Yet Another Way to Fund Housing

In a previous post I suggested that housing could be funded via equity instead of debt, an idea inspired from other economists and twisted slightly.  It's a somewhat impractical idea - at best the equity stake in a house owned by those other than the occupant would be split into tiny pieces and combined to make a "housing equity index"-style investment.  (The goal of slice and dice here is to emulate stock index funds and insulate passive investors from the occasional idiot home owner who destroys his own equity.  The goal is not to create tranches to change the risk curve like a CDO.)

The problem with this scheme is that the equity holders of the house would either have a say in how the house is managed (an annoying intrusion on home owners) or have no say (which means their capital is at risk).  This new scheme tries to work around this by keeping ownership with the occupant.

Derivatives As Insurance

Derivatives are like the force - they can be used for good or evil.  A legitimate use of derivatives is to offset one risk with the exact opposite risk.  For example, an airline (which is hurt by rising fuel prices) can use derivatives to cheaply set up an investment that goes up when fuel prices rise.  The result is that the airline's net exposure to fuel prices is smaller, which means the airline isn't as at risk to fuel price changes.  This use is a "hedge".

By comparison, derivatives can also be used to speculate - I can buy those same derivatives without being an airline - if fuel prices go up, I win my speculative bet - if they go down, I lose my money.

Derivatives that are used as a hedge are sort of like "insurance" - they provide compensation to the buyer when bad things happen.  If I buy a put option on the S&P, I have bought insurance against the stock market falling.  If the market falls (and I lose money from my stocks) the party who wrote the put will pay me - my insurance payout.  The cost of buying that put option was like a premium.

It should be noted that a derivative contract can be insurance to both parties!  If an oil company writes insurance on fuel prices going up and sells it to an airline, this is good for both parties. If fuel prices go up and the oil company has to pay out on the insurance, that's okay, they're printing money because fuel is expensive.  If fuel prices go down, they get to keep the premiums just when they need it.

(I mention this because A.I.G. has just cost us tons of money by writing insurance policies that came due using derivatives.  A.I.G.'s mistake was not writing the insurance - it was writing insurance that they didn't have the money to pay out.  What they did is equivalent to me starting to write insurance on an earthquake in California.  If it happens, I don't have the millions of dollars to pay out claims.  Maybe I could get a bailout and $165 million in bonus money...)

A New Kind of Home Insurance

So here's my scheme: home depreciation insurance.  The home owner agrees with a third party to:

• Pay the third party if the home price goes up and
• Receive money if the home price goes down.

This effectively lowers the market swings.  If I have a $400,000 house and buy a $200,000 depreciation policy, then if my house price falls by 25% I am only out $50,000, not the full $100,000.  (The other $50,000 "lost" is a loss for the third party.)  If the house goes up by 25%, I only gain $50,000, not $100,000.

In other words, I have given up some of the up-side of owning a home to avoid some of the down-side.  Given that a home is a single asset that is more expensive than most Americans savings, this improves the balance of the home-owners portfolio (which is normally over-weighted in non-diversified real-estate).

Homes are bought with leverage (e.g. I buy a $400,000 home with only $80,000 of my own money), to use the financial lingo.  Leverage (borrowing money to buy more of something that changes in price) amplifies the change in value of whatever you buy.  So our use of mortgage financing is making us all more susceptible to housing market price swings, relative to our personal income, savings, etc.  Depreciation insurance is an attempt to counter-act this problem, by letting the home owner "sell" some of the risk to a third party.

Who would be on the other side of the equation?  I can think of a few possible parties:

• Real estate investors who want exposure to house price appreciation but don't want to have to manage a rental property.*
• Pension fund managers who want to balance a series of asset classes that are unrelated (e.g. stocks vs. bonds vs. houses) to optimize return on volatility.
• Home owners who would consider buying a second home as an investment but don't want to buy less than a whole house worth of exposure.

* Buying a rental property to speculate in real-estate is a little bit tricky - the tenant and land lord have opposite incentives financially.  By comparison, in an owner-occupied house the owner and occupant are one in the same, so there is no conflict.  In other words, if you buy part of the appreciation of someone else's owner-occupied home, you don't have to be as worried that they'll scratch the hell out of the new wood floors.

What's A Bonus Anyway

I heard a commentator on the radio say "people know what a bonus is but they don't know what a credit default is". The commentator was getting at why we all have our shorts tied up over the A.I.G. bonus payout, but I think he is wrong; we (the American people) apparently don't know what a bonus is in the finance industry either.

When I did my first job for Austin, I was paid by the job - I received my payment in two lump sums (one part-way through and one upon completion) based on showing the progress of my work.  I would describe this as "deferred compensation":

• The amount of payment was predetermined.
• The work was done significantly before I received the money (this project took over a year of part-time work).
• The amount of payment was unrelated to the quality of the work.  Either the work was acceptable and I got paid, or it wasn't and I wasn't considered done.
• We had a binding contract enforcing this agreement - had Austin decided not to pay me for my work, my recourse would have been to sue for my due compensation.

That sounds a lot like the A.I.G. "bonus" situation: money promised earlier to employees based on a contract that is now enforceable.  (I can only assume that if the contract was not enforceable that Liddy would have done the easy thing and not paid the employees in the beginning.)

By comparison I received a traditional "bonus" at the end of a different project - it was simply a one-time extra payment, the amount specified by Austin, after finishing my work, as a way for Austin to reward me financially for work that he was "extra" happy with.  That's what we all know of as a bonus.

Now don't get me wrong, I am in favor of not paying the bonuses.  But...not because I think the employees don't "deserve" them for ruining the economy.

I am for not paying the bonuses because, as a tax payer, I now own A.I.G., and as an owner of a financial institution, I think that:

1. The compensation of finance employees is way, way too high.  Simply put, I feel that we bought a company with overpaid employees and we should use every technique we can as an owner to reduce salary!  Call me the Frank Lorenzo of financial services!!*
2. We bought A.I.G. not out of profit motive but to preserve the stability of the financial system. To that end, retaining the legacy employees should not be a goal.  If a side effect of cutting costs is to shed the old employees, I am okay with that.

Of course, there is one very dangerous situation: if employees who know A.I.G.'s "positions" (what derivatives A.I.G. owns/sold/is invested in) quit, can they then try to profit by trading against A.I.G.?  I can only hope that they have some kind of non-compete clause in their contract.  (If not, what on earth was A.I.G.'s management doing?)

* This is why I don't like the idea of congress taxing the bonuses to death - I am in favor of strong ownership by all businesses as a way to protect investor value - including the nationalized ones.  When we the people own a bank, we need to be careful not to let politics run operations, but that doesn't mean we have to be taken as suckers by management.  What drives me nutty about A.I.G.'s bonus payout is that it doesn't strike me as driving a hard bargain.

The Worst Finance Book Ever?

I didn't think I would find a source of financial advice worse than CNBC, but I was wrong. "Conspiracy of the Rich", at least in its present form, should be retitled "Robert Kiyosaki gives you financial advice that is somewhere between negligent and completely destructive to your financial health, while advertising his other books and trying to push your buttons."  Kiyosaki has one good point: we (Americans) are terribly uneducated, financially speaking.  Reading his book will only make the problem worse.

The book is available for free online (if you have an email address you don't mind giving up) - it is very possible that the page numbers I quote will have changed; I don't intend to spend any more time reading it.  Here's just some of what horrified me in the introduction:

"The old rule of diversification tells you to buy a number of stocks, bonds, and mutual funds. Diversification, however, did not protect investors from a 30 percent plunge in the stock market and losses in their mutual funds." (p. 7)

Either this is a gross straw man, or Kiyosaki doesn't understand what diversification means. Diversifying into a broad index of stocks rather than one or two stocks protects you from a particular stock doing something particularly bad. Diversification means that you don't get totally wiped out when Bear Stearns goes down. Diversification among stocks does not protect you from the entire market going down, and no investment advisor with more than 3 brain cells would ever say it does.

Diversification across asset classes protects you from strong movement in one asset class, sometimes. Investors who held both stocks an bonds saw less of a dip than investors entirely in stocks. For a thorough and correct discussion of the capital asset pricing model (which is at the heart of modern portfolio design) see A Random Walk Down Wall Street; for a discussion of why things sometimes still blow up, see Fooled By Randomness.

At the heart of the issue with stocks is not diversification, but volatility. Stocks as an asset class have a history of sometimes getting killed, and now is no exception. The issue at hand is risk tolerance, e.g. if your investments lose half their value, are you going to be okay?

In the end, diversification is a zero-sum game at best. If you are evenly diversified, when one asset class goes down, the other goes up. You lose money in one place and make it in another, but you don't gain any ground. You are static." (p. 8)

This is wrong too for two reasons:

1. Diversification lowers the volatility of your portfolio. If an investor diversified into bonds and lost only 15% when everyone else lost 30%, I can assure you the investor who lost only 15% will be happier than the one who lost 30%. When looking at investments, the "expected" (average) return is not the only thing you care about, and it's probably not even the most important. Diversification makes the worse case a lot less worse, which is hardly "static".
   
2. The investor who lost only 15% has more money, and now is in a much better position to exploit low stock prices than the investor who lost 30%.

Which brings me to the next quote:

"Rather than diversify, wise investors focus and specialize. They get to know the investment category they invest in and how the business works better than anyone else." (p. 8)

and later

"Don't diversify."

This is where Kiyosaki goes from simply wrong to dangerous. Telling an investor not to diversify is, to me, about the same as saying "why don't you bet your entire house on this hand of black-jack. It's a really, really stupid thing to do. It is astounding that he would put this in a personal finance book.

Of course, when you read what comes next...

"During this current financial crisis I took a few hits, but my wealth remainded intact. This is because my wealth is not dependent upon market valuesgoing up or down (a.k.a. capital gains). I invest almost exclusively for cash flow.

"For example, my cash flow decreased a little when the price of oil came down, yet my wealth is strong because I still receive a check in the mail every quarter. Even though the price of the oil stocks, capital gains, game down, I'm not worried because I receive cash flow from my investment. I don't have to worry about selling my stocks to realize a profit."

In other words, Kiyosaki invested in oil stocks, but he didn't lose his wealth when those stocks tanked, because he doesn't consider them to be part of his wealth. If this doesn't seem like the stupidest thing you've ever read, you need to read a book on basic accounting.

Now there is a grain of truth to this. If you have enough money to buy an investment that pays cash periodically and you never need that money back again, you only care about the cash it pays. But this strikes me as making a small fortune on wall street by starting with a large fortune. Let's imagine that Kiyosaki's oil stocks pay a 4% dividend. (That is a rich dividend, by the way!) If he doesn't count the principle (the stocks themselves) but only his cash flow, he will BREAK EVEN on the investment in just over 17 years. In other words, in order to truly ignore the value of the stock, he needs to hold the stocks for 17 years.

Of course, this ignores two huge problems: companies can cut dividends - they can go out of business. All sorts of things can go wrong. A bet that his dividend will stay at 3-4% for 17-24 years uninterrupted is a bad bet to take. The second problem is that there is an opportunity cost. Kiyosaki could have put his money in 2% TIPS (those are inflation-protected government bonds). In those 17 years, his TIPS will probably have doubled his money while he has only made up what he spent on the stocks with his oil stocks.

This is all a fancy way of saying that all investors with half a brain care about what happens to the principle, that is, the money they put in to start the game. It's too big of a chunk of money to ignore. There is no investment that pays such good cash flow that the principle is moot.

But my favorite is on page 10:

"The problem is that very few people know what derivatives are. To keep things simple, I explain derivatives by using the example of an orange and orange juice. Orange juice is a derivative of an orange - just like gasoline is a derivative of oil, or an egg is a derivative of a chicken. It's that simple: If you buy a house, a mortgage is a derivative of you and the house you buy."

Kiyosaki is correct about only one thing in that paragraph: apparently very few people know what derivatives are - and Kiyoaski is not one of them. I do know what a derivative is, and it's not that. A financial derivative is not a "processed" product like orange juice to oranges. A derivative is like a calculus derivative - an investment whose value is based on the change of a property of another investment.

(A stock option is a derivative - its value is based on how much a stock's value goes up - or down, depending on the type of market. A mortgage is not a derivative - it is a non-recourse loan. Fortunately web sites like investopedia can help.)

"Some of these new derivatives had exotic names such as collateralized debt obligations, or high yield corporate bonds, a.k.a. junk bonds, and credit default swaps." (p. 10)

Of the financial instruments on that list, only credit default swaps are actually derivatives. (A credit default swap's value goes up and down depending on the credit worthiness of a bond, that is, how likely is it that the bond is repaid.)

I think this quote from page 5 says it all: 

"Most people cannot tell a good financial advisor from a con man." 

Kiyosaki is 100% correct about that -- ironically it's why he may be able to sell this book.

Bob Vila is Tired of Getting Mugged

James Kwak has a great post about the AIG bonus money.  (The Baseline Scenario is one of my favorite econblogs...)  I'm not usually a fan of grandstanding and populist outrage winning out over pragmatism, but the AIG bonus situation is so outrageous that even I'm pissed off.

This year's bonus represents approximately 50 cents for every American.  That's not a lot of money...I just found two quarters the cats knocked off my desk, so clearly this isn't killing me. I think what is most offensive to me about the bonus money situation is that it took us (Americans, participants in our own financial system) such a blatant abuse to get our blood boiling. 

Apparently wall street doesn't just have to treat us like crap to piss us off, they have to do so after they completely trash the economy.

• If the economy is growing and wall street steals from us, we don't care.
• If the economy is growing, but wall street is stealing from us faster than the economy is growing, astoundingly we still don't care.
• Only if the economy crashes and burns hard and then they steal more from us do we get grumpy.

If there is a lesson for Wall Street CEOs and fund managers, it is this: take all you can during a boom - no one is paying any attention.

The problem is one of leverage.  $165 million is a lot for a small group of people.  But it is not much for the entire population of the US.  It's hard to say "I really want my 50 cents back"...it doesn't feel right.  And this is the problem with all of the ways that wall street takes our money: they take a little bit from us and it adds up to a lot for them.

Actually, it only seems like a little bit.  Consider one of my favorite rants: the lousy mutual funds that get passed off as savings vehicles for employee 401Ks.  If you are like my wife and get stuck with a lousy selection of 401K funds there's basically nothing you can do - don't use the 401K and you lose the tax incentive to save.

Consider the effect of a 1.1% expense ratio on your funds vs. a 0.1% expense ratio.  To make this simple, assume you invest $1000 in stocks when you turn 22, and then just leave it until you are 65.  What will your real (inflation-adjusted) result be when you retire?

If you invested in the cost-effective mutual fund, you have $11,763.22.  Not bad - for $1000 in principle you made $10,000 in returns!

But what about the 1.1% fund?  Should we be angry that the fund managers are syphoning off 1%?  1% doesn't sound like much.  But...in the same scenario, you end up with...

...$7,822.50.

Ouch.  33% of your returns are gone!  If you read a prospectus that said: we will take 33% of your retirement money, would you ever accept that?

So...perhaps we should be outraged about 1%.  Perhaps we should be outraged about $0.50. Because it starts to add up.  But more importantly, because the mindset that lets people syphon their 1%, their $0.50, is wrong and it's toxic.

Media Bias? Follow The Money

My views on media bias have changed from the days I used to work in commercial radio - the media business has changed too.  But this rant is directed at my favorite fish in a barrel, CNBC. Here's a taste of CNBC headlines:

• Bounce of The Century!
  
• Market Tips: Get Your Cash into This Rally
• Pros Say: Cash is Now the Riskiest Bet
• Hirschhorn: 5 Reasons to Get Back Into the Market

This from a network that was touting non-directional "absolute return" CDs.

I claim that CNBC's bias is toward advocating things that are bad for your financial health.  Market timing, active trading, complex, hard-to-understand investments with opaque fee structures, what's the connection here?

The answer is the advertisers...Charles Schwab, Fidelity, E-Trade, and off we go.  Wall Street makes its money in a number of ways, but the main way is by taking a piece of the action, often whether or not the outcome of the action is any good.  Examples:

• Investment banks take a fee for issuing bonds in a leveraged buy-out, even if the bought out company then craters under the weight of its own debt.
• Credit cards take 2.5% to 3.5% of everything from merchants, and then hit shoppers with 20% or more on an overdue balance.
• Mortgage brokers take a fee up front for a completed mortgage even if the home owner defaults.  The broker might take a bigger fee if the home owner takes a higher interest rate, regardless of whether this is good for anyone involved.
• Mutual funds take 1% of your money every year, whether their investments go up and down.  If they run up trading costs by trading like crazy, you pay that too.
• Hedge funds take 20% of the profit they make with your money.  They don't eat 20% of the losses.

So what is CNBC's bias?  I think it is to advocate strategies that create a "cut" for their advertisers.  If it wasn't they might say something like:

• Pick an asset allocation that makes sense for your financial goals.
• Build a portfolio using the cheapest vehicles that meet the asset requirements.
• Rebalance periodically, and let it sit.

And hrm...if you do that, you don't really care whether this is the bounce of the century, do you?

Let's Make Up the Biggest Number We Possibly Can

It must be fun to write articles about the derivatives market, because you can say things like "the derivatives market is now $75 octillion billion trillion dollars, or five million times the total wealth conceivable by Han Solo in Star Wars."

Okay, maybe not that much, but still, you can pick a really big number and then say some dire things.

I have blogged before that big numbers in financial reporting are often somewhat meaningless, and I suspect that the numbers being thrown around for the size of the derivatives market are similarly silly.  To illustrate, let's demonstrate how you and I can increase the size of the derivatives market by about $28 trillion.  It won't cost us much.

• We enter into a futures contract written against the US GDP.  Basically for every $1 of growth in the GDP from 2008 -> 2009 you will pay me $1 - for every loss, I pay you $1.
• We assign some kind of "value" to this contract based on the expected change in GDP (probably you will have to pay me to enter this contract - GDP is shrinking right now so I'm almost certainly going to pay you when the contract is up).

So we've exchanged some smaller amount of money based on the probably net change in GDP, and we've created a new derivatives contract with a notional value of $14,000,000,000,000.

Now we do the same thing again, but we reverse the direction.  (This is admittedly a very, very silly thing to do, but it is meant to illustrate a point.)

Now there are $28 trillion in new derivatives, and we are each in a position to make or lose exactly $0.  In financial terms, we are both "hedged" because our two derivatives contracts exactly cancel each other out.

The issue with the derivatives market is not how large it is notionally, but how well hedged all of the contract holders are.  It is possible that the major investment banks are not as well hedged as they thought (see what happened to LTCM), and in rarer cases they may not be hedged at all.  (See: AIG)

But the notional quantity of derivatives tells us nothing about their quality, which is what will really matter.

Madoff vs. LTCM

I've been trying to articulate this for a few days now...

There's this hedge fund...it returned too-good-to-be-true, above-the-market returns that were rock solid, never a blip.  Then one day people invested got a call: there's nothing left, the fund is wiped out, your money is gone.  If an investor got out of the fund early enough, they made a killing.  The ones who stayed in got nothing.

Am I referring to Bernie Madoff's ponzi-scheme of a hedge fund?  No -- I am thinking of Long Term Capital Management.

Madoff "blew up" his customers by paying old customers' pretend returns via new customers' pretend interest.

LTCM lost all their money by borrowing a ton of money and investing in international debt - the 1998 debt crisis caused bonds to do things their computers said was impossible, and they lost all their principle.

Here's what's bugging me: if you invested in either fund, the results are the same.  What Madoff done is clearly criminal; what LTCM did was pretty stupid (in hindsight) but completely legal. In both cases, people had to beg to get into the fund, everything was very secretive, and the methods were "too complex" for normal investors to understand.

Perhaps there is something fundamentally fishy about hedge funds if their normal investment behavior can look exactly like the results of a huge fraud.

Minor historical note: the principle managers of LTCM actually forced redemptions on some of their  customers.  The fund grew to a point where they had too much capital*.  The managers wanted to keep their own personal wealth in the fund, and as a result, they did their client what was in hindsight a favor and got their client's money out, while leaving their personal fortunes in the fund to get squashed.

* LTCM used leverage, that is, borrowing money cheaply, to amplify the effective return on investment.  Since there is a finite amount of money they could put into any given trade, they had to make sure their capital base was small enough that they could do the trade mostly with borrowed money, making the effective return on investment appear high.  Of course, it was that huge amount of leverage that caused them to go completely broke when the market went sour.

It's Not the Losses, It's the Fees

John Stewart had Jim Cramer as a guest last night and it was nice to see someone take a critical look at the meta problems of the financial news industry.  (What does it say about our media that the hardest hitting media criticism comes from Comedy Central?)

I think John Stewart captured "main street anger" toward the situation pretty well:

These guys at these companies were on a Sherman's March through their companies financed by our 401ks and all the incentives of their companies were for short-term profit.  An they burned the f---ing house down with our money, and walked away rich as hell.

I have to pick a bone with this though.  There is no question that the incentives of the money managers that got us here were grossly misaligned with the owners of that money (us).  And there are financial assets whose value has been destroyed that were not supposed to be destroyed.

But...the destruction in retirement savings has come about from the stock market plummeting. And, well, it's supposed to do that.  To me the problem is not that the stock market lost value, but that so many people were so heavily invested in it, perhaps beyond what was prudent.  (And you can't say that this was individual investors going crazy with E-Trade...pension plans, run by "institutional money managers", who are supposed to be well-trained professionals who know what they're doing, lost gobs of money too.)

I don't believe that it is practical to attempt to educate every citizen of the US to be his or her own certified financial planner.  We have professionals for that; I worry whether fiduciary responsibility has been lost.

But a bigger concern to me is not the losses, or the advice that got us into the losses, but the fees.  The financial sector makes its moneys by taking a cut, in the form of fees, whether they are percent of assets, percent of gain, or just fixed fees.  On every mortgage written, every security issued, every hedge fund and mutual fund managed, every stock and option traded, Wall Street takes a piece of the action.

So we should be concerned when growth in the financial sector is double the nation's GDP. That's another way of saying we're paying twice as much as we used to for our financial services. Proponents of securitization can make theoretical arguments about efficient deployment of capital, but if the industry as a whole is being more innovative and prices are going up, that's not the kind of innovation I want.

The side bets and trading and "fast short term dangerous money" that John Stewart rails against is not my main concern - I can simply stay out of it.  But the cost of doing business, the fees, the increasing price of financial services, to me that's the true danger, because they're taking our money, it happens all the time (good market or bad), and there is no indication that it's going to change because of what happened.

True Words About Facebook

My mother recently signed up for Facebook, and she wrote me this email:

Since I joined Facebook, I've gotten tons of messages saying people have confirmed me as a friend or relative but I still don't see the point of all this. Nobody has sent me a message that they could not have just as easily sent me by regular e-mail. I'm guessing I was already in all their address books. What's the point of all this???

Mom, there is no point. Facebook's most useful function is to allow office workers with uncontrolled internet access to waste time.

Robert Cringely's rant on Facebook spam is worth reading. Whenever I log in to Facebook (which is less and less often) I find myself ignoring more requests to join.

Hrm...now that I think about it, Facebook is really annoying. Can you imagine this kind of behavior in real life?

(Of course, that video was sent to me on Facebook.)

Who's The Sucker?

"Look around the table. If you don't see a sucker, get up, because you're the sucker." -- Amarillo Slim

A friend sent me this link...an "absolute return" CD.  What's not to love?

• Positive returns no matter which way the index moves.
• Guaranteed no loss on capital.
• FDIC insured.

An absolute return CD is a "structured CD" - that is, it's built out of a mish-mash of derivatives and other instruments that are complex enough that it's hard for the retail investor to understand what's going on here.  But I think Amarillo Slim has it right - if we can't see the sucker, better get up from the table.

I am not sure exactly how banks structure this investment, but a few things strike me as immediately problematic:

1. The investment is tied to an index, but synthetic instruments that track an index don't necessarily pay dividends.  The real historical long term return on stocks is around 6%, but a significant part of that is from dividends.  Lose the dividends and you're not really getting the kind of returns you'd get out of being in the underlying investment.
2. These structured CDs have a "barrier" feature.  Basically if the index exceeds some range band, you forfeit all of your interest - you only get your principle back.

This second point is easy for retail investors to ignore.  "If the market really tanks, I'm lucky to have my principle protected".  The fallacy here is to look at the possible returns (if the index tracks in-band) without considering the opportunity cost.  If I offered you a CD returning 0%, you would laugh at me, right?

And even worse, what if the market really out-performs?  Now the market is up and you get none of the up-side!  You don't even get interest.

From what I can tell, this "barrier" is necessary - that is, the banks couldn't offer you a track on the index in both directions without the barrier because the underlying derivatives that make the index tracking possible are more expensive than the interest you're not getting from the CD.

I looked up some S&P 500 option prices for six months in the future.  To create an investment that tracks the absolute value of the change of the S&P to an 8% gain or loss, we need to spend about 8.6% of our capital on the options contracts to make it work.  But the interest returned from the initial cash (in a fixed rate investment) is going to be a lot lower...less than 1% for treasuries, and certainly not 8.6%.

I figure the banks create a new derivative based on the fact that when the S&P goes out of the range they keep all of the returns and you only get the principle.  In other words, when the S&P is highly volatile, you gave them an interest free loan which they used to make money!  They can then write some kind of derivative that is backed by this "free money" and sell that derivative, to recoup the cost of the options above, and maybe make some profit.

One thing is clear to me though: if an absolute return CD is so complex that I can't even figure out how it might work, I certainly can't determine whether the expected return is a good price, or non-competitive.  (I don't even know what derivatives they use, so how do I know if I am being taken?)  I'm not going to buy what I can't evaluate!

(Of course, I'm also not going to buy what I saw on CNBC!!)

A Different Way to Fund Housing

I have said before that buying a house is a little bit crazy.  If I went to the bank and said "I want to borrow four times as much money as I have, so that I can put it all in Amazon.com stock", the bank would laugh before they threw me out.

So...why will the bank let me leverage up 5:1 to speculate in real estate?  I am not a professional real-estate developer.  All my risk is concentrated in one property.  And owing that much on one property is terrible diversification.

We've seen two things happen at the same time which have changed the nature of home ownership in the US in a bad way.

• At least over the last 5 years, home owners were allowed to put a lot less money down - that is, they had higher leverage in buying houses.
• Home prices have become volatile.

Let's look at those two things in slightly more detail: when you write a loan that is backed by an asset, you want the owner (the person with the equity stake) to put enough money up that even if the asset goes down in value, its new value is less than the loan amount.  If you don't do this, the owner is "under water" and the loan isn't secured.  By making home owners pay a 20% down-payment, banks would protect themselves from a 20% decrease in house prices.  

That was a very wide margin back in the day, but the price swing we've seen of late is larger than that in some states.  Furthermore banks have been allowing down payments to get smaller, via piggy-back loans, seller-pays-closing costs, and all sorts of other weirdness.

I think these two trends may be related: the more houses are financed, the more housing prices are influenced by interest rates (because without cheap financing, the demand for housing goes down).  And the more houses are financed, the less housing prices have to change to put people under water.

it occurred to me that we don't have to use debt to finance housing.  I'd like to suggest a different model: equity mortgages.  (I realize that the logistics of this virtually impossible, but I still think it is interesting as a thought experiment.)

Under a "debt" mortgage (i.e. what we have now) the home owner owns the house, the house is collateral on the loan, and the home owner gains or loses all fluctuations in the price of the house.

Under an "equity" mortgage (i.e. what I am proposing) the hmoe owner owns part of the house, and the bank owns part of the house.  The home owner and the bank split gains or losses due to changes in the houses price.

How does this change things?

• A home owner can't be underwater; as a home decreases in value, the mortgage shrinks proportionally.  If you own 1/5th of your house, that is true no matter how the market fluctuates.
• A home owner has a smaller exposure to house prices.  If you put down a 20% down payment, you are exposed to house price changes only on that money.  Since the down-payment is put up in cash, you can think of this as speculating in house prices with some of your own money, but not the banks.
• Banks are exposed to both the upside and down side of house price changes.
• Banks are no longer exposed to default risk due to house price changes.  Because the owner can't be underwater, the home owner always has motivation to make payments.

These bullet points reveal a question: how does the mortgage get paid off?  In practice co-ownership of the house becomes very tricky.  Does the bank get to say whether you can renovate the bathroom?  Do you have to buy out the bank's share?  If so, do you have to do it on a schedule?  Can the bank sell its share to someone else?

I don' think equity mortgages are something we'll see any time soon, but I think they do illustrate some implications of debt-based housing finance that deserve closer inspection.

John Stewart vs. CNBC

John Stewart vs. CNBC. Of course, CNBC is a useful tool for making financial decisions - you just have to do the opposite of whatever the loudest pundit says.

Here's a chart of crude for the last two years...speculative bubble, anyone?

Tim Geitner's Secret Plan

Treasury Secretary Geitner did an interivew on the Planet Money podcast.  My first reaction was "man, that's the dumbest thing I've ever heard, this guy must be a complete idiot."  Fortunately for the markets, before I posted any of that, I did some thinking on the subject, and I think I have discovered Mr. Geitner's secret plan.

Liquidity vs. Solvency

At the heart of the debate over banking, the housing market, and the economy is the question of whether the problem is liquidity or solvency.

• The problem might just be that there isn't enough money, credit, and confidence to go around.  When everything settles down and the credit crisis is over, our house prices will recover, the mortgages on them will be backed by real collateral, and therefore the banks' balance sheets won't be swiss cheese.  The only problem is that right now, temporarily, there isn't enough money.  In other words, we have a problem of liquidity.
• On the other hand, house prices from 3 years ago might have been a delusional speculative bubble.  Houses are not going back up to that price because they were never worth that much, and only reached that value due to tons of easy credit.  Houses aren't coming back, the mortgages aren't coming back, ergo the banks aren't coming back.  The banks just owe more than they have, because their mortgages aren't worth squat.  In other words, we have a problem of solvency.

While I don't think that the real answer is 100% clean cut, I do believe that solvency is the major issue here.  I don't think housing prices are coming back any time soon.  To reach the housing prices we reached, we had to have a speculative mentality among buyers (e.g. "I'll buy the biggest house I can, because houses always go up") and easy money from banks (NINJA loans and all the rest).  The crisis has burned people bad enough that we're not going back there.

So when Geitner basically said "this is a liquidity" crisis during the interview, I raised my fist at the computer and did my usual ranting and cursing.  In particular, the treatments for solvency and liquidity are very different.  If the problem is liquidity, loaning money to the banks is just what we need; cure the symptoms and cure the disease.  But if the problem is solvency, every dollar we loan is a dollar flushed down the toilet, and one that just delays the day when the system is solid and functional again.

The Secret Plan

It was then that I realized that while my personal view of the crisis is the complete opposite of Geitner's stated public position, the current plan of action is exactly what I would do.

Treasury is working on a "stress test" - basically they're going to look at the banks books in detail and find out how screwed up they are.  Supposedly they will then think deeply about how the bank would do in a crisis, and offer them "credit support" (read: loans) if they need it.

Here's what I would do, e.g. "the secret plan".

1. Conduct stress tests, learning lots of interesting things about how sick the banks are.
2. In secret, prepare a nationalization plan/task force for all the banks that will need it.
3. Nationalize them all at once, suddenly, and without warning.  Surprise!
4. Immediately cut out and sell off the functioning parts.
5. Dump the rest of the toxic crap into something like a resolution trust corp to get unwound later at a loss that's hopefully not too ridiculously huge.

One of the problems with nationalization (or any market assistance plan) is that people will try to "front-run" it, or guess what is going to happen and try to make money speculating on that event.  So if you nationalize only the sickest bank, there will be a run on the second sickest bank.

Perhaps the current "stress test" provides the cover needed to really explore who is alive and who is already dead, and to prepare to take over and unwind any banks that really aren't solvent.

Sorry About That

Blogging can have many purposes - to provide a "subscription" service without the readers having to provide personal information, to create a web-searchable repository of information, as a form of creative expression. In the case of my rantings on finance, the purpose is for me to "get it out of my system" so my dear wife doesn't have to listen to me rant about how dumb AIG's management was.

At least, that's what I thought I had here - a harmless place to blow off steam - a microphone that was off...I was pretty sure that no one was paying attention.

So I write one post loosely in favor of bank nationalization and look what happens when the markets open: the Dow down almost 300 points. Citigroup down 20%. Clearly blogs are really, really important.

In summary: um, sorry about that.

Next week: Tim Geitner's secret plan! Better hide your cash under the mattress!

AIG Analogy

Here's a good three part article on AIG in the Washington Post.  How did this happen?  Why are we (the tax payers) shelling out billion after billion to clean up the corporate equivalent of the Titanic?  To draw two analogies:

• AIG Financial Products was like an insurance company that insured against earth quakes but had never actually seen one - they didn't really believe that earth quakes existed, so they considered the risk that they might have to be cover one to be tiny.
• AIG Financial Products was like an insurance company that insured against earth quakes but wrote all of their policies for San Francisco.

Combine these things and you can see how it only took one big earthquake to completely knock them over.

If ever there was a company that made money by picking up nickels in front of steamrollers, AIG was it.

Taxation Without Representation

Being the congenital liberal I am, when people say "we shouldn't nationalize the banks" I go "why the heck not?"  William Isaac provides some good reasons not to nationalize in an interview with Planet Money.  To summarize his arguments:

• Banks need investment to function normally.
  
• Investment is predicated on the bank growing or at least continuing its business.
  
• Banks make money off financial risk.
  
• A bank that's been nationalized has by definition taken on too much risk.
  

And thus the conclusion is unfortunate: the process of nationalizing the bank to lower its risk profile to protect tax payers inherently goes against its normal functioning.

But I sure am wondering whether this is really as bad as the other option: shovel money into the banks hand over fist and hope that this somehow helps us.

If there's just one idea that I think summarizes the entire financial disaster we're in, it's asymmetric risk.    Any time we have a heads-I-win-tails-you-lose game in a financial market place, the resulting behavior from the people involved is 100% predictable, and we have to ask ourselves "why did we make the rules this way."

John Bogle talks a lot in his books about the critical role that owners play in making capitalism work.  The owners of a company have skin in the game - for them, they win when the company wins, but they lose when the company loses (by losing their investment completely).  Contrast with the managers of the company, who win (perhaps to a much smaller extent) when the company wins, but are not nearly as exposed to losses.  If Citi loses $8 billion dollars, Citi's CEO doesn't personally lose $8 billion.  (And stock options don't fix this - stock options are totally asymmetric!  One might argue that they just make the problem worse.)

Simply put, owners are the ones who have skin in the game - they put up money which can be lost completely, so they're the ones who are supposed to make sure that the managers who work for them are not being complete morons.  In Bogle's calculus, one of the biggest problems with America's financial system (his books were written before the crisis, but I think the systemic problems he describes are still fair game) is that today's owners are not keeping today's managers from looting the bank.

Managers have asymmetric a risk-reward situation, so we can't trust them to do the right thing. We need owners with skin in the game to make good decisions.

I can't think of a bigger heads-I-win-tails-you-lose situation than us (the tax payers) saying: "hey senior bank management, we know you need money, so we will give you lots and lots of money.  But don't worry, we won't fire you if you continue to screw up."

If there is one threat to our free markets bigger than having the government come in and derail economic activity via a series of arbitrary political decisions about capital deployment, it's having the government  come in and completely derail economic activity by providing free capital to the management of the largest, least-well-run institutions without imposing on management the discipline that owners must impose.