The Truth Behind the Data

The NAR is not a government agency. It's the National Association of Realtors - a trade group. Their entire mission objective is to ensure that the real estate market is healthy, and thus they, well, they basically lie about data to try to depict a rosier situation than actually exists.

The recent September home sales data contained a massive seasonal adjustment which resulted in the NAR trumpeting a "SURGE" in home sales. I'll let Barry Ritholtz take it from here:

This year, the fall was 5.3%. Hmmm, that was highly aberrational — I wonder why? We (and the NAR) know the reason: Due to ZIRP and the soon to be expiring 1st time home buyers $8,000 Tax credit, the drop was minor – much smaller than it usually is when we go from August to September in EHS.

The tax credit very likely extended the selling season by at least a month. It pulled some sales forward, and perhaps created other sales where there might not have been.

But the seasonal adjustment does not know that; The math PRESUMES THE AUGUST/SEPTEMBER DECLINE IS OF TYPICAL MAGNITUDE OF THE PRIOR 10 YEARS.

That creates a misleading — lets even say false — appearance when the seasonally adjustments are performed.

Again, someone trying NOT to mislead will inform the reader of that directly. But calling it a SURGE? Only if you are innumerate — or a liar. Any honest statistician who worked on these numbers KNOWS that the seasonal adjustment was going to create a big bump, a misleading number, based on the historical data.

And thats the whole point. The NAR knows that calling this a surge will mislead readers, but they report the data — DOWN 5.3% — as a “SURGE.” What else might their goal be BUT TO MISLEAD THE PUBLIC?

I refuse to facilitate that. And I will call anyone an unprofessional liar, a distorter of the data who claims this was surge. THIS MEANS YOU, NAR !

The folks who are unfamiliar with seasonal adjustments will get caught in the scam. This was not an ordinary seasonal adjustment — it was highly misrepresentative.

I know better. And now, you know better. Unfortunately, most folks do not.

-KD

Blogger Help!

So, I've upgraded my old template on Blogger.  I have a simple question for you wizards out there, since I'm not a master code monkey.  How do I get the main body of my posts to be WIDER, rather than 2 inches wide???

At the recommendation of an anonymous commenter, I also installed APTURE, which I will be experimenting with.  Unfortunately, it is useless until i figure out how to get the new Blogger template to work, which I am unable to do


-KD

Don't Payze Me Bro

A story I didn't comment on this week was that of the "Pay Czar" Kenneth Feinberg, who is going to limit executive pay for the top 25 employees at the biggest TARP teat sucklers: BankAmerica, Citi, AIG, GM, GMAC, Chrysler and Chrysler Financial. Even for a free markets capitalist like me, it's hard to complain about this - I mean, these firms have received oodles of government cheese, and I dare say that all of them would be up a creek without a paddle if not for the generosity of the taxpayer. Hence, the public's anger gets appeased with this symbolic offering: you certainly won't see the CEO's of any of these firms receive hundred million dollar bonuses this year. One problem is that especially at BAC, C and AIG, the top 25 titular ranked employees may not be the highest earning ones.

Marla @ ZeroHedge had an interesting post a few days ago on the subject - which I found especially intriguing because her readership generally disagreed with her.

"Citizens of the United States do not need a "special master" to deliver them a spanking for losing money. Nor do they need a handout from government coffers. It's time for enterprise in the United States to leave the nest and forgo both the extra bedroom that Mom will keep just like you left it "in case," and the time out room Dad will send you to if you blow it again. Punishing firms that accepted government funds, effectively under duress, and who have managed to actually pay those funds back (at a gain to the taxpayer, you might also notice) is a dangerous act. It is a clear sign that political whim and "sensitivity to public outrage" is driving economic policy. Again, this will all end in tears."

I strongly agree that firms who paid the funds, which were given without foresight of potential consequences (like public outrage over GS's massive bonuses) cannot be held liable forever. Also, I think the government meddling in the compensation of employees at non-government owned firms is an atrocious idea. However, the 7 firms in this case are not your average companies - they are the top of the pyramid of government largess, and I think that with these 7 companies, it's hard to disagree with limited compensation. Marla notes that populist policies can never be a good trend, which I agree with wholeheartedly.

Marla also explains:

"The proper way to have dealt with executive pay (which is a tiny fraction of corporate cost in any event) would have been to permit these institutions to fail. Period. You might notice that no one needs to modify Dick Fuld's pay today."

I agree 100% with this - but what do we do now that the horse is out of the barn? That's why I find it hard to argue with restricting comp at the worst offending firms.

Yves at NakedCapitalism also attacked the topic:

"The point is that the collection of these scalps will do nothing to comp levels ex these firms. The companies that also enjoy implicit government guarantees are free to do the “heads I win, tails you lose” game of privatized gains and socialized losses. And Ken Lewis is the poster child of why these measures are completely meaningless. He sacrificed his 2009 pay, but will still collect $125 million when he departs Bank of America. If the government is going to backstop the industry (and this isn’t an “if” anymore), it needs to limit those firm’s activities to what is socially valuable and regulate them heavily to contain risk taking."

I happen to very much disagree with that last sentence about ensuring that activities are "socially valuable." On the contrary - the key is to make sure that the activities are NOT socially DESTRUCTIVE. Those two conjectures are not equivalent. If the government is going to backstop an industry, like banking, it needs to make sure that none of the firms have the ability to take risks which have the ability to blow up our financial landscape. The government's job is NOT to make sure that banks are saving puppies and kittens and painting their offices in pretty pastel colors, or other "socially valuable" initiatives.


-KD
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Fool Me Thrice, Shame on Both of Us

We've all heard the old idiom "Fool me once, shame on you. Fool me twice, shame on me." In the words of GW Bush, channeling his inner "The Who" in the form of "Won't Get Fooled Again:"



Can anyone explain to me how John Meriwether is managing to launch a third hedge fund? For the uninformed, Meriwether was one of the principals behind Long Term Capital Management- the hedge fund which put the term "Too Big To Fail" on the map when it imploded in 1998 and necessitated a bailout orchestrated by the Federal Reserve. Somehow, Meriwether managed to start a new fund, JWM Partners, shortly after LTCM's blowup. JWM Partners closed last year after losing 44% amidst the market turmoil of 2008. Hedge funds typically have "high water marks" which means that investors don't pay performance fees to the fund manager in subsequent years unless the fund surpasses its highest point. Thus, the solution for fund managers whenever they have a bad year is to liquidate, wait a bit, and form a new fund?!?! Anyone who was invested in the old fund and the new fund thus pays fees twice: you paid when JWM Partners reached its high water mark, and now you'll pay again if/when Meriweather Cubed (not the real name) manages to make money - the same money JWM Partners effectively lost after reaching its high water mark.

Fool me once, shame on you. Fool me twice, shame on me. Fool me three times? Well, I guess we'll just go begging to the government for help when that happens...

-KD

Paradigm Shift - Live Free or Die!

The Dude chastised me for not posting enough again today. "Buddy - people want to read stuff every day - they don't want to go back every 5 days and have to scroll down for your posts, or find nothing new at all." Yes, yes, but sometimes worthwhile content doesn't jump up and throw itself on my screen every day. Stick with me, folks - you will not be disappointed.

There is big news in the Kid Dynamite household: we are leaving New York City. The change from a duplex townhouse garden apartment in the West Village to a massive house on multiple acres in the outskirts of Concord, New Hampshire will be a paradigm shift, to be sure, but Mrs. Dynamite and I are ready for it. She's been dying to get out of the city for a while, and I would rather try this new avenue than go back to work on the Street in NYC, so, that's the story. Live Free Or Die!

The most popular question is, "What are you going to do?" Well, same thing I've been doing: keep my chiseled physique in peak condition, devour massive amounts of financial information on the internet, act as the financial blogging community's ombudsman/fact checker, and switch to online poker. I hope to eventually start some sort of business - maybe a bar, microbrewery, coffee shop, or indoor soccer arena. Who knows. Oscar is almost certain to appreciate the change of scenery.



We will need a new car - we're looking at small SUV's that will be good in the snow. My mother-in-law raves about her Honda CR-V's handling in the snow, so that's a top contender, along with the Toyota Rav-4, the Subaru Forrester, the Nissan Rogue, and maybe the Hyundai Tuscon. If anyone has experience with any of these cars, please let me know your thoughts. Also, I've found TrueCar as a great source on new car pricing, and Edmunds as an excellent research resource. Are there other must-visit sites when shopping for a car?

I have some quality links today:

1) Dikshit sells most of his stake in Partygaming: I'm a Party shareholder, and this can't be good news. If Barney Frank were making any progress in getting online poker legalized in the US, why would Dikshit abandon ship? The logic in the article that the company needed him to sell his shares because the government doesn't like criminal shareholders is bunk - since his crime was running PartyGaming! Bones liked how the article pointed out the proper pronunciation of Dikshit's name: "Dikshit (pronounced Dix-it)"... yeah sure...

2) Fantastic Esquire article on the magic of the "$20 trick" - an entertaining account of the perks you can obtain by spraying $20's around to the right people

3) John Hussman's weekly note: "The stock market has never been this (intermediate term) overbought"

4) David Einhorn's comments from the Value Investing Conference: straight talk from one of the smartest guys out there, who also expresses himself very well in writing.

-KD

First, We'll Kill all the Bloggers

This NY Times article about the FTC requiring increased disclosure by bloggers, Twitterers, and others receiving free products in exchange for publicity absolutely shocks me. It's not that I'm against increased disclosure - I generally think more disclosure is usually better - but that the FTC - the Federal Fucking TRADE COMMISSION is going after BLOGGERS and TWITTERERS, as opposed to the mainstream media who, as I've discussed at length, has a MEGA agenda of their own...

"Some think it will help establish more professional standards, policing the kind of bloggers that Amber Katz, the founder of Beauty Blogging Junkie, calls “cloggers,” or bloggers who use their Web sites as platforms for soliciting the latest perfumes or garnering invitations to fashion industry events. “Cloggers will tweet about how they’d just love a free garment or accessory directly to a brand’s Twitter account,” she said. “They brazenly insist on tons of samples even though they haven’t been blogging long enough to build up any sort of readership.”"

Wait - so Ms. Amber Katz is angry that some beauty bloggers (cloggers!?!?!?) who she views as less worth are "brazenly" insisting on free samples that they don't deserve!??!?! STOP THE PRESSES!

Is the FTC going to require CNBC to publish a disclaimer mentioning that they are majorly incentivized to continually pump the markets with absurd spreading of ignorance, such as the importance of the "MYTHICAL" DOW 10,000 level (actual quote today on CNBC - MYTHICAL)? Is the FTC going to require every speaker on CNBC to mention that they have major incentive to talk people into buying stocks so that stocks continue to go up so that more people get talked into buying stocks (PONZI-RINSE-REPEAT) ???

No - the FTC has decided that some girl receiving free perfume and GAP jeans, and blogging about how much she likes the product, is violating the sanctity of American commerce if she doesn't disclose that she received a freebie.

Amazing.

In other news - this CNBC piece on the absurdity of the Las Vegas housing market is a must read. Excerpt:

"We went to a home that had been on the market for one day, and the key was stolen out of the lock box. Our Realtor said immediately, 'You want this home.' She told us another Realtor had stolen the key because they wanted their client to get it. So what did my Realtor do? She broke in. And sure enough this was the home we fell in love with. It was on for $132,000 so we decided to be really aggressive and offered $160,000, plus we had government backing on our loan. Well our Realtor called that night and said, 'You're not going to get the home. They got 30 offers and half are cash offers, so the bank is not even going to look at you.' The banks just want the cash to unload these places."

-KD

full disclosure: SHORT the stock market in general.

Using High Frequency Trading as a Scapegoat Has Jumped the Shark

Matthew Goldstein at Reuters wrote an article about what can go wrong when investors use stop-loss orders. A stop loss order is an order to sell your stock when it reaches a certain level to the downside - ie, if GE is trading at $16, and you want to lock in profits if it starts to fall, you can enter a stop-loss order to sell at $15. Then, if GE hits $15, your order will be entered into the marketplace. The catch is that if GE is plummeting and there isn't a lot of liquidity, you could sell your stock much lower than $15.

So, Goldstein describes a few investors who didn't understand that their stop-loss order doesn't guarantee them execution at their stop price. They were trading a lightening fast moving highly speculative biotech stock called Dendreon, around the time that Dendreon had news imminent regarding a potential cancer treatment drug. The stock started to fall, stop loss orders were triggered, stock was sold at a low price, and the stock quickly rebounded.

There are two real stories here: one is that the stock may have plummeted because a trader entered a "fat fingers" order in error - perhaps typing an extra zero onto the end of the order, and the other story is that someone intentionally may have leaked misleading information about the drug trial results in order to manipulate the stock. There's actually another story, and that's the danger of "market" orders, and how investors should never used them. Goldstein, however, decided to jump on the populist bandwagon, and blame high frequency trading for the price action in Dendreon's shares. He even titled his post "The Victims of High Frequency Trading." Talk about jumping the shark!

Goldstein's hack piece prompted Zero Hedge to write a post titled "Was HFT Responsible For Investor's Massive Dendreon Losses?" I think that even the guys at Zero Hedge know that the answer is "no," but they are in the business of generating page views, hence, the post.

I'm going to address some other concerns that the uninitiated may have about damage done by high frequency trading (HFT):

Did HFT kill Michael Jackson? NO

Did HFT cause the breakup between Jon & Kate Gosselin? NO

Was HFT responsible for Obama winning the Nobel Peace Prize? NO

Did HFT get Kourtney Karsdashian pregnant? NO

Is HFT helping Osama Bin Laden hide in the mountains of Afghanistan? NO

Did Jonathan Paplebon allow 3 ninth inning runs on Sunday against the Angels, resulting in the end of the season for the Boston Red Sox because of HFT? NO

Can HFT spread swine flu (H1N1) ? NO

Could HFT beat George St. Pierre in the octagon? NO

Can the dominance of the NY Yankees be explained by HFT? NO

Did HFT cause the tsunami in Samoa? NO

Did HFT help Iran obtain nuclear facilities? NO

Does HFT hate health care reform? NO

Put. Down. The. Pitchforks.

-KD

Weekend Reading

Here's what caught my eye over the past few days:

Accrued Interest on the Fed's purchases of agency paper and interpreting the facts rather than sensationalizing them.

The U.S. States suffer "unbelievable" revenue shortages.

NY Times: Congressional Panel Says Obama Plan Will Not Slow Foreclosures.

"On Thursday, Treasury announced that 500,000 homeowners had since had their payments lowered on a trial basis, celebrating this as a milestone.

But the report from the oversight panel directly challenged the administration’s characterizations.

Most prominently, the panel had grave uncertainty about whether large numbers of the trial loan modifications — which typically run for three months — would successfully be converted to permanent terms.

As of the beginning of September, only 1.26 percent of trial modifications that had made it through the three-month trial period had become permanent, the report found. Of course, very few of those trial loans had reached their three-month expiration because the program only recently began processing large numbers of applications. As of Sept. 1, the Obama plan had produced 1,711 permanent loan modifications.

Some homeowners complain they have received trial modifications only to have them canceled for what seem dubious reasons — checks sent but supposedly never received, documents once in the file but suddenly missing."

Naked Capitalism on the FHA:

"My objection is that the article implies that low down payment loans are a bad idea. They aren’t necessarily. Low down payment loans can be a viable business, but lenders need to screen borrowers much more carefully than when they have a much bigger loss cushion.

And using low down payment loans as a way to prop up the housing market IS a bad idea. The fact that the FHA is cranking so many loans through more or less the same administrative platform is strong evidence that its lending standards have gone out the window."

Calculated Risk on the FHA:

"“I don’t think it’s a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That’s a policy.”
Barney Frank, chairman of the House Financial Services Committee on recent FHA lending."

Naked Capitalism wonders why no one is talking about how 34 banks missed their TARP dividend payments:

"Of the 34 miscreants, two are pretty large, namely AIG and CIT, But the next on the list is First Bancorp, which received a mere $400 million from the TARP. Probably more important than the number is the trend, since the number of institutions that skipped dividends nearly doubled. In a supposedly improving economy and with a steep yield curve (at least until very recently), things appear to be getting worse rather than better.

I didn’t post on this because I assumed the MSM would be all over it. So I am pretty surprised to see it has gotten very little coverage. The usual suspects (Bloomberg, Financial Times, Wall Street Journal, New York Times) were silent."

Howard Marks in NY Times Dealbook:

"I think the crisis came about primarily because people of all stripes did novel, complex and dangerous things, in greater amounts than ever before. In the world of investing, for instance, people made excessive use of borrowed money — “leverage” — and committed too much capital to illiquid investments. It all happened because people believed too much, worried too little and thus took too much risk.

Worry and its relatives, distrust, skepticism and risk aversion, are the essential ingredients for a safe financial system. To paraphrase a saying about the usefulness of bankruptcy, I think fear of loss is to capitalism as fear of hell is to Catholicism. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, analyze and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return."

The New Yorker on the madness that is Martin Armstrong (courtesy of Barry Ritholtz)

Vanity Fair's long must read piece on the efforts that were made last year to save MS and GS during the financial crisis. Lost in this excerpt is how incompetent it makes Ken Lewis look again - as the piece illustrates how other CEO's (Dimon of JPM refusing to buy MS) had the balls/integrity/gumption/call it what you will to say no when bullied by Geithner and Paulson.

South Park: Billy Mays pimps Chipotlaway!




-KD

Rampant Mis-Information - and the Responsibility of Financial Bloggers

It's not that I don't like Matt Taibbi. I have a subscription to Men's Journal, and Taibbi's sports-related pieces are always worth reading and usually laugh out loud funny. For example, from his piece several months ago on all-time ugly athletes:

"Then there’s Kevin Youkilis. Youk has only three body parts, all hideously oversized: an enormous set of gnomish, bushy forearms; a massive, casaba melon–size white head; and a cauldronlike belly. He has a truly awesome bristle of thick red chin hair that makes his face look like a cross between a vagina and something out of The Hobbit. At the plate he disgustingly gushes sweat by some means previously unknown to science in which the moisture travels upward along his body, racing in a cascade from his balls and armpits up his neck, over his head, and back down over the bill of his helmet to shower the plate. Whereas a guy like Teixeira was born with a swing so gorgeous you want to paint it, Youkilis fighting a middle reliever to a nine-pitch walk looks like a rhinoceros trying to fuck a washing machine."

See - that's accurate, well written, and funny. If I want to read a lucid comparison of Youk's face to a Hobbit-esque vagina, I'll look for Matt Taibbi's name in the byline. However, if I want to read factual financial articles that demonstrate a solid understanding of what is actually happening, I am knowledgeable enough to know that Taibbi has very little idea what he's talking about. This is the reason I'm bothering to write a post about a little tete-a-tete between Taibbi and Clusterstock's John Carney on the subject of naked short selling. There are few things less rewarding than internet blog post battles - one of them being interfering in other people's internet blog post battles, but I take my self appointed role as "Protector of the Accuracy of Financial Information on the Internet" very seriously, so I'm stepping into the fray. We'll just stick to this week's happenings, and ignore the stuff from last week where Taibbi posted a presentation from GS about market structure and reached the conclusion that GS was using the presentation to lobby congress to allow naked short selling.

First, Taibbi posted a video that purported to show a trader nearly instantly obtaining a locate (which you need to do in order to short stock) on "tens of billions of shares" of a stock that only had 4.5B shares outstanding. Clusterstock's Carney misread Taibbi's post, and responded that Taibbi was a sucker for believing that someone actually shorted tens of billions of shares of said stock, and that some common sense would allow anyone who understands the process to reach the conclusion that there is no way that trade happened.

Matt Taibbi retorted that Carney was an idiot, and that he (Taibbi) never said that the trade happened (although, Taibbi DID say that: ":17 At seventeen seconds, at the bottom, you see that the firm Penson has now approved the trade and” located” the multibillion amount of shares. The trade goes through.") - insisting that he claimed only that the trader was able to quickly obtain a locate which 1) should have been impossible to obtain and 2) should CERTAINLY have been impossible to obtain so quickly, and that the actual trade was for only 100 shares. Taibbi is absolutely right on these two points - the locate should have been impossible to obtain, especially with such speed. But here's the kicker: Taibbi's video shows nothing of the sort. I'm not going to link the video here, because I'm not going to take part in spreading the mis-information - but what is shown in the video is a simple audit trail requirement. Let me explain.

Daily, traders and brokers will obtain a list of easy to borrow stocks, which get loaded into their trading system. If you go to short GE, it's on the "easy to borrow list," and as long as you don't try to short 10,000,000,000 shares, you won't have to call your stock loan department to "borrow" shares to short - everyone knows the stock is readily available. Other stocks, however, like Citi (which is almost certainly the stock in Taibbi's video) can at times be difficult to borrow - like during the summer when they were doing an exchange of preferred stock for common stock, and everyone wanted to be short the common (and long the preferred) to arbitrage the spread between the two share classes.

So, if you try to short Citibank (a few months ago), any good execution system will check its easy to borrow list, see that Citi is not on the list, and ask you where your "locate" is from - in other words, which broker agreed to lend you the stock. There are also many electronic systems where you can request a stock locate electronically - but this is not what's in Taibbi's video! What the video clearly shows is that the stock in question (let's call it C) is on the hard to borrow list. The trader gets a warning message saying that the stock needs to be borrowed, and asking for the trader to either submit the borrow information or elect not to submit the trade.

The trader in the video is NOT submitting a request for the stock to be borrowed - he's entering information into an audit trail point asking WHO the stock was borrowed from, HOW MUCH was borrowed, and WHEN it was borrowed - exactly to prevent problems related to naked short selling! This way, if the seller fails to deliver shares, the broker can easily pull the exact reference that was used for the short sale. Of course, just because I say that I was able to obtain a locate for a gajillion shares of C doesn't mean that I actually was able to - and that's why especially hard to borrow stocks should have another level of compliance checking embedded in them. If this trading system in the video allowed a trader to claim a locate that was clearly impossible, then that's a condemnation of the inadequacy of this trading system - not of the borrow market and the legitimacy of short selling. Fortunately, there was no naked short sale of tens of billions of shares of C on this trade, and Taibbi's post is a gigantic misunderstanding of what was actually going on. Of course, it's especially scary when people jump to his defence (in the comments of both his posts and of Carney's posts) and thank him for highlighting such injustices - never failing to mention how Goldman Sachs is stealing money from poor old grandmothers at the same time.

Journalists with the clout of Matt Taibbi need to take special care to ensure that their reporting is accurate, especially when dealing with topics that the general public clearly doesn't understand. It is essential that we provide MORE clarity to the uninformed, rather than misinterpreting the facts and stirring up a hornets nest of anger when none is warranted.

-KD

disclosures: I am not currently, and have never previously received any type of compensation from C, GS, Men's Journal, Matt Taibbi, John Carney, or Clusterstock.

Guaranteed by the FDIC!

The point of my post yesterday about the FDIC was not to point out that the FDIC is broke - everyone knew that. The FDIC's release yesterday gave us some serious insight into just how bad the financial situation is: the FDIC's estimates for losses continue to grow, and their time frame for replenishing the DIF (Deposit Insurance Fund) continues to be pushed out. In addition, the assets held by the FDIC are deteriorating in quality. The scariest thing to me is that the FDIC continues to try to disguise the health of the banks by using accounting tricks - like allowing them to spread out the prepayment of FDIC fees over three years when recognizing the costs, and failing to charge the banks a special assessment to replenish the DIF.

Then, after I wrote the post, I came across this gem via Calculated Risk:

"Citigroup Inc. (C) priced a $5 billion government-backed bond Tuesday, its second benchmark-sized bond offering this month under the U.S. Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program, according to a person familiar with the situation."

Wow. Wow. Can I say WOW again? If the FDIC is broke, which they are, then why is the TLGP program still going?!! Ken Lay would be proud - Citibank issues debt guaranteed by the (broke) FDIC. Then, Citi prepays a few years worth of fees to the FDIC, so that they'll have money to, amongst other things, be able to make good on the debt they just guaranteed for Citigroup! If you plugged this into Excel, you'd get a "#N/A" circular reference error.

Perhaps it went down something like this:

the players:
Vikram Pandit: Citi CEO
Sheila Bair: FDIC chair

Pandit: "Hey Sheba - what's shakin'? Look - We need to issue some debt under the TLGP - no problem right?"

Bair: "Hi Vik - ummm - actually, I don't know if you got the memo - we're broke."

Pandit: "That's ok Sheba - you won't actually have to pay out on the debt - it's guaranteed."

Bair: silence... "Sorry Vik - I don't follow."

Pandit: "It's guaranteed - RISKLESS! The full faith and credit of the FDIC stands behind it."

Bair: annoyed... "But Vik, I don't have any money to guarantee it."

Pandit: "You old fuddy duddy - don't worry about that - we'll use the proceeds of the debt sale to prepay our FDIC fees for the next three years - then you'll be able to cover us - simple math!"

Bair: hesitant... "ummm. Ok Vik - what happens when you need to payback the debt?"

Pandit: "Where have you been Sheba? We'll just issue new debt! Voila!"

Bair: "Genius, Vik. Do it up! GUARANTEED!"

Ponzi lives. Smoke and mirrors.

-KD

The Truth - Courtesy of the FDIC

Via ZeroHedge, comes a smoking gun release today from the FDIC. I mentioned last week that the FDIC, which is essentially broke (and by the FDIC, I mean, of course, the DIF - the Deposit Insurance Fund which insures customer deposits up to $250,000), was discussing a plan to re-fund itself by borrowing from its member banks. Today's FDIC press release confirms just that. "But wait, Kid Dynamite," you might say, "the release says that the FDIC will have banks prepay 3 years worth of fees." Yes - that's the same as borrowing from the banks.

Sadly, the FDIC wants to go this route, instead of using a special assessment on the banks, because, in their own words:

"Furthermore, any additional special assessment or immediate, large increase in assessment rates would impose a burden on an industry that is struggling to maintain positive earnings overall."

In plain English, that's like saying "everyone wants to pretend that the banks are solvent, but if we make them actually pay us extra money, it will make it harder to cover up the fact that the banks are insolvent." Thus, we wave a magic wand, and even though the FDIC is asking the banks for 3 years worth of money today, the banks will be able to recognize the cost over 3 years. Since when do we treat insurance as a depreciating asset? It's not like when you buy an airplane and recognize the cost over 20 years! There is a simple, unarguable fact: if Citibank pays the FDIC $1B TODAY (I'm making this number up) in fees for the next 3 years, Citibank has $1B less in cash today. Not $333MM less in cash - $1B less in cash.

The FDIC's release today is a must read - it contains some serious and scary truths about our national financial situation, despite what the press and the administration have been telling us over the past six months.

Take, for example, this gem:

"Staff’s current projection of $100 billion in failure costs from 2009 through 2013 is higher than staff’s projection in May of $70 billion over the same period. Projected failures have increased due to further deterioration in the condition of insured institutions, as reflected in the increasing number of problem institutions. Asset quality problems among insured institutions are not expected to abate in the near-term."

In plain speak: While you read headlines every day about the end of the recession, improvement among all metrics, green shoots, and how great it is to have 9.7% unemployment and over 500k in new jobless claims weekly, the fact of the matter is that in the last 4 months, the estimate for losses from bank failures over the next 4 years has increased by 43%! And guess what - asset quality problems are not expected to abate!

The FDIC also reminds us of their previous time frame for restoring the Deposit Insurance Fund:

"In October 2008, the Board adopted a Restoration Plan to return the Deposit Insurance Fund (DIF or the Fund) to its statutorily mandated minimum reserve ratio of 1.15 percent within five years. In February 2009, given the extraordinary circumstances facing the banking industry, the Board amended its Restoration Plan to allow the Fund seven years to return to 1.15 percent. In May 2009, Congress amended the statute governing establishment and implementation of the Restoration Plan to allow the FDIC up to eight years to return the DIF reserve ratio back to 1.15 percent, absent extraordinary circumstances."

So, last year, the FDIC hoped to replenish the DIF within 5 years. As reality hit, they adjusted this estimate to a 7 year time frame in February. Then, in May, despite an epidemic spread of green shoots in the media, the FDIC again extended the estimate of time needed until the DIF was replenished to 8 years.

There is another terrifying tidbit in the FDIC's release that's easy to gloss over:

"At the beginning of this crisis, in June 2008, total assets held by the DIF were approximately $55 billion, and consisted almost entirely of cash and marketable securities (i.e., liquid assets). As the crisis has unfolded, the liquid assets of the DIF have been used to protect depositors of failed institutions and have been exchanged for less liquid claims against the assets in failed institutions. As of June 30, 2009, while total assets of the DIF had increased to almost $65 billion, cash and marketable securities had fallen to about $22 billion. The pace of resolutions continues to put downward pressure on cash balances. While the less liquid assets in the DIF have value that will eventually be converted to cash when sold, the FDIC’s immediate need is for more liquid assets to fund near-term failures."

This is the doozy - the FDIC has been exchanging cash for trash - as banks fail, the FDIC takes assets (as they've admitted above: illiquid, presumably low quality paper - perhaps MBS that will turn out worthless?) and gives the failed banks cash to protect depositors. The last sentence of the quote above presumes that in the end, if they wait long enough, these illiquid assets will have value. The problem is, the FDIC needs cash now, and these assets simply cannot be sold for what we're pretending they are worth right now. If you've been following the crisis, you should realize that this is no different from what the banks the FDIC has NOT yet seized have been hoping - that their trash assets will eventually recover. Everyone is sitting around extending and pretending, delaying and praying, refusing to mark to market, and keeping their fingers crossed that in the end, these assets will be worth what we pretend they are worth. What happens if they're wrong?

Obviously, I'm adamantly against continued attempts to hide the health of the banking industry. The FDIC doesn't want to impose special fees on the banks because it's a tough time for the banks, so they concoct a plan to cook the books -they admit this! They acknowledge that the "prepayment" plan doesn't really change the balance of the fund!

"Although the FDIC’s immediate liquidity needs would be resolved by the inflow of approximately $45 billion in cash from the prepaid assessments, it would not initially affect the DIF balance. The DIF would initially account for the amount collected as both an asset (cash) and an offsetting liability (deferred revenue)."

When you pull forward revenue, you're not improving the long term health of the insurance fund- you're taking money now, and giving up money later.

We need to have another round of special assessments on the banks to shore up the DIF, write trash assets down to realistic levels, seize the bad banks, take the pain, and then we'll be able to move on unencumbered by a never ending pile of bad debt. As we stand now, failed banks have passed their problems on to the other banks, since the FDIC has inherited fantasy assets which are clogging up the balance sheet of its fund.

-KD

Good Times Never Seemed So Good

Was Neil Diamond anticipating the 2008/2009 recession when he wrote Sweet Caroline?

"Where it began, I can't begin to know when
But then I know it's growing strong
Oh, wasn't the spring, whooo
And spring became the summer
Who'd believe you'd come along

Oh, sweet Caroline
Good times never seem so good (so GOOD! so GOOD! so GOOD!)
I've been inclined to believe it never would"

Indeed, things are so good right now (sarcasm alert!) that people are having to sell their grave plots to raise money. I can't emphasize how not good that is. All I can do is picture John Stewart on The Daily Show pleading with the camera in an exasperated, sarcastic tone: "Yes Ethel - the economy has recovered and things are improving rapidly - that's why you need to sell your final resting place to pay the bills!" From the WSJ aritcle:

"As if the recession hasn't ruined enough people's plans in this life, it now seems to be disrupting the hereafter as well. Cemeteries and funeral-property Web sites report a burgeoning marketplace for the sale of burial plots by individuals, many of which have been in families for years. As times get tough, they are now being liquidated to make ends meet."

Which leads us into this terrific cartoon which Barry Ritholtz published on his blog yesterday:

While I'm at it, let me hit a few other quick ones: TARP inspector general Neil Barofsky tells the "look - we made a 17% return on the TARP funds" crowd to screw their heads on straight, and that it's highly likely that a large chunk of the TARP funds will never be repaid.

You may have seen the story from Monday about the banks lending money to the FDIC to prop up the rapidly vanishing insurance fund. For anyone who doesn't understand how absolutely preposterous this is, ponder the following: if your insurance company asked you for a loan so that they'd be able to cover the claims they will have coming up, what would you say? That's a rhetorical question. Other options include a special assessment on the banks, which is exactly what is needed. Of course, the banks don't like that idea:

"Bankers worry that a special assessment of $5 billion to $10 billion over the next six months would crimp their profits and could push a handful of banks into deeper financial trouble or even receivership. And any new borrowing from the Treasury would be construed as a taxpayer bailout that could open the industry to a political reaction, resulting in a wave of restrictions like fresh limits on executive pay. Any populist furor could be avoided, the thinking goes, if the government borrows instead from the banks."

Of course, we know that the banks can borrow at near zero rates from the Fed anyway, so it's just an absurd shell game to make it LOOK like the banks are lending money to the FDIC - which is an absolutely ludicrous concept in it's own right. Sadly, such shell games frequently CAN succeed in quelling "populist furor" - because the populist doesn't understand. Fortunately, cooler heads have prevailed (SARCASM ALERT!), and the latest discussion is for the banks to pre-pay future fees to the FDIC in order to sure up the reserves. Pull those fees forward - that will fix everything!

-KD

You Really Shouldn't Care So Much About Flash Trading

disclaimer: do not waste your time getting sidetracked into OTHER aspects of high frequency trading - this post is about one thing: FLASH TRADING. do not leave me comments about how much you hate high frequency trading - focus on the simple facts of flash trading, and I will be happy to engage in a dialogue with you.

First, let's step back and remind ourselves what flash trading is: when you enter an order on certain exchanges, you have the option to elect to have that order "flashed" to members of that market center to give them the opportunity to match prices that may be available on other exchanges. You, as the order executor, elect to have your order flashed because if the order is executed internally, you don't have to pay an additional charge to route your order out to another exchange. It's that simple. Let's make it a little more concrete: GE is trading $16.50 - $16.51, but you execute your orders on DirectEdge, and the best offer is currently on ISLD. When you enter a flash order in DirectEdge to buy 100 GE @ 16.51, all it does is give potential sellers in DirectEdge the opportunity to sell it to you at $16.51 before DirectEdge routes your order out to the other exchange. There is no theft, there is no front running, there is nothing to rant and rave about.

Now, I have all the respect in the world for Barry Ritholtz. I think he's a tremendous blogger who gets to the truth behind the data, and behind many biased mainstream media reports. Generally, he knows what he's talking about. So it was with dismay that I returned from a weekend out of town, sat down to catch up on some of his recent posts, and found this diatribe against flash trading. Ritholtz's piece arose because the SEC has proposed a ban on flash trading. Next they'll debate it, discuss it, hear comments on it, and vote on it.

A few months ago I wrote my most-read post ever, titled "We Fear What We Don't Understand." Let's revisit the flash trading component of that piece:

"Now, the intent of flash orders is to allow participants in a given market center the opportunity to improve the current bid or offer so that an order doesn't need to be routed away to another market center.

An example: let's say GE is trading $11.45-$11.50 at DirectEdge, but that there is an $11.46 bid on ISLD (an ECN). If you submit an order to sell stock at $11.46 on DirectEdge, they flash this order to select market participants to offer them the opportunity to fill your order - otherwise the order gets routed out to ISLD and you (the seller) have to pay an extra fraction of a penny for the routing. As I tried to explain on some other posts regarding flash trading, this is basically a hyper-speed modernized version of how the NYSE specialists used to verbally quote orders to offer people in the crowd the opportunity for price improvement: "if GE was 11.25-11.27 50k up, and you walked in to sell 50,000 shares, the specialist would say out loud “25c bid 50,000, 50,000 at 26c, SOLD.” Anyone could say "TAKE or BUY'EM" before the specialist said "SOLD" which would result in the seller getting price improvement to $11.26 and if no one interrupted him, the trade was done at $11.25. Markets have NEVER been setup such that every participant has the same opportunity to trade on every quote."

There was also an op-ed in the WSJ a few weeks ago defending and explaining flash trading. The op-ed is accurate, well written, and clear, yet Ritholtz still managed to take offense to it:

"The WSJ had an Op-Ed last month, In Defense of ‘Flash’ Trading, that suggested that “Flash trading is like offering to sell your house to your neighbor before you officially put it into the real estate listings.”

That description is, of course, utterly false. We have alternative exchanges where you can offer stocks privately to other willing buyers (i.e., Instinet). Flash trading is more like having access to private info from the sellers, knowing what they will accept, stepping in front of legitimate buyers, and then flipping the house to those buyers while capturing 0.001% of the transaction. No benefit to the seller, to the neighborhood or to anyone else — all at a small cost to the buyer."

I can't fathom how someone as intelligent as Ritholtz could screw this concept up: when you "step in front of legitimate buyers" it means you are paying more than anyone else. Thus, it's not possible to pay the highest price and then flip it back to the buyers who are willing to pay LESS and make a profit. If you buy stock against a flash order, and offer it out again, you're taking risk - you're not stealing fractions of a penny from anyone or arbitraging anything - what you ARE doing is helping the person who flashed the order in the first place by offering them price improvement and eliminating routing costs.

Now, there is certainly the POSSIBILITY that instead of John Q FlashMan seeing the flash order - let's say it's an order to buy GE - and instead of offering to sell stock to the flash order, he decides to act illicitly and buy stock in GE as fast as he can, before the original GE order gets completed. This is called front running - it's blatantly illegal, and you'd be hard pressed to find anyone who would argue that it's defensible. However, if the traders entering flash orders constantly find themselves being frontrun, well, guess what - they'll stop entering flash orders. They are not idiots. Guys using flash orders are highly cost sensitive, (that's the very reason they use flash orders in the first place!) and notice when their execution costs (both explicit: commission/fees, and implicit: impact costs, or negative costs associated from other trading ahead of their orders) increase - if flash orders are hurting them, they won't flash them.

Flash trading is a non-issue that people like Chuck Schumer and Ted Kaufman have jumped on in an effort to make it look like they are fighting for the little guy's rights on Wall Street. The reality is that a ban on flash trading will have little to no effect on any sort of market dynamic, and will not help the little guy at all, but will increase trading costs for some traders.

-Kid Dynamite

Marty Up! Ponzi Lives

Several years ago, the Big Show and I coined the abbreviation "MARTY UP!" to indicate it was time to implement the Martingale System. Lately, Vegas has been Martying Up their own balance sheets in classic Ponzi fashion. Last week I noted that Harrah's basically executed the very definition of a Ponzi scheme, when they issued new debt to pay off their old debt. This week MGM did something similar.

MGM had an exchange offer outstanding: they have debt coming due in 2010 ($782MM of 8.5% notes), and they tried to get investors to exchange that debt for new debt due in 2016, yielding 10%. Basically, they offered to pay you a little more, in exchange for you agreeing to wait a little longer to get paid back. There was a slight problem: of the $782MM outstanding 2010 notes, only $21MM had agreed to extend and pretend. That's how Ponzi scheme's fail.

No fear, though - today MGM announced that they were revising the terms of the exchange so that it would only effect roughly $25MM of the 2010 bonds... And in a separate announcement, they revealed a private placement of $350MM of new debt due in 2018. PONZI SUCCESSFUL! Obviously, they will use the proceeds of this placement to pay down existing debt.

There's one more important piece of fine print in MGM's 8k today:

"At March 31, 2009, the Company reviewed its CityCenter investment for impairment. The Company’s discounted cash flow analysis for CityCenter was based on estimated future cash outflows for construction and maintenance expenditures and future cash inflows from operations and residential sales of CityCenter. Based on its analysis, the Company determined that no impairment charge was necessary at March 31, 2009.

The Company expects to conduct an impairment analysis of its investment in CityCenter as of September 30, 2009. The Company believes it is reasonably likely that the outcome of this review may lead to a non-cash impairment charge but cannot reasonably estimate the amount or range of such impairment charge at this time."

You can be sure that MGM will have to recognize an (epic?!?!?) impairment charge on CityCenter when they finally decide to acknowledge the reality of the crap-tastic situation in Las Vegas.

Marty Up! Long Live Ponzi!

-KD

disclosure: no position in MGM, but looking for a place to short it, along with LVS

Your Tax Dollars At Work

Please note - this piece is entirely non-partisan. I'm not condoning or criminalizing Joe Wilson's actions in yelling "You lie!" at President Obama during his big speech before the Joint Session of Congress last week - but I am certainly saying that Congress's actions today are a disgraceful waste of time, money, and thought.

In case you missed it, the House voted to officially "rebuke," Representative Wilson, which means, well, jack shit. Here is the wording from the actual resolution:

RESOLUTION

Raising a question of the privileges of the House.

Whereas on September 9, 2009, during the joint session of Congress convened pursuant to House Concurrent Resolution 179, the President of the United States, speaking at the invitation of the House and Senate, had his remarks interrupted by the Representative from South Carolina, Mr. Wilson; and Whereas the conduct of the Representative from South Carolina was a breach of decorum and degraded the proceedings of the joint session, to the discredit of the House: Now, therefore, be it Resolved, That the House of Representatives disapproves of the behavior of the Representative from South Carolina, Mr. Wilson, during the joint session of Congress held on September 9, 2009.

Now, in case you don't understand what that means, the elected officials of our country spent time today debating and then voting to decide that it "disapproves" of the behavior of Mr. Wilson. Seriously.

They didn't spend time talking about how to recoup the hundreds of billions of dollars they've sunk into AIG, FNM, FRE, C and BAC.

They didn't discuss exactly what might be the best way to dispose of the Citigroup stake that Treasury has expressed interest in selling, and they didn't discuss the possibility of removing the guarantees that the government has given Citi on $300Billion in crappy assets.

They didn't spend time talking about how to move forward with the monumental health care bill, or if maybe it might be time to think about alternatives to continuing to extend unemployment benefits while desperately hoping the economy improves.

They didn't debate a second stimulus plan, or even consider that since the mainstream party line is that the recession is over and that things are getting better, maybe we don't need the stimulus after all.

They didn't talk about the risks to our plan to continue to roll over an ever increasing mass of national debt on the gullible Chinese.

They didn't discuss a potential backup plan in case the "delay and pray" strategy for economic improvement fails.

Instead, they spent their time debating and then voting to make sure that everyone knows they disapprove of Representative Wilson's actions... And??? Are they going to kick him out of the House? Are they going to fine him? Are they going to put him on trial for treason? Are they going to send him to Gitmo? If not, WHY THE FUCK DID THEY NEED TO WASTE TIME ON THIS?!?!!?

Again, without passing any judgment at all on Wilson's actions, I can agree 100% with his quote today:

"When we are done here today, we will not have taken any further steps toward helping" the nation deal with urgent challenges, said Wilson, of South Carolina. "It is time that we move forward and get back to work for the American people."

The American people saw Obama's speech, and Wilson's interruption. It was said that in the 24 hours after the event, Wilson's campaign donations ramped up, but that his opponent's donations increased twice as much. The people are capable of evaluating the action on their own - we do NOT need our elected officials spending their time on utter crap like this, unless they are doing it to enforce actual consequences as a result.

In related news, this Dilbert cartoon sounds like a better use of time and money than what Congress is currently doing:




edit: the entire roll call for the resolution is here. Shame on Barney Frank for taking the time to show up and vote "present" but not being able to make a decision on something as monumentally inconsequential as "disapproving" or Wilson's actions. Kudos to Maxine Waters (that is the first, and possibly the last time you will hear me commend Waters) for not bothering to vote at all.

-KD

Seinfeld?

The NY Times ran an article this weekend about protesters rallying against big government, with this picture:


I saw the picture of Pelosi with the link between "Nazis" and "Astroturf" and I was immediately impressed by the wit of the protester, who was clearly referencing the classic Seinfeld episode where George and Jerry steal a limo by posing as "O'Brien" and "Murphy," not knowing that O'Brien is the head of the Aryan Union. When they figure out the situation, George calls 911 from the back of the limo, and is pleading his case to the operator, when the host returns to the limo. George quickly shifts gears, and utters the classic line:

"Astroturf? You know who's responsible for that, don't you?! The Jews! Ah, the Jews hate grass. They always have, they always will."

Sadly, I later realized that the sign was not paying homage to this legendary Seinfeld moment, but was a reference to Pelosi's soundbite downplaying a prior protest as not grassroots, but "astroturf." I'm not ashamed to admit that I'm not up on Pelosi's soundbites.

-KD

September 11th, 2009

I wrote this piece on September 11th 2006,

and this one shortly after September 11th, 2001

"Well starry eyed and laughin' I recall when we were caught
Trapped by an old track of vows for the hands suspended
As we listened one last time and we watched with one last look
Spellbound and swallowed "Has the tollin' ended?""

-KD

Ponzi?

From Wikipedia: The definition of a Ponzi Scheme:

"A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned."

From Harrah's press release today: (emphasis mine)

"Harrah’s Entertainment, the beleaguered casino operator, says it will offer $720 million in new secured notes to give it more time to repay lenders, The Associated Press reported. The Las Vegas-based company, which was acquired in a leveraged buyout, said Tuesday that it would use the proceeds from selling the new notes, which will be due 2017, to repay debt that is due much sooner."

I'm just sayin'.... I guess if your profits from lowering payouts on the blackjack tables to 6:5 don't cut it, you just sell new debt to pay down the old debt, then sit back and wait for time to heal all wounds. I'm sure that once CityCenter and Fountainebleau open, flooding Vegas with more supply it can't handle, then everything will magically become super again.

/sarcasm

-KD

Satire Everywhere - Even Where Unintended

The first article I opened this morning was a Bloomberg piece titled "Stocks Cheapest Since '89 Show Why Analysts Say Economists Wrong on Growth." I scratched my head and plowed through the article, which spends a lot of time actually detailing some risks that the market faces going forward. Then I found the part where they explain the headline - the cheapness of stocks (emphasis mine):

"The gains spurred the steepest rise in the S&P 500’s price- earnings ratio since at least the 1950s, pushing the index to 19 times operating earnings from the past 12 months, the most expensive level since 2004, according to data compiled by Bloomberg. Based on analysts’ forecasts for 2010, the S&P 500 trades for 13.5 times income, the lowest since 1989 when compared with the trailing P/E ratio before Lehman Brothers Holdings Inc.’s collapse a year ago."

Then I read this piece on ZeroHedge, which highlights JPMorgan's upgrade of General Electric today. Remarkably, the report is titled after Pink Floyd's Comfortably Numb. We're truly in a remarkable spot in the markets when the justification for upgrading behemoth GE is that investors seem numb to the downside! I guess that means there is no downside - if we ignore it, it can't happen!

A colleague sent me this comment this morning from an analyst whom I will keep anonymous, but suffice it to say that this analyst is not a moron, and was actually mostly bearish throughout 2006 and 2007 before everything fell apart:

"All in all, we expect the coming weeks to put an end to the debate on recession vs. recovery and to bring about a major lift in investor sentiment. In essence, we expect our bullish thesis to become consensus within months if not weeks."

I replied, "WHY? Because all those people who are unemployed and having trouble with their mortgage resets will suddenly be exposed to mind erasing gas like in the second to last Batman movie?" I'd love to hear the logic for everyone suddenly waking up to the reality of the new bull market - as I'm expecting quite the opposite. I'm expecting the bulls to realize that rampant unemployment, understated job losses, stagnant wages, continuing job losses, weak hiring outlook, lack of home equity, and an eventual inevitable end to government subsidies will require us to finally address the problems in the economy. But maybe the plot of Batman Begins will turn into reality, and the government will unleash its happy gas to control the populace.

Iowahawk has written a phenomenal satirical piece which puts a mainstream media spin on the current trends in joblessness. Some snippets:

"Brian Smalley was laid off by ObamaStickers.com in late April. He didn't panic. He didn't rush off to a therapist. Instead, the 33-year-old Santa Monica resident discovered that being jobless "kind of settled nicely, once you get used to the heating grate..."

What most people would call unemployment, Smalley embraced as "funemployment." What other people would dismiss as starvation, he whimsically terms a "starve-cation..."



"Horton, who was recently laid off from her job as a ElectoChill D.J. at a boutique hotel aromatherapy spa, says lack of a daily job obligation has been "a godsend..."

"I get to sleep in late at the shelter, and I finally have time to catch up on Tweeting," she says. As she recently mused on Twitter, from an Austin public library: "Recession? More like relax-cession!...""



Never heard of funemployment? Here's Urban Dictionary's definition: "The condition of a person who takes advantage of being out of a job to have the time of their life. I found a burrito with only one bite in it; funemployment rocks!..."

"Melissa Browning, 34, is another funemployed L.A. single who has found new meaning in prostitution. After losing her job as a program coordinator for a non-profit Feng Shui education group in late March, Browning decided to go on a three-week interstate highway trek through the truckstops of central Arkansas with two friends, earning up to $30 per night while sleeping in tent-like yurts.

"I used to be so absorbed in the details of work, but prostitution has allowed me to come out of my shell," Browning said. "Now it's just so much easier for me approach new people, in idling semis, at 2 am. It's just gives you such a positive pro-active outlook. I guess that's why it's called pro-stitution." "

It's sad when the Iowahawk piece is the most sensible story I've read today...

-KD

Life Insurance Settlements

I read an interesting article last night on NYTimes.com about securitizing life insurance settlements. The gist of the process is this: you have an elderly person, say, 72 years old, who needs money badly. This person, let's call her Ethel, has a life insurance policy that will pay $2mm when she dies, but it costs her $50k a year to keep current. According to actuarial tables, Ethel is expected to live to age 77. Now, the life insurance company will "settle" the policy with her - they'll give her cash right now. How much? In the NY Times example, it's a mere $58,000. Ethel is getting screwed.

Enter the evil "Wall Street," who seeks to profit from the death of average Americans - as critics will claim. Wall Street is now acting as an intermediary to try to get Ethel something closer to the theoretical value of her policy. The securities firm buys Ethel's policy from her, giving her more money up front ($215,000 in the Times example) than the insurance company would have given her, and then continues to pay her policy. The firm turns those policies into securities or even packages them with other policies, like Rose and Marvin's life insurance settlements, and sells them to investors. The investor pays the policy until the original policy holder dies, at which point the investor receives the value of the policy. It's really not as hard as it sounds - to simplify - you need cash badly, I have cash, so I buy your policy from you, and take it over. I decide how much to pay you for the policy based on the end value of the policy and your expected life span.

Now, it's debatable whether life insurance policies should be able to be settled at all. It's pretty clear to me, though, that if you have been making payments into a policy as you age, but you now need money, you should have the right to "cash out" your policy for whatever it's "worth." Critics will immediately jump on the securitization process facilitated by Wall Street as another attempt by Big Money to profit off the ill fates of innocent Americans - even incentivizing the security holder to cheer for the early death of the policy holder. This last part is unequivocally true - life insurance settlements are worth more when the policy holder dies earlier. However, the whole point of the securitization process is that the insurance company was not giving Ethel a fair value for her policy! Instead, let investors take the risk of the policy, and price Ethel's policy at a "fairer" value. A life insurance policy is no different from a bond - the problem is we don't know the maturity date. Let investors make a market on what the fair expectation of that maturity date is! This is exactly what insurance companies do, only they don't compensate you fairly.

Yves Smith at NakedCapitalism wrote today about a potential ill effect from the securitization process:

"On a small scale, this is a useful service to people who are in a bind. But the ramp up that Wall Street intends, of marketing the idea more aggressively and securitizing the policies, is likely to put all life insurance customers at a disadvantage.

The big reason is that many policies lapse (as in the owner of the policy fails to make payments. Those lapses are included in current pricing models. Investors will not miss payments, which means insurance providers will pay out more often than in the past on life insurance policies, which in turn means their profits will deteriorate, which means they will raise rates on everyone."

This is an interesting observation, although a commenter on Yves's post notes that insurance companies have gotten better at pricing policies to "abandonment," so that this theoretical "loss" that the insurance company suffers is smaller, and already priced in.

In today's "Evil Wall Street" era, the temptation is to crucify Wall Street for ideas like the securitization of life insurance settlements, but all the process does is make the value paid to the policyholder more competitive. The claim that this process will result in a pseudo "tax" for other policy holders because insurance companies will be forced to raise rates is a red herring - it ignores the fact that the benefit of the "tax" was already paid to our hero, Ethel.

-KD