Ian Welsh

The horizon is not so far as we can see, but as far as we can imagine

Category: Securities

How to be a big pundit

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On July 13, 2010

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Figure out the truth once it’s too late to matter.

Analysis is mostly about noticing the obvious, but for the obvious to do any good it helps to notice it before it’s too late to matter.

Let me reiterate: Republicans understand opposition politics.  Also, policy matters.  As I was saying back during the stimulus debate, if the economy sucks, the incumbent party gets blamed for it,  and that means you have to make it work.  I don’t know if Democrats will lose the House (the consensus amongst the few analysts I trust seems to “no, but they will lose a lot of seats”).  I do know that they’ll be losing more seats than they should be.

The only reason Dems aren’t having a complete meltdown is that a sizable part of the Republican party is mad dog insane.

Even that won’t save them forever if they can’t figure out how to do policy right.

And, sorry to say it, they can’t.

Actual Good News

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On May 13, 2010

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The reform of the credit agencies, which creates an office in the SEC which assigns securities to the agencies to be rated, rather than the security issuer choosing (and paying) who rates them, is an actual good reform.  The Fed audit, while it is more limited than I would have liked, if done properly, should be very interesting.  Financial reform is still far from sufficient, but some intelligent good stuff is being passed.

Small Traders are Guppies for the Sharks (aka: banks)

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On May 12, 2010

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It wasn’t just Goldman who made money trading every single day in the last quarter, it was four banks.

I cannot emphasize enough: this is the sign of a fixed market.  It is impossible that this could happen in a free market.  Impossible.

This means they are extracting money from the markets, aka: from everyone who isn’t a market mover.  Small traders, pension funds, trading accounts of cities, etc…  Even if those actors aren’t actually in decline, they are making less money than they should as the banks make sure that their buy orders are filled at the highest price possible, and their sell orders at the lowest level possible.  And, in fact, many of them will be in outright decline as a result of these games.

At this point, if you are not a market mover, you can only make money in the market by anticipating the moves of the market movers.  This is now about guessing what a few people will do, so you can ride the tiger.  Just don’t fall off.

Goldman Sachs made money trading every single day last quarter

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On May 11, 2010

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Uh-huh.  Which means, as I said earlier, that the security markets are not free markets.  They are moved, at will, by the muscle, money and foreknowledge of a relatively small number of large traders.  The small time but professional traders (aka. people who used to make money) are livid, because systems which used to give reliable trading signals have become far less reliable.  This is why, on virtually every econo/market blog you will find that the commenters are angry.

This is an oligarchical society.  This is true whether you live in Europe, the US or China, it is only a question of who is a member of the oligarchy.

And, with maybe one or two exceptions, no one reading this is.

Clarifying The Dow Drop And Its Consequences

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On May 8, 2010

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Some folks seem to misunderstand what I wrote (which indicates I wasn’t clear enough.)  I do not know if the huge drop was a message, it certainly may have been.  But whether it was deliberate or not, it indicates that the big money CAN crash the market whenever it wants.  This is a sharper demonstration of what the 2008 crisis showed—that the hot money can crash the markets and the economy any time it wants.

The lesson of 2008, as understood by political elites, was that this hot money MUST be appeased.  The money wants high, risk free returns, and if it doesn’t get them, it will make everyone hurt.  This is why, instead of taxing the rich, which is where the money is and which has essentially no economic costs (a 20% tax on purchases of luxury goods or services over 1.5 million would have essentially zero cost to the real economy) what is happening instead is talk of slashing entitlements, or in edge economies like Greece, austerity.  (Britain will soon be getting cuts at their national level  and States and Cities have already had cuts in the US.)

Instead of appeasement, the 2008 crisis offered an opportunity to break the rich, by forcing them to recognize their losses, by refusing to bail out the financial institutions so that shareholders AND bondholders got smashed.  At the same time, to reduce the effect on the real economy, either the FED could have loaned directly to businesses and consumers or the FDIC could have taken over major banks which were dead, like Citigroup, and pushed out Fed money through the newly nationalized banks.

The end result would have been the power and wealth of the rich broken, and the real economy in not much worse shape, but able to recover much better, since the recovery wouldn’t be hobbled by the need to prop up insolvent banks, by crippled lending by effectively insolvent banks and by the need to provide above market returns to banks and the hot money rich.

This is explicitly what I was proposing in 2008, but of course, it didn’t happen.  So, instead, we get a decade of suck, if we’re lucky, the EU gets multiple failed economies and austerity plans, and the rich get 80%+ of the profits of the coming economic cycle.  If we’re unlucky (or maybe if we’re lucky) it crashes out sometime before then, since it is teetering on the edge.

Here is the basic thing you need to understand:

You can have lots of rich people, or you can have widespread prosperity.  You cannot have both.

Insuring Shadow Banks Without Proper Regulation Is Asking For Disaster

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On April 20, 2010

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A correspondent suggested to me that what needs to happen is to create a system like the FDIC for the shadow banking system (largely unregulated financial institutions which act like banks without being regulated like them.) The argument is that this mitigates against hysterical herd behavior and that the shadow banking system is necessary because it’s where a lot of institutions put their money.  And no one is willing to insure this system but the government.

Shadow banking didn’t always exist at these levels, institutions found places to put their money.

As I understand this, it means insurance without equivalent regulation to ordinary banks—because if you used equivalent regulation you’d just make them into banks who have to follow the same rules as retail banks.  This means investors being insured who engage in extraordinarily risky behaviour in order to get returns which normal banks can’t and don’t provide.

I should note that, in fact, other people were willing to provide the insurance.  AIG did.  They just couldn’t pay up, because only the government could afford to pay up.

So therefore shadow banks, who can’t find anyone who could possibly afford to insure their risky business model, need governments to do it?

The question is if they are willing to charge the full price for the insurance?  I’ve worked in insurance, real insurance where we worry about having enough money to pay off when the loss event occurs, and here’s the way it works: it costs more than the value of the insurance.  If there’s going to be a crisis every X years because of these fools, then we need to charge enough money to not only cover the cost of their insurance every X years, but to cover the cost of things like the stimulus to clean up their messes, the unemployment insurance costs, and so on.  Or we could move to 90% taxation on all income over a million, which would only be fair, if we’re going to have to bail the rich out again and gain.

Either way, the high cost of real insurance would mean a lot lower profits.  It isn’t going to happen that way, the real cost is not something the shadow banking system is willing to pay.

And if they know they’re insured, without proper regulation, what they’ll do is drive over the cliff again.  Why not, if they know they’ll be bailed out, and in the good times they get to pay themselves massive bonuses and wages?  Moral hazard 101: heads they win, tails the taxpayer bails them out.

Maybe there are better solutions.  Like reinstituting Glass-Steagall, forcing everyone to 10:1 leverage ratios with nothing off the books, and shutting down the majority of shadow banking, which has shown that it costs the real economy more than it can possibly be worth.  What we don’t need is investors putting money into shadow banks in attempts to pursue 15%+ returns, thus ignoring putting money into the real economy.

As for hysterical herd behaviour, the real problem was the herd behaviour involved in CDOs, CDSs and the housing bubble.

Behaviour which should simply never have been allowed to occur.

If you don’t want bad behavior, don’t insure it, just outlaw it.

Insanity is Doing the Same Thing and Expecting Different Results: Real Reform Means Reinstituting Glass-Steagall at Full Strength and Breaking Up Financial Conglomerates

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On April 10, 2010

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Ok, enough already. I’m sick of people talking about modern markets as if they are something wonderful. No, they aren’t. Obama was absolutely right during the election, they completely fell down on their job, not just for the last 8 years, but for most of the last 28 —whenever Republicans were in charge, and a fair bit when Dems were in charge. Ordinary people haven’t had a raise in damn near 30 years. This is success?

I simply, completely, and utterly fail to see what is so wonderful about the process of securitization. Sure, it allows you to create more financial products. Sure, it reduces the cost of capital somewhat. But are we really better off because of securitization? Of course we aren’t. Without securitization this current market meltdown would have been a hell of a lot milder. What securitization does is take the risk and spread it from the people who might be able to understand it and control it (the people actually issuing the mortgages, for example) to a ton of people who could not possibly know the risk even if they wanted to.

Ratings agency reform is not the solution, they completely fell down on the job and even if incentives were changed they are still not in a position to know whether a mortgage from Mr. Smith is legitimate. Are they going to visit the property? Talk to Mr. Smith? Call his employer? Of course not, they can’t. The only people who can are the people who issued the original mortgage.

Nor should risk be transfered much if at all. Risk must stay with the people who issue the mortgage. If they know it’ll be off their books they won’t do proper due diligence, and no one else can do it. At most, risk should be transfered once and must be transfered in whole and understandable form, rather than taking 20 different incomes steams (or more), melding them together, chopping them into tranches and selling them to people who really have no idea what they’re buying, while you’ve booked your profit and washed your hand, so even if you sold them crap, hahahah, it’s their crap now (or so you think.) Risk must be assumed only by people who can understand it and manage it and who are exposed to the consequences of their decisions. (Ability to manage risk, but knowledge that if they don’t they will get hurt.)

Now let’s talk about this idea that the Fed should basically regulate everyone, with the SEC occasionally peeping over it’s shoulder to see whether market manipulation is ocurring. This is necessary because there are, as Obama points out, no longer clear cut differences between banks, insurance companies, investment banks, brokerages and so on. The repeal of Glass-Steagall put an end to those differences. Glass-Steagall, remember was put in place during the Great Depression to stop another Great Depression from occuring. One of the things that people who lived through the 20s believed caused the Great Depression was not having clear cut boundaries between the businesses, again so that risk was divided appropriately and so that fewer companies became “too large to fail”.

But somehow we think we know better than the people who lived through the last Great Depression; the people who lived through the 20’s and the last great market crackup. So we’ve repealed most of Glass-Steagall and allowed everyone to be in everyone else’s pockets, huge financial conglomerates to mushroom into monstrosities, and allowed unregulated “innovative” financial “products” like collateralized debt obligation (CDOs) to grow into such monstrosites that financial markets were huge multiples of the entire real world economy.

Then it all comes crashing down and people claim to be surprised.

Enough, already. Yes, the world is not exactly the same as it was in the 20’s and 30’s, but we didn’t start having these disasters till after Glass-Steagall and other Depression era securities laws started getting repealed. First set in the 80’s, followed by most of the remainder in 99.

It’s time to break up the great financial conglomerates. Force them to cut themselves up and divide back into brokerage houses, investment banks, retail banks, insurance companies and so on. Put them all under the clear control of regulaters. Reinstitute Glass-Steagall, with very mild modernization, and get rid of most complex derivatives, excessive leverage, the carry trade and so on.

Obama was right during the primaries, the philosophy of the past 28 years has been a failure. Why don’t we, why doesn’t he, treat it as so, and re-institute what worked, re-regulate, then slowly modify from there, with complete transparency and strong regulation.

Financial markets exist to serve ordinary Americans and non-financial American businesses. They haven’t been doing that properly. Time to make sure they do.

This is a repost from September 16th 2008.  Very minor changes made to indicate when Obama said it, otherwise it stands the test of time remarkably well—which should tell you that nothing has been done since then.  The greatest economic disaster since the Great Depression, and a year and half later nobody has tried to fix what caused it to happen.  Priorities, priorities…

Worth more dead than alive—why and how credit default swaps need to be insured

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On March 11, 2010

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Dean Baker has up a good post on credit default swaps (CDSs).  He notes that CDSs transfer risk from the party best able to understand it to those who don’t understand it and that CDSs often don’t, actually, provide useful information on default risk.

Credit default swaps, at the end of the day are just insurance.  They insure against loss of money due to default.  Thus, they should be regulated like insurance.

Ae standard rule of insurance underwriting is that someone buying insurance must NEVER be better off if the event occurs than if it doesn’t.  Ideally, they should always take a loss, the insurance should not make them completely whole.

This means, if you want to keep CDSs (and I’m fine with banning them outright), that:

1) no naked CDS’s should be written. ie. you can’t bet on a company going under unless you have loaned money to that company.  You can’t sell a CDS to someone who doesn’t have that risk.
2) you cannot have a CDS whose value equals the value of your loans, otherwise you will want the business to fail.  I would suggest an absolute maximum of 80% of the value of the loans.  There’s a case for less.

I used to work in life insurance.  In life insurance there are many studies which show that people who are worth more dead than alive, tend to die more often than they should.  I am entirely confident the same is true of companies and government debt defaults.  Since companies defaulting when they could survive is not in the public interest, credit default swaps need to be regulated so that it isn’t in the interest of holders of CDSs to put a knife into companies which would otherwise live, or to yawn and say “nope, not making a deal, we’re better of with you dead.  Too bad what happens to the unsecured creditors, workers, stockholders and everyone else.”

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