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Economists don’t understand the financial system
Cross posted from Naked Capitalism.
A bit more than a week ago I went to a panel discussion at the Met about the global financial crisis. The panel consisted of Paul Krugman, Edmund Phelps, Jeffrey Sachs, and George Soros. They were each given 15 minutes to talk about what they thought about the Eurocrisis, especially Greece, the U.S., and whatever else they felt like.
It was well worth the $25 admission fee, but maybe not for the reason I would have thought when I went. I ended up deciding something I’ve suspected before. Namely, economists don’t understand the financial system, and moreover they don’t get that they don’t get it. Let me explain my reasoning.
The panelists all are pretty left-leaning guys, and each of them basically talked about how the U.S. government should stimulate the economy in one way or another. Krugman kept saying that hey, this isn’t too hard, we’ve seen financial crises before, and this is no different: we should immediately pass a massive stimulus package, that’s the one and only thing that we should be discussing. Sachs was very consistently saying we should do something else: namely, start planning long-term for the future. He focused on the percent of tax dollars going into infrastructure and basic education and research. Phelps also wanted stimulus, but he consistently referred to his own economic models in how exactly it should work. I didn’t completely follow his train of thought.
Soros was the most interesting of the four, in my opinion. He started by saying that we should all acknowledge that, as nice as it would be to think we can model the economy and feel control over the situation, this is a pipe dream and we should get used to not really knowing what will happen when we do one thing versus another. He suggested that we should instead work together to develop a theory, or perhaps even an philosophy, that assumes uncertainty itself. He ended by saying that, even with the three colleagues on the panel with him, who are essentially all united in thinking we need to be proactive, his ideas are essentially being ignored.
The rest of the evening essentially consisted of everyone ignoring Soros and arguing about how Keynesian they all were and how exactly different kinds of stimulus would work and which way they should use 2% of GDP to jumpstart the world’s economy. So basically exactly what Soros said would happen.
It got me more and more riled up. Here are these expert economists, two of whom have Nobel Prizes and the third who runs the Earth Institute at Columbia and is considered a huge swinging dick in his own right, and they don’t seem to acknowledge how much power they actually have over the situation (specifically, not much). For that matter, they clearly don’t know the nitty gritty of the financial system. To listen to them, all you need to do is spread a thick paste of money on the system and it would revive whole cloth. Soros is the exception, probably for the reason that he actually traded and made money inside the system.
At the end I asked a question, since they allowed a few questions, and as you know I’m not shy. I asked how we are going to make the system simple enough to actually make it possible to regulate it. Krugman basically said that Dodd-Frank is going to do it. My conclusion from that is that Krugman must really have only an outline in his head of how this stuff works- the devil, as we know, is really in the detail, and I’m too acquainted with the Volcker Rule’s list of exemptions to have a lot of hope on this score. To be fair, Phelps mentioned Amar Bhide’s book A Call for Judgment, which I’m reading and seems pretty good and at least addresses this exact issue head-on.
Overall, the evening brought me back to the credit crisis, and working at D.E. Shaw, when Larry Summers was consistently quoted at the firm as saying that the “magical liquidity fairy” needed to come and “spread some magical liquidity dust” in the markets to make everything better. No, I’m not kidding.
What I felt then and what I still feel is that these super influential economists are so high on their clean, simple economic models of the world (about the only variables of which are GDP, stimulus, and tax rates) that they focus on the model to the exclusion of the secondary issues. Sometimes you get important results this way: simplifying models can be really useful. But sometimes it’s really truly misleading to do so, and I believe this is one of those cases.
I’m left thinking that they (the economists) are so entranced with their simplified world view that still don’t understand what actually fucked up the world in 2007 and 2008, namely the CDO market’s implosion. Message to Krugman: this is not exactly like other financial crises, because it’s partly caused by complexity, and nobody seems to have the balls to fix it. The problem is that the financial system has been allowed to get so complicated and so rigged in favor of the people with information, that normal people, including homeowners, credit card users, politicians, and regulators have been left in the dark, and many of the little guys are still stuck in ludicrous contracts left over from the outrageous securitizations that took place in the CDO market.
What is especially enraging is how these same economists are still the experts that people turn to to help figure out how to get out of this mess, when they don’t actually understand the mess itself. Why else would a large audience be willing to pay $25 a piece to hear them talk about this? Why else would Obama be considering Larry Summers to lead the World Bank?
As an aside: please, Mr. President, do not let Summers lead the world bank. He does not understand the system well enough to lead it. And he is too arrogant to admit what he doesn’t know. I can introduce you to a bunch of people that may be less imposing but are more informed, more ethical, and wiser. Give me a call any time and we can chat and form a short list of candidates.
By the way, I’m not saying we shouldn’t have a major stimulus, or that we shouldn’t do longer term planning and invest more in infrastructure. I think we should do both. But I also think those efforts will be futile unless we enforce a basic system that is simple enough to be regulated. Otherwise we will be reliving this entire ordeal in another 15 years.
Vikram Pandit: let’s talk
Here’s the coverage from Business Insider.
Here’s the letter (also posted on Naked Capitalism):
Dear Mr. Pandit,
Last October, in an interview with Fortune Magazine, you extended an invitation to Occupy Wall Street for a face-to-face meeting. The Alternative Banking Group, an official working group of Occupy Wall Street, hereby accepts.
As CEO of Citigroup, you recently announced “a new Citi.” You said that you are now “working hard to create a culture of responsible finance.” Our mission as the Alternative Banking Group is exactly the same. We look forward to a fruitful dialogue.
Since this conversation is of importance to the general public, we will have a small camera crew with us to document it. The video will be shared on the websiteoccupy.com, an emerging media platform for the Occupy movement.
Please respond to this email at your earliest convenience to schedule a time and place.
Sincerely,
Cathy O’Neil
Facilitator
The Alternative Banking Group
Occupy Wall Street
Please comment with questions we can ask Vikram if he accepts our offer.
I am the most boring person in the world
A few nights ago I went to a CFPB Town Hall Meeting after work. The discussion in the kitchen that morning went something like this:
me: “I’m going to be late tonight, guys, because I’m going to a CFPB Town Hall meeting… I’m really excited about it!”
my husband: “What the hell is CFPB?”
me: “Oh, it stands for the Consumer Financial Protection Bureau. You know, the thing that Elizabeth Warren started but then didn’t get to be in charge of? I need to go see if this guy Cordray is going to be pushy enough to lead an effective government agency. Today the issues at the meeting are things like checking accounts and debit cards and overdraft policies. I totally need to go, can you guys eat leftovers?”
my husband: “You are the most boring person in the world”
my three sons, simultaneously: “Yeah mom, he’s right. You are the most boring person in the world.”
Whatever. I guess they’re right, but I went anyway. After lots of incredibly congratulatory introductions, including a 5 minutes speech from New York Attorney General Eric Schneiderman, there were a bunch of questions from the audience.
There were lots of community groups represented, as well as individuals. Two themes emerged through the questions that seem like particularly egregious consumer issues affecting poor people.
First was the issue of pre-paid debit cards and the corresponding fees. This guy stood up at the microphone and described his friend who get a debit card for child support, court-ordered. But this debit card extracts enormous fees every time she takes money out, including things like $5 just to check the balance. The guy was saying, you know my friend needs that money for her children, and it’s not fair that so much of it goes to fees- it’s abusive. I was totally crying. I mean, I’m an easy cry, but still. That wasn’t the only story about such debit cards where there was no choice in the matter but the fees were extortionist.
Second the issue of Walmart issuing its pay to people in debit card form came up time after time as well. So it seems that Walmart is not only a retailer, but also a financial institution of the crappiest kind now. It issues debit cards as payment to people who don’t accept direct deposit or don’t have checking accounts, and again it seems that the money on the cards is somehow deeply tied to a fee structure. I need to look into this more (as does the CFPB) but I’m wondering off the top of my head whether people can just demand to be paid in cash instead. It’s like these people are being paid really badly, with very few benefits, and even when they get paid they’re being nickeled and dimed every step of the way. It’s like it’s not really their money even then.
So in other words, debit cards are the new check cashers, but maybe worse since their fee structure doesn’t seem to be as transparent.
Of course, I took the opportunity to ask a question too, since I am not shy. And I was told not to ask a question but rather to tell a story, but whatever, I decided to phrase is as “making three suggestions.” After introducing myself as coming from the Alternative Banking group, I mentioned the following:
- The CFPB should use its powers to bring together mortgage investors and homeowners to the same table, in order to align their interests and bypass the banks as servicers, since the banks are only endlessly delaying the process in order to extract fees.
- I mentioned that our group is working on a “find a credit union app” but that the CFPB should really be doing that with us, to help underbanked people find alternatives to crappy banking solutions (like debit cards).
- I mentioned that we had submitted a public comment letter demanding that the credit score models be open sourced, since there was no legitimate reason for such models, which directly affect consumers in their daily lives, to be kept proprietary.
Akshat was there too, from Occupy the SEC, and he asked about the Volcker Rule.
Condray took notes. I mean, what’s he going to say.
Well actually sometimes he did say stuff, like to Akshat, and for the most part it was something along the lines of, “that is not in our jurisdiction”, although there was one exception when he talked about how Walmart, being a retailer, is not in his jurisdiction but since it’s acting as a banking institution it actually is.
Overall I’m a bit disappointed. Although I did certainly like the fact that he held a town hall meeting at all, I am worried that he’s just too nice, and that he’s going to try to please everyone and be kind of wishy-washy. I would have loved to see him manage to sustain disgust at the abuses he was hearing about, but instead he sounded more concerned than angry, and I would put my money on angry any day. I want the CFPB to be led by a son-of-a-bitch that pisses people off and constantly tried to enlarge his jurisdiction rather than keeping well inside the lines. Time will tell.
#OWS Alternative Banking update
Crossposted from the Alternative Banking Blog.
I wanted to mention a few things that have been going on with the Alternative Banking group lately.
- The Occupy the SEC group submitted their public comments last week on the Volcker Rule and got AMAZING press. See here for a partial list of articles that have been written about these incredible folks.
- Hey, did you notice something about that last link? Yeah, Alt Banking now has a blog! Woohoo! One of our members Nathan has been updating it and he’s doing a fine job. I love how he mentions Jeremy Lin when discussing derivatives.
- Alt Banking also has a separate suggested reading list page on the new blog. Please add to it!
- We just submitted a short letter as a public comment to the new Consumer Financial Protection Bureau regulation which gives them oversight powers on debt collectors and credit score bureaus. We basically told them to make credit score models open source (and I wasn’t even in the initial conversation about what we should say to these guys! Open source rules!!):
ECB trades crap for slightly less crappy crap
Yesterday I read this New York Times article on how the ECB is trading its short term Greek bonds, with Greece, for longer term bonds.
Specifically, in order to avoid holding bonds that Greece is officially planning to “voluntarily” default on, the ECB is turning in that super crappy crap for other bonds that Greece hasn’t yet decided how much they’ll default on.
Just to spell it out even more, the plan to get private bondholders more excited about trusting the European bond market has been this:
- have the the ECB step in (around the beginning of 2012) and provide liquidity and faith in the bond market,
- negotiate that the Greek bonds maturing in March 2012 are given a 70% haircut,
- make sure credit default swaps on those bonds are not activated (why we need it to be “voluntary”),
- change the terms of the bonds’ contracts so that the holdouts of this voluntary deal can be safely ignored, and
- have the ECB trade those bonds for longer-dated bonds at the last minute so they don’t actually have to take losses.
I’m not sure about you, but if I’m a private European debt holder my confidence in the bond market is not stronger right now. The argument for why the ECB is doing this is that they aren’t allowed to be seen giving money to Greece, by their charter. It’s odd to me that this charter, of all the various rules that have been broken here, is the one that is being fixated on as the important one we can’t break.
There are complicated politics going on, I am sure. I’m no expert in European politics, but this is about as European and about as political as things get.
Ignoring all of that, as a private bondholder, I’m putting a “ECB back-door swap” premium on all of my European debt from now on. Except maybe for German debt since I think Germany would rather jump out of the Euro altogether than default on its debt. But every other country is fair game. Bottomline is I short French debt today.
How Harvard is failing its students
In a recent Bloomberg article, Ezra Klein argues that Harvard and the other Ivy Leagues are failing their students because the students end up confused about what they can do with themselves after college and end up going to Wall Street firms as a way of making themselves marketable. From the article:
For many kids, college represents an end goal. Once you get into a good college, you’ve made it, and everyone stops worrying about you. You’re encouraged to take classes in subjects like English literature and history and political science, all of which are fine and interesting, but none of which leave you with marketable skills. After a few years of study, you suddenly find it’s late in your junior year, or early in your senior year, and you have no skills pointing to the obvious next step.
What Wall Street figured out is that colleges are producing a large number of very smart, completely confused graduates. Kids who have ample mental horsepower, incredible work ethics and no idea what to do next. So the finance industry takes advantage of that confusion, attracting students who never intended to work in finance but don’t have any better ideas about where to go.
He then talks about how the investment banks makes the application process formal, which is something that these kids are good at, and also that Wall Street promises to build them into people with careers and options. He also points out that some kids go into other formal applicationed jobs like Teach for America, so it’s not all about the money, at least not for all of them, and he concludes by saying how Harvard should change:
My hunch is that we have underemphasized the need to learn skills, rather than simply learn, while in college. The fact that Teach for America — which pays almost nothing and can place its hires far from cosmopolitan hot spots — is one of the few recruiting systems competitive with Wall Street suggests that graduates are open to paths that aren’t remotely as remunerative as finance and aren’t based in New York or San Francisco. They’re just not seeing all that many of them.
Although I agree with some of his diagnosis, I don’t agree with his solution of learning more “skills” in college.
As an aside, as I learned from Karen Ho’s excellent book about investment banking, Liquidated, and also from people I’ve met, the skills you learn on Wall Street as freshmen analysts are primarily bullshitting skills and Excel skills. These most definitely should not be taught at college.
I think he is right about these kids being comfortable with the “formal process” of applying to investment banks etc., but I don’t think he dives deep enough into why this is true. The fact is, the kids who get into Harvard nowadays are, generally speaking, professional test takers. They are moreover dependent on outside metrics for evaluating themselves. If you took away tests and grading systems, these kids would be desperately unhappy, because that’s how they’ve been trained all their lives to think about their self-worth.
When I was a tutor at one of the undergrad houses at grad school, I was incredibly impressed with the international group of undergrads I was in charge of; their credentials, even at the age of 20, were amazing, and their knowledge and self-possession were stunning. Same with the high school kids I taught at math camp last summer. But one thing I saw time and time again was how much they needed to please some outside authority. It’s like they never decided whether they themselves liked their major or whether it was a good fit- it was instead about whether they’d be successful and whether it would be an impressive path for them. So, external metrics of success.
Here’s my diagnosis. These kids are vulnerable to Wall Street investment firms and to things like Teach for America because they have application processes at all. But life, normal adult life, doesn’t have an application process. You actually, at some point, need to figure out what you want to do and what makes you happy. You need to take a leap of faith that your native talents and desires will end you up at a reasonable and interesting place.
Actually you don’t ever have to decide that, you could just keep doing what you think looks good to other people and pleases your parents or friends, without regard to whether it fulfills you at all. That’s kind of what’s happening I think with the 36% of the Princeton undergrads going to finance.
As for what Harvard et al can do about this, I would suggest trying to send the message in one of their core curriculum classes, that it’s not only about what you’re good at, it’s also about what makes you happy. I’m not sure those kids have ever really been told that. Being told that might not make a huge difference, but it’s a good start.
And instead of teaching them new “skills,” they should be told about options outside of school, and meet people who are employed doing interesting things with their liberal arts education. Have them talk about the way they made their way there, forged a path, and felt insecure about doing something weird but did it anyway. In other words, present them with role models who are living out their lives on their own terms, with independent thoughts.
A modeled student
There’s a recent article from Inside Higher Ed (hat tip David Madigan) which focuses on a new “Predictive Analytics Reporting Framework” that tracks students’ online learning and predicts their outcomes, like whether they will finish the classes they’re taking or drop out. Who’s involved? The University of Phoenix among others:
A broad range of institutions (see factbox) are participating. Six major for-profits, research universities and community colleges — the sort of group that doesn’t always play nice — are sharing the vault of information and tips on how to put the data to work.
I don’t know about you but I’ve read the wikipedia article about for-profit universities and I don’t have a great feeling about their goals. In the “2010 Pell Grant Fraud controversy” section you can find this:
Out of the fifteen sampled, all were found to have engaged in deceptive practices, improperly promising unrealistically high pay for graduating students, and four engaged in outright fraud, per a GAO report released at a hearing of the Health, Education, Labor and Pensions Committee held on August 4, 2010.[28]
Anyhoo, back to the article. They track people online and make suggestions for what classes people may want to take:
The data set has the potential to give institutions sophisticated information about small subsets of students – such as which academic programs are best suited for a 25-year-old male Latino with strength in mathematics, for example. The tool could even become a sort of Match.com for students and online universities, Ice said.
That makes me wonder- what would I have been told to do as a white woman with strength in math, if such a program had existed when I went to college? Maybe I would have been pushed to become something that historical data said I’d be best suited for? Maybe something safe, like actuarial work? What if this had existed when my mother was at MIT in applied math in the early ’60’s? Would they have had a suggestion for her?
Aside from snide remarks, let me make two direct complaints about this idea. First, I despise the idea of funneling people into chutes and ladders-type career projections based on their external attributes rather than their internal motives and desires. This kind of model, which as all models is based on historical data, is potentially a way to formally adopt racist and sexist policies. It codifies discrimination.
The second complaint: this is really all about money. In the article they mention that the model has already helped them decide whether Pell grants are being issued to students “correctly”:
Students can only receive the maximum Pell Grant award when they take 12 credit hours, which “forces people into concurrency,” said Phil Ice, vice president of research and development for the American Public University System and the project’s lead investigator. “So the question becomes, is the current federal financial aid structure actually setting these individuals up for failure?”
In other words, it looks like they are going to try to use the results of this model to persuade the government to change the way Pell Grants are distributed. Now, I’m not saying that the Pell Grant program is perfect; maybe it should be changed. But I am saying that this model is all about money and helping these online universities figure out which students will be most profitable. I’m familiar with constructing such models, because I was a quant at a hedge fund once and I know how these guys think. You can bet this model is proprietary, too- you wouldn’t want people to see into how they are being funneled too much, it might get awkward.
The article doesn’t she away from such comparisons either. From the article:
The project appears to have built support in higher education for the broader use of Wall Street-style slicing and dicing of data. Colleges have resisted those practices in the past, perhaps because some educators have viewed “data snooping” warily. That may be changing, observers said, as the project is showing that big data isn’t just good for hedge funds.
Just to be clear, they are saying it’s also good for for-profit institutions, not necessarily the students in them.
I’d like to see a law passed that forced such models to be open-sourced at the very very least. The Bill and Melinda Gates Foundation is funding this, who know how to reach those guys to make this request?
Today is Volcker Day
This is a guest post by George Bailey, who is part of Occupy the SEC. I just want insert here a congratulations to Occupy the SEC for submitting their public comments letter yesterday, and to point out that the organization SIFMA below is the same SIFMA I mentioned here and here (those guys are everywhere, defending the interests of the banks).
Today is “Volcker Day” and Paul Volcker was on a tear.
Mr Volcker added in a formal submission to regulators Monday that “proprietary trading is not an essential commercial bank service that justifies taxpayer support,” and that banks should stop “stonewalling.”
He went on:
“There should not be a presumption that evermore market liquidity brings a public benefit,” Volcker, 84, wrote in a letter submitted yesterday to regulators in defense of the rule curtailing banks’ bets on asset prices with their own money. “At some point, great liquidity, or the perception of it, may itself encourage more speculative trading (see here and here for the full story).
But then Jamie Dimon came along and bitch slapped Tall Paul. Ouch.
“Paul Volcker by his own admission has said he doesn’t understand capital markets,” Dimon told Francis in the Fox Business interview. “He has proven that to me.”
SIFMA, on behalf of the industry, took over to explain in detail just what it is that Mr. Volcker doesn’t understand in their comment letter. They reiterate their dire warning about the devastating effects on ‘corporate liquidity’’ from the Volcker Rule. Yet surprisingly, no non-financial corporate bond issuers filed any comments to acknowledge or object to this danger.
In fact, there are no comment letters from any non-financial companies. They did haul out the widely lampooned Oliver Wyman study to bolster their comment that ‘corporate’ America would suffer horribly if Volcker is enacted. But that just serves to remind us again that the corporate bond liquidity that will be affected is the liquidity in dodgy financial company ‘corporate’ bonds, like CDOs and other drek. They conclude the only solution is a rewrite . They request the rule makers go back and start all over again.
The SIFMA comment letter runs to 175 pages. I haven’t read all the other financial company letters, but the ones I’ve skimmed conform to SIFMAs position.
The Occupy the SEC comment letter logs in at 325 pages and oddly enough draws the exact opposite conclusions to each of SIFMAs objections. It’s an interesting contrast. For some reason (some familiarity with the subject matter and public interest primarily) the group seems to have understood and articulated Volcker’s (and the electorate’s) intent pretty effectively.
Of the comment letters received about 90% are from financial institutions, and another 5% are from foreign governments objecting to the priority the US regulators have gifted to US traders in US Government Bonds. The remaining 5% are from ordinary folks, like Mr. Volcker, Occupy the SEC and other public interest groups.
Its interesting that 95% of the comments reflect the views of the 1%, and the views of the 99% are embodied in the comments of the remaining 5% of commenters. I’m confident the regulators will recognize that, for all its complexity, the rules are comprehensible and can be refined to serve the public’s demand for control over a runaway financial system.
What’s going on: Greece and mortgages
There are two very confusing but important issues that you should be paying attention to in the news right now. Luckily, Naked Capitalism is covering this stuff for you (and for me).
First, it’s the mortgage settlement which was agreed on yesterday or maybe two days ago, which sucks in a lot of ways for poor homeowners but not for the banks. To see the top twelve reasons to hate the mortgage settlement, check out this post from Naked Capitalism.
Second, the Greek debt situation is not yet under control, and no matter what they do over there in Europe they can’t seem to admit it. Here’s a Naked Capitalism post from a couple of days ago, coupled with a new Bloomberg article that kind of says how awful that situation is.
I took all our money out of the money market account a few days ago because it’s not FDIC insured and because I really really don’t know what’s going to happen in Europe. Just saying.
As predicted: watered down insider trading bill
Yesterday I posted about the insider trading bill which, in addition to making it illegal for politicians to trade on their insider knowledge, was also going to force “political intelligence firms” to register as lobbyists. Note that this is simply a form of transparency- they, people who work mostly for hedge funds and private equity, didn’t have to stop getting insider information, they’d just need to admit that they were getting it. But I guess that’s TMI from their perspective. From the Wall Street Journal article:
Rep. Eric Cantor, the No. 2 House Republican, plans to bring his version of the Stop Trading on Congressional Knowledge Act, or Stock Act, to the floor of the GOP-controlled chamber on Thursday, using a procedure that will prevent lawmakers from voting on major amendments. It is expected to pass by a wide margin.
…
At issue are changes Mr. Cantor made shortly before midnight Tuesday, when he unveiled his amendment to a bill that sailed through the Senate last week.
Most notably, Mr. Cantor cut a provision that would require people who mine Washington for market-moving information to disclose their activities in the same fashion as lobbyists. The provision covering what is known as the political-intelligence industry was opposed by Wall Street and its Washington lobbyists, including the Securities Industry and Financial Markets Association (SIFMA), which mounted an effort to kill it.
Just to be clear on who is writing legislation nowadays: they are called SIFMA, and they represent the players in the financial industry. You may remember them from this post, where they hired the research firm Oliver Wyman to investigate the impact of the Volcker Rule for a congressional hearing. Shockingly, that research firm thought the Volcker Rule should be watered down.
What exactly is the argument this guy Cantor is using to defend this change? I’d love to hear him come out and say, “I did it because SIFMA told me to”. How come we don’t get to see that argument made and defended? No wonder people don’t like or trust Congress. Even so I’ll give the last word to one of their members:
The House Democrat who has pushed for the legislation for the past six years—Rep. Louise Slaughter (D., N.Y.)—opposed the GOP-backed changes.
Ms. Slaughter said in a statement that the Cantor-backed version of the insider-trading bill was crafted “in secret, behind closed doors, brokering deals for special interests.” She added: “How ironic—insiders now appear to be writing a bill meant to ban insider trading.”
More Money than God
This is a guest post from an anonymous friend. Actually is was a letter to me that I thought was hilarious and got permission to post.
———————————————————
Dear Cathy,
Earlier I mentioned that I was reading “More Money than God”, which might have been construed as an endorsement, so, in case you haven’t read it already, I thought I would save you some time by summarizing it:
Chapter {2,\ldots,(N-2)}: All the hedge fund dudes you have heard of are* sages both of human nature and of economics. When they destroy foreign currencies, it’s to correct bad governments. When they attempt to short foreign currencies but fail, it’s because they (Soros) care deeply about these developing countries and are using their money to help support them. They are huge philanthropists. They increase economic stability by being contrarian. The only time they are outsmarted is when they are outsmarted by other hedge fund titans.
Chapter N: Don’t regulate hedge funds. Regulating hedge funds would be bad for the economy and for philanthropy. There’s no need for hedge funds to be regulated. Regulate the banks or something else but for God’s sake not hedge funds. Also: no regulation!
Acknowledgments: thanks to Rubin and all my other buddies at CFR, and at Blackstone, and to Paul Tudor Jones, and all the other hedge fundies who supported me while I wrote this book for 3 years.
* They are now, but in the 60s when hedge funds started the whole “hedging” and “long-short” thing was just a distraction from organized insider trading over corned-beef sandwiches. But no one ever insider trades anymore. Except for Raj, who’s clearly not a real hedge fund guy. Who eats SIM cards? We’re not those kind of thugs.
Politicians and insider trading
There’s shit going down in Washington now around the proposed ban on insider trading of politicians (which for some weird reason up til now hasn’t been illegal). According to this New York Times article, the proposed legislation would also require certain “political intelligence firms” to register as lobbyists, and that gotten them up in a huff. From the article:
“Hedge funds, private equity funds and investment advisers — many of which are not currently registered under the Lobbying Disclosure Act — might now be required either to register or to alter their business practices to avoid the need for registration,” the bulletin said. “If, for example, a hedge fund calls a Congressional committee staffer to gather information about the status of a bill that relates to the fund’s investment decisions, the fund may need to register.”
If you can judge someone by their enemies, then this bill seems kind of like my new best friend. Let’s wait to see how much it’s watered down in the next few days:
House Republicans and their floor leader, Representative Eric Cantor of Virginia, said they would amend the bill, going to the House floor this week, to strengthen it.
But Representative Louise M. Slaughter, Democrat of New York, said, “I think ‘strengthening’ here is a euphemism for ‘weakening.’”
Opacity, noise, and overpopulation in finance
This is a guest post by Mekon:
When you come in to work nowadays, you have to read the blogs. The other day, two blogs I like to read both had pieces about Freddie Mac and whether it had inappropriately bet against people refinancing their homes. I’ll spare you the details, which live in the highly technical world of mortgage securitization, but the issue is that Freddie Mac had a large position in “inverse floaters,” which are worth more when people don’t refinance.
The first piece says this is fishy, because Freddie Mac also makes rules on who gets to refinance and who doesn’t. So they have lots of incentive to make the rules more stringent, block people from refinancing, and profit by doing so.
But the second piece says there’s nothing fishy here at all: Freddie Mac is probably holding the inverse floaters to hedge interest rate risk. That is, they might need them just to be neutral to interest rates (people prepay when interest rates go down), because the rest of their book is exposed the other way.
How do you tell who’s right?
The first thing to realize is that they’re actually disagreeing on facts. This isn’t like the usual economic disagreements, where people argue over principles (whether the Fed should worry about unemployment as well as inflation) or things you can’t prove (how bad the economy would have gotten without the stimulus). It should be easy to settle this one: take Freddie’s book and see how it goes up and down when interest rates go down/stay the same/go up and people prepay more or less.
I imagine we haven’t done this because we don’t have the book.
Some opacity in finance may be unavoidable, but sometimes it’s completely unnecessary and self-inflicted. These are government enterprises! Why don’t we make their books transparent? If we can’t do it right away, what about with some kind of time lag? We’re talking about their positions from 2010, for heaven’s sake!
The second thing – forgive me if I’m off base here, I’m a fan of both blogs – is that it doesn’t seem like either one of them has fully done their homework (to be fair, without being able to see into Freddie’s book, it’s not clear how they could have). Both sites followed up with more detail, but nothing that seems definitive – put another way, I still can’t tell who’s right.
I’d like to see people be more sure about the facts before publishing conclusions. I thought maybe this was just me, but then I ran across a paper by Andrew Lo which makes much the same point (see the last section). Andrew looks at 21 different books about the financial crisis and compares the range of conclusions they draw to Rashomon. And, like the Freddie example, he finds no agreement on the underlying facts. I hear his frustration when he urges: “By working with a common set of facts, we have a much better chance of responding more effectively and preparing more successfully for future crises.” Amen.
Finally, if you’ll indulge me, a little sociology. If you’ve been around finance for a while, I think you’ll agree with me that people being on loose ground with their arguments and a bit quick on the draw with their conclusions is more the norm than the exception. Put another way, there’s an awful lot of noise in finance. Why is this?
This blog has focused a lot on how finance today is both complicated and opaque. One thing I’d add is that finance isoverpopulated. I don’t just mean that we’d be better off if smart people thought more about curing cancer and avoiding famine and less about executing trades a millisecond faster or securitizing and sell some kind of risk that’s never been traded before. (But duh.)
What I mean is that finance today is so complicated and opaque that it requires extremely specialized skills to understand what’s going on. At the same time, the field employs way more people than could ever have those specialized skills. End result: many people working in finance don’t really understand it. Which makes noise an accepted part of the culture. Which in turn makes it even harder to understand what the hell is going on.
I don’t know how to fix this, but wouldn’t you feel a lot better about our financial system if we could (1) make it simpler, and (2) cut the number of people needed to operate it in half?
Raise capital gains and stop flying
There are two totally unrelated stories I want to discuss this morning, I hope you’ll forgive me.
First, take a look at this post, written by David Brin, which argues for higher capital gains tax. He points out VC’s or angel investors, in combination with entrepreneurs, are the true “job creators”, and also invest their money in a truly risky way, whereas generic rich people who only invest in established companies are taking risks but not on the same level. Yet these two classes of people are taxed at the same rate. I guess the counterarguments would be that they, the VC’s, also get more payoff (when things work out) and that they couldn’t make their investments without the fleet of passive rich people ready to invest if and when the company succeeds. Even so I think there’s a real difference.
It reminds me that, when I worked at D.E. Shaw and Lehman fell, there were lots of discussions around the water cooler about what the reaction would be by policy makers and regulators. The consensus fear was that the capital gains tax rate for hedge fund workers would be removed within weeks, if not days. Note this tax loophole allows hedge fund quants and traders to pay less taxes on their take-home pay than bankers across the street doing the same job. I don’t really know anyone who defends it, not even people who benefit from it. Please correct me if I’m wrong. Update: mostly people below the MD (managing director) level at hedge funds actually don’t get this benefit. It primarily applies to “buy and hold” people like VC’s, private equity, and long term debt firms.
Another argument I enjoy from Brin’s post is the refutation of lowering taxes in general to entice investment by rich people. As he said:
Supply Side assumes that the rich have a zillion other uses for their cash and thus have to be lured into investing it! Now ponder that nonsense statement. Roll it around and try to imagine it making a scintilla of sense! Try actually asking a very rich person. Once you have a few mansions and their contents and cars and boats and such, actually spending it all holds little attraction. Rather, the next step is using the extra to become even richer. Naturally, you invest it. Whatever the tax rates, you invest it, seeking maximum return.
This is absolutely true, and one of the funny things about (many of) the rich quants I know: they are obsessed with growing their pile, to the point of focusing more on money now that they’re rich than they ever did when they were poor physics or math graduate students. To be fair, to make the whole argument for raising taxes you’d need to consider the global response, whereby rich people essentially arb the tax systems of the various countries in search of the maximum return. Even so, I’m pretty sure the answer is not to try to compete with Caribbean island nations on how low we can tax.
Second, check out this fantastic article from the Wall Street Journal about how people respond to environmental impact issues by consuming more. In the article they describe what’s called the “Prius Fallacy: a belief that switching to an ostensibly more benign form of consumption turns consumption itself into a boon for the environment”. I love it, first of all because it’s completely snarky and second of all because it’s really true and annoying. My favorite line:
Even if you think that climate change is a left-wing crock, this ought to be a matter of gnawing concern. Global energy use is growing faster than population. It’s expected to double by midcentury, and most of the growth will be in fossil fuels. Disasters like the BP oil spill attract world-wide attention, but the main environmental, economic and geopolitical challenge with petroleum isn’t the oil that goes into the ocean; it is the oil we continue to use exactly as we intend.
By the way, I don’t claim to be particularly low-impact on the world myself: I’m flying to Amsterdam in March with my entire family, which definitely puts me on the earth’s shit list (turns out it’s all about airplane travel). For that matter I work at a company that makes it easier for consumers to buy airplane tickets. But at least I don’t pretend that buying a Prius or replacing my kitchen counters with less eco-unfriendly material makes me a good person (by the way, once you’ve got eco-unfriendly kitchen counters the damage is done. The best thing you can do for the environment at that point is never ever remodel your kitchen again. Can you handle that?!).
If I had my way, we’d know the fossil-fuel impact of every activity we engage in, and we’d be able to put ourselves on a fossil-fuel diet. Those people who carefully recycle their milk containers and buy local but also fly to East Asia every chance they get would be in for some major belt-tightening.
The SEC needs handcuffs
My friend Chris Wiggins sent me this link just now, about how the SEC lets big banks get away with whatever they want to in the name of investors. Aargh!
I was discussing the impotence of the SEC with someone at the SEC recently and here’s what I said. Lots of people think you need to pay people at the SEC as much as the bankers get paid in order to have an SEC with balls, but that’s not true. It’s about power, not money. If I knew that, as an SEC employee, I’d be able to walk into Citigroup, put handcuffs on Vikram Pandit, and perp walk him out of the building, that’s a job I’d take in an instant, even at government salary.
CDS data and open source ratings
What’s the current deal on credit default swap data? Is the Dodd-Frank bill going to force any CDS pricing to be publicly available?
A bit of background: a credit default swap is something like insurance you pay in case the underlying bond is defaulted on (but not exactly, see here), so it’s relatively easy to infer the default probability from its price, as long as you have a good estimate of the “recovery rate,” which is the amount the bond pays out even though it’s defaulted. This rate can vary widely, and people sometimes lose sight of how sensitive everything is to that assumed number.
Here’s the thing. I am super into the idea of an open source ratings model (see this post and this post on open source ratings models, as well as this post on open models in general), and I think having CDS data as input to the model might vastly improve it over just using quarterly filings and stock market data.
Right now the standard ratings models don’t use CDS data, but I think that’s because they’re just really old. I’d guess that some combination of the old ratings model and the new CDS market would be great for an open source ratings model. And it’s true that CDS coverage isn’t perfect (i.e. there are not liquid CDS markets on everything you’d want ratings for) but on the other hand, for what it does, the market is super timely and people really watch it (sovereign debt is a great example of this).
As of a year ago all of this data was essentially owned and monopolized by Markit, which is made up of a bunch of CDS brokers. So even if I had the money to pay for the data, for licensing reasons I wouldn’t be able to make the data open source, which sucks. I know that there’s been talk about making this data publicly available, but I’ve been so involved with stuff like the Volcker Rule, I just haven’t kept up with the current CDS transparency rules. I mean, if we aren’t going to remove the CDS market or regulate it, at the very least we should be using it. Please tell me if you know.
Alternative Banking in FT Alphaville (#OWS)
Alt Banking’s opinion piece about too-big-to-fail was published yesterday in FT Alphaville.
Woohoo!
Econned and Magnetar
Gaming the risk model
When I worked in finance, there was a pretty well-known (and well-used) method of working around the pesky requirements of having a risk model and paying attention to risk limits in your group.
Namely, you’d let a risk guy in the group for a while, long enough to write a half-decent risk model, and then you’d say thanks, and we don’t need you anymore we’ll run with this, and then you’d kick him out of the group. You’d then spend the next few years learning how to game the risk model.
In particular you’d know exactly what kind of trades you could put in that the risk model can’t “see”: things like interest rate risk or counterparty risk, that the poor risk guy didn’t think of at the time, or even better the market you trade in would have developed and changed in the last few years so you were applying the risk model to instruments it wasn’t even meant to measure.
That way you could always stay within your risk limits, as a group, even while you took larger and larger bets on things that were invisible to the risk model. As long as the world didn’t blow up, this method returned higher-than-expected profits, so your “Sharpe ratio” looked great. You got rewarded for this, and in the meantime the company you worked for took on the risk (and they typically didn’t see it as coming from your trading group but rather as some amorphous systemic risk). It’s not clear how many people how high up were in on this method, but it seemed pretty clear that they also enjoyed the ride as long as it lasted.
The CDO market
One really enormous and tragic example of this behavior is described in Yves Smith‘s brilliant book Econned, in the chapter describing the CDO market and Magnetar Capital‘s involvement.
CDOs were the reason we had a global economic crisis and not just a housing bubble. The CDO market is complicated, and you can learn a lot about it by reading the book. Suffice it to say I’m not going to be able to explain the whole thing, but let me simplify the story thus.
At the beginning (late 1980s through mid-late 1990s) there were not that many securitizations outside of the federal arena (Freddie Mac, Fannie Mae, and FHA), and they were pretty useful because they made piles of riskier but still viable-looking mortgages more predictable than individual mortgages. The top of the pile (they were separated in to groups called “tranches” depending on possible defaulting actions) were rated AAA by the big three ratings agencies (Moody’s, Fitch, and S&P) and probably deserved it, because they had a big cushion of loss protection beneath them. The lower tranches were lower rated and harder to sell, which limited the size of the overall market.
Starting around 2003 the lower-rated, harder-to-sell tranches from the BBB to the junior AAA tranche started getting resecuritized into instruments called CDOs. In fact there were riskier CDOs, called mezzanine CDOs, which consisted mainly of the BBB tranches, and “high grade” CDOs consisting mostly of old A and AA tranches. These CDOs were again tranched, with around 75% of the par value getting an AAA rating.
Yes, you heard that right: if you took a bunch of easy-to-imagine-they’d-fail low rated mortgage bond tranches (especially if you knew anything about the terms of those mortgages and how much they were counting on the housing market to continue its climb), and bundle them together, then the resulting package would, at its highest tranche, be deemed AAA. It made no sense then and it makes no sense now.
The CDS and synthetic CDO markets
Enter the credit default swaps market. The ability to buy CDS protection (insurance on the underlying bonds) on a higher tranche of the mortgage bonds (the first generation securitization) while purchasing a lower tranche made it possible for lots of people to bet that “if things go bad, they will go really bad”, while limiting their overall exposure. Moreover, the income on the lower rated tranche would fund an even bigger short position on the higher rated tranche, so this was a self-financing bet.
The demand for more cheap credit default swaps led some clever traders to realize they could create CDOs largely or entirely from credit default swaps rather than actual bonds. No need to be constrained by finding real borrowers! And you could bet against the same crap BBB bonds again and again, and have them packaged up and have most of the value of the “synthetic” or “hybrid” CDO rated AAA (again with the collusive help of the ratings agencies).
At first, the big protection sellers in the CDS market was AIG and the monoline insurers. But they only wrote CDSs on the least risky AAA CDO tranches. Later, after AIG stopped being involved, that side of the CDS market was entered into by all sorts of really dumb people, with the help from the complicit ratings agencies who kept awarding AAA ratings.
Even so, there was still a bottleneck for this re-rebundled synthetic/heavily synthetic CDO market. Namely, it was hard to find people to buy the so-called “equity tranche”, which was the tranche that would disappear first, as the first crop of the underlying loans defaulted.
Magnetar
That’s when Magnetar Capital came in. They set up deals to fail. They did this through explicitly designing the synthetic CDOs (banks gave this privelege to whomever was willing to buy the equity tranche) and by, in addition to buying the equity tranche, they bought up all of the CDS’s in the synthetic CDO.
The overall bet Magnetar Capital was taking was similar to the one above: when the market goes bad, it will go really bad. The difference is that Magnetar’s exposure was altogether very short: they set up the equity tranche to pay lots of cash in the short term (a couple of years), which would finance the cost of all of the CDSs in the hybrid CDO, which meant they didn’t just cover the exposure but magnified it multiple times. And it was again a self-financing bet, as long as they were right about the market exploding rather than slowly degrading.
How big was this? Magnetar Capital made the majority of the market in 2006, which was one of the biggest years in this market. And everything they did was legal. They also drove demand in the subprime mortgage market, during its most toxic phase, by dint of a combination of leverage and the clever manipulation of investors, specifically convincing them to post cash bonds.
WTF?
Let’s go back to the groups gaming their risk models from the beginning of this post. Same thing happened here, except the group was this entire market, and the risk guy was the combination of the ratings agencies and AIG, as well as the greedy fools who wrote CDS on mortgages in 2006. And instead of the hedge fund being on the hook for their trading group’s games, in this case it was the United States and various European governments who were on the hook.
How predictable was this whole scheme? My guess is that Goldman Sachs knew exactly what was happening and what was going to happen. They made a very intelligent bet that if and when the housing market went under, AIG would be backed by the government. In essence this entire market was an enormous bet on government bailout. Not everyone knew, of course, especially the guys who were long the market when it collapsed, but lots of people knew. The same people who right now know where the dead bodies are on the books and who aren’t coming forward with a plan to resuscitate the financial system, in fact.
At the very least I think this story argues for the treatment of CDS as insurance, with the requisite regulation. In different terms, Magnetar chose buildings where they saw arsonists enter with gallons of gasoline and matches, and bet everything on a fire in that building. The question then is, how many fire insurance claims should one entity be allowed to buy for one building?
Freddie Mac: worse than hedge funds?
Check out this outrageous article about what Freddie Mac has been doing. Seriously makes my blood boil!!
Update: Yves Smith on Naked Capitalism posted this morning about how this is maybe not such a big deal.
Complexity and transparency in finance
The blog interfluidity, written by Steve Randy Waldman, posted a while back on opacity and complexity in the financial system, arguing that it is opacity and the resulting lack of understanding of risk that makes the financial system work.
Although I like a lot of what this guy writes, I don’t agree with his logic. First, he uses the idea of equilibrium from economics, which I simply don’t trust, and second, his basic assumption is that people need to not have complete information to be optimistic. But that’s simply not true: people are known to be optimistic about things that have complete clarity, like the lottery. In other words, it’s not opacity that makes finance work, it’s human nature, and we don’t need any fancy math to explain that.
Partly in response to this idea, I wrote this post on how people in the financial system make money from information they know but you don’t.
But then Steve wrote a follow-up post which I really enjoy and has a lot of interesting ideas, and I want to address some of them today. Again he assumes that we don’t want a transparent financial system because it would prevent people from buying in to it. I’d just like to argue a bit more against this before going on.
In a p.s. to the follow-up post Steve defines transparency in terms of risks. But as anyone knows who has worked in finance, transparency is broadly understood to mean that the data is available. This could be data about who bought what for how much money, or it could refer to the data of which mortgages are bundled in which CDO’s, and whose houses those refer to and what is the credit score of the mortgagees, or all of the above. Let’s just say all of the above, say we have all the data we could legally ask for about everything on the market.
That’s still not a risk model. In fact, making good risk models from so much data is really hard, and is partly why the ratings agencies existed, so that people could outsource this work. Of course it turns out those guys sucked at it too.
My point is this: a transparent system is at best a system that gives you the raw ingredients to allow you to cook up some risk soup, but it’s left up to you to do so. Every person does this differently, and most people are optimistic about both the measurement of risk and the chances of something bad happening to them (see AIG for a great example of this).
I conclude from this that transparency is a goal we should not be afraid of, because first of all it won’t be all that useful unless people have excellent modeling skills, second of all because no two firms will agree on the risks, and third of all we are so far from transparent right now that it’s laughable to be afraid of such an unlikely scenario.
Going on to the second post of Steve now, he has some good points about how we should handle the very dysfunctional and very opaque current financial system. First, he talks about the relationship between bankers and regulators and argues for strong regulation. The incentives for bankers to make things opaque are large, and the payoffs huge. This creates an incentive for bankers to essentially bribe regulators and to share in the proceeds, which in turn creates an incentive for the regulators to actually encourage opacity, since it makes it easier for them to claim they were trying to do their job but things got too complicated. This sounds like a pretty good explanation for the current problems to me, by the way. He then goes on:
… I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.
I agree with everything he said here. We need strong and smart regulators, and we need to see regulation in every part of finance. Why is this so hard? Because of the vested interests of the people in control of the system now – they’ve even invented a kind of moral philosophy around why they should be allowed to legally rape and plunder the economy. As he explains:
I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.
Hear, hear! But how?
mathbabe 