Bob Vila Would Not Approve

Mmm....Cheese

2011-06-28T19:00:00.000-07:00

The CSA is back in session - real vegetables - what an improvement over the grocery. So we're making a lot of Kale soup. Trader Joe's spicy Jalapeno chicken sausages make a nice substitute for Chorizo. My recipe is something like:

Sauté an onion, some carrot, celery, and maybe garlic on low heat.
Throw in the chopped up sausage, brown it a little.
Throw in the Kale, mix it around a bit.
Cover with broth, throw in a few chunks of potatoes.
Leave it on low and forget about it for a few hours due to a chain of phone calls from work.

We had leftover Parmesan rinds and threw them in the soup - it tasted good, so I'll call that a success.

We also just did a blind taste test between aged Parmigiano-Reggiano, younger Parmigiano-Reggiano, and Grana Pedano. The real parm was noticeably better - I liked the older, Lori liked the younger, but the Grana was not a real substitute. (It's also not much cheaper - only about $3/lb less.)

Why My Wife Is Brilliant (part 372)

2011-04-21T18:25:00.000-07:00

~~Saltine~~Matzah Toffees. Salt 4 pieces of Matzah with sea salt. Melt 1 cup of butter with 1 cup brown sugar, boil 3 minutes, pour on top. Bake for five minutes at 400, then sprinkle on semi-sweet chocolate chips. Let them melt, spread them, let it cool (if you can) and nom.

Congress Has Never Used Shark

2011-03-14T08:47:00.000-07:00

Shark is a performance profiling tool that I use heavily at work. In a nutshell: Shark tells you what part of your program takes the most time to run, so that when you spend time making your program faster, you make the parts that matter run faster.

To construct a trivial example, imagine that my recipe program spends 99% of its time drawing beautiful 3-d recipe cards, and 1% of its time drawing the menu bar. If I want it to be faster, I have to make the cards faster, not the menu bar. If I make the cards twice as fast, the program is twice as fast. But...if I make the menu bar twice as fast, you'll never notice, because I've only affected 1% of the total problem.

Put another way: it pays to go after the whale, not the minnows.

Consistently going after whales is what has made X-Plane fast over the years.

So it drives me nuts when Congress goes after minnows.

Here are a few lists of potential spending cuts...we'll see how much of this actually happens. There are even some cuts that save more than $1 billion - that is, cuts that almost matter.

$1.1B - Office of Science.
$1.7B - GSA Federal Buildings Fund
$1.6B - EPA
$1.4B - DOE Loan Guarnatee Authority
$2B - Job Training Programs
$1.3B - Community Health Centers
$1B - NIH
$1B - High Speed Rail

(And we have some minnows: $6m for the NEA, $6m for the NEH, $7.3m for the Smithsonian, $2.3M for Juvenile Justice...if ever we optimized the menubar.)

But the real problem here is the total failure to 'Shark'. A few big ticket items seem to have strangely escaped the list.

$663.8B - the US defense budget last year, after suplementals.
$446B for Medicare

I'm pretty okay with the 'less government' idea...but I'm not okay with the 'less government except for the stuff I like' idea, and either way if you're going cut, make cuts that matter.

(Why is Social Security not on this list? Social Security takes in a lot of payroll tax, and could be made solvent by relatively small changes in benefits, the payroll tax cutoff, and retirement age. Heck, Social Security was doing fine before Wall Street cratered the economy. Compare this to Medicare, which has jumped 13% in cost in two years.)

Glengoyne 17

2011-01-25T18:31:00.000-08:00

Keeping with the "notepad of food and drink" theme, I figure I'll take note of the Scotch I finish...a bottle lasts a long time (despite X-Plane 9), so better to write it down.

People write some crazy stuff about Scotch - it's like wine tasting. "The nose had notes of hickory, burlap, and an old bicycle. Very good." I haven't taken a tasting class, so consider what follows to be totally uninformed.

Glengoyne 17 smells of caramel or honey - you'd think it smells good even if you don't like Scotch. It's fairly mellow; you can drink it neat and it doesn't burn at all. After drinking smokier whiskeys, it almost seems a little bit muted. Perhaps a good Scotch for drinkers who aren't quite prepared for more "challenging" whiskey.

Salt Fish Fried Rice

2011-01-24T19:52:00.001-08:00

It was pointed out to me (by my mother) that I never update this blog anymore...a major release will do that to you. But...I need to write cooking notes down somewhere.

Salt fish fried rice is...freaking awesome. It's also an acquired taste. An epic discovery: Top Cafe is just down the street from Apple (should you be out there on business), open late, and does a mean salt fish fried rice.

Salt fish fried rice is one of those dishes that, like a gin and tonic, walks a fine line between culinary bliss and disaster. The salty fish should add a bit of tang to the whole dish and should come out and bite you when you get a piece, but it shouldn't be so overpowering that you can't taste anything afterward.

I have made the recipe twice for myself and I'm getting closer, but have been held up by the principle ingredient: haam yu (咸鱼). The first time I made the recipe I used Portuguese salt cod. To put it bluntly, that's the wrong kind of fish. The results are quite edible, but the salt cod has no tang because it hasn't been fermented.

The second time I went to my local Chinese grocery and did my best to explain what I wanted. Unfortunately they were all out of salt fish and sent me home with...well, I'm not really sure what it was. It was a piece of carp labeled "Grandma's food products" in Chinese. I'm not sure what was done to it. It was a lot closer than the salt cod, but didn't have adequately awesome killing power.

The recipe I made is this one, and it seems to work pretty well; the results were close enough for me to know what I was going for and to know that I was only off by the type of fish.

Salt fish (咸鱼 - literally "salty fish") is xian yu in Mandarin and haam yu in Cantonese, unless Lori is punking me. One of the problems with Googling such ingredients is that there appear to be Chinese pop stars and kung fu masters with the same name. I suggest that we rename Justin Beber to Justin Hamburger in retaliation.

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

2010-08-09T09:10:00.000-07:00

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

2010-05-28T06:10:00.000-07:00

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

2010-05-27T12:31:00.000-07:00

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:

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.
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

2010-05-25T08:08:00.001-07:00

It's not so complicated...

It's Supposed To Be "Exciting"

2010-05-10T06:34:00.000-07:00

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

2010-05-04T13:47:00.000-07:00

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

2010-04-17T06:23:00.000-07:00

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!

2010-04-14T10:47:00.000-07:00

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:

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.
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

2010-04-13T09:28:00.000-07:00

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:

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.
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

2010-04-13T07:06:00.000-07:00

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...

2010-04-13T05:23:00.000-07:00

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?

2010-04-12T06:42:00.001-07:00

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:

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.
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?

2010-03-22T16:19:00.000-07:00

(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

2010-03-21T08:30:00.000-07:00

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

2010-03-20T07:14:00.000-07:00

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?

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.
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.
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?

AIG goes bankrupt.
We (the taxpayers) bail them out, giving them lots of cash.
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

2010-03-19T07:01:00.000-07:00

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

2010-03-18T06:14:00.000-07:00

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

2010-03-17T06:02:00.000-07:00

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!

2010-01-19T19:20:00.000-08:00

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.

Riffing On Tuna

2009-12-26T10:44:00.000-08:00

As this post will reveal, my recipes aren't really recipes at all - I don't follow recipes well, and find the concept of baking to be absolutely petrifying. (What do you mean, I have to use an exact quantity of ingredients?) Rather I work with themes of inter-relating ingredients that play well together, screwing around with them for my own amusement, hopefully in a way that won't result in a trip to McDonalds at the end of the night.

With that in mind, what can you do with Tuna steaks?

Cook them as little as you can stand. If you can get sushi-grade tuna, not cooking them at all would be perfectly acceptable. If you do have to cook them, coat each side with black pepper and maybe some salt or seseme seeds, then cook each side with a very small amount of peanut oil on a hot stainless steel pan. This is sort of a poor-man's tuna equivalent of pan-searing a steak. Cook time varies by how much you trust the tuna, but we're talking minutes, and a small number of them. If the fish is good, I want pink in the center!
You can chop up and serve the tuna over vegetables - avocado and cucumber are what I usually go to. Anything that is good in Sushi will do here.
For rice, you can simply prepare a small amount of rice, or make sushi rice (that is, pre-rinse the starch off short-grain rice and coat it in a rice-vinegar/sugar solution at the end). See also risotto below.
For sauce, I usually make some spicy mayonnaise, which is just regular mayonnaise mixed with Sriracha hot sauce and a small amount of cayenne pepper. (You don't have Sriracha? We must never speak to each other again.) Here my inability to measure things is going to cripple the recipe. Basically you want to use a tiny amount of cayenne pepper - it adds a ton of heat and will make the sauce unmanageable very quickly. Add the Sriracha to taste - it brings spice but also a nice tomato flavor.
For sauce you can also reduce rice vinegar and soy sauce (perhaps with some stock) into the pan after cooking the tuna. This doesn't quite work like a traditional fond in that the tuna isn't fatty enough to leave the rich drippings you get off of steak. Still, this can bring a salty flavor to the party that isn't as lethally hot as the spicy mayonnaise.
I usually serve this mess by doing something silly, like piling the tuna on top of the rice with the vegetables all around, e.g. you can play "New york chef" in the comfort of your own kitchen. The taller you stack it, the more points you get. Duct tape is cheating. The sauce can be poured right on or left on the side or safety. (If I've had a few beers before I start cooking and have been liberal with the cayenne pepper I leave the spicy mayo on the side for safety.)

Sushi Risotto

One of the weirder experiments I have done with this recipe was to make sushi risotto - that is, a risotto flavored with sushi-rice flavors (rice vineger, saki, sugar, although I probably ignored the Saki due to it not being on hand). I'm going to have to make the recipe again to remember what went into it, but the trickiest part is to get the two sets of flavors to play nice together. It can be done. I use Alton Brown's recipe as a starting point for Risotto, but in this case I backed off the white wine a lot (perhaps half a cup at most) to avoid clashing with the sushi-related flavors.

(The recipe was quite dreadful mid-preparation, and I thought we'd be ordering take-out, but as the alcohol cooked off the white wine, the whole thing mellowed.)

Anyway, if you can get a "sushi risotto" going, it can serve as a nice base to the tuna, bringing in some contrary flavors and making the rice more interesting.

Pie in the Sky

There are two other ideas for this recipe that I haven't gotten around to cooking yet:

Wasabi cream sauce. I'll have to figure out how to engineer this but the idea is to make a light cream sauce with a bit of wasabi flavor to pour over the rice. (This is a continuation of the whole "sush-like flavors" theme.) Probably this can't be done without using real cream.
Tangy sauce. Hell, I don't even know what this is. Basically at the Elephant Walk over a decade ago I had a raw tuna and vegetable appetizer, with some kind of tangy salty sauce that was just astoundingly good. If I had to speculate, there was fish sauce or oyster sauce in there, but cut with something to make it not lethal.

Bob Vila Needs Shrimp!

2009-12-26T10:39:00.000-08:00

Lori and I found a good Chinese restaurant, just in the nick of time for xmas: Red Pepper, on route 9 in Framingham.

Disclaimer: Lori and I have become Chinese food snots - we like food that is more like what you'd have in China, rather than Americanized recipes. With that in mind, Red Pepper totally delivers!

Bob Vila Needs to Make More Than the Mortgage

2009-12-11T15:03:00.001-08:00

Lori and I have entered a new phase of owning a home: we have rented it out. Lori began vet school this month, so we needed to relocate to Massachusetts). Rather than sell the home and buy a new one (or not), we rented the house and are renting a condo near school.

We ended up using a property management company. I spent almost two months in DC trying to rent the house myself and eventually gave up. Given the work that the management company did on the house, it is possible that we could have rented it ourselves. But the quality of applicants I screened on my own was...well...it wasn't good. What I've been told (and my experience bears it out) is that financially problematic tenants look for owner-landlords, thinking they won't be strict on financial criteria and/or won't do their homework. I did my homework, and what I saw was not pretty.

This is my game theory rationale for why a management company can pull better tenants. The agency cost is born by the landlord, who pays as much as first months rent in finders fees. The tenant pays nothing. High quality landlords and tenants are trying to find each other (or rather, if you are a high quality landlord, you want a high quality tenant, and vice versa). The agency cost acts as a selection signal - that is, if I am willing to burn my first month's rent on agency costs, I must believe that I will be able to sustain a high quality tenant in the long term, because my house isn't falling apart. High quality tenants know I am serious from this.

Since the finder's fee is real money, it's not a signal that can be faked easily by a landlord with a problematic house. But...why should the landlord pay the fee and not the tenant?

My answer is: asymmetric risk. As a tenant in a blue state, my landlord can't do much to me. His business is heavily regulated, the courts are sympathetic, and best of all, since he's sitting on property, he's a sitting duck for lawsuits. (That is, if he won't pay, I can get a judge to put his lien on his house.) I didn't realize how much leverage tenants had until I read the law as a landlord.

The landlord, however, is not in a great position. Give me a bottle of scotch and let me loose in your bathtub, and I can do damages to your house that will cost a full year's rent to repair. Against damage to an insanely expensive asset, a landlord has a few thousand dollars security deposit. And in terms of practical collections on damages, the tenant can skip town.

So it doesn't surprise me that the landlord pays for agency. It's worth a lot more to me financially as a landlord to have a good tenant than it is for me as a tenant to have a good landlord.

(As a tenant in Boston in 1998 I did use a broker, and it was structured where the tenant paid. Perhaps this is consistent with the brutally tight Boston housing market, where landlords can do pretty much whatever they want?)

So, Did You Make the Mortgage

The most common question I get asked when people here we're renting out our house is: do the rental payments cover your mortgage?

The short answer: yes.
The long answer: it's still definitely the lesser of two crappy housing options.

The problem is that the total cost of renting a house goes well beyond the mortgage. Besides the mortgage (which gives you a deduction against income tax on rental payments), you have property tax (a surprisingly big fixed cost), agency fees (in our case), repair and maintenance costs, and return on equity.

To focus on that last one: if you have positive equity on your home, it is not enough to get $1 more in after-tax rent than you spend per month in mortgage, maintenance, property tax, and any landlord-paid utilities. You are also losing the interest income on the money "tied up" in the house - your equity. If you would get cash out by selling, that cash could be sitting in a bank account returning...um...okay, so it wouldn't be returning squat right now, but in theory there is such a thing as interest.

I don't know what the long term outcome of renting the house will be. I do know that in the very short term, we're still in the red due to one-time costs to get the house ready to rent. (A lot of that stuff is repairs we could have done but put off as owner-occupiers.)

I will describe the trade-offs of selling vs. renting out in a future post.

Bob Vila Would Not Spend This Much Time On Green Bean Casserole

2009-11-27T08:26:00.001-08:00

My mother is a very systematic person - she keeps notes on how much food everyone eats during Thanksgiving. So when I called her to find out how many pounds of green beans we needed to serve ten people (1.5 pounds is on the safe side) she had historical data on the Supnik family green bean consumption dating back several years.

My original thought was to file this under "things that makes Mom unique"...that is, until I realized that I do the same thing. The Apple doesn't fall far from the tree.

I started logging my recipes several years ago when I was teaching myself to cook French sauces. The problem with French sauces is that if you make them frequently enough to really get good at them, you'll die of congestive heart failure before you finish your training period. So I started keeping notes on my recipes to avoid going back to square one every time.

So while normally the purpose of blogging is to rant about things I am unqualified to rant about (in an attempt to build a resume for Fox News), I'm going to start archiving my recipes^H^H^H^H^H^H^Hexperiments here for next year.

Green Bean Casserole the Hard Way

Lori and I were charged with Green Bean Casserole this Thanksgiving...you can find the "classic" recipe here. We made this recipe with two changes:

We used fresh green beans. We microwaved them for, um, a while, to soften them, as they won't cook fully in the casserole.
We made the condensed mushroom soup from scratch. It seemed like a good idea at the time.

(I did give serious thought to frying my own onions, but Thanksgiving involves cooking food, taking it in a car, having it sit, then it gets reheated. I'm not convinced home-fried food would be terribly appealing after such a long wait.)

So about the condensed cream of mushroom soup. Basically we used this recipe, but without any of the chicken stock. We started without the corn starch and water, but when it became clear that we needed thickening power, we added it. We also added some cheese to the casserole because, well, we could.

The results were reasonable I think. The main change I would consider for next time is making the soup even thicker, which could reduce casserole cooking time, either via longer cooking, more corn starch, or both.

Essence of Mushroomy Goodness

As a side note, the creamed mushrooms (that is, mushrooms sauteed with shallots in cream) is astoundingly tasty, and not unrelated to a number of other mushroom, wine and cream potions. I have a strange compulsion to make ice cubes out of anything that is concentrated and tasty, e.g. home made chicken stock, pesto, leftover pizza (you do have to put it in the blender first) and concentrated creamed mushrooms falls in that category.

Poking at the recipe:

Don't be lazy about the shallots - they bring a lot of flavor to the party.
If making a sauce, you might be able to get away with less cream - judge by consistency. I am definitely of a mind-set that while "mouth feel" can be luxurious and delicious, it's useful to know what recipes are using extra fat for feel and not for flavor. This is one of them.
You can probably deglaze in white wine, also a mix of white wine and vinegar (preferably a white wine vinegar - if you only have distilled, be careful) would be good.
Extra credit if you use tarragon with the shallots - it plays well with mushrooms.

If you have left-over tarragon and shallots, you can reduce a saute of tarragon and shallots in vinegar and white wine, then combine it with (a relatively unflavored/unspiced ) hollandaise sauce and you end up with Béarnaise sauce, which is absurdly good and can be dumped on, well, pretty much anything. (Allegedly you need chervil to make a Béarnaise correctly, but I have used up leftover tarragon and shallots and it's still very good.)

Innovation and Commodification

2009-11-17T04:51:00.000-08:00

There are fights going on in the banking industry right now that I want to rant^H^H^H^H call attention to. They are issues that most people probably don't know or care about, and yet they will affect our collective quality of life directly.

What do credit cards, mortgages, and over-the-counter (OTC) derivatives have in common? They are all products that are non-uniform - that is, each bank gets to make each product individually.

Defenders of deregulation would argue that the freedom to innovate in any way the banks can imagine is good for all of us, because the innovation leads to efficiency.

Despite having been raised by liberal socialists, I am sympathetic to this argument. I work in a highly deregulated industry (IT/computer tech) and would be at best grumpy if anyone told me how I could go about writing X-Plane.

But is that really the right analogy? I submit that banks don't fear the end of innovation - they fear the beginning of commodification, and we have a perfect analogy in the PC industry.

The computer hardware industry is, to put it bluntly, brutally competitive. It's not an easy part of the industry to make money in. Every year a PC sells for less money, but does more. Poor companies like Dell and HP are caught in the middle of that.

Okay - who are we kidding? No one is crying a river for HP or Dell, but being able to buy a laptop for under $500 is pretty awesome. There is no question that, from a price performance standpoint, whatever economic force is holding HP and Dell (and all of the other manufacturers) feet to the fire is yielding real dividends to consumers.

I believe that the force driving the price of PC hardware down is: commodification. Simply put, all PC hardware is like all other PC hardware. For any given product category, the ways a manufacturer can "innovate" is limited by the implicit rules of the PC ecosystem.

RAM & Hard Drive: you can increase capacity, decrease latency. But you can't go changing around how the part fits onto the motherboard.
CPU: you can increase the number of cores, you can increase speed. But you can't change what types of computer programs it runs.
Graphics card: you can increase how many triangles you can draw. You can increase how much detail you can draw per pixel. But you have to do this via a standard interface.

When the specifications of a product become limited, it can be commodified - produced the same way by multiple manufacturers. Purchasers can easily change between suppliers, which puts intense competitive pressure on manufacturers to compete on the "commodified" axes (that is, the official ways commodities are measured).*

So let's take this back to banking. Look at things the banking lobby hates:

"Plain vanilla" pre-approved consumer products. This would be direct commodification of anything in the consumer market. When the only thing banks can compete on is interest rate, interest rates are going to get driven down about as low as they can go. (The loss will come out of the banks margin on the product.) It's understandable why they don't like that.
OTC vs. Exchange Traded Derivatives. This is complicated enough to warrant another blog post, but basically a derivative sold on an exchange is a standardized, commodified derivative, and the companies "manufacturing" the derivatives for trade make only the thinnest margin on large volume.
By comparison an OTC derivative (a custom derivative made by a big bank for a company - think of it as getting a car designed from scratch instead of just going out and buying a Honda) is sold by one bank . There aren't any comparable derivatives to even check the price against! Which product do you think is more profitable?

Commodification is appropriate when we can quantify exactly how we want to select our products. Commodified memory works because we can standardize all but two variables: size and price. For a given class of memory, we can then buy the cheapest chips.

Could we do that for financial products? Yes! I reject the claim that exotic mortgages are useful for some class of buyers with special needs. If this were true, they would not have become the standard financing vehicle for several years. I think we know what most people want from a mortgage:

Low up front costs
Low monthly payment
Low interest rate

In other words, when it comes to a mortgage, there is really only one variable: price. If that isn't a product waiting to be commoditized, I don't know what is.

If there is a single idea I want to leave you with, it's this: different kinds of innovation are good for different parties, and commodification channels that innovation into avenues that are good for the purchasers of a product. There is nothing anti-competitive about commodification. In fact, I would argue that it is anti-competitive not to have commodification.

Banks like the current system because they can offer products just different enough, just confusing enough, just opaque enough that consumers can't direct purchasing power toward the competitor who provides the best deal. Commodification would make these products transparent, and would make the market more efficient.

In a commodified world, banks would have to innovate, but they'd have to innovate on how to get us the best price on a mortgage, not on how to hide the fees in the hardest-to-find places.

* I would be remiss if I were to pretend that this always works out well. Five years ago, the commodity for CPUs was clock speed, rather than throughput, and the result was the market producing CPUs that ran very fast, but got very little done as they ran.

Is It My Turn Yet?

2009-10-06T04:55:00.000-07:00

NAR wants us all to beg congress for an extension to the first time home-buyer's tax credit. That sounds good to me, but I wanted to punch up the text a little bit. Here's my version of the letter.

Dear ________,
I am writing to express my strong support for Congress to extend the $8,000 first-time homebuyer tax credit through 2010.

Throughout this financial crisis, there has been one consistent, clear, and very American policy: if you did something really stupid in the last decade, whether it involved making non-competitive cars that no one wants or designing financial instruments that would lose most of their value while paying hefty bonuses to bankers, congress will bail you out, and the tax payer will fund it. Should housing be any different?

Reports show that home sales to first-time homebuyers increased by 25% in 2009 and now account for 50% of all sales. In addition, the tax credit is reducing the inventory of foreclosures that are sitting on the market, helping our neighborhoods and communities recover. Like the big banks, us home buyers did some really, really dumb things over the last few years, and this government-provided bail-out is helping us "recover" from our mistakes by making future, similar mistakes cheaper.

While I believe the market has improved, I do not think it has fully corrected itself. In order for that to happen, we will have to reach similar levels of bad lending policies (NINJA anyone?) and delusional optimism that housing prices only go up. While this level of psychotic optimism has been hard to find in today's difficult economy, the best way to assure continued housing activity is to extend and expand the credit and to do that NOW. Nothing says "do whatever you want, we'll pay for your mistakes" quite like a government back-stop on bad investments.

We can't wait until late in the year to see what happens. It might turn out that houses aren't worth as much as we paid for them in 2006.
Sincerely,
_______

Now where's the bail-out for grumpy-coffee-drinking-work-at-home-computer-programmers-whose-pets-are-running-around-the-house-like-animals?

Bob Vila would not eat meat by-products (but your dog should!)

2009-10-04T09:01:00.000-07:00

I went to a talk by a veterinary nutritionist yesterday at Tufts Vet for Obesity Awareness Day. Her talk was really educational. For instance, I learned that the body that regulates pet food nutrition, content, etc. is called AAFCO (Association of American Feed Control Officials). They seem to be a lot less stringent than FDA regulating human food. Anybody can make a pet food and put it on the market, regardless of whether it meets your pet’s nutritional needs. Moreover, pet food does NOT have to be tested in feeding trials to go on the market. Why does this matter? Well, our pets generally have only one or two sources of food – whatever we feed them on a daily basis (compared to people, who eat a variety of different foods and obtain different nutrients from each one). Our pets cannot synthesize certain vitamins and amino acids, so it is important that their food provide these.

The label will tell you whether or not it’s been tested. Definitely buy one that has been tested. How will you know? Read the labels. Here is how to interpret:

TESTED wording (example): “Animal feeding tests according to AAFCO procedures substantiate that…”

NON-TESTED wording (example): This food has been formulated to meet AAFCO standards…”

Key point here: “formulated to meet” = “HAS NOT BEEN TESTED”

When buying a pet food you also need to look for the words “complete and balanced” on the label. That means the food meets all your pet’s nutritional needs.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition…”

If the food is appropriate for puppies/kittens, it will say, “provides nutrition for growth of puppies/kittens,” and for adults it will say, “for maintenance of adult dogs/cats.” Foods can be appropriate for both youth and adult stages. But some foods are only for one or the other.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition for growth of puppies and maintenance of adult dogs…”

The only marketing claim word that means anything on a pet food label is “natural.” So “organic” is just a marketing term. Which is of course the opposite of people food, where “natural” is meaningless and “organic” has to be backed up.

Don’t worry about buying the fanciest food for Fido. More expensive or prettier packaging does not necessarily equal better nutrition. Just make sure the food has undergone AAFCO feeding trials and provides for all your pet’s nutritional needs: “Complete and balanced” – just like FOX News!

Leaving DC

2009-09-16T07:31:00.000-07:00

Lori has already relocated to Boston - once W was gone, there was just no reason for her to stay.

Well, after watching this I realized that I have to get out of DC too. Actually, Canada's looking pretty nice.

Edit: this will help wash away the icky feeling you get from watching Glenn Beck fans.

Houses and Finance

2009-08-22T07:22:00.000-07:00

You might have thought that my mad rants on finance were totally unrelated to a housing blog. But...it turns out that housing and finance do intersect, in some ways that have turned out to be pretty unfortunate for home-owners.

There are a few financial bloggers who I really like - Mike Konczal is one of them. He wrote a series of guest posts on the The baseline Scenario (another really good finance blog) that are of interest to home-owners who might be asking the question: "how did Wall-Street-style price-insanity infect my local neighborhood?"

The Limits of Arbitrage. This is an idea that has also been explored for stocks, but the basic idea is that if enough people lose their minds and start buying up the price of an asset, it may be impossible for sane, well-informed people to bet against them, making money while forcing the price down. There can be two reasons why people can't "bet against" the bubble:

There is no good way to make the bet. For example, if I believe houses are going up, I buy a house. But if I think houses are going to crash, it's a lot harder. If I don't already own a home, I can't sell a house.
Since I can buy 2, 3, or 4 houses if I want, but I can only sell what I already own (1 house for most home owners) it's a lot easier to make the bet that houses are going up than going down.
If you borrow money to bet against an asset, you can go very, very broke. The problem is this: if you bet against asset X, you lose money every time asset X gains money. Your lender isn't going to lend you money once you've lost more than your own share. Put it together and a large enough rise in asset X means you're broke.
For example: Google is at $100 and I think it's going down. I have $1000 and I borrow another $1000 and short (bet against the stock). I now am short 20 shares. If Google doubles in price to $200 then my initial $1000 only covers half of those shares. At about this time the bank is going to ask me to unwind the trade and give them back their money, because if things get any more out of hands, I won't be able to pay the bank back at all.
Of course, this sucks for me - if Google later crashes down to $10, I'll never see my money - the bank forced me to sell at the worst time because I ran out of credit! Why does this matter? It matters because people can use credit to bet that an asset will go up. If they can't use credit to bet that an asset will go down (without risking the bank pulling the rug out from under them) then the amount of money betting on a rise (amplified by borrowing) will dwarf the bets on a fall, and the people betting on the price going down won't be able to "hold down" the price.

Phew. So what does this mean for houses and stocks? It means that even if smart, clever people could have predicted the bubble (some did, it remain arguable if enough did to make a difference) those smart people might not be able to keep prices sane because of structural problems with the markets. The only thing you can do is get out of the asset class entirely while the bubble goes by and wait for things to calm down. This is possible for stocks but more difficult for houses.

Prepayment. Mike is a financial engineer, so his articles can get technical, but I think prepayment is worth looking at. Cynics like me might accuse the banks of speculating on rising housing prices when they wrote all of these lame loans, but how do you make the link?

In The Giant Pool of Money NPR financial reporters explore the idea that with low interest rates and a lot of international capital, there was a huge desire for mortgage debt. In Infectious Greed Partnoy argues that often derivatives were sold to clients who didn't know what the hell they were doing.

So you can put together an argument and say "oh - the banks made subprime loans because hedge funds, insurance companies, pension funds, and other pools of money wanted the derivatives that come from subprime loans, and were too stupid to see the risk." But this doesn't explain a strange market inversion, where sub-prime mortgages were in higher demand than prime mortgages, creating incentives for brokers to push them. (A broker might make a higher fee on a subprime loan, but only because the originator set things up that way - e.g. the broker gets paid more for subprime if the originating bank wants that loan...why does the bank want a subprime mortgage?)

Here Mike suggests an answer: the prepayment penalty in a sub-prime mortage changes the very nature of what a mortgage is. One of the weird features of prime (normal) mortgages is prepayment. Owners pre-pay when interest rates fall (making a re-fi a good idea). This really sucks for the lender. If I offered you a CD that has a 5 year term but will drop to a 1 year term only if interest rates fall, would you accept it? Heck no!

(If I understand my financial engineering, mortgages have "negative convexity". Basically the longer a loan, the more its value changes with interest rates. But a mortgage's time span goes down when interest rates fall due to prepayment. So a mortgage is a loan whose duration is longer when interest rates are going up. Since a loan's value (to the lender) is inversely proportional to interest rates, this is about as bad as it gets: a loan that changes its value a lot when its value falls but only a little bit when its value goes up. If this seems totally one-sided, it is...this one-sided lender-is-hosed pricing comes directly out of the one-sided nature of pre-payment. Prepayment is heads-I-win-tails-you-lose, with the winnings for the borrower and losses to the lender.)

But if you can soak your borrower with a 4% penalty every time they prepay and encourage the borrower not to run the mortgage to its full 30 year duration (by having horribly high floating interest rates after the first few years) well....now we have something. We have a mortgage without this "negative convexity".

There's only one problem: it's a subprime mortgage - we might not get our money back. And now we can connect the dots. To the lender, a subprime mortgage has less interest rate risk but higher credit risk. And the credit risk of a mortgage has everything to do with housing prices. Ergo: the subprime mortgage as a speculative instrument exposing banks to rising real-estate prices.

(Of course we can see the problem now: as a way to speculate on housing increases, a subprime mortgage is a bit like selling a put option - you make a little money when you win but lose a lot when you lose. In the case of the mortgage, the most you make is the higher interest and prepayment penalties. The most you lose is a huge chunk of the mortgage. Which is exactly what has happened.)

More Brain-Melting Pet Photos

2009-08-14T11:48:00.000-07:00

In "The Truth About Dogs", Steven Budiansky makes the case that dogs are essentially a successful parasite. Harsh? Perhaps, but his argument provides a lot of insight into the human-pet relationship.

A successful parasite is one that takes advantage of a mechanism in the host that the host cannot live without. (If the host could live without the mechanism, the selection pressure from the cost of the parasite would slowly extinguish the required mechanism.)

Pets fit this criteria - they get us 30-somethings with our ticking biological clocks that have been snoozed for year after a year to devote our important resources (read: food) to pets instead of our own offspring. Fortunately pet food is pretty cheap. It's a good thing the pets don't have a taste for filet mignon.

I think Lori and I may be infected: we can spend hours babbling about how good the pets are and how sleepy they get. Perhaps the parasitic infection is melting our brains?

Anyway, what follows can be thought of as a chronic condition.

I am in your office paying your billz! Can haz stamps?

Corporate-espionage-kitteh is stealin your secretz.

(Without our kodez u is 2 yearz behind us. With our kodez u is 4 yearz behind us!)

Warning: absurdly cute.

I can haz kitteh?

Apartment-kat sez: upstairz neighbor is makin too much noize!

O hai...big sister, you is good pillow.

Mixed Messages About Flying Under the Influence

2009-08-13T11:45:00.000-07:00

When we bought the house 3 years ago it came with this totally awesome biplane made entirely out of Coors Light beer cans. I find it simultaneously wonderful and revolting.

I am very tempted to send it to Austin as a house warming gift...

Rent This House

2009-08-12T11:34:00.001-07:00

We spent the last two days preparing pictures for our home web page. You can see the end result here.

As usual, the pets were immensely helpful!

We're ready for our close-up.

I don't want to go in the toaster!

After a big day on set...we get soooooo sleepy!

CC Is Tired

I am ready to help if you need me!

Ch-Ch-Ch-Changes

2009-08-11T11:18:00.001-07:00

3 months without a post? 4 months? Quiet blogs sometimes indicate significant "stuff" in the lives of the posters. That's definitely true of my work blog (less posts = more code) and is true here too.

Here's the short of it:

Lori got into Tufts vet school! She starts "real soon".
We're moving to Westborough, MA.
We'll be renting out our house here in Maryland.

So we're going a bit crazy right now getting the house ready to rent, getting the move organized, etc.

The of whether to sell or rent is a complex one, and it ties together the two themes of this blog (housing rants and financial rants) into one, um, über-rant. Comparing life as a tenant, landlord and home-owner is eye-opening too.

More to come soon - we're working on our showing pictures today, and I think they're coming out pretty good...it's nice to see that the house can look good when we get all of our junk out of the way. (Then we ask: why don't we always leave the house like this? Answer: we have too much stuff!)

ETF Warnings

2009-04-15T09:59:00.000-07:00

My previous post outlined two reasons why ETFs might be more attractive than traditional low-cost indexed mutual funds. Here are some down-side risks to check for.

Does This ETF Suck?

This isn't a risk unique to ETFs - there are lots and lots of lousy mutual funds too. But suffice it to say, the biggest risk with an ETF is that it isn't a very good one. Check the expense ratio, and make sure the index makes sense for your investment goals. There are actively managed ETFs, custom-indexed ETFs, high expense ratio ETFs - lots of weird stuff.

Brokerage Fees

ETFs are "more fair" (IMHO) than mutual funds because the cost of buying and selling the shares is out front where everyone can see it: you pay a commission to buy or sell an ETF, just like you would a stock.

But this means you have a fixed cost per transaction, and this changes things compared to a mutual fund. For example, if your 401k normally buys a small amount of 4 mutual funds every pay period, that's 104 transactions a year. At $12.50 a transaction, you've paid $1300 in brokerage fees. If you contribute the IRS maximum ($16,500) that's a 7% commission! Ouch!

Simply put, heavy dollar-cost averaging over a wide number of funds isn't going to be cost-effective with ETFs. To use ETFs, you need to make contributions in fairly large chunks.

It should be noted that mutual fund buys are not really cost-free; the mutual funds that you can buy through your broker without a sales fee are subsidized by the mutual fund itself. Example: I can buy any Fidelity mutual fund for free via my Fidelity account because Fidelity's mutual funds have an agreement with Fidelity's brokerage. If I buy a Van Guard mutual fund I pay $75 - way worse than a trading commission.

Typically mutual funds that are free to buy will have a higher expense ratio - part of the expense ratio will go back to "mutual fund supermarket" brokers (like Fidelity, Charles Schwab, etc.) to offset buying costs. There is no free lunch. (One possible exception: Fidelity heavily subsidizes its own Spartan index funds to keep the expense ratios competitive with Van Guard. So there may be some loss leader mutual funds.)

The bottom line is: your buying pattern may have to change to use ETFs, and there is a cost to not dollar-cost averaging, so look at the big picture and the details.

The Bid-Ask Spread

Since ETFs are traded, there is a bid-ask spread - that is, the price you sell at will always be a tiny bit lower than the price you buy at on the exchange. That spread is the profit that market makers get for providing liquidity (that is, buying and selling whenever people want to keep the market working).

A healthy ETF should have high liquidity and thus a very narrow bid-ask spread. For example, IVV (an iShares S&P 500 ETF) has a 1 penny bid-ask spread on an $85.51 share price - that is, the spread is really, really tiny. If the ETF is less liquid, traded less often, has fewer shares, etc. you might see wider spreads.

If the bid-ask spread is too wide, treat this like an expense; you will lose the spread each time you buy/sell. If an ETF were to have a 1% bid-ask spread, you'd lose 1% when you buy and sell.

(A one-time loss is not as bad as recurring fee like expense ratios, but it does warrant examination.)

Arbitrage Failure/Tracking Error

When you buy some shares of an open-ended mutual fund (most mutual funds are open-ended), the mutual fund manager goes out and buys some stock (or bonds or stuff) - in other words, crunch all you want; when you buy, the manager makes more. To understand the problem of arbitrage failure in ETFs, we have to first ask: where to ETF shares come from.

When you buy and sell shares of an ETF, you are simply buying or selling existing shares on an exchange. But...what if everyone wants shares of IVV (an S&P 500 index ETF) at once and there just aren't enough? What keeps the price of IVV from skyrocketing above the S&P index that it should track due to the outsized demand?

The answer is in the way ETF shares are born: in-kind creation and redemption. ETF shares are created by someone coming to the ETF with the underlying stock or bind and saying "convert these stocks that make up the S&P into ETF shares". The ETF takes the stock and holds onto it (that's what the ETF does) and issues brand new shares. There are now more ETF shares in existence but the ETF now has more underlying stock to back them up.

Now when someone does an in-kind creation or redemption, he or she will make a profit or loss based on the difference between the ETF share price (as traded on the market) and the price of the underlying stocks and bonds that make up the ETF. This is what keeps an ETF's price so close to its underlying value ("net asset value" or NAV).

If the ETF share prices were ever selling for a lot more than the underlying stocks, some clever investor could buy the stocks and sell the ETF at the same time (making a profit). To then recover the sold ETF shares, the investor simply converts the bought stock to ETF shares. In other words, if the ETF trading price diverges from the NAV price, there is an arbitrage opportunity. Arbitrage keeps ETF trading and NAV prices in sync, and that's why your ETF shares are always worth the value of the underlying assets.

Well, almost always. During the recent market crisis, some ETF shares were trading at less than the value of their underlying assets. How did this happen? Vanguard explains here.

Basically if the NAV of an ETF share is below the trading price you don't want to buy (you'd be over-paying) and if the NAV of an ETF share is above the trading price you don't want to sell (because theoretically you should be able to get a better price). In practice, you're most likely to see this with bond funds, where the market for selling the underlying assets (bonds) is (a) not very fast/transparent like a stock exchange and (b) tends to seize up periodically these days.

PEBKAC

ETFs introduce one last potential risk: you. If you are the kind of person who might be tempted to day-trade your index funds, if given the tools to do so, you might not want an ETF. Mutual funds are fairly clunky to buy & sell - they're terrible for day trading and speculating. ETFs don't have this weakness - you can short them, trade them every 3 minutes, and probably even buy them on margin. If the temptation is too much, an ETF might not be a good idea.

Two Reasons to Consider ETFs

2009-04-13T05:25:00.001-07:00

I am assuming that you already use low-cost indexed mutual funds, and assuming retirement planning (e.g. ignoring taxes). Here are two reasons to use low-cost index-based exchanged traded funds (ETFs). I am not arguing in favor of high cost ETFs (they do exist!) or some of the weirder indices (people make up indices and build ETFs around them all the time) - this is just a comparison of mutual funds vs. ETFs for things like the S&P 500.

WTF is an ETF?

Here are two articles explaining (or trying to explain ETFs). But the basic idea is this: an ETF is like a public company whose business is to simply own the stocks (or bonds) in the index it tracks. Since the company doesn't really have a business plan other than holding these stocks or bonds, the share value of the company is pretty much equal to the assets inside it. Thus you can trade a single "stock" (the ETF shares) on an exchange instead of trading the 500 stocks that make up the S&P. In other words, ETFs are sort of "meta-stocks".

How is this different from a mutual fund?

In a mutual fund, when you buy & sell shares in the mutual fund, the mutual fund buys and sells the underlying "stuff" inside the fund to raise the cash to give you your proceeds when you sell, and then buys more stuff when you give them cash to buy.
In an ETF, you actually buy and sell the ETF shares itself - the stocks inside the ETF don't have to be unbundled, sold separately, then rebundled each time a share of the ETF is sold.

This structure turns out to be good in two ways...

ETFs Often Have Lower Expense Ratios

When I went looking for a broad bond-index mutual fund a few years ago, I couldn't find anything cheaper than an expense ratio of 0.45. For a bond fund, that's not very good - if I am only going to earn 3%, I don't want 15% (!) of my profits going to the managers. You can find bond ETFs with expense ratios a lot lower - more like 0.11%.

There are a number of reasons why ETFs might have cheaper costs:

The market is very competitive and very hot.
The structure may actually be cheaper to work with. When ETF shares change hands, only the ETF shares get sold, not the underlying instruments.* So it is possible that ETFs are less costly to run.
Mutual funds have this ugly property: if I sell all my shares and get out of Fidelity's Super-Actively-Managed-Wicked-Indexed-Cool-Kids-Fund (SAMWICK?!?) and you have shares, the fund pays the brokerage fee for the sale out of the fund. But wait ... you own the fund and I don't. You just paid my brokerage fees. Sucker!
By comparison, if I sell my ETF shares, I pay a brokerage fee to sell (like I would a stock). I pay my own costs.

On this last point, I would say the cost structures of ETFs are more fair - but it also means that the expense ratio of an ETF doesn't tell the whole story. (Nor does the expense ratio of a mutual fund - more on that in the next post.)

The bottom line here is that if you are shopping for cheap indices to hold, the best deals seem to be in ETFs. Van Guard has a nice set of low-cost ETFs wrapped around a number of indices -they are liquid (mostly), well funded, and have very low expense ratios.

More Control Over Buying and Selling

The way the two-step buying process of a mutual fund (step 1 - buy the fund; step 2 - the fund buys more "stuff") is implemented in the US is really lousy: I put a buy order in during the day, then the market closes, then they recalculate the fund price, and then they buy for me at the new price.* In other words, there is a huge delay in order execution.

That didn't bother me three years ago, but times have changed, and the market jumps up and down several percentage points in a single day. And that's where another feature of ETFs is handy: the ability to execute trades faster and place limit orders.

Since an ETF is traded like a stock, all of the things you can do with a stock are available on the ETF - in particular, you can place a limit order, saying "I would like to buy 1000 shares of this ETF when and only when the price dips below $50 a share". You set the limit order and walk away, knowing that if the ETF falls in value (altering the balance of your portfolio) the limit order will (hopefully) kick in and change your asset allocation back to where it should be.

(In my experience limit orders don't work as perfectly as you might hope - I don't know what kind of mechanism is behind the execution process, but exchanges aren't perfectly continuous - there will be a limit to the precision of order execution.)

Similarly, if you place a market order on an ETF, it's going to go through pretty fast. So in volatile times, with an ETF at least you know what you're buying.

ETFs also have some potentially negative features, and they're a bit more subtle than an ETF's features. I will cover them next.

* The mutual fund situation is worse - since the NAV is calculated after hours, you only know the NAV if you buy after hours - but if you do that, they wait an entire market cycle. So you basically never know what you're getting unless you calculate NAV yourself right before the close of market.

Isolating the Wrist

2009-04-06T11:09:00.000-07:00

Plenty of people have written plenty of blog entries about Ultimate Frisbee, and, being a typical perennial rec-leaguer (read: not that good) I'm not really qualified to write squat about Ultimate frisbee.

But - I did manage to "fix" my back-hand throws over the last year (more or less) and, being a big nerd with no coordination who doesn't "get" any sporting activity naturally, I can write about how I did it, because the process was deliberate, intentional, and took a while.

I think you could identify a number of important elements to throwing a frisbee - spin is always at the top of the list, as well as the relationship between the disc and its flight path, how the disc is oriented at release, etc. In my case what I was missing most was wrist isolation.

When you throw a frisbee, the wrist has a special role: many muscle groups are providing forward velocity, which will make the disc go faster (and thus farther before it falls out of the sky). For a short throw, the elbow and shoulder might be involved; for a longer throw the whole body might rotate.

But the wrist is the only part of the body that can make the disc spin. Why is that? Well, the bigger the muscle group, the slower the rotational speed it produces. I can snap my wrist almost instantly, but I can't rotate my hips 90 degrees that fast.

Thus the key to a frisbee throw is to "save" the wrist snap until the very last instant possible. If you snap your wrist too early one of two things happens:

Your wrist has rotated as far as it goes and the throw isn't over. Or more likely...
Your wrist rotates more slowly than it can so as to rotate at the same speed as bigger muscle groups.

I suspect that many attempts at "big" throws go wrong because the thrower synchronizes the wrist and another muscle group.

For my forehand, snapping my wrist at the last second just sort of happens - I don't know why. But for my back-hand, one of the keys to rehabilitating it was to learn to delay the wrist snap until the last minute - it was an issue of coordination.

What finally got my head in the game was to think of the arm movement and wrist snap as two distinct steps. The exercise I do is to first step across to 10 o clock with the arm swinging as part of the movement, and then, only once my arm actually gets to the throwing position, snap my wrist to throw, as if throwing without any arm movement at all.

(A number of websites suggest first throwing wrist-only to isolate muscle groups - I think this is a good suggestion. The next step then is to be able to move the arm and not lose the independent wrist control.)

Yet Another Way to Fund Housing

2009-03-25T10:04:00.000-07:00

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

2009-03-25T05:39:00.000-07:00

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:

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!!*
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?

2009-03-24T11:25:00.001-07:00

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:

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".
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

2009-03-18T12:13:00.000-07:00

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

2009-03-17T11:28:00.000-07:00

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:

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

2009-03-16T12:33:00.000-07:00

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

2009-03-15T11:52:00.001-07:00

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

2009-03-13T12:23:00.001-07:00

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

2009-03-12T15:09:00.001-07:00

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?

2009-03-12T11:13:00.000-07:00

"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:

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.
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

2009-03-11T10:09:00.000-07:00

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

2009-03-10T20:27:00.000-07:00

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

2009-03-04T08:56:00.000-08:00

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".

Conduct stress tests, learning lots of interesting things about how sick the banks are.
In secret, prepare a nationalization plan/task force for all the banks that will need it.
Nationalize them all at once, suddenly, and without warning. Surprise!
Immediately cut out and sell off the functioning parts.
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

2009-03-03T13:52:00.000-08:00

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

2009-03-03T09:33:00.001-08:00

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

2009-03-01T17:31:00.000-08:00

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.

If They Are Both Right, We're Screwed

2009-02-26T07:27:00.001-08:00

The 1.5 trillion dollar question (or whatever we're up to now) in Economics is: who is right...Friedman or Keynes. Is spending money going to break a brutal self-reinforcing downward spiral of economic contraction, or just waste so much future production that we'll have another "lost decade"?

The Friedmaniacs would say the Keynutjobs* will cause stagflation - if we spend a huge amount of money in a way that isn't efficiently allocated, that claim on future production is a weight around our neck. (That is, we just don't have a trillion dollars to spend, and when the stimulus is over, we still won't.)

The Keynutjobs would say the Friedmaniacs don't have a tool to increase demand - management only from the supply side is incapable of dealing with a self-reinforcing drop in aggregate demand. (That is, lowering taxes and interest rates does no good if we are all too scared to shop.)

What if they're both right? Each camp describes a real weakness of the other's, and these weaknesses have been seen in practice at times of extreme dislocation.

What if there is no middle-ground. What if there is no spending pattern large enough to break a cycle of decreasing output that won't also have long term fiscal repercussions? Then we're really screwed.

(My gut feeling is that we're screwed by design. A stimulus package, if it is going to have the psychological effect of convincing people that we aren't in deep doodoo, has to be absurdly big. That is, markets get built in expectations, and if they expect too much, you have to really clock them on the head. But the political process is only going to take a huge package and make it even bigger. So what can Obama do? If he intentionally low-balls the stimulus in an attempt to counter-act all the pork that gets added on, the market immediately gives him a vote of no confidence, and then any super-sizing of the package has to be even bigger.)

* I found the term "Friedmaniacs" somewhere on the web...I think it has a bit more ring than Keynut-jobs, which I just made up now, having not found any good derogatory terms for Keynsianism after 2 minutes of Google. I think there are ideologues in both camps that take a single policy to enough of an extreme to warrant a goofy name.

I Love the Wok

2008-12-13T20:16:00.000-08:00

Three thoughts on cooking:

All prep must be done before cooking starts, and all shopping before prep. Exposing food to air or heat starts fundamental changes that cannot be stopped once they begin. Especially once heat is introduced, you're on the clock!
It is obvious that too much heat can ruin a dish. Less obvious, but equally important: too little heat can ruin a dish. (Consider that too little heat means too much time in the cooking medium, which can be a problem whether it's air, water, or oil.)
Non-stick is a specialty pan, not a default.

The wok combines all three of these, and then some!

More Absurd Pet Pictures

2008-12-11T11:36:00.000-08:00

Some more absurdly cute dog and kitten pictures...a few notes:

I do not pose them like this! They just get in these positions on their own.
It's mostly the kitten's idea - that is, the dog usually lies down first, then the kitten finds her and joins in.
Where the dog has her legs around the kitten, this is not duress - the kitten just sleeps through it.

They pretty much do this every day...

You so STU-PIIIIIIIIID!

2008-12-05T12:36:00.000-08:00

Other shoes keep dropping as the credit crisis unfolds, but this one is really impressive:

Beginning in 1999, the Turnpike Authority entered into complex arrangements - known as credit swaps - with three investment banks as a means of raising cash to pay off rising Big Dig debt. Essentially, the banks paid the Turnpike Authority cash for the right to swap interest rates with the agency on future debt payments. The deals, while immediately raising $71.5 million in cash for the agency, left it vulnerable to fluctuations in interest rates.

So the Turnpike insured banks against interest rate changes? Why would they do something like that? They have no counter hedge. Perhaps the Turnpike Authority has a death wish - an insatiable appetite for risk that can only be filled by taking outsized bets on global financial conditions. (Or, as Bostonians might speculate, perhaps the Turnpike Authority is run by morons.)

Wait...I've heard this before...the choice of a known quantity or some unknown that might be better, but maybe not...why does this seem familiar? Oh yes!

Kuni: Ahhh, red snapper. Mmmmm, very tasty. Okay, Weaver, listen carefully. You can hold on to your red snapper...[Hiro-San emerges, carrying a table with a box]...or you can go for what's in the box that Hiro-San is bringing down the aisle right now!!! What's it gonna be? [Phyllis Weaver decides between the Red Snapper and the box. The audience points to the box]

Phyllis Weaver: I'll take the box. The box! [the audience applauds]

Kuni: You took the box! Let's see what's in the box! [Hiro-san opens the box, and the audience gasps: the box is completely empty!] Nothing! Absolutely nothing! STUPID! You so STU-PIIIIIIIIIIID!

The Bloody Mary Approach

2008-12-04T07:19:00.001-08:00

The Treasury Department has realized that the best cure for a hangover is...more binge drinking!

I was going to write a snarky blog post arguing about how that the government should bail me out instead of GM or CitiGroup. But why am I against this plan?

If Treasury buys mortgages with the goal of bringing down rates, they are essentially subsidizing the price of housing. Given that low interest rates inducing an overheated housing market is exactly what induced this mess, it seems like a step backward.

You can't undo the past. We all collectively made a bunch of bad decisions about our homes based on temporarily distorted pricing information. (This podcast has a pretty good explanation of what the implication for money is on our buying binge.) Life can return to normal only once home prices make sense.

During the boom, plenty of homes we didn't need were built, because prices were artificially high. If we prop up interest rates, two things happen, neither of which are good:

We subsidize overproduction. That's wasted economic activity.
We pay the opportunity cost. Buying down mortgage rates has no upside for the larger economy or tax payers. At least with Citi we get a dividend.

The truth is that I'm being over-dramatic. Housing prices are probably going to go below their eventual clearing level, since buyers are irrationally petrified of buying before the bottom and risk premiums on everything are through the roof.

My issue here is the same as TARP - how do you set the level of arbitrary government intervention when there isn't shared success. When we were going to buy toxic waste, the risk was that we overpay or underpay - only one of the banks or tax payers could win. Here we have the same problem - based on the interest rates we pick, one of home buyers or tax payers will win.

There is one proposal I have seen that at least hopes to address the fundamental problem with the housing market: "property appreciation rights" (PARs). Basically the idea is to allow home borrowers to sell their upside housing market risk to lenders.

Whoa. That's a huge change in how houses are priced, and one that we should not take lightly. It has the potential to destroy the middle class and the American dream.

But housing has changed since 1978 - houses now price like stocks - they fluctuate. It isn't appropriate for individual Americans to own that kind of risk exposure. If I called my bank and said "I would like to borrow $400,000 so I can speculate in the stock market -- in fact, I am going to buy just one stock, I'll put in $20,000 of my money, and you can have a lean on the stock as collateral", well, I don't think my bank would say yes. But if I say the exact same thing with a house rather than stock, I'm off to the races, and now I am leveraged 20:1 into a completely non-diversified real-estate position.

PARs would break the asymmetric risk we face today, where home owners get the upside of the housing market and lenders get the downside. When the market eventually corrects, what we'll see is a tightening of credit as the market adjusts to the fact that home prices can fall. (With a stock, you can margin about 50%. Can you imagine having to put 50% down on your home?) In some ways this whole mess was created by incorrect risk premiums - high leverage positions on homes based on the assumptions that the old rules apply...rules from before MBSs and CDOs and Reagen-era (leveraged) finance.

Under the PAR scheme someone (Government, business, whomever) can go in and refinance a pile of houses at cheap rates. The up-side for the entity providing the money is the rights on future appreciation, which is the incentive for the borrower to "get of the respirator" and switch to traditional financing as soon as it's possible. Without this, we have heads-I-win, tails-you-lose, which didn't work out very well last time around.

Turning Crimson

2008-11-28T08:51:00.000-08:00

So apparently Harvard's going to take a hit in the economic crisis. Having put international exposure into my 401k (and watched it get killed) I suppose it is reassuring to know that the best and the brightest got hit the same way.

But wait -- first, these guys had a 23% ROI for 2007. A 30% hit isn't much fun, but it's only rolling the clock back about 18 months.

But wait -- why are we even asking these questions? If you are into emerging markets, your time horizon should be really long and your tolerance for volatility should be really high. I've got this stuff in my 401k - it's about 33 years too soon to be asking the question "how'd we do"? Harvard's been doing this for a long time, and probably isn't looking to liquidate the endowment and cash out any time soon.

If there's a point to this rant it is only this: we (investors) seem to have become obsessed with whether stocks have gone up or down over short term periods (one year, five years, or worse, even months and days). Have we all forgotten what a stock is? A stock is a claim on future cash flow from now to the end of all time. Stocks exhibit enormous volatility and reasonably good long term returns. If we care about how the market moves, we may not be in the market for the right reasons.

Economics Isn't Science

2008-11-27T10:04:00.001-08:00

So first, this clip is just fun to watch. I have said before that perhaps the best indicator for how to invest is to do the opposite of whatever the talking heads on CNBC are saying to do.

(And I do have to call out the left wing media where it is full of crap -- the idiotic boosterism being put out on these shows is not particularly "right wing" and this is not a right-wing media issue or a Fox News issue...this is a Wall Street industry issue. Heck, I've heard both Democrats and Republicans try to blame each other for the current financial mess - I don't buy a word of it. For a blow up of this magnitude, everyone has to screw up at once.)

But while Peter Schiff did seem to call the crash correctly, I don't think that his proposed solution is a very good idea (even though he is right about borrowing money to live beyond our means). His idea is to cut government spending, and the fact that he thinks that this is a good idea reveals a major ideological divide within economics between the Keynesians and the Friedmanites. (These schools of thought do often correspond with left wing and right wing politics...so from a political perspective, Schiff's economics are conservative, or more accurately perhaps libertarian.)

The Keynesians would point out that as everyone braces for a recession, demand is going to fall, and demand falling will cause supply to fall, causing a feedback loop. I know I might get laid off, so I stop buying corn flakes...now the guy who works at General Mills gets laid off and stops buying X-Plane and now I am laid off - because I prepared for that event - a self fulfilling prophecy. The Keynesians say that in this circumstance it is important for governments to spend money to help break the feedback loop.

The Friedmanites would argue that efficient economic activity cannot resume until prices have normalized - in order for us to have real growth, we can't have incorrectly priced (too expensive) houses, etc. Therefore the best thing the government can do is get the hell out of the way, let prices fall until they make some sense, and only then can we get back to having a productive economy -- until that point, investment will be going in the wrong places and be wasted investment, hurting our long term future growth.

The problem is that the Keynesians and Friedmanites, while both probably at least partially correct, have completely opposite prescriptions about what to do. You can't really do both. And we can't do an experiment where we try both separately to see which advice works better. This is why no one can agree on which theory might be correct (or at least more correct): we can't do the experiment to disprove the theory.*

How do we reconcile these? Benoit Mandelbrot points out that market pricing isn't the stable equilibrium we think it is - free market prices simply go completely nuts sometimes. Behavior Economists are starting to explore why this might happen, but one thing is clear: prices sort themselves out eventually, but in the interim they can show periods of extreme weirdness.

So I would say that in looking at housing prices, government policy has to consider both sides of the economic coin:

Housing prices may become very wrong for periods of time. We saw our houses become very highly overvalued. I believe they will swing the opposite way and become highly undervalued. Buyers have a lot of (partly irrational) fear of buying before we "hit bottom"; this means that the bottom of housing prices will be lower than their natural support level and will then bounce back up, as buyers refuse to buy until they see the bottom.
On the other hand, houses do need to eventually hit a sane level - there is no other way to have a functioning economy. No policy that preserves housing prices as they were can make any sense. (We don't need any more houses - any policy that artificially raises the price of houses and causes more to be built is wasting investment and hurting future useful economic growth that should be happening in other areas.)

I don't think there can be a really good solution to the housing problem, because the only real solution would be to go back in time and stop people from making a number of poor decisions based on incorrect pricing and incorrect assumptions. But the money has been spent, the houses have been built, and we're stuck where we are. So all we can do is be pragmatic and try to make the situation as not-bad as possible with very limited tools and a lot of constraints.

* Being a congenital left-winger I am more sympathetic to Keynesian than Friedmanite theory...in particular my complaint is this: because in Friedmanite thinking a central bank fundamentally screws up economic equilibrium, Friedmanites will be able to blame the Federal Reserve for all ills, even if Friedmanite policy is enacted, thus their theory can never be proven wrong by actually trying it. That is, unless we get rid of the Federal Reserve.

Haggling

2008-11-26T09:58:00.000-08:00

I've posted a lot about the roads, because they're one of the first things a Westerner notices in India. (India's driving surpasses China's -- the Chinese stop at red lights.) Before I can really describe some of the other things that happened to us, I need to describe India's pricing system and haggling.

Basically in India, every price is negotiated - imagine that everything is priced like cars in the US. Some goods have an MSRP, which would be the price you should never pay because it's way too high, but most goods are entirely unlabeled (the store has no indication of potential price). The only things that we did not haggle for were restaurant bills and plane tickets. (We even ended up in an argument about what to pay for a metered cab, but that's another story.)

To further complicate things, the merchant can make a pretty good guess about how much money you might based on how you look. Being white, Lori and I scream money to an Indian merchant - whether we're from the US or Western Europe makes no real difference. But our friends in India (who are Indian, but look like they are upper class, with white collar jobs) have the same issue: they go into the negotiation with a handicap. The implications of what it means to have money in India (whether you live there or as a tourist) are complicated enough that I'll devote a separate blog post to them.

Our friend Tanmay has a good rule of thumb: whatever price they offer you, counter with about 1/4 of what they are asking. We had trouble pushing that low, but we were usually able to ask for about 1/3. What we actually paid varied by the situation, was virtually always too high compared to local prices, but was usually a good deal compared to US prices.

A lot of the time I enjoyed haggling, but I think this is because I could haggle while it was novel, then go home to the US and price shop online...having to haggle every day would wear me out, and there were definitely times when we thought "oy, we have to haggle now."

There are some cases of fixed price shopping, but they are invariably expensive by local standards. In some cases it's worth saving the hassle. For example, at a lot of tourist sites, people will offer to be a guide. How much do you pay for this? With strong negotiation you might get a very good price. At some sites the guide rate is posted -- the rate is invariably higher than you would pay if you were a local who could haggle, but it is usually lower than you would pay if you are a foreign tourist who isn't used to pushing on prices all the time.

(For example, the guide rate at many Rajasthani monuments is 100 rp, which is about $2. Guides making $2 for a 30-60 minute tour are doing very well for themselves by Indian standards, but if you're an American you're going to have a lot of trouble getting much below 100 rp, and even if you did, is it worth having an extended haggling session before each monument to save 50 cents?)

I realized a few things about shopping while in India:

I really don't know what most things should cost...I am used to getting my pricing information from the context of the store dong the selling.
To shop for negotiated items, you really need to be an expert at what you're buying...there are only a few items that I could really haggle for if I wanted to. Our friend Pooja told us that if you want to make a large purchase in India, you need to rely on a web of trust - that is, friends who know more about the material, and merchants with whom you have some relationship.

My favorite haggling moment was when I managed to get under the skin of the manager of a tourist gift shop at a hotel part-way to Jaipur. Our driver was having lunch and Lori was browsing the gift shop, trying to haggle down the price of a small purse. I got into an extended discussion about pricing of flash memory for cameras with the manager, and then sprung my proposal: to trade a card that I had (incorrect for my camera) for another, less valuable card. He would owe me about 300-400 rp, but I was willing to make the trade for only 100.

The manager had no desire to take my second-hand flash card (even though it was in plastic), but I kept working on him, pointing out what a great deal it was, until finally I got under his skin enough that he yelled "No Buying! Only Selling!" Having been driven nuts by people trying to sell us tourist crap we didn't want for the previous four days, it was a small victory.

Eventually my rantings about the economy and state of finance and my India posts will end up merging, but that can wait a few more days. There's still a lot more to write about! (I did get the camera off-loaded today, so I will try to post some pics soon...we took 764 pics and movies...)

7.4 Trillion Is Not That Much

2008-11-24T16:00:00.000-08:00

In a past post I suggested that $700 billion is not that big of a number when compared to the usual cost of bail-outs relative to GDP.

People are now suggesting that we're at $7 trillion +. That's a big number, but I think it's a "nominal" number, like when people talk about $47 trillion of derivatives.* Bloomberg has this nice interactive chart showing who has committed what.

Now 7 trillion is a big number, but a lot of that money isn't going to actually get spent. For example, 4.4 trillion comes from the Federal Reserve, which is guaranteeing low-risk things like commercial paper and money market funds that aren't really at risk in the first place. To understand how much of this money we might really lose, we need to look at:

Panic money: investors are so freaked out that they don't even think the sky is blue anymore...money is earmarked in the unlikely event that the sky is green and investors calm down. Since the sky is in fact not green, I don't think we have to worry about this money going anywhere.
Screw-up money: companies made really bad investments, and Uncle Sam is guaranteeing them to prop the institution up. This is where we could really get in trouble, but no one really knows by how much. Most of this spending is under Treasury, bailing out CitiGroup, AIG, Fanny Mae, etc.

Even if we ignore the panic money and only look at screw-up money, it's still a lot. As a final thought on this: we have an immovable object (massive spending) pushing the dollar down and an irresistible force (fear) pushing the dollar up (via a flight-to-safety). I suspect that when the dust settles, we'll lose our fear but still owe a few trillion in bail-outs, and that's going to make for a rough time for the dollar.

The "Lonely Planet" Problem

2008-11-18T06:54:00.000-08:00

Lori and I are in Goa now - Palolem, to be more precise, and we are again seeing the "Lonely Planet" problem. (It's really not a problem for us here, but the principle still holds.) The Lonely Planet problem is this: when the clever folks at Lonely Planet find some wonderful undiscovered nook in India and write about it, approximately a gajillion tourists all go there and discover that the nook is now no longer undiscovered. Doh!

We first hit this in Jaisalmer with camel safaris. The Sam sand dune became overrun with tourists, so people started going off the beaten path to Khurie. Now Khurie is crowded too - we didn't find that out until we were in Jaisalmer - it's hard to plan everything by remote, but we were able to set up a safari using Ganesh Travels. (They're in Lonely Planet too...)

Palolem is one of the southernmost beach villages in Goa - it's a beautiful beach, maybe 1/4 to 1/2 mile long, with two roads nearby filled with a combination of shops and restaurants and some hotels. Near the beach are thatched huts, which provide the lowest comfort (but probably also lowest environmental footprint) lodging. The lonely planet issue is: Palolem used to be an escape from tourists, but now it is just another tourist beach village.

That's okay with me though; seeing seven cities in ten days was exhausting, and the pace in Goa is a lot slower - it's not crowded like Rajasthan, Mumbai or Delhi. After all the traveling, a few days on the beach is just about right.

Why Did the Cow Cross the Road?

2008-11-11T08:34:00.001-08:00

Well, the answer is: it didn't; cows actually have excellent lane discipline -- they tend to go where they are going and not change directions too much. (Goats are much lses predictable.) And it's a good thing, because cities in Rajasthan are pretty much filled with livestock.

If the first thing an American notices in India is the driving, the second thing is the presence of animals everywhere. Cows are simply left to roam free range - both wtihin the city limits and outside; while driving between cities we had to stop several times to let a shephard and his goats cross. There is something very surreal about the whole experience.

The Rajasthani forts are very impressive - they are like the Grand Canyon, I think, in that they are so big and imposing that even if you've seen a lot of pictures, the real thing is awe inspiring due to shear size and improbable location.

As helpful as the Internet is in planning a trip like this, it is difficult to understand the "situation on the ground" without being here - I will try to write up some travel tips once I get back, so that perhaps others who are trying to use Google to plan a trip can have a slightly better picture of what to expect.

Greetings From Udaipur

2008-11-09T01:25:00.000-08:00

As I sit down to write this, an elephant just walked down the street past this cyber-cafe. Now that is remarkable for two reasons: first, it was an elephant, for crying out loud. We have seen lots of dogs, goats, and mainly cows in the roads, but this is the first elephantwe've seen go by. Second, the streets here are very, very narrow, so getting an elephant (or a car) down one of these streets is no small matter.

We read an article in the paper on the flight from Mumbai to Udaipur where a Russian dignitary described Indian drivers as "very skilled" - and they are - in that they navigate a road network without any kind of lanes, street signs, or anything else to direct traffic. The first reaction any American has coming to an Indian city (Mumbai and Udaipur have both been like this) is that it is truly a crazy driving situation. Driving here makes China look safe and boring and the beltway look like the Queen's tea.

With that in mind, Udaipur is an amazing city - the palaces are all fantastic - I'm not quite sure what to say about them. The city itself looks quite idealic from across the lake in the evening. The streets of the old city are a bit daunting - narrow, crammed with people and shops and cows and motorcycles and rickshaws...to an American, it is a constant assault on the senses. Fortunately we started in Mumbai with our friends, which helped a lot. Compared to Mumbai, Udaipur is not so crowded, and our friends live in Mumbai and were able to give us a lot of situational awareness.

As we travel around India, I am constantly reminded of China - while they are very different, they are perhaps more like each other than either is like America. The density and crush of people, the buildings, often packed so close together, often barely standing. I will have to describe Mumbai in a separate post - it is its own beast.

A final note: it is heartening that everyone here knows Obama. :-) It is great to have a president that I do not have to be embarrassed about when traveling.

New Chandelier

2008-11-05T15:33:00.000-08:00

Lori's parents were in town last week, and as always, did some really wonderful work on the house. Here is our old chandelier, which came with the house. If it looks sort of cheap, that's not because of the picture.

Lori's dad in action!

CC is alwys helpful, particularly when there are heavy things, electricity, and ladders.

The new chandelier:

Warning: Extreme Cuteness Follows

2008-11-03T15:58:00.000-08:00

After their morning hyperactivity and bad behavior, CC and Nublet like to snuggle. They both get very sleepy!

1% Money

2008-10-29T11:57:00.001-07:00

...And interest rates have been cut again.

Hrm...

1998. Asian currency crisis. Rate cut. Dot com bubble.
2001. 9/11. Rate cut. Housing Bubble.
2008. Sub-prime crisis. Rate cut. ______ bubble.

Wish I knew what _____ is...buy in now, sell before the curve gets vertical.

Asset Bubbles, Cheap Money, and Leverage

2008-10-28T12:21:00.000-07:00

Ami sent me an article about how the big banks are not re-loaning their TARP money to those in need. This doesn't surprise me, and it means the TARP money isn't expensive enough.

The whole idea of a capital injection is that it puts tax payers and banks on the same side. If we just buy toxic assets, banks that survive make a profit while we (taxpayers) have junk on our hands. If we buy equity in the bank and they are profitable, we get our money back and then some.

But our goal as tax payers is not to be speculators in distressed financial stock - it is to keep the banking system from melting down. So if a bank has enough money to go on a shopping spree with TARP, the "cost" of that equity isn't high enough. TARP bail-out money needs to be painful enough to existing equity holders that they'll use as little of it as they can.

I've done plenty of ranting about the various fire drills we've been through during the bail-out, but what about the bigger picture? Here's a thought: a return to "healthy" lending levels may not be healthy at all if our previous lending levels were way too high.

Right now the Fed is thinking about whether to further cut interest rates. Ignoring the important question of whether further rate cuts will do any useful short term good, I would suggest that too much capital isn't a useful thing. I am a fan of Mark Cuban's blog, and he says it better than I can in this post.

Cheap money means lower risk premiums, higher leverage, and it makes all sorts of great things possible:

Leveraged Buy-Outs. (Is this really useful? Ask the employees of Linens N' Things.)
High Leverage Ratios. (Worked well for Bear Sterns. Heck, it worked great for LTCM!)
The Carry Trade.

At some point cheap capital doesn't cause us to work more efficiently, it causes us to spend more time playing games with cheap capital.

We've had an internet bubble, a housing bubble...is the way out of the mess really to lay the groundwork of another bubble?

ETFs for a Crazy Market

2008-10-27T11:29:00.001-07:00

I like ETFs as a way to buy an index now (as opposed to an index mutual fund) for two reasons:

The ETF market place appears to be very competitive - you'll find more funds with lower expense ratios. Last year when I went looking for bond funds Van Guard was the only one offering a truly low-cost bond index. A number of larger players are in the ETF space, forcing expense ratios down.
When you buy an ETF, you get the price as soon as the transaction completes, which is to say, it's pretty close to what you want. When you buy a mutual fund, you put the order in during the day, the day closes, then the price recalculates, then maybe you eat the day's gain or loss. Normally this is a non-issue (and if you have a disciplined approach and simply buy mechanically at a set interval, then who cares). But if you are like me and have to make your buys by hand (I have a SEP-IRA, so no automatic anything) then there's really no reason to be eating a day's gain or loss in the internet age.

Of course, ETFs let you "trade" indices and I can't advocate that. If you want to gamble, you can at least get free drinks in Vegas.

Solar Bubble

2008-10-16T04:05:00.000-07:00

I have heard people say that clean energy is the next bubble - over-investment in solar, etc. will cause a bust.

The thing is, bubbles have gotten a bad name, just because this one nearly destroyed the world economy.

Consider the dot-com bubble. Looking back we remember the idiotic stock prices for companies whose business plan was "take random consumer good X, grab 1% of the market via X.com, become bajillionaires", or better yet "lose money on every tranasaction, make it up in volume".

But there is another aspect to an investment bubble. A technology bubble simply means we have overshot and put too much capital to work on the new frontier, whether that be railroads, the internet, or solar panels.

One result of the mis-allocation of capital is chaos in the financial markets; if you look up bank panics on wikipedia, you'll see that what we have now is a period of relative calm compared to the second half of the 19th century, during which we have the bank panics of 1873, 1893, 1901, and 1907. One of the main cause of those first panics was massive overinvestment in railroads and the instability of stock prices linked to that sector. (Really rich people doing really naughty stuff is another cause.)

But another result is really cheap infrastructure! In the case of the 19th century, all the railroads you can eat and then some - in our case, really cheap fast internet. (You'll hear bloggers talk about "dark fiber" - that's fiber optic line put down during the dot-com bubble that still hasn't been used, waiting for someone to buy it at bottom dollar.)

The solar people are talking about reaching "grid parity" - that is, the day that solar becomes as cheap as fossil fuels. What would happen if we over-invest and they over shoot? Cheap solar panels for all! To me, this would not be a bad thing. A glut in production would help make solar significantly more competitive - we'd effectively have market-driven dumping of solar panels which would help drive a conversion to renewable energy (which I believe is in the long term very good for the US, and even the whole world).

The housing bubble is so destructive because we all depend on our houses having relatively constant value to keep our lives running. Sector bubbles are only destructive if:

The sector long-term over-extends. This did not happen in the dot-com bubble. For about a year I had a lot of friends emailing me about work, but the surplus of software labor got mopped up surprisingly quickly. The investors were right about the growth of the web, just not exactly right.
The asset price is tied to people's financial security.

On this second point, I see it like this: people's retirement security should not be tied to stocks, because stocks sometimes lose a ton of value very rapidly, and don't get it back for a long time. We used to say people should be 100% out of stocks by retirement age; then the 1982-2000 bull market tempted us with greed and complacency.

Food for thought: can you imagine what would have happened if we had gone through with Bush's (idiotic) plan to let people treat their social security taxes as a 401K (and invest it in stocks)?

For one thing, a lot of that money would have flooded into the stock market, pushing up peak valuations significantly higher than the 14k dow* we saw.
We would still have had the pull-back when the debt markets blew up. We would have just fallen a lot further.
That would mean an even larger contraction in bank capital...it would have been this credit crisis on steroids. Would we have survived it?

If there are two lessons for retirement finance from this whole mess, I think it is this:

Given 50% of stocks held by those over 50 and the massive volatility in the market, I question whether it makes sense to give the average American more choice in how he or she allocates his or her retirement money. I'm all for freedom, but we have to ask: were we all better off when we got defined-benefit pensions? Have we just been tempted by the possibility of riches into accepting the risk of losing all of our retirement? When the market tanks, do a lot of people not say "thank God for social security"?
The financial industry is really good at taking our money....see all of the fees and other such rip-offs that go along with 401ks. The only winners of privatizing social security would have been the mutual funds that got to take 2% of our retirement money every year.

I realize there are serious philosophical questions here about personal and collective responsibility...a crisis like this makes us re-evaluate our principles. This is good! Our previous principles might not be wrong, but it's good to question them and think hard about them; the rules of the finance game are set by all of us to meet a greater good - they are not immutable laws of physics. We all need to think hard abou what kind of world we want to participate in creating.

* I don't think the dow is a very good measure of the stock market (and the stock market is not a very good indicator of much of anything, except for the current market price of stocks), but the numbers (14k, above 10k, below 10k) are easy to remember.

A New Member of the Family

2008-10-14T14:19:00.000-07:00

It was only a matter of time before a kitten followed Lori home from the vet's office. This is "Nubblet".

Nubblet really, really likes to sleep on my laptop keyboard - perhaps because the MacBook Pro runs pretty hot and keeps her nice an warm.

I'm on TV!

$700 Billion is Not That Much

2008-10-11T10:03:00.000-07:00

I admit to having ranted about the bailout and, in doing so, tossed around the number $700 billion like it is a really big number. And it is. It is more money than I have - roughly $700 billion more! But a few thoughts to put this in perspective:

$700 billion is about 5% of GDP, at least by last year's numbers. That's not that expensive; the average banking system collapse usually costs a country 13-16% of GDP, depending on whose research you look at, and sometimes a lot more.
The worse things get, the cheaper it becomes for us to bail banks out. This is the perverse nature of the world economy; because US Government debt is still considered the safest of the safe, every time the news gets worse (requiring more bailout money) the financing our government pays on bailout money gets even cheaper.

At one point the real return on T-bills went to zero - that is, people would loan the US government money for nothing! At that rate, we can afford to bailout the titanic with a bucket.

The scenario that scared me most about a year ago was that we would hit this crisis and a dollar crisis at the same time, and the fall of the dollar would make government financing very expensive. But that hasn't happened; this graph shows the Euro falling relative to the US dollar as things get worse. As much as people are worried that the US is in for some pain, they are more worried that Europe won't be able to apply the right medicine.

To quote Alex Bloomberg from "This American Life", the worse the US Government does, the more people want to loan us money. It's a strange, strange, strange world.

Let's Buy Us Some Banks

2008-10-10T15:35:00.000-07:00

An apparent trend in the various bail-out plans in the US, UK, and Europe: whatever one country does, all of the other ones have to do. Ireland, for example, was one of the first to start guaranteeing all bank deposits, and their move started to pull cash away from the UK. In the end, every country will have to adopt the strongest safety net of any country to prevent a flight to safety.

It also looks like the US will actually buy some banks. This is a good thing for three reasons:

How much do we pay for a toxic MBS? No one knows. There is no market for them. How much do you pay for a bank? That's easy, there is a stock price. (It's not real high, but it does exist.)
If we are going to give the banks some money, what do we get in return? If we buy a piece of the bank, we get a piece of their profits should they survive. No taxation without representation, so to speak.
The only way a bank gets more capital to invest when we buy an MBS is if we pay too much! (If we pay the amount they have "on the book", then the buy-out looks like a net change of zero for them.) So when we buy toxic assets we have to overpay or hurt the bank. By buying the bank itself, the bank can do better.

Of course, this sort of sucks for current bank management and current bank investors. We should not care! The bank lobby hates the idea of tax payers having equity, and that alone is an endorsement in my mind.

The bank lobby, in trying to claim that buying the banks is a bad idea, say that this would scare away outside private investment. George Soros, who is the kind of outside investor we need, disagrees:

http://www.ft.com/cms/s/0/d68e10cc-8f45-11dd-946c-0000779fd18c.html

And of course I reiterate what I've said before...besides the problem of over-paying for toxic assets and not knowing what to pay for toxic assets, the government shouldn't own mortgages that are in high default - too much political pressure to not liquidate the houses by foreclosing. I hate to be in favor of foreclosures, but there is no light at the end of the tunnel until we work the sub-prime crud out of our system - delaying that process only makes it hurt longer.

Other ranty points:

McCain is crazy to want to lower corporate taxes - they just had record profits for years...why would they need lower taxes? Money doesn't grow on trees! They're not going to do more business with lower taxes, they're just going to pay less taxes.
I can't tell what McCain plans to do about houses from his web site. The devil is in the details: buying mortgages at face value is a terrible idea - it's a cash give-away to banks, just like TARP if TARP buys assets. (It appears that TARP will let the treasury buy assets or equity.) Buying the mortgages at face value is a bail-out to banks with poor lending discipline and, by artificially propping up home prices, stops the market from clearing to sane price levels.

The government does need to provide mortgage financing at good interest rates to credit-worthy borrowers, but banks need to eat the loss on their loans.

Another Good Financial Podcast

2008-10-06T18:07:00.001-07:00

There is very little media on finance that is both accessible to a general audience, and comprehensive and thorough in its reporting.

"This American Life" has done a second finance podcast, and it's pretty good: , which is a follow-up to

The stock market has demonstrated clearly that it is ludicrously irrational. Who in their right mind liquidates their holdings when the Dow is down 400 points? (And yet clearly a lot of people thought that that was a good idea today...) A series of financial melt-downs (1987, 1998, 2000, etc.) have made academics question the idea that the market prices stocks efficiently. Hopefully today put the nail in the coffin of an academic model that was pure, simple, and pretty much wrong.
Stocks have to occasionally go nuclear. If they didn't, we'd all buy more of them (since they return more than bonds), driving the price up until the yield was the same as bonds. That extra money you get from a stock is payment for being first in line to be kicked in the nuts when things go bad. Occasional spectacular crashes have to be expected.
If these first two points seem to contradict each other (in point 1, I argue that markets are not efficiently priced, in point 2 I argue that they are), the contradiction comes from time. Over fairly short amounts of time, the markets can do just about anything. The kind of equilibrium of supply and demand that I describe in point 2 can easily be overwhelmed by massive panic, per point 1.
Finally, if you are young and thinking "this bail out is going to cost me", there is a silver lining...stocks have been overpriced, for a while now; the out-sized returns delivered from 1982 to 2000 are due to people being willing to pay more for stocks (and thus the value of stocks being driven up by increased demand). That kind of growth is not sustainable forever - think pyramid scheme. The end result of stock returns due to "demand growth" is overpriced stocks. Stocks have to fall in order to be able to return decent returns. (During the fall, as demand evaporates, stock prices will fall, producing negative returns, even if the economic fundamentals behind the underlying companies are solid.)

I heard a scary statistic on NPR: 50% of equities are owned by people over 50. (This may not be true after today...who knows.) Stocks can be a great investment vehicle for people with a long time horizon, but I fear that too many years of smooth sailing has caused us all to collectively forget just what a stock is and how it behaves.

Why I Thought TARP Was Bad

2008-10-01T09:51:00.000-07:00

TARP (the "$700 billion bailout bill") is now dead, and the markets had their hissy fit, then bounced back, and are now continuing to be grumpy. I was going to write a "top ten reasons TARP is bad" blog, but that's water under the bridge. But I've had enough people ask me why I didn't like it, let me try to spell out my (highly convoluted) thinking.

My main concern with the entire process of congress trying to get behind a bailout bill is that it's not really clear what problem they're trying to solve. The way I look at it, we have four groups of beleaguered souls:

Home owners who are unable to pay due to the lack of refinancing. Home owners get in trouble if they either overpaid for the house and don't have equity (which means they aren't eligible for a loan large enough to refinance) or their credit isn't adequate in the current climate.
Banks that, due to making poor investments (read: mortgages and their derived products) are no longer solvent.
Companies unrelated to the housing market who are unable to get financing (short or long term) to do business because of problems in the more mundane parts of the credit markets.
Everyone else (let's call them "tax payers") who have seen the value of all of their savings depleted due to a weak dollar. (This group is not usually mentioned as part of the crisis, but I think it is long to leave them out...the dollar has been severely bruised over the last few years, and the treasury spending half a trillion dollars or more is only going to make it worse. Tax payers lose twice - in the taxes they pay and in the value that is inflated away.

Groups 1 and 2 are fundamentally at odds with each other - every bit of relief granted to home owners makes insolvent banks that much worse off, and vice versa...either the home owners pay up (somehow) and the banks' mortgages are good, or they don't and they're not.

I believe that different action is required to address different problems. My issue with the treasury plan is that I don't see any scenario where buying things helps a lot. (That is actually not true - it's close to true though.)

If the treasuy buys distressed assets, then the question is "at what price". If the price is high, this helps solvency (if the toxic waste is worth what the banks thought it was, they're not insolvent), but the tax payers take it on the nose. The government's only alterantive would be to somehow force home owners to pay up - I don't see any way they can do this...it would be water from a rock.

If the price is too low, then this is good for home owners (because the treasury can pass the savings on to the home owners by writing down the mortgage and refinancing) but it just locks in bank insolvency.

If there were some kind of middle ground, then theoretically the treasury could do both. That is, if banks wanted to sell at a lower price than is likely to be reclaimed from holding the assets, then there would be a win-win situation. But if it was likely that the assets would return to that price, we wouldn't be having this crisis. In other words, when it comes to sub-prime the problem is solvency, not liquidity. (If the problem was liquidity, then this could be solved with repos and other loans, and no permanent buying would be necessary.)

I am all in favor of the government buying and writing down mortgages to market price. In that case, TARP is problematic because it doesn't set a clear mandate for the treasury to do that - it lets Paulson pay as much as he wants.

I expect the government to be a very gentle bank -- I can't see the treasury foreclosing very effectively - the political blow-back would be too strong. So I think you can make an argument that treasury shouldn't own mortgage-derived products at all, but for now I'll say that if they do, they need to buy them so cheaply that they never have to put the screws to home owners to pay taxpayers.

There are two groups of economic thinking on the crisis: one group believes the fundamental problem is liquidity. (I am in this camp.) When liquidity is the problem, the solution to insolvent banks is to let them go bankrupt, wiping out equity and part of the junior debt. The assets are then resold to someone who can do something useful with them and business continues. This scheme effectively "clears" market conditions by punshing debt-investors in banks. To me this is more than just acceptable - it's necessary. If we have a policy of bailing out financial institutions in a way that protects debt holders, financial debt will be priced as if it has a government guarantee, and the next insolvency crisis will be a lot worse. All investors earn their returns by buying risk - bond holders bought risk and now they need to collect it.

The other group of thinking is that banks are undercapitalized. In this school of thought, liquidity won't help if there essentially isn't enough money to loan out. TARP could help this in that one solution is for the government to buy equity stakes in banks, something permitted by the bill. But then we get into a big set of problems: does the indication that using TARP is necessary indicate weakenss on a bank that causes a panic? Does the risk of government buy-in at a low price scare off needed private-sector investment? Does government buy-in at a high price protect equity investors that do not deserve protection?

My answer to this is: different solutions for different problems.

The fed should continue to use its balance sheet to provide liquidity to "mundane" credit markets (commercial paper and friends). If the fed needs a bigger balance sheet, I'm okay with that; that's one use of government money. Since everyone goes to cash and T-bills when things get scary, expanding the balance sheet seems okay to me.
Insolvent banks should be closed down and rolled up quickly and quietly to "clear" markets by wiping out equity and junior debt holders in the financial industry. It has to happen. When we look at the "bubbles" the real bubble was in financial services - that is, wall street making collectively too much mony off our GDP by taking a percent. That can't continue - the financial mechanism is over-built and needs to shrink, and that means losses for investments who bought at the top. No one would have suggested propping up pets.com - or Country-Wide!
Fanny and Freddie should be used sparingly to provide refinancing in some cases. In other words, the government should continue its policy of subsidizing mortgages. We've been promoting home ownership this way for a long time - we really can't stop now, at a time when mortgage financing is difficult to come by. Fanny and Freddie are a mess, but they're on the books like they always should hav been, so at least we can understand how much we're in for.

Financing would be aimed at home owners who would be able to pay their mortgage if financed at sane market rates (e.g. a fixed rate, not the ugly end of an ARM), and applied in cases where the banks can be convinced to write down the loan to bring the home owner above water.

These points aim to do several things:

Keep liquidity flowing to business. We're in for a recession -- that's inescapable and happens any time one sector is massively overbuilt; we couldn't not have a recession given how many people were involved in making houses. We really don't need more houses!
Help the market "clear" as fast as possible. There is only so much we can do because you don't know which mortages will be bad until more of them reset. But generally we should aim to let the market find its "real" price, rather than slow the decline. Only once bonds and houses are priced fairly will economic activity resume. (Just watch a home buyer in this market - the big fear is "what if we haven't hit bottom yet".)
Prevent a foreclosure spiral in housing prices. The danger is that foreclosures force housing prices to artificially "undershoot" to a lower-than-bottom price, which causes foreclosures that otherwise would not have happened. The government needs to ensure that there is enough mortgage lending to prevent this from happening due to a lack of credit.

So there it is. In my next blog I'll solve world hunger.

Conspiracy or Stupidity?

2008-09-28T18:01:00.000-07:00

In my previous post (which I must admit was mostly an angry rant to the bailout) I implied that the current disaster is intentional. In particular, financial entities are profiting (compared to how they would have faired) by extending the US Government's protections that it provides home-owners. (That is, in its attempt to save home owners, we'll have to bail out a bunch of non-home-owner rich folks as well.)

But - that's not really fair - we can't assume conspiracy where stupidity and luck will explain the situation. In particular, I think it's more likely that the existing financial morass is an emergent behavior of a very, very poorly designed system, and those who will get bail-outs are getting so by coincidence of where they landed and not by a plan to leverage poorly designed housing policy.

I have heard congressmen argue that Wall Street was duping Main Street out of their home equity by selling them ARMs that would force a refinancing. Same situation -- an emergent behavior, not an intention.

Fundamentally in the crisis we have two middle-men and a blind buyer.

The first middle-man is the mortgage broker. His mission is clear: sell more mortgages. I you make a fee per mortgage and have zero skin in the game as to what happens to that mortgage, what do you do? You sell as many as you can, no matter how ugly they are.

The second middle-man is the investment bank that turns the mortgages into securities, perhaps even several times. If you make a percentage of the size of the deal, what do you do? You do as many deals as you can.

Now both middle men can get stuck holding the goods, if the contracts are written such that the middle man has to take the loan back. But here I fear the whole industry suffers from the same problem as the blind buyers: asymmetric risk/reward.

Buying all of these goods were, well, all sorts of entities....banks, hedge funds, pension funds, the investments end up everywhere. In particular, they end up anywhere that someone is willing to buy an investment that they don't understand as long as Moody's says it's really safe and it returns a few points better than cash or T-bills.

I believe that in the short term there is no fix. There is only the necessary steps to keep the patient alive and what we do in the long term.

The US Government should not buy anything. We really should not buy mortgages. I'll blog about that later.
The Fed needs to continue to enter repo agreements against illiquid (but not insolvent) assets to prevent financial seize-ups.
In the long term, we need to redesign the financial system to balance risk and reward. As long as the decision makers reap benefits when they gamble but someone else pays when they lose, they're going to bet the house, the car, and the grandchildren.

Finally, I think it's important to keep an eye on the fuzzy line between liquidity and solvency in the financial debate going on. If a bank is illiquid, there are short-term band-aids for that.

But if an institution is insolvent, the equity holders (stock holders) and bond holders need to take one for the team. The customers need not suffer (see WaMu's failure - bank customers are unaffected - only investors in the bank itself are hosed) but we can't let investors get a free ride on a failed investment - doing so encourages bad investment...it's free poker chips to the gamblers.

Sarah Palin: Framing the Debate

2008-09-22T19:28:00.000-07:00

As a defeated lefty, I have to admire the GOP for framing political debate to their advantage.

To that end, I think Sarah Palin is a pretty brilliant choice as VP for this reason: even if they lose the debate they win.

At best us lefties, who are totally distracted by Palin, prove that she is not qualified to be president. (Duh.) Is this really a victory? People voted for Bush Sr. despite Dan Quayle! I don't think a VP can be enough of a liability to warrant getting so off message.

Only one thing wins it for the democrats: "McCain is Bush Jr., and look at the mess we're in."

Bob Vila Does Not Have $700 Billion

2008-09-22T08:58:00.000-07:00

It's been a while since I've put up a good financial rant, but today deserves one, because these are special times. I have a superb deal for you:

You give me $700 billion in cash.
I will give you $700 billion in bad mortgage bonds, toxic derivative products, and whatever fertilizer I happen to have in my garage right now.

Foo - I'm too late. Uncle Sam is already signing you up for that deal.

Asymmetric Risk

At the core of the entire financial disaster is asymmetric risk. Any time you have a situation where the party who takes a loss is different from the party who takes the gain, the party that takes the gain is going to try their hardest to make the transaction happen. This asymmetric situation is everywhere:

A home buyer who is not required to make a down-payment (zero percent equity) gets the up-side of a rise in housing price, but transfers the down-side risk to the bank.
A mortgage broker that makes a commission on a mortgage but doesn't hold the mortgage makes money on the deal but doesn't get penalized if the mortgage goes into default.
A bank that has FDIC insurance, but does not have to back up its risky investments with capital holdings gets the up-side of the risky investments but gets bailed out for the down-side. (See below.)

Fundamentally what we have is a situation where risk has been transferred (often using derivatives) from the party making a profit to a party that has insurance (whether real or implied) from Uncle Sam.

Grass Fires

Derivatives are the vehicle that makes this possible. Basically a derivative is a contract that obligates parties to perform a financial transaction (one that will usually be really bad for one party) but does not require the party at risk to hold any money in reserve.

In the good old days, your bank took deposits from working people, loaned money out in mortgages to home owners, and kept the interest rate difference as profit. Now since working people always want their money bank but home owners sometimes default, the bank had to keep a little bit of deposit money aside (its reserves) just in case; the size of that reserve has to be proportional to the risk of the home owners failing to make their mortgage payments.

Derivatives have no such capital holding requirements. To see how insane this is, let's look at a "credit default swap" (CDS) - one of the most ludicrous inventions ever. A CDS is basically insurance on a bankruptcy. Here's how it works:

You have $100 in General Motors bonds and are a little bit worried that GM might go under.
I have $100 in treasury bills.
We enter the following contractual agreement: in the event that GM does go broke, I will swap my treasury bills for your (now quite worthless) GM bonds.
You will pay me some money right now to take this idiotic deal.

So basically what we have is bond insurance - you pay me a small premium, and in the rare event of a default, I insure you. Now here's the rub: I don't have to keep the treasury bills locked away!!! Heck, I don't even have to keep a fraction of them locked away. I can go spend them on beer and pray that GM doesn't go broke.

Of course, this has some unfortunate effects. Perhaps your GM bonds had a low rating because GM is in deep doo-doo. But if you buy some insurance from me, you can "enhance" the credit of the bonds...GM bonds + insurance are a lot nicer than GM bonds. But what happens if I, the writer of the insurance, go broke? Your GM bonds instantly turn back into a pumpkin, so to speak. At that instant, any other deals that made sense only if GM bonds are good is now quite screwed up.

And this is the nature of counter-party risk. If you enter into a derivative contract and you need that contract to be valid for your business, you take on the risk of the other side of the contract going broke.

The experts told us that derivatives would spread risk and make the system more robust. They were half right - derivatives definitely spread risk. Derivatives on risk is like on a grass fire.

Selling Uncle Sam

Now we can start to see why Uncle Sam is considering spending $700 billion dollars to buy a huge pile of toxic waste. If you have counter-party risk, it becomes in your interest to keep the other party alive. Uncle Sam's umbrella of protection has been wrenched out from over the small depositor and home owner and extended to wall street through the mechanism of derivatives.

John Hussman has a great explanation of how you can hook Uncle Sam into insuring things that the tax payers really should not be insuring:

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

The financial alchemy is in Citibank exposing itself to risk (and making money by doing so) without reserves. Remember the good old days? Well, in this transaction Citibank didn't put any money inside to cover the case where GM goes under. (If GM goes under, Citibank is left writing mortgages at fixed rates while paying depositors a floating rate. If interest rates go up, Citibank will lose money with every transaction. But Citibank has no "nest egg" of cash stashed away to cover this case.)

Simply put, if you can get Uncle Sam to be counter-party to another entity, Uncle Sam has to protect the other entity. And thus here we are, trying to bail out all of Wall Street.

Extending the Umbrella

Let's go back even further - how did we get here? We have a policy in this country (the "American Dream") of subsidizing home ownership in the form of tax breaks and credit enhancement. Basically Uncle Sam is willing to spend money to get you to buy a home by:

Providing tax breaks for mortgage interest (which creates an incentive to borrow money, not save, and makes financing of houses effectively cheaper).
Keeping interest rates low, which also makes financing cheaper.*
Providing credit enhancement to borrowers (that is, guaranteeing mortgages).

To this last point, the Government does this both by writing guaranteed mortgages (FHA, etc.) and also by creating Fanny Mae and Freddie Mac - two companies that write mortgages. Fanny and Freddie make mortgages cheaper by using their good credit rating to get cheap financing for home buyers. Why would Fanny and Freddie have a good credit rating if their job is to make housing a little bit too easy to get? Simple: we all assumed that the government would bail them out if things got ugly. And of course, that is exactly what happened. As a net transaction, Fanny and Freddie represent Uncle Sam backing up a huge number of home buyers on their mortgage.

So we have the government providing credit enhancement. How can Wall Street profit off of this? Simple: they need two things:

They need a lot of people to buy homes and utilize that credit enhancement, so that it can then be transferred.
Wall street then needs to find a way to transfer that credit enhancement from the individuals doing the borrowing to other parties, who will pay a fee for this.

Getting people to utilize the credit enhancement is pretty easy: offer them cheap financing. Offer them all the up-side of a market increase without the down-side by writing nothing-down mortgages.

You then write products that are tied to this sea of government-backed paper and you pull in Uncle Sam as a counter-party. You sell this off with the wink-and-a-nod that the products are credit enhanced because you-know-who is a counter-party. The huge chain of derivatives and "engineered" financial products spreads the risk all over the place, and thus spreads Uncle Sam's umbrella all over the place.

If Uncle Sam walks away and lets Wall Street go down, the chain of derivatives guarantees it hurts "main street", the little guy, for whom cheap housing was invented. This is the true price of subsidized housing.

Only Pain Will Heal

Besides a huge credit mess, what we have is overproduction: too many houses and too many mortgage bonds. The only way out is to stop making houses and mortgage bonds for a while. And this is where I have the greatest fear; falling prices for houses and mortgage bonds is the market's way of dealing with the extra product floating around.

If the Government starts spending hundreds of billions of dollars to prop either, that is money spent on an inefficient and overproduced part of the economy, destroying real investment in future US growth. But I fear that the debate in Washington is on who gets the bail-out, not whether there should be a bailout.

* I know, there is an immense amount of hand-waving in that statement and it isn't really supportable. In fact, this whole rant scrambles cause and effect pretty thoroughly. But I must point out that this is the nature of asymmetric risk; parties may not have known Uncle Sam would bail them out, but they didn't have to care, since they were in a position to make all the profit and take none of the pain.

Going For Broke

2008-07-18T07:22:00.000-07:00

Lori got an awesome graph in her mail the other day - it was her Van Guard 401k statement from a former employer. This is a "2040" plan - that is, they mix the stocks and bonds for you according to theoretical models so that you can retire in the year 2040. As 2040 draws closer, they move from stocks to bonds so you get higher return on higher risk when young, but the bottom doesn't drop out of your retirement 3 days before you need it.

Due to the employment duration and market performance, the graph was a simple straight line going from "more" to "less". The caption had some marketing drivel about preparing for retirement...extrapolate the line out and Van Guard will have carefully lost all of her money by the time 2040 rolls around.

Now it could be a lot worse - the expense ratios on Van Guard's plan are really low, and we have to accept that stocks are risky and there will be periods like this when the market gets the hell beaten out of it.

But what caught my attention was the mix. For someone retiring in 32 years Van Guard recommends 90% stocks and only 10% bonds! Wow! (By comparion, the "old" models would have been 70% stocks.)

Hrm...how did we get here?

Nerdy analysts look at historical stock-bond returns and recommend a 70-30 mix.
Lots of people put 70% of their retirement into stocks via mutual funds.
This increases demand for stocks, their value goes up and up and up.
Stocks now have a higher historical return.
Nerdy analysts recalculate. The mix should be 80-20 because stocks are even better than we thought.
People put even more money into stocks!
Stocks go up even more.
Now stocks have an even higher historical return.
Nerdy analysts recalculate...

I think I hear Adam Smith laughing at us...

Bob Vila Would Never Club a Robotic Baby Seal

2008-06-26T06:47:00.000-07:00

...Because they're too cute apparently. I must admit that, having heard the story before viewing it on the web, I imagined the robotic baby seals to be cuter than they really are.

Now part of me thinks that when we are using a robotic pet to comfort the elderly, we have really, really lost our way.

But the truth is, I am a technological grumpy-old-man, and the war between the young and old regarding technological integration (that is, integration of technological into the domain we would have reserved for "life") is being lost every time a new baby is born.

Having had my formative years before the internet and instant messaging and ubiquitous wireless technology, the notion of asking someone out on a date (or ending a relationship) via text message or posting all of your personal information on a MySpace page strikes me as moderately ridiculous.

But to my own self I must be true: I am a fossil. Human beings, when presented with these technologies (among others) see nothing unusual - we integrate every technology we develop into our lives. I don't think my 2-year-old nephew sees any difference between the remote control and wooden blocks. They are all simply objects to be explored, touched, chewed on, and mastered until, like all tools and technologies, they are an extension of him, part of the fabric of human life.

My negative reaction initial to robotic seal pets* (besides being caused by a lack of coffee) comes from a line in the sand that is crossed when technology starts to affect us emotionally. But this is a ludicrous line in the sand; all technology affects us emotionally, even ones that are not supposed to. (Tell me there isn't enough hate caused by Microsoft Windows Vista to start a war!!) We connect emotionally to our cars and computer programs, perhaps because we connect emotionally to everything.

And robots don't have a monopoly on button-pushing. In "The Truth About Dogs" Stephen Budiansky argues that dogs are fundamentally parasites. A successful parasite attaches to its host using a property of the host so integral to its survival that the host cannot "close the door" on the parasite . In the case of dogs, by triggering all of the responses that make us care for children, they obtain food, shelter, medical care, toys, belly rubs, and in some cases trips to spas. If we didn't think dogs were cute, we'd probably toss our babies out on the street too.

As Lori and I sit around blathering about how cute it is that the dog is rolling around under the bed or that the cat approves of the new sofa (as shown by sleeping on it) we realize that we have animals in the house that have reduced our mental functioning, and in the process, mooched hundreds of pounds of pet food. If Martians came to do a documentary on human culture I am sure the narrator (who would sound just like Morgan Freeman) would say:

"This human pair has become infecting by a dog and a cat. The animals play on the humans nesting instincts, diverting their normal course of development. The humans do not yet have offspring, but instead foster the dog and cat."

In the end I think Daniel Ariely's view makes sense; we humans are hopelessly hard-wired for some irrational behavior. Whether it's another species that wants a free meal, or a robotic baby seal engineered by researchers, we are going to attach to things emotionally whether it makes any sense or not. We can't change who we are. All we can do is be aware of our human heritage and navigate the murky waters of technological change as best we can.

* If someone makes a robotic baby seal with laser beams mounted on its head, I will be the first to buy it!

This Is My Day

2008-06-08T07:30:00.000-07:00

CC and Nala's relationship has come a long way in almost a year; originally we could not have them in the same room, and we had a gate or door separating them at all times. We've reached a point now where I don't have to separate them at all.

The turning point in their relationship was when Nala decided it was more fun to hit CC than run away from her. Nala's previous owners declawed her - if she had a little more firepower they would have found a balance of power much quicker (basically the dog doing whatever the cat wants). Instead this drama plays itself out probably about once a day.

Now I must admit, I did intentionally allow this to happen by asking the dog to come sniff the cat once I had the camera ready. It's a situation with a predictable course:

Dog decides she really, really, really needs to smell the cat - perhaps the cat smells different than yesterday? You never know!
Dog attempts to smell the cat, usually by jamming her nose as close to the cat's belly as she possibly can.
Cat decides she does not like the dog doing this and hits the dog, perhaps 8, 9, 10 times in a row.
While it didn't happen this time, the cat usually then immediately washes her paws because she has "dog cooties", which are totally gross.
Cat decides to leave and go somewhere else.
Dog whimpers because the cat doesn't love her.

Never a dull moment.

These days I have been catching both of them sleeping in the same room (once even in my office) fairly close together, e.g. dog on the floor, cat on the chair, or cat on the dog's bed, dog on the floor...but the cat is always on alert so I haven't been able to get a good picture yet.

Ah, CNBC

2008-05-31T10:30:00.000-07:00

http://www.cnbc.com/id/15840232?video=753754816&play=1

I have a simple rule of thumb for resolving economic questions: whatever the loud guy shouting on CNBC says is wrong. Ergo, there is oil speculation.

This argument has been thrown out before: because the spot price is based on real oil, "paper speculators" (index funds that buy and sell futures to avoid actually ever having the oil) then the real price of oil (the spot price) can't be influenced by speculators.

To paraphrase the Simpsons, Rick Santelli makes a very loud point.

His argument is essentially that if there's a lot more people speculating on oil going up then down, then when those speculators defer receiving the oil, they'll pay a premium since no one wants the oil (supply and demand).

Of course, that is exactly what's happening: the market is in contango - that is to say, there is a cost to paying someone else to hold your oil for you (so you can lock in the speculative gains). The index speculators are paying month to month. (Of course, they are rolling from 2 months to 1 months, at least in the case of Barclays oil ETF.)

So how can the spot price be affected? Simple: oil producers are in a perfect position to make a killing off of the contango.

Imagine I drill for oil in my back yard and can produce a barrel of oil a month. I enter a futures contract (locking in a higher price due to contango) to deliver in two months and put the oil in my garage. At the end of the month I look at the market and see that I can make a profit by selling another two-month contract while buying a one-month contract.

That one-month I bought perfectly balances the one I sold (two months ago, so now it's a one-month) and the barrel of oil in my garage backs the new two-month. I make (for free and risk free) the roll yield the commodity indexes are losing.

Of course, I've shut my well down. Is this a big problem? It depends on what I'd rather have: oil in the ground or dollars (which I'm making anyway).

Of course I don't even need an oil well to play this game - I could just buy one barrel of oil, sell it forward, and start rolling the contract. Essentially contango pays people to store oil.

So when you invest in rolling oil futures, you really are hoarding oil - contango is the "rent" you pay someone else to do the dirty work of stashing your barrels somewhere. (But you most certainly have a real claim on a real resource - that's what a futures contract is. No one is going to do anything else with "your" oil until the contract is settled.)

So what about the spot price? If this is all about contango and negative roll yield, why are we paying $4+ at the pump? What ties the spot price to the futures price? (Santelli's argument is that since the speculators only play with futures, they can only move futures prices.)

The answer is arbitrage. In a situation where the prices of futures contracts have gone much higher than spot prices, oil producers can make a ton of money with zero risk. They sell less oil on the spot market and more using futures contracts. As long as the price difference is larger than the storage cost, the producers make a profit, and the spot price goes up (due to a lack of supply).

Yellow Books

2008-05-28T17:10:00.001-07:00

I enjoy spotting the yellow "X for Dummies" books in Barnes & Nobles...the topics that the books hope to explain to dummies strike me as, well...ambitious. Still, "Currency Trading for Dummies" cracked me up.

By comparison, I thought "Hedge Funds For Dummies" was a fitting title - with the hedge fund manager taking 20% of the profits and 0% of the losses, how could a hedge fund be for anyone else? :-)

Wicked Good Eggs

2008-05-28T10:21:00.000-07:00

I read The Omnivore's Dilemma and strongly recommend it. Even if you don't agree with Pollen's opinions on food culture (I do, but that's just my opinion, not something I would argue about) I believe the book is a good for its treatment of farm economics, something that city slickers like myself might not be aware of.

The factor that I think is now so relevant (with both high food and high oil prices) is the chain of subsidies and non-renewable inputs that goes into our food.

It starts with oil, something we can't make more of, and something we don't really have (to the scale that we require) in the US. I'll blog about oil some other time, but for now let's just say that starting the chain with oil gets us off on the wrong foot.
The oil is used to make fertilizers...basically you couldn't grow corn to the quantity we do without adding a lot of fertilizer, and that process requires energy, which in the US means fossil fuels. (I suppose that we could move some of our energy dependence to nuclear power - I am for this, and not just because I could then blog that the beginning link in a bag of Dorritos is Uranium!)
The farmers grow a pretty huge amount of corn - the Government pays them to do so, allowing them to spend more on production costs than the corn is worth.
That makes corn so cheap that we go feed it to cows who aren't even supposed to be eating corn (and get really sick from it).*
This ends with a Quizznos add telling us that for $5 we should get more meat!
Actually, it ends with us all getting really fat.

When I look back at the entire chain of events, it strikes me as completely absurd, and more importantly really inefficient! A lot of expenditure for something (in this case fast food) that isn't even that great. I'd like my taxes back, I can live without fast food, thank you.*

But it turns out that Polyface Farms, which is featured in Pollen's book, delivers to the DC metro area via buying clubs. So Lori and I signed up.

Now I do have to admit that while signing up makes my liberal conscience feel good, the amount of food we ordered is a drop in the bucket of our total callorie consumption - we're going to have to find sustainable sources for a wide range of other types of food.

But the point of this blog post is not that Polyface is sustainable, with almost no outside non-renewable inputs. It is that their eggs are magical.

Lori and I try to buy the freshest eggs we can, but Polyface eggs are in a different dimension. I found this out last night when making meringues and zabaglione; the meringues whipped in perhaps half the time normal eggs would and became so thick as to lower the RPM of the mixer. The initial beating of the yolks takes significantly more effort than with your regular store-bought yolks-break-by-looking-at-them variety.

Forget sustainability and the planet, I would like all my food to be farmed the Polyface way because the quality is unreal!

* There is now a fork in the road - we could go down a different path and use our cheap subsidized corn to make fuel...sort of like the fuel we used to make the fertilizer to grow the corn. I've read that the output-input energy ratio for Ethanol is 1.2 (that is, it's a slight win, prodcuing 20% more energy than it took to make) but 1.2 is still totally lame.

Bob Vila Would Not Invest in Fixed Income

2008-05-27T09:23:00.000-07:00

Or would he? One of my friends told me he's only 10% in fixed-income in his retirement savings account; for the last two days I've been trying to write a blog post on why that's not a good idea for someone in their 30s, and each time have failed. The problem is I can tell you more about why any investment theory is built on shaky ground than I can about why any particular one is good.

I have some entertaining performance numbers from various investments over the last two years, but while they're good for a laugh, but not much else. If someone says "my investment strategy is to play the lottery" we'd call that person a moron. If the person then won would we go "no, you were smart all along"?

My gut feeling is that my generation doesn't adequately fear the stock market. Consider the following:

Periods of relative success increase risk. When things are quiet, we humans with our short-term memory think we can gamble more, until something bad happens. This is essentially what happened with the housing crisis: complex engineered fixed income investments were quiet and steady so people built more and more risk into them for less reward; when they went awry, the result was carnage.

Both bonds and stocks have return both on investment fundamentals (the coupon for a bond, dividend and earnings yields on a stock) and speculation (sell the investment on to someone who pays more). Since 1982 we've seen a huge increase in how much people are willing to pay for a stock with a given return. The results of this are two-fold: the investment yields on stocks keep going down, but along the way people make specualtive yield.
This means that the potential for future returns keeps going down (since the investment component is getting smaller) and yet we think that stocks do well because their past growth has been high (due to speculative yield). We have to see this for what it is: a pyramid scheme. The speculative component of stoc k yield cannot grow indefinitely, and the investment yield is low due to high prices. I'm not saying stocks won't make money, I'm just saying that when people say "the stock market returns 10%" they're throwing out numbers that were true from 1980-2000 but probably won't be from 2010-2030.

So here is some data, mostly food for thought.

Sometimes the Rules Change

This chart shows the relationship between stock earnings yields, stoc dividend yields, and bond yields. Note what happens in 1955: until then, bond yields have always been lower than stock dividends. In 1955, this relationship changes and it never goes back.

My point here is that sometimes the rules of the game change forever. Benjamin Graham said that in the short term the market is a voting machine, in the long term a weighing machine. Basically he was saying that in the long term speculation will wash out and your long term return will be based on fundamentals.

But I'd say: sometimes in the long term the rules of the game change and you don't win what you thought would be yours. If you made investments under the assumption in 1955 that the weighing machine would vindicate you, you'd never make your money back.

This has applicability to two cases:

More strongly for "regression to the mean" or "value" investors - that is, investors who try to identify temporarily incorrect prices and invest to profit when they come back. This is often a good stragey, but it is not risk free - every now and then the rules change and you blow up.
More subtly, but also more importantly, this also applies to arguments that "X has never happened in the past". For example, you'll find a ton of posts in the last year suggesting an over-weight in equities for retirement investors. The logic is: they return more and over N years they've never lost money" where N is long enough that the stock market recovered. There are specific problems with this argument I'll blog about some other time, but it's worth noting that in 1955 stock dividends had never been lower than bond yields, until that wasn't true forever.

Sometimes the Rules Don't Change

This is a graph of the Nikkei 225, that is, Japan's major stock market index. My generation is too young to really understand Japan in the 1980s I fear. Note that not only has it not made back its peak pricing, it hasn't even come close.

Whenever there is a bubble, you'll hear "this time it's different" - think dot bombs that lose money on every transaction but make it up in volume with $100+ stock valuations. Sometimes the rules change, but a lot of the time they don't.

The Nikkei provides a number of warnings about stocks:

If your underlying asset is subject to bubbles and heavy speculation, you might never get your money back. A diversified, balanced portfolio is a good defense to this.
When you invest really does matter...if you hear "99% of the time strategy X returned great results" ask yourself: what happened in the 1%? Would you take a drug that will fix your headache 99% of the time and kill you 1% of the time?
Stock markets don't "always go up". That's what they said about housing.

The Life of a Turkey

There is a wonderful graph in The Black Swan called "The life of a turkey" - it is a steadily increasing graph of the amount of food fed to a turkey on a given day, until right before Thanksgiving the graph abruptly plummets to zero.

The fundamental problem with a whole pile of the financial tools we rely on is that they look at past data to answer questions about the future. But, as the life of the turkey points out, before Thanksgiving there was no data in the Turkey's history that could predict what was going to happen.

Taking Stock

And this is where I recommend a certain amount of skepticism when approaching stocks. You will see articles like this one, but as you read, remember the life of the turkey! In no 30-day period in the turkey's life did our poor bird die once - and yet he was not immortal.

There is simply no guarantee that trends from past data will sustain themselves - the "30 year win" theory of stock investing does not make a stock investment safe. Stocks can and do lose money - we have to look at the underlying mechanism of the investment, not just what the numbers have done in the past.

Stocks do not become like T-Bills over 30 years just because their average peformance shows the same volatility over a long enough time frame!

To end with my favorite epistemologist, Donald Rumsfeld, there are known unknowns and unknown unknowns. Past stock performance might give us some insight into the known unknowns, but it does not tell us anything about the big unknown unknown: namely how and when have the rules of the game changed?*

Unfortunately we go to war with the investment analysis tools we've got, not the ones we want. I am not saying "put your money under the mattress", and I do believe that diversification is a damned good idea.

My point is this: when you look at "risk", consider whether scenarios exist where you would lose more money than you are comfortable with, not the average and typical outcomes. There is no guarantee that the average or typical will happen, or even that it really is likely. Today Modern Portfolio Theory has become gospel, but don't let the gospel keep you from thinking about the unthinkable.

* Of course, people now are saying the rules have changed because we will have "decoupling" of the US and Asian economies. This strikes me as even more ludicrous than past statements about dot.bomb valuations, but that's another blog post.

A Good Podcast on Housing

2008-05-11T10:46:00.001-07:00

Well timed for the week that we've spotted our first short sale in the neighborhood, "This American Life" (which you should listen to all the time anyway because it's great) did a really wonderful comprehensive one-hour show on the housing crisis. It should be mandatory listening for, well, everyone. Not only did they cover all aspects of the crisis, but they did so in a way that was both accessible to non-nerds and yet not dumbed down to ignore important details.

Last post I ranted about the issue of over-exposure...that is, in our attempt to own our own houses, most Americans are totally over-exposed to housing price changes with no diversification within the sector (real-estate); the equivalent of borrowing a million dollars and then investing it entirely on a single internet stock. (After a bubble bursts, it's a lot easier to see how stupid an investment idea is; I think an important lesson we all have to learn from the housing crisis is that if we're going to directly connect real-estate to the global financial system, the chaotic, non-linear, unpredictable nature of the financial system is going to infect housing prices.*)

A trend that you'll spot over and over when you look at the current financial crisis and how we got here is intermediation - that is, the ability of Wall Street to take something, process it like a TV dinner, and then send it back out to someone else. The effect of this "financial engineering" (financial processing might be more correct) on our system is about as healthy as eating heavily processed food is on our gut.

But John Bogle puts financial processing in the right perspective: Wall Street's profits are the fees they take on transactions. To the extent that their profits have grown faster than GDP (that is, their growth cannot just be explained by taking the same cut from more general economic activity), we can see that Wall Street is taking a bigger slice of the pie than they used to. Finance-geeks will give you all sorts of lines about increasing efficiency of the market, but this is crap; if the financial-sector's profits grow faster than GDP, they're simply keeping more for themselves.

Financial processing is how they do it. When you listen to the slice-and-dice game that financed the housing bubble, with a mortgage getting passed on over and over, you have to remember that the parties involved didn't just do it because they wouldn't be bearing the real risk. They did it because they got paid every time they made a transaction. Wall Street had a few years of huge profits, and those profits were a slice coming out of everyone's mortgage payments. Someone did get rich off this whole mess.

Another Case of Food Processing

A caller on Marketplace Money wanted to know what to do about his auction-rate securities. If you don't follow this kind of thing, basically the investment banks convinced very reliable long-term municipal borrowers like the NJ turn-pike authority to set their bonds up in an auction-like scheme where the bonds were constantly resold each week. (Normally the bond would be 30-year fixed rate, someone would buy it, keep it for 30 years and everyone goes home. Life is boring for 30 years.)

The rationale for this scheme was: by re-auctioning the bonds, the turn-pike would constantly be getting "the latest" interest rates, which were at the time very low. (When interest rates are down at 1%, it's basically impossible to convince anyone to buy a 30-year bond at that rate.) The theory was that by making a municipal bond look variable-rate instead of fixed-rate, the borrower could get the lower current variable rate (1%).

Investors in this were told that this was just about the same as holding cash, but for slightly higher interest; since the auction is every week, you can always sell your bonds off in the next auction.

If you get higher interest, you're always taking a risk, so it's good to know what that risk is. It turns out the risk here is that the entire auction system would break down when the investment banks who ran the system ran out of money. The poor caller needed to sell his bonds ASAP (his short-term funds were in the bonds) but the auction system had ground to a halt so he couldn't find a buyer. In the long term he's not going to lose any money; the odds of the Turnpike-authority defaulting is very, very low. But he needs his money now!

(These are long-term bonds that are resold in the short term...so you can get your money now if there is an auction, or you wait 30 years if there isn't.)

Now you could say that this investor was chasing higher returns without knowing the risks, but I think we need to look at the roll of the brokers and investment banks. This poor guy got these bonds through a broker, who gave him some "good advice" - look at this clever way you can make more money. Look how clever we (the investment bank) is in creating this new trick to improve returns. Look how kind we are to let you in on this little secret. (Implicit message: returns are higher because not everyone knows about this. Truth: there are nerds on wall-street who control such large piles of money that if it's worth knowing about it, they know about it and buy it before you ever find out.)

There's a conflict of interest that was present in the dot-com bubble burst that's present here both in the housing crisis, and in all of the other instruments (like auction-rate bonds) that have started to break down as a result of the stress the housing crisis has induced. And that is the conflict of interest between profits for Wall Street itself and profits for the investors who are one set of Wall Street's clients (and the borrows who are the other)!

Auction-rate bonds turned into a deal that went ugly for both the investors and the borrowers. One might speculate that the only group for whom the deal was any good was the investment banks who ran it and got to collect transaction fees all over the place, without having to carry any of the risk themselves.

Good Advice

So if there is a common thread to this rant, it is: don't trust "advice" - see that any party that makes its money on transaction fees has an incentive that goes against your best interests. This would include:

Real estate agents. (See Freakanomics regarding agent selling practices for their own houses vs. client's houses.)
Mortgage Brokers. (See This American Life for poor recommendation on Mortgages.)
Stock Brokers. (See the dot-com bubble.)
Investment Advisers. (See the recent 401k kick-back scandle)

Of course if you believe any of what I've written, it does beg the question: why are you listening to some cranky blogger on the interweb?

* That's actually a bit disingenuous of me - real-estate has been subject to bubbles for hundreds of years; but connecting real-estate to hedge funds certainly doesn't make things better.

Housing: Why We're All Doomed

2008-02-27T10:26:00.000-08:00

I don't think there's any even remotely good way out of the housing crisis - here's why:

For any market where the supply of housing can be increased, high prices are not sustainable. If a 3 bedroom house in Nevada is selling for half a million dollars, someone is going to go build another house in Nevada for less than half a million dollars, sell it, make a profit, and repeat until the price of housing comes down.

So for any market that isn't limited by available land, there's no sane way to prop up the price of housing. Anyone who took a mortgage based on bubble-level housing prices is simply screwed; when we (homeowners) buy a house, we are assuming market pricing risk ourselves. The only way out is to give up on equity (if there is any), stop payments, let the bank foreclose, and forget about your credit rating for the next decade. This transfers the market risk unceremoniously onto the investors who bought the mortgage.

(Requiring a real down-payment was the safety mechanism that kept these kinds of things from happening - of the people I know who bought a house, I don't think any of them actually put 20% down.)

Most of the "rescue" packages I've heard discussed on the media come down to some mix of either strong-arming lenders into accepting new financing terms or providing new financing. I have no qualms with strong-arming lenders even if it makes libertarians cringe. The libertarian in me says: buyer beware...investors should know that if their investment requires elected officials to stand by while citizens get the short end of the stick in an investment, someone is going to step in and do something populist. That's part of the risk of the investment. When you buy asset-backed whatevers, you should care about what the underlying asset is because that's the only thing protecting you. (Sure the house behind the mortgage has value, but having to foreclose to make good on the loan is an ugly solution.)

However I simply don't think adding additional financing is going to do a lot - we could hope to stem the wave of foreclosures but not the price change for anyone who bought a house at peak prices. If you're underwater, why would you want to accept fixed rate financing so you can protect your negative equity? I think it's a question of "how much is a credit rating" worth. Is a credit rating worth $50,000?

I'm not saying we shouldn't have additional loan help. In particular, I think that there needs to be disintermediation in the mortgage business (letting the people writing the mortages not own them has proven to be a bad idea). Securitization of mortgages has lowered their cost; if we are going to go back to traditional lending and we want to maintain credit costs similar to what we've had for the last twenty years, new investment has to come from somewhere.

Subsidizing housing prices seems like a non-option and unfeasible; not only would additional housing subsidies further increase the overall supply of housing (via new construction), but the scale of the problem is too large. Consider: by spending $150 billion we don't have, the government is putting a mere $600 in our pockets per person. How many home-owners are only underwater by $600 or only behind by $600? The rebate is a drop in the bucket, which is why it won't address housing problems at all. You can see how the market correction is beyond the scale of government intervention.

Stepping back, I come to a question more fundamental than "what went wrong" and "what should we do"...I want to know: should we even own our own homes at all?

When I plan my retirement savings each year, I try to diversify my investments - within stocks, I have an index fund to protect me from one company's downfall. Not all my money is in stocks, etc. etc. If I said "I'm going to put all of my life savings into Raytheon stock" you'd say I was an idiot.

But wait - look at my total set of investments. I have more money plugged into domestic property (in fact, into a single unit in a single neighborhood) than I have in all of my other investments combined!! That's not diversification at all? I am subject to an immense amount of market risk!

Home ownership is heavily subsidized in the US, and that's one of the reasons Lori and I bought - it's generally a better deal than renting. But this exposed us to huge market risk. I think one of the reasons that the housing crisis has hit so hard is that the nature of houses as a commodity has changed over the last thirty years. With the invention of securitization, REITs, etc. it's possible for speculative money to enter the real-estate market in a much bigger way and this means that the volatility of housing prices is going to resemble the rest of the instruments wall-street pedals. I think that, as a country, we didn't see our houses as dot-com stocks until it was too late.

(Here's my alternate approach: owner-occupied REIT coops. Basically the ownership rights (when you move, what you can do to the property) remain with the owner-occupier of the house. But the capital gains are owned collectively by all participants in the co-op.

(The owner-occupier would be forced to hold a larger stake in his or her own property, perhaps a minimum of 20%, so that the owner has a strong interest in maintaining property value.)

This would allow home owners to spread market risk across geographically diverse areas and/or different market profiles, or even sell off market risk to outside investors who want to buy it.

Bob Vila Probably Picks His Own 401k

2008-02-16T12:57:00.001-08:00

Why can't we all? With tax time approaching and the recent news about 401k abuses, a simple remedy occurs to me.

The fundamental problem with 401ks is that they provide the only outlet for someone to save 25% of their income for retirement with tax deferral. So your choice is: use the company's 401k (no matter how expensive, how lame the investment choices, and how much the kickbacks) or lose that tax-deferred savings vehicle entirely. (A traditional IRA pales in comparison, with its $4000 limit, plus if you're married the maximum income ceiling is relatively low.)

This isn't a problem for me - as a self-employed contractor, I get a SEP-IRA. I get all the savings of a 401k (up to 25%) but I can put it anywhere I please, shopping the market place for an IRA that has investment choices I like and isn't gummed up with fees.

So my proposal is greedy - it solves our problems but doesn't help savers who aren't
paying attention. Simply put:

The IRS should allow savers to treat all employment income as eligible for a SEP-IRA as long as the tax payer opts out of his or her company 401k.
Matching benefits would be paid to the employee for direct deposit into the SEP-IRA.

The tax treatments and infrastructure already exist! Consumers could vote against their company with their feet.

A Financial Mini-Rant

2008-01-28T20:04:00.000-08:00

It's been a while since I've posted a financial rant on this blog, but we seem to be cursed with "interesting times"....a few random thoughts on the economy:

Compared to 2001 the upcoming financial pain has to be worse. If there's any industry I'd want to be at the focus of a bubble-collapse-recession it'd be the computer industry; we're an industry with high growth and usually low unemployment; we bounced back. I think this time around, with housing hit hard it's going to be worse for more people with fewer options.
I think the hopes of "decoupling" (the idea that the rest of the global economy will march on, allowing the US to quickly turn around via exports to strong foreign economies) will prove to be a fantasy. Over and over when finance gets ugly, everything moves together. Perhaps it is because there are so many positive feedback cycles. Read the downfall of LTCM - the experts are always surprised by "perfect storms".
The stimulus package strikes me as a poor idea. We're in a jam because we've collectively borrowed and spent a lot of money we didn't have - the heart of this financial mess is about insolvency. So borrowing another $150 billion seems like a supremely poor idea. It's like our solution to maxing out our credit cards and getting a pink slip is to go apply for another credit card and immediately max that one out too. I don't know how the US will get over its debt addiction, but buying an eight-ball isn't the right approach.
The financial system is parallelized by fear of counter-party risk, but I don't buy that we got anything useful out of the heavily engineered products that got us here. You could make some kind of argument about greater financial efficiency, but it looks to me like Wall Street invented a series of instruments whose primary feature was to make Wall Street rich. If we can't understand how to value these things, are they really helping us manage capital more efficiently?
The recent bond-insurance melt-down shows a conflict of purpose to me. On one hand, insurance involves taking money now for services to be rendered later, so there's a lot to be said for your insurance company not going broke. On the other hand, if we don't let financial companies fall flat on their face when they do really stupid things, we introduce a moral hazard. The way to mediate this would have been more regulation - not letting any insurance company play with fire. (And frankly if we didn't have municipal bond insurance, the world would continue to turn. If Louisiana doesn't need bond insurance, no one does.)

Okay that's enough of that for now. I have to go hide my money under the mattress.

Bob Vila Would Not Eat Low-Carb Ice Cream

2008-01-07T09:02:00.000-08:00

There is no experience as heart-breaking as coming home from Europe to the US and then eating. I have made this fall from food grace five times now, and it's painful every time. The five steps are:

Denial. The food in the US can't really be that bad, can it?
Anger. Why the hell is our entire country's food supply such a disaster. Why are there hormones in the milk? Why is their E Coli in the meat? Why doesnt' a tomato have any flavor any more? Why is it legal to sell a baked good that can go unrefrigerated for four years?*
Bargaining. So you make a plan - I'll make my own bread, I'll go to whole-foods, I'll give up Doritos, anything!
Depression. What's the point of eating?
Acceptance. Let's go to Taco Bel..

If you haven't been to France or Italy, here's what I have experienced: food is of better quality all the way up and down the spectrum. From the sandwich you buy on the street to a restaurant meal, the ingredients are better, the preparation is better, the experience is just better.

Now if I may tangent slightly, Lori and I made a really really good pizza the other day. The dough was made from scratch (thanks to our bread-maker this is really easy), cooked on stone, with caramelized onions and fresh Mozzarella, it was just a really good pizza.

But if you buy into the latest "healthy eating" trends in the US, what we did was not healthy because it's high in carbohydrates.

So here's my rant: back in the 70s, fat was the evil food. Americans ate a ton of processed food. So the food companies did their best to remove as much fat as possible from processed food. We kept eating processed food (now jam packed with carbohydrates) and we continued to get fat.

Then the Atkins diet gets all trendy*, and the processed food companies try to remove all carbs from processed foods, we keep eating processed foods, and we keep getting fat.

Perhaps we should just stop eating processed foods?

* I had a science teacher in 7th grade who took a Twinky, injected it with water from a local pond (read: water with a heavy concentration of microorganisms) and then left it on top of the blackboard on a shelf. Several years later he took a job in another state. Before he left, he unwrapped the Twinky and cut it in half. There was absolutely no sign of organic growth.

** I know many people who have lost weight from the Atkins diet. But the trend I see is that it really really disrupts your regular eating habits. I can't help but wonder to what extent the Atkins diet causes weight loss by either (1) lowering total caloric intake or (2) eliminating "empty" foods like processed snacks.

Pod-cast induced rants...

2007-11-19T05:00:00.001-08:00

As I listen to pod-casts...

We have a strange idea of what it is to be rich...our houses got more expensive, as did oil and gold and fuel and food...didn't the dollar just fall? Measuring the cost of living via consumer electronics is silly! I can't eat my iPod (not that I haven't tried).
Yelling at China about how they "rig" their currency strikes me as disingenuous. You only need to have one multi-course dinner for two with a lot of beer for $3 in Beijing to realize that no adjustment in currency is going to undo the huge cost of labor advantage that China has. The RMB could go up 50% and we wouldn't get our factories back.
Countries don't "rig" their currencies with willpower (ask South America). China has earned the right to do whatever they want with their currency by having about a gajillion billion trillion dollars in reserve. Having them release that reserve would be a lot worse than the "low" price of their currency is now. China does what they do via market muscle - if they didn't have the muscle to back it up, they'd get taken apart by speculators.

The deteriorating domestic opinion of our relationship with China is what worries me most. I think there's only two ways forward: the Chinese population consuming more, fueling growth and balancing trade deficits (and destroying the environment, plus they are not trending toward increased consumption) or we could have a trade war that would remove the largest potential upside for our local economy (exports to other growing economies) while making everything more expensive at the same time. Plus, who would we borrow money from?

Devil Puppy!

2007-11-01T21:29:00.001-07:00

This year for Halloween CC dressed up as "Devil Puppy".

Here you can see her trying very hard to be good and not eat her costume. (But it's so tasty!)

Nala says: I do not trust Devil Puppy at all.

Furniture and Curtains

2007-10-27T13:14:00.001-07:00

We have furniture!

These are a few pieces from the bedroom set. The bedroom was prety spotless when it was delivered, but no more.

Lori's parents came to visit and helped us put in the other set of curtains that my mother made - here they are in the new dining room. The room is not really that red, but with the sun setting the photo is a bit over-exposed. We also have new dining room furniture.

The sideboard and it's contents, mostly weddign leftovers.

Nala also got some furniture for her sun room...she likes to sleep on the chairs!

Honey, I zapped the Sox...

2007-10-16T19:19:00.001-07:00

So I was watching Wakefield pitch knuckle balls in a scoreless game when I hit the cable TV wire with a dog toy while playing fetch. Sparks flew and the circuit blew...turns out that the junction box near the cable TV wires is held in by what might generously be described as metal clips (tinfoil seems more accurate) and the impact of the Kong flying ring with the cable TV wires next door bent a clip into a screw terminal, shorting the whole circuit.

Half an hour later, after finding the problem, unwelding the clip from the screw terminal and bending it back into place, we turned everything back on to discover Cleveland up 7. Apparently the clip wasn't the only thing that suffered a melt-down. :-(

Houston, we have FIOS

2007-09-25T18:30:00.000-07:00

No matter how grumpy I was with Verizon I was about the complete slurry they made out of my order, I just can't stay angry while connected to the Internet with 2 Mbs of upload. (Compare to less than 400 Kbs with Comcast.) For my work we use CVS, and CVS has the design flaw^H^H^H^H^H^H^H^H^H^H charming property of uploading everything and letting the server do the real work - it is thus really sluggish on asymmetric home connections, and is a lot more usable with FIOS.

We also have a new DVR, sort of. Comcast and Verizon use the same dual-tuner Motorola DVR (I think it's the 6412), but the software is different. A comparison of the two (this is with Verizon's newly revised software):

The layout and navigation of the Verizon DVR is a lot simpler. It's still not Tivo, but it's a lot closer.
The Comcast software was a bit of a mess to use - it had a way of changing channels on you surprisingly, or asking you if you wanted to change channels in ways where the right answer wasn't obvious. The Verizon DVR will be a lot less surprising.
On the other hand, the Comcast DVR provided access to both tuners for TV browsing...it wasn't easy to do, but you could have "history" on two shows at once. (This wasn't real useful - the Comcast DVR's tendency to drop live TV for recordings without warning means you lost your history a lot.)
While the Verizon DVR doesn't provide both tuners for live TV "browsing" (a feature that's confusing at both), it also seems to lose your recording history after just about any operation, which is a bit annoying.

Overall I think for anyone who's not a programming nerd, the Verizon DVR provides a better interface - it comes closer to the princple of "least astonishment."

This Blog Has Gone to the Dogs...

2007-09-04T08:58:00.000-07:00

...which I think is indicative of how much time we spend on the dog and how little we have to work on the house these days.

We don't know what breeds CC is (she's clearly a mix of something and, um, something else), and I think I don't want to know. There are breed specific behaviors and I'd be tempted to attribute at least some of her actions to genetics if I knew.

Now that is theoretically fine, since some of her actions probably are genetic, but in practice dogs learn, and they learn in ways we might not expect. It's easy for us to say "Rover is doing X because he's a Y" but perhaps Rover learned to do X...perhaps we taught him without realizing it.

CC had a behavior that I finally figured out (which says more about how stupid I am about dogs than about her behavior): she would dig a little in the lawn, grab a big chunk of grass in her mouth, and run like hell.

I finally realized, it's not somethign she's predisposed to, it's something she learned. Normally digging would involve trying to bury something, or digging in its own right (a 'play' behavior, one part of a normal sequence of behaviors taken out of sequence). I don't know if she learned it from her previous home and we reinforced it, or she learned it from us, but our attempt to stop this behavior (by moving toward her to reclaim the hole, yelling at her, or chasing her to attempt to get control of her) all reward what she's done. She figured out that the best way to ask her human friends to play a nice game of chase was to dig, eat the lawn, or both.

We have figured out something that does stop the behavior almost immediately: Lori and I say nothing, don't react, and simply walk into the house, closing the door behind us. She immediately drops what she's doing and comes to the door.

The moral of the story (besides "CC is bad for the lawn") is that social recognition is enough of a positive reward to encourage behaviors, and being told "no" is probably more fun than being told nothing. (And being chased after is really, really fun!) As we've internalized this (I would not have thought before getting a dog that yelling "no" at it would be a reward) it's changed how we manage problem behaviors, and helped us get CC under control.

As a final thought: sometimes dogs become anxious in the dog park, sometimes with merit, sometimes just because. The humans (owners and otherwise) almost always react the same way: "you poor thing", comfort the smaller, more fearful dog. But what is that smaller dog really learning? In mathematical terms...

big dog + anxiety = affection

Hrm...accidental operant conditioning...that's probably not what we want to teach our dogs.