Friday, January 30, 2009

Systemic Risk Super Cat Insurance


Let's take a break from splenetic rants about bad government to contemplate the possibility of good government, shall we? Fast forward to 2025: Our economy is chugging along at 5% annual growth. Warren Buffett cloned himself 51 times, then those 51 clones were employed to overcome every state and federal pension deficit. Each has succeeded mightily, avoiding what could have been a catastrophic burden on future development and growth.



Various aggregator banks took over the heaping pile of dog poo that was our national banking system, and they've made it hum again. We've got industrial growth across the board, most notably in the paint-solar energy field. This neat little innovation has allowed us to place solar cells inside common paint products, enabling cars, houses, and hovercrafts to power themselves with their decorative coatings. It's a marvelous development, and it comes in thousands of shades, from mauve to burnt Siena. Everyone's happy, though talk of "Peak Oil" production has been replaced by fearmongers babbling on about "Peak Paint."

Still, the forward-thinking regulators of 2025 are starting to worry. Once again, there are many businesses growing to the size where, if they were to face hard times, their collapse could unhinge the entire financial system. Much like Lehman, AIG, Morgan Stanley, and General Motors in the days of yore, these companies have created systemic risk, even though there's no imminent risk whatsoever. That doesn't matter, though, because our 2025 brethren are wise and forward thinking, and they understand that we need to address this problem BEFORE we are on the brink of systemic failure.

These folks decide what the USA needs is "systemic risk insurance." You heard it here first, folks. These wise souls devise legislation that mandates systemic risk insurance premiums be paid by our nation's most successful companies while they are at their healthiest. The legislation contemplates the creation of a seven-person panel, comprising bankruptcy and insurance experts from across the land, whose job it is to appraise the balance sheets of the largest companies to assess the impact that their liquidation might have on the general economy. Based on this actuarial assessment ((cost of systemic failure*likelihood of failure over 50-year time horizon) + administrative costs of the program), these companies would be levied a tax that would insure the overall economy in the event of their failure. Being "big" doesn't automatically mean you have high payments. McDonald's, for example, would have a low risk of failure and low premiums. If you're levered 20 to 1 or insuring CDS beyond your capital base, your premiums might make you think twice about the way you run your business.

The responsibility to pay out on this "super cat(astrophic)" event could be handled by a well-capitalized private company (along the lines of a Berkshire Hathaway, not an AIG) or by a federal agency.

Right now, we're dealing with the costs of systemic risk at the time we can least afford it. You don't try to buy renters insurance after you burn your apartment complex down. You do so before it happens. I think a similar maxim should apply to systemic risk. That's all I have to say about that.

Wednesday, January 28, 2009

Viscerally Bad Banks

CNBC's Steve Liesman announced yesterday that the "Good Bank, Bad Bank" idea was gaining momentum. In its essence, the government will purchase the toxic asset on the balance sheets of the world's largest banks. They will pay more than these assets are worth on the open market, because if they didn't, all these banks would go bankrupt. They will use "models" to determine these prices. These models will almost certainly be devised by the very folks who priced them badly three years ago. And once again, I'd bet all my nachos that they're going to get it wrong on their second go-around, too.

Regardless what you have heard on TV or read in the newspapers, this idea is not a mulligan for everything bad that happened between 2005 and 2007. It doesn't make the problem go away. It just makes their problem our problem. It means that you and I get to take responsibility for all the mistakes that happened between 2005 and 2007, and the big, well-connected banks get to go on doing what they've always done, which is to make crap-tons of money. We get to be the bad bank, and those arrogant swindlers who gave themselves insane bonuses over the past five years at Goldman and JP Morgan get to be the good bank. Yes, I'm angry. Yes, I'm jealous. Because it's unfair to everyone who acted wisely and played by the rules. (It helped my portfolio, as I kinda saw it coming, but that makes me no less upset.)

I'll give my money to help the poor. I'll give my money to heal the sick. But it makes me want to stab my own eyes out with a spoon when I know that a cent of my hard-earned income is going to sustain the unsustainable practices of the arrogant and foolhardy souls at these banks. They made reckless/negligent/fraudulent (pick one) decisions, and we have given them a blanket pardon.

I voted for Barack Obama. He ran on a platform that those who are most fortunate should help those who are least fortunate. I'm down with that. But this decision creates a different dynamic: those who are most responsible are paying for the sins of those who were least responsible. That's a dynamic I don't like. That's a dynamic that must change, or he will not get my vote a second time.

Puke.

Monday, January 26, 2009

Hypocrisy, from a guy who got famous writing about Liars


Michael Lewis has made a return to Wall Street prominence. See here, here and here. Lewis, the author of Moneyball and Liar's Poker, among other things, has adopted a staunch tone of self-righteousness about everything from CDS to bonuses to mistrust of Wall Street. His arguments are sweeping and broad. Wall Street's a mess, and had anyone listened to his message from 20 years ago, well, none of this would have happened.

He mocks the young guns who succeeded him at Wall Street, the ones who read Liar's Poker as an instruction manual, rather than as a cautionary tale. The book was designed to inform us against Wall Street's excesses, he claims, rather than encourage those to follow the same path.

Hmmm...that's a nice thought. Lewis muses throughout Liar's Poker about how overpaid and useless he was as a young bond trader. He didn't have a clue what he was doing, but he was paid more than his parents ever had been -- though he was just out of college. A short while after he started, he coolly opted to offload $86 million dollars of near worthless bonds onto his best customer, abusing the trust he had built up to impress his superiors. (See Lowenstein's Buffett, pp 404-405). This act made him a "big swinging dick" around Salomon. He got rich off his unscrupulous act. He cashed his chips in, and he hasn't looked back since.


Were it not for Wall Street's rewarding his lack of ethics, Mr. Lewis might be an intelligent but unknown teacher of French lit at a parochial school in Jersey. Yes, Mr. Lewis would have been a wage laborer. Wall Street afforded him renown, wealth, independence, and respect (from some). But until Lewis agrees to disgorge every cent he earned from 1) his time at Salomon 2) the book he wrote about Salomon 3) everything that followed in its wake and 4) the subsequent compounding of wealth from those experiences, I would appreciate it if he simply saved us the moralizing. The lectures ring a little hollow for those who work hard, don't betray our clients and customers for our own profits, and still manage to earn a modest living at the end of the day. I enjoy his books and his writing, but I don't believe that Michael Lewis is a meta-observer of Wall Street. Rather, he is a just a man who profiteered in the same cowardly fashion as others, a few years prior. And, while he seeks to blame others for those who followed in his path, I consider it a failure of his character that he does not shoulder that responsibility himself.

Tuesday, January 13, 2009

Paging Dr. Krugman, please report to the ICU. Dr. Krugman, to the ICU, please.


I've taken two economics classes in my life. As I recall, I got a B+ in both classes. Not bad, considering my attendance was under 25%. But it certainly does not match up to Paul Krugman, who just won the Nobel Prize. I suspect he attended his classes and got A's.

But I do read and think about finance all the time, and I'm starting to get annoyed by the whole "stimulating aggregate demand" mantra, and I don't think I'm the only one. I'm sure that if Paul Krugman were reading this blog, he would be able to answer any questions I have for him. So I'm going to format this post as a serious of questions. Bonus points for anyone who wants to impersonate Krugman in the comments section and answer these questions.

Question Number 1:
Let's say we spend 1 trillion dollars to stimulate the economy this spring and it doesn't work. Then our national debt is 12 trillion, nearly 1 times GDP, and our economy is still in the s***er. What do we do then?

Question Number 2:
Ok, I'm guessing that the answer to #1 is to do it again. But let's say we do it again, and that doesn't work. What then?

Question Number 3:
I'm guessing that the answer to #2 is to do it again. But let's say we do it again, and that doesn't work. What then?

This brings me to my ultimate question for Dr. Krugman, which is, is there ever a point at which you stop trying to stimulate aggregate demand? Because I'm a fairly young man, and I'm starting to get nervous about how many times you're going to try this. With the ever-increasing cost of pension and entitlement benefits needed to take care of baby boomers such as yourself, I doubt that paying off our national debt is going to be any easier in 2020 than it is in 2010. And, in 2020, when we have to cancel government programs across the board to repay this fiscal stimulus, when the concept of a school bus is as quaint as a Studebaker, what effect will that have on aggregate demand?

A negative one, I presume.

Saturday, January 10, 2009

Of Black Swans and Big Juicy Turkeys

A few years ago, Nassim Taleb published a couple of books (Fooled by Randomness and The Black Swan) that analyzed, among other things, how highly improbable events can have a powerful effect on the economy and on one's portfolio. For those that haven't read the books, the black swan reference comes from an analogy devised by British philosopher David Hume, who said that just because an event hasn't happened yet doesn't mean it can't happen. Back then, no Englishman had ever seen a black swan. Later, when Europeans happened upon Australia, they discovered that black swans did indeed exist. These are excellent books, and Nassim Taleb, though a bit of a pretentious boob, is one of the sharpest minds who comments on markets.

Akin to Gladwell's "Tipping Point" in its pop-philosophical repercussions, the "Black Swan" analogy has bumrushed its way into the lexicon. And the horrific market turns of the last couple of years have certainly helped it along its path. For those masochistic enough to frequent television market commentary, it has become common for talking heads to posit that we've experienced a black swan event, that an unpredictable state of affairs has befallen us, and it's just hard to know what to do. I think this commentary completely misses the point in Hume's analogy, but I'll get to that later.

This commentary is delicious in its irony, because they, the very folks whom Mr. Taleb lampooned in his book, are using it to justify their own incompetence. They think that the "Black Swan" excuses them for the role they played in the collapse. Whether it's the regulators who failed to anticipate the impact of excessive leverage or a housing downturn, or an investment manager who couldn't have fathomed a 38% year-over-year market decline, the Black Swan has become the blankie your mommy drapes over you before you go to bed. Everything's going to be fine. It's not your fault, Junior, it's the Black Swan. No one could have seen it coming.

This line of thinking is insanity on a stick. First, the existence of Black Swans does not justify the failure to prepare for them. Knowing that highly improbable events occur is the reason you take precautions to protect yourself, your constituents, or your clients. You never know for certain what you're going to wake up to tomorrow. It's the reason we have (or should have) regulators, emergency preparation, and competent money advisors. Everyone makes mistakes, but leaders limit the impact of those mistakes. If you lost more than 20% of your clients' money last year, I'm sorry, but you shouldn't be advising people on how to manage money. Period.

Second, this wasn't a frickin' Black Swan event. It was a big juicy turkey sitting there for anyone with an inclination for analysis to see. When you have a 100% run-up in housing prices in ten years, a 40% draw down is not a black swan event. When you have a 1500% explosion in stock prices in 26 years, a 38% haircut is not improbable at all. When total credit market debt extends beyond 3.5 times GDP, one should expect credit seizure and convulsions. Massive credit expansion has historically always been followed by a massive credit contraction. This was as true in Rome, Mesopatamia, and Post-Renaissance Holland as it is today. The Panic of 2008 was highly probable and, dare I say, predictable.

Since we know what a black swan isn't, let's discuss what it is. A black swan, in the Humian sense, is not only something that's never been seen in your lifetime, it's something that's never been seen in anyone's lifetime. It's not a hundred-year flood or a biblical flood. It's not even Jesus walking on water. It's something that no one has ever claimed to have seen.

A black swan event is not the stock market falling by 38% in a year. A black swan event is the Dow Jones Industrial Average going to 0. Zilch. On Monday. And everyone's wiped out. You were managing $10 billion? Guess what, now you're managing no money at all, because you had all of your assets in US equities, and those don't exist anymore! A black swan doesn't appear when your 401(K) fails to perform as you had hoped. A black swan appeared in Argentina this year when the government decided to take over private pensions and give the pension-holders soon-to-be-worthless government bonds in return.

Now, lest I confuse my point, I'm not saying that good money managers and regulators should have to protect 100% of their client/constituent interests when the Black Swans come. But having a contingency plan for the highly unlikely is what separates the ho-hum from the exceedingly competent. Drastic events are not so impossible as the fatuous like to think. Americans have had a great run of it in the last 63 years, but we are not immune from history. While severe dollar devaluation, government confiscation of property, and wholescale reallocation of wealth are not likely in the immediate future, they are not impossible. For those who think that all the Black Swans already happened in 2008, be careful, because you might end up feeling like a turkey again in the not-so-distant future.