If You Can't Stand Up, You've Probably Been Fouled

I've been reading the official rules of Ultimate; I realized I didn't really understand the criteria for fouls. And now that I've read them, it's clear that a lot of casual and semi-serious players don't understand them either.

Here's a big distinction that gets lost in recreational play: a general foul vs. a receiving foul. To put it simply:

• If you can't keep playing because you got hit, it's a general foul.
• If you would have caught the disc, but you didn't because you got hit, it's a receiving foul.

The difference matters because the standard for each is different, and the penalties are different too.

Receiving Fouls

First the receiving foul. You're running for the disk, and before you can catch it, your defender crashes into you and knocks you down. That's a receiving foul; you would have caught the disk, but he hit you so you couldn't. If that's the case (and he doesn't contest the foul) you get the disk where you got hit.

Receiving fouls are the ones that people know about, and thus a lot of offensive players think they will get the disk every time they get hit. But here's the rub: in order for the foul to be a receiving foul, it has to happen before you could have made a play on the disk. So if some big guy jumps over me, grabs the disk, and on the way down knocks me over, it's not a receiving foul because at the time of the foul, I had no play on the disk. (This ignores dangerous play, which is a different story.)

The continuation rule also applies; with the continuation rule if there is any violation by the other team, but it doesn't affect the play, and there is a turn, the turn stands. So if your defender checks you, but the throw was just terrible and hits the ground immediately, it's not a receiving foul, and play wasn't affected because the disk was turfed no matter what.

So the moral of the story for receiving fouls: you're only going to get the disk where you got hit if you got hit while you still had a chance to catch the disk. If the disk was not catchable at the time of the hit, too bad. (Delightfully, the defender who hit you can contest that you had a play on the disk; contested receiver fouls go back to the thrower.)

General Fouls

There are a bunch of ways you can get hit and not have it be a receiver foul. But that contact might still be a general foul. If the contact "affects continued play", it is a general foul even if the criteria above for a receiver foul aren't met.

Here's an example that actually happened to our team this weekend: a large man on the other team knocked down a (poorly thrown) huck by our team. After he knocked the huck down, he subsequently crashed into one of our women and knocked her over. Our woman's defender (who was now on offense because of the turn) promptly bolted down field to participate in a score without a defender, while our woman sat on the ground trying to figure out what the hell hit her.

This is a perfect case of a general foul that isn't a receiving foul. The collision happened after the other team grabbed the disk, so our woman's ability to receive the disk was not impaired by the hit; she had no chance of getting the disk at that point under any circumstances. But the hit definitely affected continued play: she was unable to play defense because she had been run over!

This is a general foul, and she can call foul. The key here: while she would not receive the disk (it's not a receiving foul), play would stop! This stoppage of play is critical for allowing fouled players to readjust after being knocked over. Without the stoppage of play, an effective way to play defense would be: hit your opponent away from the disk (no receiving foul), then run deep while they're down. General fouls make this impossible.

So: if you can't stand up, you've probably been fouled. It may not be a receiving foul, and you don't get the disk, but it's still a general foul, and play stops, everyone freezes.

Asset Allocation for Fun and Profit

In my previous post I suggested that commodities speculation was a poor idea and not a good use of retirement funds. But the fact that I think it's a lousy idea doesn't explain why a brokerage like Fidelity would suggest such a strategy. To understand why commodities are being promoted as an "asset class" (and Fidelity is neither the only nor the first brokerage to start pedaling commodities as an asset class) you have to look at what half a century of efficient market theory has done to investing.

Modern Portfolio Theory

To understand anything a brokerage ever does, you have to understand at least the basics of Modern Portfolio Theory. Here's the short version, it's not very complicated.

• Markets are efficient - you can't beat them because they already "know" everything you do. So picking stocks isn't going to get you a better retirement fund. You might as well buy an index of all stocks and keep the fees low.
• If two separate markets have low covariance (that is, they go to hell at different times) that's the only free lunch you'll ever see. By investing in both, you can limit how far down your portfolio tanks. If stocks and bonds go to hell at different times, then at any one time maybe only some of your money is hosed.
• Combine these and you realize something strange: the important question is what types of things you invest in (the "asset class") and in what ratio. The important thing is not the details. In other words, your ratio of stocks to bonds matters a lot, but which stocks you buy doesn't.

MPT dominates the "buy" side of investing (e.g. the institutions that manage people's retirement money) in a huge way. "Lifecycle" funds are just funds that adjust the ratio of stocks vs. bonds as you get older, based on MPT.

Go Off the Cliff With the Herd

There's another boot-print from quantitative finance on the face of investment management. Since the market is "efficient", it's not the place of your investment adviser to try to beat the market. And MPT provides cover for this. If I am in my 30s and my adviser suggests that I should be 70% in stocks, and then the stock market loses half of its value, that's not negligence, incompetence, or a breach of fiduciary duty. MPT says that I have to be heavily in stocks for my risk-return profile. And that investment adviser has a certain amount of cover: pretty much every other investment adviser has suggested the same thing, so "no one could have known".

Unfortunately, MPT strikes me as a difficult approach to long-term investing. MPT "works" based on the historical long term (or sort-of-long-term) relationships between asset classes. But because everyone now uses MPT, the "good ideas" that MPT suggests may not be so good any more since those ideas move markets.

(Put another way: if everyone piles into stocks, the return on stocks isn't going to be very good. But MPT says we should pile into stocks because past returns were good. We saw the bull market of the 80s, we piled in, and in the process we guarantee that we won't have a bull market like that again.)

Look, Fees!

Now here's the problem with MPT from the perspective of a brokerage: it makes it really hard to make any money. If I manage your money, I make my return based on a fee (usually a percent of assets under management for a mutual fund or ETF). But the actual asset classes that I can manage keep moving toward lower fee structures. For example, Van Guard's total market return stock index fund (TMI - this is the ETF I use quite frequently) has an expense ratio of 0.07%. And now (finally) you can get bond index funds with low expense ratios too. BND, another Van Guard ETF has an expense ratio of 0.12%. (This is a huge improvement over the 0.5% you'd pay on bond mutual funds; with only a few percentage of return a 0.5% fee was a huge chunk out of returns.)

Fidelity seems to now be charging me $8 to buy/sell ETFs. So let's review: Fidelity takes $8 to make my purchase every now and then, and Van Guard gets between 0.12% and 0.07& in fees. How does anyone make any money off of this?

To make matters worse, Fidelity can't (and no one else can) credibly come to me and say "you should pay more for this proprietary product" - some magic 'beat the market fund' or the advice to 'stay out of stocks'. MPT says that they can't beat the market and they shouldn't be messing with my asset allocation. So no way to add value there. (Heck, if they did come up with a product that went against MPT and it tanked, they'd probably get sued.)

And now we have enough pieces to understand my cynical view of commodities investing. Currently "buy side" money management companies have only two asset classes to sell (stocks and bonds) and the margins on those products have gotten very, very low. But if they can invent a new "asset class", investors would nearly have a mandate to buy it (due to MPT) and while the market is fresh and new, there's still a hope of raking in fees.

A quick screen of commodities ETFs shows expense ratios from 0.3 to over 1%. And ETFs are usually the cheapest investment vehicle available to retail investors.

In summary: it has become to save for retirement very cheaply. Commodities investing isn't necessarily a good idea, but because it's a new market it's still profitable. Investment advisers have to make the case that commodities are an "asset class" in order to justify selling commodities funds to investors.

In all of this discussion I have not mentioned gold. That is going to have to be the last (and separate) part of this rant. Buying oil, coal, grain, or copper - that's commodities speculation. But buying gold is something very different, and in my opinion, even more loopy.

You Too Can Be a Commodities Speculator

If there is a magic to investing, I believe it is this: on average, investing is a game of chance where you win more often than you lose. This is because underlying a quality investment is a business idea or a use of resources that produces more than it consumes. If I provide capital to a business (whether buying stocks or bonds) that business might be able to grow and add value. Thus my investment isn't just a zero sum speculation where I hope to guess better than others - it's a chance to create something new.

Of course, that's not really true if you are a commodities speculator. I received this note from Fidelity the other day. The idea is pretty simple: if you're a long term investor, you should have some exposure not just to stocks and bonds but also to commodities.

The problem: it's a terrible idea. Commodities "investing" isn't investing at all. It is speculation. You are making a bet that commodities will be more expensive in the future. That's the only way you will make any money. A business borrows money and pays interest because they believe that what they can do with the money will generate more cash flow than the interest payments. A business issues equity (stocks) because they believe that they will be able to retain earnings (that is, make a profit that will belong to the stock holders) or pay dividends to the stock holders.

What kind of a dividend does a barrel of oil pay? What interest rate do you get on a bushel of wheat? Here's a hint: zero. Commodities "investing" strips away the "investment" part of investing and leaves only the speculative component.

Hoarding

The traditional way to invest in a commodity is to hoard it - that is, to buy a claim on production of that commodity and then sell it later when it's worth more. It's hoarding, plain and simple. When you buy a bond, your capital is temporarily useful to someone else - you are making available capital more plentiful. When you hoard a commodity, you're simply taking away from everyone else.

And this brings me to my first major concern about commodities speculation via hoarding: it bites back. If enough people hoard enough of a commodity, the price rises (through increased demand) and one or two things happen:

1. Suppliers of the commodity increase production, anticipating support form higher prices. (E.g. oil producers start drilling more wells.) This increases supply, which will lower the value of your hoard.
   
2. Real users of the commodity find alternatives to using the commodity. (E.g. cars become more fuel efficient.) This lowers demand, which will lower the value of your hoard.

In other words, the value of your commodity is influenced in the wrong direction by your interference in the market. And most commodities markets are quite small relative to capital markets; when investors all decide they want to buy oil, they overwhelm the actual users of oil.

It Takes Two To Contango

The second concern is the cost of hoarding. Even if you do want to hoard, how do you do it? Most ETFs don't stash commodities in a warehouse because that's expensive. Instead they buy forward contracts, which require them to buy the commodity in the future. When delivery time comes around, they then sell the commodity (at the price for the commodity with immediate delivery, called the "spot price") and buy a new future, "rolling" the commodity contract. By doing this forever, the ETF can claim a commodity without ever having the real materials show up.

The problem with this is that the price of the futures contract and the "spot price"aren't the same. If the spot price is lower than the futures price, the market is in "contango". Let's review that transaction. Once a month the ETF sells at the spot price, buys at the future price and...uh oh. We're losing money with every transaction and making it up in volume.

There are some good reasons for commodities markets to be in contango - in particular, if a ton of investment money is trying to roll futures contracts, the increased demand for futures and supply of spot is going to drive the market into contango. The gain or loss is called "roll yield" and it's been negative for a while, since so many "investors" decided to speculate in oil a few years ago. Even if your speculation is correct, making the profit minus roll yield might not be much fun.

A Lot To Pay For Stock

Fidelity suggests a series of mutual funds with exposure to commodities. The letter specifically quotes the manager of the Fidelity Global Commodity Stock Fund (FFGCX). This fund hasn't been around long enough to look at its correlation and beta, but there is one statistic that sticks out to me immediately: the 1.42% expense ratio. (Fidelity has been generous to subsidize the fund to get the expense ratio down to only 1.25%. Great.)

The other funds have expense ratios of about 0.9%, betas greater than 1 (meaning they are more volatile than the whole stock market) and R-squared of about 0.5 (meaning that when your stocks tank, they're going to tank a bit too).

Basically you're paying higher fees to buy volatile stocks that will still take a hit when the market tanks.

In summary, investing in commodities:

• Isn't really investing at all.
• By its very nature forces down the commodity you are investing in.
• Costs real money just to speculate.
• Is still expensive when done via corporate exposure (which isn't even a direct play on a particular commodity).

But I don't think that any of this has to do with why Fidelity is advocating commodities. I'll explain what's really going on here in another post.

The Global Economy, Explained

It's not so complicated...

It's Supposed To Be "Exciting"

Bloggers seem concerned about the temporary 1000 point drop in the Dow last week.

I don't think this price move changes anything. But it does remind us of something:

If you need your money back tomorrow (or really any time in the next few years) stocks are the wrong investment vehicle.

The day-to-day price of stocks is anchored in...well, it's not anchored at all. Stocks can fall indefinitely.

So my argument is this: any investment scenarios that are no longer appropriate for stocks (now that we "know" that the market is highly volatile) were never appropriate in the first place.

Having a 30-year time horizon for stocks implies that you can wait out the kind of excitement we're seeing.

The Limits of Imagination

Hrm...

BP just couldn't imagine that their equipment could catastrophically fail and dump 200,000 barrels of oil a day into the gulf.

Citigroup just couldn't imagine that their super-senior CDOs might lose value.

From now on, I am not going to free up the memory I allocate. I just can't imagine X-Plane running out of memory.

Rational Actors: What We Knew

I have blogged in the past on our decision to rent our house out (rather than sell it) and just a little bit on the ideological food fight over human decision making going into the crisis. Before the crash, did lenders and home buyers act rationally (according to perverse incentives) or did they simply lose their minds? I can only provide insight into one tiny transaction within the housing boom, the one I was involved in.

Why did we buy the house? What were we thinking? In hindsight it is clear that the correct decision would have been to defer buying the house to avoid the 25% decline in asset valuation. But when we bought in 2006* (near the top of the market), what did we know?

• We knew we wanted a house. We were old enough, and had rented for long enough that we wanted to try it the other way.
• We knew that we would have to live in the house for at least 4 or 5 years just to break even on high transaction costs related to housing purchases. We had no intention to sell the house on a shorter time frame. (In hindsight we ended up leaving after 4 years - a bit earlier than expected.)
  
• We knew the house was unlikely to appreciate in value. We were aware that the rent-to-mortgage ratio was pretty far out of whack, and we believed that house prices couldn't really go up any more. In other words, we had no speculative interest.
• We "knew" that high housing prices were sustainable. Before Washington DC, we had lived in Boston, and I had worked in San Francisco, two markets with sustained unusually high housing costs. So it didn't seem implausible to us that in the suburbs of Washington DC, housing prices could simply remain high.
• We knew that we could get decent financing with a manageable fixed long term interest rate, and that this was desirable. We put down a very large down-payment. We had no expectation of strategic default at all.
• We knew that there had been rapid turn-over and price appreciation (a "boom") in the housing market over the last few years, with crazy things going on (bidding wars, no inspections, etc).
• We knew that there were tax incentives to pay a mortgage rather than rent, and we could do a monthly-cost analysis to show that we'd get a reasonably good deal (in terms of monthly payment) despite rent-to-mortgage ratios.
  

We did not know that underwriting criteria had so totally fallen apart; stories of NINJA loans and liar loans were not mainstream and the Giant Pool of Money was two years away. And we had no idea why Wall Street would make loans that would not be repaid (nor did we realize that this they were doing such a thing).

We also did not think that Washington DC was likely to suffer a real-estate bust they way Texas did in the 80s; it seemed that the government was hiring lots of people and would keep on doing so and that the housing build up was reasonably permanent, similar to other high-priced east coast cities. The notion of a nation-wide, rapid, steep housing crash wasn't on our radar; we didn't recognize that the volatility in housing prices we were seeing was, in fact, real volatility.

So putting it all together: our purchase of the house was not speculative. We expected flat home values and tolerable expenses, and we were willing to accept that to not rent. We had no sense of the price volatility that a house might display.

Better Late Than Never

I started reading finance books after we bought the house; before the house purchase, my strategy was "save money for the house." It was only after the house down-payment was paid for that I started to ask "what else to save for."

So one of the questions I have to ask is: had I read all of the books first, would we have avoided buying the house? Upon writing up our assumptions, I think the answer is "no". In particular, simply making a case that houses are tied to interest rates and interest rates can be volatile would not have scared us off. Houses are illiquid and expensive to sell, so we would have expected a rate spike (even a serious one) to only slow the market down, not murder it. The missing piece of information was the huge exposure to ARMs and deteriorating lending quality. It's not that this information wasn't know-able back then, it's that we didn't know about it.

If you want to categorize this transaction, the best label is probably "information asymmetry".

* This is not meant to be a "cry-me-a-river" post regarding the house; we are very, very lucky that we were able to absorb the loss without having to put our career and life plans on hold. Many others are not so lucky.

Too Big To Fail? I'd Be a Fool Not To Invest!

The question of what caused the housing and banking crisis we are now in* is more than just an academic question - the root causes have profound implications on what we might change to avoid doing this all over again in 2020. There are a number of schools of thought on what made bankers do what they do: were the banks the dumb money, did they knowingly dig a hole, or were they pushed in the direction they were pushed by the structure of the system?

Jeffrey Friedman refutes the notion that bankers acted irresponsibly because they knew they were too big to fail. This is probably true. (I would argue that they acted irresponsibly because they'd make huge amounts of money in the very short term for doing so.) But the entire issue is a bit of a red herring; the problem with Too Big To Fail isn't that it makes bankers do stupid things; the problem is that it makes investors do stupid things, and it forces us to pick up the bill.

There are two fundamental problems with really, really big banks:

1. They are so big that we don't have a practical way to disassemble them if they go bust. The FDIC does a great job of taking apart small banks. But this process won't scale up to an institution as large as Citi or BoA. See Simon Johnson's comments.

   So the first problem with TBTF is that should a TBTF bank go bust for any reason, we're going to end up picking up the bill with a giant bail-out. It doesn't matter whether the banks sink the bank intentionally; unless you believe that bankers are infalliable and will never screw up, you have to recognize that TBTF is hazardous to the well-being of the American taxpayer.

2. Even if the bankers aren't counting on a bail-out, the bond-holders may be. If there is a lesson to be learned from this crisis, perhaps it is this: BoA and Citi's debt is safer than that of smaller institutions because BoA and Citi can't be put into bankruptcy or liquidation due to their enormous size. Therefore if they do fail, a bail-out is a more likely solution than liquidation.

   The problem with this is that this is going to make their debt less risky to bond-holders; private investment will be directed toward these large institutions because of their "structural guarantees" (that is, they are so huge that their disposal in the event of disaster is going to be in the form of a bail-out, not a liquidation). Thus they will have cheaper funding (since their debt is less risky) than smaller banks, and thus they will be more profitable, crowding out otherwise more fit competition. (And you thought there was no economy of scale in banking?)

In summary, my problem with TBTF is not that it caused the crash; my problem with TBTF is that it caused me to get stuck with the bill, and it's going to make the next crash more likely.

The Democrats talk about regulation, and the Republicans talk about ending bail-outs, but I am waiting for either of them to do what would really make a difference (but go directly against a huge stream of lobbying dollars): break up the biggest banks into smaller pieces. Too Big To Fail is just Too Big.

* Some insist that it is strictly a banking crisis - those of us who have lost significant value on the houses we own, or are in some other way connected to reality, think otherwise.

Rent This House - Pay No Tax

In past posts I have tried tried to describe the math behind keeping the house as a rental. Main points:

• Consider all expenses when calculating whether rental pays. Property tax is a big one!
• Consider return on equity; if you have equity, you need to earn more than you would by selling and putting the money you get in a bank. (Of course, the banks will give you 0.0001% now, so that may be moot.)
• Consider high transaction costs - it's just not cheap to buy and sell real-estate. In our case, we considered the market dislocation as driving up transaction costs (in that we'd have to have the house on the market for a while).

Well, it's April and the tax man is upon us.* Here is what I have learend:

1. Losses on the rental property (there are a lot of up-front expenses; since we rented in October we're definitely in the red against those up-front costs for 2009) do not lower taxes on your regular work-type income. So we just "carry the loss forward" - that is, we can use our loss to pay less taxes next year if/when we make some money on the house.
2. We have to depreciate the house - that is, we claim for tax purposes that it loses about $3000 of its value as an asset every year. This produces another "loss" for tax purposes.

If we have a good year with the house, we will still make less than $3000 in profit, so it turns out that due to depreciation, we will probably never have to pay taxes on the house.

To explain this second point in more detail: think of your rental house as a business; the business "buys" a house and thus has an asset. The IRS requires you to treat that house as losing value over 30 years. (This is silly because you will almost certainly be able to sell your house for more than $0 in 30 years, but hey, I only work here.) Your business recognizes a "loss" every year of a little bit, and thus you are less profitable to the IRS than you are in real life. (Clearly you didn't lose any real money to depreciation.)

There is a flip side: when we go to sell the house, the price we paid will be lowered by all of that depreciation. We paid $400,000 for the house (plus closing costs), so the odds of us making money on selling the house are approximately zilch. But for tax purposes, the price we bought at will appear lower for every year of depreciation.

(The IRS calls this "recapture" - the idea is that we really did think the house was trending toward $0, so when we actually sold it for more than $0, we were surprised that we made that unexpected money. Again, this strikes me as very silly indeed, but I'm not in charge.)

The final piece of the puzzle: if we have accumulated "losses" with the IRS every year (it's possible, because depreciation will be larger than our profit margins) we do get to use those losses against selling. So when it finally comes time to sell the house, the taxes on any gains (should they, due to some freak accident, exist) will be made larger by depreciation but smaller by losses carried over.

Does this affect the net calculation of whether it pays to rent a house out? I don't think it really matters substantially. It does change all of the numbers a little bit, but the way I see it, there are enough unpredictable factors (how long will you be renting, what will future interest rates be, what will the rental market bear) that the unknowns dwarf the imprecision of calculations done without correct tax treatment.

* You should really not treat anything I say on this blog as professional advice. The best thing to assume is that I am a computer programmer who is woefully under-informed in financial matters, because, well, I am a computer programmer who is woefully under-informed in tax matters.

Come On Man...Everyone's Doing It

This American Life has some of the best long-form reporting on the financial crisis. In particular, normal people like us have a prayer of understanding what happened.

Their latest story coveres the Magnetar Trade. Depending on who you believe, Magnetar either bet both for and against the housing market (that would be Magnetar's view - they were just doing their jobs and "hedging") or they created particularly crappy CDOs just so they could bet against them (that would be ProPublica's view).

You can understand the Magnetar trade like this:

• You put 5% down on a house.
• You come to me and ask me to put in 95%. This is an equity sharing arrangement, not a loan; that is, I will own 95% of the house, and you will own 5% of the house. I am nervous; to entice me, you say that you'll eat the first losses if the house value goes down. (In other words, you are enticing me by offering up your 5% investment as some kind of "price protection".)
  
• You take out fire insurance on the entire house.
• The house burns down. You lose your 5% up front but collect the entire insurance payment. I'm out my 95%.

The claim against Magnetar is that they requested the house be built out of matchsticks - they requested that the CDOs be built as badly as possible. This implies that they expected return on their insurance payment, not their initial small investment.

To look at this another way: in order to take insurance out on the house, Magnetar needs the house to be built. They put up their 5% money to lure others in. (Come on man, come invest, everyone's doing it, we have our money in.)

There are two separate sets of losers from the Magnetar trade:

• Whomever bought the end CDOs that lost value (burned down) lost their investment.
• Whomever sold the insurance to Magnetar lost money when they had to pay out.

For the end CDO buyers, ProPublica lists some of them, and I can't imagine they won't sue. In particular, I would expect them to sue the investment banks that built the CDO with Magnetar's money. The problem is that the banks building the CDOs may simply have been stupid.

(It is a certain special kind of stupidity of course, one that earns the banks lots of up-front fees. The problem that the bank can take your money, lose it all, earn a fee in the process, and not be considered criminals is a topic that will have to wait for another blog post.)

I don't know who sold insurance to Magnetar, but it may have been a similar group. Wall street banks can turn insurance into synthetic bonds. (This post by Felix Salmon may help explain how this works.)

The real problem here is: I don't see how we'll ever really know what happened; since Magnetar is a hedge fund, they're not required to disclose who they traded with, and they're not offering up a list of trades to prove their claim that they were not hoping to burn the house down. Since Magnetar is quite successful, there won't be an autopsy. (Compare to LTCM, which failed in 1998 and is now described in detail in dozens of financial history books.)

I'm Only Happy When It Rains...

On On the Media, Adam Davidson describes the difficulty of explaining anything financial on the Planet Money podcast. And this has to be a concern to all of us for a simple reason: we (the tax payers) got totally looted this time around, and if we can't even understand the arguments about how to fix the problem, Congress isn't going to "fix" the systemic problems in our financial system in a manner that works out well for us. Simply put, if we can't understand it, we're going to get looted again.

So what do we do when we find explanations like this? Friedman is arguing that people buying homes at of market were acting rationally, the bankers weren't acting irresponsibly due to their paychecks, and that regulation, not deregulation caused the crisis. His arguments are more nuanced than I am describing; I am phrasing them a bit more bluntly to draw out how ludicrous they are. Mike Konczal takes apart point three here.

But can we even understand what they are arguing about? What are these capital minima, and why do we care?*

Rainy Day Funds

As part of our personal finances, we maintain "rainy day" money - that is, money that just sits in a boring old FDIC insured bank account for the sole purpose of having money on hand if something bad happens, like I lose my job or the car gets hit by a meteorite.

Now we have a friend, let's call him Joe. Joe has a good job that pays a lot of money, and Joe has expensive taste. He pays for his car, mansion, caviar, champaign, and Armani suits using credit cards, mortgages, car payments, etc. In other words, Joe has a ton of debt, but he also has strong cash flow coming in to pay that debt. He swears he has the situation "under control".

Joe has a rainy day fund too! But...his rainy day fund is only $5000. We keep telling Joe "that's too low". What if something happens?

Unfortunately Joe's high paying job was in banking, and he was laid off last year. The $5000 of rainy day money wasn't even close to being able to absorb the avalanche of debt he was faced with. In fact, it got a lot worse; since his house went down in value, he can't sell his house to make back the money he owes on the mortgage. Clearly $5000 wasn't enough.

Rainy Day Funds for Banks

You can think of reserve capital as rainy day funds for banks. Every time a bank makes a loan, they are required to put a little bit more money into the rainy day fund, just in case the loan goes bad. The Friedman and Konczal are arguing about what effect the government minimums on the rainy day fund had.

Konczal's argument is an important one to understand, and it is basically this:

• If banks are going to have the minimum rainy day funds the law will allow, then banks are trying to live on the edge, and the law has to assume that bankers are crazy.
• If banks are going to have larger rainy day funds than the law will allow, then you can't blame the law for being "too lenient" because the bankers are choosing their own (larger) rainy day funds and thus it is the banks own decision that is right or wrong.

In other words, you can't claim that banks are grown-ups who can manage their own finances and then blame the law when banks fail.

This begs a question: why wouldn't banks set up larger rainy day funds to avoid failing? The answer is that banks profitability is measured relative to their rainy day fund - that is, relative to their capital base. Thus the closer to the edge a bank runs, the more relatively profitable it is as a business.

I would argue that there is also assymetric risk (something that deserves its own post). Basically if the bank is more profitable, the bankers might get higher pay, their stock options might be worth more, they might get a bigger bonus pool. But if the bank fails completely, once the bank is bankrupt, life doesn't get worse for the bankers if it is more bankrupt. If the bank fails gently (is insolvent by $1) the result is the same for the bankers as if the bank completely implodes and needs a huge taxpayer bailout.**

One more thought: while I think Konczal is right to point out the flaws in Friedman's logic regarding regulation, I consider the capital requirements (rainy day arguments) a little bit silly; the rainy day requirements that would have been necessary to keep a bank functional in the face of the crisis at hand now would have been so high that anyone suggesting them would have laughed the idea out of congress or the boardroom. The requirements would have been too large for banks to function at all.

The heart of the problem isn't banks having inadequate reserves for a crisis, the heart of the problem is the banks making an astounding number of loans that will never be paid off. It's the equivalent of Joe buying the state of Florida on his bankers salary; no amount of rainy day savings is going to protect against that.

* Regarding whether bankers who made money by doing deals regardless of whether they failed may have had incentive to do stupid things, and the mentality of home buyers in 2006, I'll leave that to you to judge - human nature is what it is.

** That result under Bush and Obama appears to be that the bankers get to keep their jobs, which is astounding.

So...How Did We Get Here?

Housing wise, it's been a good four years. Let's review:

• Housing prices are down about 25% where we used to live, more so in less fortunate parts of the country.
• The economy is on its ass, with high unemployment and poor growth.
• Interest rates for consumers are very low - if you have money in the bank, you're not getting much for it.
• Credit for businesses is hard to get, see also poor growth.
• The Federal Bailout Agency^H^H^H^H^H^H^H^H^H^HFederal Government has spent all kinds of money on the crisis* so when we come out of all of this, our national total national debt is going to look at lot more like Italy's than it used to.

You might ask yourself: how did I get here?

Let's trace backward. The problems we have today come from two sources:

1. The results of a housing bubble. The housing bubble represents a massive mis-allocation of resources. Simply put, we spent the Bush years (I don't want to call them the "oughts") building houses we didn't need; this hasn't set us up for future growth, rather it was squandered investment.
2. The bursting of a credit bubble. There's a lot less credit than their used to be, which makes it hard to invest in new growth.

These bubbles are actually interlinked; since most people finance their houses, house prices are tied to housing credit (that is, cheap mortgages). So really we had a mortgage bubble that is now hitting us twice: it hurt our real economy by misdirecting investment into houses, and it hurt our banking system by creating a lot of bad debt.

How did we end up with a mortgage bubble? The answer to that is: financial alchemy.

Simply put: Wall Street banks discovered that they could turn lead (sub-prime mortgages and other low quality debt) into gold (AAA-rated CDOs) because the credit rating process wasn't very good. Banks could stuff their securities with "thin file" borrowers (borrowers with a good credit score but short credit history) and low-score borrowers and the average was good enough for the pool to be acceptable.

Wall Street made money on these transactions from the difference in the cost of raw materials (crappy mortgages) and the price of the finished product (high-grade AAA debt). This explains the strong pressures for lower lending standards: the worse your mortgage, the less the bank has to pay to buy it; if they can still manage to turn it into a CDO, they make more money by lowering their cost of supplies.

You can think of this as painting lead bars in gold paint because the gold inspector only looks at the bars, rather than testing them more carefully. Get the cheapest lead you can to make the most money when you resell your fools-gold.

The banks building these CDOs would have done quite well by this strategy except for one problem: they kept their own defective product. In trying to answer the question: were they malicious or were they incompetent, this pushes me to suspect gross incompetence; if you know you are making a truly defective product, the last thing you want to do is keep it. If nothing else, I think the CDO losses being eaten by the major banks indicate that they didn't realize the scope of the mess they were making.**

So to summarize: Wall Street discovered they could make money by financial alchemy, and the raw material was housing debt; this demand for housing debt as raw material drove down the cost of financing and thus drove up the price of houses, which caused a building boom. (You gotta love how commodities markets react to prices.) When the whole thing fell apart, we're left with too many houses, too much bad debt, and not a whole lot of money. Not a whole lot of money unless, of course, you received bonus payments for creating CDOs.

* I am very critical of the Fed and Treasury's handling of the crisis, which I think has created moral hazard and burned fiscal and monetary resources without either fixing real problems for "main street" or addressing any kind of long term problems. This approach has been consistent under both Bush and Obama.

** This doesn't make their actions even remotely acceptable; but I think the issue is important when we consider how to prevent this from happening next time. Regulations to stop "bad guys" aren't going to help; we need regulations that stop the amount of damage that can be done by "dumb guys who have our money".

Why Did We Keep The House?

(I am just now finishing up this post, which I realize has been sitting half-written for months now.)

In my previous post I tried to at least enumerate the costs of renting the house rather than selling it. The rent checks have to cover not only the mortgage but also property tax, maintenance, and return on equity.

(That last one is often overlooked: if you somehow still have positive equity in your house, then if you don't make at least some profit from renting, you're missing the money you would have made by selling and gaining interest on the cash you'd free up.)

And the short answer is: we are probably slightly behind when renting - that is, the cost of property tax, maintenance, mortgage, and a conservative return on equity* are more than the rent minus property management commission. (With the initial costs of getting the house ready, we're definitely behind but that's perhaps to be expected.)

So why did we keep the house? The short answer is: selling it would have been a lot uglier.

Before going on to the specifics, I have to rant about real-estate agent fees. The transaction costs to sell a house are 6%. I can't come up with words to describe how obscene that is. (Even if I could, I'm told that my mother is linking to this blog for the pet pictures, so I'll keep the language tame.) If you had a stock or bond that had a 6% commission to sell it, you'd throw it straight out the window and never look back.

(Wait - mutual funds did have commissions - these were "loaded" mutual funds, and had something like a 5% fee to buy in. They've gone the way of the dinosaur.)

Unfortunately with housing we're still stuck with high transaction costs - any strategy for managing housing investment has to take them into account. I don't think that FSBO represents a great way to save on transaction costs - if we announce FSBO, we probably have to accept buying agents, and even then we're going to get low-balled because the buyer knows we aren't paying that 3% on our side. For transactions to become more affordable, the cost structure needs to decline across the entire industry.

Besides the high basic transaction fee to sell the house, there was another factor: time on market. At the time of the decision, there were almost a dozen short sales in our neighborhood, many where the house was the same layout as ours. The short sale price (yes, many won't sell at all at that price) was perhaps $20k to $40k below "market", which was already really low.

Would we have been able to sell at market by waiting? Well, having let this blog post sit, we now have a historical data point. Our neighbors have been trying to sell their house. Personally I think they have over-priced it (it's easy to call your neighbor's house over-priced, hard to call your own...) but the operative number is over 200 days on market, or over $10,000 in lost rent.

With the great options of fire-selling (at least $20k loss), leaving the house on the market (at least $10k loss) and paying at least $15k in transaction fees, selling didn't pay.

Executive summary:

• We "make the mortgage".
• While this feels good, the net return on the house is probably a loss, when you go account for everything.
• The specific losses to selling in this environment would be worse.
  

* How do you know how much "return on equity" you should be getting? One simple way to figure this is to ask what you'd get back if you put the money somewhere else. I would suggest a conservative proxy, like: what would you get in an FDIC-insured savings account. It isn't fair to compare return on equity to a highly volatile investment like stocks. Sure you aren't making 6% on your housing equity, but then it is unlikely to plunge by 50% one year.

Who Drank the Spicy Soup

So there is one remaining question to answer: who drank the spicy soup? If the effect of securitizing all of this mortgage debt was to create more risk than we could handle, who ate that risk and ended up with a case of indigestion?

To quote top gun, the list is "long and distinguished". (Wikipedia has a chart but I'm not convinced it is accurate.

First: the investment banks.

• Lehman and Bear Sterns dropped dead. While their losses weren't huge, they didn't have the capacity to sustain much damage either.
• Merrill Lynch lost the most - almost $30 billion. I'm sure Bank of America feels good about that purchase. ("We want to be just like Citi - flat broke!")
• Goldman apparently didn't lose anything, although Goldman's financials can be opaque at best. They shorted the market at the last minute to offset losses - on the other side of that bet: AIG

Of course if the Wall Street investment banks are dumb, you know someone has to be dumber.

• UBS managed to lose $37.7 billion. They were one of the big suckers at the table.
  
• Citigroup lost $39.1 billion - their strategy of creating toxic waste, then keeping the toxic part didn't work well.
• Bank of America lost $7.95 billion. I believe this is the losses they earned the hard way, not the losses they "bought" by buying Merrill before Merrill's losses were fully disclosed. Note that they also own Countrywide - clearly BoA has a talent for aquisition.
  
• Washington Mutual and Wachovia both went under and were sold off (to JP Morgan Chase and Wells Fargo, respectively).
  

Finally we have the insurance companies. Since insurance companies "sit" on your premiums while waiting for something bad to happen, they are natural buyers of securities. Some insurance companies are crazy enough to try to insure financial products. Both MBIA and AMBAC had multi-billion dollar losses, but the big whale, the big sucker at the table was AIG, who have lost over $100 billion dollars since the crisis hit. Don't worry, though, you and I have their backs.

If you want a short list of suckers, basically it's:

• AIG, who bet wrong on sub-prime for the first half of the housing boom.
• Citigroup and Merrill Lynch, who were dumb enough to keep their own toxic waste. (Bank of America has managed to buy plenty of sick companies, so Citi and BoA are now the dynamic duo.)
  
• UBS, who bought toxic waste late in the game.

Of course, the real sucker is you and me, because it's our tax dollars bailing out AIG, Citi and BoA.

Synthetic CDOs: I Punch You In the Face

This is where my tortured analogy of spicy soup dies: the synthetic CDO. Let us recall:

• Tranched bonds (like mortgage backed securities): spicy soup that has been allowed to settle. Some people buy spicier soup for less money.
• CDOs: let the soup settle again so we can divide it up yet again - a way to try to recover a little more value from the spicy soup.

Now here's where we have to break from reality. In real life if you buy that really spicy bowl of soup and drink it, your mouth is going to be on fire. No one else's. You drink it, you burn. We can't get away from that.

But in the world of finance, pain comes in the form of losing money. This means...pain can be transferred. It's not impossible to set up a deal where you drink the spicy soup and someone else's mouth feels like an inferno.

(Hrm...that might be a really good deal. Remember, the spicier the soup, the cheaper. So you could get cheap soup and someone else hurts like hell...hrm...)

That is the synthetic CDO. You get paid a little bit, and your mouth hurts like hell when someone else drinks the soup. It's as if we have a side agreement that if I drink the soup and it is too spicy, I can punch you in the face.

To get more technical:

• Normally I get paid interest by taking a little bit of risk. I get more interest for more risk.*
  
• Normally the way I take this risk is by loaning someone money. The risk is I don't get paid back.
• For a CDO, the whole thing has been through a blender. (Hard to spot those Wall Street bankers taking fees with all of that blending!)
• For a synthetic CDO, you've got my back! I loan some money out, and you take the risk of me not getting paid back. If I don't get paid back, you pay me. I give you a bit of my interest to convince you that this isn't the worst idea ever.

For me, the synthetic CDO lowers my risk (I will get paid back no matter what) and it lowers my return (since some of my interest money has be used to pay you to take this insane gamble).

For you, you get paid a little bit now and you might have to pay me later. If this looks a lot like an insurance policy, that's because it is. You're insuring me against the loss of my loan. In real life, a synthetic CDO might be built out of Credit Default Swaps (CDS), which are just that - insurance on a loan or bond.

With a synthetic CDO, we've separated the party drinking the soup from the party getting burned. What are the implications of this?

1. I still get some interest, even though you took the risk of not getting repaid. Wha? Well, not getting repaid is not the only risk of a loan. I could make a loan at a low interest rate, then interest rates shoot up. I lose out on the chance to make a loan at a higher rate. This is "interest rate risk" and I still am exposed to it even though you insure me against a total loss. So by selling you this synthetic CDO, I got rid of some of my problems, but not all, and I got rid of some of my return (interest) but not all.
2. Since I get repaid no matter what, I can now loan money to just about anyone I want. Uncle Joe likes to place bets down at the track, but I don't care. If he can't repay, you've got my back.
3. I can only loan uncle Joe as much money as I have. But you, you've got a very different situation. If you have my back, you don't have to put up any money right now! You only owe me money if Uncle Joe doesn't make book. So you could insure me against a bunch of loans without actually having the money!** This would be profoundly stupid of you, because I'll have to break your knee caps (and me, because how are you going to make good on the loan if you have no money and no knee caps) but not impossible.

Of course, item 3 is precisely what AIG did - they told Goldman Sachs they'd make good on loans Goldman had made if the debtors went under. AIG didn't have enough money on hand to actually pay off all of the loans. How did this play out?

1. AIG goes bankrupt.
2. We (the taxpayers) bail them out, giving them lots of cash.
3. They use the cash to pay back Goldman, whose original loans have not paid off.

Well, that worked out well, didn't it.

The astounding thing is that AIG wasn't required (and still isn't) required to record in their financials that "in the event of a bad day, we will owe Goldman Sachs a crap-load of money."

If it seems astounding stupid that you could possibly owe someone a gajillion dollars and go around pretending that you don't have a burden on you, well, it is. A good start to financial reform would be to require such obligations to be recorded on balance sheet.

* This is a little bit surprising to normal people because the most basic savings vehicle, the bank savings account, has no credit risk because the FDIC has your back if the bankgoes under. But then that savings account isn't paying much interest is it?

** To be clear: you can sell a credit default swap without having the full amount of money to cover the loss. That's the AIG case. When the insurance is packaged up in the form of a synthetic CDO, in theory the principle of the synthetic CDO should be equal to the amount we might lose. Thus the worst case is losing all of the synthetic CDO. That's why it's called a synthetic CDO - it looks just like a CDO in that it earns a little bit of "interest" and in the event of a bankruptcy loses all of its principle - just like a regular loan.

CDO Soup

We can understanding tranching via soup - it's the uneven distribution of risk and reward in a financial, um, mixture.

So what the hell is a CDO?

Well, recall in our soup example, we let the soup settle and ladle off the "really hot stuff". We can then sell spicy soup as not-so-spicy because we've put a disproportionate amount of the "hot stuff" into just a few bowls.

What do we do with the left-overs - those few bowls of soup so hot that no one can drink them?

Well, if you're Wall Street, this is what you come up with:

We'll just let the spicy soup settle for a day! Then we'll come back and it will have settled into: a really goddamn spicy bowl of soup at the top, and the rest will be drinkable. We can sell that.

That's a CDO*. We cut up and unevenly divide the remnants of what we already cut up and divided.

And if really want to push it to the limit, we'll take that settled soup and we'll let it settle again (no, really!) and try to ladle off some of that as a CDO-squared.

And if we really want to...oh wait, the whole financial system blew up. So much for the CDO-cubed.

* Technically a CDO is a tranched mixture of any pile of underlying stuff, but the ones that have gotten us in trouble are the ones that are a cut up mixture of mortgage backed securities.

Really Spicy Soup

In my previous post I tried to explain tranching via a soup analogy - you take the spicy soup and ladle it out unevenly so some get more spicy hot paste and some get less. This does leave a few questions unanswered.

Why the hell would I ever drink the bowl with all of the hot sauce?!?

The answer to that is: it's cheaper. If you and I were splitting the cost of take-out, maybe I pay for 2/3 of the soup and you pay for only 1/3rd. That's only fair, because you're going to take all the heat, so to speak.

Tranches are the same way - the tranches with an "unfair" share of the risk also return higher interest. So...do you feel lucky, punk?

Tranching is just dividing up the hot sauce - how does this affect the system?

One of the effects of tranching is to bring players into the market who might not normally buy in.

Let's consider my mother. My mother will not eat spicy food. Her spice tolerance is really, really low. If we have her over for dinner, we're not going to buy the spicy beef soup, even though it is very tasty.

But wait -- if we just tranche it, we can buy the beef soup! All Lori and I need to do is not stir it up and serve the first bowl to ourselves, taking all of the hot paste to ourselves. The remaining soup is quite mild, and my mother, who normally would not be able to drink it (if it were evenly mixed) will be able to drink the remaining tasty broth. She'd probably like the beef ribs too.

If you are the Korean restaurant, this is a hell of a discovery - you can sell a lot more soup now, because you can sell soup to everyone, not just customers with a taste for spicy food.

There's just one hitch: you have to convince a few people to drink that first bowl, the hot bowl, the one with most of the spicy paste. I have had that bowl, and let me tell you, it's an experience!

Motivation to Lie

Now before I continue, I must be clear: the Westborough Korean restaurant has never lied or misrepresented the spiceyness of their food. They have never suggested that we not mix the soup, and they have never suggested that drinking the first bowl of unmixed soup would be a smart thing to do. Our discovery that the soup will "tranche" itself happened by accident, and this whole post is just a (badly stretched) analogy.

So if I can sell more soup by letting it settle (so the less spicy part is palitable to a wider audience), I might find that the limiting factor is finding people to drink the first bowl. Sure the first bowl might be cheaper, but how else can I sell it?

• I could simply misrepresent how spicy it is. When someone asks me: "will I roll over and scream in pain if I chug the first bowl", I'll just answer "oh no - it's spicy but it's not that bad. You'll be fine." This isn't a very good idea - my customers might get angry at me for setting them up for pain, but that'll happen tomorrow, and I want to sell soup now.
  
• I could agree to drink the first bowl myself if no one else wants it. This is a damn stupid thing to do because I might have to drink the soup, but again, I want to sell soup now.

That is pretty much what Wall Street did: they got the ratings agencies to represent the more dangerous tranches as "not that bad". In some cases, they agreed to buy the tranches back, or they kept them for themselves, a move that has caused them to lose a lot of money.

Those stupid bankers...how could they be so dumb? Oh wait - they made bonus money when they sold the tranches. And...wait - we (the tax payers) are bailing the firms out now that they're in pain. Maybe we're the dumb ones.

Subprime Soup

I'm a huge Michael Lewis fan, and his interview on Fresh Air is a good one (as is his 60 minutes piece).

The Planet Money team recently bought their very own toxic asset. They look surprisingly cute in the animation for something that has completely destabilized our economy.

One barrier to getting real reform is that most people's eyes glaze over as soon as you say the word tranche - and yet tranching is fairly close to the heart of the shell game that was built on top of some really poor mortgages.*

If you want to understand most of structured finance in one delicious meal, just buy the spicy beef soup from the Westborough Korean Restaurant, our new go-to take-out place.

The soup is a delicious beef broth with noodles, beef ribs, bean sprouts, and this really spicy red paste - in small quantities the paste is delicious. But if you pick up takeout, then by the time you get the soup home, the paste has settled to the top. The first bowl of soup is going to have more of the red paste than its fair share, and is going to be really, really hot. You'd have to be a little crazy to drink it.

That is tranching, in a nut-shell. Given a pool of "stuff" with a little bit of danger mixed in, tranching just means the Wall Street firms who are dividing the soup up put more of the spicy sauce in some bowls and less in others.

This is generally good for those getting the less spicy bowls - it allows them to make a pool of "stuff" less dangerous.

What do you call those pools that have more than their fair share of hot sauce? Those pools are called 'toxic waste', and that's where our toxic assets come from.

* I believe the true heart of the crisis is not any one financial technique - it is asymmetric risk - that is, the ability of Wall Street bankers to make money when a bet wins and have someone else pay when a bet loses. But in order to get anyone to play a game like that with them, they need to make the game complicated, so that the absurdity of the rules is less obvious. If you slice and dice your securities into enough tranches, it becomes a lot harder to see what you actually own.

Of course, when you actually look, it's an eye opener!

Massachusetts to Other 49: Screw You!

Dear Other 49 States,

Screw You! We've already got universal health care.

Love, the Massholes

PS, we voted for freaking Mitt Romney, of course we went for the naked guy with the truck.