Category: business

My favorite story so far involving the financial crisis.

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This post and the underlying story comprise the most amusing anecdote I’ve read since this entire mess began. I don’t know what the ethics are of blockquoting an entire post but whatever, it’s too good:

How to lose on a sure-fire bet

There was a wonderful story in today’s WSJ about how some big banks managed to lose some of their hard-earned TARP money. 

Let me begin with a little background. A credit default swap is sometimes described as an insurance contract written against the possibility of default of a particular underlying asset. If I buy a CDS and the specified asset defaults, I get to collect money from whoever sold me the contract. If I also have a long position in the asset in question, I might consider buying a CDS written against that asset as an insurance or hedge against the possibility that the asset loses its value. 

But I don’t actually have to own the asset in question in order to buy a CDS from somebody else. I might want to buy a CDS as a partial hedge against some other asset I hold with which the specified security could be correlated. Or maybe I just feel like making a bet with somebody I think is dumber than I am. 

The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event– the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset– becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event). 

And so the WSJ recounts the tale of a security based on $29 million (par) worth of subprime loans in California, half of which were already delinquent or in default. Betting that the loans weren’t worth $29 million sounds like easy money, and the smart guys were willing to pay 80 to 90 cents for each dollar of CDS insurance. 

It appears from the WSJ account as if little Amherst Holdings of Austin, Texas was happy to sell the big guys like J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America something like $130 million notional CDS on a $27 million credit event, used the proceeds to buy off and make good the underlying subprime loans, and pocketed $70 million or so for their troubles. The big guys, on the other hand, paid perhaps a hundred million and got back zip. 

Where Pitchfork Meets Keynes

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I was having a discussion with some friends in the media and music business recently, specifically about the much-discussed (read: over-discussed) phenomenon where bands emerge and bubble up from the blogosphere and become overnight sensations in a teapot, taking the hipster world by storm, becoming ubiquitous in all the tastemaker places almost simultaneously. Someone commented that this phenomenon is really particular and endemic to the indie rock world — where there's a massive wave of over-hype and artists are thrust out into the world not even fully formed, subject to a premature "next thing" consensus and an inevitable backlash to come. 

I don't think this is confined to music at all. Political consensus among the chattering classes is probably the most direct and clear example, with so much media, so much airtime to fill on deadline, and so many predictions that "have" to be made in the face of subjectiveness and a major herd mentality. It's also common to quickly moving technology trends (iPhone, Twitter, lots of other gadgets) and even
financial opinions (Jim Cramer and Motley Fool come to mind especially). And probably quite a few other things. Just straight old TMZ style pop culture too.

But confining the discussion specifically within the confines of the music business, what I think is interesting is the degree to which the indie rock world
exemplifies a certain set of attributes. You don't see
the same hyper-"meta" discussions and self referential issues in other
genres so much, at least not in my estimation. In straight bubblegum pop you
might just as easily have the overwhelming hype and meteoric rise, and even
in more esoteric niches like country or jazz or even bluegrass you
definitely have flavors of the month, someone who makes a breakout
performance at a festival or a last minute substitution. 

As a sidenote — I actually think classical is a close second to indie in the
herd-hype department, with that last example of a last minute substitution
and seemingly coming out of nowhere being a great example of how many well
known artists — most notably Leonard Bernstein and Lang Lang, among others
— got their big breaks. And both suffered a torrential backlash several
years into their career as well. 

But anyways, the basic concept is pretty well established. What's
interesting to me is that in indie rock (which I should make sure to define here as the hipster, Pitchfork, blogger world, etc — not in the indie=independent sense) it seems to have come to dominate
the landscape. 

And of course, it conjures up parallels in economics. Specifically the classic quote about the stock market and investing from The General Theory, by John Maynard Keynes: 

"Professional investment may be likened to those newspaper competitions in
which the competitors have to pick out the six prettiest faces from a
hundred photographs, the prize being awarded to the competitor whose choice
most nearly corresponds to the average preferences of the competitors as a
whole; so that each competitor has to pick, not those faces which he himself
finds prettiest, but those which he thinks likeliest to catch the fancy of
the other competitors, all of whom are looking at the problem from the same
point of view. It is not a case of choosing those which, to the best of
one’s judgment, are really the prettiest, nor even those which average
opinion genuinely thinks the prettiest. We have reached the third degree
where we devote our intelligences to anticipating what average opinion
expects the average opinion to be. And there are some, I believe, who
practise the fourth, fifth and higher degrees."

I've always thought this was a pretty good metaphor as well for the worst
parts of the hype machine that seems to swirl around indie rock, in the way mentioned above. The issue here isn't that you have a scene that's incredibly dynamic and
changing, that artists come out of nowhere and get a ton of hype and then
recede. There are plenty of reasons why you'd see those kinds of things happen. For example, another just-as-plausible hypothesis would
be that it's an artistic scene that is intensely focused on novelty, hence
the quick rise and short shelf life of many such artists. 

But I don't think that's quite it. I think it's the self-referential nature
of the whole thing that is the most fundamental attribute. Everyone is
looking at what everyone else is doing. In economics or ecology you'd
describe it with some concepts from complex adaptive system dynamics, where
you have systems or implied algorithms that are self-referential and loop back on themselves, and have both positive and negative feedback loops working at cross
purposes. Not too far from the idea Keynes intuited in the 1930's in the quote above. 

So the more hype builds around you the more success you have. That's a
positive feedback loop, a network externality. If 10 influential indie blogs
plug you then that might lead to 30 more the next month. But there's a
negative feedback loop. The more success you have the more you arouse the
distaste and backlash of many members of the community.
You have everyone looking at everyone else to see what they think before
they make up their mind. 

People's opinions of an artist's intrinsic merit
are in part based on their perception of who else likes them, what kind of
people like them, how many of those people there are, and how long this has
been going on.
Like in the beauty contest example above, many participants are picking the
prettiest competitor at a beauty contest not based on what they personally
like, but based on their impression of what they think other people's
impression will be. 

So you have two countervailing forces at work — and the result is the
classic boom-bust cycle that has tons of parallels. In ecology the textbook
one is watching deer populations skyrocket, then they eat all the available
food, and then half of them starve and die. Then they do the same thing over and
over again. In economics it's the classic business cycle boom/recession wave
in the stock market and economy as a whole.
It's the natural outcome of a wicked combination of positive and negative
feedback loops, both governing the same variable, in this case success and
prestige and "hype." 

Or to simplify: 1) The more successful you are the more people like you. 2) The
more successful you are the more people hate you. Pour them together, and
you get breakneck change, massive and premature over-hype and massive and
premature backlash. Both often divorced from any underlying actual merit of
the music in question. Just like financial bubbles tend to affect the good
firms as well as the bad, both on the way up and the way down. The truly
great stuff endures, but when you're looking at a week to week timetable
that boom-bust cycle is all you can see.

I think it's food for thought. The interaction of positive and negative feedback loops in self-referencing systems with network effects is well known in complexity theory to be the driver for some very interesting emergent phenomena, not just in simple rules-based systems but in applied social sciences as well. Perhaps there are some parallels to be drawn in marketing, media, and even entertainment and popular culture. 

Bubbles, they always seem so novel…

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So the talk over the past weekend has been deafening and all on one subject, the Paulson proposal to inject $700 billion dollars directly into the financial sector with no oversight or accountability or review whatsoever. It's beyond what anyone might call a "nuclear option."

Here's a sample of the kinds of discussions I found circulating over the weekend:    

The real problem is that the underlying assets are sharply overvalued due to liberal bank credit schemes from the 2001-2007 real estate bubble. People with no savings, bad credit, and low income could buy $250K to $500K homes. If banks are unable to finance the crazy prices that people pay for homes, then home prices have to come down equally sharply.

Paulson may be able to save banks from some of their stupidity by loaning them $700 billion, but the reality is that this is a $7 to $10 trillion problem, if not greater. 

How is a 10% bailout going to help anything or anyone? Is it not slowing down the inevitable for a six month soft landing at the taxpayer's expense?

If banks can't continue to lend in the crazy format of years past, how can home prices not deteriorate exponentially? If housing prices continue to drop, banks will not be able to continue to lend due to rational reserve requirements. How will banks with no lending capability dump the foreclosed assets that they hold in mass, keeping in mind that houses deteriorate quickly without maintenance? If they sell these foreclosed homes to the government, won't the government dump them for pennies on the dollar and tank the housing market

 

Well in my opinion it's even worse than that description. Paulson's proposal is not to "loan" $700 billion dollars. It's basically to just hand it over. And it happens whatever terms he sees fit with no review or accountability whatsoever. It is quite literally insane. It's more than the entire defense budget, more than our entire social security payouts for the year. All to be given to one person with no real restrictions whatsoever on what he can do with it, with the express purpose of basically just handing it to Wall Street firms. 

It struck me as insane, so literally and unbelievably crazy that I found it odd over the weekend to think that he wasn't literally laughed out of the room when he proposed it. It's the kind of thing that you'd think would cause armies of torches and pitchforks to descend upon the Capitol en masse.

We've all closed on a real estate transaction or worked up financing for something right? Can you imagine a $700 billion dollar deal sheet with the terms on 4 single spaced sheets of paper saying essentially: here's all the money, have fun, and there's no recourse to courts or anything else if we don't like what happens. It sounds alarmist but that quite literally was the proposal.

Thankfully, and somewhat to my surprise, people actually seem to have figured this out and the plan is going to be dead, or amended. As a gambit though it was classic disaster capitalism. Create a crisis and then act like we have to do something right now that gives massive power and money to the people responsible. As they say, it's not a bug in the system, it's a feature. It's the point, it's how this philosophy works.

But returning to the above it's not just a $7 to $10 trillion dollar problem. It's much bigger than that even, by far. It's not just mortgages, the total value of credit default swaps is well over $50 trillion dollars (yes, as much as five times the entire US GDP) and as far as I can tell — and I'm far from a complex securities expert — many of these were traded/exchanged with no regard to the counterparties ability to pay. So it appears there are companies "insuring" perhaps $100 billion in default risk, when they have nothing like that kind of money if there in fact is a default. It's madness, again it's hard to believe it really happened this way. But here we are.

But again, it's interesting to read the discussions of how this all relates to the real estate market as I still think it represents a classic fallacy, which loosely translates to the idea that 1) The problem is primarily based on home prices, and 2) The lack of liquidity and a newfound unwillingness to lend is a main culprit.

Indeed, prices of homes are always affected by access to capital, and bank willingness and ability to lend. But at the end of the day — always — the prices of any asset reflect underlying demand. Sure, housing prices rise and fall by interest rates. But the question is why? Because interest rates help determine monthly payments. And people buy houses based on a calculation of what payments they can afford, guesses as to their future income, and perceived value of being able to actually use and live in the property (ie rental equivalence). Of course as we know the housing bubble installed another variable — perceived appreciation. That's always been there but in this last market that became dominant. Which as we've seen is a problem.

I think it's actually pretty instructive to put this in the context of another bubble we can all understand and remember from the not too distant past, the dot com bubble. Stock prices and home prices have some similarities. Much like the price of Pets.com stock was based on the idea that someone else would be willing to pay more in the future for the stock, the same was true of a lot of marginal real estate. When capital dried up — and it did — I'm sure we all remember CEO's saying that the business was on track to be successful but recent developments in the market have made it impossible to continue. Remember all those homepages that had a note to that effect?

BubbleTech.com is sad to announce we are ceasing operations, even though we had a great product and lots of users the current climate has made it impossible to finance continued growth, so sorry to everyone.

Ummm… sure. But the reason Pets.com had problems at root was not that it lost access to capital. To channel my friend, the brilliantly blunt Phil Kaplan for a minute the reason was that nobody wanted to buy kitty litter over the internet via UPS delivery at a price that could make a profit. The underlying model was, in the parlance of the time, f*cked. Completely.

There was no relationship between the value provided by the company and the value people perceived from it and their willingness and/or ability to pay.

What does that have to do with houses? They're pretty similar actually. Sure, problems with lending are an issue. Just like in technology, where in late 2000 there were undoubtedly actual good — meaning potentially profitable — ideas that could not get funded. Right now there are no doubt people with willingness and ability to pay who are having trouble getting a mortgage.

But as a rule, housing values relate to income and perceived value (demand) and availability and quantity of housing (supply). Some things don't really ever change much. When housing prices got so out of kilter with income and rent equivalency then they were inevitably bound for a crash. That's just the way it is. Just like when dot coms spent $1 to get $0.50 back they were f*cked. Period.

But in housing, like all markets, at root there are market clearing prices. In fact probably quite a few of these mortgage backed securities have value. Because of the way they structured them (ie first loss provisions and tranches) many of them, literally, are valueless. But some will have value. Many of these foreclosed houses have some value.

So yes, there are market clearing prices for real estate, though a discrepancy between buyer and seller expectations can demolish liquidity, compounded by a credit contraction. Nonetheless things are falling fast — but they won't fall forever. Housing prices will probably fall to rental equivalency, overshoot, and then stabilize. Of course it's a moving target as incomes (demand) can drop too during a recession, but still, it's inevitable.

But the banking crisis involves a lot more than just residential real estate and mortgage backed securities. The debt insurance market dwarfs this problem. The reality is that the losses have already been made. People essentially spent on borrowed money, through HELOC abuse and equity withdrawals and the like. It propped up the economy for awhile, but that's over.

But to reference a phrase that was going around quite a bit this week – the fundamentals of our banking system are weak. I think there might be a chance that a good treasury plan will involve recapitalizing the banks (by giving the funds but taking equity in return, which is mandatory and insane that it was not part of the original plan). That kind of capital infusion could indeed work just fine. It could make the banks solvent, and return the economy and sector to some sense of rationality.

But housing prices got too high when they were decoupled from rent equivalence and incomes. Just like dot com stock got insane when it was decoupled with standard notions of profitability and return on investment and revenue. And to keep the metaphor going many people made money in technology during that time. And there will be much money to be made now in real estate for smart people. But the sector will contract and housing prices will continue to fall (in real terms — the idea of inflating our way out of this is another issue, and another 2000 word post). But that aside there's no other way for things to go.

That's a good thing. It just sucks for everyone holding the bag this month.

Two Envelopes

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I was just trying to refresh my knowledge of Bayesian probability theory (don’t ask) and I came across something I hadn’t seen before, the Two Envelopes Problem. I’m a fan of the classic game theory paradoxes, the most commonly known one being the Prisoner’s Dilemma.

The latter, as trite as it might seem after endless repetition, is still really a cornerstone of game theory, and the usual entree into discussions of how game theory can apply to economics and strategic financial decisions. For myself at least it was the first introduction to Nash Equillibrium, a state where no player can unilaterally benefit by changing strategy.

What’s so eye opening when you dive into Nash Equilibrium after a heavy indoctrination in efficient markets theory is the realization that a perfectly understandable system with clear rules, where each player is acting perfectly rationally, can produce an outcome that’s decidedly sub-optimal. It’s a dilemma indeed, which is why cops have been using it for centuries. No matter what strategy the prisoner chooses it’s nearly always optimal to confess, though clearly the optimal strategy for both prisoners is to keep their mouth shut.

Thoughtful and prudent market players acting rationally don’t always produce efficient (or Pareto-Optimal, to use the jargon) results. Interesting. We’ll have to get back to that one.

But back to the envelopes. To summarize, assume an actor is given two identical envelopes, each of them containing a sum of money. One envelope has twice as much as the other. The player selects one envelope and keeps whatever is in it, but as soon as they choose, and before they open the envelope, they are offered the option of switching.

Should they take the offer?

If the envelope in your hand has X amount of money, then the other envelope has either .5X or 2X, with a probability of one half. Now as any self-respecting gambler can, you should run an expected value calculation and thus determine that the value of switching will pay off at .5X half the time and 2X the other half, for an expected value of the switch that works out to 1.25X.

So switching, on average will yield a 25% better return than not switching. Of course once you’ve switched, and you have the other envelope in your hand, you start the problem over from the beginning. And now it makes sense to switch again, for exactly the same reason. And again, and again, and again.

Using math, we’ve proven that switching to the other envelope is always the better choice, no matter which envelope is in your hand. Sounds like the statistician’s version of proving that the grass is always greener.

If you’re waiting for the punch line, there isn’t one. That’s why it’s called a problem.

I’ll pay you to quit.

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It’s a story that has been forwarded around a lot this week, but I was struck by an interesting philosophy at Zappos. They offer people $1000 to quit after a month — the idea is that people who aren’t committed will take it, but the people who stay will be serious about working there.

I found it here:

I spend a lot of time visiting with companies and figuring out what ideas
they represent and what lessons we can learn from them. I usually leave
these visits underwhelmed. There are plenty of companies with a hot product,
a hip style, or a fast-rising stock price that are, essentially, one-trick
ponies‹they deliver great short-term results, but they don¹t stand for
anything big or important for the long term.

Every so often, though, I spend time with a company that is so original in
its strategy, so determined in its execution, and so transparent in its
thinking, that it makes my head spin.