On the importance of Excel

Four years ago, when global markets were going completely haywire, one of the more important events that helped "turn things around" was FASB's relaxation of mark-to-market accounting standards, a decision that allowed banks to value many of their "distressed" assets based on, basically, whatever their internal models said they were worth. We can argue all day about the long-term costs and benefits of this decision (as you might imagine, I'm pretty aggressively negative on the decision), but ultimately the short-term impact was to place a significant amount of the world's financial stability on the shoulders of one computer program—Microsoft Excel.

We'll turn things over to Baseline Scenario's James Kwak for some more color on the topic (all emphasis mine):

I spent the past two days at a financial regulation conference in Washington... In his remarks on the final panel, Frank Partnoy mentioned something I missed when it came out a few weeks ago: the role of Microsoft Excel in the “London Whale” trading debacle (note: read more about it here)...

To summarize: JPMorgan’s Chief Investment Office needed a new value-at-risk (VaR) model for the synthetic credit portfolio (the one that blew up) and assigned a quantitative whiz (“a London-based quantitative expert, mathematician and model developer” who previously worked at a company that built analytical models) to create it. The new model “operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.”

The internal Model Review Group identified this problem as well as a few others, but approved the model, while saying that it should be automated and another significant flaw should be fixed. After the London Whale trade blew up, the Model Review Group discovered that the model had not been automated and found several other errors. Most spectacularly,

“After subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a factor of two and of lowering the VaR ...”

Microsoft Excel is one of the greatest, most powerful, most important software applications of all time... it provides enormous capacity to do quantitative analysis, letting you do anything from statistical analyses of databases with hundreds of thousands of records to complex estimation tools with user-friendly front ends. And unlike traditional statistical programs, it provides an intuitive interface that lets you see what happens to the data as you manipulate them.

As a consequence, Excel is everywhere you look in the business world—especially in areas where people are adding up numbers a lot, like marketing, business development, sales, and, yes, finance...

But while Excel the program is reasonably robust, the spreadsheets that people create with Excel are incredibly fragile. There is no way to trace where your data come from, there’s no audit trail (so you can overtype numbers and not know it), and there’s no easy way to test spreadsheets, for starters. The biggest problem is that anyone can create Excel spreadsheets—badly. Because it’s so easy to use, the creation of even important spreadsheets is not restricted to people who understand programming and do it in a methodical, well-documented way.

This is why the JPMorgan VaR model is the rule, not the exception: manual data entry, manual copy-and-paste, and formula errors. This is another important reason why you should pause whenever you hear that banks’ quantitative experts are smarter than Einstein, or that sophisticated risk management technology can protect banks from blowing up. At the end of the day, it’s all software. While all software breaks occasionally, Excel spreadsheets break all the time. But they don’t tell you when they break: they just give you the wrong number.

Yikes. As Kwak later points out, this is likely a systematic problem, and not just an unfortunate one-time mistake. If the modeler's error had served to increase the amount of risk at the end of the day, then the mistake no doubt would have been caught, since it would have affected the bank's bottom line. But because senior executives and traders were explicitly hoping for a model that underestimated the risk profile of their portfolios, the "mistake" here went unnoticed and uncorrected, which is so absurd that it's almost comical.

If a mortgage officer at a small regional bank made a similar mistake—say, inadvertently doubling the annual income number for a loan applicant, and then approving said applicant for a number of low-interest loans—that officer would undoubtedly be fired at the end of the day. But here, at JPMorgan, we have a guy who made a similar error on a much larger scale, with much riskier assets and a whole lot more money on the line, and the whole world shrugs its shoulders and goes on about its business. That's scary.

What are some of the other bank models out there telling us about banks' risk profiles and the strength of their capital bases? Should we expect those models to be any better than this one? I suspect not, and I think the (over)reliance on Excel will likely lead us to some very negative outcomes down the line. Of course, as I've said before, this doesn't mean that we should blame the model if and when things go horribly wrong—models, at the end of the day, are only as good as the people who write (and monitor) them. Instead, we need to start blaming the people who write and implement these models, and then holding them accountable for their errors.

[Baseline Scenario]

More stadium financing follies

I've written about the lunacy of publicly-funded sports arenas and stadia here before, and I think the issue deserves to be revisited given recent developments. On the one front, there is the city of Miami, which was taken to the cleaners by the disgrace that is the Miami Marlins franchise. Unfortunately for that city, their woes may just be beginning, as the Dolphins are also reportedly looking for public funding to fix their dilapidated home.

It would be easy to write this all off as Miami's loss, and theirs alone, except that it's not the case. When municipalities like these go into debt to fund stadium boondoggles, the whole country pays, as a recent Bloomberg article points out.

New York Giants fans will cheer on their team against the Dallas Cowboys at tonight’s National Football League opener in New Jersey. At tax time, they’ll help pay for the opponents’ $1.2 billion home field in Texas. 

That’s because the 80,000-seat Cowboys Stadium was built partly using tax-free borrowing by the City of Arlington. The resulting subsidy comes out of the pockets of every American taxpayer, including Giants fans. The money doesn’t go directly to the Cowboys’ billionaire owner Jerry Jones. Rather, it lowers the cost of financing, giving his team the highest revenue in the NFL and making it the league’s most-valuable franchise. 

“It’s part of the corruption of the federal tax system,” said James Runzheimer, 67, an Arlington lawyer who led opponents of public borrowing for the structure known locally as “Jerry’s World.” “It’s use of government funds to subsidize activity that the private sector can finance on its own.”...

Tax exemptions on interest paid by muni bonds that were issued for sports structures cost the U.S. Treasury $146 million a year, based on data compiled by Bloomberg on 2,700 securities. Over the life of the $17 billion of exempt debt issued to build stadiums since 1986, the last of which matures in 2047, taxpayer subsidies to bondholders will total $4 billion, the data show. 

Those estimates are based on what the Treasury could have collected on interest from the same amount of taxable bonds sold at the same time to investors in the 25 percent income-tax bracket, the rate many government agencies assume. In fact, more than half the owners of tax-exempt bonds pay top rates of at least 30 percent, according to the Congressional Budget Office. So they save even more on their income taxes, a system that U.S. lawmakers of both parties and President Barack Obama have described as inefficient and unfair.

Yes, that's right, when tax-exempt municipal bonds are used to pay for these stadiums, that means that the FEDERAL government is effectively subsidizing these projects. So when the Cowboys build a stadium with "public" funds, that "public" isn't limited to the Dallas area—it includes the entire nation. This amounts to taxation without representation for those of us who don't get to enjoy the Cowboys' new monstrosity, and that used to be something that mattered in this country (but of course, doesn't any more).

Sure, we could try to argue that some of this comes out in the wash, because it's just a transfer from taxpayers to bondholders, and there is significant overlap between those two populations—it's just taxpayers stealing from themselves. But unless every taxpayer is also a municipal bondholder (and I'm at least one taxpayer who owns no munis), then this becomes a very serious constitutional issue, and yet one that is perpetually ignored by nearly everyone in the nation. I, for one, have no interest in paying more in taxes so that Jerry Jones can build a playground for the super-rich in Texas, but I was never afforded a say in the matter.

Ultimately, this trend of public financing of private enterprise must end in all its forms. There's no reason for taxpayers to be funding private business, in Miami, Dallas, or anywhere else. This is a long-running scam that has been run on Americans who love their sports (and teams) too much to say no to this extortion. We all must stand up and say that we are unwilling to pay for stadiums that we then must pay to enter—if it's a public facility, then we should have the right to do with it what we please. Otherwise, the Jerry Joneses of the world can figure out their own ways to build the things. I'm getting out of the stadium-building business... who's coming with me?

[Bloomberg]

Pay for Congressional performance?

Sheila Bair baffles me. Every time she starts making a ton of sense, the former FDIC head says or writes something else that comes across like low-grade satire, except I don't think it is. Her most recent piece for Fortune falls into the latter camp.

Will the elections bring about improvements in our increasingly dysfunctional government? I fear not. Successfully running for office these days is more about political fundraising and negative campaigning than about the art of governing. Only one in 10 Americans thinks Congress is doing a good job, and no wonder. Our economy is stuck in low gear, and our fiscal situation is precarious. How do we motivate our national leaders to deal with these problems? As with most organizations, it comes down to economic incentives. If our elected officials can keep their paychecks by being adept at fundraising and negative campaigning, then that is what they'll do. But if at least part of their pay is based on performance, maybe we could get them to focus on doing their jobs. Pay for performance has improved management in the private sector. Why not try it with the folks in D.C.? 

For instance, one-half of compensation for corporate directors is frequently paid in stock, which they must hold for several years. The idea is to align their economic incentives with the long-term profitability of the corporation. There is no stock ownership in the federal government, obviously, but we do issue a lot of debt (boy, do we ever). So here is an idea: Let's start paying members of Congress and the President half of their compensation in 10-year Treasury debt, which they must hold until maturity. Members of Congress make roughly $180,000, so under this proposal, they would get $90,000 in cash and $90,000 in 10-year Treasuries. (We would add a housing allowance, too, given the high cost of living in Washington.) For the President, it would be $200,000 cash and $200,000 in T-bonds. If the economy does well and if they get our fiscal house in order and institute pro-growth tax and spending policies, those 10-year bonds should hold their value. But if we continue our profligate ways, inflation spikes, and interest rates skyrocket, those bonds may end up being worth as much as the stuff Czar Nicholas issued shortly before the Bolshevik revolution (some of which I bought at a flea market and now use as wallpaper in the bathroom).

She keeps going with her proposal, but I refuse to further indulge her ramblings here. Realistically, the very premise of Bair's argument is fundamentally flawed.

"Pay for performance has improved management in the private sector," she writes. No, Sheila, it hasn't. Reams and reams of research have been produced which prove your argument wrong. What pay for performance tends to do, instead, is encourage leaders and executives to make company-betting moves which promise huge potential payoffs but equally large risks. If those risks pan out, the executive in question makes millions and retires happy, but if they don't, the whole company blows up and the manager walks away scot-free, moving on to the next gullible company to rinse and repeat (see: John Thain).

These schemes have led to an epidemic of short-termism on Wall Street in particular, where traders and executives have little interest in the firm's profitability beyond the next quarter or year. Making those stocks or options or bonds vest at a later date does little to change the underlying risk/reward dynamic from the standpoint of the executive. While things may be slightly different for Congressmen than for Fortune 500 CEOs, those differences aren't nearly as great as we would like them to be. The folks in Washington have already shown themselves to be experts at trading long-term security for short-term gain, and the last thing they need is another scheme from us that encourages them to do more of the same.

You see, even if our Congressmen (and women) were to blow up the whole country under Bair's proposal, they'd still be pulling in $90k a year (oh, and a housing allowance, of course), well above the national average. That's not exactly giving them the "skin in the game" that they might need in order to ensure that they don't screw things up terribly for the rest of us.

Worse still, the plan suffers from a serious flaw in design by tying compensation to a bond price rather than some other more tangible measure of actual long-term American prosperity. If our Congressmen suddenly own millions of dollars worth of U.S. government debt, then all that does is give them a huge incentive to encourage the clowns over at the Fed to keep on keeping on with their ridiculous quantitative easing, which sends bond prices skyrocketing (and yields plummeting) even while the fiscal state of the union deteriorates by the day.

The real flaw in Bair's argument, ultimately, lies in its presumption that Congressmen and Senators control bond prices and economic outcomes with their policies—they don't. The Fed controls these things, they have for decades, and that won't be changing any time soon, regardless of any "pay for performance" scheme that you want to put into place. Not until the voters force it to be so, that is.

The truth is, the only kind of "pay for performance" scheme that will ever work in a democracy is to vote the bums out when they screw over their constituents. That requires real, actual responsibility on the part of the voters, more than some lazy "autopilot" compensation scheme that won't work and represents a further abdication of the voters' responsibility to hold their elected officials accountable.

Now as ever, we as voters get the government that we deserve. If we refuse to hold our Congressmen accountable with our votes on Election Day, then we can't expect the mess to sort itself out just because they own a few more government bonds then they used to. Bair should know better than this, and yet somehow she doesn't. Unless, of course, this is satire, in which case the joke is, once again, on me.

D.C. politicians have in large part ascended to their lofty positions by being experts at gaming whatever system has been placed before them. Unless a pay-for-performance scheme is meticulously designed to avoid any unintended consequences, you can bet that they'll find the loopholes and design ways to maximize their compensation, regardless of the externalities that may result from their actions. What a joke of an idea. Our politicians need fewer systems and schemes to try to game, not more. Go back to the drawing board, Sheila.

[Fortune]

Catastrophe bonds, QE, and you

Following up on my favorite topic (the Fed), and making a connection with this week's biggest news (Hurricane Sandy), we have this piece from last week from Businessweek.

Bonds designed to protect insurers from payouts on natural disasters are headed for the best returns since 2009 as a superstorm expected to develop from Hurricane Sandy threatens to strike the U.S. Northeast. 

Catastrophe bonds, which lose money if they’re triggered, have returned 10.3 percent this year through last week, more than triple the 2.79 percent gains in the corresponding period of 2011, according to the Swiss Re Cat Bond Total Return Index. The measure, which tracks dollar-denominated debt sold by insurers and reinsurers, includes bonds linked to potential storm damage in the U.S. 

Investor demand for the securities has grown with yields on speculative-grade corporate bonds hovering at record lows as the Federal Reserve holds down interest rates to boost the economy. About $1 billion of catastrophe bonds may be exposed to the storm, according to a “loose” estimate by Patti Guatteri of Swiss Re Capital Markets. 

“Some investors are looking for bids on specific bonds that are the most exposed to the Northeast,” Guatteri, director of insurance-linked security trading in New York, said today in a telephone interview.

Yeah, toss this one in the old "unintended consequences of QE" pile. People can't get investment yield from traditional securities, but they feel the need to do something to keep up with inflation, so they start scrambling around looking for yield wherever they can find it.

So it is that we end up with individual investors starting to play around in the catastrophe insurance business, taking on risk that even the large insurance companies don't want. As a result, the price of these things skyrockets (and the yield goes down), even as the exact opposite should be happening with Sandy bearing down on the East Coast.

This is (was) nothing but outright gambling by a bunch of desperate investors who can't see any other way of keeping up with Fed-sponsored inflation. All of this is absolutely fantastic, what could possibly go wrong? Seriously, taking all of your money to Vegas and betting on black would be a better bet than this. The investors who thought this was a good idea deserve whatever they get as a result (i.e., no bailouts), no matter how much they may have thought the Fed "forced them" to do it. Dumb investing is dumb investing.

[Businessweek]

Quote of the Week

As usual, I've got some catching up to do here on the blog. We'll start things off today with your belated Quote of the Week, then your Clip of the Week will be right behind it. I may throw in an extra post just for kicks, but I'll probably hold off on it until tomorrow—you all know how much I love writing on Fridays.

The leader in the clubhouse for this week's Quote was this post over on the Marginal Revolution blog, which shared some seriously bizarre tidbits about people's intense love for K-Pop (what's K-Pop? This is K-Pop; so is this). Fanaticism knows few bounds, apparently.

But then I came across this post at The Motley Fool, which was frankly so terrifying that I couldn't help but write about it on the blog. So here's your Quote of the Week... go America.

This week's QUOTE OF THE WEEK

"As part of the Dodd-Frank Act, lawmakers directed the [Securities & Exchange Commission] to figure out how much average investors knew about the stocks and mutual funds that they held. Here's what they found: You are an idiot... Statistically, the SEC found that American investors—regardless of age, race, or gender—'lack basic financial literacy,' and that they generally do not understand even 'the most elementary financial concepts such as compound interest and inflation.' The surveys suggest that certain sub-groups, including the elderly... 'have an even greater lack of investment knowledge' of concepts like the difference between stocks and bonds, and are unaware of investment costs and their impact on investment returns.
                                                  - Bill Mann, Motley Fool Funds

What's perhaps most concerning about this post is what Mann later points out—this study didn't consider ALL Americans, it ONLY CONSIDERED THOSE WHO ARE ALREADY DEEMED TO BE ACTIVE INVESTORS. If active investors can't adequately answer a question like "what's a stock", then I admit that I have seriously overestimated the intelligence level of my nation. Unfortunately, it appears that's the case.

Now, granted, my inner tin-foil-hat man does look at this survey data with a fair bit of skepticism, recognizing that the SEC has a vested interest in reporting that investors are gullible fools who need to be saved from themselves (by the SEC, of course). That said, I have a very hard time contradicting the study's results—frankly, it all sounds just about right.

If you watch the Presidential (and Vice Presidential) debates this fall, and you start to notice that the candidates are speaking about the economy and the markets in a way that seems designed to confuse, please know that it's absolutely on purpose—they assume that you don't understand this stuff, so it's in their interest to speak in circles so as to confuse you.

You won't know the difference either way, and you'll therefore be forced to choose the guy who "looked the best" doing it. That is, unless you choose to educate yourself. And if you read this blog, I'd like to think that you're already doing so. Otherwise, I've probably been confusing the hell out of you for a long time now. My bad, guys.

[Motley Fool]

Quote of the Week

This week's Quote of the Week is going to be a bit of a cheat, in that it's really a Clip of the Week. I'm not going to do any setup of this quote (short of posting up this blog post, which is particularly apt), except to say that this is actor Craig T. Nelson, it's three years old, and yet I just saw it for the first time and think it's terrific.

I'll be referring back to this Quote in a blog post that I intend to write tomorrow, but for now, enjoy the awesomeness.

This week's QUOTE OF THE WEEK

"We are a capitalistic society. Okay, I go into business, I don't make it, I go bankrupt. They're not gonna bail me out. I've been on food stamps and welfare, did anybody help me out? No." 
                                             - Craig T. Nelson

Simply stunning ignorance. Amazing work.

"Inside Job" and bank criminality

A little over a year ago, I posted a Quote of the Week (and also this follow-up) from Charles Ferguson, the director of the Oscar-winning documentary "Inside Job". Ferguson was complaining about the lack of prosecutions of fraud committed by financial executives, a topic I've also discussed here more times than I can remember.

However, until this week, I hadn't actually watched the documentary—not until Barry Ritholtz tipped me off to the presence of the entire movie on Vimeo. I'd avoided "Inside Job" in part because I (arrogantly and incorrectly) thought that I had read and learned everything there was to know about the financial crisis already, and figured that the film probably didn't have much new to add to the discussion. How wrong I was.

The greatest compliment I can give to any non-fiction piece is that it's worth reading even if you think you already know everything about the topic in question—that certainly applies here. "Inside Job" provides incredible access to a who's who of characters in the mess that is our financial system, from economists to bankers to politicians and everyone in between. Ferguson pulls few punches, and he is particularly harsh with respect to the (role of the) academic world, including my alma mater.

Like many pieces on the topic, I think "Inside Job" is a little too forgiving of the borrowers who made the real estate bubble possible, but that's certainly nothing new here (and I've discussed that dynamic before as well). All in all, though, if you haven't yet watched the doc, I highly recommend it. It does a great job of showing just how ugly things have been behind closed doors at our banks, and also how this financial crisis is far from over—in fact, it may still be in its early stages.


Inside Job, Narrated by Matt Damon (Full Length HD) from jwrock on Vimeo.

But if you don't have the time to watch the film, and you somehow still doubt my assertions that banks continue to commit crimes that have systematically gone unpunished... just read this little post (also courtesy of Barry Ritholtz) and be done with it. In fact, I'll just go ahead and reproduce the whole thing right here.

Here are some recent improprieties by the big banks:

- Laundering money for drug cartels. See this, this, this and this (indeed, drug dealers kept the banking system afloat during the depths of the 2008 financial crisis)

- Laundering money for terrorists

- Engaging in mafia-style big-rigging fraud against local governments. See this, this and this

- Shaving money off of virtually every pension transaction they handled over the course of decades, stealing collectively billions of dollars from pensions worldwide. Details here, here, here, here, here, here, here, here, here, here, and here

- Charging “storage fees” to store gold bullion … without even buying or storing any gold. And raiding allocated gold accounts

- Committing massive and pervasive fraud both when they initiated mortgage loans and when they foreclosed on them (and see this)

- Pledging the same mortgage multiple times to different buyers. See this, this, this, this and this. This would be like selling your car, and collecting money from 10 different buyers for the same car

- Cheating homeowners by gaming laws meant to protect people from unfair foreclosure

- Committing massive fraud in an $800 trillion dollar market which effects everything from mortgages, student loans, small business loans and city financing

- Engaging in insider trading of the most important financial information

- Pushing investments which they knew were terrible, and then betting against the same investments to make money for themselves. See this, this, this, this and this

- Engaging in unlawful “frontrunning” to manipulate markets. See this, this, this, this, this and this

- Engaging in unlawful “Wash Trades” to manipulate asset prices. See this, this and this

- Otherwise manipulating markets. And see this

- Participating in various Ponzi schemes. See this, this and this

- Charging veterans unlawful mortgage fees

- Cooking their books (and see this)

- Bribing and bullying ratings agencies to inflate ratings on their risky investments

The executives of the big banks invariably pretend that the hanky-panky was only committed by a couple of low-level rogue employees. But studies show that most of the fraud is committed by management.

Indeed, one of the world’s top fraud experts – professor of law and economics, and former senior S&L regulator Bill Black – says that most financial fraud is “control fraud”, where the people who own the banks are the ones who implement systemic fraud. See this, this and this.

But it's all okay, because Wall Street is our Main Street, love 'em or hate 'em, right? Bullshit.

That list should just about do it for the "banks never committed any crimes" line of argument, forever. So, watch "Inside Job" if you haven't already—and even if you have, watch it again. It's worth it.

[Barry Ritholtz]
[Max Keiser]

Where the Millionaires Are

Barry Ritholtz shared this fascinating list of the nations in the world with the highest percentage of millionaire households.

15. The Netherlands (Total population 16.7 million; 2.1% millionaire households)
14. Ireland (4.8 million; 2.2%)
13. Oman (2.8 million; 2.5%)
12. Belgium (10.4 million; 2.9%)
11. Japan (125.2 million; 2.9%)

10. Bahrain (1.3 million; 3.2%)
9. Taiwan (23.2 million; 3.2%)
8. Israel (7.8 million; 3.6%)
7. United States (322.4 million; 4.3%)
6. United Arab Emirates (8.3 million; 5.0%)

5. Hong Kong (7.2 million; 8.8%)
4. Switzerland (7.7 million; 9.5%)
3. Kuwait (3.6 million; 11.8%)
2. Qatar (1.9 million; 14.3%)
1. Singapore (4.8 million; 17.1%)

I do have to say, though, I'm not totally sure what to do with this list--there's a lot going on here, and it's tricky to unpack it all. Some of these countries are millionaire-heavy because they have an industry (like, say, oil) that tends to create a lot of them. In others (like Switzerland and possibly Singapore), the explanation seems to have more to do with political considerations that would make those nations more millionaire-friendly--that is, those countries don't create millionaires, they just harbor them after they've already been created elsewhere.

So if I'm a millionaire, should I be going to where there are a lot of me already, or where I'd be a relatively scarce commodity? Seems like my money would go a lot farther in a country where I was the only millionaire in town, right? But I also wouldn't want to become a target. See you in the Netherlands?

[Barry Ritholtz]

One chart that sums it all up

This chart (courtesy of the Illusion of Prosperity blog) is one of the most frightening charts I've seen in a long time, and it says quite a bit about what's happened to our economy over the last 50 or so years. The ratio of net worth to debt in our nation is absolutely plummeting, and has been for decades. If you ever wonder why things are the way they are, just call up this chart and remind yourself. See you in 2059!

David Einhorn on the Fed and The Simpsons

I don't always agree with hedge fund manager David Einhorn, but the piece that he wrote for The Huffington Post regarding Fed policy is one of the better pieces I've read this year.

It's not easy to take a complex subject and make it easy to understand (not to mention entertaining), but I think Einhorn's pulled it off here. And the fact that he brings The Simpsons into it just makes it all that more appealing to me. I'm easy.

I'll excerpt a couple of sections of it here (basically the beginning and the end), but I seriously suggest that you take a few minutes and read the whole thing. At the very least, it'll help you understand just why the economy can't seem to get out of its own way.

A Jelly Donut is a yummy mid-afternoon energy boost. 

Two Jelly Donuts are an indulgent breakfast. 

Three Jelly Donuts may induce a tummy ache. 

Six Jelly Donuts -- that's an eating disorder. 

Twelve Jelly Donuts is fraternity pledge hazing. 

My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn't giving us energy or making us feel better. Instead of a robust recovery, the economy continues to be sluggish. Last year, when asked why his measures weren't working, he suggested it was "bad luck." 

I don't think luck has anything to do with it. The blame lies in his misunderstanding of human nature. The textbooks presume that easier money will always result in a stronger economy, but that's a bad assumption... 

I think we've reached the point where even Homer can see that the last thing he needs is another Jelly Donut, but the Fed Chairman is oblivious. 

We can all say "D'oh!"

Since I left out the entire guts of the argument, you'll have to go to the full article to see what he's saying. I like the analogy, and I definitely agree with Einhorn's conclusions. The Fed needs to get out of the way, allow the market's price mechanism to work properly (even if that means significant short-term pain), and let the economy begin to heal itself. Doing otherwise will only prolong the pain, and could even create the next crisis--I might in fact argue that it already has.

[Huffington Post]

About that Facebook IPO...

Today's much-hyped Facebook IPO (see here for evidence of the hype) turned out to be the non-event of the year, as the stock (and the broader market) fizzled. As my main man Ted pointed out over on the Twitter, Facebook was one underwriter bid away from the most embarrassing IPO in history.

What does he mean by that? Here's two pictures that tell the whole story:

The first one is today's 1-minute chart for the stock, which literally looks like somebody cut off the bottom portion of the chart, right at its IPO price of 38. Charts aren't supposed to have floors like that.

The second picture tells you why that happened--it shows the bids and offers for Facebook stock during those few minutes (courtesy of BusinessInsider). I've circled the monstrous size of the 38.00 bid for you--that is so big that it could only be the underwriters of the IPO, protecting the stock to make sure that it didn't trade below the IPO price (which would be an epic embarrassment).

Without that bid, the stock easily could have traded down into the mid-30s if not lower.

I'll get back to my usually scheduled programming to send you into the weekend, but I felt like I had to share this, because I know a lot of you are (and were) following the hype on this one. Very, very strange day, and one that has to be somewhat ominous for Facebook and its shareholders.

How JPMorgan profited from its massive trading loss

Yes, the title of this post is intentionally nonsensical. That's because we have clearly crossed over from the bizarre into the downright absurd, as was pointed out in this item on the Sober Look blog.

For those in need of a primer, on Thursday evening JPMorgan disclosed a massive $2B trading loss in a portfolio whose ostensible purpose was to "hedge" underlying bank risk, though it clearly does nothing of the sort (read Barry Ritholtz for more on that point). The bank's stock price plunged nearly 10% on Friday, and its bonds were hit hard as well. That last part is where the crazy comes in.

With all the talk about JPMorgan's losses out of the CIO's office, nobody is discussing the money the firm made on Friday due to the accounting magic called DVA. After all, CIO's positions were (at least in principle) meant to act as an offset to this earnings volatility. 

As an example the chart below shows the price action for JPM's newly minted bond (issued just last month). It's a 4% coupon bond maturing in 20 years. 

Source: Bloomberg

With roughly $12bn of this bond outstanding, JPMorgan will record a gain of some $350MM based on Friday's price move just for this bond. It's important to note that this bond represents only a fraction of the $2.3 trillion balance sheet funding. Since the firm's long-term debt is some 12% of total liabilities, one can do a quick back of the envelope estimate. A two point drop (which is lower than the bonds above moved on Friday) in JPMorgan's long term bonds results in roughly $5bn in DVA gains. This more than offsets the reported losses on the CIO's portfolio. Welcome to accounting magic.

That is absolutely amazing. By disclosing a $2B trading loss and sending its own outstanding debt to the woodshed, JPMorgan will actually get to disclose a paper profit as a result (as they did last fall, along with just about every other bank).

The concept of DVA is simple, but also completely retarded. Essentially, the downward movement in the bond price is interpreted as reflecting an increased likelihood that JPMorgan will default on its outstanding debt. In bank accounting land, that means that it won't have to pay back money that it previously expected to have to pay... free earnings!

Of course, in order to ACTUALLY realize these "earnings", JPMorgan will have to actually default on its debt, which would tank the company in every way imaginable. But in the magical short-term world of bank accounting, a $2B trading loss can instantly transform itself into a big-time profit.

And hey, that $5B DVA gain that was calculated in the blog post assumed only a 2-point decrease in bond prices (i.e. from 100 to 98). Just imagine what JPMorgan's earnings would look like if their bond prices REALLY got whacked, like... oh, I don't know... Spain?

So remind me again, how exactly am I supposed to know when a bank is actually making money these days? And why should I ever trust a bank earnings report? Shaking my head...

[Sober Look]

Quote of the Week

For this week's Quote of the Week, my initial instinct was to go the light-hearted route and pull something humorous from Jimmy Kimmel's address at the White House Correspondents' Dinner. He did a solid job on the whole, including a crack about Obama's ears that takes some serious guts to make.

But yesterday, after hitting "Publish" on my rant-y little diatribe about how borrowers need to take responsibility for their own poor financial decisions, I came across a couple of other items that convinced me that I had to add a little more to this topic. The first of those items will be the source of this week's Quote of the Week, while the second will (hopefully) serve to illuminate on it a bit. Let's get to it...

This week's QUOTE OF THE WEEK

"It has been argued that one formula known as Black-Scholes, along with its descendants, helped to blow up the financial world."
                                              - Tim Harford, BBC Radio

First of all, before I launch in, I have a journalistic bone to pick with Mr. Harford, a pet peeve that's been bugging me lately as it's begun to spread. Tim, just who exactly has been making this argument to which you so casually refer? Do you have a specific name, or an example? If you don't, then YOU'RE THE ONE making the argument. Enough with the passive-aggressive bullshit. If you want to make an argument, just make it and defend it--don't try to shift that responsibility elsewhere. Thank you.

Now, that peeve aside, whoever made the argument (whether it was Tim or the Unknown Soldier) happens to have made a brutally flimsy and careless argument, among the worst I've ever heard. To try to deflect responsibility for an economic crisis onto a model (or that model's creators) is fraudulent on many levels, and doing so rivals the behavior that I mentioned yesterday in the annals of denial of personal responsibility.

It's often been said that guns don't kill people, people kill people (hey, look at that, I found a source, unlike Tim Harford). Generally speaking, I agree. Similarly, models don't blow up economies--people blow up economies.

We all use models in our daily lives, because they help us to make sense of what are often very complex problems. Models simplify, organize, and categorize the variables in an uncertain world so that we can better understand the impacts of our decisions. But they DO NOT, ever, have the power to tell us what to do. You don't even need to know a thing about Black-Scholes (and trust me, a lot of people who should know a lot about it... don't) in order to accept that assertion as fact.

The intelligent person knows to use a model only as a guide to confirm (or refute) what our intuition tells us. Very often, our painfully simple heuristic models (which you can learn or hear more about from Gerd Gigerenzer's speech, if you're a nerd like me) actually outperform very elegant statistical models. How can this be? The answer lies in this brilliant polemic from economist Robert Wenzel (which is almost as great as a similar recent rant from Jim Grant).

In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed. 

There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.  

And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist.

Wenzel is dead on. We all know that models are useful, but they do not remove responsibility for rational risk management--only people have the power to do that. When callous risk managers at huge investment banks take another man's model on faith, and make huge bets with billions of dollars on the line without sanity-checking the model, that's nobody's fault but theirs. They can't come around and say "but... the model said...", any more than our old friends at Long-Term Capital Management did back in the 1990s.

When an individual buys a house with a mortgage or takes out a student loan, it's that individual's responsibility to know the risks associated with that loan. Similarly, it is the bank's (or hedge fund's, or mutual fund's, or pension fund's) responsibility to know the risk profile of the trades it is putting on. They can't blame a model or a formula for "understating" the risk--they're the ones who used the model, so the responsibility is theirs.

Black-Scholes is a great formula, an elegant formula, and one that enabled us to easily price contracts that we couldn't price without it. The fact that some people traded those contracts in a manner that was inconsistent with rational risk management standards has nothing to do with Black-Scholes--the formula was at best an accessory to the crime.

Why is it that we have seemingly lost our ability to claim responsibility for our own actions? Will our federal government blame John Maynard Keynes if and when our debt ceiling hijinks finally blow up in our faces? Will people try to blame the food manufacturer when it turns out that chocolate frosting isn't, as it turns out, a nutritious snack? Oh crap... you're right. They already have.

[BBC News]
[Economic Policy Journal]

On Goldman, "asymmetric service", Apple, and (the lack of) jail time

It's been a little while since I ranted about the rampant and blatant illegality that is allowed to persist on Wall Street ever since the bailout (because, remember, Wall Street is our Main Street), but I simply can't let the events of the last week go by without mention. I'll present to you three separate news items, all of which... ahem... may or may not be related.

First up, directly from our friends at the SEC (dated April 12th, emphasis mine):

The Securities and Exchange Commission today charged that Goldman, Sachs & Co. lacked adequate policies and procedures to address the risk that during weekly “huddles,” the firm’s analysts could share material, nonpublic information about upcoming research changes. Huddles were a practice where Goldman’s stock research analysts met to provide their best trading ideas to firm traders and later passed them on to a select group of top clients. 

Goldman agreed to settle the charges and will pay a $22 million penalty. Goldman also agreed to be censured, to be subject to a cease-and-desist order, and to review and revise its written policies and procedures to correct the deficiencies identified by the SEC. The Financial Industry Regulatory Authority (FINRA) also announced today a settlement with Goldman for supervisory and other failures related to the huddles. 

“Higher-risk trading and business strategies require higher-order controls,” said Robert S. Khuzami, Director of the Commission’s Division of Enforcement. “Despite being on notice from the SEC about the importance of such controls, Goldman failed to implement policies and procedures that adequately controlled the risk that research analysts could preview upcoming ratings changes with select traders and clients.” 

The SEC in an administrative proceeding found that from 2006 to 2011, Goldman held weekly huddles sometimes attended by sales personnel in which analysts discussed their top short-term trading ideas and traders discussed their views on the markets. In 2007, Goldman began a program known as the Asymmetric Service Initiative (ASI) in which analysts shared information and trading ideas from the huddles with select clients. 

According to the SEC’s order, the programs created a serious risk that Goldman’s analysts could share material, nonpublic information about upcoming changes to their published research with ASI clients and the firm’s traders. The SEC found these risks were increased by the fact that many of the clients and traders engaged in frequent, high-volume trading.

Okay, so for those of you keeping score at home, Goldman admitted to engaging in a blatant insider trading scheme (with a very catchy name, the Asymmetric Service Initiative) for several years before and after the bailout, and paid a paltry $22 million fine as a result. Similar behavior by you or me would land us in jail for several years, but that's beside the point.

Up next, from last night, per Reuters (again, emphasis mine):

U.S. stocks scored their biggest gains in a month on Tuesday after Coca-Cola led a round of strong earnings and as concerns about Europe's debt crisis eased as Spanish bond yields fell. 

Apple Inc shares ended a five-day losing streak with a rally of 5.1 percent, helping the Nasdaq Composite close above 3,000. The stock closed at $609.70 and booked its best day in almost three months after it dropped 8.8 percent in the previous five sessions.

Wow, that's a pretty strong rally after a pretty ugly sell-off. I wonder who was buying... NEXT! From this morning...

In a research note this morning Goldman Sachs is not only sticking with its its “conviction” buy rating on Apple, but it also boosted its 12-month price target on the stock to $750 from $700. 

“Despite recent volatility, we continue to believe Apple’s shares are very attractive at current levels,” said Bill Shope, an analyst at Goldman. “It remains our top pick, and we’d be buyers ahead of March-quarter results.”

Oh, really? You "would be" buyers? Ahead of "March-quarter results"? YOU ALREADY WERE the f*%$^&cking buyers, ahead of your own freaking upgrade, you scumbags (ahem, allegedly).

This is truly epic. The week after Goldman admits to the SEC that it's been kinda, sorta, possibly, illegally leaking info regarding its rating calls to its own traders and top clients for years, it goes ahead and (ahem, allegedly) does the exact same thing with Apple, the largest market-cap company in the world (and therefore also one of the most watched and most heavily traded). That's... bold.

Not surprisingly, Apple stock opened up higher this morning, then began to sell off after the initial pop. What do I think happened? Privileged clients got the leaked info, bought ahead of the news (along with Goldman's traders), then sold some or all of their shares back out today to the suckers on the street who waited for the news to become public. It's a cute trick, and it's also viciously illegal (it's basically a variation on the old "pump and dump", but nobody was ever bold enough to try to pull it off on a huge company on this kind of scale... until Goldman). But no worries, just pay a small token fine and all is well. Move along, folks.

"Asymmetric service", indeed. I'll tell you what, I'm going to start a bank robbery scheme, but I'm going to refer to it as my "Selective Wealth Redistribution Program"... think I'll be able to get away with that one by just agreeing to pay back a small portion of what I stole? Yeah... I didn't think so.

[SEC]
[Reuters]
[WSJ]

A few of my favorite charts

I realize I went radio silent last week, and I apologize. Work and family concerns took a front seat for a bit, but I'm intending to get back to blogging business soon. For now, enjoy a few of my favorite charts that I've come across lately. There's a bit of a common thread here... see if you can spot it.

STUDENT LOAN DEBT OUTSTANDING

GLOBAL CENTRAL BANK ASSETS (i.e. MONEY PRINTING)

MARKET IMPACTS OF "QUANTITATIVE EASING"

APPLE STOCK (AAPL)

Remember, buy Apple. It's "cheap". And now it even pays a dividend!

The lunacy of Dow 116k (or, why all our pension funds are screwed)

I'm going to try to make this one as quick as I can, because I could really rant about it for days. I've talked here before about how the only market analysts who get publicity are the ones making outrageous calls (Dow 3,000! Dow 25,000 by August!), and how this has everything to do with the severely skewed incentive structure surrounding punditry.

Now, with the market nearing multi-year highs, we're in prime territory for these kinds of silly calls, on both sides of the bear/bull debate. This one just happens to be the most absurd, and for those of you who follow me on Twitter, you may already have seen my teaser of this issue. From MarketWatch's Chuck Jaffe:

My favorite market forecast of all time came in the fall of 1995, when mutual fund pioneer Bill Berger came to Boston and predicted the Dow Jones Industrial Average would rise to 116,200.  

He didn’t think it would happen overnight. In fact, the 70-something founder of the Berger Funds figured the market would need until the year 2040 to reach it. (He wryly suggested that if he was proved wrong, people come find him to discuss it; sadly, he died a few years later.) 

Of course, Dow 116,200 would be a far more ridiculous thought than even, say, Dow 36,000, the title of a popular-but-wrong-headed book from the bubble days of the late 1990s, were it not for one thing: As the Dow touched 13,000 this week (and the Nasdaq Composite flirted with 3,000), it’s actually stunningly close to being on track toward making Berger’s prediction come true.

Stunningly close, eh? Let's unpack this one for a minute. Jaffe goes on to extrapolate the annual return over the last 17 years (a completely arbitrary time period that is only relevant based on the exact timing of the prediction he's attempting to analyze), assuming that it will persist at exactly this same rate (7.2% compounded--he actually uses 6.75% because he's starting in June and not March, whatever) over the next thirty years. Using that compounding, the Dow will be well above 100k and on its way to 200k by 2046.

The problem is, this compounded annual rate is absolutely an accident of the time period he's using. For the first five years following Berger's Dow 116k call, the market went on an unprecedented vertical run-up, fueled by an influx of Baby Boomer cash and the dot-com bubble frenzy. The compounded annual return between 1995 and 2000 was a staggering 21%, leading the stock market to more than double over those five years.

Unfortunately for Jaffe (and Berger), it's made basically zero headway since then. In the 12 years following that once-in-a-lifetime bull market, the market has simply lurched from one asset bubble to the next, treading water for a long enough time that just about any index with a continuous compounding assumption (like, um, a pension fund) now finds itself hopelessly behind the curve. The only reason that the Dow 116k call looks like anything resembling a reasonable prediction is the specific and arbitrary points that our author has selected for his analysis.

To show what I mean, let's use a couple of other equally arbitrary starting and ending points for our analysis, to see what kind of wildly different conclusions we can reach (we'll list the author's prediction first, for comparison's sake). You might want to click on the table to get a clearer view.

I'm a particular fan of the "Dow 26 Million" call that you could make if you extrapolated from the March 2009 bottom until today--that's a good one. And the "Dow Zero" call at the bottom of the table is a bit harsh--the Dow would actually hit an asymptotically small level of nine cents by 2046 under that projection, so you wouldn't be totally wiped out.

The point is, any time you try to extrapolate too far based on arbitrary data sets, you're completely a slave to your small sample. Yes, I recognize that the 1995 to 2012 time horizon is the widest range of the bunch, and therefore your biggest and hypothetically least-random sample. But is the 12 years since 2000, where the market has eked out only a 1.9% annual return, meant to be ignored simply because the 5 years prior were so good? If 12 years isn't a significant sample, then why is 17? And if those 5 years from 1995 to 2000 are so important, why aren't the 5 years from 2007 to 2012--with their meager 1.43% annual gain, even after this year's ramp job--equally important?

You get my point by now, so I'll back off. The problem is, every single pension fund in the country uses exactly this kind of infinite compounding analysis in order to claim its solvency. These funds generally assume a consistent return of 7% to 8% (sometimes more) into perpetuity, in order to have enough funds to pay out their accumulated liabilities.

In other words, if the Dow isn't at 116,200 by 2046, these funds are gonna have one hell of a problem on their hands. So, you can laugh at this prediction if you want... but in doing so, recognize that your pension (if you've got one) relies on just this kind of mathematical lunacy. Gooooooooo Dow!!

[MarketWatch]

The blight of interest rate swaps

It's no secret that state budgets (not to mention their public pension funds) have been under intense pressure lately, a problem made significantly worse by perpetually accommodative Fed policy. Much like our federal budget, these state funding crises have stemmed from both the revenue side and the spending side, caused by decades of politicians who habitually promised the world to their constituents without bothering to do any contingency planning at all.

But a recent report from SEIU sheds light on yet another drag on state and municipal budgets at a time when they can least afford it, once again aided and abetted by Fed policy--and, of course, benefiting banks everywhere at the expense of taxpayers. To summarize...

Big banks are profiting at state and local governments’ expense using the same toxic financial instruments that helped crash the economy.  These derivatives known as interest rate swaps, were sold to governments with a promise that they would lower their borrowing costs but have now become a huge liability. The banks have already taken as much as $28 billion from state and local governments.  Now, during the worst public budget crisis in memory, the big banks seek to collect billions more from toxic deals that local and state governments are trapped into and are forcing layoffs and cuts to services to cover payments to banks.

I do take issue with the assertion that these are "the same toxic financial instruments that helped crash the economy", but that disagreement is immaterial to this discussion. The quick and dirty of it is that banks enticed state and local governments everywhere to "lock in" their interest rate costs--both pre-existing and projected--at what were at the time multi-decade lows. Those governments were effectively borrowing money in advance, often paying interest to the banks on loans never made (for projects not yet approved or begun). When the economy tanked and interest rates went even lower, the governments were still on the hook for the higher interest rate expense.

Adding insult to injury, the weakened economy meant that those not-yet-approved projects would in fact never begin (as spending measures were reined in), meaning that the governments had "locked in" interest rates on non-existent borrowing needs--without a project to fund, the swaps became naked bets on interest rate movement, bets that the governments had no way of winning in the face of loosening Fed policy.

The governments therefore were (and still are) left paying an insane tab to the banks for no reason whatsoever. If this whole scenario sounds familiar, that's because it is--I wrote several months ago about a similar scenario involving Bobby Bonilla and the Mets, in which case Bonilla was effectively playing the role of the bank. These interest rate swaps also cost the Port Authority of New York/New Jersey vast sums of money, sums that they are now trying to recoup via increased tolls and fees (as though they weren't high enough to begin with).

While the states should have known better than to get into these arrangements to begin with, the fact that these local budgets are now suffering so badly as a result shows yet another side effect--an unintended consequence--of the Fed policy that I have spent so many words on this blog deriding. The only way to solve the problems that these governments--state and otherwise--now face is, of course, through more monetary stimulus!! And round and round and round we go... aren't centrally planned economies fun?

[SEIU]

Get your professional financial advice here

Given my profession in the financial world, I'm often fielding questions from friends, family, and acquaintances as to what they should be doing with their money. I'm never comfortable giving a strong answer (except for "invest it with me"), because my opinions are long and rambling and chock full of conditional language (usually starting with "well, if the Fed...").

Now, finally, my problem is solved. Friends, don't ask me what to do with your money--ask the Random Financial Advice Generator. He's awesome.

That's some top-notch advice there, really. You just can't pay enough for that kind of insight. He's also terrific at coming up with corporate slogans, if you're in need. Try and stop that, SOPA/PIPA!