a disaster was inevitable, it was just a matter of time.

Now, this is a partisan Republican piece, and surely many Republicans were in on the disastrous idea that increasing homeownership would be riskless, but I think the balance of blame is clear. [Interestingly, George Bush's biggest failures were, in my opinion, his efforts to do classically liberal policies, such as No Child Left Behind, the Iraq War (very Wilsonian), and the 'ownership' society.--But the Left hates him more than ever].

Market Intervention

Most closed-end funds are at a steep discount to Net Asset Value, many around 25%. That is, you can buy $100 worth of equities or bonds, for $75, because everyone is selling. This would seem to suggest the market is panicking, and a solution would be to force some buying, and put the market back in order.

But market prices are symptoms of reality, not so much the cause, and prices exist in a complex constellation we rarely fully understand. Thus, the effect to eliminate short selling has potentially made things worse, because it really hurts all those who need to hedge to make markets in other products such as options or convertible bonds. Note how the fund JPC, which mainly owns convertibles, has tanked in recent days, in part because convertible bond owners can't hedge their positions, so demand a discount to bear the risk.

Top down cures create problems policy makers rarely anticipate. I bet the dislocation by option and convert markets is worth the one-time boost from banning short sales. I don't have an opinion on the $700B bailout, because I haven't seen the details of what they are buying, and that makes a big difference. But I do know shutting down some markets is no way to boost the overall efficiency of the financial sector

Harvard Subprime Discussion

Several Harvard experts spoke on about the subprime problem. Elizabeth Warren talked about how come toasters don't blow up at the same rate as financial instruments? Answer: regulation! Merton, speaks last, and says, paraphrasing, 'I agree with all the distinguish commenter prior to me and only have a few things to add...I don't think regulation is a solution because these areas were already highly regulated, and many regulators were pushing mortgage innovations that were part of the problem, not the solution.'

So in other words, I agree with your usage of 'a' and 'the', but the rest, not so much.

Specificity matters. As most concerns about Fannie and freddie were about their interest rate risk, and academics and regulators were pushing for lowering underwriting standard under the banner of increasing home ownership. 'More' regulation would not have helped given those priorities.

Many of the concerns mentioned, are spilled milk. That is, worry about people being able to securitize loans with little recourse to the originator no more. There are no buyers for this kind of paper. Other issues, I think, would make things much worse. That is, focusing on helping the current mortgage owners by forestalling bankruptcy just makes the problem worse, because it increases the time were no one really owns the property. Giving the current mortgage owner an option at a time when he has no skin in the game, just creates a situation where you are creating hundreds of thousands of people with bad incentives: they should squeeze the banks to the degree they can per the law, because they have zero to lose.

My impression was, warnings by Rogoff, Mankiw and Merton would go unheeded, and Harvard would prioritize more cookie cutter regulation that merely would increase the costs of lending under the guise of helping the little guy. William F. Buckley once famously said he would rather be ruled by the first 100 names in the phone book than the faculty at Harvard. I agree. Their average opinion is usually a train wreck based on top-down egalitarianism based on flawed assumptions about human nature and the relative ethics of the poor vs businessmen (the poor are saintly naifs fighting selfish captains of industry).


Great Quote: "Most researchers want to put this in the greater context of their own research" ~ Greg Mankiw

Bad on Many Levels

An article about nasty anonymous comments on a Chicago Tribune story about a rape in a housing project, prompted this response:

The poison's damage came even clearer when I phoned Deanese Williams-Harris, the Tribune reporter who wrote the piece.

I was wondering what else she might know about any suspects. Immediately, she mentioned the comments.

"It just broke my heart," she said.

The comments enraged her. Disgusted her. But they also simply hurt.

"These people they were talking about," she said, "that's me and my parents."

Williams-Harris' mother grew up in the Robert Taylor Homes, her father in Stateway Gardens. She spent part of her own childhood in public housing, as a kid in the Washington Park Homes, as a teenager in Stateway Gardens. Like her parents, she attended college, then went on to earn a master's degree.

Of course, not every public housing resident has such credentials. But a shortage of master's degrees isn't the same as a lack of morals.

"Public housing has its issues," she said. "But rape isn't something that's accepted there."

First, the columnist seems shocked at how nasty anonymous commenters are. Gee, give anonymous people a microphone, and who would predict that it bring out massive incivility? This is why reputation matters and a system that monitors people, to validate a reputation, is essential. If people could act without accountability, like anonymous commenters, they would be rude and uncivil, because there is no downside to being an asshole when no one knows who you are. Similarly, tracking your payment history allows us to have credit cards, something not so common in Mexico, to say nothing of Haiti or Liberia. Big brother is too far, but there is moderation in all things.

Second, if you go to college and are in public housing: fail.

Third, I'm glad she clarified that even public housing has limits.

Prost!

Happy Oktoberfest my lederhosen brothers. Here's to a holiday without a pretext of spiritual purity or nationalism. Just drink and enjoy.

Deep thoughts on beer and cognition, by Cliff Clavin of "Cheers":

Well you see, Norm, it's like this... A herd of buffalo can only move as fast as the slowest buffalo. And when the herd is hunted, it is the slowest and weakest ones at the back that are killed first. This natural selection is good for the herd as a whole, because the general speed and health of the whole group keeps improving by the regular killing of the weakest members. In much the same way, the human brain can only operate as fast as the slowest brain cells. Now, as we know, excessive intake of alcohol kills brain cells. But naturally, it attacks the slowest and weakest brain cells first. In this way, regular consumption of beer eliminates the weaker brain cells, making the brain a faster and more efficient machine And that, Norm, is why you always feel smarter after a few beers.

A Modest Proposal

ATTN:
Dear Sir/M,

I am Mr. Hank Paulson. A TREASURER of THE AMERICAN STATES(USA). I have the courage to Crave indulgence for this important business believing that you will never let me down either now or in the future. Some years ago, a Federal Reserve President commissioned a study that argued for enhanced mortgage technology to help the poor. It lent out 1,000,000,000,000,000.00 USD to assist in this matter, with innovative underwriting standards such as NINJA and Section 203(b) loans. This worked for almost a decade, but this time, upon maturity, the bank sent routine notifications to the various forwarding addresses but got few replies. After a year, the bank sent more reminders and finally contracted their companies, such as the FANNIE MAY, FREDDIE MAC, and THE BEARS STERN CORPORATION, among others, who all wrote to inform the bank that they all died without MAKING A WILL, and all attempts by the bank to trace the next of kin were fruitless. I therefore, made further investigation and discovered that the beneficiary was a single immigrant from Nigeria who had only recently obtained American citizenship. He did not declare any kin or relations in all his official documents, including his Bank deposit paper work. Some idiots actually made payments on their mortgages, so that there is a remaining money total amount of $700B.USD (SEVEN HUNDRED BILLION US DOLLARS) still sitting in my bank as dormant Account. No one will ever come forward to claim it, and according to American Banking policy, after some years, the money will revert to the ownership of the AMERICAN Government if those account owners are certified dead. This is the situation, and my proposal that we buy it first, for the current price of $700B.USD, which is well below its market price of $17.6T.USD (as calculated by my cousin, the Honorable Benjamin Bernanke, Chief of Federal Reserve). All you have to do is write a blank check or give me your account anywhere in the world and send me its detail for me to arrange the proper money transfer paperwork, and facilitate the transfer. Once we buy the debt at cheap prices, my old colleagues at THE GOLDMAN SACKS company will most assuredly buy it from us for at least $2.3T within a couple year. The money will then be paid into the Account for us to share in the ratio of 60% for me, 35 %for you and 5% for expenses that might come up during transfer process. There is no risk at all, and all the paper work for this transaction will be done by me using my position and connections in the banks in America. This business transaction is guaranteed.And the first phase of the transfer will be ($100B.USD) ONE HUNDRED BILLION DOLLARS as advised by our insider in the bank. If you are interested, please reply immediately through my personal email sending the following details: (1) Your Full Name/Address (2) Your Private Telephone/fax Number (3) Bank Name (4) Account Number(s) (5) Bank Routing Number(s). Please observe the utmost confidentiality, and be rest assured that this transaction would be most profitable for both of us because I shall require your assistance to invest some of my share in your country. I look forward to your earliest reply.

Yours,
Mr.Hank Paulson

Shocking!

Clay is gay: Aiken comes out of closet

Not exactly up there with finding beta decay varies by our distance from the sun.

Where Intellects Get Their Intuition

Hayek disliked intellectuals, because he said they often applied intuition in a very sloppy way. Their education and articulate writing was applied using superficial reasoning, and so they were lightweights. For example, in his day, it was socialism vs. capitalism, and most intellectuals favored socialism because the simple idea that 'planning' is better than 'not planning'. There superficial application of this idea led them to a bad opinion.

I was watching Bloggingheads, and political pundits/operatives Mark Schmitt and Byron York both admit they don't know much about what is going on in this crisis, but highlight the reference 'Liar's Poker' by Michael Lewis as informing their intuition.



Michael Lewis is a good writer, in that he has a lot of good similes, allusions to Greek literature, and is funny. But his understanding of finance is pretty thin (he worked on wall street for all of three years). He basically argues that finance is filled with a bunch of smart but thoughtless, deceitful men, who rise to the top the way elephant seals take over a harem of cows. This is true to some degree, and it is very appealing picture to bring these people down in such a way, because it's always popular to say prominent people in field X really know nothing and are overpaid or overrespected. Unless one can highlight a key flawed assumption in the field, and what the better assumption should be, this is really shoddy commentary. But this is a 'top shelf' reference for understanding finance to a political pundit because it is a book they can understand, it talks mainly about motives and human frailties. It's as if your opinion of the electorate was based on episodes from 'All in the Family'--fun stuff, but a caricature, and and so fundamentally more wrong than the idiot being caricatured (eg, not all Republicans are bigots like Archie Bunker).

This is why I turn the channel whenever the talking heads start commenting on Fed policy, it's like listening to a celebrity's opinion on the Iraq War.

Shiller's Housing Call

Robert Shiller's new book, The Subprime Solution, has this blurb by Lawrence Summers:

Robert Shiller is two for two in predicting and identifying bubbles that will burst.

I suppose he is referring to the 2005 revision to Irrational Exuberance, where he has a chapter on housing. A bunch of information, and concern, but no real call that housing was ready to decline. Lots of qualifiers.
From page 206:

The bubble in housing prices that began in the late 1990s shows signs of slowing down in some cities. But it is not at all clear when it will be over. Slowdowns can be reversed, and prices can take off again...
In cities where prices have gotten so high that many people cannot afford to live there, the price increases may start to slowdown, and then to fall. At the same time, it is likely the boom will continue for quite a while in other cities.

I boldly predict that in our current uncertainty, some firms will rally hard over the next year, and some may go bankrupt.

No Karma

Bill Syron got $38MM. Jamie Gorelick, an attorney general from the Clinton era who joined Fannie's executive ranks for her fixed income and credit perspicacity, pocketed more. David A. Andrukonis, who was fired for standing in the way of Syron's mortgage innovations, left Freddie for teaching in 2004.

One might blame the greed of the markets, but what about the divergent careers of Alicia Munnell, the lead author of the initial Boston Fed study that 'proved' there was rampant racial discrimination. Well, this 20 year staffer at the Fed then became extremely successful by economist standards: her paper became published in the American Economic Review, the leading publication of economists, member of the NBER, part of the Council of Economic Advisors to the President, and is a full professor at Boston College business school. Her antagonist, Stan Liebowitz, is having a fine career at the University of Texas, Dallas, but clearly lacking the blue plated accolades of Ms. Munnell. His rebuttal of Munnell only made the Economic Inquiry, a good journal, but ranked 36th in one study.

The incentives for this mess, encouraging home ownership by eviscerating underwriting standards, was deep, and academics and regulators were just as wrong as the big banks; indeed, they provided the intellectual arguments. Who were you, as a mere risk manager, to disagree with such august authority? To think 'more regulation' would have prevented this problem is wrong because the regulators thought this was a cure, not a disease.

Stan Liebowitz

I read Stan Liebowitz's article on the subprime crisis. I loved this point:

Fannie Mae announced: Spurred in part by the FHEFSSA mandate, Fannie Mae announced a trillion-dollar commitment. The result has been a wider variety of innovative mortgage products. The GSEs have introduced a new generation of affordable, flexible, and targeted mortgages, thereby fundamentally altering the terms upon which mortgage credit was offered in the United States from the 1960s through the 1980s. Moreover, these secondary-market innovations have proceeded in tandem with shifts in the primary markets: depository institutions, spurred by the threat of CRA challenges and the lure of significant profit potential in underserved markets, have pioneered flexible mortgage products. For years, depositories held these products in portfolios when their underwriting guidelines exceeded benchmarks set by the GSEs. Current shifts in government policy, GSE acquisition criteria, and the primary market have fostered greater integration of capital and lending markets.
These changes in lending herald what we refer to as mortgage innovation.

That's from Fannie Mae in 2002. Then Liebowitz notes:

One man’s innovation can be another man’s poison, in this case a poison that infected the entire industry. What you will not find, if you read the housing literature from 1990 until 2006, is any fear that perhaps these weaker lender standards that every government agency involved with housing tried to advance, that congress tried to advance, that the presidency tried to advance, that the GSEs tried to advance, and with which the penitent banks initially went along and eventually enthusiastically supported, might lead to high defaults, particularly if housing prices should stop rising.

Liebowitz also goes over a Bear Stearn's sales pitch from 1998, which argues the change in underwriting standards would have no impact. There was a lot of reliance on the Community Reinvestment Act, and the Boston Fed Study that supposedly showed racial discrimination was at fault for excessive minority mortgage rejections. The implication was clearly that having a negative view of these changes was almost racist. As bear Stearns showed, at least they were sincere.

Success Through Failure

'No more mistakes, and you're through', was one of the big corporate talks given by John Cleese. His funny, but serious point, is that if you don't make mistakes, you also won't make any great innovations. The book Success Through Failure, by Henry Petroski, argues that mistakes are essential: "We learn wisdom from failure much more than success. We often discover what will do by finding out what will not do; and probably he who never made a mistake never made a discovery". He notes that large bridge failures tend to happen at intervals of approximately thirty years: 1847, 1879, 1907, 1940, 1970. He suggests this is because as time goes on, people forget about failure, and push extensions too far. When was the last residential housing crisis? Before any current politicians, businessmen were around, so it was easy to dismiss those highlighting risks.

The mortgage mistake seems to have been wanting an ownership society that was not consistent with paying its bills; some people saw this coming, and we would have been wise to heed them. Freddie Mac’s former chief risk officer David A. Andrukonis, recalled telling the Bill Syron, who was rewarded for his Boston Fed pieces on mortgage lending discrimination by being made CEO of Freddie Mac, in mid-2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.” Syron disagreed, and either fired him, or he left for other reasons. Andrukonis was right, Syron was wrong. Syron pocketed $38MM over his tenure. I doubt Andrukonis got anything close to that before leaving. Stan Liebowitz had written about the declining underwriting standards. He too was ignored.

I think mistakes as learning tools are highly overrated, because they often have little generality. There are a million ways to do something wrong, and one way to do it right, so going one by one through the wrong ways is a very inefficient way to learn. Theory beats trial and error. Nevertheless, at the margins, we will make mistakes, and can't get too down about them. The key is, the policy on homeownership was debatable before, now it's not. As a society, we can move on to the next mistake. Trial and error is not the best way to learn as a general strategy, but it is part of our overall strategy, that we use towards those risks we take where, from a societal standpoint, the risks were not obvious.

Those who knew this was going to happen should not be mad, but rather, have a kind of wistful regret, comforted by the effect of the correct call on their personal portfolio. If they did not have a sufficient amount of capital to take such bets, then they also did not lose money. So those who are full of self-righteous fury on the risk takers, are hardly credible. There are those like David Andrukonis, whose career suffered, and Bill Syron, who made millions perpetuating this mistake, are rare, and probably both going to be involved in a lot of litigation. Hopefully, Syron will be made to pay like the Enron executives did, but he has a lot more friends than they did.

So now, as we try to fix the problem, it is best to mind two independent issues. One is preventing a banking crisis caused by a run, because the nature of banking is that if all the lenders try to withdraw their money, the banks are all insolvent because their assets are illiquid. This is especially so for banks that have lots of mortgages whose prices are currently unknown,and so assumed to be of very low value. A sequence of bank failures does no one any good. Secondly, we need to adjust underwriting standards back to the bad old days, where people needed to verify income, have a proven credit record, and a 20% down payment. Unfortunately, the bill commented upon today by legislators included saving bad credit card debt, forgiving the current mortgage owners on their payments, and limits on executive pay. These all may have some merit, but they a distraction, and generally difficult implement well (remember, the Clinton surtax on million dollar salaries gave rise to the stock option boom we saw in the 1990's).

Why Last Week Was a Panic

Lots of talk about how Paulson and Bernanke got a bunch of legislators together, and told them about how terrible things were. He actually got them to put aside partisanship for a little while, which basically means, he scared them shitless. The scene was described as this:

Mr. Bernanke and Treasury Secretary Henry M. Paulson Jr. had made an urgent and unusual evening visit to Capitol Hill, and they were gathered around a conference table in the offices of House Speaker Nancy Pelosi.

“When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

Mr. Schumer added, “History was sort of hanging over it, like this was a moment.”

When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.”

“What you heard last evening,” he added, “is one of those rare moments, certainly rare in my experience here, is Democrats and Republicans deciding we need to work together quickly.”

Now, looking at merely equities, this was not obvious, but you can see it in the bonds, where last week they fell of a cliff for our best financial companies. The sky was falling, because if the big AA companies can't get credit, no one can, and without credit, everything stops. CitiGroups bonds dropped from a price of 92 on Monday, to 81 an Tuesday. This why there was panic at the Treasury and the Fed.

Note also that bonds for Citi, an erstwhile AA company, traded in junk territory, which means, they started trading on price, not a spread. So, any good bond dealer is hedging his long bond positions with shorts on the equity once it traded below 90, but then, bam, shorting is declared 'illegal'! Ouch. The stock rallied hard, while bonds rallied but not so much. I would say, short the stock, buy the bonds, but you can't short the stock, so I guess you have to buy puts. But puts have really high implied vols: the 10 strike puts of Dec 08 have implied vols of 122! Current at the money vols are around 70. Now, historically their vol is around 20, so you are paying panic prices.

A Fifth Force?

Radioactive decay was thought independent of most everything. Now these guys find a striking pattern in the rate of beta decay as a function of our distance from the sun. String theorist Lubos Motl calls it 'bizarre', which is always fun to hear (even better than, 'that's funny...'). Like any really good result, you can just eyeball the graph, and see its true (no 3-stage least squares or GMM applied to equations pulled out of the aether). They found this pattern looking at data from two entirely different laboratories, and two entirely different elements.

Obviously, it's a homing beacon of sorts to our betters. On behalf of Earth, I welcome our new overlords, and would like to remind them that as a trusted quantitative investor, I can be helpful in allocating capital while others provide biomass for their Illudium Q-36 Explosive Space Modulator.

My Take on Sailer

My take on the Sailer piece was that this crisis was caused by a confluence of good intentions and a good track record. Failure is endogenous because people will always extend whatever works until, and only until, it fails. Thus, the effort to create an ownership society, ie increasing home ownership, seemed like a costless way to make the world a better place. Plus, it was consistent with targeting minority home ownership, because lowering underwriting standards disproportionately helps minorities, who have lower than average credit quality. As there were no major losses for home mortgage portfolios for the past 25 years, noting the risks was unpersuasive, especially as the standards seem to morph over 10 years, and any previous naysayers were shouted down years ago. Rating agencies also missed out on the relevance of adjusting the underwriting standards, and no one called them on it. Lastly, the fact that home builders, Fannie and Freddie, are some of the most powerfully connected lobbyists in Congress, ensured this effort was going to accelerate until failure.

I don't see how you could have seen this before the fact, unless you were aware of the change in underwriting standards for mortgages (lower credit rating, no income verification, lower down payment). I haven't seen anything where someone has defended their ignoring the changes of underwriting standards in real time, only a couple statements after the fact that are obviously stupid. That is, I don't know if people were just asleep at the switch, complacent by the low defaults in this space, or they actually did the math and thought it didn't matter. I suppose the former.

The Best Take on the Subprime Crisis

Steve Sailer's piece in Taki's magazine is, I think, the best analysis of how we got here, and he's not an economist. When you think about something that gestated for 10 years, you get a better sense of how inevitable it was, because the people warning against this 10 years ago were all 'proven wrong' a long time ago. The key is that everyone wanted more home ownership, which we know is correlated with all sorts of good socioeconomic things: lower crime, more education, etc. But some people are not meant to be owners, that is, there is an equilibrium amount of home-owning, and it is less than 100%.

This is not reassuring

On the Wall Street Journal notes breaking news: "Bush calls the financial crisis a pivotal moment in the life of the U.S. economy and says now is the time to solve the crisis by taking unprecedented action."

Legislation created during a crisis is always so thoughtful and measured.

Liberal Facism

I like Matt Yglesias. He seems like a thoughtful young guy. But in a crisis, a liberal's ugly tendencies are revealed, specifically, the desire for top-down power. Read this positive spin on the current crisis with this insane plan:

But if the government directly controls major financial institutions, that would give the new administration extraordinary leverage over the national economy. Suppose the new CEO of AIG decided he didn't want to insure assets of companies whose executives make unseemly multiples of the national median income? There are all kinds of crazy things you could do. And of course not all of them woul dbe good ideas. But some of them would! And the smart folks on our side need to be figuring out which ones they are. It seems doubtful to me that a progressive administration would ever be able to get away with this much nationalizing of everything, but what's done is done and I think it creates a real opportunity for "socially conscious insurance underwriting" or whatever you care to call it.

You see, with state control of private industry, you have no volatility, and those becoming fabulously powerful do it out of love for the worker and have modest salaries. You never heard about recessions or financial panics in Russia, even in the 1930's when millions of Americans were out of work while every Russian was occupied in some way. Further, just think about how awesome the world would be if disinterested smart people could make all the decisions! Regular people are so dumb. I don't see how it could go wrong.

Stat Arb Cleaning Up

Lots of independent corroboration that stat arb is making a lot of money in this tumult. Stat arb is basically trading based on the theme that stocks mean-revert over short horizons, and is based on statistical patterns. When applied to hundreds of stocks simultaneously, it has very low volatility. DE Shaw, Morgan Stanley, and Renaissance, are big players.

Anyway, for everyone selling indiscriminately in panic, their are lots of millionaires in hedge funds saying, 'thanks!' Note the lack of any large hedge fund blowing up in this mess.