paulw's Blog

Banking deregulation will be a good thing when pigs fly

2009-07-01T15:31:04Z

The analysis abstracts from the important issues of poverty and income distribution, which might alter our assessment of past deregulation episodes, but that does not make our analysis less relevant looking forward. . For example, for the type of social welfare function considered here, if income distribution remains fairly constant, one would reach the same pro-deregulation conclusions even if one entirely focused on the welfare of the poor, à la Rawls. This shows that financial deregulation would be desirable under the Rawlsian criterion if one can find suitable social protection mechanisms, and that the effectiveness of those mechanisms should be explored as part of the grand design of new financial regulations - especially before enacting new regulations that would stifle the dynamism of the financial sector.

(h/t Ezra)

"If income distribution remains fairly constant". Uh.

Here's the thing: people in the financial industry don't invent innovative financial instruments because they want GDP to increase. They invent them because they want to make piles of money. Said another wayl, they want their country's income distribution to become more unequal, with them getting a bigger share. So if you set them loose, that's what they'll do. The rise in GDP is, for the finance people, an interesting byproduct of their getting rich. Important only insofar as more money sloshing around means more that they can get their hands on.

Then there's the misallocation-of-funds issue, which may be captured by the data the authors are analysing, may not. (In other words, would things have gone better if financial deregulation weren't pushing investment into particular sectors that were most ripe for manipulation.) And there's the fact that they're using historical data on developing countries, where the finance industry arguably wasn't in control of such a huge chunk of the economy as it currently is in the more-developed world. And where bubbles and crashes were contained by the fact that they weren't occuring simultaneously around the globe.

So if your financial industry is pretty small, and there are a lot of other countries that will remain on an even keel while you zoom upwards and then crater, and if you can get your bankers and brokers to do a whole bunch of stuff aimed at earning them piles of money without actually letting them earnbig enough piles to change your country's income distribution, then by all means go for the roller-coaster. Your surviving citizens will thank you for it.

Way beyond regulatory capture

2009-05-18T13:59:13Z

The Associated Press: FBI probes possible insider trading by SEC lawyers

For example, they both traded in the stock of a large financial company after being told by a colleague about investigations of the company, a violation of SEC rules, according to the report. "SEC attorneys are supposed to spend their time trying to prosecute insider trading, not profit from it," Grassley said in a statement Friday. "The SEC needs a better system to deter misconduct and give the public confidence that this sort of thing isn't a systemic problem." Two months before an SEC investigation of a large health care company was opened, according to Kotz's report, the female attorney sold all her shares in the company. She traded stocks 247 times between in 2006 and 2007, the report said.

This is what happens when you put a bunch of Wall Street anti-regulation types in charge of the SEC. A culture of corruption so deep that the people involved in it barely even understand that they're corrupt. Maybe they just think of it as a nice perk of their job. But if you're making 100+ trades a year in companies you and your colleagues are charged with overseeing, you can't help but have your trading influenced by what you know. (And for that matter, you can't help but be taking time out from when you should be doing your job to think about how your job is going to make you a profit in the market.)

And SEC top management thought it was a good idea to rely on everybody to just tell them when they made trades that could present the appearance of a conflict of interest.

This kind of thing makes me angry not only because it means corrupt administration of a public trust and companies getting away with stuff because their regulators are busy thinking about graft. But also because it effectively penalizes all the people at the SEC or elsewhere who play by the rules. The ones who do their jobs right and honestly get treated as if they're corrupt, get paid as if they were padding their incomes with corrupt side deals, get hassled within the organization for making their corrupt colleagues lives more difficult.

Too Big Not to Fail

2009-03-22T23:34:14Z

The financial industry really is like the auto industry, only with more devious accountants.

Something clicked while I was reading experts talking about overcapacity in the financial and banking sector and also came across an old quote from the heyday of GMAC: "We build cars so we can lend money on them." And we all know how well that turned out, so why should we be surprised when the same thing happened in the finance industry: they wrote mortgages so that they could sell securities made out of them, and they issued securities so that they would have something to write swaps against.

In both GM's case and the financial industry's case, there's a good argument to be made that what should have been an ancillary business ended up wagging the tail of the main enterprise: if you're making piles of money financing each care, then you don't have to look as seriously at how the auto industry is going, because that's not really what drives your profits -- what drives your profits is the spread between what you can borrow at and what you can make your customers pay. If you're securitizing mortgages, what drives your profits (like the auto industry, till the whole thing goes south) is how much paper you can push out the door, because you're taking a cut of each billion. If you're insuring credit defaults (that you believe will never happen, or at least not before you've cashed out) it's the same thing: volume, not quality.

When the car industry started its long decline, pretty much everyone knew it, because you can watch how many cars are being sold and what incentives dealers have to offer to get them off the lot. With the financial-industry bubble, things were less obvious because the markets were private -- even now, no one seems to know exactly how much of this crap is out there. So it was easier for the tail to wag the dog because most people had no idea this multi-trillion-dollar tail even existed.

Yeah, yeah, you know all that. So why should anyone care? Because overcapacity breeds stupid risk-taking. If you have a dozen car factories you don't want to write off, that's a million-plus cars a year you have to sell whether it makes business sense or not. If you have 10,000 masters of the universe who all insist on their next yacht, that's $100 trillion in deals you have to do, whether they make economic sense or not. The biggest banks simply have too many smart people for the volume of sane deals available, so they're bound to take on crazy ones instead.

That's why the financial sector has to get smaller -- not just because so many parts of it are actually or effectively belly-up, but because operating the rest of the economy in such a way that finance wizards can take an ever-increasing cut of the profits is unsustainable.

The power of belief

2009-03-02T23:12:24Z

I had the same reaction as pretty much anyone with a basic background in statistics or simulation had when I saw Felix Salmon's very nice piece in Wired on how mortgage-backed securities and credit-default swaps were modeled: They paid people millions of dollars a year for this utter crap?

As an interesting equation for looking at how you might model prices -- you know, the kind of thing a grad student might do for an exercise or write a thesis on -- Li's work is pretty cool. But as an actual expression of the way the world works, it and its applications were wrong in so many ways it's hard to wrap your head around it. (It reminds me of an old-school video-game programmer, who once explained that you could make at least three different errors in the same line of code: intending to do the wrong thing, implementing that thing incorrectly, and using the wrong syntax.)

As Salmon explains, the equation was wrong for real use because it effectively assumed that the correlations between different securities' prices were fixed, and because it used an entirely inappropriate data set to calculate those correlations. Oh, and because the beliefs about the world that supported the assumption of fixed correlations were at odds with reality. But it was tractable.

At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.
"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee. The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations

In short, everybody buying and selling CDOs and CDSs was living in a dream world, but they were all living in the same dream world, so their results lined up, and as long as housing prices kept rising (preferably at an accelerating rate) their market was internally consistent. If there had been a competing relatively simple formula for pricing these securities, or if people had had the computing power (probably available today on a couple dozen network Playstations) to crunch the behavior of the underlying mortgages or other paper, things might have come out quite differently, but with everybody using essentially the same set of wrong assumptions and biased data, the market didn't have any huge contradictions.

(About 20 years ago, I gave a talk about the advantage that easily-computable ideas about the world had over hard-to-compute ones, regardless of whether they were right; silly me, I thought the blowup would come in some esoteric application of artificial intelligence.)

So just how far out of sync with reality did the quants' dream world get? From the FT:

From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)
Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.
The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt - or the stuff that was supposed to be so ultra safe that it always carried a triple A tag - has been 32 per cent for the high grade CDOs. With mezzanine CDO's, though, recovery rates on those AAA assets have been a mere 5 per cent.

In other words, Holy Crap.

But it's worse than that. It's bad enough that someone would put forward a modeling technique with this level of wrong assumptions and lousy training data. To actually create trillions of dollars worth of securities with pricing based on this known-bad technique took a special kind of greedy stupid, and that same greedy stupid will be right back the next time some mathematician comes up with a crappy-but-computationally-attractive formula.

Why AIG's management should spend the next 20 years in jail

2009-03-01T13:23:56Z

Or at the very least, be stripped of every penny they possess.

Here's the crucial passage from Joe Nocera's short, sweet, damning analysis:

When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That's why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn't have to put anything aside for losses. And it didn't.

Nocera misstates things a little bit here, in a way that shows the underlying sickness of the high financial industry. Insurance companies don't have reserves because of regulatory requirements , they have reserves so that they can pay the lawful claims of their customers when the risk against which they've insured comes to pass. Making promises to pay while knowing (or having reason to know) that one doesn't have the assets to do so is fraud, either civil or criminal depending on the details of action and intent. Regulations are there simply because it's boring and expensive to let insurors commit fraud, prosecute them, strip their personal assets and put them in prison. So we short-circuit the process a little.

(Those with a little knowledge of history may remember why insurance regulation became necessary in the first place: during the 19th century, it was a popular and profitable business for grifters, because you can usually arrange for a nice long delay between the day you start collecting premiums and the day you have to start paying out. Fire insurance especially, because in a small town center without municipal water, any substantial fire will burn most of the buildings, and the grifter can decamp amid the general confusion. Note, by the way, the violation of the presumption of independent risks.)

At the very least, it looks like AIG's management and directors were negligent. They failed to set aside adequate reserves, and they failed to model the risks correctly, or to establish conservative rules for writing their guarantees (when there's not a lot of history on a particular risk, it is not prudent to assume it will never happen). They continued to make their unlikely promises even when there were plenty of indicators that the market they were underwriting was headed south.

But the most obvious evidence for actual, intentional fraud (what Nocera politely calls "greed") comes with the collateral triggers they wrote into their contracts to extract just a little more revenue. It should have been obvious to any reasonable person that exactly the circumstances under which the collateral triggers triggered would the the circumstances where mortgage-backed securities wouldn't be worth the paper they were printed on. Every security that's based on people's ability and willingness to pay takes a hit during a recession and stock-market slump. And knowing that you won't be able to make a payment precisely under the circumstances when it's called for: there's that nasty f-word.

Also in on the scam: the head of the SEC and the entire chain of command underneath him who didn't call a halt to the operation (fraud is always against the rules, even if there's no specific rule forbidding some particular kind of fraud). And AIG's auditors. For the government employees it's malfeasance and quite possibly honest services fraud, for the auditors, what happened to Arthur Andersen is none too good.

And why the thirst for revenge in parallel with keeping the economy afloat? Because a few million here, a few million there, and you can make just that many more fraud victims whole without tapping the ordinary taxpayer. And because plenty of these folks are young and healthy, and unless they're stripped bare, in 20 years they'll have the resources to do it all again.

Stupid, stupid, stupid

2009-02-18T19:36:21Z

So the North Dakota House has just declared that

> "any organism with the genome of homo sapiens" is a person protected by
> rights granted by the North Dakota Constitution and state laws.

What the hell does that mean? Seems to me that this declaration, should it get through the state senate and past judicial review, will do both way more and way less than its crackpot enactorss intend. Depending on how you define "organism", pretty much all cell culturing, tissue grafting, and organ transplantation in the state would require the appointment of a guardian ad litem for the "persons" involved. As would removal of teratomas (and possibly any other tumor as well, depending on whether the "person" in question is required to have a unique genome). Meanwhile, unless the state constitution and laws include a right to be hooked up to someone else's circulatory system and derive warmth, nutrition, immune protection and so forth from their bodies, I can see how it could affect the legality of abortion in the state. (And this is even before we get to unimplanted blastocysts...)

Sometime I have to wonder whether people who have such contempt for the american system of laws really shouldn't emigrate to somewhere more in keeping with their views.

Atrios gets suckered

2009-02-03T19:20:32Z

Perhaps we could just reclassify most household employees as self-employed?

...I'm actually quite serious. It's an absurd amount of paperwork for people who might work for you a few hours per week.

No, it's not. Because you don't have to do all that paperwork for people who might work for you a few hours a week. If they're independent contractors setting the hours and conditions of their work, who also work for a bunch of other people, the paperwork is minimal. If they're part-time or full-time employees (hint: when someone employs the same "baby-sitter" for 12 years with enough total hours a year to trigger tax reporting, that's probably not the right descriptor) whose hours and conditions of work are set by you, and who don't work for a bunch of other people, then by golly you have to behave like an employer.

The reason I say Atrios is being suckered is that this is like the inheritance tax. Plenty of people can imagine a time in their lives when it would be nice to have someone come in and clean for a few hours a week or to take care of the kids for a few nights out a month. So now they're all being recruited to think they're in the same position as people who employ a maid for 20 hours a week or a nanny for 40 or 50. The comparison of tax complications is pretty much the same as that of your or my estate-tax liability to that of a Mars or a Walton.

And even for the people who have to behave like employers, it shouldn't be a big deal. For the last 20 years or so of her life, my mother was an accountant doing small-business and personal taxes. Plenty of her clients had household employees, which meant that a couple times a year she prepared all the necessary forms, put little post-it flags saying "sign here" in the right places, and sent them to those clients. Total elapsed time, a few minutes. (And yes, if you're paying people somewhere north of $10-20K a year to take care of your household and your offspring, you can spare another few hundred for a good accountant.)

Pardon me for suspecting, just a little, that one of the reasons for these patrician complaints is a desire not to behave like an employer. When you're filing taxes for employing someone, you have to obey wage-and-hour laws; you have to pay them on time; you can't lawfully harass them. All those pesky rules that apply to bigger employers for the protection of employees apply to the household ones as well.

Bush is Che's political heir

2008-12-30T02:05:17Z

All this baloney that's being spun about the "Bush Legacy" (no, not the one that our grnadchildren will still be forking over the interest and principal payments on) made me think that there is one truly distinctive thing George Bush has done in the past 8 years: he made it not only possible, but necessary to our national survival that a black man be elected president, something that almost no one in 2001 could have imagined would come so soon.

The part of Che's political philosophy that Bush inherited was the idea that you could hasten the revolution by "heightening the contradictions" of capitalism, otherwise known as blowing stuff up so that ordinary people's lives became (more) miserable and provoking (more) violent repression so that people's eyes were opened to the callousness and evil of their rulers. Bush has done almost nothing but heighten the contradictions of GOP government. Politicallly-motivated war, corruption and incompetence on a breathtaking scale, apparatchiks inserted throughout the government just like the "political officers" who guarded the ideological purity of Soviet enterprises, stupidly indefensible regulatory decisions, contempt for the very notion of a government of laws -- how much more obvious could someone make it that the current corporatist, christianist, anti-fact incarnation of the republican party is incompatible with the national welfare?

If we get through the next 10 or 20 years more or less okay, Condi may be right. A less ideologically driven, less venal, less box-of-rocks stupid cadre of republicans could have pushed our economy toward feudalism more quietly and effectively, could have stripped us of our civil liberties with less opposition-generating fanfare, could have continued the destruction of our environment less outrageously. And then they'd probably still be in power. If we get through the next 10 or 20 years, we'll have George Bush and his cronies to thank for that.

Madoff and Ponzi

2008-12-15T14:10:49Z

The first rule of running a Ponzi scheme is to take the money you're stealing. Madoff may have looted $50 billion from his clients accounts, but that doesn't mean he actually has $50 billion squirrelled away somewhere. If he did, he wouldn't have broken down and confessed, he would have gotten some plastic surgery and a new passport (or a new country to issue him one -- $50 billion is a lot) and gone to live in the south of somewhere. Instead, he put whatever money he skimmed into the same lousy investments as the the money that was coming in. (That's probably the biggest piece of evidence that he didn't start out completely crooked.)

I think Josh is right when he says that there's not that much difference between Madoff and the mark-to-model crowd. Banks (and things that claim for regulatory purposes not to be banks) always use new depositors' money to pay off old ones, because the old depositors' money is invested somewhere. That's how banks work: money is fungible. The difference between that and Ponzi is supposed to be that the bank has enough assets to pay off all its depositors, assuming the assets were sold in an orderly fashion and not a fire sale. But then you get mark-to-model, where the bank or bank-equivalent really has more of a promise that its analysts truly believe it has enough assets to cover deposits if the assets perform the way the analysts think they will, and you're treading awfully close to Ponzi territory. Then, when you get executives arguing against changes to the model that would make the assets look less valuable you've stepped right over the border and set up shop near the capitol. People who run real Ponzi schemes don't bother with huge staffs of analysts running rigged models, they just make up the numbers outright, but the intent and the effect are the same.

But that brings you back to the beginning, because the Masters of the Universe (mostly) didn't have the brains to take the money they were skimming out of the system either. It's just gone. Usually, when you run a scam, you end up with a mark who has less money and a scammer who has more, but here the scammers are stuck with the same worthless investments as their marks. Sure, they took out millions of dollars in salary and bonuses, but that's nothing to the amounts of money they had in play. And then they took most of those millions and invested them right back in the market they themselves were running into the ground. So a few people are a little richer by all this, but most of the money is just plain vanished.

Whipsaw?

2008-12-03T15:52:22Z

Maybe I'm thinking at the wrong level, but it seems like there's a fairly clear answer to the question Paul Krugman asked a few days ago about the Fed buying up Fannie/Freddie/soforth bonds, and it's not that Bernanke is stupid. Instead, I think it's his potentially very profitable answer to Keynes on market irrationality: when it comes to federally-guaranteed debt, the fed can stay rational longer than you can stay insolvent.

Bernanke (we can pretty much assume) knows these bonds are good because he's one of the people guaranteeing them, and he has a license to print money. So if they're trading at well below the value of other federally-guaranteed debt, he can buy them up, make some interest income, and then sell for a profit when other people come to their senses. If the bonds go south, the treasury makes good on the guarantee, the fed still makes a profit, and the treasury isn't out anything because the fed turns its annual surplus (after operating expenses for those nice buildings and all) back to the treasury. Whereas if the bonds were in private hands and went south the treasury would have to spend real money to make them good. The fed is spending T-bills, whose interest rate is pretty much zero, to buy stuff whose interest rate is not zero, and any sensible investor would jump at the chance to do that.

Although Bernanke, Paulson et al may just be floundering around, there's also an outisde chance that they may be playing a high-stakes (ahem) game of arbitrage with insider information. A lot of people have pointed out that the banks selling or pledging sh*tpile assets have a better idea of the current value of those assets than the fed or the treasury -- and hence can stick the government with the really toxic stuff -- but it's also the case that the fed and the treasury have a better idea than the banks about what they're going to do next, and have the ability to manipulate conditions -- such as foreclosure rules and restructuring terms -- to affect the value of the toxic stuff they hold. So any financial institution looking to unload crap on the feds runs the risk that the feds will turn it into non-crap and make a tidy profit that could have gone to the financial institution instead. And that could introduce a little discipline for ongoing attempts to fleece the taxpayer.

Or, yeah, they might just be making stuff up as they go along.

Shorter Insurance Industry: Give us all your money, and we won't have to run those ads again

2008-12-01T15:30:06Z

You can see from this article just how skewed the debate on health care is going to be. I don't know whether the reporter is transcribing FUD from an insurance industry source, or has just internalized it, but let's unpack the notion that there will be terrific opposition to taxing "excessive" insurance benefits paid by employers to people earning more than $100K a year.

Where to start? Well, $100K a year is twice the median household income in the US, so talking about the impact on the "middle class" is just a touch deceptive. (Except that you have to havethree or four times the median income these days to feel "middle class".)

Then there's the amount of the impact, which maxes out at half a percent of income for people getting the "average" benefits package. What a terrible price to pay for universal coverage and removing the deadweight of paying for coverage for the uninsured and for all our excess morbidity and mortality. People getting more-than-average benefits packages would pay more, but then they're getting more from their employers, so what's the complaint, other than that they're well-off and entitled and don't want to pay?

Oh, and about that average: the cut-off points for taxing benefits are from a study published in 2004. The average cost of plans cited is current. Anyone think that the price of insurance has gone up by only 20% total over the past 4 years? In other words, the cutoff was well above the average in 2004 when it was published, and there's no question that any legislation passed next year would put its cutoff well above the average too. Heck, it might even -- gasp -- set cutoffs according to the average family and individual plans in each state, so that people in high-cost states would bear an extra burden. Unless, y'know, there's no one in the entire federal government who can do simple arithmetic.

Why is it so important for insurance companies to skew the debate on this? Because what they would like is universal coverage along the lines of Medicare Part D: everybody ponies up to pay whatever they set as the going price, and the federal government picks up the extra tab. Taxation of excess benefits, community rating, anything that puts pressure on to reduce costs, is anathema for private companies under the current multiple-payer system because the most obvious target is that big fat 20% in administrative costs. (Yeah, there are lots of other ways to reduce spending, but they typically can't be made profitable when you customers can jump to another carrier every year.)

If this is what the discussion looks like when things have barely gotten started, I can't wait for the real thing. My only hope is that the anti-reform people are going to overplay their hand early, but I'm not holding my breath.

Voter fraud trolling is for people who miss the poll tax

2008-11-02T16:06:14Z

I know I'm late to the party with this, but I was thinking about about how some of the GOP dead-enders really seem taken with the idea of voter fraud, even though they don't allege any noticeable amount actually going on. And in line with Josh's "voter registration fraud almost never leads to fraudulently cast votes" it came to me that there's pretty much no plan for creating and then using fraudulent registrations that isn't more difficult, more expensive and more dangerous than just effing registering real people and getting them to the polls on election day.

That's because registering to vote under your own name is dead easy (unless someone discards your form). Sure, once you register you might have to spend 8 or 10 hours in line waiting to exercise the franchise, but imagine trying to keep a crack team of impersonators waiting in those same lines for the same length of time. Still easier and safer to use real people.

It's dead easy because, with few exceptions, pretty much everyover-18 citizen of the US is eligible to vote somewhere. Maybe not in the district of the house they've just been foreclosed out of (or maybe), maybe in the town where they go to school instead of the one where their parents live, but somewhere.

And that in a nutshell is the problem for people who want to suppress the vote. A few people voting in the wrong place might affect races for village coal-measurer or selectboard, but for statewide and national races they're completely irrelevant. A vote for McCain or Obama in Ohio is, as far as the spirit of the law goes, a vote for McCain or Obama regardless of where in the state it's cast. (Sure, you can imagine busing those impersonator teams into small states like Rhode Island or Alaska and swinging a crucial margin, but only if you have a really fervid imagination.)

Of course, it didn't use to be that way. In the good old days, when only the right kinds of white men were elected, people who didn't own land, couldn't pony up the fee, or who couldn't extemporaneously construe Jarndyce v. Jarndyce, weren't allowed to vote. And that's the way Hans von Spakovsky and his cronies still think it should be. The fact that every citizen of the country really is eligible to vote galls them, and they disguise it by nattering on about people voting under the wrong name or in the wrong place.