More on High Frequency Trading

The sworn enemy of high frequency trading, Themis Trading, has a new "white paper" out titled "Latency Arbitrage: The Real Power Behind High Frequency Trading."  In my opinion, this paper is better written than Themis's prior missives on the subject of HFT, which is rendering them obsolete as traders, yet there are some glaring errors in the report that undermine its points.

The paper attempts to illustrate by way of example how exactly the latency arb algos are eating your lunch - let's call them LAHFT for short.    Themis describes it:

Here’s an example of how an HFT trading computer takes advantage of a typical institutional algo VWAP order to buy ABC stock:
1. The market for ABC is $25.53 bid / offered at $25.54.
2. Due to Latency Arbitrage, an HFT computer knows that there is an order that in a moment will move the NBBO quote higher, to $25.54 bid /offered at $25.56.
3. The HFT speeds ahead, scraping dark and visible pools, buying all available ABC shares at $25.54 and cheaper.
4. The institutional algo gets nothing done at $25.54 (as there is no stock available at this price) and the market moves up to $25.54 bid / offered at $25.56 (as anticipated by the HFT).
5. The HFT turns around and offers ABC at $25.55 or $25.56.
6. Because it is following a volume driven formula, the institutional algo is forced to buy available shares from the HFT at $25.55 or $25.56.
7. The HFT makes $0.01-$0.02 per share at the expense of the institution.

Now, item #2 above is the first problem - it implies that the LAHFT "knows" that there is an order that is coming in to buy stock.  This is not correct.  Themis continues to imply that the LAHFT is frontrunning orders, which is simply not the case.  What is happening is that the LAHFT is reacting to publicly available trade data faster than other people are.  The LAHFT computer does not see your buy order and trade ahead of it.  What MAY happen is that the HFT algo is offering stock, and when they get lifted, they go and lift offers on other market centers.  Again, this is nothing new, and is a basic, old, trading strategy - they just do it faster. Similarly, HFT Latency Arb algo's may see (and react to) publicly available trade data before JoeSixPack, but there is nothing immoral or illegal about that.  The LAFHT can see the publicly available data that shows 100 shares of ABC just traded on exchange ABCD, and go lift offers on exchange WXYZ.  So can you.  They just do it faster than you.  You are free to go write the software code to process the information faster  - there is no secret club you have to join - all you have to do is do the development work and pay for the connection.

Even more importantly, though, Themis writes

"6. Because it is following a volume driven formula, the institutional algo is forced to buy available shares from the HFT at $25.55 or $25.56."

NO. NO. NO .NO .NO.. NO ONE is forced to buy shares from anyone else.  If the institutional algo thinks the price is to high, it can sell stock instead of buying it.  That's the beauty of markets.   NO ONE forces you to trade at a price you don't want to.  The LAHFT is not forcing anyone to lift their offers or hit their bids.   If the institutional algo is leaving a footprint that lets everyone see what it's doing, that's it's own fault.  Again, this is especially ironic because Themis's Saluzzi has previously admitted that he's a "tape reader" which tries to do EXACTLY what he complains about:  forecast stock movements based on trading volume patterns.   Why Saluzzi continues to think it's ok for him to try to do this, but not for a computer to try to do it faster is beyond me, and it's why I continue to write these reubuttals everytime he pens a piece against the technology that's making him obsolete.

-KD

ps - The term "predatory trading" is redundant:  trading is predatory.

For more on the subject of high frequency trading, see:

We Fear What We Don't Understand
You Really Shouldn't Care So Much About Flash Trading    and
Dark Pools Are Not The Enemy

Heard It Through The Grape Vine - Exclusive! (Possibly NSFW)

WARNING: If you're looking for a thought provoking post on finance, you might want to come back another day - this post may be unsuitable for workplace reading.

still here?  ok...

While I was in NYC to see Phish, I got my haircut for the first time in almost 6 weeks.  The New Hampshire woodsman look was perfect for blending in with the Phish crowd, but my beard was starting to look like curly pubes, and I had an unruly mop on the top of my head.  I made an appointment to see my trusty old Italian barber, who I'll call Dino to protect his anonymity.

After exchanging pleasantries, Dino immediately got into a rant on Tiger Woods, and more importantly, one of Tiger's alleged concubines, Rachel Uchitel.  Dino's inimitable Italian accent made the story world class:

"Heya man - let me-ah tell-ah you something my friend.  Dis guy I know - his-ah friend, he-ah meet dis girl in the Hamptons this summer.  He-ah at-ah a party, and he-ah meet her on a Monday night.  He-ah call me on-ah Tuesday morning and he-ah say "Dino - that-ah girl, I-ah banged her in the ass-ah last night-ah"

Boom. Great stuff. If it comes from an Italian barber in NYC, we all know that's about as reliable a source that exists in the world of information.  So there you have it.  Rachel Uchitel gives up the butt on the first night.

-KD

The Financial Week That Was

I've been busy enjoying myself in NYC at Phish this week, but I saved a bunch of financial stories to mention:

 - Nassim Taleb gives up:

"What I am seeing and hearing on the news -- the reappointment of Bernanke -- is too hard for me to bear. I cannot believe that we, in the 21st century, can accept living in such a society. I am not blaming Bernanke (he doesn't even know he doesn't understand how things work or that the tools he uses are not empirical); it is the Senators appointing him who are totally irresponsible -- as if we promoted every doctor who committed malpractice. The world has never, never been as fragile. Economics make homeopath and alternative healers look empirical and scientific.

No news, no press, no Davos, no suit-and-tie fraudsters, no fools. I need to withdraw as immediately as possible into the Platonic tranquility of my library, work on my next book, find solace in science and philosophy, and mull the next step. I will also structure trades with my Universa friends to bet on the next mistake by Bernanke, Summers, and Geithner. I will only (briefly) emerge from my hiatus when the publishers force me to do so upon the publication of the paperback edition of The Black Swan."

-Dan Loeb:  "It's a bull market in government regulation and intervention."  Via Dealbreaker

- Karl Denninger:  none of the trial mortgage modifications have been made permanent.

- Via Felix Salmon:  Fama and French's latest study on fund returns:

"For the vast majority of actively managed funds, true α is probably negative; that is, the fund managers do not have enough skill to produce risk adjusted expected returns that cover their costs."

- MISH 3-pack:   Virginia Borrows Money To Pay Unemployment Benefits,  Arizona Maxes out Credit Line in Two Weeks Flat,  24 States Borrow Money To Pay Unemployment Benefits

 -Somali Pirates Form Stock Exchange:  again, a real story - not from the Onion:

"The shares are open to all and everybody can take part, whether personally at sea or on land by providing cash, weapons or useful materials ... we've made piracy a community activity."

A COMMUNITY ACTIVITY!   My graphics department, which consists soley of my most loyal reader, Bones, provides this graphic for the pirate story:

-Karl Denninger on how banks are ripping off the FDIC 

-Baseline Scenario:  BankAmerica paid back TARP money to avoid executive compensation caps. 


-Michael Panzner: "An altogether different picture,"  anecdotal stories of just how "not good" things are.


-Floyd Norris thinks unemployment may have peaked.  I happen to think he's wrong (see: exhaustion rate, average length of employment, employment/population ratio, number of people unemployed over 26 weeks, etc)



-quality satire:  Zero Hedge announces new partnership with Google

- The solution to our economic woes.  cartoon: "much like the Federal Government, my wife has a plan to spend us out of debt." 


Another graphic from my hard working graphics department, Bones:

"Come on - that HAS to be photoshopped,"  I told him.  He merely replied with the link: http://www.columbiadailyherald.com/, where the ad is displayed.


-KD

Inside the Bee Hive

I joke with my friends that I'm a terrible trader.  Never mind my market prowess, or lack thereof - it extends to other avenues, like procuring Phish tickets.  Although I thought that tickets to the three MSG shows would be virtually fungible: trade-able for each other, I somehow ended up with 8 nearly worthless tickets to Wednesday's show and had my friends bail on me, while I needed 4 tickets to Friday's show which had a Super Bowl aura of impossibility to them.

After spending 4 days staring at the screen on StubHub, prowling Craigslist relentlessly, and reaching out to my network of ticket providers with zero results, I stumbled upon a 4-pack online that looked to be golden.  Section 62, Row C, for a relatively reasonably price (note: it's all RELATIVE!).  I pounced on them, and the only concern now was how I would be able to get them in time for Friday's show, since it was Thursday afternoon.  At Thursday night's show, I noticed that there might be a slight issue with these seats, as Phish has a little soundboard guy on Page's side of the stage, and these seats might be directly behind said soundboard.

Well, Friday came, the tickets arrived without incident, and all fears diminished when Dan, Lee, Mitch and I sauntered down to our seats.  Front row, level with the soundboard guy, right next to Page.  I have been to hundreds of concerts, plays, and other events in my life, but I have never before had a seat that I would not trade with any other seat in the venue.  Until tonight.   I finally got one trade right.

My buddy Alex had bailed on me for Wednesday and Thursday's show, telling me he wasn't going to any of the three.  He got caught when I found out he was taking a former colleague of mine to Friday's show, and was in the 8th row on the floor.  Alex tried to make amends by offering to "stub me up."  "Stub me up?  Stub up my balls bro - your seats are the cheap seats compared to mine!" I taunted him back, thinking of Moe Green's "No, I buy you out, you don't buy me out," from The Godfather.

Things got groovin early in Possum, and then absolutely frenzied during the anthemic Wilson, with the screaming question: "I must inquire Wilson - CAN YOU STILL HAVE FUN?"     I've used the word "anthemic" in each of my three recaps, and it's really the word to describe Phish.  Although so many of their songs are anthemic to the fanatical fan base, there are still a handfull that are really rallying cries for Phish nation.  Wilson is in this basket, in my opinion.  The security guards in the front of the floor were pretty cool - retrieving balloons that ended up over the rail and putting them back into play.  Our section had the most miserable usher in the history of civilization, who was a major buzzkill for everyone, but at least she kept ticketless wooks out of our seats.  Mitch made several leaning reaches to keep balloons up in the air, and I marveled at how dedicated the fans were - having taken the time to draw smiley faces on each and every balloon. 

I also laughed at a guy on the floor holding a sign that read "I AM HAPPY," which seemed to be a partially sarcastic reply to Trey's new craptastic song, "Joy," and it's refrain of "We want you to be happpppppy."  I tried to hit Alex with several glowsticks, but only managed to ding the girl standing in front of him.

The first set closed with an absolutely insane trio of Guyute, Maze and First Tube.    I saw Phish about 5 years ago in Vegas - in the Thomas and Mack Center which is like a smaller version of MSG - a tight bowl.  I will never forget the description by one of the people I was with of the energy at those shows - he said it was like being inside a bee hive.  There is no better way to describe the way the energy ripped around the Thomas and Mack Center that week - like bees buzzing louder and louder in their hive, reaching a crescendo, feeding off each other.  I felt a lot of that on Wednesday night, but not much Thursday.  Friday, during First Tube, there was a bona fide bee hive moment, as the crowd just went ballistic.   As Dr. Pauly described it, everyone went "batshit crazy."  It was, quite simply, a "moment."  Check out Dr Pauly's review for a more detailed description of Trey's on stage orgasmic actions.  In the video below, you can get a sense of the hysteria starting around the 3 minute mark, and you can see Trey waving the guitar at the end.

Alex came up to visit us during the set break, and we busted his balls for having crappy 8th row seats.  I don't know what happened to my memory during the beginning of the second set, because I have absolutely zero recollection of "Scents and Subtle Sounds."   I definitely remember Rock'N'Roll, however, which brought the energy back up.

Mike's Song was one of the highlights of the three nights.  Absolutely RAGING.  It anchored the second set, leading into Hydrogen and then Weekapaug of course.  After the mellow Horse --> Silent in the Morning, YEM closed the set.   Mayhem ensued when the band reached the crescendo and MSG exploded in an ejaculation of energy.   My boy Lee always has Loving Cup on the top of his list of "songs to hear," but he was pleasantly satisfied with the Shine a Light encore closer.

As the lights came up, I noticed that the hippie chicks in the row behind us were barefoot.  Oh man.  Under what circumstances does one go barefoot in Madison Square Garden? None, in my book. Perhaps they needed to take off stiletto heels to dance?  Nope - they pulled on their boots and trudged up the aisle.  I just don't get it.

I woke up this morning, back home in the silence of a snow covered New Hampshire with my ears ringing.  Note that it's Sunday.  The third MSG show was Friday night.  Why are my ears ringing?  I wondered.. Oh yeah - three nights of Phish in NYC followed by the system shock of total silence in the country.  Three nights of raging.  Three top notch nights.  I got out of bed and my knees creaked.  I have dark yellow bruises on the tops of my calves.  Huh?  Oh yeah - I repeatedly smashed into my own chair as I was bouncing up and down during the shows.

My voice has recovered, my calves will recover, and I still have my wallet and my cellphone.  

I'd say it was a raging success.

-KD

Waiting For The Time When I can Finally Say...

Last night I returned to Madison Square Garden for the second of three consecutive Phish shows.  I was not about to make the same mistake I made on Wednesday night - drinking on an empty stomach - and got a solid cheeseburger base in me before the show.  I remembered a few more funny tidbits from Wednesday night too:  at the bar preshow, I reached into my pocket for my cash, and a individually wrapped Lactaid pill I was carrying fell to the ground.  I could sense the tension in the place, as the Phish wookies contemplated diving on my potential contraband.  "Relax folks - it's just Lactaid,"  I laughed.  It won't get you high, it will just save you from agonizing stomach pain when you eat milk products.

There was a scary moment early on in Wednesday's show, where a girl who was probably about thirty years old was nodding and swaying a little to the music at the end of my aisle, 3 people away.  Suddenly, she stopped moving, stared straight ahead, teetered, and then collapsed as her friends shook her and yelled at her.  Ten minutes later, she was back, fine, as her friend explained to me "she doesn't even do any drugs."  Just a Kuroda-induced bona fide seizure i guess.

On Thursday, we were sitting in section 309, which was fine - it was near the stage, and offered a sweeping bowl of the mass of gyrating hippie humanity that was Madison Square Garden on that night.  I said hi to Doctor Pauly before the show, and finally met the elusive Change100.  I also spotted a guy in my section wearing one of Pauly and the Joker's Phish/Lost Dharma Initiative lot shirts.

I didn't think the crowd was nearly as loud as the night before.  Perhaps it's because I was in a different spot - the music was bone shakingly loud the night before in section 73, and the sound was significantly more dissipated up in the 300 level, but I wouldn't think that would effect the crowd noise I was hearing.   

Hans shot this pic on his Iphone, through the lazer glasses I brought, which he throroughly enjoyed wearing.

To me, the crowd didn't really get rocking until Julius closed the first set.  The second set led off with another anthemic song:  Down With Disease.  I had a Phish Virgin with me, my friend Hans, and I urged him to try to listen for the part when Phish would come out of the jam and bring it back to the closing refrain of the song.  Sadly, they didn't finish DWD, they segued into Piper instead.  Piper is good too, but I love the way the band ends DWD jams, and was diappointed not to get brought back to the hook.  Piper, in turn, morphed into Fluffhead, which really got the crowd fired up again.

"Fluff came to New York

Askin' me for change

His eyes were clear and pure

But his mind was so deranged"

The second set was quite solid, including Free, David Bowie, 2001 and a Character Zero encore.

A few funny moments:  1) security/ushers simple gave up trying to corral the mass of dancing wookies that flooded the aisle around the 300 level.  I saw an usher with a simply exasperated look on her face - she wasn't even going to try to stop the dance fest.  2) there were two guys behind me who were probably 17.  One looked to be the chaperone, guiding his buddy who was clearly stoned out of his mind.  During the set break, stoner-boy was expounding "dude - we are just so inherently SMALL. Do you realize that the universe is expanding at an ever-increasing rate?"  It was like Donald Sutherland's character in Animal House.   I laughed and turned around, to find the chaperone buddy looking completely embarrassed.  "Enjoying the show?"  he asked me, rolling his eyes at his buddy.

Tonight we return for the final show, which is likely to be a barn-burner.

-KD

Papa Needs A New Pair of Shoes

Some of you may have noticed that I've finally whored myself out and added Google Adsense to my blog.    I know, I know, I'm a sellout, blah blah blah.  I don't choose the ads that are displayed - Google provides them based on some algo that determines what my readers would like to see based on the content I write about.  This can also result in some funny ads (meaning: odd/inappropriate) showing up.  If you see anything bizarre, let me know.

Please click on my sponsors every once in a while if you see something you find interesting - if you click through, I get paid.

Ship it.

-KD

The Hangover

I tried to write a post about last night's Phish show at MSG, but it simply didn't translate and I deleted it in frustration.  Without further ado, here's what I remember about last night:

Severe inebriation.  There is really no other way to describe it.  Staggering.

"Can't I Live While I'm Young?!!?"  Anthemic.  That's the word.

"Brain dead, and made of money - no future at all" for some reason I always feel like that line is for me - not that I'm brain dead, but that I'm wasting my talents.  Anyway.

The crowd was DEAFENINGLY loud.  Probably the loudest I've ever heard.

There were an ample supply of wookies looking for freebie tickets before the show.

Trey was fired up during Tweezer Reprise - so much so that I thought they might audible one more song.

"I sawwwwwwwwwwwwwww you - with a ticket stub in your hand!"

"Set the gearshift for the high gear of your soullllllllll. You've gotta run like an antelope - out of control." - also anthemic.

My boy Ryan pulled an advanced maneuver when I went to "cheers" him by knocking my beer bottle against his.  He simply took the beer from my outstanded hand, tipped it in my direction, and drank it.  Well done, sir.

I texted Dr. Pauly "I cannot drive right now."  "I thought you took the train?" he replied. "I did. I'm just giving you a benchmark of how drunk I am" I explained.

Staggering out of the subway in the rain after the show, I walked the wrong direction for 3 blocks before I realized that I was off target. 

I knocked down a cheeseburger at 1am - which was essential to absorb some of the booze in my stomach.

Beers at MSG cost $8.25 and up!  What recession?

Ryan brought a pair of 3D glasses - which were tremendous to wear during the show, distorting all the lights. "It's like drugs, without the drugs," we opined.

This morning I was awakened at 5am by the sound of a little kid screaming, coming from the air conditioning vent in the bedroom I was in.  I quickly realized that this was a fun game - for the kid at least - he was literally screaming INTO the vent (on another floor of the same building).  Thanks, parents. 

Checking my inventory - I seem to still have my wallet, phone and clothes from last night - so we'll call it a rousing success.

Can't wait to do it all over again tonight - and tomorrow.

-KD

AIG Gets Foreclosed On - "I'm Paying You With Your Money"

Irony continues to flourish.  The first story I saw this morning was: "AIG Reduces Government Borrowings by $25B."  Hmmm.. note the careful wording - clearly AIG didn't pay back $25B to the Government - let's read on:

"American International Group Inc. on Tuesday slashed the amount of money it owes the government by $25 billion as it moved two subsidiaries into special holding units ahead of their planned spinoff or sale.

AIG moved American International Assurance Co. and American Life Insurance Co. into special purpose vehicles, which are used ahead of a move to separate a unit from a parent company. The government is receiving preferred equity stakes in the two life insurance companies worth $25 billion in exchange for a reduction in the amount of money AIG owes the government.

AIG will continue to hold the common stakes in AIA and Alico until it determines whether to complete initial public offerings for the companies or sell them privately. No timetable yet has been announced for when an IPO or sale will be completed."

This actually isn't a total shock - it was announced preliminarily back in June, and I wrote about it then.    AIG tried to sell these two businesses, but couldn't get either 1) a buyer or 2) a buyer at the price they wanted.  Thus, they decided to make the Government the buyer at their price, and somehow the Government agreed.

The analogy here is if you have a house with a $1mm mortgage (in AIG's case, it's more like a $180 BILLION mortgage, but let's play make believe).  You owe the bank $1mm, and you've lost your job, so you put your house on the market.  After a year, no one wants to buy your house, and your neighbors' comparable houses have sold for $500k.   You can't just call the bank and say "hey man, the house is really worth $1mm, so you can just take the house and we'll call it even."   Actually - you CAN!  It's called foreclosure - the US Government is foreclosing on AIG.   Also note that while this relieves you of your debt, the bank (the Government in this case!) eats the loss!

What can we learn from this?  Well - we're never getting back the money that was lent to AIG - this is more evidence to that fact.  Once we (the Government) start accepting assets that no one else wants to buy as repayment of debts, it's because they're better than nothing - better than the cash we will NOT be getting!

Now, let's get back to the absurdity.  There's another big problem with this transaction: the Government already owns 80% of all of AIG - from the bailout a year ago.  Sooooo.... Why do we need to get paid back with stakes of companies (AIA, ALICO) which WE ALREADY OWN?!?!?!?!?!    Pure insanity.

Finally, notice that AIA and ALICO will be placed into special purpose vehicles to facilitate this chicanery.   Is anyone else laughing out loud at this?  One of the big problems for the banks was that they had all sorts of off balance sheet assets - lousy MBS, CDO's and other structured products - sitting in SPECIAL PURPOSE VEHICLES, which is a fancy term for "off balance sheet black holes where we can pretend that we no longer have risk, but are merely an accounting ploy."   The banks pretended these assets weren't really effecting their balance sheets, and avoided recognizing the losses associated with them for as long as possible (and some still haven't been recognized.)

Investopedia explains it thusly:

Investopedia explains Special Purpose Vehicle/Entity - SPV/SPE
Thanks to Enron, SPVs/SPEs are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk.

A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating.

I guess when AIG is giving us assets that we already owned and no one else wanted to buy in exchange for a reduction in $25B of debt, the SPV nature (place the assets in a bucket with a made up value slapped on them) of the transaction is the least of our problems.

This post wouldn't be complete without this apropos quote from Teddy KGB

Still Up 20 Grand sound bite  Matt Damon sound bites

"It's a fucking joke anyway, after all, I am paying you with your money."

-KD

Seriously - These are Real Stories

As if Foreign Policy naming Ben Bernanke their top Global Thinker wasn't absurd/ironic/laughable enough, Zerohedge brings us the announcement out of Rochdale Securities that they will be restricting access to Dick Bove's research reports:

"Research by prolific banking analyst Dick Bove won't be as widely available for at least the rest of the year and possibly longer, as his employer aims to preserve its value."

PRESERVE ITS VALUE!  The irony is impossible to express in mere words...  If you don't understand why, check out an old post from Karl Denninger regarding Bove's history of calls on the stocks in his sector.


Bove comments, today:

"The information is getting to [people] who are not paying," Bove, of Rochdale Securities, told Dow Jones Newswires by phone Monday. "It's weakening our whole approach to how we want to price the product."

I guess Rochedale only wants Bove to blow up their official paying clients - not to poison the whole investment world with his reports.

-KD

Mind Boggling - The Top Global Thinker ?!?!!?

From Michael Panzner, writing on The Big Picture comes a post he titled simply "Say What?":

"Foreign Policy has just published a list of its “top 100 global thinkers” and the winner is…

1. Ben Bernanke
for staving off a new Great Depression.
Chairman, Federal Reserve | Washington
The Zen-like chairman of the U.S. Federal Reserve might not have topped the list solely for turning his superb academic career into a blueprint for action, for single-handedly reinventing the role of a central bank, or for preventing the collapse of the U.S. economy. But to have done all of these within the span of a few months is certainly one of the greatest intellectual feats of recent years. Not long ago a Princeton University professor writing paper after paper on the Great Depression, “Helicopter Ben” spent 2009 dropping hundreds of billions in bailouts seemingly from the skies, vigilantly tracking interest rates, and coordinating with counterparts across the globe. His key insight? The need for massive, damn-the-torpedoes intervention in financial markets. Winning over critics who have since praised his “radical” moves (including Nouriel Roubini, No. 4 on this list), he now faces an uphill battle in his bid for permanently expanded Fed powers. The radicalism is far from over.

For those who still ask "hey - what was Bernanke supposed to do?  Come on - the guy prevented another Great Depression."  The answer is simple:  Bernanke cannot and should not be exalted for his response to the crisis which HE failed to prevent. The accolade from Foreign Policy is mind boggling to me. To bring back an old analogy: it's like commending the captain of the Titanic for getting people out on lifeboats after he steered the ship into an iceberg.  If Bernanke were the top global thinker, he would have acknowledged the reality in the economy - the bubbles that were forming throughout the 2000-2007 years as a result of the free money policy enacted by the Fed.

Also make sure you read MISH's point by point response to Bernanke's op-ed this weekend defending the Fed's policies.

Finally, I assume most people have seen this video of Bernanke's past errors in evaluating our economic situation.  While it may be unfair to selectively cherry-pick each prediction Bernanke has made which has proven to be downright wrong, the point is that he is far from infallible, and that we shouldn't assume that he has the solution for our problems.

-KD

Capital Depreciation Fund - Nice Trades!

Courtesy of Barrons:

"Almost 10 years ago, in January, 2000, America Online CEO Steve Case announced one of the boldest, craziest ideas in modern business history: a $182 billion stock-and-debt deal to buy mighty Time Warner, creating an Internet and media colossus with a combined market cap of $350 billion. It was the largest takeover ever, and a symbol of the turn-of-the-millennium power of the Internet. "Together, they represent an unprecedented powerhouse," Bear Stearns analyst Scott Ehrens told CNNfn at the time. "If their mantra is content, this alliance is unbeatable."

Well, as it turned out, that wasn't even close to true. Almost a decade later, Bear Stearns is gone, and so is CNNfn. Steve Case quit as AOL Time Warner chairman in January 2003, and left the board for good in 2005. A few weeks ago, he sold a company called Revolution Money to American Express. Gerald Levin, the former Time Warner CEO who engineered the deal with Case, now helps his wife run a holistic health center in Los Angeles. And in less than two weeks, the great and terrible combination of AOL and Time Warner, mighty destroyer of careers and shareholder wealth, and vivid reminder of the excesses of the Internet bubble, finally will be undone.

On Dec. 9, Time Warner will spin AOL back out to the public, issuing one share of its stock to Time Warner holders for every 11 shares of the parent company. The shares began trading on a "when-issued" basis on the New York Stock Exchange last Tuesday -- and the debut wasn't pretty. Trading started at 27, but the price dropped to 23 the day after Thanksgiving. At that price, the new AOL had a stock-market value under $2.4 billion. Having swallowed a whale, it has in the end been transformed into a minnow."

If you're calculating a cumulative return, Time Warner's purchase of AOL for $182B and subsequent spinout at $2.4B works out to a loss of 98.68% over almost 10 years.  Nice trade Time Warner!

Not to be outdone, the City of Detroit sold the Pontiac Silverdome last week for pennies on their cost basis dollar:

"Nearly 35 years after taxpayers spent $55.7 million building the Pontiac Silverdome and a year after a $20 million sale fell through, city officials have sold the arena once called the most desirable property in Oakland County.

The price: $583,000."

My handy HP-12C tells me that's a loss of 98.9%, although it took the Silverdome much longer to achieve a similar rate of return as AOL did for Time Warner.

-KD

The Fed Fights Back

Fed Chairman Ben Bernanke has an op-ed in the Washington Post today defending the Fed's handling of the crisis (again) and explaining why he thinks proposed changes to the Federal Reserve system could be hazardous to our financial health.  Yves Smith at NakedCapitalism does a nice job rebuffing much of Bernanke's rhetoric.  David Merkel also has a response well worth reading.

For me, the most important thing to remember each time we talk about how the Fed saved us from the brink of collapse (for now) is that the Fed's policies also drove us to the same brink!

-KD

Two Crazy Stories

Something smells funny to me about the story of the Virginia socialites who "crashed" the White House state dinner on Friday.    Really?  You can be a good looking couple, dress up nicely and TALK YOUR WAY INTO THE F'N WHITE HOUSE?  Come on... Something is funky here.  Did Bravo grease the wheels for publicity for the Real Housewives of DC?  Is it really possible to get into the White House and shake hands with the President when you're not on the guest list?

If that story smells funny, then the Tiger Woods story absolutely stinks.  Let's review the facts/claims:  Tiger left his home at 2:25am, and promptly crashed into a fire hydrant and a tree in his neighbor's yard.  Tiger had scratches on his face - from the crash, according to reports.  Reports said alcohol was not involved.   Then his wife, Elin, supposedly smashed the back window of his SUV with a golf club, in an attempt to get him out of the vehicle.

Now, I don't want to jump to conclusions, but come on... If alcohol wasn't involved, and I hope it wasn't, then how did El Tigre crash into two obstacles after pulling out of his driveway?  Where was he going in the middle of the night?  Was Elin trying to pound him with the golf club as he tried to escape?  TMZ's explanation is much more plausible than the official story being propagated.    This story has been spun even harder than the economic news of the past 6 months.

-KD

When the Train Leaves the Station, You Have to Be on Board

I don't want to forget about this article from Clusterstock last week which quoted Raymond James' Strategist Jeff Saut.   Over the past several months, Saut has been repeatedly bullish.  What's interesting about Saut's view is that he hasn't been saying "buy stocks because they are cheap,"  he's been saying "buy stocks because everyone else is buying stocks."  In other words, "Don't fight the tape." (note: none of those are direct quotes).

This time, Saut elaborated on this phenomenon, explaining the concept of "career risk" for money managers:

"Nevertheless, we think the upside should continue to be driven by “game theory,” which suggests that the under-invested institutional portfolio managers have to buy stocks into year-end driven by their under-performance, their subsequent “bonus risk,” and ultimately their “job risk.”  Verily, many of the portfolio managers we know remain under extreme pressure to commit their outsized cash positions in an attempt to “catch up” to their benchmarks between now and year-end"

Saut's point is an essential one:  in the money management profession, for some accepted reason, it's one thing to lose 35% when the market is down 35% - you can write it off to a global clusterfuck - "hey - there was nothing I could do - did you SEE what happened to the S&P?!?!?"  But if the market rallies 65% and you're not on board because you're acting rationally and saying "nothing has changed, the banks are still insolvent, we haven't fixed the problem,"  well, you're clients will tear your head off.  Note - I'm in the latter camp here, trying to act prudent, and looking like a fool.  Thankfully, I don't have to answer to any investors - just myself, and I can justify my decisions to my own second guessing conscience, even if I'm missing the rally.  One thing this tells me is that I'm not a spectacular (and maybe not even a good) trader - a great trader has to be able to trade the market and make money even when it's not cooperating with his own thoughts about valuations.

This is related to my anecdote last week on Return Free Risk  - one explanation (although certainly not a valid one, in my opinion) for the behavior of merger arb fund managers who parked money in deals offering returns on par with riskless rates is that these fund managers are not paid to own treasury bills - they are paid to trade merger arb deals - so they buy the deals even if the risk/reward may not be adequately compensating them.

-KD

Happy Turkey Day

As you stuff yourself this Thanksgiving, enjoy these two Saturday Night Live skits - two of my favorites from recent memory.  I don't know what it is about "What Up With That?" that I find so funny - but Keenan Thompson simply OWNS it.

enjoy:

and then the follow up:

-KD

Ya Think?

From the FOMC minutes:

"Members noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations. While members currently saw the likelihood of such effects as relatively low, they would remain alert to these risks."

Hmmm.. deja vu.  The risk is "relatively low?"  Really?  Look at the markets boys!  ALL asset classes!

-KD

They Said It

From this week's Barrons, courtesy of my friend, Ted:

"On the equity/fixed-income side, the traditional rule of thumb has been for retirement portfolios to have a 60/40 split between stocks and bonds. But until the Fed starts raising interest rates, retirees should consider curbing the fixed-income portion of their portfolios. Because bond prices fall as rates climb, cheaper fixed-income investments will be available down the road. A 65/35 or even 70/30 tilt might be best now. Warns Jim Marlowe, a 61-year-old retired broker supervisor at Merrill Lynch: "Bond funds are where all the money is going right now, so when the market gets a whiff of higher rates, it'll be 'Katie, bar the door.' "

Ummm... stock prices might fall also when interest rates are raised!   This points out a conundrum faced by retirees right now:  do you keep your money safe, in short term treasuries (let's just ASSUME that short term treasuries are indeed safe -that's a debate for another day) - earning less than 1%, providing almost no income?  Or do you invest your money into another asset class where the prospects for price declines are signficant at the least?

It's return-free-risk all over again.

-KD

Back to the FHA

Last week I wrote about the absurdity of the F.H.A's mortgage insurance - requiring only 3.5% down payments and insuring mortgages up to $739k!  CalculatedRisk followed up with a post titled "Possible Changes to FHA Insured Mortgages,"  where they summarize 4 possible changes, as outlined by the San Francisco Chronicle,  that may help shore up the FHA.  Let's focus on this one, emphasis mine:

"Currently, FHA charges an "up-front" mortgage insurance premium of 1.75 percent of the loan amount. Most borrowers roll that into their loan and finance it. FHA also charges an annual premium, paid in monthly installments, of either 0.5 percent or 0.55 percent, depending on the down payment. To rebuild reserves, FHA could ... raise the up-front premium to 2 percent or as high as the current statutory maximum of 2.25 percent. It could also raise the annual fee..."

Ummm  - the first thing the FHA could do, in lieu of raising the up-front premium, is actually CHARGE an up front premium!  There is no way that the lender (the bank) is paying this fee to the FHA up front, right?  If the FHA is charging an insurance fee that gets rolled into the mortgage which it itself is insuring, well then, they aren't going to collect that fee on defaults!  Plug it into Excel and you'll get a circular reference error.  Divide by zero.  Does not compute.   The borrowers are essentially paying the FHA with their own money!   I guess the FHA will make up for it in volume...

If the FHA doesn't want to actually charge this fee up front, then they will likely have to raise the insurance fee - as buyers who default will not end up paying the full fee.   Who am I kidding - they'll likely have to raise the insurance fee anyway, as their actual default results cannot be in line with what they expected!

-KD

China Wants Their Money Back

Is it funny cause it's true?  or sad?



SnL nails it with this one.  "I like to be kissed when someone is doing sex to me!"

Ponziiiiiiiiiiiiiiiiiiiiiiiiiiiiiiii

-KD

The Magic of the F.H.A.

Thanks to Calculated Risk for pointing out this remarkable NYT story about FHA insured loans in California.   Now, obviously, we have to be careful drawing conclusions and condemning a program based on one example - but this is not a one of a kind story.    Let me summarize my view up front, in the paraphrased words of Mike Shedlock: "You cannot keep home prices from falling by selling homes to people who cannot afford them."  Some excerpts from the NYT article:

"In January, Mike Rowland was so broke that he had to raid his retirement savings to move here from Boston.  A week ago, he and a couple of buddies bought a two-unit apartment building for nearly a million dollars. They had only a little cash to bring to the table but, with the federal government insuring the transaction, a large down payment was not necessary.

“It was kind of crazy we could get this big a loan,” said Mr. Rowland, 27. “If a government official came out here, I would slap him a high-five.”

In its efforts to prop up a shattered housing market, the government is greatly extending its traditional support of real estate, including guaranteeing the mortgages of middle-class and even upper-class buyers against default."

High five!  Sold to you SUCKA!

"Some F.H.A. borrowers here say they have the cash for a full down payment but would rather invest it in the stock market or use it for remodeling. Others, like Mr. Rowland and his friends, simply do not have the money required by private lenders — which would have been nearly $200,000, in their case.

“We were resigned to waiting another year,” said a second partner, Michael Bedar, 31. “Then we read about the F.H.A. I had never heard of it before, and couldn’t quite believe it. But it was the answer to our problems.” They put down about $33,000, split among the three of them."

Lever it up, bayyyy-beee!  Of course, with a 3.5% down payment, they could be underwater in no time, and then disincented from actually having to pay back their mortgage.    Wait a second - isn't this what caused the housing crisis in the first place?  Banks making reckless, highly levered loans to individuals who couldn't afford the homes?   Now, it's possible that these three gentlemen each make hundreds of thousands of dollars a year, but the article makes it sound unlikely, explaining "Mr. Kurland and Mr. Bedar, who are employed full time, are the buyers of record. Mr. Rowland, a freelancer, will have his interests protected by a legal agreement."   Note - I clearly cannot judge the ability of these three 3 guys to cover the mortgage - but my point is that it's irrelevant  - 3.5% down mortgages are like playing with nitroglycerin.  If borrowers can afford a real downpayment, they shouldn't be given government sponsored leverage, and if they can't afford the downpayment, they shouldn't be given government sponsored leverage!  

 

"“Is this going to be the next wave of the housing downturn?” asked Eileen Bermingham, an agent with Pacific Union. “With such a minimal down payment, how do we make sure people don’t get in over their heads?”"

Good question, Eileen - almost by definition, anyone who can only put down 3.5% is already in over their heads.

"The F.H.A. commissioner, David H. Stevens, said recently that its loans were relatively safe because the buyer was required to live in the property. They “are for shelter. They aren’t speculative-type investments,” Mr. Stevens said.

But the idea of a house as an investment dies hard. Mr. Bedar, Mr. Rowland and the third partner in their property, Jordan Kurland, are all in the technology field, but their dreams of wealth do not feature stock options.

“We’re banking on real estate,” said Mr. Kurland, 24. “Everyone expects prices to keep going up.”

Aiyahhhhhhhhhh!!!! The bubble is still alive!

"A few weeks ago, Congress extended the higher lending limits for another year. Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that he planned to introduce legislation next year raising the maximum F.H.A. loan by $100,000, to $839,750."

Oy vey.  And when the real estate market crashes again as a result of this attempted double down strategy (MARTINGALE!), Barney Frank will say that he was against giving these loans, and blame the Bush Administration.   I mean - really - why do we need to have the F.H.A insure $800,000 mortgages?!?!?  Isn't the point of the F.H.A to help poor buyers who can't afford a down payment - maybe we should have them buy MORE AFFORDABLE homes!  As the article notes: "F.H.A. insurance was created for minority and low-income families who could not come up with the traditional down payment of 20 percent required by private lenders. Buyers receive loans from government-approved lenders and are required to document their income and assets."     The F.H.A. limits should be LOWERED, not RAISED!

MISH also touched on the subject last week, exposing the lunacy in Frank's thinking:

First, MISH quoted a Richmond newspaper article:

"Exactly who made Bernadine Shimon think that she could buy a new house shortly after declaring bankruptcy and losing another home to foreclosure? The American taxpayer, that’s who.

Without a Federal Housing Administration willing to guarantee a $125,000-plus mortgage, this Denver-area schoolteacher’s recurring “dream of homeownership” could not come to pass. Shimon’s down payment was a tiny 3.5 percent.

This single mother is so strapped that she had to cash in her retirement savings to come up with the 3.5 percent. Her case was cited in a New York Times article about, not surprisingly, the sad shape the FHA finds itself in."

"With nearly a quarter of FHA loans insured in the last two years now in trouble, you’d think that the agency would show more discretion in deciding which homebuyers to help. And you’d think that Democrats running the House Financial Services Committee would be more upset over the way the FHA still hands out taxpayer guarantees.

But committee Chairman Barney Frank of Massachusetts insists that these mortgages are needed to “keep prices from falling too fast.”

Then he explained the absurdity:

"Home prices are falling precisely because houses people bought homes they could not afford.

Note however, the thought process of Barney Frank: We have to keep selling houses to people who cannot afford them in order to keep home prices from falling.

That mentality all but assures a bailout of the FHA is coming"

This is proof to me that we have not seen the bottom in housing.

-KD

full disclosure - I just bought a house - which is FURTHER evidence (based on my contrary indicator nature) that we have not seen the bottom in housing

Return Free Risk - A Merger Arb Anecdote

Most people are familiar with the concept of risk free return.  Today I want to tell my personal anecdote about return free risk and how I should have seen the liquidity bubble forming back in 2006.  Don't be alarmed by the mention of arbitrage spreads, cost of capital, and short rebates - the concepts are simple.

When I was on the buy side of the business - working for an internal hedge fund at a major sell side firm - we ran a large merger arbitrage portfolio. Merger arb is simple in theory:  when a cash acquisition is announced (ie, ORCL buys JAVA for $9.50 per share), you buy the shares in the target company if the risk vs reward payout being priced by the market is favorable (in your opinion).  If and when the deal closes, you make the spread between where you bought the stock and the acquisition price.  If the acquisition is an offer for shares in the acquiring company instead of cash (ABC is buying XYZ, and giving XYZ shareholders 2 shares of ABC stock for every share of XYZ that they own), you buy shares of the target (XYZ)  and short 2 shares of the acquirer (ABC) for each XYZ share that you've bought.  If and when the deal closes, your long XYZ will be converted into an ABC position that will cover your short hedge, and you'll have captured the spread, and be left with no stock positions.

Now, there are other costs and considerations as well - dividends you will pay (on short positions) and receive (on long positions), and more importantly, the cost of carry.  The cost of carry is the opportunity cost on your money - the risk free rate that you could otherwise be earning, or your "cost" of borrowing money.  At my "fund,"  we had access to a large amount of capital courtesy of the bank's balance sheet.   The catch was, each dollar we used we paid for.  In other words, I could buy $100MM in stock, and they'd charge me for that money - say, 5% annualized.

Thus, when calculating the return on merger arb deals, I had to back out the cost of capital.  For cash deals, this meant basically subtracting 5% from the annualized return that the market was pricing in.  For stock deals, it's a little more complicated, but don't fret, it's not rocket science:  when you short stock, you usually earn a "rebate" on your short position.  This is a fancy way of saying that the proceeds from the short sale earn interest for you - although not quite as much interest as you have to pay on your long position.  Thus, in calculating my cost of carry I need to add the cost of buying the long position, and deduct the rebate that I earn on my short position.   In stock for stock deals where the company I'm shorting (the acquirer) is an easy to short, top rebate level stock, the impact on the cost of carry will be small - since the rebate on the short stock will be very close to the cost of funds for the long stock.

Anyway, fast forward to "ideas dinners" where a bunch of merger arb hedge funds get together and talk about their best ideas in the field.  We'd have 20 supposedly smart guys from different firms sitting around a table, and talking about arb spreads.  "the ABC-XYZ spread is 5% - it's a layup,"  one guy would say, and I'd raise my eyebrow.

"It's not 5%, it's 0%.  You have to adjust for the cost of your funds,"  I'd say.

"We don't pay for funds," he'd respond, as others in the room nodded.  See, most hedge funds just have a pool of client money that they're investing - they don't have to pay to borrow it from their firm.

Now my other eyebrow would go up, and I'd say "Are you guys serious?  Even if you don't actually get charged for the funds, you still need to deduct the risk free rate from your return profile."   I mean - this is finance 101.

Amazingly, most of these traditional hedge fund traders didn't look at it this way - they way they looked at it was that they had $100MM to invest, so if a deal returned 5%, they were making 5%.  Never mind the fact that US Treasuries returned 5% also - they were earning their 5% of RETURN FREE RISK.  ZERO excess return (above the risk free rate) with risk included!  Where do I sign up!  Of course, it's not entiely return free, as there were a number of merger deals in 2005 and 2006 that saw bumps or increases in the bid price to a higher price.

Shockingly,  in stock for stock deals, these same guys would add back in the rebate they earned on their short position to make their "return" look even higher - STILL without accounting for the cost of capital on the long side!   In a room full of twenty people, there were maybe 2 others in the same boat I was who approached me after the events to explain that they understood my point. 

I'd return from the events and explain to my boss that the Street was batshit crazy, and that they were absolutely mispricing the risk in these deals.  Every time a broker called us and said "Check out XYZ-ABC - it's 5% annualized,"  my boss would just mutter "don't educate them,"  and we'd say "thank you," and hang up the phone.  Obviously, you know how this story ends:  the merger arb world blew up in 2007, and guys who were recklessly putting on every spread at rates which didn't compensate them for the risk they were taking on got wiped out.

How does this relate to today?  If you read Bill Gross's monthly piece today, he talks about the Fed's efforts to reflate the market by keeping rates so low that investors are almost FORCED to plow their funds into riskier asset classes to avoid earning a near 0% return on their money - which is what the risk free rate is now paying.

"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until."

If you're wondering why the stock market (not to mention the government bond market, oil market, gold market,  corporate bond market, junk bond market) seems to be rising without logic, it's because of all this liquidity that is MANDATING the devouring of risk assets.  In my opinion, this can only end one way... badly.

-KD

Misusing Statistics - Distorting Tax Statistics

Look, I'm a fiscal conservative.  I hate the idea of solving all of our problems by taxing the rich.  I admit that I would normally spout a statistic like I quoted yesterday such as "the top 3.5% of earners pay over 60% of the tax dollars," to illustrate the iniquities in the tax code.    Unfortunately, there's a big problem with that stat  - it's a red herring designed to misdirect the reader, and I'm shocked that every time it's mentioned people don't shoot it down.  I am ashamed to admit that, despite my math background and statistical prowess, it wasn't until AsphaltJesus's comment yeterday on my post that I realized how inane/insane that stat is.

The point is that we need to know what percentage of the income the top 3.5% of earners earns!  If they earn 60% of the income, and pay 60% of the taxes, well then, that seems pretty darn fair.  According to TaxFoundation.org,  the top 5% of earners earn roughly 37% of the income and pay roughly 60% of the taxes.   So, phrasing it as "the top 5% of earners pay 60% of the taxes," while comparing apples to oranges, sounds a lot more "unfair" to the wealthy than "the group that earns 37% of the income pays roughly 60% of the taxes."

Yeah, of course the rich still pay a higher relative share of the tax pool, but it's not quite as absurd as misleading or irrelevant statistics can make it seem.

-KD

Quality Readings Link Dump

I was honored to be included in the Reformed Broker's Periodic Table of Finance Bloggers under the category of "rogues gallery." 

Paul Kedrosky's chart of the price of gold, in gold, is good for a laugh.

Howard Lindzon'z New New NASDAQ is worth a read.

Peter Boockvar on how the Fed has done in its goal to maintain the purchasing power of the dollar (hint:  not very well!)

MISH on the jobs outlook - even with assumptions about job creation, we're going to have very high unemployment for a very long time.

Calculated Risk:  record mortgage delinquency

Barry Ritholtz with a graphic from Mint.com:  Who Pays Taxes in the USA?  (the top 3.5% of earners pay over 60% of the tax dollars)

-KD

Nothing to See Here - Everything is Fine.

I really thought/hoped that this report was lifted from The Onion:

"During the best of the times, Miguel Salcedo’s son, an illegal immigrant in San Diego, would be sending home hundreds of dollars a month to support his struggling family in Mexico. But at times like these, with the American economy out of whack and his son out of work, Mr. Salcedo finds himself doing what he never imagined he would have to do: wiring pesos north."

I mean - come on - things are so bad in the US that Mexican families are wiring money TO their relatives in the US?  That has to be a joke - I've been reading the financial press every day and I've been told that the recession is over and that everything is fine. 

Then, this:

"In other cases, the migrants are returning home, as the many passengers who hop off the bus that runs regularly from northern California to a gas station in Miahuatlán make clear. “There’s nothing up there,” said a young man with an overflowing suitcase who returned one recent night."

Come on - are you kidding me?  Sadly - no - that's the truth of the economic situation in our country.  The ponzi scheme of confidence doesn't solve our problems - telling people that things are better does not make things better.  

"There's nothing up there."   That should be the headline in the mainstream media - not "recession over" or "jobless claims data improves."

Things are so bad here that 1) Mexican workers who came to the US to earn money to send home to their families in Mexico are now having to receive money from their families instead, and 2) Mexican migrant workers are going back to Mexico. 

I mean - what more do I need to say?

-KD

F U NYT - DYKWTFIA?

The NY Times writes an article about bloggers going to the Treasury without nary a mention of Kid Dynamite's throrough, detailed recaps?  WTF?  DYKWTFIA?  

-KD

ps - Mrs. Dynamite spotted a possum in our yard last night.  More wildlife updates to follow as necessary.

Monday Morning Quarterback

Last night's Patriots-Colts game ended in spectacular fashion, with the majority of the sports world coming down hard on Bill Belichick's decision to go for it on 4th and 2 from his own 28 yard line with just over two minutes remaining.  The Patriots led by 6, and Indy had 1 timeout remaining.  The Colts had fought back from deficits of 17 points to start the 4th quarter, and 13 points with only 4 minutes remaining.

After watching Indy put together two quick 79 yard touchdown drives, each taking roughly two minutes (5 and 6 plays respectively), Belichick didn't want to give Indy QB Peyton Manning a chance to win the game, and elected to try to convert a first down, which would have sealed the game for the Patriots.

Obviously, when Belichick's gamble failed, the entire Monday Morning QB universe came down on him for his "horrendous decision."  Advanced NFL Stats, however, attempts to quantify the expected value of the decision to go for it instead of punting:

"With 2:00 left and the Colts with only one timeout, a successful conversion wins the game for all practical purposes. A 4th and 2 conversion would be successful 60% of the time. Historically, in a situation with 2:00 left and needing a TD to either win or tie, teams get the TD 53% of the time from that field position. The total WP for the 4th down conversion attempt would therefore be:

(0.60 * 1) + (0.40 * (1-0.53)) = 0.79 WP

A punt from the 28 typically nets 38 yards, starting the Colts at their own 34. Teams historically get the TD 30% of the time in that situation. So the punt gives the Pats about a 0.70 WP.

Statistically, the better decision would be to go for it, and by a good amount. However, these numbers are baselines for the league as a whole. You'd have to expect the Colts had a better than a 30% chance of scoring from their 34, and an accordingly higher chance to score from the Pats' 28. But any adjustment in their likelihood of scoring from either field position increases the advantage of going for it. You can play with the numbers any way you like, but it's pretty hard to come up with a realistic combination of numbers that make punting the better option. At best, you could make it a wash."

What seems like an asinine decision is actually probably pretty close when you run the numbers.  Obviously, the probabilities are not exact - Indy may be more likely (maybe 70%)  to score from the Patriots 30 yard line, and less likely to score from their own 35 yard line with 2 minutes and one timeout.  New England may be closer to 70% to convert the first down attempt.  Indy also may get better field position if New England punts - or they may fumble the punt (like Buffalo fumbled the Pats' kickoff with 2 minutes remaining in week 1!) - it's not an exact science.  The point is that perhaps Belichick's apparently insane decision wasn't quite as crazy as it seemed.  I'd use the estimates of 70% for New England to convert the first down, 70% for Indy to score if the Patriots failed to get the first down, and 30% for Indy to score if they got the ball inside their own 35 yard line.  Those assumptions yield a win percentage of 79% for "going for it" and 70% for "punting."  I think we actually need to DECREASE the win percentage for "punting" though, because Indy may get better field position.

Now, what I have a problem with is the strategy change the Pats made in the fourth quarter - playing a softer defense - not quite a prevent D, but one that allowed Manning to pick them apart for two quick scoring drives.  Against many teams, when you're up by 17, this strategy is ok - but against Peyton Manning and the Colts, who run a precision no huddle offense, taking less than 12 seconds to re-snap the ball after each completion, time just doesn't become an issue for them.    Similarly, when the Patriots had the ball on their final two drives, they shouldn't have tried to kill the clock - they should have kept up the offensive pressure that Indy couldn't stop all game long.

Anyway, this was a gutwrenching loss for Pats fans - it will be interesting to see if the anger at Belichick is tempered over the next week as fans try to understand his likely considerations - or if they will view him as having jumped the shark and become a crazy old man.

-KD

Stat of the Day

Via CalculatedRisk:

"86 percent of homebuyers relying upon FHA mortgage insurance in FY 2009 had downpayments of less than five percent."

Yowza.

-KD

Veteran's Day

Thanks to all the past, present and future members of the United States Armed Forces.

I have two links today, both from Tyler Cowen of Marginal Revolution:

1) Who knew you could tell so much about a person by the way they phrased a Google search?  This is a fascinating look (Cowen didn't do the research, he just linked to a few different projects) at how beginning your search with a phrase like "how 2" will result in an entirely different class of suggestions than if you begin your search with "how one might."  Cowen's blurb links to this piece and this piece and this piece - both are well worth a click.

2) Whoops!

"If you believed all the talk from Chrysler about how our tax dollars would help finance its fast-track electric-vehicle future, you're in for a big disappointment.

Chrysler has disbanded the engineering team that was trying to bring three electric models to market as a rush job, Automotive News reports today. Chrysler cited its devotion to electric vehicles as one of the key reasons why the Obama administration and Congress needed to give it $12.5 billion in bailout money, the News points out."

-KD