Monday, March 31, 2008

Paulson Plan

I think this quote from Secretary Paulson is just fantastic:
We need regulation, but if we have it, it should be just structured in a way that it has some way of being more effective.
Now, I'm not really sure I believe in more regulation for the financial markets (though at the same time I do believe that what makes the US markets great is the fact that there are fixed rules that, by and large, everybody plays by -- trust, in a word). And I'm even sympathetic to the idea Paulson goes on to discuss in this interview, that NO regulatory structure will prevent a meltdown from happening every so often in the markets. But, for the love of god, the government is even now in the process of bailing out Wall Street, and here you've got a Bush administration that is going to use the opportunity to advance what everybody agrees is an "ideological agenda". Why do we think that putting the guys who don't believe in regulation in charge of the regulation is a good idea? The language of the quote express this perfectly.

Saturday, March 29, 2008

Hot Commodities

Commodities are of course the hot new asset class, and as a born contrarian I'm bound to think it's all bunk. Naturally, it would be good to come to a slightly more reasoned conclusion, so I have lately done a lot of reading about how this asset class works.

There are essentially two ways to invest in commodities: physically, and through futures trading.

Physical commodity investing does not have a stellar history over the long-term, as the first chart clearly indicates (though your eye may come to a slightly different conclusion if you look at the second). Presumably this decline in real commodity prices is driven primarily by technology -- we get better at digging stuff out of the ground, and we get better at making use of the stuff we dig out of the ground. I'm not sure if this is simply the same thing as saying that GDP is getting "lighter".

At any rate, actually burying gold or oil in your backyard does not appear to be a winning strategy. The other option is trading commodities futures. This turns out to be a pretty complicated game with its own rules that have little overlap with equity or debt markets. Which is why I find myself agreeing with Barron's that we may be seeing a bubble in the commodities futures markets that has little to do with the real supply and demand situation for the underlying products. Naive commodities speculators and institutional investors who read a white paper and decide they need 5% of their assets in commodities can now immediately and easily invest in an ETF. I doubt if all these people put in the effort required to understand exactly what it is they are investing in (MBS and auction-rate securities anyone?).

This is not meant to imply that investing in commodities futures over the long-term is not a potentially viable strategy. In fact, from the academic research I've read it absolutely is. I simply think that even the best strategy will produce subpar results when implemented at the height of a bubble.

Auction rate markdown

Someone just told you that the CASH in your brokerage account is worth 80 cents on the dollar. How can this be anything but deflationary? The only problem is again one of numbers. The article mentions that Moody's thinks this is a $300 billion market in total, implying that this haircut will add another $60 billion to the bad debts out there. A billion here and a billion there and pretty soon you're talking about real money.

Friday, March 28, 2008

Inflation vs Deflation

This post by Calculated Risk referencing the recent speech by Fed Governor Mishkin is another piece in the ongoing puzzle of whether the credit mess will leave us with inflation or deflation.

The speech outlines some of the reasons that deflation can be damaging and why it makes sense to have a 1-2% inflationary cushion to protect against it. He gives three reasons:
  1. Deflation makes it difficult for labor markets to find their equilibrium because simply have a psychological problem with accepting a lower nominal wage
  2. Deflation makes debt more onerous
  3. Fed monetary policy will longer work because the fed will "run out of math". If the inflation rate is close to zero, there is no way to create negative short-term real interest rates.
Yesterday there was a related post on Naked Capitalism. The basic question seems to be whether, with a deflationary debt shock of the magnitude we're seeing in the housing market, the fed is even capable of reflating the economy. Printing money is easy, physically, but to reflate, you have to actually get people to spend it. I wonder whether the transmission mechanism that would accomplish this may be broken. The main links in the chain, namely the banks, no longer want to, and indeed cannot, lend this new money out.

One might wonder what happened to the old money. My immediate response is in accord with the post already cited -- it ended up in the hands of the sovereign wealth funds we hear so much about these days. But I still don't feel like I completely understand how this part of the machine works. Exactly how does a US sub-prime loan end up sitting in treasuries in China's coffers? Presumably through the consumer spending the loan encouraged, the resultant trade deficit and foreign reserve build-up, and the subsequent reinvestment of this in treasuries, which kept the dollar high and interest rates low, hence feeding the whole cycle otra vez de nuevo.

Great story. No numbers. Which is what prevents macro economics from being a science.

Thursday, March 27, 2008

Corrupt by design

From the NYT:
In a sweeping accusation against one of the country’s largest accounting firms, an investigator released a report on Wednesday that said “improper and imprudent practices” by a once high-flying mortgage company were condoned and enabled by its auditors.
Luckily there's absolutely no need to read this report -- you've already read it hundreds of times. It happened with Enron, it happened with Fannie and Freddie, it happened with dozens of internet companies, and it will happen again.

Of course, The principle at work goes well beyond the accounting profession. We wonder why congress and the president are corrupt even though we all know how they fund their campaigns. We wonder why Moody's rated the monolines AAA until they were on the brink of collapse even though we all know who paid for the rating. And we wonder why there are so many accounting scandals even though we know who pays for the audit. These systems are not corrupt because they are filled with crooks, or because they are not sufficiently regulated -- these systems are corrupt by design.

Wednesday, March 26, 2008

MMM - Mortgage Market Meltdown and Financials

This is actually the second time I've seen this Goldman report on the total amount of credit-crunch losses.

Wall Street banks, brokerages and hedge funds may report $460 billion in credit losses from the collapse of the subprime mortgage market, or almost four times the amount already disclosed, according to Goldman Sachs Group Inc. Profits will continue to wane, other analysts said.
The basic implication is that despite all the calls of a market bottom, and the belief that we may be seeing a historic buying opportunity in financials, the market does not seem to have fully discounted how bad the fallout from this is going to be. According to the study, write-downs to date only reflect around 1/3 of the future total. This makes something like Rich Pzena's claim that the long term earnings power of many financials has not been damaged somewhat difficult to sustain. One would have to take a closer look at how any particular business (say Citibank) generates its earnings, but the correct general stance with respect to financials appears to me to be one of skepticism. Clearly, all of these stocks have been destoyed, but a crucial presumption in any sort of historic-buying-opportunity hypothesis is that they are cheap relative to normalized earnings. But what are normalized earnings in this case? The housing bubble was every bit as big as the internet bubble, and taking into account the massive benefit of a one-time run-up in debt as you calculate normalized earnings is every bit as difficult as it was for Or do we really think that the financial sector will always account for 40% of corporate profits?