Sunday, December 19, 2010

A Roundup: The FCIC Republicans and an Intellectually Fraudulent Take on the Financial Crisis

Alas, I'm late to this story, but it was so mind-boggling I had to weigh in with something. The four Republicans on the Financial Crisis Inquiry Commission went rogue and issued their own (slim, fact-lite) report on their findings about what caused the crisis ... beating the publication date for the actual report. Sadly their analysis of the crime scene looks something like this, for the comprehension impaired:


Most disturbing was the report (on Huffington Post -- nice job, guys) that the four Republicans voted to ban the following phrases from the official FCIC report: "Wall Street," "shadow banking," "interconnection" and "deregulation." Which is sort of like writing the history of apartheid in South Africa and not being allowed to use the words "race," "white," "black" and "prejudice."

Anyway, my best contribution at this point isn't opining but stepping back and rounding up the financial blogosphere reaction. So much good has been said that it deserves aggregation and linking (please click through and read each!) without any further commentary from me. So here you go:

Yves Smith, naked capitalism:

How can you talk coherently about the crisis and NOT talk about the shadow banking system, which grew to be at least as large as the official banking system and was the primary object of the various government rescue operations? It’s like trying to talk about AIDS and pretend there is no such thing as intercourse. Similarly, excessive interconnectedness, or as Richard Bookstaber vividly called it, “tight coupling” was another critical driver. AND HOW CAN YOU NOT TALK ABOUT DEREGULATION?!? What is there left to talk about once that is excised? Sunspots?

Barry Ritholtz, The Big Picture:

They released a silly analysis that could have been written by wingnut think tanks like the AEI or others BEFORE the crisis even occurred (and indeed, there are many examples of this findable via the wayback machines of the intertubes). ... The Gang-o-four absolves Wall Street and the banks, blames the government — for everything — and ignores the data that conclusively demonstrate otherwise.

Joe Nocera, New York Times:

To fix a problem ... it helps to know what the problem is. The F.C.I.C., with all those witnesses and documents, could have really helped here. But the paper released by the commission’s Republicans this week reads as if they couldn’t be bothered. It simply reiterates longstanding Republican dogma that could have been written without a $6 million investigation.

Mike Konczal, Rortybomb:

I have to hand it to them. They decided to take one for the team and release this report that implies markets can never fail, only governments. No sources, no numbers, no new info, not even 10 pages, but they put it out there so reporters have the option to go “well, on the other hand the Republicans said this.” That’s how seriously the conservative movement takes ideological warfare.

Paul Krugman, New York Times:

We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.

Alain Sherter, BNet:

The document is a wholly expurgated version of events that omits key facts while twisting others to fit certain ideological preconceptions.

Nick Baumann, Mother Jones:

In this story, Wall Street, shadow banking, and deregulation had nothing to do with the meltdown. Republicans have been pushing this fairy tale for years.

Dave Ribar, Applied Rationality:

A report on the financial crisis that omits the words, "Wall Street," "fraud," "underwriting," "collusion," and "derivatives" and that overlooks Wall Street's view of most clients as "suckers" isn't worth the paper it's written on.

Ezra Klein, Washington Post:

I'm puzzled by the decision the panel's Republicans made to break away, declare certain words off-limits and release a nine-page report that reads like a long op-ed from a generic Republican politician.

Cardiff Garcia, (on the Republican vote to ban "deregulation" etc. from the FCIC report)

Depending on your point of view, this is either sad, funny, weird, pathetic, or just idiotic.

Wednesday, December 15, 2010

Revolving Whores, Dec. 15 Edition

That didn't take long!

After launching my "Revolving Whores" feature a few days ago, I've already got a second installment as Wall Street greases the palm of another public official, according to Bloomberg:
Theo Lubke, who headed the Federal Reserve Bank of New York’s efforts to reform the private derivatives market, joined Goldman Sachs Group Inc. to help Wall Street’s most profitable firm navigate the looming overhaul of financial regulations.
Ka-ching! Mr. Lubke, your bathtub full of caviar awaits ...

Saturday, December 11, 2010

Too Big to Fail, the Book, and Inside Job, the Movie

I just finished reading/watching both of these (okay, I know I'm way late on "Too Big to Fail;" it's been a busy year). Some quick takeaways:

"Too Big to Fail" -- here's what particularly struck me in this fascinating fly-on-the-wall account (in fact, I've never read a more "fly on the wall" book than this one) of the events immediately leading up to the financial crisis in the fall of 2008:

* Christopher Cox, former SEC head: Inept. Clueless. Ineffectual. Stupid. It's truly mind-boggling just how bad this guy was.

* Speed dating, capitalism style: It was amazing how many mergers people were trying to engineer behind the scenes at the fever pitch of the crisis. Goldman buying Wachovia? Bank of America buying Lehman? And the Jewish mothers arranging the hookups were usually Hank Paulson and Tim Geithner (some banking executives even started calling Geithner eHarmony).

* The U.S. could have saved Lehman. Sure, you can parse all the differences between the Bear Stearns situation and Lehman's mess and make a lot of rationalizations for why the two were different -- but once Sorkin shows you how creative and frantic and ad hoc things were behind the scenes, you realize that grounds could have been concocted to save Lehman. The government just decided to draw a line in the sand and see what happened.

"Inside Job":

* If you've read a lot about the financial crisis, much of this film will be like "Sing Along with Mitch." You know the words, the characters, the plot, the outrage that's on slow simmer ...

* "Inside Job" is still a great film because, for my money, it makes its argument about what happened with the most coherence and the least distracting shrillness/gimmickry (plus, where else are you going to hear that old Ace Frehley classic "New York Groove" dusted off?)

* The film's original contribution is the spearing of the academic economists. Watching Glenn Hubbard's facade of reasonableness degenerate to hostility is revealing, as Ferguson pressures him about his connections to the financial industry. Even more unnerving though is watching Marty Feldstein, who seems amusedly detached and really doesn't appear to give a shit about all the havoc that ensued from flawed theories about economics and deregulation.

Revolving Whores

The debut of my new acerbic feature, "Revolving Whores: An Attempt to Shame the Shameless and Expose How Broken Our Damn Government Is." (I'm channeling my inner Denninger today, with some spicy zero hedge-type attitude on the side.)

Today's featured personality: Peter Orszag. (I meant to blog about this earlier in the week, but now Mike K. has alertly jumped on the story; he has some good observations about Orszag's latest career zig).

Reuters lead:
Citigroup Inc. named U.S. President Barack Obama's former budget director as a senior global banking adviser on Thursday, strengthening its ties to high-profile former officials the same week the bailed-out bank finished shrugging off U.S. government ownership.
So a bank that was, not long ago, the largest in the world in assets, the quintessence of "Too Big to Fail," has now paid a (presumably) big contract to free agent Peter Orszag, who will help Citi hit a few dingers out of the park using his special knowledge of all recent things White House.

America, cleanse thyself.

Sunday, November 21, 2010

L'Arrogance: The High-Finance Scent That Never Goes Out of Fashion

By now, unless you've been under one of those proverbial rocks, you've heard about the massive, pending insider-trading charges, a story apparently broken by the Wall Street Journal:
Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.
Admittedly, I'm a guy sometimes entranced by small detail, so I found this bit of the article most curious, an e-mail sent by a John Kinnucan, a principal (or analyst) at a firm called Broadband Research LLC (and former portfolio manager at Crabbe Huson Special Fund, so his high-finance bona fides are legit):
Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information," the email said. "(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman's gracious offer to wear a wire and therefore ensnare you in their devious web.
My first reaction was: Wow. You could build a whole psychology class around the tone of this e-mail. If you were enterprising, you could even bottle it into a scent to be sold to financiers.

"Obviously," the first thing you notice is how effortlessly the writer captures a breezy arrogance. There's a strong grace note of condescension, as if a visit from a couple of FBI agents is to be treated with the same disdain as the appearance on one's doorstep of a pair of vacuum cleaner salesmen. A sniggering-up-the-sleeve quality ("ah yes, these bumbling little investigator types!"). Self-importance. High-brow sarcasm. Haughty disdain for the rule of law. Megalomania.

Where have we seen this before?

Oh yeah. Throughout the whole damn financial crisis.

Banks ungrateful for being bailed out (remember it made headlines when a few bailed-out CEOs actually managed to say "Thank you, America," in testimony a good year after the meltdown). Banks riding the Bernanke liquidity wave to enormous profits and, with little sense of irony, declaring themselves master surfers and paying out lavish bonuses for their "skill." Indignant workers at AIG Financial Products who couldn't believe anyone would try to reduce their fat bonuses even though their division cratered the damn company. Lord Blankfein telling us that Goldman Sachs is doing "God's work."

Plus ca change, plus c'est la meme chose.

Tuesday, October 12, 2010

The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think

We're in a big, big mess with home foreclosures in the U.S. (foreclosuregate, if you will). I'm not sure many people understand the awful magnitude of this train wreck. So here is my look at seven reasons why it's much worse than you think. Below I partly synthesize much of the fine analysis being done elsewhere (Mike Konczal has been absolutely superb on this issue, as has Yves Smith).

Quick background: In 1996, a private company was formed called Mortgage Electronic Registration Systems, or MERS for short. Why should you care? Chances are better than 50-50 that, if you own a home, MERS officially recorded the mortgage -- probably unknown to you. MERS is headed by R.K. Arnold, a former U.S. Army Ranger with a law degree from Oklahoma City University, ranked #104 in the nation this year by the Association of American Law Schools.

Now you may be worried that Arnold, a guy who apparently doesn't exactly have a stellar legal pedigree, is the CEO of this giant institution that registers millions of mortgages from Big Sur to Beacon Hill. Don't be. Because MERS doesn't have any real employees. It's kind of a shell. MERS Treasurer William C. Hultman revealed as much during a deposition in Bank of New York v. Ukpe:
Q I thought, sir, there’s a company that was
formed January 1, 1999 [sic], Mortgage Electronic Registration
Systems, Inc. Does it have paid employees?
A No, it does not.

Q Does it have employees?
A No.

Q Does MERS have any employees?
A Did they ever have any? I couldn’t hear you.

Q Does MERS have any employees currently?
A No.

Q In the last five years has MERS had any
A No.
Why the heck would you form a company, then not hire anyone? Well, what's the purpose of your company? If you're making widgets, you need widget inspectors, widget engineers, widget fabricators etc. But MERS was created for mortgage banks to dodge paying local recording fees (and doing the associated paperwork, one assumes) when mortgages were re-assigned. So let's say Wall Street wants to bundle a bunch of mortgages into a security, which then is cut up into teeny pieces to go into another security, which is diced once more to go into another security ... thanks to MERS, you can do all this with a minimum of hassles/expense.

Cool beans, until it all starts to come apart at the seams, and you realize that the companies making the original loans were extending credit to people who could barely fog a mirror in the midst of a huge housing bubble and you've got to foreclose and where's all that paperwork you're going to need dammit?

So, without further ado, here are seven reasons we're in the middle of a really epic mess right now:

1. MERS may be a fraudulent company at its very core.

This becomes obvious in the answer to a simple question: How does a company with no employees foreclose on millions of homes across the U.S.? Easy. Apparently it "simply farms out the MERS Inc. identity to employees of mortgage servicers, originators, debt collectors, and foreclosure law firms." MERS even sells its corporate seal for $25 on its Web page. This corporate structure "is so unorthodox as to arguably be considered fraudulent," says Christopher Peterson, a law professor at the University of Utah.

Exacerbating this problem: no state legislature or appellate court ever gave its stamp of approval to MERS in the first place, so it has no acknowledged legitimacy.

2. Widespread fraud may be taking place to cover up the lapses of MERS.

Mike at Rortybomb does a great job explaining how your mortgage consists of two parts, a promissory note (you promise to repay the lender X dollars, and under what conditions, and with what penalties for missing payments) and a mortgage, known in some states as a deed of trust. Mike reduces all this nicely: "The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid." Common sense dictates that both parts are necessary to move to foreclose. You can't apply the enforcement without knowing the terms of the note and how much remains unpaid.

But as Yves Smith alarmingly details at naked capitalism, the banks apparently got impatient with the messiness of paper notes in an electronic age. Again, without anyone's approval to do this (no courts signed off, no legislatures gave authority), it looks like they converted physical notes on a massive scale to electronic documents -- safer, cheaper, easier to store etc. ... and destroyed or misplaced a lot of those original notes.

The trouble is when the homeowner being foreclosed on demands that the note be produced. The ensuing document scramble has led to fraudulently created replacements. It's hard to say on what scale this is occurring, but Yves included a chilling quote that she says came from the CEO of a big subprime lender, who defended the practice of transfers lacking paper notes, then had a nervous moment of doubt: “Well, if you’re right [that it's a problem], we’re f**ked. We never transferred the paper. No one in the industry transferred the paper.”

3. This mess is greatly complicated by long, complex chains of securitization.

Mike at Rortybomb provides a good diagram. Start with Joe Homeowner, whose mortgage is originated by say Easy Mortgages 'R Us. Easy Mortgages 'R Us passes the note to the next link in the chain, a sponsor for the security being created (say it's Bank of America, which will scoop up a thousand mortgages, including Joe Homeowner's, and turn them into a product called a residential mortgage-backed security). Then there's a depositor that stands between Bank of America and the trust itself for the mortgage-backed security.

Phew. That's plenty complex. But Mike gave readers only the short form. The residential mortgage-backed security can itself be bundled with other similar securities into a creature called a collateralized debt obligation, or CDO (that should sound familiar from Congressional hearings). And then the CDO can be sliced up and bundled with other strips of CDOs into something known as a CDO squared. Now do it one more time and you get a CDO cubed.

Now remember that old saying: a chain is only as strong as its weakest link. Now here are the many links we've just created for Joe Homeowner's mortgage:

Joe Homeowner --> Mortage Originator --> Sponsor --> Depositor --> Trust for RMBS --> CDO --> CDO squared --> CDO cubed. Moreover, I've probably left out a few entities on the CDO level; I'm sure they use similar intermediary units as the RMBS to create their securities.

Exacerbating this problem: The chains were created too quickly, during what turned out to be unstable times (a bad real estate bubble being inflated). So they're not even relatively robust chains.

4. Ladies and gentlemen, I present: Lawsuit-palooza.

Mike delves into this. Foreclosuregate is a full employment act for lawyers. You could have lawsuits anywhere up and down that chain of document transfer. Investors in the mortgage-backed securities will sue servicers. Homeowners will sue on being foreclosed on, demanding to see the note (with the number of suits increasing exponentially as there are more victories, creating a crushing backlog of cases in our legal system). Investors in the securities will jostle for position and battle with each other, the junior debtholders aligned against the senior. The RMBS trust will go after the sponsor for dumping mortgages on it that lacked the proper paperwork.

5. This will be resistant to fixes, for one, because the mortgage-servicer system for the securities is badly set up, with all the wrong incentives.

Mike nails this one too. The smart way to fix these problems would involve lenders working with homeowners to pare down the loan principal for deeply underwater homes. This approach has been shown consistently to work out better for all parties than foreclosing. At the same time, the lender could take the opportunity to remedy the defective paperwork.

But the mortgage servicer, the one who controls what happens with the mortgages that are now embedded in a security (or maybe multiple securities -- remember those CDOs squared?), doesn't have an incentive to do this. His incentives are narrowly structured: he gets fees, on a certain schedule, for foreclosing. He doesn't get paid for the time-consuming process of working out a solution that would ultimately benefit the investor in the security and the homeowner as well.

In fact, as Mike notes, securitizations must be passive entities to win a bunch of tax breaks. As such, they can't do much hunting down of notes or anything else, it seems, without risking losing their tax-exempt status. A really miserable setup, which is going to be an obstacle to resolving this mess.

6. This will also be resistant to fixes because it's going to be hard to wave a magic wand on the federal level and make the problems disappear.

This situation is playing out locally, not federally -- county by county, state by state. And as the political heat builds on the big, bad banks -- much of America already hates them for their oversized bonuses, for their lack of repentance after driving the economy into the ditch, for the bailouts that saved their asses while leaving double-digit unemployment in its wake -- it's going to be hard for Congress, operating under the klieg lights, to ram through the kind of legislation that could straighten things out. Congress is already perceived as being snugly in the pockets of Wall Street. One thing is for certain: NOTHING will happen before the election. This is a live third rail right now.

7. MERS owns more than 60 percent of U.S. mortgages.

I haven't seen anyone sort through the implications of this, but I've seen in the comment sections of blogs, some people sniffing about, sensing the implications. Namely: I make regular mortgage payments, I have great credit, but what if I ask to see my note? What if they can't produce it? Does that then make me foreclosure proof? This will add an interesting element to valuing more than 60% of the mortgages in this country. How much will Joe Investor pay for the right to payments from a mortgage that may be "foreclosure proof"?

So there you have it. Seven reasons why we really need to be paying attention to the mortgage mess. It's hard to overstate how serious it is.

Verdicts on TARP: What I Wish I'd Said

When the authority of TARP recently expired, a predictable flurry of opinions made cases for and against the largest bank bailout Western civilization has ever known. I could weigh in too, but I found someone who expressed my sentiments so well, I'd just like to quote her for a few short paragraphs.

Alice Schroeder was writing in Businessweek about Charlie Munger, Warren Buffett's right-hand man, who rather scornfully told an audience of Michigan college students that we "shouldn't be bitching about a little bailout" of the banks. Munger also said, in a curious application of the second-person pronoun (is he secretly from another civilization? or planet?), that the bailouts were "required to save your civilization." (The phrasing carries the whiff of the moral harangue from the elder who knows best; one imagines gramps pulling his cracked leather belt from his trouser loops and announcing to the youngster about to get a good strappin', "I'm doing this for your own good.")

And this is Schroeder's very intelligent response (my bold):
... the problem is the false dichotomy it presents. The choice wasn't between the bailout or no bailout. It was between the bailout we financed, which didn't resemble capitalism in any known form, and a bailout more intelligently executed.

No one made us bail out shareholders along with the banks' bondholders. We didn't have to preserve institutions that are still too big to fail in any meaningful sense of the term. We could have propped them up temporarily, then recapitalized them as smaller, more manageable entities, with former equity holders assuming the cost of the risk they assumed.

We missed the chance to reduce systemic risk by comprehensively rewriting regulation for the financial-services industry. Instead of withdrawing government guarantees, we increased them. So there are plenty of reasons to complain about the bailouts.

Thursday, September 16, 2010

What I Don't Get About the Opposition to Elizabeth Warren

Okay, so Obama just appointed Elizabeth Warren to set up the new Consumer Financial Protection Bureau, which makes her the interim head of the agency, or something ... it's all still kind of confusing. She really deserves to be named to the job outright. What's the hold up? King Richard III had a lame leg and didn't do this much foot-dragging.

Ah, she may not be confirmable by the Senate, says Chris Dodd, head of the Senate Banking Committee. Why not? This too is a bit hazy; Senators can be maddeningly elusive when they don't want to discuss something. But the case against Warren seems to boil down to:

1. Lack of experience/qualifications.

This line of argument quickly falls apart though. She hasn't been knitting doilies in Dubuque and teaching night classes in creative writing for the last decade. She is (1) a bankruptcy law professor at Harvard who has "written several books over the years focusing on how debt, predatory lending and bankruptcy affect average middle-class Americans" (Bloomberg News) (2) the head of the TARP oversight committee, who in that position became intimately familiar with the mechanics of the massive bailout of the financial sector and the shenanigans that led to the financial crisis (3) (and here's the kicker) the person who argued in a 2007 article for the creation of an agency just like the Consumer Financial Protection Bureau.

2. Lack of objectiveness/not friendly enough to banks

This seems to be the real line of argument. Just listen to Senator Shelby of Alabama, from the Bloomberg story quoted above:
Shelby said he “would like to see a more objective person in that job. Elizabeth Warren, obviously, is not an objective person when it comes to the consumer issues.”
So Warren is perceived as too aggressive an advocate for consumers. She's not "bank-friendly" enough. (The banking sector has vigorously lobbied against her.)

Now think hard about this second point. Because it's the main reason the Senate would shoot down her candidacy, it's the point the Republicans are preparing to rally around, it's what has Dodd quaking with fear apparently ... and it's COMPLETE BULLSHIT. I'll show you why:

Say we're going to create a Dog Protection Bureau. Because, it so happens, there's a class of people who aren't always nice to dogs. These are rich, powerful people. They can afford to hire high-priced lobbyists to represent their interests in Congress (unlike the dogs). Sometimes, they abuse dogs in some reprehensible fashion and get away with it.

Now I'm not saying all these people are always horribly bad to dogs. Some of them may just steal a few milk bones here and there, or maybe they're making dog toys out of substances that aren't carcinogenic exactly, but that still cause mouth sores and runny eyes and nuisance stuff.

So we need to appoint someone to head the Dog Protection Bureau. We find a person who's an excellent, unquestioned advocate for dogs, float her candidacy, and the U.S. Senate says, "Eh, I don't think she's confirmable. She's not objective enough. She's too pro-dog."

To which a sane, logical person might respond: So what the hell are you creating the Dog Protection Bureau for? To be an impartial judicial arbiter on all matters dog, trying to see both viewpoints: the need to protect dogs and the need to abuse them/kick them around a little, for whatever reason? And if so, why are you calling it the Dog Protection Bureau? Why not call it the Dog Issues Administrative Court or something?

But if you are trying to protect dogs, you should welcome a strong advocate for dogs.

And if you are trying to protect consumers, you should welcome a strong advocate for consumers.

What am I missing here? Senate Republicans and Democrats, can you fill me in?

Saturday, September 11, 2010

Is Diversification Really a Free Lunch?

Scooting around the Net today, I found myself checking out what Greg Mankiw has been up to (besides relentlessly plugging the half dozen textbooks he's written). I drop by his blog from time to time, even though he doesn't allow comments on his posts, which I find a bit strange. Dropping by feels like the equivalent of paying a visit to someone but only being allowed to peer in the house windows: You can watch what they're doing, and eavesdrop to your heart's content, but no talking please.

So I came across this New York Times column by the good Harvard professor, brimming with advice for the college bound. I nodded enthusiastically at his scold that high schools spend too much time on Euclidean geometry and trigonometry (when was the last time someone stopped you in the street and asked if you knew the cosine of the angle of the shadow being thrown by the lamp post on the corner?) and not enough on probability and statistics.

Amen, brother!

In fact, I found myself pretty much onboard with the whole piece -- until I reached this paragraph and started scratching my noggin a little:
The evidence of financial naïveté shows up every time some company goes belly up. Whether it is Enron or Lehman Brothers, many company employees are often caught with a large fraction of their wealth in a single stock. They fail to heed the most basic lesson of finance — that diversification provides a free lunch. It reduces risk without lowering expected return.
Okay, let's think about this. Note that, first of all, the good professor has provided a lopsided universe of examples. Yes, Enron and Lehman Brothers flamed out, spectacularly, and punched a saucer-plate sized hole through plenty of their employees' 401(k)'s. Very true. But how many Microsoft and Google millionaires have we also heard about, ordinary secretaries or maybe even guys who changed the water in the fish tank on weekends and scrubbed the toilets, who got a glory ride to early retirement on their company stock? Had they properly diversified, they might have made only enough to buy a used Vespa.

So am I anti-diversification? A heretic in the investing community? Diversification, after all, is one of the ten commandments of smart investing.

Nope. Not at all. I believe in a diversified portfolio (I personally own a mix of U.S. stocks, bonds, emerging market equities, Japanese shares -- ugh, cash-like instruments and cash itself).

The problem is, I think Mankiw's only half-right in his last two sentences.

I agree with: Diversification reduces risk without lowering (or increasing -- he neglects the corollary on the upside) expected return.

Simplification: You work at an S&P 500 company. Let's say the average yearly gain on the S&P is 8 percent. You invest in only your company's stock. For any given year, it may rise 8 percent -- or it may surge 22 percent, or conversely, fall 15 percent. Lesson: an individual stock can be quite volatile. But say you buy shares in 30 S&P companies instead. Some may go up, negating the declines of others, and at the end of the day, you'll probably have a smoother ride -- less volatility.

I strongly disagree with: Diversification provides a free lunch.

What you just witnessed in the example above isn't a free lunch. It's a smoother ride (to mix metaphors). To wit: there's a greater chance, in any year, your company's stock will soar 40 percent or plunge 40 percent than a basket of 30 stocks will do the same. By diversifying, you tamp down volatility. But for the basket, while the losses may be bounded at say 25 percent, the gains won't be as high either (let's say 25 percent to keep it simple).

So by diversifying, you lose your chance to become a Google millionaire, but you also won't have to eat cat food and sleep under the freeway overpass during your golden years.

Ah, but if only "diversification provides a free lunch" were only wrong ... no, it's worse than that. It's very dangerous, as the financial crisis attests to.

Consider that a collateralized debt obligation, or CDO, is the poster child of diversification. It's stuffed with mortgages from all across the country, and once you get into the strange beast known as the CDO squared, it's more bewilderingly complex (and more diversified). Investors obviously thought that, through diversification, they were getting a free lunch by buying up CDO tranches.

Why do I say that? Somehow they came to accept that a CDO could be worth more than the sum of its parts. They must have by definition, because the assembler of the CDO must be paid to put together and market the thing (and extract a profit). So if the mortgages contained within it collectively yield say 6.4 percent on average, the CDO genie will do his magic and transform them into tranches that collectively pay 6.1 percent on average (or whatever the typical spread is for these products).

So where did the 0.3 percent go, which was being paid for assuming a certain amount of extra risk? That's your diversification "free lunch" (arrived at by manipulating correlation numbers foolishly, as it turned out, through the Gaussian copula). Actually it gets even better: investors thought they were getting free dessert too! Because, remember, through the copula wizardy, the slices of the CDO earned high ratings while paying more than similar-rated debt! (A free eclair with that sandwich, sir?)

The "free lunch" was later revealed to be a "fraud lunch" when CDO prices cratered and the ratings turned out to be ridiculously inflated. However, here's what the illusion of the free lunch did: it spawned a long line of hungry investors, who couldn't get enough of these amazing CDOs, which created further demand for dicey mortgages, which got sausaged into more CDOs, until finally the whole sham famously exploded.

So beware of savants, even Harvard professors, touting "free lunches" in the investment world.

Wednesday, September 1, 2010

Dick Fuld: Crazy Like a Fox?

Dick Fuld appeared before the Financial Crisis Inquiry Commission today and, some would say, showed himself as completely untethered from reality. The former Lehman Brothers CEO wasn't about to mince words; at the outset of his prepared remarks he asserted:
Lehman’s demise was caused by uncontrollable market forces and the incorrect perception and accompanying rumors that Lehman did not have sufficient capital to support its investments.
"Say WHAT?" was more or less the reaction over at naked capitalism. For how could any man be in such denial?

For my part, I think Fuld may be playing a role on a stage. Consider that a large Wall Street investment bank doesn't just go gently into the night. Lehman wiped out a lot of wealth on its way down. And note that phrase that keeps recurring in Anton Valukas' very, very thorough report on Lehman's demise: "colorable" claims. In other words, plenty of hungry lawyers may have sufficient grounds to sue Fuld's butt ten ways to Tuesday.

Also lots of prosecutors would love to put him behind bars for a long while. Let's not forget that Sarbanes-Oxley requires that a CEO sign off on financial statements as true and accurate, and in doing so, takes responsibility for their content.

Now, if you're Fuld, and you're sweating and conniving a way out of this mess, you know you can't really plead insanity. As bizarre as some in the current crop of U.S. CEOs are, they hardly qualify as insane. Yet there is another option that looks a bit like insanity, a sort of blind and resentful denial of any responsibility. Don't even try to be reasonable.

So if we could rig Fuld up to a lie detector, it would be interesting to find out if he really believes what he's saying right now -- if his public face concords with his private thoughts.

In other words, is Dick Fuld crazy? Or just crazy like a fox?

Sunday, August 8, 2010

The Cause of the Financial Crisis in Two Words

The other day I was thinking: ask any knowledgeable observer what caused this financial crisis, and you'll probably get a long, rambling explanation with anywhere from four to ten villains, their identities largely depending on the speaker's ideological/philosophical bent.

But what if that person was allowed only a word or two to capture the essence of the problem? What would the best word(s) be?

Some might say "greed." But that's no good. Greed's a given on Wall Street. If anything, greed is the grease that makes the wheels move over there. The greedy may have become greedier, but this still doesn't supply a satisfying explanation for the whole mess that paralyzed our financial system.

My two words (you're welcome to suggest your own), which provide a prism through which I think most of this crisis can be understood, are simple:

Mispriced risk.

Now for the walk through. First, the obvious stuff. Peel off the outer layer of any CDO and you'll find plenty of mispriced risk. What about that super senior tranche rated AAA, while it rests on mezzanine slices of crappy mortgage securities? Way mispriced.

The infamous Gaussian copula that aided the creation of AAA gold from subprime dross? That's a handmaiden to mispricing. And the credit raters: they're right at the center of the rampant mispricing, slapping AAA labels on stuff they didn't understand as they grubbed around for rating fees.

How did the credit crisis get so large? Mispriced risk. If a AAA corporate bond yields say 3.2 percent, and a AAA chunk of a CDO yields 3.5 percent, what are you going to buy (assuming you trust the ratings, and AAA implies the same level of risk, no matter the security). So money will start pouring into the new AAA category that promises the same low risk but a higher return.

What about credit default swaps? Consider a big issue there: many were sold much too cheaply, considering the dangers they were insuring.

Again: mispriced risk.

What was at the heart of the seize-up in the credit markets in 2008? Remember, the shadow banking system froze up. Counterparties to repo transactions wanted much bigger haircuts on collateral they were taking for overnight lending. Why? Fear of mispriced risk on the collateral. In other words, that collateral purported to be AAA might actually be some variant of C.

You could even argue that excessive leverage ties back to mispriced risk. Why is a bank willing to take on so much leverage? Because it thinks its overall risk is actually fairly small. Just look at the "value at risk" metric, and its widespread adoption, and how it lulls Wall Street into a false sense of security.

For their part, regulators failed to do a number of things that would have helped correct the epidemic of mispriced risk. They failed to insist on greater transparency that would have flushed some of this risk out into the open. They failed -- actually, didn't even attempt -- to reduce the complexity of financial instruments that artfully conceal risk. They simply abdicated their duty to police the financial system as instruments that mispriced risk created a vacuum, sucking in huge piles of cash because investors were enticed by the prospect of a free lunch.

The financial crisis, explained, two words: mispriced risk.

Thursday, August 5, 2010

Taleb With a Telling Anecdote on the Regulatory Mess

Nassim Nicholas Taleb weighs in on the regulatory mess in our financial system through a curious tale of being approached while at Davos with the following (legal) proposal to avoid FDIC regulations:
[He] tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and [the] company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.
Got it? I left out the name of the salesman for this scheme for shock value, because it was none other than ... Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States.

So, in case anyone was left wondering, government officials apparently don't feel any regret/guilt/sense of impropriety about crossing over to the other side -- going from regulator to regulatee -- and profiting off the knowledge/connections gained while enforcing financial rules.

But Taleb makes one other must-ponder point dear to my heart:
... the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation [i.e., the current financial reform bill] will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.
I've repeatedly said on this blog that the answer to our financial system's regulatory woes is not a rules-based approach of trying to anticipate every situation, of trying to plug every hole, of trying to cover every contingency in this or any other possible world. It's impossible to do. We need to look at more flexible solutions, such as principle-based regulation with teeth. We're foolish to head back down this path of growing a new regulatory bureaucracy that is doomed to fail as smart financiers parse out endless loopholes.

Monday, June 14, 2010

So How Should We Respond to Regulatory Failure?

Mark Thoma poses the question on his blog. Specifically, he notes:
I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.
Agreed. And the conservatives beating the anti-regulation drum are getting tiresome. Let's do a 30-second review of regulatory failure and the financial crisis.

There were structural reasons for the failure:

1. We have a confusing hodgepodge of regulators (OTS, OFHEO, FDIC, SEC, OCC, Fed, etc.). Is it any surprise that regulatory issues fall through the cracks between their respective walled fiefdoms? Or that their regulatees go "regulator shopping," trying to find a sympathetic ear, with such a plethora of choices? Our Balkanized regulatory system is defeating us. What if the Food and Drug Administration, an acclaimed regulator, were broken up into the Vegetable Administration, the Fruit Administration, the Meat Administration etc. Is there anyone who thinks that would be more effective?

2. What needed to be regulated wasn't regulated. The huge shadow banking system wasn't on anyone's watch list. That needs to change by, say, yesterday. By rights the Fed is the best equipped to oversee shadow banking. But the Fed, we're learning, is an academic-minded, banker-sympathetic institution that enjoys gazing at its theoretical navel. These guys have no appetite for bare-knuckles regulation. So we'll have to figure out another way to do it, unless we can graft a pair of cojones onto this gelding.

There were cultural causes of failure:

1. Regulators didn't believe in their mission. Christopher Cox. SEC. Need I say more? And that's just one example. Under Bush, too many foxes were assigned to head The Association for the Safety of Chickens.

2. Regulators who didn't believe in their mission were, not surprisingly, uninformed about the latest innovations/questionable activities going on. Why spend your afternoon learning about credit default swaps/CDOs/some other complicated thing when your boss doesn't really care anyway and some really racy porno on the office computer is only a few mouse clicks away?

The single most important part of the solution, besides fixing the above:

Disable or at least severely crimp Wall Street's loophole-diving, rule-evading capability. Wall Street will always be a step ahead of the regulators in "innovating" cool new products that avoid tax payments and arbitrage capital regulations. We can shrug and meekly accept regulatory impotence. Or we can have a deeper conversation and realize it's time we started thinking outside of the box.

What about saying to the lords of high finance: any new product, whether intended for institutional or retail consumption, is illegal unless it has been approved by a new "Financial Products Safety Commission." Sure, Wall Street would howl. And such a requirement would quash some innovation. But, as we've seen, in this Brave New World of high finance, a lot of innovation is ultimately destabilizing and incredibly complex to no good purpose.

Or what about getting radical on accounting? Currently we let Goldman, Morgan Stanley et al do the limbo in a thousand creative ways to avoid capital constraints and make themselves appear more robust than they are. What if we told them the game has changed? That they are liable for criminal/civil penalties for using any accounting treatment that later is found not to accord with the spirit of existing regulations, as judged by say a "reasonable corporate accountant" or some such? Will this be chilling and cause more conservative accounting? Sure. But isn't that what we need after the free-for-all of the last decade?

It's fun to dream, though I'm not optimistic that any of my ideas will be adopted. We need big thinkers, big thoughts, ambitious men (and women!) to pull off meaningful change. And that's not what we have right now in Washington.

Friday, May 28, 2010

Was the Top Kill "Chance of Success" a Made-for-TV Number?

I'm always curious about how people use and abuse the tools of probability and statistics. In structured finance, slices of CDOs failed at a rate completely inconsistent with their high-level ratings. Okay, that's bad. But even worse is that when strips of CDOs started being packaged in other CDOs, not only did the level of complexity rise in the new products (the "CDOs squared"), but sensitivity to initial misrating -- and the implied low probability of default -- exploded. (The explanation of why this is so is a bit technical, but is worth checking out at Marginal Revolution's The Dark Magic of Structured Finance.)

Now Top Kill has failed.

Failed to plug the spewing oil pipe a mile below the water's surface in the Gulf of Mexico.

Failed to stop the environmental carnage taking place in the ocean and along Louisiana's shores.

Top Kill came with its own simple, straightforward probability: a 60 to 70 percent chance of success. The number gave us comfort -- BP was doing the right thing, because it had better than even odds of stopping the oil belching into the seawater -- but not too much comfort, because, obviously, the flip side of that rate of success is a 30 to 40 percent chance of failure.

I thought for a while about BP's public stance on the likely effectiveness of Top Kill, and thought some more, and finally concluded: Whether BP planned it this way or not, they came up with the perfect public relations probability of success. If Top Kill's chance of success was exhaustively and scientifically studied then ascertained to be a number anywhere between 10 percent to 90 percent, and BP came to me, and I was a seasoned PR professional, my advice would be:

"Say publicly that Top Kill has a 60 to 70 percent chance of success."

Why? Well, imagine it actually has a 10 percent chance of success. And BP admits that. What's going to happen? The public, media, elected officials -- everyone will turn on BP and excoriate the oil giant for not coming up with a plan that has reasonable odds of working. Then when Top Kill fails, everyone will roll their eyes and say, "Of course it was going to fail. It was a lousy plan with only a 10 percent chance of success."

Now imagine the converse: there is actually a 90 percent chance that Top Kill will achieve its objective. And BP announces that. If the operation then succeeds, there will be a sigh of relief, but also a sort of collective shrug. What did you expect? After all, a 90 percent chance is the equivalent of an uncontested layup in the game of basketball. But if Top Kill failed, reaction would be furious: how could they screw up something with a 90 percent chance of working?

Now where's the sweet spot? It's a percentage that aligns with "cautiously optimistic." It's a percentage a little north of 50 percent -- but not too far north. It's a percentage that, if you fail, you can say, "Well, we knew from the beginning there was a large chance we weren't going to be able to do this," but if you succeed, you can say, "This was far from a sure thing, but we pulled it off, and congratulations to the great team at BP blah blah blah." That sweet spot, quantified: 60 to 70 percent.

Who knows what the actual chances of success were? I'm not an engineer, but once I learned a bit about Top Kill, it sounded fairly dubious. It sounded more like an operation with a 25 percent chance of working -- if that.

What if we wanted to find out what BP's top executives, in their heart of hearts, really thought were the odds of pulling off Top Kill?

Here's one way: the top 50 BP executives could've been forced to stake half of their wealth to a "futures" market on whether or not Top Kill would work. Sort of like betting on a prize fight. They would be allowed to trade in and out of odds that would fluctuate (much as is done for a heavyweight championship fight) depending on which position the money is favoring, and by how much ... and eventually, we'd get something resembling what BP really thought were its chances of plugging the leak. So, for instance, one guy would be betting half his wealth that Top Kill had a 65 percent chance of working (and would collect 35 percent if he won) and another executive at BP would be wagering it had a 35 percent chance of working (and would collect 65 percent if he won).

A little fanciful, and you may wonder -- well, who cares if BP lied to us (note: I have no idea if they did, but wouldn't be surprised) on the odds? Actually we should care because when the odds are 10 percent, not 60 to 70 percent, there's much more pressure to develop a "Plan B" -- and "Plan C" and "Plan D" as well. And I kind of wonder if the odds were at say 65 percent of Top Kill being a success -- and BP executives could take that position, but it would cost half of their wealth to play -- how many would've gamely said, "I'm in on that bet!" My guess: very, very few.

Saturday, May 15, 2010

So Why Did the Stock Markets Do a Bungee Jump on May 6?

What I find interesting about this story (and if you think bungee jump is hyperbole, you haven't looked at the intraday Dow chart) is there's a decent analogy: Imagine that murder victims start turning up in some small, idyllic U.S. city. Throats slashed, bodies mangled. Residents grow fearful. They start locking their doors all the time, glancing over their shoulders, going out less. The pressure mounts for police to find the killer, to calm a jittery city.

Now imagine a hit-and-run of sorts in the financial markets. Stocks make a sudden, vertiginous plunge, only to rapidly recover. Billions of dollars of wealth evaporate, then reappear. But how did this happen? Who caused it? Who profited from it? Could they do it again, and what if the next time the markets don't bounce back? And so investors grow fearful. They wonder: Should I continue to put more funds into volatile stock markets? Can they be trusted?

And the search begins, among the financial forensic teams, to find a culprit for the turbulence on May 6.

Except -- here's where our serial killer analogy breaks down -- was it really a lone actor? We'd like to think that; it fits into a more comforting narrative, with justice to be meted out if we find wrongdoing, and if we don't, we at least know where to take measures to fortify the system. Could it be Mr. Fat Finger Trader? The clumsy oaf who pressed "b" for "billion" on his keyboard when he meant "m" for "million"? Or here's the latest suspect, according to
Shares of money manager Waddell & Reed Financial Inc. fell Friday as it was identified as the stock trader that sold off a large number of index futures contracts during last Thursday's market collapse ...

Waddell's sale of 75,000 e-mini futures contracts in a 20-minute span on May 6 drew the attention of regulators, Thomson Reuters reported.
These "minis" are tied to the S&P. A futures contract is a way to bet on which way you think a market, stock or commodity is going to move; narrowly defined it's an agreement to buy or sell something at a set price on a set day in the future.

Now that 75,000 number does seem impressive. Well, at first. tells us:
The current average daily implied volume for the E-mini is over $150 billion making it the most liquid trading derivative in the world.
What was the implied volume (I'm assuming "implied" refers to the contract's notional amount) for the 75,000-unit trade? Start with the notional value of an e-mini: $50 times the price of the S&P index. The high for the S&P that day was 2,407.8, so this trade was probably executed at somewhere south of that. Let's say the e-mini "dump" amounted to less than $9 billion of implied volume on May 6.

In other words, less than 6 percent of the typical daily volume came from this sale. Was this a big trade? Sure. Was it a little hard for the market to digest? Probably. Was it the real villain that we're seeking? I doubt it.

It's a media-ready story though. The storyline is simple. The government also surely realizes that finding a lone actor will make its job so much easier.

Unfortunately, a more sophisticated analysis of possibly the real culprit on May 6 has emerged, an analysis that is not so comforting. It suggests that our stock markets have a deep, systemic flaw. Paul Kedrosky at Infectious Greed nicely, and succinctly, laid out the argument in "The Run on the Shadow Liquidity System."

His view: good old-fashioned liquidity in the stock markets has been transformed in the age of supercomputers and high-frequency trading and algorithm-driven strategies:
... traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health. This is ... mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers...
The result:
... all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim.
Certainly we need to find what went wrong on May 6. We need to, to reassure the investing public that our stock markets are safe, fair, reliable -- places where you can feel comfortable putting a large chunk of your retirement nest egg. But, in the rush to judgment, we should be on guard against trying to largely pin the events on a lone actor, just to avoid a truth that is both complex and inconvenient.

Update: Actually, the fingerpointing at Waddell & Reed appears even more misguided than I thought ... you can blow up those calculations I made above; they were for a normal trading day. Turns out that during the 20-minute freefall on May 6, 842,514 e-mini contracts swapped hands (says Reuters). 75,000 is less than 9 percent of that number (and is probably only a few percent of the total for the day) ... again, it's sizable, but remove Waddell & Reed, and you still have a heavy, heavy volume.

Tuesday, April 27, 2010

Levin vs. Blankfein Faceoff

Some quick observations on the performance of Goldman Sachs' CEO at the roasting before Congress today:

1. Blankfein technically outpointed Senator Levin during the opening exchange, I think -- Levin doesn't have a particularly deep understanding of high finance -- but Goldman's chief lost the big point: how Goldman's actions appear to Main Street. Basically Blankfein condoned the practice of "betting against a product you're selling." That's the damning headline. Here's what it sounds like to Joe Blow: I sell you my car, and meanwhile, I bet with someone on the side that the car will break down within six months. No graceful way to put lipstick on that pig.

2. Notice how often Blankfein used the phrase "market maker" when facing off with Levin? Nice defense except -- Levin wasn't really interested in being tutored on what a market maker does. Levin was too busy cudgeling the head of the investment bank with the "conflict of interest" point. Main Street doesn't understand "market maker." It does, however, understand quite well "conflict of interest."

3. Is the successful beating up on Goldman a sign that the investment banks have been hoisted on the petard of the complexity they nurtured? They produced synthetic CDOs that the rating services couldn't understand and mis-rated; these same synthetic CDOs were so complicated, with so many sliced and diced mortgage-backed securities underlying, that arguably the disclosure standard should have been higher than normal, even for sophisticated investors; "synthetic CDOs" are raising a lot of eyebrows among members of Congress who are wondering -- "What the hell is the point of something that's this damn confusing? There's got to be a rat in this woodpile."

4. Senator McCaskill scored points, along with McCain, by noting that with a synthetic CDO, there's no real there there. It's just a side bet on actual assets that have already been sold, so you're not actually buying anything concrete. McCaskill shook her head in befuddlement before saying, "seems like a hamster in a cage trying to get to compensation." Blankfein defended the product with some mumbo jumbo about managing risk profiles. But what we're left pondering is McCaskill's image of hamsters manically tunneling through the wood chips for dollar bills.

5. Is Blankfein this dumb, or did he have a convenient "idiot" moment: Senator Pryor asked him about structured investment vehicles (actually, Pryor used clumsier wording, and then Blankfein hastily corrected him, knowledgeably saying "structured investment vehicles.") And then Blankfein goes completely ignorant, it seems, when asked why the bank would use an SIV. His reply: "I'm not sure." (Cue laughtrack at home.)

Ah, a little more cathartic financial-crisis theater ...

Monday, April 26, 2010

Financial Reform: Unsung Proposals that I Wish Were on the Table

We will be getting reform, and soon, it appears. Mike over at Rortybomb nicely table-izes six big areas/rules/issues to watch as legislation takes shape.

Maybe I'm just getting jaded, but what's on the table doesn't excite me much.

Transparency in derivatives through exchange trading? Yes, deeply important, but lobbyists will probably carve out small exemptions that Wall Street banks will then funnel as many of their trades through as possible. Too big to fail? Yeah, sure, cut 'em down to size, but Krugman is right on this one. Smaller banks, sufficiently interconnected and freighted with risk, can haul down the system too.

Hard leverage cap? I wholeheartedly support limiting leverage, but remember: leverage is a number. As Repo 105 and the continual perversion of accounting for capital under the Basel Accords show us, annoying numbers can be massaged. So under a hard leverage cap, I predict an explosion in "leverage-friendly financial innovation." Just wait.

So what is there to do? It won't happen during this round -- maybe the system has to seize up again, horribly, in the next few years -- but I wish we would look more at meta-type solutions. Here are some unsung proposals that I wish would get more consideration:

1. Contingent debt. This comes from the Republican side of the aisle, and though I confess to not having studied in great detail how the idea would work, I like the gist of it: banks hold a chunk of bonds that, when they come under duress, automatically convert to equity, boosting their cushion of capital. The percentage of such debt could be adjusted, if need be. The concept is market-oriented, as investors help police the institution's risk-taking. As Greg Mankiw writes:
This contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.
2. Financial transaction tax. I know, I know: to have efficient and liquid markets, you want participants to be able to trade as freely as possible. But I think that, sometime over the last decade or two, the amount of trading vaulted through the point of maximum efficiency and into something else -- something born of supercomputers run amok that just encourages volatility and instability. We need to slow down the financial machine a little. A small tax might encourage the bloated financial sector to shrink a little (a good thing) and raise money for our deficit (also a good thing).

3. "Deep clawback." Misaligned incentives are clearly an issue. And there'll be some feeble attempts to better align pay with long-term performance, but little will probably change. What we need is a way to get deeper into the pockets of bank executives and directors who allow their companies, through negligence or a desire for risky growth, to spin out of control, endangering the financial system. It sounds radical, but let's consider putting their personal houses and cars on the line -- or at least make them easier to prosecute criminally. Then behavior will change. If bankers hate "deep clawback," there's an alternative: Regulate the financial industry like a utility.

4. Move away from a rules-based to a principle-based system. This would be tremendously useful. With a squadron of lawyers and accountants in tow, every major Wall Street bank knows how to game and evade and twist every single rule that's been thrown at them. They will ALWAYS beat a rules-based system. But what if, in certain places in our laws, we used the language "what a reasonable accountant would ..." or something similar? This would stop them dead in their tracks. Because then they can't simply say in defense, "Well, you don't explicitly prohibit what I'm doing, so it must be okay."

So those are some of my favorite ideas that aren't seriously part of the discussion, unfortunately. We will get reform. It may not be that impressive. But if the financial system blows up again -- and relatively soon -- someone in Congress may get the idea that what we really need is more meta-reform -- and less tinkering around the edges.

Saturday, April 17, 2010

The Goldman vs. SEC Story That No One Has Written ...

When I saw that the SEC had finally decided to go after Goldman Sachs, I immediately rejoiced: Yes. At last. What the hell took you so long?

Then, when I started sifting through the strange case of Abacus 2007-AC1 (fairly trips right off the tongue eh?), I had a "pullback" moment, especially after seeing Goldman's defense (see the bottom of the page).

First, I have no love for Goldman. Far from it. I think it's rather creepy the way they release their ideological spores throughout our political system by practicing "civic responsibility" and occasionally shipping a handful of executives off to the Treasury Department, to keep the U.S. approach to the financial system appropriately capitalist at all times. But this Abacus case -- ah well, it doesn't make sense, unfortunately. I think the SEC will lose unless Goldman wants to pay up to make the bad publicity go away.

Here's why.

Read the SEC complaint. Read Goldman's denial. Observe the Venn diagram point where the two fact sets overlap in a significant way.

From Goldman: ACA had the largest exposure to the transaction, investing $951 million.

From the SEC: On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.

Think about that for a second. Whether it's $909 million, $951 million or $927.33311 million -- ACA, both sides agree, had a huge exposure to this deal. This was a $2 billion synthetic CDO. The German bank IBK, the other banner investor, only had $150 million of exposure (though to riskier tranches, true).

So ponder this a bit: why would ACA, whose duty was "portfolio selection agent," allow itself to be duped into stuffing the CDO sausage with the RMBS equivalent of rat tails and nose parts, if it was so hugely on the hook for the losses? Because consider this (all part of the SEC's own fact set in its complaint):

1. Paulson was a known short on subprime mortgages at this point. In 2007, the synthetic CDO was set up. Here's what happened a year earlier, according to the SEC:
Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities.
2. ACA wasn't some newbie from Canoobie when it came to setting up CDOs. The SEC tells us:
ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.
And, what's more, ACA knew that Paulson was heavily involved in helping pick the securities for Abacus. Again, the SEC:
On February 5, 2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2 level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?”
So get a load of this: You're ACA. You're among the best at structuring CDOs. You should be able to evaluate the mortgage bonds being assembled for the security pretty well. You should know how the risks work. You should also know what's going on in the larger market: who's bullish on these things, who's bearish (Paulson, Paulson, Paulson).

And you swallow risk on about half of a synthetic CDO that you let Paulson fill with, um, crap?

I think there's more to this story than meets the eye. My guess is that ACA is much more guilty (of stupidity or something else) than anyone is suggesting. I think (1) they got caught being idiots, essentially making a longish bet on residential mortgages by insuring the super-senior tranche of the CDO (this is the last one to take losses, when the defaults start to mount) (2) they may have been making a cynical play, on the bottom part of the synthetic CDO, letting Paulson pick some crap, thinking that the super-senior tranche would be amply protected if the housing market deflated a little OR they were simply grossly negligent and unbelievably stupid by not reviewing the bonds that a known subprime-mortgage short was stuffing into a CDO they were insuring almost half of.

So I'm doubtful the SEC will win this one, unless there's something big I'm missing. But I think the SEC's case will be the perfect stalking horse for achieving the financial system reform that we do need pretty badly -- so maybe it's not so bad to put Goldman on the rack for a year or two.

Saturday, April 10, 2010

Must-Read Story of the Morning

I've grown a little numb to the shocking revelations of this financial crisis, but every so often, a story will drop my jaw and make me go "wow."

Today's candidate: Pro Publica's The Magnetar Trade.

One of the authors, Jesse Eisinger, you may remember from the Wall Street Journal. I admired his stuff during his tenure there. He impressed me as a smart guy who liked to dig -- and then dig some more.

The "Magnetar trade" Yves Smith apparently has written about at some length in her new book Econned. She has mentioned Magnetar a few times on her blog, without going into too much detail (I'm sure her book does, and I'm dying to read it. Where's my review copy, dammit? :))

Right now, Magnetar looks like the scariest enabler of this subprime bubble I've seen so far. Of course Michael Lewis looked at the enabling role the shorts played in his The Big Short. But the players he interviews were small. And they were only indirectly feeding the subprime lunacy.

To wit: as long as there was appetite for products packed with questionable home mortgages (the securities known as CDOs, or collateralized debt obligations), his shorts would happily take the other side of the trade. But, as far as I can tell, they weren't actively instigating the creation of these crap-congested things.

Magnetar apparently had a more clever, and dangerous, approach. It offered to buy the lousiest portions of the CDOs (the so-called "equity tranches" -- they're not technically equity, but tend to behave like equity, thus the name). For a high risk investment, the equity tranche is like the canary in the coal mine, an early-warning signal of trouble ahead. Or, to mix animal metaphors: A fish rots from the head down. A CDO rots from the equity tranche up.

So the equity tranche can be hard to place, especially for a shaky investment. And if you can't place it, then the CDO just doesn't get created. So was Magnetar crazy?

Crazy like a fox, it turns out. Because the hedge fund turned around and shorted the entire CDO.

How it made money initially puzzled me, but as far as I could tell (Eisinger keeps it sketchy, presumably because he's writing for a general readership), Magnetar's equity investment was a rather small piece of the CDO, and since the hedge fund was going short on the entire security, it stood to gain more than it would lose. The disturbing brilliance of this strategy: while the CDO is "in the clover," making money, the income thrown off by Magnetar's equity tranche funds its short bet on the CDO. So the fund solved the classic short problem of "how long can I afford to hold out if this thing doesn't blow up soon?"

Read the story. I have a feeling that "Magnetar," before this a name that's been largely under the radar, is about to start attracting a little (unwanted) attention.

Update: My further reading leads me to believe that Magnetar was buying credit-default swaps against other slices of the CDO (larger slices than what it owned certainly), though not the entire CDO.

Friday, April 2, 2010

"So, My Friends, What is This ... 'Financial Innovation' You Speak Of?"

I've sometimes wondered what would happen if aliens teleported in to Washington and -- since they're aliens, of course, and naturally inquisitive -- began asking questions about anything and everything ("You peel it before you eat it? Ah yes, fascinating. So this Seinfeld, he is like a king to you?"). Eventually they'd get around to the financial crisis and how we plan to prevent such a disaster in the future. And our "wise men" (Geithner, Summers, with some bespectacled lackeys in tow) would patiently explain how we have to restrain bad behavior in the system, while not discouraging financial innovation.

At which point I imagine the lead alien, Zrigfryx, would scratch his ample, hairless dome and say:

"So, my friends, what is this ... 'financial innovation' you speak of?"

And if I were sitting in the back row of the small assembly -- lucky enough to have snagged one of the lottery tickets for the the limited seats available to the public -- I'd thrust my hand high in the air and say, "Oh, I know. I know. Let me answer that one."

Because I'm really starting to understand what this "financial innovation" is that the industry is so hellbent on preserving.

Just the other day, I happened to come across this Bloomberg story about how the investment bank Macquarie Group hired a guy by the name of Christopher Hogg. What particularly caught my eye was Hogg's signature accomplishment: "a developer of one of the most popular financing tools of the 1990s."

So what did he innovate? A way to finance infrastructure projects in poor countries, expanding GDP and turning generous profits at the same time, a real win-win? A more efficient pipeline for getting capital to struggling small U.S. businesses that deserve it?

Nope ... and nope. Hogg came up with "Mips." Cute name. Sounds like a Christmas stocking stuffer that turns into a runaway bestseller. Mips are actually "monthly income preferred securities." They're described as "a type of preferred stock that resembles debt." Now you may wonder, "Why the heck do we need these things? What greater purpose do they serve?"

Well, it's sort of like this: You look at "Mips" through your right eye and you see an equity, like a preferred share of stock. But you look at "Mips" through your left eye and you see a bond -- or debt. Mips involve special purpose vehicles (what doesn't these days, eh?) and an appropriate amount of complexity that I'll skip over here.

The bottom line is, after all the innovating, here's the payoff:
The shares provide benefits of stock because they’re considered equity by debt-rating companies while offering tax advantages of bonds because companies can deduct the dividend payments from income they report on their tax returns.
Got that? Basically Mips are a tax dodge. It's not that Mips have found a way to provide capital more efficiently or smartly ... in fact, in a world with an ideal tax code, Mips probably contribute to the less-efficient allocation of capital. Remember those CLO "innovations" that appeared to offer higher returns for the same risk as other similarly rated products? And how they started inefficiently sucking in capital and no one bothered to ask, "Hey, is the risk just being mispriced here or is there really a free lunch sitting out there on the sidewalk?"

Of course with Mips the rejoinder might be: the U.S. doesn't have an ideal tax code. To which one might reasonably reply: Okay, so which option is better (1) Try to fix the tax code (2) Let people exploit whatever loopholes they can find and the hell with it; happy Easter egg hunt!

Mips are hardly a rare example of loophole-seeking "innovation." Just this week in Dealbook, Andrew Ross Sorkin nailed another one: dividend payments that are embedded in derivatives so investors can avoid paying any taxes on the income. Nice huh? While you and I are faithfully mailing off checks to the IRS for our dividend taxes every year, certain wealthy people, helped along by "innovators," aren't playing by the same rules (note: this loophole is being closed, thank God).

I imagine that after I finish explaining all this to Zrigfryx, and he extends a spindly forefinger to scratch his dome again in puzzlement, he might say something like:

"So why is preserving all this financial innovation so important to you Americans?"

And I guess I'd say:

"Larry? Tim? You want to take that one?"

Monday, March 29, 2010


I was shocked today when one national daily quoted a senior officer in-charged of Islamic rating at a well-known Rating Agency as referring to Sukuk as Islamic debt paper. I am perplexed as to the fact that that statement, which is far from the truth about Sukuk that is globally defined as investment rather than debt certificate came from someone who is supposed to know the basic. However the maker of the statement can be excused if what he meant was that type of the so-called sukuk structured based on sale of debt that have been flooding the market for quite sometimes. This type of sukuk is no sukuk as far the international perspective is concerned, at least in theory. The truth is that sukuk if they are to be understood correctly must refer to certificates issued as evidence of investment and not of money lent to the issuer. But unfortunately, given the conventional framework within which many sukuk have been hitherto issued, that original basic concept has been forgotten more frequently than ever. It is perhaps thus not surprising to find series of reports that talk about defaults in sukuk as similar to default in loan repayment or point towards the need for any relevant issuer of sukuk to redeem the sukuk at the designated time at par value or to pay as a matter of contractual obligation the profit as contracted. If this is the true description of sukuk, then why in the first place there is any need to name the same as sukuk; just name them as bonds where money is borrowed and lent based on a contracted price@ interest.
Just because sukuk were viewed as no different from fixed income instruments based on debt, any failure to pay the so-called profit will constitute a default irrespective of whether such non-payment is due to fault or negligence or breach of rules or not. If this is truly what is intended by the relevant parties they have to accept that they are not issuing sukuk but just any other bond or fixed income instrument in respect of which Islam has nothing to do with.

Saturday, March 27, 2010

Were There Widespread Fire Sales of Assets During the Financial Crisis?

Last week I argued that Gary Gorton failed to prove there were fire sales of assets during the financial crisis. Of course he chose a bad indicator, and so set himself up for a formidable challenge, sort of like trying to hit a home run with a plastic whiffle bat. He looked at spreads of investment-grade corporate bonds -- specifically, at periods during the crisis when, inexplicably, investors demanded higher yields for AAA corporates than for AA. But, alas, the inexplicable proved all too explicable on closer examination.

Still, that's a narrow example. What about those big U.S. banks that refused to sell securities, citing "fire sale" prices they were being offered. Was that accurate at least?

This is worthwhile to ponder because the Treasury and the Fed completely bought into the "fire sale" story. They fashioned a response to the crisis appropriate to a situation where the biggest problem was not bad assets, but investors with bad (irrational) thoughts about assets that were good ... or at least not all that bad. Remember these words from the Treasury rollout of PPIP?
The ... need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
For starters, it's worth disentangling some self-interest here. The banks had a huge vested interest in having us believe the "fire sale" thesis. Because, if we did, that meant: (1) They could justifiably refuse to sell the assets at the "fire sale" price and not confront the fact that they might be insolvent. (2) They not only could keep the asset on their books, but also they could justify fudging the price -- after all, if a market isn't rational, shouldn't you inject your own rationality? (3) If the problem lay not in the asset, but in the broader market, they could slough off blame for having made a bad investment. (5) Not only could they shed blame, but they also could make a play for sympathy: "vultures" who prey on the distressed by seeking "fire sale" prices aren't very sympathetic figures. (6) They could wait for a bailout that they could already see coming on the horizon.

So the "fire sales" thesis was a very, very powerful one, in many ways, for the big banks.

But again: to what degree was it true?

I thought about this for a while and came up with a back-to-basics approach to understanding where the truth lies. It starts with a typical "fire sale" example from real life.

Joe, in Detroit let's say, just lost his job Friday. It's Saturday. He needs to make rent Monday. He's on the front lawn next to a large hand-lettered sign that says, "Yard Sale." All around him: the armoire, his old Spider-Man comics, a few boxes of hand tools, and other odds and ends marked really cheap. Consider the armoire alone. Say its "true" price, secondhand, should be $100, but Joe's selling it for $20.

80% off! A real "fire sale" price.

But what is meant by its "true" secondhand price? "True" in this context is a slippery word. So let's define further -- okay, a bit arbitrarily, but some benchmark of value must be established. Let's stipulate the "true" price represents what a used-furniture dealer in the middle of Detroit would typically get for the item within a one-month time frame, were it offered for sale in his showroom.

This example allows three important factors to be isolated, in determining whether something is being subject to a "fire sale" price:

1. Time urgency -- The quicker something needs to be sold, the more "fire sale" pressure on the price, all else being equal. If Joe had more than two days to sell the armoire (the furniture dealer typically counts on a month), chances are good he could get a better price.

2. Breadth of universe of buyers -- Joe is counting on finding a buyer among the people who happen to drive by his house, and who at the same time happen to be looking for an armoire. The furniture store, on the other hand, has more relevant buyers by virtue of the fact that there's a regular flow of clients that cross the threshold expressly looking for pieces such as what Joe is selling.

3. The "money like" nature of the asset -- The less "money like" the asset, the more likely it will be subject to "fire sale" pricing pressure. Joe's armoire is very "un-money like." But if Joe was selling a $100 savings bond coming due in six months (and, to keep the example simple, we assume a zero interest and inflation environment over that time), he should receive close to $100 for it.

Now consider a residential mortgage-backed security in the fall of 2008. A big U.S. bank holding the asset says it's worth 90 cents on the dollar. A buyer says it's worth 40 cents. So is that a "fire sale" price? How does the above criteria apply here?

1. Time urgency: Does the asset need to be sold immediately? Small hedge funds and thinly capitalized speculators did have to dump assets at stress points during the crisis, trying to meet margin requirements or cover large withdrawals. But the big banks didn't appear to be in dire straits. They freely turned away buyers. So there really wasn't time urgency that the buyer could leverage for advantage.

2. Breadth of universe of buyers: Markets these days are increasingly global. U.S. subprime dreck, after all, found a home in insurance company portfolios in Taiwan. Likewise, if there really was a liquidity crunch in the U.S., the big bank's assets could have been offered up around the world. The Chinese have huge dollar reserves. Well before 2008, they complained publicly about having to hold so many Treasuries. If the "fire sale" assets were really woefully underpriced by investors in the U.S. and a surefire bet to offer reasonable returns at 90 cents on the dollar, China's state investment vehicle could have snatched them up.

3. The "money like" nature of the asset: The RMBS is a bond backed by streams of payments from mortgage holders. So it's fairly "money like." Granted, you do need to crank through calculations of expected defaults etc. But that all translates into a degree or risk, for which you demand a premium. At the end of the day, you still get compensated with money.

So what happened? How can you get so fast from 90 cents on the dollar to 40 cents without a fire sale? There must be some irrationality wrapped up in that low price, right?

Maybe not much. Consider that a buyer of the asset will demand some discounts, for sensible (not "fire sale") reasons:

1. The underlying assets, as home prices plunged, were starting to rot out, even if homeowners were at that moment current in their payments. Negative equity loomed.

2. The assets were further suspect because it was becoming obvious that the ratings agencies had improperly bestowed AAA ratings on many of them when they shouldn't even have been rated investment grade.

3. The buyer would have to do a certain amount of due diligence on a complex asset to become comfortable with the risk contained in the thousands of underlying home mortgages, and would naturally need to be compensated for this information gathering.

4. The broader RMBS asset class was tainted and so the asset was no longer as valuable for use in the huge repo market (just as, in the repo market, a bond that becomes "special" becomes more valuable in a quantifiable way, so the reverse is true -- when it becomes "stinky special" it's worth less for repo transactions and so a bond that's heavily repo'ed -- as AAA securities were -- should drop in price).

5. The very complexity of the asset, and its reputational damage, would impair the ability of the buyer to resell it, so the perceived illiquidity would impair value.

6. The complicated nature of the asset created possible minefields for the buyer, minefields that would most likely start blowing up if the asset were to deteriorate further, so taking on the risk related to complexity demanded some discounting.

7. There was significant systemic risk in the world at large, and this led to risk profiles being adjusted upwards for even apparently safe tranches of dicey securities.

So of the 50 percentage point gap, what can be attributed to "fire sale" pressure? Of course it's impossible to say without a concrete example. But I think if you went through these assets for the big banks, one by one, the "fire sale" factor would generally account for a small to very small part of the discount.

If you want another take on this issue -- basically agreeing with me, but using a capital asset pricing model where equity and credit markets are compared (and using a lot of formulas) -- check out The Pricing of Investment Grade Credit Risk during the Financial Crisis. Its conclusion:
Many analysts appear to be looking at large recent price changes and concluding that we must be witnessing distressed pricing and widespread market failure. This conclusion is based on intuition that fails to appreciate the extreme nonlinearity in the risks of credit securities, especially those manufactured by securitization (i.e. CDO tranches). Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its volatility, and an improved investor appreciation of the risks embedded in these securities. From this perspective, policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay -- and perhaps even worsen -- the day of reckoning.
Now, after having expressed all this skepticism, I'm going to do a bit of a pivot here and move in the other direction: I do think that "fire sale" risk is a growing danger going forward.

If the first of the three stress points for "fire sales" is time urgency, that means when everyone beelines for the exits simultaneously, you're in deep trouble. Now the way the modern financial system has been evolving -- quants who seem to be copying each other's homework and modeling the same assumptions, super-computers that trade at blistering speeds, a global system where money flows easily across borders, interconnected networks of growing complexity -- it's becoming easier to imagine a situation where everyone does try to cash out all at once, and that causes the system to lock up. And a systemic regulator should be looking hard at this issue.

But in late 2008 and early 2009, I don't think the "fire sales" thesis explains the huge pricing gaps for securitized assets such as RMBS the big banks were trying to sell, especially considering the Fed's activist role during this period. Rather, this was simply a clever decoy that the banks used to redirect attention away from the truth. It's what they want you to believe happened because it lets them off the hook ... and helps create the rationale for the Great Hidden Bailout of 2009 that we'll all be paying for, in ways large and small, for years to come.

Saturday, March 20, 2010

Debunking Gary Gorton's "Fire Sale" Thesis

A few weeks ago I looked at Gary Gorton's Somewhat Flawed Take on Shadow Banking. One big problem I had with his paper (which now has been enshrined as part of the public record at the Financial Crisis and Inquiry Commission) is his analysis of a very curious phenomenon during the first half-year of the worst part of the crisis. Namely, at several points, AAA rated corporate bonds paid bigger yields than AA rated. This is a real "upside down topsy turvy" kind of thing. Bonds that achieve a triple AAA rating -- the highest possible -- are supposed to be really safe, almost U.S. Treasury safe. AA, the next ranking down, denotes a bit more risk. And a bit more risk means that investors demand a higher yield.

But over two periods -- one in the fall of 2008 and the other early in 2009 -- investors were getting a dramatically lower yield (well, dramatic in the bond world) for AA than AAA. That's Alice in Wonderland stuff, it seems.

Gorton explains the market weirdness on page 13 of his paper to the commission. (First, here's background you need: just before the excerpt below, he was discussing the sudden withdrawals of funds from the shadow banking system, withdrawals that took the form of repo haircuts on structured debt -- if you're lost by that last sentence, see my earlier post on Gorton's paper, linked above):
Faced with the task of raising money to meet the withdrawals, firms had to sell assets. They were no investors willing to make sufficiently large new investments, on the order of $2 trillion. In order to minimize losses firms chose to sell bonds that they thought would not drop in price a great deal, bonds that were not securitized bonds, and bonds that were highly rated. For example, they sold Aaa‐rated corporate bonds.

These kinds of forced sales are called “fire sales” – sales that must be made to raise money, even if the sale causes to price to fall because so much is offered for sale, and the seller has no choice but to take the low price. The low price reflects to distressed, forced, sale, not the underlying fundamentals. There is evidence of this. Here is one example. Normally, Aaa‐rated corporate bonds would trade at higher prices (lower spreads) than, say, Aa‐rated bonds. In other words, these bonds would fetch the most money when sold. However, when all firms reason this way, it doesn’t turn out so nicely.

The figure below shows the spread between Aa‐rated corporate bonds and Aaa‐rated corporate bonds, both with five year maturities. This spread should always be positive, unless so many Aaa‐rated corporate bonds are sold that the spread must rise to attract buyers. That is exactly what happened!!
When I read this, his "fire sales" thesis didn't smell right. Before we see how it falls apart -- I chose to look at a puzzling period in March 2009 when it appears that the worst outbreak of "fire sales" occurred, according to his own graphic -- let's make a couple of stops.

Why does this matter anyway? This "fire sale" section is buried on page 14 of his presentation.

Because -- and this is very important -- there are two dominant views of this financial crisis. They are so critical to shaping perception, they are practically worldviews. Depending on which you hold, you're likely to propose a different set of policies to revive the financial system. They are:

At the heart of this crisis was a liquidity crunch. The banks peddled this line furiously. Credit markets seized up and poor bankers were innocent bystanders, stuck with valuable assets they could only sell at ... here it comes ... fire-sale prices. The market was valuing their assets, worth 90 cents on the dollar, at 40 or 50 cents! If you believe this: you probably thought that Geithner's PPIP proposal made sense and was going to work, and that the big banks just needed a little breathing room and an infusion of liquidity (which the Fed happily provided in spades) and they'd get back on their feet and start lending normally again.

At the heart of this crisis were plain ol' crappy, overvalued assets. Their values had become inflated by a combination of loose money spurred by too-low Fed interest rates, rating-agency complicity, opaque markets (RMBS, CMBS), and maybe a dash of housing-bubble mania. If you believe this: you probably thought that tougher measures needed to be taken with the big banks, that these crappy assets had to be honestly accounted for and cleared at market prices, and that large swaths of the banking system were insolvent.

Notice most smart observers would assign some truth to both; they are not mutually exclusive concepts. However, people tend to align themselves with either the first or second idea. I am in the second camp, firmly, and Gorton seems to be more in the first.

Okay then: why doesn't Gorton's explanation smell right in the first place?

This is sort of interesting. Let's go meta-finance for a moment.

There are many classes of assets. And there is money, the ultimate liquid asset, extremely flexible and wonderfully fungible. One way of looking at assets is to see how "money like" they are (I'm not precisely talking about liquidity here, so I'm going to stick with "money like"). By "money like" I mean how much "objective value" (as expressed in a unit of money, say dollars) the asset contains. So if we all were guaranteed $2 for any loaf of bread (that met certain criteria of course, pertaining to such attributes as dimensions), and the bread could be redeemed at "bread banks" (a groaner, I know), loaves of bread would be very "money like."

Okay, let's take Beanie Babies. Gong! Not very "money like" at all. At the height of the fad, you might receive $50 for a rare stuffed penguin that might not fetch 15 cents a year later. Let's slide quickly down the asset scale. House -- more "money like." Share of stock: even more "money like." A plain-vanilla corporate bond: very "money like."

For what is an ordinary "bullet" corporate bond? A series of interest payments, usually semi-annual, and then a lump sum spit out at the end of its lifespan of maybe 5, 10, 20, or even 30 years. And these payments are all made in ... money. Bonds don't pay you in Toblerones, iPads, or dental floss. It's all money, money, money.

Now what's a simple way to think about a bond's coupon? Say IBM's 5-year plain-vanilla bond pays 4 percent interest and is rated AA. Part of that coupon -- let's say 2.5 percent -- reflects interest rate and inflation risk over the five-year life of the bond. The remainder -- and this is where it gets interesting -- is for credit risk. Since IBM is perceived as really safe, it pays out 1.5 percent interest for credit risk. If it were Johnson & Johnson, let's say, and rated AAA, and perceived as really, really safe, it might pay only 1.3 percent.

Now which of these bonds would you, Joe Investor, buy? You might think the IBM at 4 percent instead of the Johnson & Johnson at 3.8 percent. The IBM pays more, right? But that company also stands a higher chance of defaulting on its debt. There's no free lunch. You take more risk; you get more money.

But what if the Johnson & Johnson, with its AAA rating, paid 4 percent, and IBM, a whole grade lower, paid only 3.8 percent. That's a no brainer. Bonds are very "money like," remember? You don't "like" a bond more because it's prettier, has a dormer window on the third floor, or would look good on a pendant. You like it for its money-ness. So you'd snap up Johnson & Johnson at 4 percent and marvel at your wonderful luck.

Which brings us to our main subject ...

Why did yields on AAA corporates balloon out over AAs if that doesn't make any sense? Was it indeed a "fire sale" as Gorton claims, a mass rush to the exits, with perfectly good AAAs being chucked overboard at whatever price the market would offer?

I did some research. I did so knowing that Gorton's thesis would stand under three conditions: (1) the AAA corporates were "true" AAAs and not lower grades masquerading as AAAs (2) the universe of AAAs was reasonably diverse in nature (as in, not skewed to one particular industry) (3) there was a reasonably large number of AAA corporates trading (as in, you might have a diverse selection of bonds, but if there are only six of them, that's too few and the volatility of small numbers could explain the strange inversion between AAA and AA yields.)

I could have looked at the period in late 2008, but instead I chose an even more dramatic one, where an even larger inversion occurred (even more "fire sales"!). If you look at Gorton's graphic on page 14, you'll see the icicle-shaped spike in early March of 2009. Briefly, AAA corporate bonds paid more than 2 percentage points more than AAs! That's a huge spread. Gorton would have us think that investors were just dumping truckloads of perfectly good AAAs and the market, facing a glut of the bonds, irrationally pushed their prices way down (and their yields up).

So I looked behind the curtain, using a handy Bloomberg machine. And what I found was nothing like what he suggested was going on.

First, using Merrill Lynch indexes, I saw evidence of the inversion easily enough. The components of Merrill Lynch's AAA index may not exactly match what Gorton looked at, but the curves seem pretty close, so I think we're on fairly solid ground (as you'll soon see, there aren't a lot of AAAs in the first place, so I'm confident there's large overlap in both our data sets; I may graph my numbers later and drop in that visual here). Also I focused on AAAs because that's where the real story is: while AA yields did creep higher during that period, the AAAs zoomed past them and were mainly responsible for creating the gap.

And what a gap it became: AAA pulled ahead of AA by 11 basis points on March 2. That spread widened out to 191 on March 4, hit a high on March 5 of 195, then subsided to 135 on March 10 and fell to 74 on March 13. (Note: there are 100 basis points in 1 percent, so 195 basis points is 1.95% -- which may not seem like much, but in bondland, between investment-rating grades, it's huge.)

Then the meat of the investigation began. Who was in the AAA corporate index at that time? A diverse, large number of companies?

Nope. Not by a long shot. Not many companies win a AAA rating, understandably, only the best of the best. I went through a half-dozen screens of the bonds in the Merrill Lynch index as of March 6, 2009 (the screens show a company name, and the specific bond that belongs to the index). And guess what? To call it an index at that time was pretty much a misnomer. It was General Electric.

General Electric bonds (or those of its financing arms) accounted for 71.5 percent of the index weighting. Berkshire came in second at 8.9 percent. That leaves less than one-fifth for everyone else (and there weren't a lot of others, though it hardly mattered because they made up so little of the overall weighting anyway).

(Note: a careful reader of Gorton will see that he looks at only 5-year bonds. Even so, it turns out that when I filtered for that criterion, it mattered little: GE's weighting drops a little, but only to 68 percent, and Berkshire's rises a little, and everyone else is about 20 percent again.)

So the story of AAAs in March 2009 is not really a market story about AAAs ... it's a story about GE. Still, to be fair to Gorton -- it could be that investors were irrationally chucking their solid GE bonds, desperating trying to raise cash, even though GE was a top-tier company. So what was the GE story right about March 5, 2009? A great AAA corporation with the wind at its back, sailing toward a sparkling future? Let's concede that the early part of that year was turbulent, and markets were down, so one might expect a ding or two in the giant's armor.

It turns out GE's armor was more than lightly dinged:
1. Its stock had plunged 61 percent from Jan. 1 to the end of the day March 5, almost three times the drop of the S&P 500.
2. Its credit default swaps were trading sky-high, meaning investors saw GE as a poor credit risk. The swaps were 1,037 basis points on March 5, compared with JPMorgan's 219 -- and JPMorgan was rated only AA! So let's mull that: JPMorgan at the time was considered almost five times safer than GE, even though GE was a higher-rated company.

And, if you're still not convinced, a March 5 Bloomberg story quotes Marilyn Cohen of Envision Capital Management on GE: "It's a leper right now."

A AAA rated leper? Sounds like an oxymoron. What were investors so bent out of shape about? Bloomberg's article says:
Investors are punishing the shares on a presumption, which the company disputes, that GE Capital will need more outside funding to cover potential writedowns and losses in real estate, consumer credit cards and leasing.
There was a fear that GE's finance arm would need to post $12 billion in collateral if its long-term ratings were cut to single A. Whence this downgrade fear? Well, Moody's said on Jan. 27, just a month earlier, that it was looking at lowering GE's rating. And in fact, if you look at the same AAA Merrill Lynch index on April 15, 2009 -- about a month later -- neither GE nor Berkshire are there; they've dropped off.

So did AAA corporates irrationally leap above AAs during this tumultuous period in March, when the greatest spread inversion of the financial crisis occurred? Absolutely not.

There were no "fire sales," as Gorton would have us believe. This wasn't a story about investors in hard times selling grandma's fine china at big discounts so they could afford a little soup for dinner. This is a story of ratings lagging behind reality, legitimate investor concerns, and GE's peculiar circumstances. So next time you hear the "fire sale" argument advanced, approach with full skepticism.