Twofish's Blog

December 20, 2008

Sophisticated investors – aren’t

Filed under: finance — Tags: , — twofish @ 10:56 am

The question I’ve heard asked is how could so many “sophisticated investors” be duped by Madoff.  The answer is simple.  Just because you have money doesn’t mean that you are sophisticated.  You can just be used as easily fooled as some who is poor.  Perhaps more easily fooled, because a lot of poor people feel less pressure to present themselves as smart or sophisticated as rich people do.

Part of all of this is has to do with the American ideology of wealth.  There is the assumption that if you are rich in the United States somehow you did something to deserve the money.  It’s because you are smarter or faster or something else.  The problem with that view is that it isn’t true.  There is a huge amount of luck in how rich people turn out to be, and this involves what family you were born into, who you happen to meet, and a lot of different issues that you have no control over.

But the ideology that people with money somehow deserve it, leads to the idea that people with money happen to be wiser or more sophisticated than people that don’t, when in fact people with more money just have more money.

December 12, 2008

Incentives in US and Chinese corporations

Filed under: china, finance — Tags: , , — twofish @ 6:18 am

RBG: This is very interesting, but I cannot quite picture what kind of incentive structure would encourage such behavior. Could you please give me some example?

That’s actually quite simple. You need to ask what situation personally benefits the managers that make decisions. With Chinese companies, the more money you have in your bank account, the higher the salary and benefits of the managers. If you have large amounts of cash in the bank, you are more able to pay yourself large salaries and give yourself a better car. It doesn’t matter to the management where the cash comes from, but as banks have tightened lending, it becomes harder to use bank loans to create large cash accounts, so the tendency has been to hoard cash from operations. Also it’s not the ratio that matters but the absolute amount of cash. You can have company with huge amounts of cash, but even larger amounts of debt.

By contrast, American managers are rewarded if they have high stock prices and you have high stock prices come from having large amounts of return on equity. This encourages American companies to borrow heavily and have as little in cash reserves as possible. Also US corporate law makes if very dangerous for a large company to have large amounts of cash because any company with huge amounts of cash is susceptible to a leveraged buyout.

The theory behind American corporate governence comes from the University of Chicago is that by rewarding companies based on profitability that you are encouraging efficient use of capital, and unencouraging people not to keep capital and encouraging people to move capital from low return uses to high return uses.

The problems with this idea are that:

1) you get high returns by boosting risk, and by boosting risk, you are putting the people you are borrowing from at risk

2) if you are highly leveraged, you are very vulnerable to economic shocks, and

3) this sort of structure encourages people to borrow short term liquid instruments to fund long term illiquid investments, once this funding runs out, you are in some serious trouble.

My belief is that Chinese companies and banks will find themselves in better shape than American companies and banks because the companies that were not shut down have large supplies of cash and hence are more shock resistant. Being shock resistant is important since it gives you time.

If you are highly leveraged, you could go from seemingly healthy to dead in a few days (see Bear-Stearns and Lehman Brothers) and if you have an economy which is highly leveraged you run the risk of a domino effect that can bring down the entire financial system. By contrast, if you have a lot of cash, and something bad happens, you have a few weeks, months, or in some cases years, to do something about it.

The contrast here is Chinese banks which were far more insolvent than Bear, but in which the government had a decade to deal with the problem, because unlike Lehman and Bear, they had huge cash reserves. Another contrast is between GM and Toyota. Both of them are seeing extremely large declines in sales and both of them are seeing huge losses. The difference is that Toyota has cash reserves whereas GM does not.

I’m feeling fine about the economy next year. We are going to see a very nasty recession with massive job losses and deleveraging. The reason this makes me feel fine is that two months ago, we were on the brink of something much, much worse in which rapid uncontrolled deleveraging was close to destroying the entire world financial system (and I mean this literally). One way of making you feel alright about something bad, it to show you something much, much worse, and we’ve already had enough deleveraging to avoid total meltdown.

Also, I do not think that trade will be a big issue next year. You will see a lot of bailouts, currency games, and capital protection, but I don’t think that either the US or China will call for anything that would require leaving WTO. The reason is that most jobs in the US are dependent on the world trade system being intact, and anything that destroys trade will kill jobs in the US. Things would have been very, very different had things completely self-destructed in September, in which case there would have been no interest in keeping existing jobs, because all of them would have disappeared.

This is also why I think GDP and import projections are bogus since this quantity depend on unforeseen and perhaps unforseeable events. It was a funny moment when the rating agencies downgraded Lehman’s rating from investment grade, several hours after the default.

October 25, 2008

More about failing gracefully

Filed under: finance — Tags: , — twofish @ 6:01 pm

I think that there is a huge misconception here about what happens when a company “fails.” When a company goes bankrupt, the first thing that happens is that you infuse the company with “debtor in possession” financing. If you don’t immediately infuse a failing company with emergency cash, then everything will fall apart quickly, and the creditors will end up with nothing.

Immediately after Lehman went bankrupt, it got an emergency loan of several billion dollars in cash to keep itself operating while people figured out what to do with it. People are willing to lend to bankrupt companies, because the bankruptcy laws insure that those loans will be repaid regardless of what the balance sheets look like. Also bankruptcy laws *encourage* these sorts of loans in precisely to prevent a bankruptcy from destroying suppliers, employees, and yes even creditors.

So yes, I agree with Ms. Schwartz that what we have is a solvency problem rather than a liquidity problem, and that the thing to do is to let the bad banks “fail.” The difference is that people don’t have an accurate idea of what a “corporate failure” looks like. The problem with using standard bankruptcy laws with financial institutions is that you not have a company that goes bankrupt, you have an entire system, so a lot of what has happened are ad hoc efforts to adapt the concepts of bankruptcy to the financial system, and one of those concepts is to deal with a bankruptcy by flooding the company with enough money to pay for its immediate cash requirements so that people will still do business with it, and so that you have time to figure out what to do with the rest of the company.

One bit of annoyance I have with people in academic economics is that they seem really out of touch with the day-to-day activities of how markets operate. If the solution to the problem is “let the banks fail” (and I think that it is), then the question should be “what are the standard procedures for dealing with corporate failure” and standard operating procedure is to put the company under the control of a government official (i.e. usually a bankruptcy judge) and flood the company with immediate emergency cash under the oversight of that government official. We have to change the play book somewhat but what is going on right now in the financial markets looks a lot like a bankruptcy proceeding.

The importance of failing gracefully

Filed under: china, finance — Tags: , , — twofish @ 5:13 pm

Also one reason I’m somewhat optimistic about the informal finance sector in China is looking at how well the informal finance sector in the United States (i.e. hedge funds) are doing.  Yes hedge funds are falling out of the sky left and right, but it’s not causing a financial crisis, now the way that they did ten years ago.

There are two reasons….

The reason for this is that hedge funds can do something that banks can’t, which is to shut their doors to redemptions.  When you go to a bank and demand your money, they have to give it back, but if you put your money in a hedge fund, there is a contract clause that limits the amount that people can redeem hedge funds.  Typically, what happens is that the clause says that only some percentage of people can redeem hedge funds on one quarter, and that if that quota is filled then you have to wait to the next quarter to get your cash.  So instead of having a fast train wreck, you have a slow motion train wreck, which is a good thing because it allows the markets to adjust.

The second reason is that hedge funds are not leveraged as much as they were a decade ago.  When LTCM fell, it was leveraged at 100:1.  Today no prime brokerage will extend that much credit, and the Federal Reserve will not let a prime broker extend that much credit.  The maximum leverage that a prime broker will allow a hedge fund is something like 10:1, and that was reduced to something like 3:1 in the current crisis.  This is important because if a hedge fund starts having problems, the first reaction is to “double up the bets” which means that when things finally collapse, it could take the entire financial system with it.  If you leverage is limited, then if you start having problems, then the bank calls you put and demands that you put up more capital.  This could lead to a “death spiral” in which the hedge fund has to fold, but in that situation it folds quietly without destroying the financial system.

Now if you look at the informal sectors in China and look at these two factors (ability to limit redemptions and leverage), they look more like hedge funds in 2008 than hedge funds in 1998.  In particular, because the informal sectors are quasi-legal or illegal, you can’t use them as checking accounts because if your a check written against a informal account bounces, you have no legal recourse.  This means that if you want your money, an informal money lender can do what banks can’t do.  Tell you to come back tomorrow.  Also, because the informal sectors are quasi-legal or illegal, this means that there are limits to the amount of leverage that they can have.  Now I’m sure that there are all sorts of complex and tricky methods that people us to get money out of the formal system into the informal.  But the important question is whether or not you can get the huge amounts of leverage that create a crisis that is big and fast, and my sense is that in a crisis, the mechanisms that people use to tunnel money from formal to informal sectors will fall apart, which causes things to fall apart before you have huge amounts of damage.

This also gets at two things that I *don’t* think are issues:

1) Transparency – Hedge funds make a good test case for financial theories because they are unregulated and non-transparent.  Transparency is usually a good thing, but in the case of a bank run, it can be quite a bad thing, because people see people losing money, and this generates a panic.

2) Monetary policy – My thinking is highly influenced by Hyman Minsky, but I think one point of Minsky is lost and that is that boom-bust cycles are *inherently* part of market economics, and that it results from the dynamics of how these systems operate.  Booms naturally create risk seeking activities that will fall apart when the boom turns into a bust.  I’m also more interested in looking at what is political possible.  Yes, the problem may be solved by having people be less greedy or by tightening credit, but it is hard to take away the punch bowl when the party is going, and solutions require that people behave in ways that they don’t want to are not solutions.

Academics often come up with solutions that are politically not workable, and when you come up with a policy that people just don’t want to do (restricting credit in boom times is one), the reaction tends to be to curse the politicians and then figure that people deserve what they get.  I don’t think this is a useful reaction, and if people want accept plan A, I think the thing to do is to think of Plan B, which they might accept.  If they don’t accept Plan C, then you go with Plan’s D, E, and F.  Plan F might not create a perfect utopia, but I don’t think that perfect utopias are possible with imperfect people, and trying to make people perfect causes more problems than it solves.

So my thinking involves less trying to tell people to be less greedy in the boom times, but rather thinking ahead to the time in which everything falls apart, and trying to structure things so that you reduce the amount of damage when you have a bust.  If Minsky is right, then things *will* fall apart every few years, and the goal is to make sure that when things fail, they fail gracefully.  This makes it much easier to reduce the craziness when times are good, because setting things so that things fail gracefully reduces the desire to keep the bubble pumped out, and to engage in increasingly desperate “doubling strategies”.

October 19, 2008

How to take over the world

Filed under: china, finance, wall street — Tags: , , — twofish @ 5:41 pm

black swan: The solution is so simple. Instead of having the Fed/Treasury insure the new senior debt of the nine banking institutions that sheltered the architects of our present worldwide solvency crisis, have them insure muni bonds.

Not so simple. If you insure municipal bonds, but don’t insure the banks, then you don’t have anyone to underwrite the issuance of the bonds. What typically happens when a municipality wants to float an municipal bond is that they go to a syndicate of investment banks that buy the bond, and then the bank takes the bond and sells them on the credit markets. If you insure the bonds, but the banks aren’t willing to underwrite them beause they have no cash, then it’s pretty useless, since you have no mechanism to sell the bonds.

black swan: I believe the Treasury is not talking about doing anything like this, because the Treasury is Goldman Sachs (Paulson, Kashkari, Wilson and Forst).

Precisely. They know the securities markets well enough to know that some things just won’t work. This is a big problem that I’m not sure how to deal with. Anyone that really understands the market is heavily involved in it and is going to have connections, left and right, and hence conflicts of interest. Anyone with no conflicts of interest probably doesn’t have the experience needed to do the job. Another problem is that if you need someone to do a job quickly, you find someone you know and trust, but this tends to squeeze out competent people that you don’t know, and the people who Paulson trusts are precisely the people that a lot of voters *don’t* trust.

I’m not that worried about Goldman-Sachs taking over the world, since if Goldman-Sachs starts acting out of line, the other big investment banks will start screaming. Of course, then there is the valid question of what you do when the big investment banks collectively act out of line.

black swan: There isn’t a modicum of evidence to suggest that any of the Treasury’s ‘fixes’ are done to benefit the US taxpayer.

We’ll see in a year. Goldman-Sachs is making one of those “bet the firm” bets that they are famous for. If three years from now, the economy is in great shape, and you point to the voter that Goldman-Sachs is in control of the Treasury Department. They may react with “Great!!! We need more people from Goldman-Sachs running the world. I want my kids to work for Goldman-Sachs. God bless Goldman-Sachs” If three years from now, the economy is in a depression, then Congress is going to hold lots of hearings on cronyism and people will be demanding human sacrifices.

The first case may sound odd, but there is precedent for something like this. At the start of the Great Depression, a small group of people figured out that they that could run the world by putting key people in charge of the economic infrastructure of the United States, and if did it competently that they would amass more power and wealth than anyone could dream of, and they could do it in a way that the general population would actively support their efforts. These people were in charge of running Harvard, Yale, Princeton, MIT, Stanford, University of Chicago, etc.

September 30, 2008

Cry wolf

Filed under: Uncategorized — Tags: — twofish @ 12:58 am

There is the story of the boy who cried wolf.  One day the wolf came and no one did anything because they boy had cried wolf too often.  The wolf is finally here, and after hearing politician after politician talk about the end of the world, when you finally have a crisis that can cause the end of the world, no one believes them.

What happens next depends on how quickly things unravel versus how quickly people just get over their anger and realize how bad the situation is.  One reason that I think Paulson’s bill failed was that there really hasn’t been a bad impact to the economy, and I think that things will have to get a little worse before people really realize that the wolf is out there.  I think the challenge now is to have things fall apart slowly so that as people realize that this isn’t the usual politics, things don’t get so bad that they are unfixable.

September 28, 2008

Reports of the death of Wall Street have been greatly exaggerated

Filed under: wall street — Tags: — twofish @ 3:52 am

I really do think that people are being much too premature about the death of Wall Street.  Sure a lot of the stupid craziness is going to end, but that isn’t necessarily a bad thing.  Yes the new institutions that are going to be running Wall Street may be much less highly leveraged, but you can make up for lack of leverage with volume and as long as the underlying economy is more or less sound, you can find volume.

This might sound odd.  Two days ago, I was saying “Oh my God, we are doomed!!” and now I’m talking about the economy being fundamentally sound.  It’s there a contradiction, here?  Not really.  Think of it as flying on an airplane.  There isn’t that much difference between a smooth comfortable ride, and a life threatening situation in which you end up dying in a huge fireball.  The sense that I had a few days ago, was that of a passenger strapped into an airplane seat, entering a massive thunderstorm heading toward a mountain, and then suddenly seeing the pilot with this crazed look that suggests that he might be drunk or suicidal.  Once it becomes clear that the pilot isn’t drunk or suicidal, and once the airplane suddenly swerves and misses the mountain, then I can finish vomiting and try to relax.

The fact that there is no contradiction between “the economy is fundamental sound” and “oh my God, we are all doing to die” is what makes things like the Great Depression rather tragic.  In the United States in 1929 (or Japan in 1988), there was a lot of craziness, but you had an economy with factories, jobs and employment, and the fact that things spiraled out of control shows how a financial crisis can turn into an economic crisis if that crisis isn’t handled very carefully.  To use another metaphor, if you cut off someone’s oxygen, they are going to die.  It’s true that if you are unhealthy, you are more likely to have your oxygen cut off, but if someone dies from lack of oxygen, that doesn’t mean that they were basically unhealthy to being with.

Hedge funds not going boom

Filed under: finance, politics — Tags: — twofish @ 3:32 am

One thing that is interesting about the mess on Wall Street is how hedge funds didn’t go boom like they did in 1987.  There are reasons for this, the main reason of which is that hedge funds are nowhere near as leveraged as they were in 1987, and without leverage, it’s less likely that you will end up with a financial crisis, and much, much less likely that you will end up with a financial crisis quickly.

The interesting thing is why hedge funds are less leveraged, and a lot of that has to do with prime brokers that lend hedge funds money.  Prime brokers are a lot less willing to lend hedge funds large amounts of money sight unseen than they were when Long Term Capital Management blew up, and the main reason for this is that the prime brokers are overseen by government regulators such as the Federal Reserve and the SEC.

Now the world seems to be saved for the moment, and we start turning over to what worked and what didn’t, and what sort of regulatory scheme that we need, and I think one thing we need to look at is how hedge funds generally didn’t manage to blow up.

September 21, 2008

Thoughts about the Paulson plan

Filed under: china, finance — Tags: — twofish @ 1:44 pm

It’s actually quite simple really.  Congress gives the Secretary of Treasury a $700 billion blank check to do whatever he thinks he should do to fix the problem.  One reason I think that he is trying to get this done now is that it’s not clear who exactly is going to be using that power, and it’s going to be much harder to get people to support something once they realize that their guy isn’t going get to use the power.

The thing that bothers me is the term “Gulf of Tonkin Resolution.”  I’m quite worried that this transfers a huge amount of power to the Secretary of the Treasury without much oversight.  The powers are theoretically limited to two years, but the bill lets the Treasury Secretary write contracts that may likely bind the United States for quite a bit longer than that.  I’m especially worried that the powers in the bill will be used before the new President takes office. Part of what I’m trying to figure out is what the conspiracy theorists will say in about a year (hi Naomi Klein) and set things up so that they will have less ammunition.

If the mortgage assets get auctioned off to banks and private equity firms that make a large amount of money on this, then I don’t want there to be a “well Paulson and those evil banks planned this all along” mantra.  One thing is that it is likely that banks and private equity firms will make a large amount of money on this.

Right now people are willing to get rid of anything they can.  It’s called a “fire sale.”  It’s likely that they are going to end up selling some very good assets at very cheap prices because they just want out.  In crisis, people want cash right now, so have a house on fire, you can make a lot of money by paying for the assets, putting out the fire, and then reselling the house, which is what I think is going to happen.  The thing about a lot of these assets is that they are actually worth reasonable amounts of money if you are willing to hold them for 30 years or so, but they are almost worthless if you want cash now.

Personally, I think that there ought to be some changes that the next administration puts in:

1) soak the rich – This is a taxpayer supported bailout so we need to hit the right taxpayers.  A surtax on salaries over $1 million/year, capital gains surtaxes on profits over some large number (say $300,000/year) would help put the pain where it should be put.  Also a large tax on golden parachutes would be useful.  If a company has to pay an executive $15 million to leave then fine….  It would be good to take say $2 million and put it into a fund to clean up that executive’s messes.

2) easier personal bankruptcies – first there is this issue of social fairness.  Why can’t ordinary people wipe out their debts if the big banks can.  There is also a more important reason.  If the big banks had been hit by a huge wave of early bankruptcies and foreclosures, this would have given them a much early signal that maybe they were doing things that were stupid.  As it is the lack of bankruptcies meant that you can people stuck paying loans that they the couldn’t pay and it was going to end up in tears.

3) higher capital requirements – People are talking about “more regulation” but the question now should be “what types of regulation.”  The big one I think are higher capital requirements.  The problem with bans on things like complex derivatives is that they are easy to get around.  Statements that you must not do something cause people to find all sorts of clever ways to do it.  However, if you say that you must have X% of capital reserve and then define things careful so that when people cleverly try to get around the regulation they end up doing useful things, then when things go bad you have an insurance fund that you can go to.

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