Two Sides to Every Story

It really shouldn't be this hard. I don't want to spend every day correcting the ignorant rantings of other bloggers, but when they completely misunderstand simple press releases in my area of expertise, I can't help myself.

Last week I addressed some misunderstandings regarding the risk (or lack thereof) in the ETF-Underlying trade. Yesterday, I mentioned how ZeroHedge erroneously got all wound up about an announcement from the NYSE regarding a change in the reporting of the weekly program trading statistics. ZeroHedge received a reply from the NYSE relatively quickly, which they published.

Today, Karl Denninger has a ludicrous rant on his website which gets the story completely wrong, incites his readers who follow him blindly, and stokes more conspiracy theories which are a waste of time. Again - I enjoy reading Denninger - but he and his readers need to understand that not everything is a conspiracy. By "crying wolf" when there is no wolf, Denninger discredits himself, and also distracts himself from his legitimate arguments and causes.

Denninger writes

"what this means, in short, is that the ability of people (like you and I) to see the fact that a handful of banks, most specifically Goldman Sachs, constitute the majority of NYSE trading volume - and they're trading for their own book, not for customers, will no longer be disclosed."

On the contrary - this is not even close to correct. I invite Denninger to contact me any time he needs an explanation of program trading related items - I'll be happy to explain it to him.

As I explained previously, Broker-Dealers were previously required to file a nightly report with the NYSE called the DPTR - the Daily Program Trading Report - detailing their program trading activities. A "Program Trade" was classified as a trade consisting of 15 or more different stocks, totalling at least $1MM in notional. There are different kinds of program trades: agency (for customers), principal (for the firm) and index arbitrage (capitalizing on differences between the price of futures and the baskets of stocks they represent). In addition, there is "customer facilitation," which is when the brokerage firm commits its risk capital in executing the trade for the client - it takes the risk off the client's books and onto its own books.

Here's what the new rule change from the NYSE does: it automates the DPTR. It's that simple. When program trades are entered into the NYSE systems, they are already coded as "agency," "principal" or "index arbitrage." The exchange is just updating their reporting to take advantage of technology and use this data that they already have, instead of relying on the firms to submit it themselves. It will result in MORE transparency, not less. Why rely on the brokerage firms to submit the data to the NYSE when the NYSE already has the data? That's why they are making the change.

Of course, the headline

"NYSE Uses Simple Technology to Improve Data Quality and Transparency"

isn't quite as catchy as Denninger's "Conspiracy to Hide Bubble Formation."

Brokerage firms like to report large volumes so that they can show their customers that they have the most liquidity and, presumably, expertise in the area. The new rule change will likely reduce reported volumes, as it will prevent brokers from reporting questionable trades such as ETF creations and redemptions on the DPTR. Also, I'm not sure what will happen to the "risk trades" which were previously classified as "customer facilitation." Such trades were somewhat double counted - the trade would be counted when the client traded it to the broker, and again when the broker traded out of the positions.

So why does it bother me so much when someone errs in reporting a simple story? Well, I read the comments on Denninger's site to see how his readers would react. Sadly, they follow like hypnotized sheep. It irks me to no end to read "Well, this is the straw that broke the camel's back for me. I've just stopped contributions to my 401k." Really? You read an article about finance on a website (written by a guy who has expertise in network and computer systems) that's not even close to correct and you're stopping your 401k contributions? Ouch.

Our role as financial bloggers should be to educate people into making smarter decisions - not to scare them into making dumber ones.

-KD

note: I have never worked for GS or the NYSE, and have no particular love for either of them. Also I am still short the broad market (SPX), long gold, long silver, and long TBT.

Worthy Readings

Here's the best of what I'm reading lately:

Barry Ritholtz has finally thrown down the gauntlet to John Carney and others regarding the CRA's role in causing the housing crisis. Ritholtz says the CRA didn't play a major role, Carney says the CRA's role was much more than insignificant. Ritholtz challenges anyone to a debate for $100k on the topic.

Barry also has an interesting list of who he thinks is responsible for the housing bubble and credit crisis.

Good and bad from Zerohedge: first the good: Tyler Durden highlights a "data glitch" that resulted in a massive overstatement of housing data improvement in San Diego:

"The California Association of Realtors expects to make sharp downward revisions in its recent monthly reports of soaring home sales in the San Diego area, Robert Kleinhenz, deputy chief economist of the trade group, said in an interview. Those revisions will mean modest downward revisions in statewide sales, he added...

The California Realtors have reported that San Diego sales in April were up about 63% from a year earlier. Mr. Kleinhenz said that is expected to be revised downward to a gain of about 20%. For May, the group reported an 89% increase in sales in San Diego; that will be slashed to about 6.5%, the economist said."

Ummm - revisions from +63% to +20% and from +89% to +6.5% are not a glitch - they are a colossal fuck up.

Now the bad: Tyler Durden misunderstood a change in the reporting of program trading numbers to the NYSE and got his readers all hyped up again about lack of transparency and conspiracy theories. The NYSE will be automating the data instead of relying on the firms to submit it themselves, and it should make the data more transparent and more accurate. TD's impact is noted, however, as he garnered a speedy reply from the NYSE which explained the change. Clusterstock jumped on the original ZH story, again spreading paranoia where none is needed.

The NY Times published a pretty amazing article about China limiting the use of online gaming currency.

"China is one of the world’s biggest markets for huge so-called multiplayer online games like World of Warcraft, and tens of millions of young people are believed to be trading virtual goods and credits for real goods and cash.

The coin of fantasy realms have already moved markets here. So-called QQ coins — a form of currency produced by the Chinese Internet giant Tencent — have sometimes risen sharply in value against China’s official currency, the renminbi, alarming officials at the nation’s Central Bank.

Some people have even traded virtual currencies in China, and exchanged them for clothes, cosmetics and other goods.

Last year, nearly $2 billion in virtual currency was traded in China, according to the China Internet Network Information Center. Some experts say they believe there is a much larger underground economy in the virtual world...

Chinese officials have worried that online currencies could ultimately serve as an alternative to China’s official currency, the renminbi, and have an impact on the country’s financial system."

I mean - WOW. This is actually a pretty mind boggling story. They are worried that World of Warcraft ducats will screw up their financial system?

NY Times' Joe Nocera has a message to Madoff's victims: "Get Over It" (courtesy of Dealbreaker)

"Besides, as I’ve argued before, the S.E.C.’s negligence notwithstanding, shouldn’t the Madoff victims have to bear at least some responsibility for their own gullibility? Mr. Madoff’s supposed results — those steady, positive returns quarter after blessed quarter — is a classic example of the old saw, “when something looks too good to be true, it probably is.” What’s more, most of the people investing with Mr. Madoff thought they had gotten in on something really special; there was a certain smugness that came with thinking they had a special, secret deal not available to everyone else. Of course, it turned they were right — they did have a special deal. It just wasn’t what they expected."

I agree with Nocera to SOME extent, but not completely. After all, as I've mentioned before - if Madoff was sending me bogus trading confirmations showing made up trades, I'm not sure how I'm supposed to figure that out.

This Bloomberg story is from last week, but it's absurd headline highlighted a continuing cognitive dissonance we seem to be suffering from: "Housing in Peril as Obama Fails to Get Financing Breakthrough." See, in case you haven't figured it out yet, there is not a new financial invention Obama can create that will make unaffordable homes suddenly affordable. We actually DID that already - with negative amortizing loans, where people actually paid LESS than the interest they owed on their mortgage, causing their balance to increase. That's part of what caused this crisis. There is no magic pill - home prices will fall until they are no longer unaffordable. They aren't falling because they are too low, they are falling because they are still too high.

Karl Denninger wants to stage a modern day revolt for the 4th of July.

until next time,

-KD

Don't Believe Everything You Read

One of the mantras my supervisors taught me on the trading desk was not to make other people smarter - if you hear someone say something that you know to be incorrect, assuming they don't work for your firm, you let them go on with their misconceptions. Knowledge is money.

I always had a slight problem with this, since I hate rampant stupidity, and now, since I'm no longer trying to profit off the ignorance of others, I am eager to shed some light on some misconceptions that are spreading amongst some blogs that I read daily, enjoy immensely, and find tremendously valuable.

Tyler Durden at ZeroHedge has quickly made a name for himself as an intelligent and detailed blogger in the financial realm. TD's deep investigative insights and tireless work ethic have earned him a rabid following for his blog, where he posts detailed, insightful posts several times a day. However, it's clear to me that TD is a fixed income guy at heart, and that his equity observations are frequently based on conspiracy theories or erroneous conclusions.

What's dangerous is that in this day and age people seem to believe everything they read on the internet. Financial bloggers have done a MASSIVE service in educating the public (or those who want to be educated at least) but that doesn't mean that everything that is written is the truth. Even more dangerous is when one blogger writes something erroneous, and others pick up on it - spreading the errors amongst their own rabid blog readership.

So, Tyler Durden at Zerohedge has been on Goldman Sachs's case for a while about their massive increase in principal program trading volume. The numbers are published publicly by the NYSE, based on a report the broker dealers file nightly called the DPTR (daily program trading report). Principal trading volume is volume that the firm trades for its own account. TD's thesis is that Goldman Sachs is manipulating the market via fancy computer trading models, and ripping off the public. Now, interestingly, Tyler's posts gained so much traction that Goldman Sachs actually replied to them, explaining that the increase in volume was the result of GS participating in a new NYSE program called the SLP - supplemental liquidity program - where Goldman provides liquidity by posting bids and offers on the NYSE, and is compensated by the NYSE by receiving a tiny "rebate" whenever a counterparty accesses their quote.

To simplify, Goldman Sachs narrows the bid-ask spread by posting inside quotes, and they get paid a fraction of a penny if someone trades against their market. There is a temptation by the uninformed to conclude that sophisticated computers are controlling the market and ruining the world, but the truth is almost certainly that most investors are benefited by this added liquidity, as it lowers their cost of execution (in the form of a narrower bid-ask spread).

But that's not even what I wanted to write about today!

Today, Tyler Durden included the following quote in his post about this week's NYSE Program Trading numbers:

"Zero Hedge is compiling materials to demonstrate the phenomenal gamble CS is taking by being the largest holder of the ETF-underlying pair trade. The ensuing implosion, once the market loses the invisible futures bid, will likely destroy Switzerland's second biggest bank and likely take down the country with it.

Probably most notable is the screaming increase in overall program trading, from 30.7% of all NYSE volume to 40.4%! Virtually every broker saw their Principal PT operations double week over week: seems like everyone is brokering those ETF trades now. Poor SPY and IWM are being mangled 10 ways from Sunday nowadays."

Never mind the massive increase in the weekly principal transaction numbers - it's due to June's quarterly expiration, where brokers trade massive baskets of stock against expiring futures and options. I can tell you already that next week's program trading statistics will show a large increase in the "customer facilitation" numbers, because that's how the trades for today's annual rebalancing of the Russell indices will be coded. What I want to talk about is the misunderstanding about the "ETF-underlying pair trade." First, let me take a quick tangent.

Another blogger who I enjoy for his relentless attempt to try to expose the wrongdoings of the authorities is Karl Denninger. Denninger had some additional insights related to my recent post on AIG dumping its assets on the Fed, pointing out that the Fed's actions here are outright illegal. However, Denninger also jumped all over the ZeroHedge quote about the ETF-underlying trade and its relationship to increased program trading volume:

"For those who aren't savvy in this stuff what's going on here is a pair trade between the underlying instrument(s) and the ETFs on the exchanges. This is an arb play and it works until it doesn't - for an example of "doesn't" in the single-name world witness what happened to VW/Porsche earlier this year when the arb speculators on their merger got rammed, or those hedgies who were playing the Citibank preferred-conversion arb earlier this year.

These are allegedly "hedged" transactions in that there is an alleged unbreakable correlation that protects the person doing it from loss.

In truth there is no such thing as an unbreakable correlation and the alleged "protection" against getting reamed is illusory. This is the same sort of "genius trade" that was run with AIG's CDS positions - remember the claim that "we're unlikely to ever see a loss"? "

So, now it's time for a lesson about arbitrage. There are many types of arbitrage. The simplest, which I still remember reading about in the famous "Gold Book" that UBS Warburg provided all of its new employees back in the 1990's as an introduction to options and markets theory, was "if you can buy gold for $400/oz in New York, and sell it for $450/oz in London, that's called an "arbitrage." This is a pure arbitrage. You buy gold for $400 and sell it for $450. You profit $50, minus the cost of transporting the gold.

Another type of arbitrage is merger arbitrage: Let's say company ABC is buying company XYZ, and that ABC is offering shareholders of XYZ 1 share of ABC stock for each share of XYZ they currently own. The prices of the two stocks should converge as the deal nears completion. There will be a spread between the two stock prices, depending on the risk of the deal (and some other factors like the dividends that will be paid out until the deal closes, and some financing costs). Merger arbitrage has risk - the deal might fall apart - if you buy XYZ shares and short ABC shares at a higher price, you are very much NOT guaranteed to capture that spread. The Citi vs Citi Preferred trade that Denninger mentioned falls into this category - the traders got hurt because the spread widened, but if the conversion actually goes through, they will recapture the spread they have lost (although there are still issues with this trade due to the high costs associated with borrowing C stock to short it for a longer period of time than initially expected.)

Then there are convergence trades like the ones Long Term Capital Management made famous, based upon traditional trading relationships between two assets. LTCM would buy the "cheap" asset and sell the "expensive" asset and expect the two to converge. Clearly, there is no assurance that the prices will converge here - and when you add massive leverage to the mix like LTCM did, small adverse price movements can have disastrous consequences. The Porsche-VW stub trade which denninger mentioned is most related to this class of convergence trades.

We also have share class trades - for stocks like Berkshire Hathaway, which have two classes of shares: BRK/A and BRK/B. In Berkshire, the B shares are supposed to trade, I think, at 1/30th the price of the A shares - but there is no mechanism for which you are entitled to exchange shares between the two share classes. Thus, if you put on a trade seeking to profit from the disparity in value between the A and B shares, you have to wait and hope the prices converge so you can reap your profit.

This brings us to the ETF-Underlying pairs trade. Now, forgive me if I'm putting words in Tyler Durden's or Karl Denninger's mouths, but it seems that they are referring to the trade where a broker, say CS, buys an ETF (like IWM) and shorts the underlying basket of stocks against it. The IWM is composed of the 2000 stocks in the Russell 2000 index, and the trust that issues the IWM owns these underlying stocks against the IWM shares it has issued. Lately, CS has shown up as a large holder of IWM and SPY, as well as some other ETF's.

Today, both ZeroHedge, and, jumping on the bandwagon, Karl Denninger, decry this as a potent of doom - a potentially lethal arbitrage that could blow up in CS's face. There's only one problem - if CS is buying the ETF's and shorting the underlying baskets of stocks, as expected, there is no risk. This trade is not like the trades I mentioned above for one specific reason - ETF's can be created and redeemed daily: If you own a chunk of IWM (the minimum unit is 50k shares) you can take your IWM shares and deliver them in to the trust (aka: redeem) in exchange for the corresponding number of shares in each of the 2000 underlying stocks (which you then use to cover your short positions). Similarly, if you are long the underlying components, you can deliver them in to the trust (aka create) and they will give you IWMs. It's precisely this fungibility that completely nullifies TD's and Denninger's fears. It's a very simple concept, and it's not at all like the convergence trades above, where you cannot control the collapsing of the two legs of the trade.

Denninger isolates all of the comments on his posts in his forums, and regarding this topic, he elaborated:

"Let's say that there's a "divergence" of a nickel betwene the two instruments. You short one and buy the other, allegedly pocketing the nickel. The theory is that the correlation will remove the spread, at which point you close both positions."

Again - with ETF's you can create and redeem at will - so you don't have to rely on any "theory" or "correlation." You can make it happen yourself.

I'm somewhat surprised that two bloggers as intelligent as Tyler Durden and Karl Denninger erred in their assault on this concept, but I was even more troubled by the comments in each of their respective posts, which show that the misinformation spreads rapidly, as their readership takes what they write as truth. In the ZeroHedge post, I offered a possible explanation of why CS has these trades on: "CS probably has some sort of funding efficiency where they lend out the long ETF and charge a borrow rate that exceeds their cost of capital (courtesy of near zero short term rates from the Fed)... if this funding efficiency goes away they just redeem the ETF to cover their short stock position."

Financial blogging has been a great breakthrough in the last several years, with a plethora of blogs offering an educated, insightful look at issues that the mainstream media could never understand. Many bloggers are actually former professionals in the topics that they blog about, which gives them unique insight into topics that journalists could not attain. Still, the flaw of the internet is that it spreads all information equally, and as a reader it's up to you to verify the thought processes and make sure you understand them before you take them as fact.

-KD

note: I have never worked at GS or CS. I have no incentive to defend GS - I don't particularly like the "walk on water" status they have attained. Also, I do not intend for this post to be an assault on TD or Denninger - I think they both write excellent blogs, they are just wrong on this topic.

AIG Dumps Toxic Assets on the Fed

AIG, unable to sell its two "crown jewel" businesses to anyone for real money, has slapped theoretical values on them and transferred stakes to the Fed in exchange for a reduction in the debit balance they have with the Fed.

In layman's terms: AIG tried to sell their two "prime" businesses, AIA and Alico. They couldn't get the price they wanted, so they sold the businesses to the Fed instead. The Fed is getting $16B worth of AIA preferred shares, and $9B worth of Alico preferred shares, and AIG's balance due to the Fed is being decreased by $25B.

Owning massive stakes in the banks and auto industries wasn't enough for the Government, I guess.

This is especially ironic, because it again focuses on the issue of "temporary impairment" of toxic assets. If you recall, banks claimed that the problem was that their assets were still worth 90c on the dollar but that there was just a temporary lack of liquidity which was causing the market to value the assets at, say, 60c. AIG is doing the same thing: they couldn't actually sell their businesses, because no one wanted to pay them their asking price. So they said "well, they're still worth that much," and dumped them on the Fed.

Sold to you, Sucka... Oops - I meant, Sold to ME, Sucka. Crap.

-KD

Leverage Baby!

Presented without comment:

"ProShares Launches First ETFs to Provide Triple Exposure to S&P 500®

• Press Release
• Source: ProFunds Group
• On Thursday June 25, 2009, 10:17 am EDT

“The S&P 500 has the largest following in the ETP industry with nearly $90 billion of assets benchmarked to it,” said Michael L. Sapir, ProFunds Group Chairman and CEO. “As the leader in short and leveraged ETFs, we are committed to giving investors more choices to manage risk and pursue returns.”

ProShares now offers five ETFs benchmarked to the S&P 500:

ProShares		Ticker Symbol		Index		Objective*
New UltraPro ProShares
UltraPro S&P500		UPRO		S&P 500		300% Daily
UltraPro Short S&P500		SPXU		S&P 500		-300% Daily
Existing ProShares Benchmarked to S&P 500
Ultra S&P500		SSO		S&P 500		200% Daily
Short S&P500		SH		S&P 500		-100% Daily
UltraShort S&P500		SDS		S&P 500		-200% Daily"

Cause that's what we need... More leverage.

-KD

Eff You Vonage and Random Readings

I am a customer of Vonage - the VOIP phone service. I actually like them - they have some pretty cool features (like call forwarding, or call multi-ring - where I can set up incoming calls to ring on as many different phones as I want and whomever picks up first gets connected) but they set me off with this email today:

"At Vonage, we're committed to providing our valued customers with the best experience possible through meaningful updates to our services. To ensure that we continue to deliver top-notch service and quality, we will modify two of our existing fees as follows:

The Emergency 911 Cost Recovery will become the Emergency 911 Service Fee, which ensures we maintain nationwide E911 service in compliance with FCC regulations. Our customers' safety in an emergency is our primary concern and this update allows us to continue delivering reliable emergency services.

The Regulatory Recovery Fee will become the Regulatory and Compliance Fee, which covers our regulatory-related and legal compliance expenses. For example, this fee pays for charges associated with benefits like procedures to ensure customer privacy, identity theft protection measures and phone number porting.

These fees will each increase from $0.99 to $1.49, effective July 15, 2009. This change allows Vonage to maintain our commitment to safety, innovation and customer service.

If you have any questions, call 1-VONAGE-HELP and speak to a customer service representative. We're always available, 24 hours a day, everyday.

Thank you for your business"

Ok, so it's net another buck to me per month, but since it's a slow blogging day, I'm going to bitch about it. Guess what Vonage - I shouldn't have to pay you EXTRA for things like keeping my information private and ensuring that you don't let someone steal my identity - that's not something you charge your customers for - that's a cost of doing business. As for the E911 crap - that's bullshit - you already had me register my address - it's updated - you don't have to maintain anything. It's there - it's done.

Anyway, here's other stuff I'm looking at today:

Matt Taiibi's Rolling Stone piece: "The Great American Bubble Machine."

"Goldman sachs has engineered every major market manipulation since the Great Depression. They're about to do it again."

The National Association of Realtors is fighting against appraisal reform. Sick. From Barry Ritholtz:

"So the very people who were enormous contributors to the credit bubble (mortgage brokers), and their colleagues who helped feed the housing boom and bust via friendly (i.e., corrupt) appraisals (RE Brokers, appraisers), are now mobilizing to make sure that honest appraisal reform is thwarted.

The NAR and NAMB apparently have no ethics to speak of. Their shameless self-interest, regardless of the damage it may cause, disgusts me . . ."

China's overdue credit card debt increases. The absolute numbers aren't onerous - YET... Give them a few years and they'll have a credit crisis of their own.

"China's credit-card debt at least six months overdue rose 133% in the first quarter, though the total overdue debt was still at the relatively modest level of 4.97 billion yuan ($727.7 million), the People's Bank of China was reported as saying in a state-run media report.

Accounts overdue by six months or more accounted for 3% of total outstanding credit-card debt at the end of March, a 60-basis-point rise from a year earlier, the China Daily cited the PBOC as saying in a report dated Tuesday.

The PBOC warned of the potential risks of rising levels of overdue consumer debt, which come as financial institutions expand their credit card businesses, the report said."

Ron Paul on the topic of a bailout of California:

"Californians know they are overtaxed, which is why they decisively the recent series of initiatives designed to close the state deficit, largely through tax increases. Yet, they want to maintain high public spending.

Unlike the states, Washington can temporarily delay budget woes by firing up the printing presses. But we can no longer ignore economic reality. The financial crisis came from too much shortsighted borrowing and spending, and it cannot be solved with more of the same. It would be unconstitutional, and irresponsible, for Congress to enable California’s fiscally reckless ways.

A decision by Washington to loan billions more it does not have will further increase our national debt, devalue our dollar, and foster the moral hazard created by its previous interventions, thereby increasing the burden felt by all Americans.

Instead of seeking federal aid, California should cut spending, rethink some of its unsustainable public pension programs, tame down the expensive and failed drug war, and repeal regulations that discourage economic growth. According to a 2008 piece by The Independent Institute’s William Shughart, the state owns more than 20,000 buildings and 6.7 million acres of land, a portion of which is “surplus” property that could be sold to private owners.

The federal government can best aid California, and all other states, by setting a fiscally responsible example and easing the load it places on taxpayers. It is time to end the unconstitutional federal mandates that force the states to subsidize programs they can’t afford, to reduce taxes and give Americans more of their own money back, and to stop the inflationary monetary policy that is destroying the dollar and fueling the boom-bust cycle that has pummeled California and the entire nation."

Carolyn Baum's Bloomberg article, "Obama Bulks Up Too Big Too Fail," has a few handfuls of well written paragraphs at the beginning, with clear, succinct points that echo some I've made previously.

"The Obama administration’s architects went back to the drawing board and last week produced a blueprint for regulating financial institutions. One controversial aspect of the plan is the creation of a systemic risk regulator, the Federal Reserve, with the power to oversee any financial firm, not just a bank holding company, “whose combination of size, leverage and interconnectedness could pose a threat to financial stability if it failed.”

In other words, the same folks who missed, or did nothing to prevent, the worst crisis since the Great Depression will definitely, absolutely, positively be able to anticipate the next one. Uh-huh.

It gets worse. Instead of eliminating the doctrine of “too big to fail,” which encourages risky behavior because of perceived government backing, the Obama plan defines, institutionalizes and expands on it.

“All systemically important companies will be subject to enhanced regulation,” says Peter Wallison, senior fellow at the American Enterprise Institute, a conservative Washington think tank. “What could that possibly mean? It means they are too big to fail.”"

I can't get enough of Jimmy Kimmel's "This Week in Unnecessary Censorship."

-KD

Entitlement Programs

From AM New York - the free daily paper:

"Straphangers, start bringing a broom on your commute. Because of budget constraints, the MTA has curtailed station cleaning, with Transit officials acknowledging they are down by about 100 workers. The agency has also slashed overtime for cleaners, and workers say they simply can't keep up with the mounting trash.

“Maintenance took a hit,” said Mark Jones, a commuter from Harlem, who said a rat recently boarded the No. 6 train he was riding. “I feel like it is going to get worse before it gets better.”

Station cleaners sweep platforms and stairs, remove graffiti and clean token booths and MetroCard machines. Busy stations receive 24-hour cleaning, with workers floating among most of the other stations throughout the day."

There are more than 300,000 unemployed people in New York City alone. I'm going to take it as fact that the vast majority of these people are physically able to work. The article above started off by facetiously asking commuters to bring a broom with them, but they are on the right track. Why are we paying people unemployment insurance benefits NOT to work when there is clearly work that needs to be done for an organization (the MTA) which is part of the state budget already???

Why don't we arm the people who are collecting unemployment with dustpans and brooms and let them (actually, REQUIRE them) to clean the subway and the sidewalks?

I'd love for someone to give me a reasonable, legitimate answer to this question. As I mentioned in a previous post, my friend Eric once answered a similar question by saying that it depends on if you think the government should provide a minimum standard of living for its people, or if you think the people have to earn it. The difference here is that the government itself lacks the funds to provide this standard of living. It's clear to me that instead of paying people not to work, while at the same time cutting back government services, we should instead pay the people to do the government services!

Jeez - that just made me realize how uber-absurd this whole thing is: the workers who were previously getting paid to clean the subway will lose their jobs and instead collect unemployment insurance while they don't clean the subways... I can't make an ounce of sense out of how that policy can be justified.

-KD

The Solution - Limit Leverage!

My friend Eric emailed me regarding my post "Skin in the Game," noting that I made some good points, but asked me what my solution would be. He suggested limiting leverage, which I agree with completely, and I realized that the Bernanke quote I liked so much from yesterday's post is illustrative of exactly this concept.

"October 15th, 2007 – Bernanke: "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

See, the problem isn't that investors buy MBS and lose their money. The problem is that investors can put up $100MM in capital and buy $3B of MBS with someone else's money - that's called leverage, and that 30-1 ratio was not at all uncommon. The Fed's role should be to prevent systematic risk - in other words, it doesn't matter if you lose all your money, but there should be regulations to make it so that you cannot put the financial system at risk. Examples of things that put the financial system at risk, in case you're unaware, are described by the Top Gun quote: "Your mouth's writing checks your body can't cash," aka, the AIG problem - selling insurance (credit default swaps) you can't make good on.

Allowable leverage ratios can and should be different for assets with different risk profiles: if you have 30-1 leverage, a decline of roughly 3% would wipe out all your capital, so you'd better be buying very safe assets. But herein lies the rub: you may have heard of LTCM - a hedge fund that blew up about 10 years ago. The problem was that LTCM, and the banks they dealt with, thought that the trades LTCM was making were very safe - and allowed LTCM to amass massive positions with minimal capital - they had leverage of up to 100 times. This meant that if LTCM put up $10Billion in capital, they could control $1Trillion in assets. At this ratio, all it takes is a 1% decline in the value of LTCM's positions for them to get wiped out.

Well, the recent crisis was similar - investors were massively levered in AAA rated, "safe" mortgage backed securities, which turned out to be not safe at all. Interestingly, this time there was no big hedge fund like LTCM that threatened the health of the financial system by levering up and risking the capital of a number of banks - the problem we saw was that banks did this themselves - they figured instead of earning small returns, they could lever up and earn bigger, still "safe" returns by buying these new products like CDO's and MBS.

So as we can see there are two problems - the leverage allowed, and the misjudging of the safety of the assets. Since we've proven again and again that we ("we" being everyone) cannot accurately assess the risk of severe downturns in asset prices, the solution should be to limit leverage across the board.

I want to address two similar comments that I've had from two different people regarding my analogy in the "Skin in the Game" post where I asked, rhetorically, why underwriters aren't being asked to hold 5% of equity offerings or corporate bond offerings.

"The problem with IPOs as an analogy is that an IPO represents one security, which the buyer has a reasonable chance to analyze thoroughly. With an MBS package, the buyer has no chance to analyze the quality of the multitude of underlying mortgages. "

"If I'm buying a share of a mortgage-backed security, I can't get info about the people whose mortgages I own pieces of. I *have* to trust the middleman, because that's who (hopefully) met these people, that's who read their tax forms, that's who got their credit reports. If I can't check on that info myself, then there is a higher burden, both on the original lender, and on the rating agency. "

This attitude is perfectly illustrative of why we're in this mess. The answer is simple: if you cannot value the security, you should not buy it. You don't "trust the middleman," - you buy something else.

-KD

Unemployment Data - Improvement?

Two weeks ago I wrote about the increasing Unemployment Exhaustion Rate, which means more people are using up all of their unemployment benefits and will thus roll out of the "continuing claims" jobs numbers which are reported, making the numbers seem better than they are.

Today, although initial jobless claims filings increased slightly from last week, to 608,000, the number of continuing claims fell by 148k, to a total of 6.69 million. Now, there are two main reasons continuing claims can fall: the first is that people go back to work, and the second is that people exhaust their benefits and are no longer eligible to collect unemployment. My thesis is that the latter explanation is more realistic, and that despite the Bloomberg story touting this "plunge" in continuing claims, the number does not indicate a return to euphoria for our markets and economy. The analysis is complicated because there are all sorts of varying extensions of unemployment benefits (achem - are we extending unemployment benefits because the economy is looking so good? of course not), but let's look at some of the data from when initial jobless claims spiked:

Date	Initial Claims
12/6/2008	759,531
12/13/2008	629,867
12/20/2008	719,615
12/27/2008	717,000
1/3/2009	731,958
1/10/2009	956,791
1/17/2009	763,987

Most states offer roughly 26 weeks of benefits, so it makes sense that the people who were filing for unemployment 6 months ago, when the initial jobless claims really spiked, would be exhausting their benefits now. Obviously, it's presumptuous to assume that each and every initial claim filer from 12/6/08 remains unemployed, but my point is that EVEN if none of them found jobs, the continuing claims number would still go down! (due to the simple math that the number of people exhausting their benefits is greater than the number of new filers). That's why I'm not jumping up and down about the slight downtick in continuing jobless claims.

-KD

full disclosure - short SPY via common and options