The Fed’s policy space is not one-dimensional

It’s easy right now to view the Fed as trapped. If the Fed fails to lower rates, asset prices will continue to collapse, the housing crisis will worsen, and the broad economy will suffer. If the Fed does lower rates, capital flight from the US will continue, gold, commodities, and foriegn currencies will surge, and weakness of the dollar will eventually translate into a dangerous inflation. The Fed is damned if it lowers, damned if it raises, and damned if it does nothing at all. In the usual cliché, the Fed is “in a box”.

But the Fed has more options than “raise or lower”. Let’s go back to Bernanke’s famous 2002 speech about deflation. Note that the root of the current crisis is deflation, though of a particular kind, a deflation in the value of certain financial assets. If all the terrible paper Wall Street has been producing over the past few years really had been as solid as their boosters and the rating agencies claimed, we’d have no crisis today to fuss about. A collapse in the value of supposedly “ultrasafe” assets held by parties with little capacity to take risk or bear losses is at the heart of the today’s financial mayhem. Whatever its deeper roots, the proximate cause of the crisis is a deflation.

Here’s Dr. Bernanke:

[T]hat deflation is always reversible under a fiat money system follows from basic economic reasoning… [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services… Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral.

The first thing to note here is the candor and prescience of Dr. Bernanke’s remarks. The future Fed chairman is describing very unconventional monetary policy options, and discussing how the central bank could, in a time of crisis, circumvent regulatory obstacles designed to constrain bank behavior. And obviously, these turned out to be more than mere musings. Bernanke’s first response to the present crisis was to try to lend indirectly to holders of struggling collateral via the discount window.

Suppose that the Fed were not restricted in the sorts of assets it could buy. What might the Fed do about the present crisis? Consider the obvious. The Fed could bail out holders of the compromised paper. It could determine a “fair long-term value” for all those struggling RMBSs and CDOs, something less than par but much higher than the market bid, and purchase securities outright with freshly printed money. You might think that a cash bail-out would be inflationary, and “ceteris paribus”, it certainly would be. But “ceteris paribus” doesn’t hold here. By strategically choosing which assets to buy, the Fed could mitigate the harm that higher interest rates would otherwise do to the financial sector. Becoming the “bagholder of last resort”, the Fed would purchase the freedom to raise interest rates without provoking a “nonlinearity” (knzn‘s delightful euphemism for a meltdown). The Fed would have its cake and eat it too. It would promote full employment by stopping a dangerous financial crisis in its tracks. It would promote price stability by hiking interest rates to support the purchasing power (and FX value, and commodity value) of the dollar.

There would be some danger that, even with the banks bailed out, interest rate hikes would slow the economy. But that hazard is unusually small now, because the binding constraint on lending is not the Fed-set interest rate, but concerns about creditworthiness and quality of collateral. The larger the credit spread is, the less of an effect changes in core rates have upon behavior. Raising rates certainly won’t help homeowners struggling with their mortgages, for example. But it won’t hurt homeowners who have no hope of refinancing affordably anyway. There will always be someone caught at the margin. But in macro terms, a bad situation would be made very little worse by a moderate rate hike, if the financial sector could withstand it.

In reality, the Fed is not permitted to buy up dodgy CDOs outright. But as Bernanke has suggested, lending on sufficiently easy terms can approximate a purchase. Bernanke’s initial try at using the discount window to fight the structured-credit deflation didn’t work. But it was not a very radical attempt. So long as there is a “penalty spread” between the federal funds rate and the discount rate, any use of the discount window signals a lack of confidence by other banks and is reputationally costly. Suppose the Fed were to offer to lend against specific sorts of collateral at a negative spread to Federal Funds. Then all banks would have a clear financial incentive to take advantage, regardless of the quality of their own portfolio. Banks holding the privileged collateral might claim their assets are performing beautifully, but that it would be foolish not to take advantage of the Fed’s subsidy. Lining up at the discount window would suddenly become shrewd rather than shameful.

Of course, this might not work. Markets might be spooked rather than reassured, a l&agrave the Northern Rock fiasco. And even if it would work, I don’t advocate any of it. I don’t mean to be a “liquidationist“. But piling moral hazard on top of moral hazard, making ever lighter the consequences of poor choices by people whose choices are consequential for all the rest of us, strikes me as a bad way to encourage quality decision-making.

Nevertheless, if financials and asset prices continue to struggle, while commodities spike and the dollar falls, expect the unexpected from the Federal Reserve. Ben Bernanke has devoted his career to thinking about how a central bank might forestall financial catastrophe. He will not confine his options to “quarter point or half a point, up or down”.

Update History:
  • 11-Nov-2007, 2:00 p.m. EST: Removed an excess “but”. Changed “expected the unexpected” to “expect the unexpected”. Oops.

GM — Holy negative accounting equity, Batman!

Apparently GM is going to take a $39 billion dollar writedown of deferred tax assets this quarter. Wow.

The phrase “deferred tax assets” is one of many powerful hexes the accounting profession has invented over the years. Recitation of the words before ordinary mortals causes eyes to glaze and specks of spittle to appear at corners of the mouth. For an explanation, see the end of this post.

Anyway, as all the overnight press on the matter is careful to emphasize, these are non-cash charges, and they could be reversed if GM becomes profitable soon. Nothing to look at here, just move along. It’s an accounting thing, you wouldn’t understand.

But here’s an accounting thing for you. Check out GM’s top-level balance sheet last quarter (the quarter ending Jun-07). Look at the line called “Total stockholder equity”. Yes, it really does say negative 3.5 billion dollars.

Suppose GM offsets the writedown of tax assets with $9B of gains elsewhere, so that the net charge is, um, only $30B. (For example, they’re expected to report a gain of $5B on their sale of Allison Transmission.) A $30B net charge would bring GM’s accounting equity down to negative 33 billion dollars.

Is that a record? What’s the maximum negative accounting equity ever reported by a going concern? Or, consider this: GM is not a penny stock. The market imputes a lot of real value to those claims worth negative dollars on its balance sheet. GM’s market cap as of yesterday was about $20.5B. That’s a positive number. GM’s stock price fell after-hours on announcement of the charge by about 3%. So, incorporating (at least partially) the new information, the market imputes about positive $19.9B of value to roughly negative 30 billion dollars worth of book assets. There’s a nice fifty-billion dollar spread between market and book value. If GM could keep that spread, but bring its book value up to positive a billion, it would look like an incredible growth company, with a market to book ratio of 50 times! Google looks cheap by comparison.

Now, there are serious problems with accounting equity as a measure of value. GM is an old company. Perhaps it owns a lot of real assets that were purchased decades ago and are still valued on its books at 1940s cost. Could be. But it takes a lot of adjustments to get out of a hole $30B deep.

An interesting factoid from the WSJ. GM’s total net income for 1996 through 2004 totaled $34 billion dollars, less than is disappearing in tomorrow’s accounting “poof”.

Here’s a question: What percentage of GM’s market valuation do you think is based on a market-perceived “too big to fail” guarantee by the US government?


For those who want to know, “deferred tax assets” arise when firms recognize expenses before they are allowed to take a tax deduction for those expenses. Let’s say a large New York bank decides some of its assets are worth 10B less than originally thought, and writes those assets down on its balance sheet. If the bank pays a 35% tax rate, 3.5B of that “loss” should eventually be absorbed by the government in the form of reduced tax payments. But companies don’t get to pay fewer taxes whenever they change their estimate of the value of an asset. The bank gets a cash write-off on its taxes only when the assets are actually sold and the firm realizes a loss. In the meantime, the firm recognizes a 3.5B “tax asset”, the value of the future tax savings it expects. This is all perfectly legitimate — writing down the assets without recognizing the expected tax-savings would badly overstate costs. But sometimes a firm’s estimate of future tax savings turns out to be wrong. Say the bank is forced to sell the impaired assets when it is already losing money. Then there is no immediate tax savings, because the bank wouldn’t have paid taxes that year anyway. The firm may still be able to “carryforward” the loss, and recover some of the tax savings. Or it may not. Tax laws are complicated.

GM had previously estimated that it had $39B in future tax write-offs coming to it. Its accountants now think the company might never get the chance to use them. Though this is not a cash charge, it is not a good omen either. Firms realize tax assets when they are profitable enough to have a large tax bill to take deductions from. GM is basically announcing that it’s unsure it will earn enough money to be able to take advantage of its pent-up tax offsets before they expire. Tax asset writedowns are insult-to-injury kind of events. Firms get hit with the accounting charge when, and precisely because, they can’t make enough money to have a tax liability to escape from.

Tax asset writedowns might also be a signal of distress, indicating that a firm lacks the flexibility to time its loss realizations advantageously. Tax laws are complicated, and sometimes tax benefits expire regardless of what a firm does. One mustn’t draw conclusions. Still, it does make you wonder.

FD: I have no direct position in GM, but I am short the Dow.

Update History:
  • 07-Nov-2007, 11:33 a.m. EST: Changed “tax asset write-offs” to “tax asset writedowns”, since I use “tax write-offs” and the mix is confusing. Changes “to big to fail” to “too big to fail”.

Bricking someone else’s iPhone is a crime

Suppose, accurately, that I am a small software developer. Suppose I write a shareware application that includes a click-through license that states, ordinarily enough, that if you wish to use my application for longer than a 15-day trial, you must pay me. Suppose, ordinarily enough, my application periodically checks for updates, notifying users and offering to install the updates when they become available.

Now suppose that in the click-through installation process, I include a message, in bold text even, that says “Warning: If you’ve been using this application for longer than the 15-day trial period and have not entered a license key, installing this update may cause your hard drive to be erased!” And, suppose the update does just that.

I would be in jail. Not in a month, or a week, but yesterday. What I’d done would be considered equivalent to distributing a malicious virus. The click-through “authorization” wouldn’t be worth the electrons they were written on. In the computer crime world, “social engineering” — getting people to let one into a system to do bad things, rather than breaking in by technical means — is the norm, and it is illegal. When an e-mail virus begs you to run a malicious attachment, it is not the virus that kills your computer, but you, by double-clicking. After all, you ought to have known better, right? We still put the pimply teenager or smoky mafia don who sent the thing in jail, if we can find him. If there were a click-through warning, just prior to the swiss-cheesing of your computer, disclaiming liability and saying the program “may be harmful”? We’d still put the perp in jail.

Now if Apple has done what they appear to have done — if they have broken other people’s palmtop computers permanently as payback for having violated the terms of a license agreement — they have committed a crime. Sure, Apple made those iPhones, and they forced people to sign up to certain terms before selling them. But once they were sold, they were other peoples’ property. And whatever remedies Apple may have had against customers who violated the non-negotiable contracts they signed onto when purchasing the phone, those remedies did not include destruction of customer property without any adjudication by an impartial arbitrator. A click-through warning of the type every computer user, um, clicks through hundreds of time a year does not affect the criminality of Apple’s action.

If it was, in fact, a technical necessity that resolving customer issues on the iPhone required doing things that would break unlocked or modified iPhones, that would be a different situation. Apple would not be off the hook, but it would have some toothpicks to stand on. But I think that’s unlikely. At the very least, Apple’s update could have checked for incompatible changes to the iPhone and refreshed to initial state prior to applying the update. Apple didn’t brick people’s iPhones because it couldn’t help it. It bricked people’s iPhones because Apple is playing a “cat and mouse” game with customers who “think different”, who like to play with the gadgets they buy. (Bricolage is an especially apt term here.) Apple decided to play hard, and dropped the digital equivalent of a horse’s head on the beds of first-adopters who dared cross them, in order to deter future customers from using their device in a manner other than that prescribed for them.

This is criminal behavior, regardless of any violation of license terms by the victims of the crime. It’s illegal for Muscles to come by and cut your thumb off, even if you really do owe Da Boss some money. It’s illegal for Apple to gain entrance to your property under the pretense of improving it and then purposefully wreck the place because it found you were doing something you said you wouldn’t do there. A boldface sentence in a click-through agreement doesn’t change that.

I should say, this is not a personal gripe. I don’t own an iPhone, or an iBrick. (I did just buy an iPhone for my sister, but she’s unlikely to do anything with it that Uncle Steve would disapprove of.) I have been a rabidly enthusiastic consumer of Apple products since my parents bought the family an Apple ][+ in 1980. Just within my immediate family, there are at least 9 Mac laptops, largely as a result of my love of the platform and enthiusiasm for Apple’s products. Jobs and Woz have been heroes of mine since I was a kid. I know Steve Jobs is a tyrant. I even support that, when it comes to product development, running his company. Jobs can fire whoever he wants for not conforming to his remarkable vision of how Apple products ought to be. But he cannot purposefully destroy my stuff for the same offense.

I hope Apple is not simply sued, but prosecuted under criminal statutes for what they’ve done. Anything less means that big corporations live under different laws than pimply teenagers and small software developers.

It is getting so hard to find the good guys these days.

Update History:
  • 01-Oct-2007, 1:50 a.m. EDT: Dropped the word “electronic”, which was redundant with “digital” in the context of a horse’s head. Respelled “heros”. Changed “impartial third party” to “impartial arbitrator”. Redundancy is redundant.
  • 01-Oct-2007, 4:00 a.m. EDT: Replaced a vague “their” with “Apple’s”. Replaced one repeated use of the word “warning” with “message”. Removed some wordiness (“of the violation”).

Gabriel Mihalache — Streets are places too?

If Canada is divisible, then Quebec is divisible. If Quebec is divisible, then Montreal is divisible.

Gabriel Mihalache tries to pull the old reducto ad absurdam on my contention that nations are places, and the implication that quality-of-place considerations might lead to deviations from the traditional case for free trade. He writes:

Why not ask… if localities can benefit from these deals, this industrial policy—to quote another skeptic—then why not apply the same idea to streets, town squares, and beyond? — Maybe we should have a sort of street prefect, with his own budget, ready to subsidize business start-ups on his street?

Why allow for free movement between 1st Avenue and 5th Avenue? Maybe 1st Avenue could benefit from some regulation or from offering subsidies? Why not?

To which I answer enthusiastically, “why not indeed!” Shopping malls are places too. Shopping mall developers often want big-name retailers as “anchor stores”, so they offer national chains great deals on rent, and sometimes sweeten the deal with cash. This might seem economically foolish, at first glance. But the subsidy turns out to be small compared with the increased certainty that the mall will attract customers, and the higher rents boutiques will pay to sit between popular behemoths.

Malls are hardly a unique example. Most commercial real-estate owners will offer discounts to tenants they consider particularly “desirable”, whose presence will in some hard-to-pin way increases the value of the property they have on offer.

People who live who live on nice streets often spend a great deal of money to maintain the exteriors of their homes, the quality of their lawns and gardens, etc. Part of this one can chalk-up to “consumption” — people take pleasure in having a nice spaces. But a lot of this represents a kind of informally coordinated public investment, enforced by social norms. The value of properties is contingent in part on the niceness of the street, and everyone is expected to do their part. Some neighborhoods are developed as mini nanny states, with coercive regulations one must adhere to as a homeowner in order to ensure that residents don’t shirk in maintaining (often uninspiring) “standards”. Neighborhoods organized as condominiums have the power to tax and spend to maintain and enhance the quality of space. Lots of people are pleased to submit to all this. (I don’t necessarily endorse these neighborhoods. The uptight, snooty ones make me go “ew”. But hey, it’s the free market in action!)

Gabriel:

Maybe, but exactly like free trade, these deals have winners and losers (who, just as with free trade, won’t get compensated). Also, there’s the issue of the “relevant moral community”. (Do poor Chinese children enter into your welfare judgments?… and the like.)

Basically, this boils down to choosing between two patterns of winners and losers, which is a political choice. You can show, maybe, that with an utilitarian “social welfare” function, the “development deal” is preferable. But that’s a big “maybe”. And it’s still politics, so it’s not a matter of knowing something that the economists don’t.

I won’t argue much with this, except to note that, just as with free trade, enhancements of place may create winners and losers, but large overall gains. Many shopping malls could not survive without subsidized anchors. Boutique owners might be unhappy to subsidize the rent of retailers with much deeper pockets than themselves, and some potential renters might be so pissed off they refuse to rent. Still, it’s hard to argue that there isn’t a large overall gain from the subsidy.

A condominium association might decide that common spaces need to be repainted annually, and fees will be increased to cover the expense. Some homeowners undoubtedly will consider the fresher halls to be worth less than the money they pay out. Given heterogenous and uncertain utility functions, one objector’s sheer misery might be enough to outweigh any gains to other tenants. But, under ordinary assumptions, if the vast majority enthusiastically support the change, we usually presume overall gains. The case for overall gains is at least as clear as in the argument for free trade.

Of course, if leadership of the condominium association has been hijacked by unrepresentative busy-bodies, or by a board member whose kid brother is a painter, large overall losses might result. But the possibility of agency problems oughtn’t prevent us from considering potentially welfare-enhancing subsidies. Both action and inaction are potentially flawed choices. In the real world, we do our best to control agency costs, but we still make decisions.


I do want to emphasize that I am playing with ideas here, and not quite endorsing the idea of legitimizing state subsidy as a normal part of international trade. It’s a surprisingly interesting idea, and one can make the case for it in very “orthodox” terms. (If one does so, one finds that what is destructive of overall welfare is to abstain from subsidizing!) But the agency problems are, to say the least, daunting.

Regardless, people like Don Boudreaux who want to argue for traditional free trade based on the example of trade within the United States need to grapple with the historical fact of ubiquitous subsidy. And I’m not just playing when I suggest that any model of trade that looks only at gains and losses to individuals without considering quality of place is simply inadequate as a basis for policy.

Bear Stearns: What happened to the assets?

Interfluidity still has unfinished business with Felix Salmon, but that will have to wait. Usually we take great pleasure in disagreeing with Felix, but today he makes one point that is unassailable: Bear Stearns Needs English Lessons. The firm sent out a letter to its unlucky investors that managed to communicate almost nothing. Shorter Bear Stearns (my paraphrase): “You have lost all, or nearly all, of your money. But do entrust your wealth with us in the future. Ordinarily we don’t stiff our clients quite so badly. Besides, we hired some new guy, so everything is better now.”

If I were an investor, I might wish to console myself with some of the lurid details. In particular, I’d want to know what happened to the assets I used to own. To whom were they sold, under what circumstances, at what price? Were assets liquidated in arms-length transactions, or are fund managers still holding assets but reporting losses based on estimated valuations? How were the claims of creditors settled? Did the funds repay their debts in cash? Did creditors confiscate and liquidate assets, or in some kind of workout, did creditors accept collateral in lieu of repayment?

If creditors did accept repayment-in-kind, under present circumstances that might not be an arms-length transaction. (After all, the asset managers and creditors likely have continuing relationships unrelated to the two funds, and a shared interest in avoiding perceptions of conflict or disorder in the market.) As an investor in one of the funds, I’d want to know how much debt was extinguished for each of the assets surrendered, that is, what sort of valuations were implicit in the workout, and how they were arrived at. If the assets were not in fact auctioned, perhaps creditors paid less in terms of debt forgiven than the assets were in fact worth. Perhaps Bear’s interest in putting an embarrassing incident behind it without causing turmoil in a fragile market led it to drive less-than-a-hard bargain with creditors, who were after all in an exploitably poor bargaining position. Were fund managers gentlemanly among Wall Street colleagues, or fierce on behalf of their investors? I’d want to know.

If there was any repayment-in-kind, I’d also want to know about that if I had a position in one of the banks that were lenders to the funds. Perhaps Bear did drive a hard bargain, and my bank was forced to extinguish too much debt for the privilege of owning iffy securities. Perhaps my bank decided that accepting questionable collateral as full repayment was better than forcing the bankruptcy of the funds, because no matter what, the collateral was all it could hope to get, and calling it “repayment-in-full” avoided the embarrassment and potential loss of confidence associated with having been defaulted upon. In this case, risks and potentially outright losses have been transferred from the troubled fund to my bank, which may force a write-down of bank assets in the future. I would want to know.

Does anybody know these details? Thus far, all the reportage I’ve seen conveys very little more than Bear conveyed in its letter to investors. Which is to say, practically nothing at all.

William Polley on free trade among the 50 states

I’ve been hung up (unfortunately not hung over) for the last few days, and I’ve pent up a list of short comments I can’t wait to get of my chest. Here’s the first one…

William Polley understands that what happens between the 50 United States deviates significantly from an economists ideal of free trade, and that economists who wish to argue for international free trade by virtue of an American success story need to deal with this fact. Polley writes:

…Here in the U.S., the framers of the constitution were smart enough to establish the fledgling country as a customs union and monetary union. This was in order to form a more perfect political union that that Articles of Confederation was unable to deliver.

Unfortunately, this does not stop the states and localities from pursuing other policies (wooing multinational factories, establishing tax-increment financing districts, etc.) that do with a series of knife cuts a bit of what a tariff would do with a hatchet blow.

…Tennessee would not do itself any favors by unilaterally abstaining from offering incentives to companies to locate there. But reducing state level competition of that sort would benefit everyone.

I’m not sure I agree with that last point. States and localities may well gain from the deals they make to encourage development. Overall gains attributed by economists to “undistorted” free trade still involve winners and losers, and it is perfectly rational for localities likely to lose (and unlikely, in the usual dodge, to be “compensated by winners”) to try to change the game. Taking Don Boudreaux‘s original point to heart, I do think the sausage factory of trade among the 50 US states has worked reasonably well. So rather than arguing from a model that the system of subsidy-by-locality should be dismantled, I’m inclined to keep an open mind about whether politicians responsible for quality of place might not know something missed by economists, whose models often lack recognizable notions of place entirely.

Capital markets and just desserts

Last night’s was one of those posts one regrets immediately after hitting “publish”. Somehow, those always attract notice. (Thanks Felix!) But, sometimes when one puts more cards on the table than one intends, it’s a good way to start a conversation. In fact, unintended candor is one of the great blessings of the blogosphere, and we must be thankful for that, even when we are our own victims.

Anyway, let’s continue the conversation. Who deserves to get paid in capital markets? I wrote…

Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts.

Felix Salmon‘s rejoinder:

[T]here’s only one species of investor who “deserves to get paid”, and that’s an investor with a contract which guarantees him money. I think they’re called bondholders. If you buy a security in the hope that its price will rise, or sell a security in the hope that its price will fall, you don’t “deserve to get paid” anything, whether you’re right or whether you’re wrong. Markets are not some kind of primary-school sports day where prizes get awarded to the most deserving. In the words of parents worldwide, “life’s not fair”.

Life is not fair, and Felix is quite right to note that markets don’t exist to mete out some kind of wise and just reward to each and every trader. But at the same time, markets ought not be poker games or casinos, where it is the lucky who are compensated, or those whose talents have to do with games disconnected from real events. Market outcomes are supposed to attach to external referents. It is no tragedy when the winds of randomness overtake any particular trader. But on the whole, for a capital market to be “good”, in a strong normative sense, it ought to compensate predominantly those who make wise judgments about the application of capital to real world enterprises, and to punish those who make poor judgments. Capital markets, actual, historical, and conceivable, are not all alike, and it is quite possible, and quite right, to make normative distinctions between. A capital market is not good because its prices go up. Nor do happy investors and happy fund-seekers define a good markets, in and of themselves. As Martin Wolf recently wrote, “Finance is the brain of the market economy.” What distinguishes a good capital market from a bad capital market is how well it does the economy’s thinking.

Bondholders absolutely do not “deserve” to get paid, any more than stockholders, or holders of derivatives, or any other financial position. A bondholder who lends to profligates to fund consumption, for example, absolutely deserves to lose, coupon and principal. And an investor who finds a firm that needs capital, and who correctly judges the firm’s activities and management as being of the sort that could put capital to good real world use, absolutely deserves to be paid, regardless of whether that payment comes in the form of capital appreciation, dividends, or interest. The purpose of capital markets is to compensate managers of capital for putting scarce resources to good use, and to punish managers who squander what is precious. Markets needn’t and can’t offer perfect justice. But if they fail on the whole to compensate the deserving and punish the wasteful, then we might as well banish them to riverboats.

Many of the best and brightest of this giddily corrupt moment err by forgetting that capital markets are human creations subject to wide variation in design and behavior. They mistake whatever some prominent market does for “the market outcome”, and forget that alternative arrangements in security design, regulatory regime, macrostructure of financial instititions, and microstructure of trading systems are all possible, and might produce very different outcomes, all of which would have equal claim to being “market-determined”. And the fact of a market doesn’t absolve us from making judgments about whether outcomes are good or bad, even though our nonmarket means of evaluating the world are at least as flawed as our markets. Failing to subject markets to reality checks, relying on them entirely for all of our economic thinking without letting other measures of economic sense weigh in at all, invites corruption.

I write not to attack markets, but to defend them. Dani Rodrik has suggested we must save globalization from its cheerleaders. It is equally urgent that we save capital markets from their cheerleaders. I believe that well-designed markets generally are the best way to make most large-scale economic allocation decisions, and that market-like systems could be productively employed in a variety of other contexts as well. But current capital markets are frankly off the rails, in a manner that most people not subject to ideological blinders are perfectly capable of seeing. I could be wrong. I’m not a market, after all, so perhaps I have no standing to opine. But even still, I could be right.

Which gets us back to the bit about short sellers. If I am right about bad things down the road, good capital markets should, on average, compensate me if I trade on my superior-to-market knowledge of future bad outcomes. The repricing brought about by my trading and the trading of many others who see what I see should work to make those bad outcomes less likely and less damaging. The “on average” is important here. I can be right, but foolish in execution or just unlucky, and get wiped out. That’s life. But markets that are systematically biased towards integrating positive information and ignoring negative information (until sudden “Wile E. Coyote” moments), that have institutional biases against short-selling or that delay price declines because some actors have more at stake in market prices than real-world referents, may, on average, fail to compensate shorts. If so, then rational people won’t short, prices far higher than reasonable economic value will be stable for long periods of time, “greater fool” strategies of investment will be profitable, and “adjustments” will come sharp, large, and painful when underlying economic realities can no longer be papered over. Markets compensate next-to-last fools in preference to wise allocators of capital, and leave everyone else with a mess. That, unfortunately, is the world we live in today.

Felix writes:

Steve is living in cloud cuckoo land if he believes in the “real-world meaning of market prices on the basis of direct valuation of the assets being traded”. If that was really the case, then there would never be any price difference between voting shares and non-voting shares, for starters. Capital markets, in this sense, have been failing for as long as they have existed. And a lot of smart, long-term investors have made a lot of money by arbitraging those failures. On the other hand, a lot of smart, long-term investors have also lost a lot of money by attempting to arbitrage those failures. Being smart and right is not enough to make you rich.

Although I plead guilty to living in cloud cuckoo land, I do not actually believe that actors trade only on the basis of real-world valuation. I do, however, believe that to the degree actors trade for “strategic” rather than fundamental reasons, they are corruptors of price signals, creators of noise, and that well-designed market systems will work to punish rather than compensate their behavior. To the degree there are “limits to arbitrage” that systematically pay off game-players and punish those who price the real world accurately, that’s a real problem that should be fixed. Felix is right that being smart and right will never be enough to make one rich in capital markets. Life is uncertain, and luck always matters. But if on average people who are smart and right about underlying realities lose, that’s a problem.

Felix:

But the surprising thing is precisely that there is some efficient allocation of real resources – not that there is inefficient allocation of real resources. Real resources have always been allocated inefficiently, and they always will be. Just look at the fashion industry.

No human institution is perfect. A glass is always empty or full by some fraction. But, when the glass seems so empty that you think lots of people are going to die of thirst, looking on the bright side is not the appropriate response. Maybe, hopefully, I’m just mistaken. But if one sees capital markets as broken in ways that could cause serious hardship and perhaps outright catastrophe, pointing out the flaws, even ranting a bit, is not entirely uncalled for. Or so I like to think.


On a personal note, my previous post was perhaps too “heartfelt”. The fate of my own portfolio doesn’t matter that much, even to me. I’ll not starve when I’m forced to cover my shorts. I only personalized the tale because, after telling others they should be ashamed of themselves, I felt ethically bound to reveal that my scolds could be taken as self-interested and manipulative.

I’ll end with a bit of Keynes, which resonates with my view of investing, short or long:

I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holding with equanimity and without reproaching himself. Any other policy is anti-social, destructive of confidence, and incompatible with the working of the economic system. An investor is aiming or should be aiming primarily at long period results and should be solely judged by these.

Update History:
  • 14-July-2007, 3:40 p.m. EET: Replaced wordy “bears no relation to” with “disconected from”, “external reality” with real events”.
  • 19-July-2007, 4:52 a.m. EET: Removed the ungrammatical “s” from “a good capital markets”.

A sprawling rant inspired by an urban legend…

The story referenced below (hat tip Felix Salmon) may well be apocryphal. It has the feel of an urban legend, and I think I’ve read variations of the tale before, but without the topical Bear Stearns reference. Watch me take the bait, swallow, turn bright red.


From CDO Pool PMs – Just Chillaxing:

Asked how [a CDO pool portfolio manager] is doing, he says “nothing.” I ask, “What do you mean nothing, I hear all these stories about CDOs and losses (Bear Stearns for example)?” He shrugs and says nothing will happen until the rating agencies do something. Asked about losses, he says they are there but he doesn’t have to mark to market his portfolio until someone discovers it or the rating agencies force his hand. So his plan is to lie low and collect the management fees (and bonus) and pretend as if there are no losses…

He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don’t downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10 million spoils (minus the expenses for one Park Avenue office, and a secretary).

If this is real… Just two words. Jail time. If you take your 50bps on unimpaired values of assets that you know or should know are likely to be inflated, jail time is what you should get. And not just a little. That goes double (quadruple and 40?) for hedge fund managers taking fees on phantom value.

Do think about this while you’re “chillaxing” (in DealBreaker‘s colorful slang). Of course, you have your defenses. You rely on standard industry practices. You can claim that writing down assets prematurely would be unnecessarily damaging not only to you, but to your investors, to CDO investors as a whole, your mom’s pension fund, and the Western financial system. Of course your lawyers are confident the charters, prospecti, indentures, whatever are airtight, that valuation procedures are clearly spelled out, and everything is hunkydory if you can just hold back the tide a few more months. But it’s amazing how little the lawyers can do for you once transit workers’ retirements and university endowments go up in smoke and pitchforks. It’s like China, with this guy just executed for making a buck looking the other way on food safety. Probably lots of similar players got away with deadly corruption. Maybe a dispassionate look at the odds of getting caught said this was a rational game to play. But somebody somewhere is gonna get unlucky, gonna get smoked. It might as well be you.

Here’s another word: Shame. Aren’t you at all ashamed to take money from your investors in this way? Would you take a Rolex from a jewelry store window if you could get away with it? Don’t give me that crap about professional investors and big boys who know what they’re getting into. Asset managers (CDO pool, hedge fund, whatever) don’t have an adversarial relationship with their investors. They have a fiduciary relationship. That is, they have an ethical obligation to do what is in investors’ best interest even if it conflicts with their own. I believe that’s a legal obligation, by the way, even if it’s not spelled out in contracts and founding documents. A judge surveying the wreckage might take that into consideration, if you get my drift. Especially when the big boys you “out-traded” were themselves fiduciaries for thousands of ordinary broken dreams.


Now before I go finger-wagging too much — shame, shame — I should emphasize that I have a dog in this fight. Here’s “full disclosure” in the lingo. I belong to a maligned, belittled, battered and bruised species, the unhedged speculative short. I don’t have positions directly related to CDOs or hedge funds or housing — I’m a broad macro pessimist kind of guy. (I am short financials, short semis, short the Dow, short USD, long gold, an FX basket, TIPS.) Should I be ashamed? Am I just talking my book? Trying to provoke an apocalypse for thirty silver coins? Felix claims that “courts are unlikely to have a huge amount of sympathy for short-sellers.” Everybody thinks that we’re the bad guys.

But I’ll tell you what. Short sellers are the good guys in financial markets. We’re the guys who take risks that by most people’s lights are simply irrational. Markets generally do go up and inflation does inflate. Nine times out of ten, a short is just a subsidy to a long. Short sellers are the true idealists. People like me, we’re not traders, we don’t backstop. We hold our positions and payout dividends until our margin runs out, and then we die (metaphorically), simply because we believe that assets are overpriced. We believe that prices are not numbers you trade, but references to real-economic facts. If prices are out of whack, in order for financial markets to work, someone has to try to arbitrage them back, and it might as well be us. We do hope to make a buck. We have our evil dreams of profiting just when everyone else is taking losses, and thereby being well positioned to buy value when it finally comes around again. But objectively, that’s never a good bet. At some level, being a short is a vote for how financial markets ought to behave, rather than how they do behave. In the late 1990s, most unhedged shorts were right, and were slaughtered for the privilege. I fully expect that in the late 00’s, I will have the same experience. But my sense is that the consequences of the capital market mispricings we have been unable to correct this time will be much more painful than the aftermath of the 1990s. We shorts don’t want to see a “financial armageddon“. After all, we’d never collect our paper profits from bankrupt brokerages and clearinghouses. We become shorts because shorts are supposed to be the mechanism by which catastrophic misalignments (and the distorted real-world incentives that accompany them) are prevented. Ordinary investors are pulled by fear and greed. “Buy and hold” shorts run on greed and idealism (and, many would suggest, sheer idiocy). Fear doesn’t matter. We generally start losing money the day we take our positions, and we keep losing money until we can’t. We are irrational, because we believe that markets should be rational. We believe that market prices have consequences, and that exaggerated asset prices do at least as much damage to the real economy as depressed prices.

I’ve been at this for a couple of years. I may be wrong about the fundamentals, in which case I’ll take my losses with a shrug and rebuild my wealth in a healthy economy. I don’t advocate fire sales, and am glad to see loan workouts and liquidity support that allow unwindings of positions to last more than a few days. But I have no patience with those who claim that the best thing to do is not acknowledge financial asset impairments that would persist even over a month-long auction (in contrast to a day long liquidation). Asset values can always change, but at some point you’ve got to concede that the issue isn’t liquidity but uncertainty-adjusted value. Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts. Similarly, investment banks who knowingly overpay for assets in order to prevent larger losses on derivative positions are market-manipulators, and should face consequences for that. As should central banks and sovereign wealth funds, if their trading in markets other than their own debt is driven by anything other than direct return maximization as ordinary price-takers. There is no theory that lets us give real-world meaning to market prices when price-setters are driven by second-order side effects rather than direct valuation of the assets being traded. We have no reason other than blind faith or ideology to believe that anything resembling efficient allocation of real resources would occur in an economy driven by capital markets with bizarre feedback loops. I think we are watching capital market failure happen all around us, and it will work out badly.

Failing to take write-downs and tolerating central bank subsidies will eventually drive all us bears away. But that won’t mean good times as far as the eye can see any more than all the successful 5-year plans of the Soviet Union meant that socialist paradise was at hand. Sometime within the next few years, today’s shorts and chicken littles will be vindicated. But we’ll still be poor, along with the rest of you. And that’s too bad, for all of us.

Free trade in the 50 states?

Tyler Cowen invokes a case frequently made (among Americans) in favor of free trade:

…I am still waiting for someone to defend trade barriers across the 50 states.

It’s important to note that even among the 50 states, textbook “free trade” does not exist. There are no tariffs, but the United States is riddled with internal “export subsidies”. When a state or locality puts together a deal to attract a factory, retain a corporate headquarters, or support a local industry, what is that about? Those tax breaks, underpriced loans, and infrastructure buildouts are explicit subsidies whose purpose is to ensure some economic activity happens “here rather than there”, for reasons that elude sterile Econ 101 models of trade. They are usually granted to firms or industries that produce for markets much larger than the subsidizing locality, and, as with export subsidies, the benefits are shared by far-flung shareholders, managers, and customers, while the direct costs are borne locally by taxpayers. Yet they are still popular. States worry openly and realistically that they may lose industries without competitive incentive packages. The usual justifications for these programs precisely match the arguments for export subsidies — jobs (first and always), fighting poverty and blight, creating “clusters” (“Silicon”-everywhere in the late 1990s), and defending against depredation by other localities. Lots of governors, mayors, state legislators, and city councilman routinely defend these trade barriers across the 50 states.

Using the United States, plural, as a standard-bearer for “free trade” argues for a world with few tariffs, but a whole lot of strategic government subsidy. That might be a good model, actually, but it is not the model free trade ideologues usually have in mind.

Update History:
  • 12-July-2007, 5:15 a.m. EET: Gently reorganized sentence beginning “They are usually granted…” (for style, not substance).

Synthetic greater fools

Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were “losers at the start”. Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, “[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.” Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here’s another explanation, on the buy-side.

Do you remember the “greater fool” theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and “fundamental” valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a “greater fool”, would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play “double-or-nothing” indefinitely, did very, very well for themselves.

At first blush, today’s markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not “institutions” that buy this paper, but managers who are paid for performance. And from a manager’s perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to “earn” money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime’s wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A “safe” position, from a manager’s perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague “systemic” problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and “diffusing” risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.