Steve Waldman's dark musings

Steve Waldman (interfluidity) is my all time favourite blogger.  

We disagree on a lot - but his is the only blog I have ever back read every article on.  I really like smart people I disagree with.

Today he has some (very) dark musings about the Geithner plan.   His musing is that conflicts of interest could render the Geithner funds liable to massive fraud.

I agree.  

I remember chatting to a journalist about the Geithner plan and I suggested that one of the big problems is that almost everyone is conflicted – and conflict-of-interest with that much government participation poses a very serious fraud risk.  

The solution of course is to find non-conflicted funds.  

May I suggest – and I am only half joking here – Bronte Capital. 

The only problem is that the criteria for eligibility specifically include only those with a conflict of interest.  Here they are:

Fund Managers will be pre-qualified based upon criteria that are anticipated to include:

• Demonstrated capacity to raise at least $500 million of private capital.

• Demonstrated experience investing in Eligible Assets, including through performance track records.

• A minimum of $10 billion (market value) of Eligible Assets currently under management.

• Demonstrated operational capacity to manage the Funds in a manner consistent with Treasury’s stated Investment Objective while also protecting taxpayers.

• Headquarters in the United States.

Given that we are start-up we fail the first, second, third, fourth criteria.  We are Australian and we fail the fifth criteria.

Now did I once say something positive about the Geithner plan?

Actually I have too much integrity to withdraw that – but the dark musings are to be taken seriously - and indeed the criteria described above are precisely the criteria you would pick if you want conflicted people to rip off the taxpayer.

John

Felix Salmon misrepresents me...

Felix Salmon mischaracterises my views… 

In particular he says

The status quo, absent any Treasury proposal, is basically the Hempton plan: let profitable-but-insolvent banks work their way slowly back to solvency by making large operating profits and not paying dividends. But the problem with the Hempton plan is that it only works on a kind of don't-ask-don't-tell basis: the banks can't be publicly insolvent, since then they need to be taken over by the government.

No.  My view is that we should have nationalisation after DUE PROCESS.  My view is that very few things will be nationalised – but I could be wrong.

What I like about the Geithner plan is that it provides PRICE DISCOVERY.

The price discovery gives regulators a process for marking the banks' books.  The bank “stress test” is no longer a “self assessed exam in which the punishment for failure is death” but an externally assessed exam, assessed by (admittedly subsidized) private money.

Once you have the true bank capital position determined you can allow the banks with adequate capital to muddle through (possibly with government liquidity support) and force the insolvent banks to raise capital.  If they can’t raise the capital you nationalise them.

As the exam is now objective – not self assessed – a lower capital standard (say a third normal) should be allowed.  High capital standards are really required in part because banks lie.  If they can’t lie a lower standard should be acceptable.  Moreover you suspend dividends whilst they muddle through.

Now the Geithner plan – done on a larger scale – can also support another policy objective.  If a bank comes to the Treasury and says “we are illiquid – help” the Treasury can now say “sell some assets”.  The bank cannot any longer claim there is no market for those assets – they can sell them to the Geithner plan fund(s).  

When they are forced to sell them the difference between illiquidity and insolvency will become clear.  If the assets sell near their book value then the bank really is just illiquid.  If large haircuts are required the bank is insolvent.  The government response can be dictated by a market price.

I never advocated that muddle through is the right policy.  I just happen to think that muddle through will work for most banks because most banks are not that insolvent.

But – after this process – I could be found to be wrong.  Very wrong.

And we will have nationalisations.  And they will not appear as theft because markets determined who was solvent and who was not.

John

The Treasury held a blogger's conference call...

Apparently the Treasury held a blogger conference call yesterday.  

http://www.businessinsider.com/treasury-department-holds-surprisingly-calm-blogger-conference-call-2009-3

My readership is large enough - and my blog is on-topic.

I am even modestly supportive.

Can I have an invite next time?  

Please.

Keener body surfers than me

This guy - Gordon Hempton - is a second or third cousin.  

http://seattletimes.nwsource.com/html/othersports/2008906553_surf23m.html

He is also a Grammy award winner for his nature sound recordings - but otherwise makes a living recording sounds for computer games.  You have almost certainly heard his recordings in some Microsoft game or other...

I went to visit him outside Seattle and he looks like me too.

Anyway - I am a keen body surfer.  But not as keen as this.  When you have to clear the snow in front of your van to take you to the beach you know that you will not be rescuing a hapless Japanese tourist.

J

Brad deLong joins me!

He posts that he thinks Paul Krugman is wrong.

And his nervousness about that statement matches mine...

He notes that if the past decade has taught [him] anything, it has taught [him] that mistakes are avoided if you follow two rules:

1. Remember that Paul Krugman is right.
2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

I have a similar view of the quality of Paul Krugman - and I am equally nervous saying he is wrong.

Nonetheless I formed the view that he was mistaken about five or six weeks ago...  and posted it here and here and here and here and here and here and in a few other places.  

I asked Paul Krugman for an email - because I am sure we could identify where we differ very accurately with an email exchange.  No such luck.  

Please Paul...

John

Geithner's part plan

Henry Blodget has noted that I do not think that the Geithner plan is a bad idea.

That is I do not think it is a bad idea to lend money to hedge funds at low rates to buy dodgy bank assets.

I do not love the idea.  I just think it is better than any of the alternatives.  I do require a good level of private capital before I am happy with it.

Henry Blodget publishes an objection to my plan which I quote:

Hempton's point is well taken.  As he comments to one of his readers, "If I set up a new bank and borrow with brokered deposits I can lever 12 times non-recourse. If I win I keep the profit. If I lose the FDIC pays the losses. ... Geithner lends the money to the special purpose fund. Not against the pool of purchased assets - but with private capital pitched in. Sounds like banking to me."  So Hempton objects to what he sees as Krugman's inconsistency.

But Hempton's analogy isn't quite right.  Krugman wants big banks nationalized, giving taxpayers the equity upside.  The Geithner plan is at best an inefficient way of bolstering bank capital because some of the taxpayer funds go not to bank capital, but to bank shareholders and hedge funds.

However, Henry Blodget’s objector – and most other people are forgetting the second part of my plan – detailed in the long post and elsewhwere on this blog.

I want the regulators to come into the banks and say – now you have a ready – if somewhat subsidized market for your assets then it is no longer tenable for you to say that the market price for them is unrealistic.

This asset that you have marked at 95% of par.  We want you to sell some of it (or a part interest in it or similar.)  If you get 75% of par – then we want you to mark your book to 75.  

If – given a real market for bank assets – you are shown to be capital inadequate then you should have time (say 6 weeks) to raise private capital.  Failing that your bank becomes government property.

The objection detailed in the Blodget post is still right – which is that this plan is better for shareholders than outright nationalisation of banks without a process to determine who is capital adequate. 

Nationalisation without process – which appears to be the alternative – is a dagger to the heart of capitalism.  

Tell me a process that will have banks and regulators with adequate external parties indisputably saying to bank management “this asset should be marked at 75 and you have it marked 95” then I will listen.  Until then the objectors to the Geithner Plan are left saying “nationalise now”, but without an answer to the nasty question of which banks to nationalise.  And do not say the stress tests are adequate - because they are a joke.

It is of course open for the Federal Government to follow a process that will scare liquidity away from the banking sector and result in everything being nationalised.  So far that is the only real alternative I see to a more complete version of the Geithner plan.  It is of course also open for the Government to guarantee everything and get no upside – but that is a really bad non-plan.

John

Weekend edition: racial profiling at the beach

Regular readers will know that I double as a surf lifesaver at Bronte Beach.  I was on patrol today.

It was relatively calm, warm without being hot and 21 centigrade (70 Fahrenheit in the water).

Bliss.

The patrol captain (Johnson) wandered by – said you should keep an eye on (he points) those three guys… then shouts “I am going in”.

I went in after him.

Two of the three made it back to the sandbar but the third guy – a Japanese tourist was pretty close to drowning.  Johnson was holding him up – but it was tough.  The extra person made it easier.  We waived to the shore for more assistance (a board) and with some effort we got our victim onto the board.  Five minutes later (and after I had swum in against the rip) he told me we saved his life.  I confirmed we knew that.

Like most people rescued he disappeared pretty quickly – I suspect a mixture of shock and embarrassment.  

How did Johnson know?  Well the victim was Japanese and pretty clearly a tourist.  Maybe it was racial profiling – but there are a fair few Asian Australians.  Maybe it was just fashion profiling (the tourists dress differently).  But Johnson was watching from before the victim got in the water.

Racial profiling is a large part of how surf lifesavers operate.  It is hard to see the struggling swimmer when there are 300 people in the water.  Much better to identify "customers" in advance.

Many of our “customers” fit clichés – pasty English of both sexes*, drunken Irish men (but seldom their women), militant Germans, strapping men 6 foot tall who say to female lifesaver dressed in baggy figure-hiding clothing** that they are champion swimmers only to reveal they have never swum in the surf by picking the most dangerous part of the beach to swim, Slavic men who see big surf as a test of their machismo, hoards of Asian (especially Japanese) tourists, and Muslims whose modesty means that they often swim in so much clothing that they risk drowning when knocked over by a wave in waist-deep water.  Racial profile here is mostly a short-hand for detecting inexperience in the surf.  Race is fairly well correlated with competence.

Racial profiling doesn’t work at all on a really hot day because then the Australians who go to the beach only once a year (and are as inexperienced as the pasty Poms) get in the water.  They need rescuing too – and we find it hard to tell who they are in advance.  Fortunately on those days the beach is so crowded that other swimmers do most the initial rescue.  Anyway on really hot days the correlation between race and competence breaks down.

I don’t think our Japanese tourist today – safe back in his backpackers’ hostel rather than being shipped back to Japan in a body bag – is unhappy about our racial profiling.  I would prefer a better method for doing this – but frankly we don’t have one.

John

*The pasty English needing rescues include a fair number of younger female backpackers whose idea of an adventure on their holiday is to seduce a Bondi surf lifesaver.  I have seen more than one deliberately get themselves in a position that they needed to be rescued.

**The female lifesaver hiding behind the baggy (sun protective) clothing is an Olympic triathlete and is generally amused at what the German guys think passes for good swimming.   By contrast I know what good swimming looks like - and it is not and never will be something I can do...

PS.  Investmentgardener's comment below - is I think an accurate appraisal of this...

Stereotyping is a method that allows our brain to make split-second decisions based on a 'shortcut' reasoning. It doesn't matter that you're wrong sometimes, as long as you are right when a split-second reaction is needed. Nevertheless the 'shortcut' is not a rational way of reasoning. There is no rational reason why someone who looks like a pasty pom (and very well may be one) would be more likely to drown than his olympic swimmer girlfriend. At least not on an individual level. Stereotyping and generalisations are good, as long as you don't confuse them with reality.

It pays to use stereotypes - especially in split-second decision making like life-saving - and it pays to be absolutely conscious of how wrong they can be when making complex decisions...

Now the goal is to get good at both the split-second and the long-term decision making...

AIG bonuses

Despite all that has happened there are still some good businesses at AIG.  21st Century – an auto insurance company largely based in California is one.

AIG was not fraudulent from top to bottom – and not everyone working there stuffed up the real economy though AIG FP was probably ground zero for bad lending.

I have no idea what the guy who runs 21st century is paid – and I haven’t looked.  But if 21st Century were private – and I controlled it – I would have no problem paying a good guy there 15-20 times average earnings – that is something in the 1-1.5 million range.  Those sums would make the said executive extraordinarily wealthy by the standards of the average American.  If he is good – and I was a shareholder – I would just wear it.  

I might make a fair bit of the salary bonus – and make it contingent on some performance metric – but I would have no problem justifying it.

I would have an awful time justifying paying the guy 50-100 times average.  There is just nothing that the guy could do that would justify that incremental level of salary.  

We have executives paid 30 million a year and executives paid 1.5 million a year and they generate the same level of outrage on Main Street where (compared to say $65000 in household income) both numbers are incomprehensible.  That said – 30 million per annum is enough money that you can’t spend it unless you run multiple houses with servants and fly private jets fractional share.  1.5 million per annum buys you an upper middle class life in Manhattan – or an opulent existence in Los Angeles – but multiple houses with servants are still out of the question.  Private jets are unthinkable.

The bonuses paid at Merrill Lynch were 3.6 billion - 22 times the AIG bonuses.  

They were paid by a firm that would not have survived without a bailout by the US Government through Bank of America.  Moreover they were sometimes large – the 30 million variety – not the 1.5 million variety.

We should be at least 20 times as outraged over the Merrill Lynch bonuses than the AIG bonuses.  But as a society we are not.

And don’t tell me it is because AIG is ultimately public and Merrill Lynch private.  I used to be a retail fund manager – and my end investors included a broad cross-section of society.  The low paid council worker was a part owner of companies where senior staff were paid $20 million per annum.  

I have come to the conclusion a long time ago that most people are ill equipped to handle large numbers.  They can’t see the difference between a billion and a trillion.  This leads to irrationality in bull markets and bear markets.  The irrationality is common amongst rich and poor and across genders and political views.  

There has to be investment opportunities in that.  But also in the eyes-glaze-over aspect of big numbers there are plenty of opportunity for management to loot shareholders entirely.

Gold is very expensive

When priced against real assets.  

I know the gold bugs – and there are many of them – compare the amount of gold in existence (160 thousand tonnes being the total ever mined) with the amount of nominal money (including bank deposits etc) in existence.  Gold adds up to $4.7 trillion at $950 per oz – nominal money maybe 60 trillion.

They thus assume that gold must go up.  

I am not going to approach that argument – because much of the cash really is trash (or should be trash after we have got through throwing it out of helicopters).  

What I want to note is the widespread headlines that maybe 50 trillion dollars of nominal wealth has been “wiped out” in this crisis and that something between 150 and 200 trillion remains.  The official figure for the total US household wealth about 51 trillion.  I don't have a number for the whole world – but just under 200 trillion is a reasonable guess in total – the US being just under a quarter of global activity – and having slightly more expensive equity markets than most the rest of the world.

Now does anyone really believe that the store of gold in vaults is worth over 2% of all tangible assets everywhere?  Seriously?    

Gold may be cheap against nominal assets in which case you would be better off holding gold than US Treasuries.  But I can't believe you would be better off holding gold than diversified timberlands or other real assets.  Unless of course the world degenerates into total war and all your timberlands burn down.

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.  We spend a lot of money (and kill a lot of birds with cyanide) to dig gold out of the ground only so we can bury it again with expensive guards on the vault.  

And I am not bullish on nominal assets.  Long Treasuries at very low yields look like a very bad bet to me.  But maybe now is the time for lowly levered real assets.  

Even better is highly levered real assets – but where the debt is very long dated and cannot be called and has no covenants attached.  You get to be long the real assets (good) and short the nominal assets (also good) without the financial crisis risk of being called on the debt (very bad). Candidates for that (rare) category highly desired.

John

Post script - looking at the comments in the email most people are giving me assets where the asset value has not been marked down appropriately (lots of real estate for instance) or where there are problems rolling the debt (most assets).

I am being pretty picky.  I want an asset appropriately priced for NOW as if it were non-leveraged - but with huge leverage and with NO DEBT ROLLS at all.  If it requires a debt roll I am not interested.

Leverage is death if you need to roll it.  But long dated debt that you do not need to roll for 20 years - that is wonderful.  That is effectively short treasuries.  

Fannie versus Freddie credit performance

For a long time I was convinced that Fannie's credit criteria were slightly more stringent than Freddie's.  

It appears I was wrong.

Fannie and Freddie give cumulative default curves in their latest results.  The 2006 pool (which is very bad at both) has 115 points of cumulative default at Freddie and 148 points at Fannie.  The cumulative default curves are pointing to the sky at both companies.

This occurs across almost all vintages.

Is there anyone knowledgeable who can explain to me why the cumulative defaults are so different between companies.

Thanks

John