Friday, September 26, 2008

Takeshi Kovacs

Finally managed to get through Altered Carbon, Broken Angels and Woken Furies. I can see why Hollywood optioned the first book (AC) - there is enough sex and violence to satisfy the average American audience. AC was "fresh" and "gritty" and "dark" and I enjoyed it as well as the novel concept of "resleeving" and that the UN was now an "enforcer". The subsequent books seemed to gradually go downhill for me: not in terms of the quality of the writing but the novelty of the first book was so great that it seemed hard to maintain that level. BA still had its twists and turns and surprises but not as much as AC. The introduction of the Martians was perhaps meant to be novel but it didn't seem to grab me as much as "resleeving". Perhaps I'm not as interested in alien life as much as technological concepts. By WF, it began to feel like Richard Morgan didn't really have anything new to offer. Bringing Quellcrist Falconer (who has been in the background of all the previous book) back to life via Martian technology (as a follow-up to BA) was again perhaps meant to be novel but didn't seem to register with me. WF also did not seem to have as many surprises as the other two and felt like the weakest book. I'm hoping that if there is a next Takeshi Kovacs novel, it will be better than the third (but in my mind it'll be hard to beat AC).

"Resleeving" has the added advantage of letting a person store his or her personality into a "cortical stack" which can be transferred to a new "sleeve" thus allowing them to "live" several hundreds of years or until the stack is destroyed. Even though the real time difference between AC and BA was 30 years, technologically and socially very little has changed which seemed hard to believe. Perhaps he was making a point that nothing really changes in BA - wars always occur and there is always a struggle for power but I was hoping for something fresh technologically. Perhaps I am also a little sensitive but the dialogue about UN missions on Sharya (BA, WF) and Beards (WF) smacked a little of Islamaphobia. I think though it was meant to be against religious fundamentalism in general but it was a little too overt for me.

And if it were made into a movie, I'd probably see it. Will it be a blockbuster the way Terminator was? I highly doubt it. I don't think any sci-fi movie will ever approach the Terminator movies. Those were the years when violence was "in" - Die Hard, Rambo - these days I don't think any movie that is violence filled will pull in crowds the way they used to. As for sci-fi, the last blockbuster was probably The Transformers and that was based on a known concept. The Matrix is probably a better comparison to the Kovacs series but that also seemed to suffer in terms of plot by the sequel. This movie if it ever gets made will need to build some buzz and that's hard to do.

Thursday, September 25, 2008

Inside Poultry Farming

An incredible look (for me) inside poultry farming on Maryland's Eastern Shore by author and chicken farmer, Tom Horton:

We re going to see Elvis. I'm following geneticist David Pollock down a country road on Maryland s lower Eastern Shore where an unmarked turnoff leads to a compound locked behind sturdy fences and surrounded by forested swamps. We strip, shower, shampoo, and don sanitized clothing, then slosh through a long pan of disinfectant before approaching the inner sanctum. Lusty cock-a-doodling erupts as we enter the domain of some of the biggest chickens you ll never see: The great, state-of-the-art roosters sequestered here are too valuable ever to leave. They are the source, the future of all chicken from tandoori to Kentucky Fried, barbecue to coq au vin.Each rooster struts in his own pen, shared with eight hens which he must mount at least 40 times a week to produce a flow of fertile eggs. Should he falter, a pen full of reserve roosters awaits. The laggard stud is euthanized and incinerated on site we can t risk competing poultry companies getting his elite genes, Pollock explains. ...

... Lou Ann can raise a chicken nowadays to more than four pounds, twice the weight of Cecile Steele's [in early 19th century], in 42 days versus 116 back then and on half the feed.

For the flock of 90,000 chickens that represented nearly a sixth of her work year, she [farmer, Lou Ann Riely] made around $11,000, compared with maybe $26,000 had she been the top grower that week. What happened? The flock before was a near record setter, she says.

... in 1925, Japanese researcher Kiyoshi Masui proved that male chicks did have a copulatory eminence, though a mighty subtle one. To recognize it you had to look hard and recognize a lot of subtle variations. By 1938 the American Chick Sexing Association was operating training schools, though the demanding profession was to remain mostly with Asians (Japanese sexers were given special releases from WWII internment camps).

Lou Ann's flock undergoes no such indignity of having its hind ends probed. Most of today s birds, geneticist David Pollock explains, are bred to exhibit uneven wingtip feathers in females and even ones in males. Sexers today work faster and cheaper. The poultry companies can tell you precisely how much cheaper 4½ pennies per chick to sex the old way versus just seven-tenths of a cent with feather sexing.

... The crew at Lou Ann's are total pros; stooping, plunging gloved hands deep into white drifts of massed chickens, arising magically in a few seconds with four struggling birds head-down in each hand. A house man thumps the walls and shakes stones inside a Clorox jug to keep the panicky chickens from mobbing up and smothering.

The job's gotten more efficient and easier on man and chicken since I did it 40 years ago. Modern houses can be kept much more ventilated and closed so daylight doesn't make the birds go bonkers. And you can drive machinery through today s big houses. We used to carry our chickens to a truck outside, where the birds were roughly handed up and jammed into wooden coops. Now a forklift follows the catchers, bringing and removing cages into which they slide the birds. The crew of seven catchers fills a tractor-trailer with 7,000 chickens every 45 minutes. They will pick up 40,000 to 60,000 chickens before their shift ends.

Today's catchers are better trained than we were and constantly evaluated to minimize bruising and breakage among the chickens they catch. But for labor, economic, and animal-welfare reasons, the Holy Grail for poultry companies remains a machine that can automate catching to match most other phases of the industry. Perdue tried years ago, but the machines couldn't take it, couldn't keep up . . . the dust, the corrosion, breakdowns; our crew'd catch two loads to every one for the machine, recalls David Marshall, 42, a compact man with the effortlessly firm handshake that comes from picking up 2 million chickens a year for the last 25 years. Perdue says it is constantly testing new mechanized options. ...

The birds, still in cages from the truck, enter a chamber dimly lit with red lamps to keep them as calm as possible. Workers, who get premium pay for this job, hang them upside down by their feet in shackles on a moving line, which pulls them into a warm-water bath where a mild electrical current stuns them. An auto-killing apparatus positions the moving, unconscious birds for a precise cut to the neck that opens veins and arteries to encourage blood drain but leaves the head on, spinal cord intact. This minimizes pain and struggling, veterinarians say.

Slaughter systems continue to improve. A gas process used in Europe and by one small US company renders chickens unconscious before they are hung for killing. It s almost the consensus among poultry scientists that this results in better welfare, says Paul Shapiro of the Humane Society of the United States, which is suing to expand the use of gas.

After a three-minute scald water hot enough to loosen feathers but not to blanch their skin the dead chickens enter the ear-splitting, steamy confines of the picking room. Seldom seen but key to the whole operation, it reminds one of the boiler room in the bowels of a great ship.
Two attendants constantly adjust long rows of roaring, rattling machines, each big as a pickup truck. These lash the chickens from hocks (ankles) to neck with thousands of corrugated rubber fingers, defeathering even the hardest-to-reach crevices with improbable delicacy. Twin lines of glistening, golden chickens whiz out into the main plant at a bird every half a second. A machine slices them off the line, cutting cleanly through their hocks, then automatically rehanging the birds by their drumsticks on another moving line. Long rows of golden feet march off in another direction, bound for China as chicken paws, a chewy snack.

Since the 1950s the processing industry talked about its automated plants, and these were marvels in comparison with the old New York dressed chickens sent to market with heads, feet, and guts all intact. But until the 1980s, most plants just had moving lines of chickens along which dozens and dozens of workers still performed by hand every minute job slitting throats, sucking lungs, scooping viscera, extracting crops and windpipes, snipping off such marketable organs as hearts, livers, gizzards; carving wings, drumsticks, breasts, backs. No more. About 80 percent fewer workers now staff the lines, and most of them are just backing up machines, says Rod Flagg, who manages Purdue s Georgetown, Delaware, plant. In the embrace of all this latest machinery of evisceration and disassembly, the chickens at times appear Borglike, half flesh, half steel.

Quality control, however, gets almost obsessive human attention in comparison with the operations I knew as a kid we d soak chickens overnight in ice water to disguise bruises. Each eviscerated chicken glides past multiple inspectors, its brightly colored entrails moving with it on a separate belt. The birds are checked for bruises, cuts, color, and other imperfections, while their viscera are examined for disease. When Perdue is running its premier Oven Stuffer Roasters through the plant, only about half are deemed good-looking enough to sell whole the rest are sold as parts. In one corner of the plant is a group of women in red hats, over whom Flagg says I have absolutely no control. . . don t even talk to them. They work for corporate quality assurance and are authorized to pull chicken products from all sectors of the plant, grading them from a thick book of specs for everything from fat scraps in the meat to unattractive wrapping. The women post results continually on a big bulletin board in full view of the plant. Supervisors are expected to watch it and make immediate corrections.

More in the article which first appeared in Washingtonian Magazine, Sept 2006.

Wednesday, September 24, 2008

End of the world scenario

Of what does a 20th century financial meltdown will look like? As far as Willem Buiter is concerned, this is the end of American capitalism as we know it. But not being a financial market participant I cannot quite imagine it. Let's put it this way: we've withdrawn all of our money market accounts. Here's the White House scenario:

More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession.

However, if I were a market participant I may be "too close to the problem" in the sense that I may think the entire universe revolves around financial markets. In any case, I want to play devil's advocate because it is more fun:
The devil in me claims that there is no credit crunch or if there is, it is minimally affecting Main Street. The credit crunch is only in the financial sector (interbank lending, overnight loans) and my assumption is that these are only to meet margin calls between financial institutions due to deleveraging and marking-to-market. Assuming that the government intervenes, will we actually observe a world where all the financial institutions fall like dominoes? Aren't financial institutions rational enough to realize that after one or two failures (okay, maybe five or six), they need to save themselves by renegotiating all of their positions?

Yes, there is a coordination problem because no one wants to be the first to say they are going to write down their losses and actually put their own valuation of their toxic securities because if they do realize the losses, the price of the security may increase due to perhaps less downward pressure as some of the possible supply is taken off the market. This is assuming that there is a downward spiral not only due to actual sales but in anticipation of future sales of these securities as institutions deleverage. Consequently, the volume of trade in OTC derivatives such as CDS and CDOs will shrink.

In my warped view then, the only participants will be hurt are those in the financial sector with very little spillover to the real sector except in the following cases:
1. Those employed in the financial sector will be the hardest hit as their employers go bankrupt. Does the payroll of the financial sector amount to $700 bn?
2. Retirement accounts and investments in the financial sector will see their returns fall.
3. A mild recession will follow as banks try to recapitalize.

What are the wild cards?
The intangibles like trust and confidence, i.e. Keynesian animal spirits. All the talk about calamity and end of the world will actually make people believe the end of the world is coming. Like our withdrawal from the money market funds. :) The foreign sector, i.e. all the SWFs that are holding U.S. assets. What would they do? With all the talk about systemic risk and the financial system "seizing up" there really has not been enough clarity about what it all really implies. The White House scenario doesn't lend itself to clarity, it's a scenario. What I mean by clarity is the following:
If we don't do the bailout then 80 percent of the banks will go bankrupt. 4 million employees in the financial sector will become jobless. Banks will stop lending to companies and entrepreneurs because .... (why? I actually can't think of any reason).

But continuing on,
Banks will stop lending and businesses will be unable to operate for lack of cash flow. An additional 50 percent of the economy in various sectors will close. Another 80 percent of the population will become unemployed. We will all fall to disease, pestilence and death, etc.

In the end, this bailout and a lot of others are justified on the assumption of an end-of-the-world scenario: a small probability of large negative losses. (Some have referred to this as the peso problem.) What we still lack is a good way of analyzing such situations in particular, estimating probabilities of catastrophe.

Another way to look at it is the following: Is it cost effective to use $1 trilliion to prevent a crisis that never occurs? (Assume that all of $1 trillion used to buy toxic securities/bailout is not recovered.) I think we can get a partial answer on the costs using analyses of lost output from previous crises by making the assumption that a crisis will occur. Assuming US GDP is about 14 trillion, 1 trillion of 14 trillion = (1 x10^12)/(14 x 10^12) = 1/14 => 7 percent of GDP. Assume that this is only a banking crisis that does not result in a currency crisis, and that the crisis lasts for 5 years and for each year of the crisis, output falls by 5 percent with no bailout. Now assume that the bailout cost is 10 percent per year (no one really believes that $1 trillion will be the final word on this) and manages to "cushion" the crisis so that output falls by only 4 percent per year and the crisis last for 4 years - is this still money worth spending? From this point of view then my opinion about the bailout can change. For instance, what is the breakeven probability in a series of changing assumptions to the above? Am I comfortable with the probabilities?

An old post on Catastrophe: Risk and Response uses cost-benefit analysis.

But what about the role of CDS and CDO?

This is from an old post by Naked Capitalism:
Despite the use of the term "swap," CDS are really insurance contracts. A protection seller (effectively, the insurer) agrees to make a payment to the protection buyer if specified bad things happen (a "credit event" usually defined as bankruptcy or failure to pay) to a "reference entity" which can be a company ("single name") or an index. See here for more detail. Now while it may look like the risk being traded here is default risk, there is a second risk: counterparty risk. CDS are the largest credit derivative product, and they are traded solely over the counter. That means that the CDS agreement is only as good as the protection seller that wrote it.
...
What seems odd, given all the foregoing, is that Swiss Re, admittedly a new player but one with a small book, is the only concern to have reported CDS losses. Someone has to be on the other side of the eyepopping trades entered into by Paulson & Co. and for that matter, Goldman, which has been short mortgage-related credits. That raises the question of how much latitude financial firms have in marking their derivative books (and auditors have no hope of getting to the bottom of their economics).The other open question is what happens to the CDS market as banks continue to shrink their balance sheets? CDS have become integral to the way a lot of players measure and manage credit risk, but if the market becomes illiquid, there will be a lack of reliable price information and a dearth of protection sellers to write new contracts.

The link in the above post is also useful. Posted in 2007, it looks almost prescient now and the blogger holds his own against comments from CDS traders. (Yes, a little sensationalist as some have commented but now...)
1. There are too many CDSs being written by speculators against relatively few borrowers, just as the probability of default events is increasing sharply. Therefore, the possibility of a generalized financial infection through the CDS medium is substantial and rising.
2. CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.
Putting the above two points together, we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

From Seeking Alpha in June of this year:
Participants in modern derivatives markets may not have devoted sufficient time, resources and systematic thought to the subtleties of the theory of counterparty credit risk, OxAn says:

"The concept of ‘wrong-way risk’ is as old as the modern derivatives market. Yet in part because its systemic effects are relatively difficult to model, the threat it poses in particular derivatives transactions — and to the financial system more generally — is often overlooked."

"Over the past year, wrong-way risk has chiefly been a problem on credit derivatives markets. However, it could easily worsen, or spread to other markets — such as energy derivatives."

This variety of counterparty risk can be effectively priced and modelled, but this is very time consuming, expensive and often does not fit well with other forms of mathematical risk modelling, OxAn says. The risks associated with wrong-way risk have not been dealt with effectively, and are increasing.

Moreover, the most pernicious type of counterparty risk — the danger that counterparty transaction risk might increase for all counterparties, simultaneously — has become systemic. This threat, known as ‘wrong-way risk’, has become a chronic problem in the developed world.

"This situation represents both a failure of risk management modelling and a failure of imagination."

The trouble with credit derivative hedges emerged due to the parlous financial health of some derivative dealers and the monoline insurers that, in effect, act as credit insurers. Dealers and banks are facing the unsettling thought that the credit default swap (CDS) hedges that they had entered into with monolines to help manage risk on their structured credit origination activities will become worthless if these troubled counterparties themselves lurch into bankruptcy.
OxAn says the key to quantifying wrong-way risk is to model correlation between contract values (across a portfolio of derivatives) and counterparty credit quality. The most common generic theoretical approaches include :

-simulation of counterparty default and exposure jointly;
-simulation of exposure conditional on counterparty default; and
-adjusting the expectation of (unconditional) exposure in order to approximate the risk expectation conditional on default.

Significantly, when wrong-way risk is modelled, it is often done via the last approach, due to the fact that it is less computationally expensive and time consuming, and it generates measures of exposure that risk managers find easier to incorporate into their overall risk management framework. However, given the gravity of the crisis, this approach may have been insufficient, OxAn says.

And finally, from Angry Bear after the collapse of AIG:
My thoughts on Credit default insurance.
1) You can hedge against default on bonds by buying a diversified portfolio of bonds
2) Prudential regulations do not take account of this fact, but rather include restrictions on total assets as a function of capital and on the types of assets which entities can own.
3) Credit default insurance makes it legal for regulated entities to own bonds whose rating is low. 4) it is no more effective in avoiding risk than is plain diversification, because a nationwide crisis will bankrupt the insurer.
5) it exists as a means of evading prudential regulation.

... What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ? If the original pools were already well diversified, they would be almost perfectly correlated so all tranches of the pool of pools would be middling risky (mezzanine). Were the original pools poorly designed or was the aim to get an AAA rating for a risky asset ? Even assuming the bond rating agencies are honest, they must work according to rules. I think it very likely that everyone knew that the senior tranches of pools of pools were risky (they paid higher than standard AAA rates) and that entities which weren't allowed to buy risky bonds didn't care.

That this was not a way of diversifying risk but a way to evade prudential regulations.

Jim Hamilton:
Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there's a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we've been fighting. But I think the uncertainty itself may be even more destabilizing.

Since the CDS and CDO markets are over the counter, this seems sensible but I suspect that requiring annual reports as a way of making things clearer while is a start is probably not going to be as helpful as we would hope. Didn't Enron issue annual reports?

What caused the current financial crisis

Causes abound:
Here's Rodrik:
Here are some of the culprits we regularly see mentioned:

1. A bubble in the housing market
2. The originate-to-distribute model of mortgage lending
3. Lack of transparency in structured finance and mortgage-backed securities
4. Lack of regulation of derivatives
5. Poor credit-rating practices
6. Fannie Mae and Freddie Mac straying from their original mandates
7. Implicit government guarantees for Fannie and Freddie
8. Lack of regulation of hedge funds and private equity
9. Inadequate capital requirements for financial intermediaries
10. The too rapid or generous extension of Fed credit to non-banks
11. The rescue of Bear Stearns
12. The failure to rescue Lehman

And some others:
1. Repeal of Glass-Steagall
2. Gramm-Leach-Bliley
3. Treasury Agencies: (Brad Setser)
4. Liberals and the Community Reinvestment Act

Jim Hamilton: Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.

But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.

Barry Eichengreen blames unintended consequences of Glass Steagall and borrowings from China. My opinion and Angry Bear says Never let economist use unintended consequences again. Economists excel (or should excel) in looking at how regulation affects incentives and either they've been sloppy or lazy or both.

Alternatives to Paulson plan

Or what needs to happen.
Mark Thoma has a summary:
1. Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer. The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly [and this leads to the "paradox of deleveraging", see Krugman's description]). By having the government trade for these frozen assets (some of which are perfectly fine) and replace them with safe, low risk or risk free assets, the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing.

That's an illiquidity problem. It's caused by toxic assets, the hidden ones freeze up the whole system since nobody wants to end up with them. Why give up cash unless the interest rate is really, really high, too high?

2. The other problem is solvency. Now, some people think that if you solve the illiquidity problem, that's enough, it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves.

Others think the solvency problem can only be solved with additional injections of safe assets - say cash or bonds - solving the illiquidity problem alone won't be enough.

I don't want to take chances, so I say (1) get rid of the toxic stuff, that helps the liquidity problems and gets credit markets moving again (they froze up severely after Lehman was allowed to collapse, that was a mistake), (2) add additional capital to help with solvency, this is extra insurance in case freeing up credit markets by solving the liquidity problem isn't enough by itself, and (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.

Use the 3R's from Naked Capitalism:
a) Recognition. We need to find out what the assets on the balance sheets of banks and other financial institutions are really worth, and what the balance sheets of the most troubled institutions look like under a regime of realistic marks.

b) Recapitalization. The US banking system needs a lot more capital. Credit losses are depleting equity capital, and deleveraging increases the required equity capital per unit of balance sheet capacity. So capital infusions are needed to avert a sharp contraction in lending.

c) Relief. In many cases, we need to restructure the loan terms of homeowners who lack the ability (or economic incentive) to service their mortgage. This isn't just in the interest of the home buyers, but it's often also in the interest of the lender (given the cost of foreclosure) and certainly in the interest of the macroeconomy (given the feedback effects between foreclosures, home prices, and economic performance)....In any case, recognition is only a start. In fact, recognition actually increases the need for recapitalization because it brings capital shortfalls out into the open. So it will be important to see how the Treasury proposal addresses this. Do they force banks to seek equity infusions from private investors in a specified time period? Do they simply "pay over the odds" for the assets (this would promote recapitalization but jeopardize recognition)? Is part of the program earmarked for the purchase of preferred stock in banks? Or is there a public/private partnership scheme such as an issuance of publicly financed puts in exchange for warrants for would-be private investors?

From Calculated Risk:
First, a recognition phase with complete transparency. Have private investors bid on some assets to establish market prices (some portion should be sold to the private investors to encourage bids), and then let the banks argue for their own valuations. Based on an analysis of these valuations, have the Treasury make an RFC type investment in the bank with a convertible debenture that would count as regulatory capital. This capital infusion would keep the banks lending (the primary goal) and the amount required would be far less than the amount needed to buy the troubled assets.

If a bank can pay off the debentures with interest - possibly because the assets perform as the bank expects, or perhaps by bringing in private capital - then there would be no dilution from the debentures. Otherwise the debentures convert into preferred shares and significantly dilute the shareholders - and then the government can sell the shares on the public market. Ideally the debt holders would take a haircut too (before the taxpayers), but that is probably too complicated. This alternative would keep the banks lending, minimize the cost to the taxpayers, and reduce moral hazard.

Krugman:
... the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

Luigi Zingales:
Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. ...

If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?
· First of all, there is a coordination problem.
Even if each individual debt holder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay.
· Secondly, from a debt holder point of view, a government bail-out is better.
Thus, any talk of a government bail-out reduces the debt-holders’ incentives to act, making the government bail-out more necessary.


Willem Buiter:
To get new capital into the banks, and to reduce leverage dramatically at the same time, I propose a mandatory debt-for-equity swap for all US financial institutions. For the most junior debt (subordinated or tier one debt), 100% could be swapped for equity. For more senior debt, the share of the notional or face value of the debt that is subject to compulsory conversion into equity (preferred or common stock) would be lower. Even the most senior debt should, however, be subject to a non-trivial ‘conversion ratio’ - 25 percent, say.

This form of debt forgiveness would not extinguish the claims of the current creditors, but would convert them into equity - a pro-rated claim on the profits - if any - of the banks. It would have the further benefit of diluting the existing shareholders - a desirable action both from the perspective of fairness (I was going to say equity!) and from an efficiency point of view: incentives for a repeat of past incompetence, reckless lending and mindless investment would be mightily diminished.

The proposal amounts to a compulsory re-assignment of property rights - a form of expropriation. So be it. Extreme circumstances require extreme measures. It is time for the creditors of the banks to make a more significant contribution to the resolution of the financial crisis and to the prevention of an economic crisis.

My own 2cent alternative?
Assumptions:
1. Financial institutions need to be recapitalized because,
2. "Toxic" securities are causing deleveraging.
3. "Bailing out" by paying "market prices" or book value for securities with tax payer money is unacceptable. Moral hazard, taxpayers should have an upside for bearing the risk, blah, blah, blah
4. Some "dictatorial" powers by Treasury will be necessary.

So here goes and these are presented as a menu of choices for the financial institutions.
1. Financial institutions should turn over whatever security they want to unload to Fed/Treasury for a loan a la IMF loans to countries in crisis. Part of the problem with having to pay "market prices" for the securities is the following:
There are private investors willing to buy these troubled assets right now, but the banks do not want to sell at those prices. Why? Some banks believe the assets are worth more than the current bids (it all depends on future house prices, and different banks and investors have different projections). And many banks are unwilling to accept the current bids because the banks would then be insolvent. (From Calculated Risk.)
With a loan, financial institutions can realize some gains and be given an opportunity to buy back the securities. The size and terms of the loan of course as in all bailouts are the details that can break any plan. With a loan, there is a risk that the firm will still become bankrupt which means that federal regulators will be appointed to monitor how the firm is run (i.e. IMF surveillance).

2. The financial institutions can turn over the "toxic" securities to the Fed/Treasury at zero cost to the taxpayer. The tax payers bear all of the risk. The firms are required to recapitalize by issuing additional debt/equity. Hence, some dictatorial powers are necessary.

3. Financial institutions can opt out and recapitalize on their own by issuing security and debt. Yes, this dilutes the interests of current debt holders and shareholders but it seems like fair is fair in bailouts. After all, countries who ask for IMF loans get all kinds of conditions dictated to them and this is nothing in comparison to IMF conditionalities.

4. Financial institutions who opt out should bear the risk of being nationalized. Debt holders will take a large haircut, equity holders will be wiped out, and all current top executives ousted with no pay. In addition, current executives bear the risk that the government will take legal action to recover losses by the institution through legal action. here is a precedent in Enron, but then Enron engaged in criminal activities. But if financial institutions do not accept any of the above shouldn't they be charged for reckless endangerment of the "foundations of capitalism?" (Already, Fannie Mae, Freddie Mac, AIG and Lehman are under investigation for possible fraud.) Again, the necessity of some dictatorial powers to "knock some heads" together. Yes, I realize that this threatens the "very foundations of capitalism" but then doesn't any massive bailout do the same thing? For all we know, this already is the end of American capitalism as we know it.

These proposals address mainly recapitalization. It doesn't guarantee that deleveraging will be halted with these steps. Again, the IMF tactics of raising interest rates to stop capital outflows is my analogy. Therefore,

5. Fed/Treasury should be given the power to call a moratorium on marking to market. See Thomas Palley via EV. Mark-to-market makes sense when the market is able to assess information but in a panic and with possible herding and informational cascades it makes more sense to suspend marking to market.

Note:
Brad Delong has a good recap of how policies should work. He would disagree with every single one of my above proposal. (I.e. This isn't the time for a morality play or punish someone for their excesses.)

Hmm, the proposal is sounding a lot like a rant. So here's another one:
Unfortunately, with a Wall Street man in charge of Treasury it is unlikely that such proposals will even be considered. At the end of this year, Paulson will be looking for a job and he doesn't want to be pariah among his kind. And I'm not the only conspiracy theorist:
From Bloomberg:
Goldman Sachs Group Inc. and Morgan Stanley may be among the biggest beneficiaries of the $700 billion U.S. plan to buy assets from financial companies while many banks see limited aid, according to Bank of America Corp.
``Its benefits, in its current form, will be largely limited to
investment banks and other banks that have aggressively written down the value of their holdings and have already recognized the attendant capital impairment,'' Jeffrey Rosenberg, Bank of America's head of credit strategy research, wrote in a report dated yesterday, without identifying particular banks.
Many banks may not participate in the Troubled Asset Relief Program because they haven't had to write down as much assets under accounting rules, meaning decisions to sell into the program would cause them to lose capital, Rosenberg wrote. Investment banks operate ``under a mark-to-market accounting model while commercial banks hold assets at cost until realizing a loss (or until they reasonably expect one),'' he wrote.

Wrapping my head around the RTC like proposal

I actually never considered that the Fed/Treasury would have to purchase the "toxic" securities in an RTC like bailout.

Here's Luigi Zingales:
The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt-forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

1. Removing assets from the balance sheet of the firms only decreases regulatory capital. Likewise, buying them at a steep discount forces firms to realize their losses and thus decreases their capital. From Krugman:
“Removing these assets from institutions’ balance sheets” — what an evasive phrase.
I mean, any bank that wants to remove toxic assets from its balance sheet can do it at a stroke — just declare them worthless, and poof! they’re gone. But of course, that would reduce confidence and capital, not increase it — ...
More from Krugman:
The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

2. This means that Treasury will have to buy the securities at "above market prices":
Paulson is trying to swap $700 billion of US Treasury assets in return for $700 billion of assets valued what I suspect effectively amounts to their original value when the asset was created. Presumably, once this swap was complete and the questionable assets were purged from the system, financial institutions could raise any additional new capital needed via private sources. Such a swap would make sense if the assets the Treasury was purchasing could be sold back into the market at some future date at their purchase price. But no one actually believes this is possible; those assets will undoubtedly fetch less than their $700 billion purchase price, and the taxpayer will eat the difference.

3. A lot of vitriol is directed to Treasury is asking for dictatorial powers in trying to solve this crisis. Again, from Tim Duy:
That Paulson should even propose that he be given authority that supersedes all other should be grounds for demanding his resignation. I am not prepared to anoint Paulson or Federal Reserve Chairman Ben Bernanke or anyone to the position of economic dictator, regardless of the danger to the economy. How ironic would it be if the unbridled push toward free market capitalism brought about the same dictatorship via economic chaos that a worried Frederick Hayek opined would be the end result of socialism in The Road to Serfdom?
From Interfluidity:
The oldest technique for the usurpation of power by the executive from the legislative is the manufacture of a state of emergency. That is not to say the present financial crisis is not actually an emergency. But the how the crisis is understood by legislators and the range of options by which it might be addressed have been set by Messrs Paulson and Bernanke. They have presented a single option, one more radical than seemed reasonable even at the height of the depression.
From Naked Capitalism:
This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse.

4. Again from Naked Capitalism (same link):
Losses on the paper acquired are guaranteed. This is not a bug but a feature. The whole point of this exercise is an equity infusion to banks. The failure to be honest about it upfront will lead to a taxpayer backlash (or will lead to the production of phony financial statements for the rescue entity, which will lead to revolt by our friendly foreign funding sources).

Taxpayers have no upside participation.

There is no regulatory reform as part of the package. This would seem to be a minimum requirement for a donation of this magnitude.

There is no admission that deleveraging is inevitable. This plan seems to be a desperate effort to keep bad debt from being written down. Yet the sorry fact is that a lot of these assets simply will not be repaid.

There appears to be no intention to do triage. The financial services industry, on the back of an explosive growth in debt, has reached an unsustainable size. The industry will have to shrink. Yet the Administration does not address this issue; indeed, it appears it intends to forestall the inevitable. Regulators need to decide who will make it, who won't, and figure out what to do with damaged institutions. Instead, the reaction is ad hoc.


5. Investors Consigliere considers the upsides:
Another potential defense of the Paulson plan: as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG. Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself. Suppose for instance that tomorrow Treasury buys AIG's entire CDS book at something close to market value--wouldn't it instantly make a lot of money on its $85 billion bailout, while over time perhaps making money on the CDSs?

Bottom line: It may be time to join the mortgage bailout protest.

Friday, September 19, 2008

Today and Yesterday

1. Three R's:
Yesterday: Reading, 'Riting, 'Rithmetic
Today: Reduce, Reuse, Recycle

(Works better today)

2. Anwar Ibrahim:
Yesterday: A onetime Islamist student radical ...
Source: http://www.nytimes.com/2008/09/14/world/asia/14malaysia.html
Today: Malaysia moved closer to a potentially momentous political transition on Tuesday as the country’s insurgent opposition leader, Anwar Ibrahim, asserted that he had secured enough votes to take power from the party that has run the Southeast Asian nation for more than 50 years.
Source: http://www.nytimes.com/2008/09/17/world/asia/17malay.html

Hope this works better today.

What I didn't know about AIG and CDS

Diamond and Kashyap writing on the Freakonomics blog may be the best primer on the subject so far.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.

Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

My question at this time that is not addressed: Did the failure of Lehman cause the failure of AIG? Perhaps indirectly by increasing the prices of CDS and thereby triggering margin requirements. I haven't seen anything that addresses this claim as yet. If this is the case then it must be that the Fed and Treasury underestimated the systemic risks of the Lehman bankruptcy. Alternatively, it is possible that this was deliberate in such a way that the Fed and Treasury would let institutions fail and intervene only when systemic breakdown is "near and present". In this case, if there are a chain of institutions A,B,C and the failure of A does not cause a systemic risk but causes the failure of B which also does not cause a systemic risk the Fed and Treasury are willing to let A and B fail up to the point when it triggers the failure of C which could cause a failure in the system.

My only introduction to derivatives is Introduction of Structured Finance by Frank Fabozzi, Henry Davis, and Moorad Choudhry where the authors espouse the brilliance of structured finance by informing the reader that whenever an entity wishes to issue a security and wants a better rating from the rating agency, it merely enters into a credit default swap. In fact they announce triumphantly that the entity can get any rating it wants (as long as they are willing to trade off a higher cost to enter into CDS).

The credit rating agency rates the security after all the satisfactory documentation has been generated and essentially gives the security a clean bill of health and collects its fee. As the underlying asset decreases in value, the same credit rating agency downgrades the security. If they were going to downgrade then why give the security an investment grade in the first place?
Ah, the credit rating agency says - what happens after we give the initial grade is out of hands. Well, I'm sorry but they don't get off that easily. It is the role of credit rating agencies to assess the risk of the underlying asset and if there is a possibility of a decline in value then it should be priced accordingly. Ah, but they don't want to displease the client - after all, they are the ones paying for the rating. It all smacks a little too much of a transaction where there are a lot of hand shakes, knowing winks and nods and everyone leaves happy. When the s**t starts to hit the roof, its everyone for themselves.

The role of credit rating agencies will also be scrutinized as this financial crisis unfolds.
Update:
Paul Wimott in the NYT:
I spend a great deal of time speaking to people in banks about their mathematical models. I know which are using good models (a very few banks) and which are using bad models (most banks). I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so. So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.

Too complex to fail


Economists View pointed to this picture above. The authors of Too Big To Fail have recognized this for a while now (as well as the risks posed by GSEs). It's an interesting thought - to come up with an index of connectedness - and I think these are already available somewhat in the form of social networks analysis and as one commenter noted - elements of graph theory can be used.

The main problem is access to this information and whether the Fed or anyone has the right to require all firms to send in this type of information. Recall that not just an financial institutions enter into derivatives contracts. AIG was an insurance company and firms like the Boston Beer Company enter into futures contracts for hops in order to lock in prices. Should they be required to report their positions as well even though they may have a "small" notional amount of derivatives (compared to financial institutions)?

From an information perspective, it seems like having a central clearing house for all derivatives might be the best way to attack the problem. This way all the information is centrally located.

And to try to take this a little further and try to operationalize it. Let's consider two institutions A and B. If the failure of A causes the failure of B and the failure of B causes the failure of A, then the "index of systemic risk" is 100 (or 1). If neither fails then the index is 0. What if the failure of A causes the failure of B but not the inverse so that if B fails A is still safe. Would this index be 50?

If there are 3 institutions, A, B, and C and the failure of A causes the failure of B and the failure of B causes the failure of C then again the index is 100. If A fails and neither B nor C fails then the index is 33 while if A and B fails but not C the index is 66.

The main issue then is not just connectedness (where connectedness is defined by whether "lines" can be drawn between two vertices(?) but also by how "degrees of separation" can be reduced so that in a sense we are all 100 percent connected) because in the above example, A could be connected to B (e.g. have derivatives with B) and B could be connected to C but C need not be connected to A (or vice versa). The main issue has and always had been how to trace the probability of failure of one institution to the rest of the institutions in the system. Here C is 2 degrees away from A but the failure of A also implies C's demise and thus the degree of separation is reduced to 1.

Just rambling thoughts here. A "working" example of using social network analysis has been in epidemiology. EPISIMS is an attempt to model the outbreak of small pox in Portland, OR. Some slides are also available. In epidemiology, when two people meet there is a probability that one will contract small pox from another. (The analogy to contagion or financial panic is that because one bank is related to another does not automatically imply that if one collapses the other will as well.) This probability varies with among other things the length of exposure. The simulation (which is agent based) tries to find the most effective way of preventing the epidemic by graph shattering, i.e. removing nodes. Weakness? Like many agent based systems it assumes that behavior is invariant to knowledge of the epidemic (contagion/financial panic).

More on financial regulation

From David Brooks:
We gotta have smart regulation that offers security but doesn’t stifle innovation. We gotta have rules that inhibit reckless gambling without squelching sensible risk-taking. We should limit excesses during booms and head off liquidations when things go bad.

It all sounds great (like buying a house with no money down), but do you mind if I do a little due diligence?

In the first place, the idea that our problems stem from light regulation and could be solved by more regulation doesn’t fit all the facts. The current financial crisis is centered around highly regulated investment banks, while lightly regulated hedge funds are not doing so badly. Two of the biggest miscreants were Fannie Mae and Freddie Mac, which, in theory, “were probably the world’s most heavily supervised financial institutions,” according to Jonathan Kay of The Financial Times. ...

We don’t even have a clear explanation about the past, yet we’re also going to need regulators who understand the present and can diagnose the future.

We’re going to need regulators who can anticipate what the next Wall Street business model is going to look like, and how the next crisis will be different than the current one. We’re going to need squads of low-paid regulators who can stay ahead of the highly paid bankers, auditors and analysts who pace this industry (and who themselves failed to anticipate this turmoil).

We’re apparently going to need an all-powerful Super-Fed than can manage inflation, unemployment, bubbles and maybe hurricanes — all at the same time! We’re going to need regulators who write regulations that control risky behavior rather than just channeling it off into dark corners, and who understand what’s happening in bank trading rooms even if the C.E.O.’s themselves are oblivious.

My thoughts are here and here. Some of these thoughts are that the reason a lot of derivatives come about is to evade regulation on capital.

Update: MR links to an old post that confirms this.
Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people...don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship.

Investors and operating companies buy derivatives for two basic purposes: speculation and risk transfer. A derivative, (a financial contract based on the price of another commodity, security, contract or index) either eliminates an exposure, creates an exposure, or substitutes exposures. That last one, substituting exposures, is important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives salespeople in the last two decades, only slowing down in the late 1990s. The fundamental reason for this is not because insurance executives were stupid, but because they manage their investments in a thicket of proscriptive regulation. Insurance companies have to respond to their national regulatory organization (the NAIC), their home state insurance department and the insurance departments of states in which they sell or write business. They file enormous statutory reports every quarter using special regulatory pricing, and calculate complex risk-based capital reports and "IRIS" ratios regularly. ...

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield.

...[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.

Update:
Jim Hamilton disagrees:
And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else's.

But here is Rogue Economist:
Building on a previous post I had on Basel capital adequacy standards, I’d like to add that this well-intentioned set of international standards also contributed indirectly to the current mess. Basel standards recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital, and in no way includes funds coming from bank deposits or bank borrowings. Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in equity capital. The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards. But raising bank equity does not happen in a vacuum. Just because a bank has sufficiently high deposits to loan out doesn’t mean shareholders will be flocking to provide it with new capital. To attract these investors, the bank would have to provide a comparable return to other investment alternatives. But to maintain the capital adequacy, the bank would have to redeploy this equity capital in low risk weight assets. Government securities have zero risk weight, but in the environment of low Fed funds rate, the liquidity that resulted ensured that government securities provided meagre yield. Certainly not enough to increase bank earnings sufficient to attract new equity holders. So a good number of banks and insurance firms chose to put these funds into the asset class available at the time that had the next to lowest risk weight , AAA-rated CDO bonds. Of course, the fact that these toxic CDOs made up of sub-prime loans were ever rated AAA by ratings agencies has already been widely discussed in public forums. But the fact is, banks and insurance firms, compelled by international best standards to maintain adequate equity cover, for loans in the case of banks, or for cover liabilities in the case of insurance firms, but also compelled by equity holders to provide the highest possible yield at reasonable risk, investing in AAA-rated CDOs seemed like a reasonable thing to do. Granted, much more due diligence should have been done on the underlying assets backing up these securities, but then, the presence of a rating meant that reasonable due diligence had already been done by experts on these matters.

What I don't know about the proposed RTC like solution

In an earlier post I was relieved that perhaps my idea of a RTC like solution was not that whacky after all. But I didn't know then and still don't know now:
Assuming that the same institutions who invested in these securities can classify them as toxic or possibly non-radioactive then a workout perhaps similar to the Resolution Trust for S&L can be created for the toxic securities (and its underlying assets -- again assuming these can be identified).

Can these securities be identified and if so what does this new entity do with these securities? Calculated Risk wonders the same thing:

The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market".

With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets.

In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk.

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

Another previous entity mentioned today was the Reconstruction Finance Corporation (RFC) that was created in 1932 by Hoover. A key purpose of the RFC was to purchase preferred stock in banks to increase their capital positions and expand their landing capacity. This might also be part of Paulson and Bernanke's "comprehensive plan".

A new RFC might help certain FDIC insured banks, especially banks with significant losses associated with Freddie and Fannie preferred shares. But since the first part of the plan - buying impaired assets at a steep discount - appears to reduce regulatory capital, a RFC preferred investment might be included to help boost regulatory capital. We will know more soon.

My other thought: Will the government by holding the toxic securities for a longer amount of time than originally intended eventually lead to these securities gaining in some value? My thoughts here are along the lines of the LTCM liquidity crisis (except that in this case, it is not a liquidity crisis) - if LTCM had enough capital to meet margin calls it would eventually have survived and made a gain in its positions. (I've heard this argument made, but is this true?)

My sense is that firms really do know how bad their securities are or at least have a rough idea. My assertion is based on this statement:
For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Or perhaps, they don't know what they have - here is Paul Wilmott, the quant of quants:
“You have traders and you have quants, and very rarely do you have someone who sees both sides,” says Wilmott, who considers this disconnect to be the root of the current crisis. The quants were using their models to value products that they had no experience trading, and the traders were dealing with products they could never properly value themselves.

“Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don’t understand them,” Wilmott wrote in a recent post on his blog. “And people are surprised by the losses!”

Thursday, September 18, 2008

Risk aversion and age

It seems like as I get older I'm also getting more risk averse. I'm wondering if this is true in general. I don't find results using asset pricing models very useful because it seems that these results might be contaminated by asset allocation rules over the lifetime. If it is true in general then why might it be true? Is there some genetic or evolutionary basis for this? At the same time I can think of a counter-example right away: Steve Fossett.

It's not so bad that I'm even afraid to drive but it's getting close. Or maybe it's because I've just read this article on what it's like to hit a pedestrian with a car.

Drivers weren’t charged in most of the 16 pedestrian fatalities in DC last year. Pedestrian error accounted for 10 of the 15 fatalities in Montgomery County in 2004 and 11 of the 13 fatalities in 2003. All 15 pedestrian deaths in Prince George’s County in 2004 were the fault of the pedestrian.

A collision with a pedestrian or bicyclist can be especially graphic. There’s often very little separating a driver from the person who’s been hit.

“It’s more personal,” says detective Bruce Werts, a member of Montgomery County’s collision-reconstruction unit. “There are times you might be a foot from each other, looking at each other.”

Drivers who are at fault in a collision are left with the guilt of knowing they caused an injury or death. They face traffic violations and possible criminal charges.

Innocent drivers such as El Sawi may be haunted by lingering questions: Why was that person there at that moment? What if I hadn’t stopped to run that errand?

“It doesn’t matter how many times we tell them they did nothing wrong,” says detective Nate Ratnofsky, a former member of the Montgomery County unit. “They still have to live the rest of their lives knowing they killed somebody.”

Wednesday, September 17, 2008

Not all CEOs and their strategies are best all of the time

But the trick is to figure out what is best when. Did Citigroup CEOs follow the best strategies?

1. Sanford Weill (empire building)
2. Chuck Prince (cleaned out legal and regulatory mess, inherited no doubt from 1.)
3. Vikram Pandit (reorganize unwieldy institution inherited from 1., clean up subprime mess inherited from 2.)
I'm thinking Citi is going to break up.

Story here. Here's my story (or a parable of capitalism, regulation, and why competition is inherently unstable).

I run a lawn mowing business and I start by canvassing many different neigborhoods for business. Soon I have some customers and begin mowing lawns. Then I find out that it would be more efficient if I have most of my customers in one neighborhood. My costs would be lower since I don't have to drive around as much. As an incentive, I offer those who can recommend me to their neighbors a discount on mowing if they can round up some neighbors. Soon I can focus on just a few neigborhoods. My costs are lower and my profits are higher even though I am charging less. I'm making up on volume what I'm losing on margins.

Business is good and I notice that some new entrants are trying to break into my territory. I go on a two pronged strategy: 1. I woo them to become my employees, promising them a steadier income. 2. I start buying up other lawn mowing companies to discourage competition as well as to grow into new neighborhoods.

Things work out well and soon I am mowing the lawns of local politicians. I treat them like a VIP by offering them lower prices on cuts but with additional teasers such as planting. My competitors become envious and attempt to introduce legislation that regulates the size of lawn mowing companies. My friendships with VIPs become useful and I try to persuade to vote against the legislation.

I point out that there are economies of scale in my kind of business and my growing big is good for the consumers because I pass the savings on to them. Meanwhile, my company is growing through aquistions and mountains of debt as I branch into landscaping and retailing (selling lawn mowers, shrubs, mulch, etc.). I contemplate going public.

Growth sputters and I start to raise prices to increase earnings. The company becomes unwieldy as I try to make all its parts move in sync. My attempts at stopping legislation are only partially successful. Different agencies start to look into my operations. My growth which has been exponential resulted some flaws in my bookkeeping. Legal costs mount as I try to meet new legislation requirements. While my landscaping business is doing okay, my retail operations are bleeding red ink. I start laying off people.

I hire new managers but it is too late. Retail operations are sold. Other lawn mowing divisions are divested to pay off debt. I'm soon back to mowing in a few neighborhoods.

1. All small companies want to grow.
2. The process of growth sows the seeds of its own destruction.
3. Stakeholders view growth enviously and try to undermine growth.
4. Competition is good as long as I was doing well, not otherwise.
5. And this is why capitalism is fragile. Economists would say that this is efficient.

What randomized trials do not reveal

From the same story in this post:

In 1983 the first rotavirus vaccine was ready for testing. ... From all vantages, the first trial, conducted in Finland was a landmark success: the vaccine reduced the changes that a vaccinated child would get severe rotavirus by 88 percent demonstrating that immunity could be induced with a live oral vaccine. Moreover, the vaccine had no troubling side effects.

Encouraged, Smith Kline-RIT (now GlaxoSmithKline Biologicals) launched trials in other countries, and by the late 1980s the end of rotavirus-related deaths seemed at hand. But then the results from trials in Africa and Peru proved inconsistent and disappointing. Lacking certainty about the reasons for the troubles - although poor health untreated infections, malnutrition and parasites are known to affect a child's immune response to vaccines - the company put its rotavirus program on hold.

I highlight this and the earlier post because development economists have begun to embrace randomized trials as a solution to finding out what kind of development aid works. Randomized trials have had a long history in medicine and economists have the advantage of adopting the best practices from those experiences. While they have not ignored the main criticism that randomized trials are a 'black box' the enthusiasm that has been coursing through the veins of development economists is palpable. Why have economists so ardently embraced randomized trials?

1. It gets at the question of causation. No more instrumental variables! The treatment-control differences are a clear cut answer as to what works and what doesn't. It doesn't matter if we do not know why it doesn't work -- accountability is ensured when a program is thrown out on the basis of a randomized trial. Yet as the above story shows, it can matter to know why a program works in one location but not another. As Atul Gawande writes so eloquently in the New Yorker, even knowing what works is not sufficient. We need to get at the question: why does it work better in one place and not another. While it is not a story about randomized trials, it is a story about treatment.

Over the phone, the doctor told Honor that her daughter’s chloride level was far higher than normal. Honor is a hospital pharmacist, and she had come across children with abnormal results like this. “All I knew was that it meant she was going to die,” she said quietly when I visited the Pages’ home, in the Cincinnati suburb of Loveland. The test showed that Annie had cystic fibrosis. ...

The one overwhelming thought in the minds of Honor and Don Page was: We need to get to Children’s. Cincinnati Children’s Hospital is among the most respected pediatric hospitals in the country. It was where Albert Sabin invented the oral polio vaccine. The chapter on cystic fibrosis in the “Nelson Textbook of Pediatrics”—the bible of the specialty—was written by one of the hospital’s pediatricians. The Pages called and were given an appointment for the next morning. ...

The one thing that the clinicians failed to tell them, however, was that Cincinnati Children’s was not, as the Pages supposed, among the country’s best centers for children with cystic fibrosis. According to data from that year, it was, at best, an average program. This was no small matter. In 1997, patients at an average center were living to be just over thirty years old; patients at the top center typically lived to be forty-six. By some measures, Cincinnati was well below average. The best predictor of a CF patient’s life expectancy is his or her lung function. At Cincinnati, lung function for patients under the age of twelve—children like Annie—was in the bottom twenty-five per cent of the country’s CF patients. And the doctors there knew it.

2. The earlier post highlighted that even within a randomized trial, subgroup interactions can be important. In that case, it was infants under 3 months. The search for subgroup effects (i.e. is the treatment most effective for this particular subgroup?) can easily become a fishing expedition or is sometimes referred as data mining. The number of hypotheses tested can easily reach into the hundreds. This type of analysis essentially puts the analyst back where they were before the randomized trial.

Because a randomized trial is so expensive to run, finding a positive treatment effect on a particular subgroup, means that another randomized trial on that subgroup cannot be repeated. The analyst has to stand by the statistical analysis which raises issues of multiple comparisons, sample power, independence and a whole host of other issues that the analyst had tried to avoid in the first place by putting his faith on the results of a randomized trial.

3. One of the main reasons for using randomized trials is to get at the selection problem. Looking at the results of a program by comparing those in and out of the program is biased because some participants self select into the program. However, the selection problem has only been pushed back one step in a randomized trial. There are experiments where those selected to receive the treatment refuse the treatment (known as "non-compliance") while those who are selected to receive the placebo somehow manage to circumvent the experimental controls to receive treatment ("crossovers"). In randomized trials and in econometrics, the selection problem has given rise to a whole host of estimators: ATE (average treatment effects), ITT (intent to treat), TOT (treatment on treated) and some others I'm not familiar with. Not surprisingly, the compliance problem has own estimator: CACE (complier average causal effect).

Just as growth econometrics has abandoned its search for causes of economic growth and settled for correlations, development economists seem to have abandoned its search for explanations and settled for finding out what works without knowing fully why it works.

This is meant to only to be a note of caution and nothing more but economists need to look at the experiments they are conducting and subject themselves to a cost-benefit analysis: Are the costs of running randomized trials greater than the benefits received by the participants? What about the benefits of the data that is gathered - can they be used to advance the knowledge in the field or are the results of these 'black box' experiments to be filed away and forgotten when the fad is over?

Why cost benefit analysis will always be unacceptable

A rotavirus vaccine is developed and the vaccine goes to clinical trials. (Full details here - preview only.)

In 1991 the Food and Drug Administration granted the pharmaceutical company Wyeth Ayest (later Wyeth Pharmaceuticals) permission to make and test this vaccine, which they named RotaShield. Over the next five years it launched large-scale clinical trials in the U.S., Finland and Venezuela, verifying RotaShield's safety, ability to induce a protective immune response and lasting efficacy. ... Over the next nine months months more than 600,000 children received an estimated 1.2 million does of RotaShield. ...

The disaster struck. In 1999 several infants suffered a serious complication within two weeks of receiving the vaccine: a segment of the intestine folded into a nearby region (like part of a telescope collapses into another), creating a blockage called intussusception. The condition can be excruciatingly painful and must be quickly reversed with either an air or fluid enema or fixed surgically. In rare cases, the intestine perforates and the infant dies. The CDC, which was monitoring experience with RotaShield, called for an immediate halt to the immunization program, thereby sinking a vaccine that had taken 15 years and several hundred million dollars to launch.

The agency initially estimated the risk to be one intussusception in 2,500 vaccine recipients, which was considered unacceptable. Later studies pegged the probability at only one in 11,000. Then Lone Simonsen of the NIH correlated risk with age: infants younger than three months were in less danger than older ones. If the vaccine were given only to young babies, the likelihood of intussusception could drop 10-fold to perhaps one in 30,000.

The new data raised new questions. Was this risk acceptable in the U.S., where children are often hospitalized but rarely die of rotavirus? Were the odds more palatable in the developing world, where one child in 200 dies of rotavirus? If 150 lives could be saved for each complication from intussusception, might the risk be justified? Given these statistics, was it unethical, in fact, to withhold a vaccine that might save half a million lives a year? Or no matter what the risk-benefit analysis showed, was it unethical to market a vaccine in the developing world that had been withdrawn from use in the U.S.?

The CDC and the WHO called a meeting of policymakers from developing countries. After heated discussion, science bowed to politics. As a high-ranking Indian official said, "I know this vaccine would save 100,000 children in my country. But when the first case of intestinal blockage occurred, I would not be forgiven for allowing a vaccine that had been withdrawn in the United States to be used in my country."

Intelligent design or efficient evolution

Gary Stix's article An Antibiotic Resistance Fighter (preview only) has a graphic on how a bacteria can undermine the effectiveness of antibiotics. I only reproduce the text here:

Rapid-fire mutations in Escherichia coli bacteria can undermine the effectiveness of ciprofloxacin (cipro), an antibiotic that is increasingly being prescribed by physicians.

1. Cipro's Action: Cipro usually harms bacteria by binding to an enzyme called gyrase and preventing it from functioning properly.

2. How Resistance Arises: Resistance is initiated when E. coli responds by generating single-stranded DNA. Individual molecules of another protein, RecA, the line up in a chain and attach to the single-stranded DNA. RecA facilitates cleavage of a regulatory protein, LexA. This change frees a set of formerly repressed genes to induce mutations elsewhere. The mutations end up blocking cipro's binding to gyrase, thereby preventing the drug from working.

3. A Possible Solution: Drugs that bound to LexA and prevented its cleavage - such as the hypothetical compound X detected here - would stall that sequence and thus could overcome resistance and restore effectiveness to the antibiotic.

The above mechanism was hypothesised and experiments were run to confirm this hypothesis by Romesberg, Cirz, Chin and others and the results were published on PLoS Biology.

An unexpected - and undesired - aside to the publication of the PLoS Biology paper emerged when the intelligent-design community embraced the results as confirmation of its unorthodox worldview. The frenzied mutations in Romesberg's experiments were not random, its members contend, but were set off under deliberate direction of the bacterium: "Life takes control of its fate. Living things are not passive participants of the interplay between stochastic events and envrionmental pressures," writes the pseudonymous Mike Gene on the website idthink.net, while adding, "That evolution may be under some form of intrinsic control is only a piece of the telelogical [design in nature] puzzle. But it is a significant piece, in that the ability to adapt, at least to these two antibiotics, is under control."

Struggles of entrepreneurs

Interesting read from Meg Cadoux Hirsberg, wife of Gary Hirshberg, the founder of Stonyfield Farms yogurt:

Gary often quotes Winston Churchill's famous remark that "success is the ability to go from one failure to another with no loss of enthusiasm." We certainly became practiced at ricocheting from failure to failure. It's hard to say when we had our darkest hour. There are so many that could qualify. Was it in 1987, when my desperate husband asked me to lend the business the only cash we had left? A year earlier, I had told Gary that we were going to pretend that the $30,000 my father had left me in his will didn't exist; it would be the down payment on our home, if we could ever afford one. But our new co-packer had suddenly gone belly-up, and we had to start making yogurt at the farm again. "I need the cash to buy fruit," he said simply. Numbly, I pulled out the checkbook.

Or perhaps the worst moment occurred the following spring. A large dairy had agreed to partner with us and retire our debt -- Gary had worked with the company for months on a detailed agreement. I was excited and relieved on that day in April when he and Samuel drove to Vermont to sign the deal; in our recently completed fiscal year, we had burned through $10,000 in cash each week and lost $500,000 on sales of about $2.3 million. ...

I shared Gary's vision, but not his method or his madness. I admired -- and still do -- his passion and determination. I wanted to believe that we could expand this business and make a difference in the world, but over time my confidence faded. The level of risk that Gary and I (along with our partners) had assumed was way beyond my comfort level. We had come perilously close to losing the business dozens of times. Frankly, there were many times I wanted to lose the business -- anything to be put out of our misery. ...

From 1983 to 1991, Gary raised more than $5 million for the business, all from individual investors, none from venture capitalists. He raised $1 million in 1989 alone to build the plant that he and Samuel had cost out on that car trip the previous spring. We eventually had 297 shareholders, even though we had never closed a quarter with a profit. We didn't see our first profits until 1992, when Stonyfield's revenue reached $10.2 million. You can do the math -- it took us nine years to break even. Gary and Samuel's gamble on the promised efficiency of the new facility, located in Londonderry, New Hampshire, was, in fact, the turning point.
Frankly, I was amazed that Gary was able to persuade so many investors to write a check, given the bleak history of our little company. I'm certainly grateful that none of them ever asked me about my own confidence level in our enterprise. My sense is that they were investing in Gary -- his smarts, his persistence, his commitment, and his confidence. They were also persuaded by the quality of our product (though my mother, Doris, the third-largest shareholder at the time, didn't even eat the stuff). ...


Just when I had begun to think that my husband was not so crazy, I found myself begging him not to do something that was patently insane. Gary and Samuel made several trips to St. Petersburg and set up a small facility there. Everything went wrong. Finally, after someone was shot and killed in Gary's hotel while he slept, and an American colleague was briefly held hostage, Gary called it quits. "I lost half a million dollars and my innocence," he says now.

At that point, even Gary started to wonder if it was time to bring in some bigger guns to move the company to the next level. In 1997, he began to hire professional managers in sales and marketing. Corporate people from Kraft (NYSE:KFT) and Harvard M.B.A.s now started to populate the company. By and large, these new hires did not work out, and Gary and I both learned important lessons about the company's culture. I had been vastly relieved to see the infusion of what I termed "grownups" into our company, but now we both came to realize that a mission-driven business requires employees with more than flashy resum├ęs; energy, spirit, and dedication to the work are essential.

Gary started looking for a way to get the shareholders an exit, to give them a well-deserved high return on their risky investment and allow him to focus on expanding the company. He often spoke with Ben Cohen of Ben & Jerry's during this period and eventually soured on the idea of going public after Ben was forced to sell his company. In 2001, when sales were $94 million, Gary sold 40 percent of Stonyfield to Groupe Danone (owners of Dannon yogurt); it bought an additional 40 percent in 2003. The deal, finalized in 2001 after a two-year negotiation, gave our shareholders a highly profitable exit, allowed Gary to retain control of Stonyfield, and provided us with financial security.

But I was mistaken in believing that the deal would bring with it some measure of calm. Gary doesn't reach a plateau and then stop. Financial security was never his ultimate goal. There's always that next venture, that new new thing, that (in Gary's case) will reach more people with important messages about organics or climate change.

After we got some cash, Gary created and invested heavily in what is possibly the only business riskier and more likely to fail than yogurt-making: restaurants. He conceived of and co-created O'Natural's as a healthful, organic, and natural fast-food alternative. The concept is excellent, as is the food, but its fate, like that of all restaurant start-ups, remains uncertain. Gary has poured a lot more money into it than I expected. Once again, I try not to ask. Gary also co-founded the nonprofit Climate Counts, which measures the climate change commitments of major companies. Recently, he has been busy promoting his new book documenting how businesses can make more money by going green. People say they don't know how he does it all, and the truth is, neither do I.

It's all exciting, but I'm a slower, more deliberate, and (as Gary would say) "evidence-based" person. Gary is a consummate multitasker, while if there are more than four things on my plate, the fifth slides off. The person who runs faster sets the pace; usually, I am the one who must adapt.

On a more personal note:

Our wood stove could not compete with the farmhouse's leaky windows -- my hair would ruffle in the winter wind, indoors. Unidentified furry creatures often skittered over my slippered feet as I loaded laundry in our dirt-floor basement. One winter, when my brother Bob was visiting, the Dumpster caught fire and nearly incinerated our barn, which contained all of our nonperishable inventory. After Gary dealt with the fire, Bob headed up to his freezing bedroom and deemed Stonyfield Farm "a hard place to crash." The moniker stuck.

Even the coming of spring heralded problems. The effluent from the yogurt plant was piped into the leach field adjacent to our bedroom. As soon as the weather warmed, the sickening odor of fermenting curds and whey wafted through our windows as we tried to sleep. When I was nine months pregnant with our first child, Gary and I laid polyethylene tubing through an overgrown field to direct the effluent away from our bedroom window so the stench would not be drawn in with our newborn's first breath. The field turned out to be overrun with poison ivy. I went into labor a couple of days later, my skin itchy and red.

This read made me think or formulate some hypotheses about the characteristics of successful entrepreneurs:
1. Risk takers
2. By all accounts, constrained by existing capital, until an infusion mainly by friends and family.
3. Desire to retain control
4. Visionary

Now the opposite side - "entrepreneurs" who ride on the coat tails of earlier successors (i.e. imitators). Here I am mostly thinking about the dot-com boom
1. Imitators which implies no vision
2. Small startup hoping to be bought up or taken public
3. Looking to cash out with no desire to retain control
4. By extension, imitators are more risk averse than the "real" entrepreneurs.