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

This Time It's Different?

I've previously addressed the topic of "why are we listening to the same pundits who have demonstrated a complete lack of ability to predict our economic future?" Today, Austrian Filter blog, via ZeroHedge (who has it in a slightly better format) compiled a list of quotes from former Secretary of the Treasury, Hank Paulson, and current Fed Chief Ben Bernanke. It's a must read.

One Bernanke quote I actually agree with wholeheartedly is this one:

"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."

Alas, the tone seems to have changed on that point these days...

-KD

Skin In the Game

My friend Ted sent me comments from George Soros today, where the old man opined on the proposal I discussed weeks ago from Barney Frank to ban 100% securitization. First a quick refresher course: banks take loans and repackage them into securities such as MBS (mortgage backed securities) and then sell these new securities to investors. This makes the investor who buys the MBS the ultimate "lender" - they are providing the capital for you to buy your home. This also enables the bank to go and make more loans, as they have sold the risk on the previous batch of loans, and now have capital freed up. The negative effect of this is that it doesn't incentivize the banks to use stringent lending standards - because they have someone who is willing to take the risk for them.

My point is simple: that's how markets work! As I've said before, all securities transfer risk from a party who doesn't want it, to a party who does. The "security" in question could be a bond, an option, a stock, an MBS, a CDO, or something even more complicated. Let's get to Soros's comments:

"To avert a repetition, the agents must have “skin in the game” but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement."

Soros is addressing the proposal which would require banks to hold 5% of the securitized products on their balance sheets, unhedged - as a way of ensuring that the banks have incentive to offer only securitized product with sound risk-reward profiles. It shouldn't be hard to see why this is hypocritical - why single out MBS? Why not force BankAmerica to hold 5% of the outstanding stock in OpenTable - an IPO it recently underwrote? Why not force JP Morgan and Morgan Stanley to hold 5% of the bonds they underwrote for Microsoft? I'll tell you why - because that's not how markets work - and we shouldn't single out MBS as any different. People are wiling to buy OpenTable stock, people are willing to buy Microsoft bonds, and people are willing to buy mortgage backed securities. Buyers who fail to understand the product should not buy it - we shouldn't penalize the middle man for bringing together buyers and sellers.

My friend, Ted, highlighted these same points in an email he sent while debating the topic with a colleague of his. I thought his comments were clear and concise, and I'll share them here (emphasis mine):

"In most cases, I don't think the lenders thought they were making bad loans. In some cases, that may be true. That's also irrelevant, though. If there is a person that wants the loan and a person that wants to buy the loan, it's not up to the MIDDLE MAN to say no. That's absurd. That's like saying when iVillage.com filed to go public in the 90's, Goldman Sachs would turn them down because of their view on the business. THAT'S NOT THEIR JOB. If the company wants to sell some stock to the public and the public wants to buy some stock, then we have a MARKET. Welcome to capitalism!!!!! If you want something else, move to Cuba or go back in time to Germany during WW2. This new law that congress is passing that requires banks to hold 5% of the loans they issue is missing the point. Are they going to make the banks hold 5% of the equity of all IPOs? No!"

If people are blindly trusting (which they should not be!) the ratings agencies to guide them on the valuation of these fixed income instruments, then it would make more sense (although still not a lot of sense!) to require the ratings agencies to hold the securities in question. Maybe the ratings agencies should be paid in kind - when they rate a security AAA - their $20,000 fee or whatever the number is should be paid in said security - but don't blame the underwriter - the guy enabling the capital markets to flow.

-KD

Super Sized Claw Game

That's right mofo's - in another demonstration of my versatility, this weekend I operated the logging boom at the Dynamite In-Laws Mulch Empire in upstate New York

Wall Street, poker, cunning linguist, tele-handler driver, and now, operator of the life sized Claw Game logging truck. Ship it.

-KD

Bajungi Tilt

There is really no other way to describe this video. BAJUNGI!

As my friend Big Show put it eloquently, "Unreal. Just kill me if I can't wipe my own ass."

Bones wondered if there were different colored attachment heads for each member of the family, kinda like the detachable heads for the Braun Oral B electric toothbrush.

KD

Democracy at its Worst

The headline is "Senate Fails to Meet as Rebels Seek Support." Oooh - what could we be talking about here? Rwanda? Pakistan? Darfur? Nope - it's the state of New York. If you're unaware of what's going on in the NY State Senate, basically there was a coup. Democrats controlled the Senate floor by a count of 32-30, but two Democrats crossed the line and voted with the Republicans in a coup to establish a new majority leader. Never mind the fact that both of the "defectors" are under investigation by authorities, one for a potential conflict of interest with grants to a business he owned, and the other "was indicted on felony assault charges in March stemming from an attack on his companion."

What did the Democrats do when they found out about the coup? They turned out the lights in the Senate chamber to try to prevent the vote. Nice. Great work New York. As my most loyal reader, Bones, pointed out "flicking the lights off and on didn't even work in Kindergarten." When that failed, they took another approach - locking the doors to the Senate chamber to prevent the Republicans from entering and voting.

New York is basically bankrupt, and our elected officials are spending their time staging and attempting to thwart political coups. Why does it even matter who is the majority leader of the Senate? First of all, the majority leader is in line for succession if something happens to the Governor. Secondly, I guess the majority party has more leverage over which items come up for vote - but if the two Democrats vote with the Republicans, don't the Republicans have a majority anyway - regardless of who is sitting in the "majority leader" seat? The article makes it sound like the majority leader can prevent items for coming up for vote - if that's the case, then the whole system is a f'n joke.

Shameful behavior by all involved.

-KD

Chart of the Year

Kudos to Geoff at Innocent Bystanders for creating a chart that's significantly better than my chart on the exhaustion rate. Geoff simply took the chart from Christina Romer's presentation (Council of Economic Advisors, 1/9/2009), and added the actual unemployment data to it.

As my friend Ted put it: "This is the scariest thing ever - not because unemployment is at 9.4%, but that we were so optimistic as recently as 2009!"

File this under "the main reason you shouldn't get excited when an economist tells you the recession is over, or will be over in a few months." If you can't draw the logical conclusion - it's that economists consistently demonstrate that they can do one thing well - FAIL to accurately predict what will happen in the real world. I don't really think the topic needs any more explanation - but if you're looking for more, Karl Denninger covered it pretty well today also.

-KD

Quick Hits

1) Barney Frank GQ interview. It's sad that the GQ interviewer spent more time asking about Barney Frank's boyfriend than about Barney Franks financial hypocrisy.

2) Ford Says Government Backed Debt for GMAC is Unfair. The story headline kinda makes Ford sound like a bunch of whiners, but I sympathize with them. The conundrum is that when the US Government guarantees the debt of a firm, the (healthier) competitors of that firm get screwed. In this case, GMAC recently issued government backed debt at a yield of roughly 2.25%, while Ford issued debt at 13 percent. Now, if the government didn't back GMAC's debt, Ford would still pay double digits for financing, but, more importantly for them, they'd probably pick up a ton of business (which would also eventually lower their debt costs) when their competitor went out of business. The government backstop on GMAC's debt issuance is a double whammy for Ford - it keeps their competitor in business, and keeps Ford's debt costs high.

3) NY Times Op-Ed: Five Ways to Fix America's Scools: I was intrigued by the second suggestion, which was that truant officers should use higher pressure tactics to reduce school absences. The author cites the statistic "In many cities, including New York, roughly 30 percent of public school students are absent a total of a month each year. Not surprisingly, truants become dropouts." This made me think - we should remove all government assistance programs for people who do not finish public schooling. If you're not going to take advantage of the free education that the State provides you in an effort to ween you off the government tab, well then, you don't deserve to receive the government's aid! I ran this idea by my liberal but logical friend, Eric, who replied that he wasn't crazy about my idea, and that "whether or not you think it's a reasonable solution depends mostly on your outlook of whether the gov should guarantee a minimum standard of living for it's people, or if the people have to earn it."

I was surprised to hear the idea of requiring school attendance classified as requiring someone to "earn" something. Education is the first stepping stone to helping people get out of poverty, homelessness and unemployment. We provide that privilege without charge to the end user. It seems clear to me that if people don't want to use this resource, they should also forego other resources designed to help those in need.

While I'm on subjects that will draw liberal ire (even though there is no reason for them to!), here's my favorite: unemployment insurance. In a city like New York, where I live, I believe that no one who is capable of working should receive unemployment insurance for doing nothing. There is ALWAYS plenty of work to do - even if it's just sweeping the streets, which are generally filthy. Essentially, it would be kind of like a larger version of The Doe Fund. Now, logistically, this may be difficult - as the cost of administering such a program could make it unfeasable - but I can't understand how anyone can have a philosophical disagreement with this plan. If there is work to be done, which there is, people should do that work in order to earn their unemployment benefits. If you disagree, instead of making partisan political comments, explain to me why you think I'm out of line.

-KD

-KD

TARP Repayment

Today's story is that a number of "banks" have been granted approval to repay TARP monies. What's especially ironic is the several of these firms had to engage in some shenanigans just to get the money in the first place. American Express, Goldman Sachs, and Morgan Stanley all had to convert to bank holding companies in order to suck from TARP's teat. Why are they so quick to give the money back? Isn't it obvious? When these companies converted to bank holding companies in order to get the government cheese, the funds were essentially free money with no restrictions. Then came the public outrage, the pay caps, the government oversight - the strings attached!

Meanwhile, these firms also managed to issue government guaranteed debt - further shoring up any financial needs they had. Now they'll pay back the money (while still enjoying the FDIC guarantee on the debt they issued), tell Uncle Sam to Eff Off, and resume business as usual. Am I complaining? No - I certainly would rather have them repay the money - but I haven't heard anyone talk about a future stipulation that we MUST institute: any firm that repays TARP funds does not get a second chance in the future when we have TARP 2.0, TARP 3.0 whatever acronym we give the next bailout. Remember - banks never took the losses on their "toxic assets" and everyone is hoping that these assets were just temporarily impaired in value (due to a "lack of liquidity") and that the lenders will reap a full return on their investments. If reality turns out to be as ugly as I (and many others) expect - it's imperative that we don't allow these firms to come crawling back for more free money in the future.

The whole point of forcing the TARP funds on two handfuls of banks was to avoid the stigma of any banks having to look bad by going to the government for help. In other words, "If everyone is doing it, it's ok - there's no stigma." Barry Ritholtz has a piece today about how the whole thing was a ruse to hide the fact that Citi was insolvent. I actually mentioned this to a friend via email this morning before I saw Barry's post - which is to say, I agree with him.

-KD

Must Read - "Do These Homeowners Deserve Help?"

From Matthew Padilla, via Calculated Risk, comes the article "Do These Homeowners Deserve Help?"

"Homeowners who treated their houses like cash machines, tapping the equity as home values rose, are among the most likely to end in foreclosure, even more than those who bought at housing’s peak, a new study finds.

Often homeowners have had second, third and even fourth mortgages at time of foreclosure — a trend not adequately addressed by any of the federal or state foreclosure avoidance programs, said Michael LaCour-Little, a finance professor at Cal State Fullerton who authored the study.

For example, for the early November 2008 data sample, he tracked 2,358 properties. Here’s what he found:

• They were purchased at an average price of $354,000 and average year of 2002 (long before the housing peak of 2005).
• Total debt on the properties averaged $551,000 at time of foreclosure. That’s 56% more than the properties were worth when purchased, meaning at least that much was cashed out!
• An automatic valuation model estimated average value at time of foreclosure was $317,000, which suggests a combined loan-to-value at foreclosure of more than 170% ($551,000/$317,000). And that is a conservative estimate. Properties that banks later sold had an average resale price of $271,000!

Pretty remarkable numbers.

You can read Padilla's full piece here.

-KD

More on Exhaustion Rate

So the folks at Seeking Alpha had the good sense to make my last post regarding the Unemployment Exhaustion Rate (KD's World, Seeking Alpha) an Editor's Pick - thanks guys. I received a number of interesting comments on both my own blog, and on the Seeking Alpha version.

Some people commented that I needed to adjust the data for population growth. I realized that I hadn't properly explained what the "exhaustion rate" data was depicting. The exhaustion rate is this: the number of people receiving final benefits divided by the number of people receiving first time benefits. Thus, since it's already a ratio - not gross numbers of people - I don't think it needs adjustment - it's essentially self standardizing for the most part.

I also want people to realize that I wrote the post on Thursday - it was not related to Friday's BLS employment data. I was writing about what I expect will happen with the "continuing claims" numbers in the future.

Some people requested information on the total dollars paid out or average hourly earnings - I have the data - you can get it easily on the Department of Labor site, but those definitely need to be adjusted over time, and I am not about to get into trying to normalize dollar statistics to adjust for inflation - I think the labor data paints a pretty convincing picture.

Commenter "Hooligan" asked for the gross number of exhausted workers. He suggested I also sum them up to get a cumulative running total, but I don't want to do that because it involves a lot of potentially inaccurate assumptions about exhausted workers staying unemployed - we can't tell how long they remain unemployed. I did, however, graph the gross "number of exhausted workers" data, and the chart looks like this:

Surprisingly, perhaps, for the people who thought I'd made a mistake in the initial post by not adjusting for population growth - these numbers do NOT seem to be trending up as much as the exhaustion ratio numbers are. One may have expected the gross numbers to trend higher as the population grew.

The important thing in all of these charts is the spike we're currently seeing. We're seeing more workers than ever exhausting unemployment benefits, we're seeing a higher percentage of workers exhausting unemployment benefits - as well as an uptrend over time in that ratio, and we're seeing a similar increase and uptrend in the % of unemployed people receiving benefits for longer periods of time.

So what does it all mean? Well, for one, it seems we're hardly well on the road to recovery. I also interpreted the upward trending numbers to be indicative that the United States is becoming more of a welfare state - with more people using unemployment benefits more extensively. We're more dependant than ever on the government to look after us, but the government is in more debt than ever at the same time - this seems like a clear recipe for disaster to me.

-KD

full disclosure: net short SPY (via common, and options)

Unemployment Data - Exhaustion Rate

I have a feeling that in the not too distant future the continuing jobless claims numbers are going to start "improving" due to a negative effect - let me explain. Unemployment benefits are limited: the standard is for up to 26 weeks of insurance benefits. There are currently Federal programs offering an extension of 13-20 additional weeks.

The markets like to focus on the jobs report, which releases two main numbers: 1) the number of first time jobless claims - this is a measure of new unemployment - how many people are filing for unemployment for the first time in the week in question. 2) the number of continuing jobless claims - this is the total number of people collecting unemployment. Well, it seems obvious to me that as we extend our fiscal problems, many people will exhaust their unemployment benefits - they will drop out of the continuing claims number NOT because they have found a job and are going back to work, but because things are so bad that they have used up their benefits and will no longer be counted in the statistics. Of course, this makes the continuing claims number smaller, and leads to chatter of "green shoots" in the job force.

The United States Department of Labor publishes statistics on the "exhaustion rate" - this is a measure of the number of people who have used up their benefits, and will no longer be receiving unemployment checks. I took it upon myself to run some numbers based on their data, and produced the chart below:


I'm not sure if "parabolic" is a strong enough word to describe the current upswing (a record!) in the exhaustion rate. Again - this is why economists who refer to what "typically happens in a recession" are spouting nonsense - this is clearly not a typical recession.

It turns out the Department of Labor allows you to easily generate charts on their own website too. Unfortunately, they make it so that you cannot grab the pictures, so I had to regenerate one more telling chart:


As you can see, the percentage of people who have been collecting unemployment benefits for a longer amount of time is also at a record.

Don't be fooled if and when continuing claims numbers begin to ebb - it's likely a numerical manifestation of exhaustion of unemployment benefits - but don't expect the media pundits to mention this part of it!

-KD

Zero Down! I Wish I Were Making This Up

I feel like I'm stuck in the movie "Groundhog Day." A few weeks ago I read a piece about some state - I think it may have been Arkansas - working on a plan to increase home affordability by instituting a lending program so that first time home buyers who lacked funds could borrow against the $8,000 tax credit they'd be eligible for. This was so ridiculous that I ignored it, out of fear of smashing my head through my monitor.

Today, however, I read that this plan is back - and it's going national: from Business Week via Clusterstock:

"Buyers who haven't owned a home for three years or longer are eligible for an $8,000 tax credit, thanks to a provision in this winter's stimulus package. Now, under a little-noticed program announced May 29, the Federal Housing Administration will steer the funds to cover closing costs directly—in some cases even offsetting the 3.5% minimum down payment FHA loans require. That's enough to cover most or all of the down payment and fees for homes up to the U.S. median price, now about $169,000.

Officials hope "monetizing" the tax credit will help revive the housing market, because meeting closing costs is one of the biggest hurdles for new home buyers. The National Association of Home Builders predicts it will add 40,000 to the 160,000 sales originally expected to be spurred by the tax credit. Supporters say the move avoids the worst effects of seller financing, in that the credit is essentially the buyer's money, and government assistance doesn't give sellers a perverse incentive to inflate prices in an unsustainable manner."

Let's take this back to third grade level: the problem is that people can't afford to buy homes. So what's our solution? Give them a tax credit to make it more affordable. Ok - good idea. But wait - many people STILL can't afford to buy homes, because they STILL don't have money for a down payment. Solution? (beware - I'm about to turn on my sarcasm meter) Easy - just advance them the tax credit so that they can cover the 3.5% down payment and closing costs, and the FHA will then cover the other 96.5% with a mortgage! We've now let them buy a house with little or no money down! (sound familiar?) As Clusterstock asked sarcastically in their writeup: "What could go wrong?"

It's simply remarkable to me that we're addressing a bubble caused by people buying homes they couldn't afford by... wait for it... THINKING UP NEW WAYS TO PUT PEOPLE IN HOMES THEY CANNOT AFFORD! Folks, here's a simple, bi-partisan fact of home ownership: if you don't have the 3.5% down payment, you cannot afford the home. Fact. Never mind that first time home buyers are probably the most likely to under estimate the costs of owning a home - and that the $8k tax credit would probably come in quite handy when they get plugged with a bunch of unexpected bills in the first few years - with this new program, that credit is already spent, and we can only assume that the home buyer is financially tapped out already.

unreal. Hopefully Barney Frank will put a stop to this plan - since he claims to be against increased home ownership.

-KD

full disclosure: I do not own a home I cannot afford

Quick Hits

I loved this Karl Denninger critique of the NY Times article about homeowners having trouble getting help when they are not yet in default.

"See, we are here because people at all levels of society, including you, Ms. Ulery, seem to think you can spend more than you make.

You did it.

The government, both state and federal, is doing it.

The New York Times is holding you forth as a paragon of virtue, and a "victim" of the evil banking system.

It sucks that you've got an employment problem Ms. Ulery, but that's not the reason you're in trouble and about to lose your house.

No, the reason you're about to lose your house is because you treated your home as a permanent and inexhaustible ATM machine - a demonstrably unsafe, unsound and FRAPPING IDIOTIC act."

Read Denninger's full rant. I have to say I pretty much agree with all of it. Here's a hint for the reader: whenever you read about someone (usually, when you're reading the Times, an elderly person or couple who bought their house decades ago) who now owes much more than they originally paid for their house and is being made out to be a victim, there's an excellent chance that the person is not a victim at all.

I also loved Steve Ballmer's populist threats today, claiming that if Obama's corporate tax plan goes through the stock market will go down. This is akin to screaming "OBAMA HATES PUPPIES!" After all, if there's one thing Americans hate more than taxes, rich people, or Wall Street, it's when the Dow Jones Industrial Average (side note: the most absurdly constructed index in the history of indexing - how ironic that it's our benchmark!) goes down.

"Ballmer estimated that higher taxes under the proposal would reduce profits for companies that comprise the Dow Jones Industrial Average by between 10 and 15 percentage points.

“It’s just a question of how much will the Dow come down,” Ballmer said. “It’s not about companies anyway; we’re talking about shareholders.”

Attaboy Ballmer - hit 'em where it hurts - right in the POPULISM. Ballmer also said the tax plan would force more jobs overseas. If there's another thing Americans hate more than rich people, Wall Street, taxes, and the Dow going down, it's good old American jobs being forced overseas by new laws!

-KD

full disclosure: max long puppies