Nostradoofus

Investing does require a competitive edge, but the “information edge” set forth by rational-agent economists is not the only kind of edge that emerges in the real world. Other kinds of edges:

1. Temporal — willingness to hold one type of instrument, such as stocks or cash, for a very long time, i.e. years, until conditions are right to switch.
2. Emotional — ability to sleep at night while holding a highly volatile instruments.

These sound trivial on paper, but are actually rare and valuable enough to confer a big advantage. Illustrative example:

Since the 1870s, a simple rule to outperform the market has been to buy 100% into the index when its P/E ratio falls below 9, then sell 100% (go all cash) whenever the index P/E ratio is above 22. This rule outperformed the index by a factor of 7.

But this is so simple. What critical edge could be involved? The discipline of inaction. The temporal and emotional wherewithal to make only 9 trades in 125 years. This rule would have had you sitting on the sidelines since May 1995. It might require making no investment moves for most of your adult life. It would be impossible to be an investment adviser, or to hire one: who would pay a fee to a manager who did nothing for 15 years?

This strategy is impossible to execute unless you are currently very young, and prove to be exceptionally long-lived. Thus almost no one has the necessary edge to pursue it.

In a way the investing edge is like marketing strategy: there are many different paths to advantage, but they all involve being unique in a significant and sustainable way.

General Motors continues to seek a buyer for Hummer. From the WSJ:

General Motors Corp. said Friday it has begun sending out a sale prospectus for the Hummer brand to potential buyers as it moves “as quickly as practical” in deciding the fate of the division.

Imagine the prospectus: “For Sale by Owner: loss-making American car brand. Primitive 1970’s-era body-on-frame design. Poor safety record. High vehicle price point and operating costs. Collapsing demand. Most buyers require credit, now unavailable. Brand image symbolizes failed and globally vilified American military gambit. No export potential. Huge idle plants with high fixed costs and unruly labor force. Acres of unsold inventory. Make offer.”

Sign me up.
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This post was inspired by a recent NPR program.

Several years ago, Warren Buffett famously referred to financial derivatives as “financial weapons of mass destruction.” Unfortunately, he, and nearly everyone else, didn’t elaborate. For nearly everyone, “derivatives” remained just a word, vaguely associated with big money and big danger.

This post attempts to explain why one particular type of derivative, “credit default swaps,” caused the financial system to implode.

The layman’s confusion is caused in part by opaque naming. (”Credit default swap?” What the heck does that mean?) But it’s really pretty simple. “Credit default swaps” are bond insurance policies. The buyer of such a policy pays a premium to the insurer, for protection against the default of a bond. If the bond doesn’t default, the insurer just keeps the premium. If the bond does default, the insurer must pay the buyer the face value of the bond.

If it’s a bond insurance policy, why don’t they just call it “bond insurance” instead of CDS? There is a reason, and it stinks. More on that in a moment.

Among other uses, CDS were widely employed to improve the credit rating of mortgage-backed securities. For example, a dicey pile of Countrywide mortgages would be securitized, and might have a fairly risky default rating. To reduce risk, the end buyer might simultaneously buy both the securitized mortgages AND a credit default swap (again, bond insurance) to insure against the risk that the mortgage securities might fail to pay off as agreed.

The obvious problem here was that the mortgages were much dicier than expected, too many of them defaulted, and too many insurers (sellers of credit default swaps) were forced to pay insurance claims.

So far, this is a case of bad risk management, but not bad enough to take down the whole financial system. To see where the dynamite was hidden, let’s return to this mysterious reluctance to call these financial contracts “insurance,” even though that’s clearly what they are.

Insurance is a regulated industry. Insurers are required to maintain capital reserves (e.g. cash and investments), to ensure they can actually pay out claims on the policies they sell. This regulation stabilizes the financial system, but irritates the more aggressive financial types, who could enjoy vastly higher return on capital if they didn’t bother to maintain reserves to actually pay claims.

Their ultimate dream of avarice: an insurance company that has no capital to pay claims. Divide by zero: infinite return on capital. Just write policies, collect premiums, and if a claim rolls in, just declare bankruptcy and start over. Easy money.

In the 1990s, when the idea of securitization was expanding rapidly, prospective sellers of bond insurance, fueled by this utopian vision of infinite return on capital, decided not to call their product “insurance.” Instead, they called it a “credit default swap,” and argued it was not really insurance, but a “forward contract” between two private parties. This clever definition meant that, from a regulatory perspective, these products weren’t insurance, and weren’t listed securities, placing them outside the purview of all regulatory agencies.

This unregulated environment was made explicit in law with Web-Bubble-era legislation led by Phil Gramm (John McCain’s chief economic strategist until a few weeks ago).

Freed from the irritant of capital requirements, a credit default swap (CDS) free-for-all ensued. Increasingly, they were used not by bond holders, but by speculators. For example, you could buy a CDS contract to insure against the default of a bond you didn’t actually own.

To see how strange this speculation is, consider an analogy. Suppose you think your neighbor will default on his mortgage. Imagine if you could buy an insurance policy on your NEIGHBOR’S mortgage. If he defaults, you collect the entire value of his mortgage. Everyone on your street could do it, and would each collect the entire value of the mortgage if your neighbor defaults.

This is exactly what was going on in credit default swaps. Today, for every dollar of mortgage backed securities, there are believed to be about 12 dollars of CDS contracts. This is a form of leverage, in that, if a dollar of MBS defaults, then 12 dollars must be paid out by someone.

Now we start to see how the entire system could fail (but it gets worse — see below). The maximum exposure to MBS is not the total MBS market of $5 trillion, but 12 times that, the entire CDS market, or $60 trillion. This is more than 4 times the entire annual output of the United States.

How could the CDS market be so huge? One reason is that they could be structured, typically by hedge funds, into a seemingly riskless bet, known as “netting.” This trick takes advantage of the simple fact that insurance premiums are higher when a claim is more likely. (For example, it costs more to insure a 16-year-old driving a red Ferrari than to insure a 40-year-old bookkeeper driving a Honda Accord.) Hedge funds took advantage of this fact as follows.

Say you run a hedge fund. You buy a CDS on a bond when the risk of default seems low. The price of such a CDS is low, because the perceived default risk is low. Then, as the mortgage collapse unfolds, you also SELL a CDS on the same bond. In the latter transaction, you, the hedge fund, are acting as the insurer. (Why not? CDS are totally unregulated, so anyone can write a policy.)

Because the mortgage collapse is under way, the underlying bond seems more likely to default than it did before. So you can charge a much higher premium for the insurance you are selling than you paid earlier for the insurance you bought. Your profit is the premium received in the second transaction minus the premium paid in the first transaction.

Superficially, you are taking no risk, because if the bond actually defaults, you collect on the insurance policy you bought, and use that money to pay out on the insurance policy you sold. That nets out to zero (hence the term “netting”), but you still have your profit described in the previous paragraph.

What’s the problem here? Something called counterparty risk. In an actual default, you make your insurance claim and try to collect on the policy you bought (the first transaction above). What if they don’t pay you? For example, what if you bought that policy from Lehman Brothers, and they went broke before you could collect? Now the person to whom you SOLD insurance (the second transaction) comes to collect from you. You can’t pay, because Lehman stiffed you, so you are suddenly insolvent, aka broke.

So many people were netting, and the CDS speculation market had become so large over the years, that everyone was dependent upon the counterparty risk (ability to pay a claim) of everyone else. Everyone had booked profits on netting transactions, but in an actual MBS default, if any link in the chain failed to pay, everyone would go broke. Circle of interdependency. Cascading defaults.

The first link to fail was Lehman. The federal government appears not to have understood until very recently (just the past few weeks) that CDS were mainly used to speculate, not to insure one’s own bonds. As a result, the feds didn’t realize that letting Lehman fail would break the chain of interdependencies on CDS claims, causing everyone else to collapse.

So AIG went down. In addition to their regular insurance business, AIG was dabbling in CDS. Well, more than dabbling: they sold $400 billion of CDS, and in the wake of Lehman, enough of these went south to take down the company.

Belatedly, everyone understands that the CDS market should be regulated either as insurance, or as listed securities, or both.

In the meantime, we face the problem of a money supply collapse. For every dollar of MBS default, 12 dollars vanishes from the money supply. This is why the Fed is massively loosening monetary policy.

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American “exceptionalism,” a euphemism for “we’re better than everyone else,” ends with the Baby Boom. You see a clean break at birth dates around 1960.

Most educated people born before 1960 think about US policy (economic and otherwise) from a basic assumption of unlimited economic, financial and military resources. Most born after 1960 assume we have limited resources, and must prioritize and allocate accordingly.

You see this break vividly among political candidates. The Boomers (Hillary Clinton, John McCain, and especially George W Bush) unconsciously assume limitless American power and wealth. By contrast, the Gen Xers (Obama), who reached adolescence after Vietnam and during the oil shocks, assume limited resources.

Limited resources require prioritization, compromise, and cleverness. These skills are best learned early, so Gen Xers have a built-in advantage. But no matter who wins the election, America and its constituents will imminently and painfully relearn rusty skills.

(Updated 10/9/08 – minor corrections)

This post attempts to explain why it may be necessary to bail out the U.S. financial system. I’m writing it because the federal government is not publicly connecting the dots, not explaining what is at stake, nor are the best blogs and news sources on the subject.

The following is NOT a defense of the Paulson plan, which may be the wrong solution. It is NOT a defense of Wall Street fat cats whose practices brought us here. It does NOT argue we need a bailout in just a few days or weeks. This is just a specific explanation of the problem, and why it is fairly urgent.

When politicians talk about a “failure of the financial system,” they are specifically referring to a panic among banks, which become unwilling to take basic day-to-day lending risks that act as the grease to keep all commerce working.

This dramatically affects your daily life, but it may be hard to see exactly how. So let’s use an example.

Say you use your credit card to buy lunch. When you swipe it, you are not actually paying, not right away. Instead, you borrow the cost of the meal from your credit card issuer. The restaurant trusts your card issuer to pay for your meal within 3 days; your card issuer trusts you to pay for your meal when your credit card bill comes at the end of the month.

But where does your credit card issuer get the money it loans to you? In almost every case, they borrow it. Credit card issuers extend billions of tiny short-term loans to their cardholders for things like restaurant meals. To pay the merchants, issuers borrow the money they need by issuing short-term bonds called commercial paper, typically with a term of only 30 to 90 days. Credit card issuers sell those bonds to investors.

Who are the investors that buy commercial paper from credit card issuers? One of the biggest buyers is banks. Banks receive cash from customer deposits, and look for places to lend it: generally writing mortgages and buying bonds. Most often, it is specifically money market deposits that are invested in commercial paper.

Lehman Brothers routinely borrowed a lot of money via commercial paper. This paper was purchased by banks and money markets, because Lehman was a trusted borrower. When Lehman unexpectedly failed, it defaulted on all its commercial paper, causing money market depositors to lose money. This shocked depositors into withdrawing massive amounts from their money markets, which greatly reduced the funds available for such funds to buy commercial paper.

Meanwhile, many banks today hold mortgages that are in default, or mortgage securities that are declining in real value. This makes bankers afraid to make risky loans, lest they lose more money.

The nightmare scenario, which we have flirted with a couple of times in the past year, is that banks and money market funds stop buying all commercial paper.

What happens to your credit card if the issuer cannot sell that 30-day commercial paper to fund its loan to you for the restaurant meal? It’s pretty simple: the credit card issuer fails, the restaurant doesn’t get paid, and restaurants across the country stop accepting credit cards. Cardholders who routinely “run balances” on their cards every month have no cash to fall back on, so they default on everything simultaneously.

Now, in my opinion, there are actually benefits to being a cash-only society, but here is the problem: the abruptness of such a transition would certainly cause a depression.

Still don’t believe it? Then consider a much bigger issue: payroll.

Thousands of US public companies fund daily operations with commercial paper, those same 30- to 90-day loans. For example, they may fund payroll with commercial paper during the month, while they await payment for their factory’s output. No commercial paper market, no payroll.

Commercial paper is not the only way they could do this. They could keep a much bigger bank balance, and pay short-term obligations from cash reserves until they are paid. As with the credit card situation above, this cash-based solution is inherently more stable: pay employees out of savings, and then refuel cash at the end of the month after receiving payment from customers. Works great, in theory.

But industrial firms all buy from each other. If all of them simultaneously needed to stop spending for a couple of months to pile up cash, then there would be no buyers for anything. All commerce would stop. Thus, as with the credit card example, it is the overly abrupt TRANSITION from credit-based to cash-based operations that would cause all payrolls and much other commerce to fail simultaneously, triggering economic collapse and depression.

The more people pull money out of their money market and bank accounts (this is accelerating), and the more mortgages and mortgage-backed securities that default (also accelerating), the less banks and money funds are willing or able to buy commercial paper, and the greater the risk that everyone’s payroll and credit cards seize up more or less simultaneously.

This is the reason everyone is so frightened. This is why Paulson, who takes risks for a living, looks like he hasn’t slept in a week.

Not to say I trust Paulson, but one part of his bailout proposal potentially makes sense.

Many MBS are illiquid because default rates are totally unknown. The fastest way to restore their liquidity would be to reduce default risk in a transparent way, e.g. write down the principal. This would require voting majority of a given MBS issue.

But ownership of these issues is spread widely. So a fast path to majority would be a Treasury reverse auction on a given issue. Once in control of a given issue, they could write it down so far that anyone would consider it investment grade, which would create instant liquidity.

Such writedowns would reduce the burden on homeowners in those pools, and restore liquidity at the same time.

Would the Treasury actually make money? Hard to say. Kinda doubt it. But if we are truly in a panic, you can construct a scenario: buy an issue at 10 cents on the dollar, write the principal down by half, and resell at 20 cents on the dollar.

UPDATE (9/26/08): A reader points out that purchasing MBS doesn’t entitle the majority owner to modify the individual mortgages, according to this and this. However, those sources also acknowledge that the mortgage servicer can make such modifications, subject to a majority or supermajority vote by MBS owners. So the situation is more complex, but substantively the same, as what I wrote above.

Longstanding US policy is to economically ostracize nations we don’t like. Hence the decades-long embargoes of Iran, Cuba, North Korea.

There is no experimental evidence that this works. No nation has changed policy as a result. In fact, the lack of economic ties to these nations means they have nothing to lose economically in a confrontation with America.

Thus, logically, the opposite policy would work better: kill them with carefully chosen kindness.

For example, Iran lacks refining capacity, so they are an oil exporter, but a gasoline importer. An interesting Mideast stabilization policy might be to build refining capacity in Iraq, and encourage gasoline sales into Iran. Increasing Iran’s dependence on a hostile neighbor creates strong incentives on both sides to stabilize both countries.

I happen to be a Republican. But before arguing about political platforms, one might consider four basic qualifications for national office: to be smart, self-made, emotionally measured, and without known health problems.

Not so long ago, in a presidential election, both candidates consistently met these requirements. Whether you liked the platform of Bill Clinton or George HW Bush, you could rest assured they were both smart, self-made, emotionally measured, and without known health problems.

This was true, with a few exceptions, of candidates for at least the past century, but it changed with George W Bush. Here, for the first time, a presidential candidate was not smart or self-made, and had a known, serious health problem in the form of past alcohol and drug dependency. Is it unrelated that his presidency is considered by most in both parties to have been a disaster?

As a Republican, I actually don’t have a problem with most of McCain’s stated policies. The problem is that he is not smart (5th from the bottom of his class), not self-made (entered the Naval Academy on family connections, married into money, entered politics on monied family connections), not emotionally measured (famous temper — physically attacked another senator in 2006, at age 71), and not in good health (four-time cancer survivor, and won’t release his medical records).

This is simply a bad bet, no matter what your political leanings.

Today’s little earthquake reminded me of a really big one. In 1989, I was on the same floor in the same building as this guy.

Amid the housing bust hype, there is much talk of ghost towns in the most marginal suburbs.

Lest you worry too much about that, consider this, the world’s largest ghost town, likely to remain uninhabited for centuries.

There are worse things than financial crashes. America is not immune to such things, but better protected than most anywhere in the world.
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