Saturday, May 29, 2010

Human Use Causes Much More Ocean Oil Than Drilling Accidents

From "Oil and Pollution in the Ocean" by the National Academy of Science, National Research Council:
accidental spills from platforms represent about 1 percent of petroleum discharged in North American waters and about 3 percent worldwide.

...surprising to many, is that oil from individual cars and boats, lawn mowers, jet skis, marine vessels, and airplanes contribute the most oil pollution to the ocean. This includes land runoff from oil slicks on urban roads and hydrocarbons deposited from the atmosphere. According to the report's estimates, use-related oil pollution dwarfs that from oil and gas production activities, accounting for about 87 percent of the oil from human activity in North American waters.
Earlier in the report:
natural seeps are the largest single source of oil in the sea, accounting for about 60 percent of the total in North American waters and 45 percemt worldwide. Seeps form when crude oil oozes into the water from geologic formations beneath the seafloor. Oil and gas extraction activities are often concentrated in regions where seeps form.

What Is a Small Business?

There is a tendency to focus on small businesses. The media is fond of reporting that small businesses employ and create most of the jobs in the US. The media and the government are also concerned with the availability of bank loans and credit to small businesses. So, I thought I look up the definition of small business as defined by the Small Business Administration, a government lending program to small businesses.

Like all things government, the SBA has a 44 page booklet, "Table of Size Standards" for identifying small businesses.

Also available from here.

Surprisingly, a small business, depending on the industry, can have $35.5 million in annual receipts (gross profit plus cost of goods sold) or up to 1500 employees.

Small is relative and in comparison to the other companies in the industry.

A shop owner may think 1500 employees is big, but an auto manufacturer may not.

Thursday, May 27, 2010

Federal Spending Crowds Out Local Private Investment And Lowers Employment

Specifically, we find statistically and economically significant evidence that firms respond to government i.) reducing investments in new capital, ii.) reducing investments in R&D, and iii.) paying out more to shareholders in the face of this reduced investment opportunity set. Further, we find that when the spending...reverse..., most all of these behaviors reverse. Finally, we also find some evidence that firms scale back their employment, and experience a decline in sales growth.
From "Do Powerful Politicians Cause Corporate Downsizing?" by Harvard Business School Professors Lauren Cohen, Joshua Coval and Christopher Malloy.

Also see Harvard Business School article, "Stimulus Surprise: Companies Retrench When Government Spends" on this research.

Tuesday, May 25, 2010

Costs Of Fed's Actions In Financial Crisis: CBO Study

The Federal Reserve System used its traditional policy tools to reduce shortterm interest rates and increase the availability of funds to banks, and it created a variety of nontraditional credit programs to help restore liquidity and confidence to the financial sector. In doing so, it more than doubled the size of its asset portfolio to over $2 trillion and assumed more risk of losses than it normally takes on.
In CBO’s estimation, the fairvalue subsidies conferred by the Federal Reserve System’s actions to stabilize the financial markets totaled about $21 billion.

The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the Financial Crisis by Milton Recht

Friday, May 21, 2010

Goldman Sachs' Best Strategy Is Not To Settle SEC Charges

The best strategy for Goldman Sachs is not to settle the SEC fraud charges against it. Goldman can ask for a non-jury trial before a federal judge and avoid a public jury's dislike for the banking industry.

Federal rules of evidence would benefit Goldman since it will force the SEC to provide evidence, and not innuendo or popular opinion, of the fraud and the necessary intent to defraud. A mere description of the transaction, in of itself, would not show fraud.

Witnesses will be allowed to testify as to the exact meaning and context of emails and other communications. A judge would understand that typical company employee water cooler banter, which now is in the form of email exchanges, is not proof of Goldman Sachs' fraudulent intent or fraud.

The judge would hold the SEC to the existing law and not to what the law should be.

Penalties for this single instance of fraud are limited by securities law to an amount most likely substantially lower than any settlement amount Goldman would enter into with the SEC.

The judge will be unimpressed with the SEC's attempt to broaden the scope of the securities law to include transactions that maybe unethical but not fraudulent. The judge will also be unimpressed with any political pressure the SEC may feel to show it is a strong watchdog agency of the securities industry. In fact, the political climate and popular sentiment may appear to the judge that the SEC is over zealous in its prosecution of Goldman and find that the case does not have any merit.

Federal judges would be even tougher on the US Attorneys on proof of criminality.

Passed Senate Financial Reform Legislation: S3739 Substituted For S3217

Embedded copy of Senate financial reform legislation, Senate Amendment S3739 substituted for S3217. S3739 was incoporated into House Bill HR4173 and passed by the Senate at 8:02 PM on Thursday, May 20, 2010. Incorporation into HR4173 allows bill to go to joint conference to reconcile differences. [Corrected May 21, Noon, by adding reference to HR4173].
Senate Amendment 3739                                                            

Thursday, May 20, 2010

No Improvement In Electric Car Range In Last 100 Years

From "The status quo of electric cars: better batteries, same range" by Gail the Actuary (Gail E. Tverberg) on the Oil Drum Blog:
Electric motors and batteries have improved substantially over the past one hundred years, but today's much hyped electric cars have a range that is - at best - comparable to that of their predecessors at the beginning of the 20th century. Weight, comfort, speed and performance have eaten up any real progress. We don't need better batteries, we need better cars.

From about 1895 to the mid-1920s, and following the bicycle craze of the 1890s, electric cars shared the road with petrol and steam powered cars. EV's were comparatively slow, heavy, and had a smaller range than their alternatives. During the very early years, however, electric automobiles were the most popular option for a short time, mainly because of two reasons.

Firstly, they were easy to start, while a gasoline car had to be cranked up and a steam powered car required a long firing-up time (not unlike a wood gas car). Secondly, there were few paved roads outside the city at the turn of the 20th century, which made the limited range of EV's not that problematic. The production of electric vehicles peaked in 1912: during that time there were 30,000 EV's on the road in the United States, two-thirds of these were used as private passenger cars. Europe had around 4,000 electric vehicles.

Wednesday, May 19, 2010

CFTC/SEC Release Preliminary Findings on May 6 Unusual Market Events: Was NYSE The Cause?

The staffs of the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) released preliminary findings related to the unusual market events on May 6, 2010.

The report notes:
In addition, we are exploring the impact of “self-help” being invoked by NASDAQ and BATS against NYSE Arca. As NYSE Arca is the primary listing exchange for almost all ETFs, the loss of access to NYSE Arca’s liquidity pool may have had a disproportionate impact on market liquidity and trading for ETFs.
Self help is declared against an exchange when that exchange is not responding in the proper time frame. Many of the ETFs are traded on NYSE Arca and many of the NYSE Arca ETFs trades were canceled because the prices of the ETFs were below, after the fact, acceptable levels.

Additionally, there is anecdotal evidence that computerized traders withdrew their bids to buy shares (turned off their algorithms) because they expected many trades would be canceled because of the sharp decline in the price of the trades and they did not know beforehand the cutoff price for canceling trades.

One has to wonder if the NYSE Arca system and the lack of known SEC and NYSE price bounds for canceling trades was the cause of all the problems and not traders. Of course, since the SEC and NYSE are the ones looking for the causes of the decline, one wonders how much responsibility they will take for the stock market loss of liquidity and intra-day decline in the final report?

The 151 page report is available online from the CFTC, on Scribd and embedded below.

SEC-CFTC Preliminary Findings Regarding the Market Events of May 6, 2010

Tuesday, May 18, 2010

SEC Proposes Circuit Breakers For Stocks In S&P 500

SEC to Publish for Public Comment Stock-by-Stock Circuit Breaker Rule Proposals

Washington, D.C., May 18, 2010 — The Securities and Exchange Commission announced that in response to the market disruption of May 6, the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) are filing proposed rules today under which they would pause trading in certain individual stocks if the price moves 10 percent or more in a five-minute period.

The SEC is seeking comment on the proposed rules.

The markets are proposing these rules in consultation with FINRA and staff of the SEC to provide for uniform market-wide standards for individual securities in the S&P 500® Index that experience a rapid price movement.

These rules reflect a consensus that was achieved among the exchanges and FINRA after SEC Chairman Mary Schapiro convened a meeting of exchange leaders and FINRA at the SEC early last week. That meeting took place within days after the market dropped significantly and after approximately 30 S&P 500 Index stocks fell at least 10 percent in a five-minute period.

"We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges," said Chairman Schapiro. "As such, I believe it is important that all the exchanges quickly reached consensus on a set of uniform circuit breakers that would be triggered when needed. Today's filings reflect that consensus. I am pleased by the constructive cooperation of the exchanges and FINRA as evidenced by their rapid response."

Under the proposed rules, which are subject to Commission approval following the completion of the comment period, trading in a stock would pause across U.S. equity markets for a five-minute period in the event that the stock experiences a 10 percent change in price over the preceding five minutes. The pause would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion. Initially, these new rules would be in effect on a pilot basis through Dec. 10, 2010.

The markets will use the pilot period to make appropriate adjustments to the parameters or operation of the circuit breaker as warranted based on their experience, and to expand the scope to securities beyond the S&P 500 (including ETFs) as soon as practicable.

The proposed rules will be available on the SEC's website as well as the websites of each of the exchanges and FINRA. The Commission intends to promptly publish the proposed rules for a 10-day public comment period, and determine whether to approve them shortly thereafter.

"I believe that circuit breakers for individual securities across the exchanges would help to limit significant volatility. They would also increase market transparency, bolster investor protection, and bring uniformity to decisions regarding trading halts in individual securities," said Chairman Schapiro.

During the pilot period, Chairman Schapiro has asked the SEC staff to consider ways to address the risks of market orders and their potential to contribute to sudden price moves, as well as to consider steps to deter or prohibit the use by market makers of "stub" quotes, which are not intended to indicate actual trading interest. The staff will study the impact of other trading protocols at the exchanges, including the use of trading pauses and self-help rules. The SEC staff also will continue to work with the exchanges and FINRA to improve the process for breaking erroneous trades, by assuring speed and consistency across markets.

The SEC staff is working with the markets to consider recalibrating market-wide circuit breakers currently on the books — none of which were triggered on May 6. These circuit breakers apply across all equity trading venues and the futures markets.

* * *

The SEC also has sought public comment about a concept release on a wide range of topics concerning the equity markets to help facilitate the SEC's ongoing review of market structure issues.

# # #

Why Isn't Obama Pushing Free Trade Agreements To Create Private Sector Jobs And Grow The Economy?

A comment I posted on Carpe Diem, "Inexcusable: Obama's Failure to Pass the FTAs" by Mark Perry.
To add to the idiocy of the administration's support of the anti-free trade, union position is that private sector union membership in manufacturing and construction is only 7.2 percent, a decline from the 35 percent peak in the 1950s.

State, local and federal government workers make up the majority, 52 percent, of union members. 43 percent of local government workers are union members.

So it is basically the teachers, the firemen, the policemen, the garbage man and other local community workers who live off everyone's tax dollars, have generous pensions, health benefits, vacation and sick days and who have not felt the effects of the recession and layoffs anywhere near the same extent as the private sector.

People who do not make anything, who do not compete in international markets, who need not worry about international trade and competition, and who do not have to worry about private sector job creation are the ones stopping the US economy from expanding, adding private sector jobs and from benefiting from free trade agreements.

Will A Value Added Tax (VAT) Help US Exports?

If you are interested in whether a Value Added Tax (VAT) will help increase US exports over imports, read Greg Mankiw's post, "Is a VAT good for exports?"

Basically, the foreign currency exchange rate will adjust to remove any hoped for price advantage created by an import export tax difference.

Monday, May 17, 2010

Video Of Rachel Maddow's Commencement Speech At Smith College

Rachel Maddow gave the commencement speech at Smith College's 132nd graduation ceremony on Sunday, May 16, 2010, in Northampton, MA. The following is a video archive of that speech. Her speech was very well received. Overall, it was less political and more cautionary than usual for Maddow.

[Added May 19, 2010]
Transcript of Rachel Maddow's Smith 2010 Commencement Address on Sunday, May 16:
This is very impressive -- all of you.

Thank you for asking me to be here today. I know by virtue of the achievement that earned you these seats down front today that you are too smart to take advice from anyone who hasn't earned it; let alone an erstwhile Northampton radio show D.J.

However, I do have a story to tell that I admit is a little woolly.

In June of 1900, a self righteous, by all accounts quite unpleasant woman in Kansas had a religious vision. Her name was Carry Nation. And years later when she wrote her autobiography in which she all but named herself a saint, she said that while she was praying in June 1900 and lamenting, weeping, trying to find a way to be a better Christian, she said that God spoke to her in a clear voice and directed her to go destroy saloons. God told her to leave Medicine Lodge, Kansas, and go and Kiowa, Kansas, and destroy any saloons she found there, and she did.

She stormed these turn-of-the-century bars, these saloons with their long mirrors, and she had a big rock and she used the rock to smash bottles of liquor -- she just laid waste to these barrooms.

Turns out Carry Nation had a hankering for this. She lustily enjoyed destroying property and terrifying people.

She soon made both a habit and a career of it. She traveled all over: Kansas first, and ultimately all over the country, destroying barrooms. She first used a rock and then a hatchet. She adopted the hatchet as her symbol. She called her saloon smashings "hatchetations," which is probably the one really cool thing about Carry Nation: "hatchetations."

Carry sold these tiny pewter hatchet pins and fundraising souvenirs. You can buy them on eBay. I have one. It looks like a labrys though. It's a nice idea but different.

Carry Nation's fundraising was actually for herself so she could market herself as essentially a sideshow act, as a “saloon smasher,” and she had a traveling sideshow manager promoting this traveling saloon-smashing road show she did around the country.

As a person who has become not a little obsessed with Carry Nation, I have come to think of her as mostly an American huckster, just promoting herself. But she was also promoting her cause: temperance, outlawing drinking, prohibition. And that campaign worked – she was one of the reigning symbols of the Prohibition movement from when she started smashing saloons in 1900 to when she died in 1911. By 1917, the combined effort of activists like her and the women's temperance union had actually succeeded in passing an anti-booze amendment to the United States Constitution -- as if we didn't have other things to do.

It passed overwhelmingly through both houses of Congress less than a year and a half later, ratified by two-thirds of the states; and, starting in 1920, the incredible stupid idea of Prohibition was the law of the land -- and it was a disaster.

Alcoholism went up. Dozens and then hundreds and thousands of illegal drinking establishments opened up. Bootleggers ran the black market to end all black markets. A whole new variety of organized criminal activity blossomed.

With the massive surge of profits flowing through that criminal underworld, this country reached whole new levels of government corruption that puts anything we've got today to shame -- except for maybe the Interior Department of the Bush administration.

It's not about the Bush administration -- remember they put the Abramoff guy as the Number Two guy in charge of the Department of Interior and there was that one office where they were snorting meth off the toaster oven and the people who worked in the office regulating the oil industry were actually having affairs with oil industry lobbyists? So the Bush administration Interior Department maybe can compete.

And actually, when you think about it, there was that morning last summer when 44 people got arrested all at once in New Jersey on corruption, and then there's Rod Blagojevich -- so alright maybe we can imagine what super corrupt criminal government looks like. But in Prohibition it was really bad.

In the Depression, the criminal economy that was a side effect of the Carry Nations of the world convincing us to ban booze -- that criminal economy was big enough that it crowded out a lot of the real economy. Trying to recover from the Great Depression meant, in part, finding a means of stimulus spending that wouldn't just disappear into the gangster economy, which was quantitatively an actual competitor to the legitimate economy.

Now granted, we do remember some cool things from that era -- flapper dresses, every drink you've ever had with orange juice because they needed something with a strong flavor to disguise the taste of the disgusting bathtub gin -- but basically it was a huge public policy failure.

I'll give you just one more concrete example of how barbaric and stupid this time was in American public policy. Consider industrial alcohol. There's alcohol for drinking and then there's alcohol for solvents -- rubbing alcohol. People were so desperate to drink that they would sometimes drink industrial alcohol, or people in the wildly profitable business of bootlegging would steal or rip off industrial alcohol and then redistill it to make it vaguely drinkable.

The government decided during Prohibition that that must be stopped, and their genius idea to stop it was to poison the industrial alcohol. Deborah Blum wrote about this for recently. The government took industrial alcohol and they added things like kerosene, gasoline, benzene, mercury salts, nicotine, ether formaldehyde, acetone. They would add known poisons to these things that they knew people wanted to drink and then people would still drink them and they would die. It's been estimated that as many as 10,000 people may have been killed by government actions in this way during Prohibition when the government decided to discourage people from doing things that people already knew was bad for them but they wanted to do it anyway.

Prohibition was really stupid on a million different levels. Finally after 13 long, dumb years, it was repealed in 1933, and then we as a country promptly set about forgetting we had ever done it.

I think it's important to remember Prohibition because enacting it was a huge disaster for our nation, but it was a personal triumph for Carry Nation.

I would like to offer the hypothesis on this beautiful graduation day that personal triumphs are overrated.

If you think about it, when Jack Abramoff got the White House to install his on- the-take, corrupt, patsy as the Number Two job at the Department of Interior thus leading to the snorting-meth-off-the-toaster-oven, sleeping-with-the-oil-lobbyist vibe at the Department of the Interior, that was a personal triumph for Jack Abramoff.

Someone at Yum Brands this year achieved their personal triumph by getting KFC to remove the bun from a cheese and bacon sandwich and replace that bun with pieces of fried chicken -- the double-down sandwich-designer's personal triumph.

When the current president hit upon the strategy of co-opting his political opponent's wish list in order to get a climate bill passed this year, President Obama, adopting “Drill-Baby-Drill,” was lauded in the Beltway press as a political and personal triumph.

Someone invented the AMC Gremlin and got a car company to build it for nine years -- that was a personal triumph.

There's a Tennessee businessman who has mass-marketed a legal means of charging 400 percent interest on something called "payday loans" despite laws against usury and loan-sharking in this country. He made so much money off of ripping off Americans that way that he built himself a full-scale college football stadium with lights and seating and a field house and everything in his backyard for his personal use, and he hires college football teams to play there for his own enjoyment, he markets himself as a great American personal triumph.

Al Capone rose from humble beginnings in Brooklyn to build a huge crime empire that essentially owned Chicago during Prohibition -- a personal triumph.

All these people dream their dreams and work hard and achieve their dreams.

Some dreams are bad dreams.

[Stopped to recognize a cheer]

Will you do that again? Yah? The hooting -- that's very nice, thank you.

Everybody always says around occasions like this: life is short. It might be. If it is for you, I'm sorry. I wish that was not the case. But I would caution against believing life is short and to live everyday as if it is your last as if you're ever only going to be roughly the age you are now.

Frankly, if all goes well, life is long. So if you might take advice for me I would offer this, hopefully life is long. Do stuff you will enjoy thinking about and telling stories about for many years to come. Do stuff you will want to brag about.

No one brags to the grandkids that they were one of the geniuses behind poisoning all the industrial alcohol in the country. Nobody's going to brag to grand kids about "Who-needs-wetlands? Let's-have-a-subdivision-and-a-shipping-canal-instead" decisions that made New Orleans the tragedy and the distant hope that it is today -- and the 40 percent of our nation's wetlands that is Louisiana's beaten, bloodied coast.

Nobody's ultimately going to brag to their kids about having told the country that we ought to invade Iraq because, you know 9/11, and it ought to be easy. Imagine in the family history: "Yeah, then granddad went onto TV and said war in Iraq would take six weeks, max." Nobody wants to remember that about granddad.

So I would advise, if you have the choice, don't be the granddad, don't be the grandma whose temporal personal triumph is something you only hope is something that gets forgotten in history.

In the big picture, standing at the age 22-ish or 40-ish or 62-ish -- Ada Comstockers, right on -- standing at the age you are now at graduation, looking for your own deep-water horizon, consider the possibility that you might very well get old -- everybody hopes you do. Be part of good decisions because the stuff you do now you will want to be bragging about when you become 90.

How do you become part of good decisions in the absence of a crystal ball? The best way to guess what is going to work out in the future and to figure out what you'll be glad you played a role in is to get smart and get smart fast, to take the opportunities you've got very seriously, to continue your education not necessarily in a grad school way, but in a lifelong way, be intellectually and morally rigorous in your own decision-making and expect that the important people in your life do the same if they want to stay important to you.

Gunning not just for personal triumph for yourself, but for durable achievement to be proud of for life is the difference between winning things and leadership; it's the difference between nationalism and patriotism; it's the difference between running for office and devoting yourself to public service; it's agreeing that you're part of something; taking as your baseline that you will not seek to reach your own goals by stepping on your community; it means coming to terms that your country needs you, Smith Class of 2010.

There will come times in life and career ahead when you have to choose between integrity and more short-term temptations. You will be the press secretary who is asked to lie to the press; you will be the regulator asked to approve the drilling with the Mickey Mouse safety plan; you will be the artist commissioned to make what you suspect is propaganda; the engineer pressed to use the cheaper, unsafe welds; the job applicant asked to cross the picket line; the research scientist expected to round to the nearest publishable conclusion; the spouse tempted to cheat; the physician tempted to schill; the staff sergeant asked to keep quiet; the politician confronted with the focus group that proves how well appeals to racism poll in your district; the pundit offered the talking point; the procurement officer offered the kickback.

In the short term it's always crystal clear what advances you further, what makes you famous, what gets you your boss' job, what gets you elected, what gets you rich.

In the end, though, blood will out.

History has a way of not remembering that some of those Iraq War press secretaries had real talent in the White House press room; or that BP and Trans-Ocean had a real talent for drilling down to find oil deeper than anyone else.

When given the choice between fame and glory, take glory. Glory has a way of sneaking up on fame and stealing its lunch money later anyway.

Life might very well be long, keep your eye on the horizon and live in a way that you will be proud of. You will sleep more. You'll be a better partner. You'll be a better mom. You'll be a better friend. You'll be a better boss, and you will not have to remember any complicated lies to brag about at the old age home because you can brag about the truth of your well-lived life.

In conclusion, I'm not going to be egotistical enough to ask you to remember any of this advice. I might ask you, though, to remember Carry Nation. Carry Nation got what she wanted against the odds -- a product of her hard work -- it's not meant to be inspiring. It's meant to worry you. You are graduating from Smith College. You are well prepared. You are poised. You're well connected. You are wicked smart. You are already accomplished.

Do not for yourself today, but for yourself to be proud of at the end of your life. Do not for the fame, but for the glory – learn the difference. Do not just for your own life, but for the life of your nation, that is still, for all its challenges and its flaws, is in many ways the best hope on earth. A country that needs you and the best you have to offer and your best judgment.

Thank you for asking me to be here. Thank you for already having done the hard work that got you here, and please enjoy this moment. Be proud of yourself. We're all so very, very proud of you.

Sunday, May 16, 2010

Gulf Naturally Leaks 48 Million Gallons Of Oil Each Year, 5X To 25X BP Leak

In comparison to BP's leak in the Gulf of Mexico, the natural oil leaking in the Gulf from the ocean floor is 5 times to 25 times greater the amount of oil that BP's well is leaking into the Gulf.
[Thomas] Shirley, the marine biologist [at Texas A&M University], notes that oil is not a foreign substance in the gulf: "What most people haven't considered is that there's 48 million gallons of oil that's leaked naturally in the gulf every year.

Ian MacDonald, the Florida State University professor who has gained attention with his estimate, based on aerial images, that the leak is five times the official estimate of 5,000 barrels a day, said nature will ultimately have to fix the gulf mess. "BP is not going to clean up this spill," he said. "The Coast Guard is not going to clean up this spill. What's going to clean up this spill is the physical, chemical, biological process of the good ol', poor, downtrodden Gulf of Mexico."
From "Oil spill imperils an unseen world at the bottom of the gulf" by Joel Achenbach in the Washington Post.

[Also, see later post, "Human Use Causes Much More Ocean Oil Than Drilling Accidents"]

Friday, May 14, 2010

Remove Credit Rating Agencies From Financial Institution Regulatory Oversight Process

A comment I posted on "Find the Mistake" by Robert Waldmann on Angry Bear blog.
CDOs (including synthetics) and other combinations of mortgage securities and indices of mortgage securities used models to determine their pricing and expected returns. All models contain a finite set of explicit and implicit assumptions. No set of assumptions will reflect real world events under all future scenarios. CDOs in addition to normal market price risk of expected cashflows also have modeling risk. All pricing based on models will contain modeling risk. No pricing model will accurately predict outcomes under all circumstances.

Traded securities prices reflect investor cashflow expectations of those who think it is fair valued, over valued and under valued. Private placement underwritings, such as CDOs, do not have a trading market price. A potential investor who thinks a CDO underwriting is too risky or overpriced will walk away from the deal, not participate, and have little if any effect on valuation. In a trading scenario some overvalue investor will sell their holdings or find ways to short and will affect valuations.

In a trading market, there is a tension between investors who believe a security is over or under valued. In CDOs, the tension between over and under value investors did not exist and all pricing relied on a single valuation model. Investors, who believed they were overvalued or too risky, did not participate in the deals and did not influence the pricing of the deals.

It does not take a PhD in math or structured finance to understand that it is naïve to rely solely on models of future real world events. Investors in CDOs failed to account for modeling risk of the pricing and expected return.

One of the reasons that investors overlooked modeling risk was the desire to invest in highly credit rated securities. Regulators (Basel capital requirements among others) created the appetite for safe credit rated securities. The regulators embedded the credit ratings in their oversight criteria for capital, solvency and safety of financial institutions.

While many are blaming the credit rating agencies, the credit raters also will use models and under some set of scenarios, their models will fail.

The solution is not to blame the model of CDOs or that credit raters fail to accurately rate the securities. The solution is to remove credit raters from the regulatory process of overseeing financial institutions. Removal of the credit raters from the regulatory process would have reduced the appetite for these securities by financial institutions. A lower appetite would mean fewer CDOs, fewer loans with poor credit scores, and a reduced investor appetite in general for home mortgages

Thursday, May 13, 2010

2005 Bankruptcy Reform Increased Mortgage Defaults By 200,000 Per Year

The 2005 US bankruptcy reform increased the severity of the financial crisis and caused the number of mortgage defaults to increase by around 200,000 per year.
Abstract: [The] U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged—thus loosening debtors’ budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. We estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage defaults to rise, using a large dataset of individual mortgages. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. We find that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.
From "Did Bankruptcy Reform Cause Mortgage Default to Rise?" May 2010, NBER Working Paper No. w15968, by Wenli Li, Federal Reserve Bank of Philadelphia, Michelle J. White, University of California, San Diego - Department of Economics; National Bureau of Economic Research (NBER) and Ning Zhu, University of California, Davis - Graduate School of Management; Yale School of Management; China Academy of Financial Research (CAFR).

Ungated version is available here.

Wednesday, May 12, 2010

Can't Bad Investments Just Be A Mistake Without Blame?

A comment I posted in response to Arnold Kling's blog, "Cognitive Failure or Moral Failure" on Econlog.
To call it a cognitive failure, doesn't one have to show that prices of trades in a liquid market substantially deviated from fundamental value? An underwriter's CDO price based on models and ratings is a guess at the value of a market based price. In the case of CDOs, the guess was off the mark.

The financial crisis began because CDO collateral value (a type of market price) declined, requiring more collateral to fund overnight borrowing, which created the liquidity and solvency crises at Bear Stearns and Lehman. No cognitive failure here.

As equity market participants recognized that the booked par value of CDOs was higher than the market value, bank stocks such as Citi, tumbled, reflecting the lower value of bank assets, the need for more capital and the potential of insolvency. No cognitive failure here.

Additionally, initial investors in CDOs chose these investments because they promised a higher yield than the equivalently rated US Treasury security. Investors switched from US debt to CDOs because of a promised higher yield. Higher yields mean higher risk and were required by investors to switch to CDOs. If investors truly believed the CDOs were AAA and not more risky than US debt, they would not have wanted a higher yield from CDOs. No cognitive failure here.

I have not seen any analysis that says that the ex ante promised yields of CDOs was not commensurate with the higher expected risk at the time of investment.

Analysis after known losses does not reflect the investment world before the losses. It is easy to recognize a poor investment after it loses money. It is not so easy to recognize one before the losses occur.

No one claiming they saw the coming housing crisis and bubble is claiming they sold their home(s) before the downturn, rented and then bought an equivalent home at a lower price and pocketed the profit.

Investors without cognitive failure make investment mistakes. Why can't all the housing market investment just be a mistake without resorting to all kinds of cognitive, modeling and analytical failings?

Is there really any surprise, that a bureaucratic, rigid regulatory scheme using the rating agencies did not reflect real world events? Doesn't that happen all the time with all regulatory agencies?

The future is always difficult to predict. Do we always need to blame someone or something for our inability to predict tomorrow's events?

Market Circuit Breakers Are Really Censorship

Market prices, price changes and price volatility of publicly traded shares and commodities convey important information about company valuation, relative sector valuation, the economy and geopolitical risks. Circuit breakers prevent trades, hide prices, and decrease apparent price changes and volatility.

Circuit breakers prevent prices from reflecting new information, whether based on speculation, rumor or fact. Algorithm computerized trading, while disparaged by many for the wild up and down US stock market price swings of last Thursday, use public information, such as last trade, relative prices, price changes, trade volume, etc. to determine if stocks should be sold, bought or held.

As computerized trades sold stocks on Thursday, as prices dropped to low levels, other computerized trades bought stocks. Sure, some stocks were sold at very low prices only to see the prices recover to near their old, higher levels very quickly. To the extent that the way trades are allocated among stock markets caused the price swing, that should be fixed to avoid a future occurrence. However, sharp price swings over short time periods in themselves are not a cause for reform or circuit breakers. Short term volatility captures the information uncertainty about risky political events and other risk at the time of the trades.

The European Finance Ministers, frightened by the price drop in global stock indices including the intra-day 1000-point drop on Thursday in the Dow Jones Industrial average, worked over the last weekend through Sunday night before Asian markets opened to put together an enhanced and bigger Greece bailout package to calm Monday morning financial markets.

On Monday in response to the EU's new, larger Greece bailout package, global stock markets surged.

With Greece facing default on its debt, with news coverage of Greeks rioting in the streets, and geopolitical uncertainty about the stability of Greece, other European countries, the EU and the Euro currency, it not not surprising that there was a large volume of shares traded last Thursday. It should also not be shocking that with so much geopolitical risk and uncertainty that there would be sharp price swings in share prices over very short time frames.

With geopolitical risk, there are no press releases as events unfold. Speculation and the merest hint of a rumor could cause trades and price swings. Information, speculation, rumors and political fear travels in microseconds across the globe among traders and investment managers these days. Without a press release or a defining moment, such as a declaration of war, or a military coup, market investigators will be hard pressed to discover any triggering event for the sharp price drop or price swing.

If markets had remained smooth and not reflected the markets' concerns about the first Greece bailout package through Thursday's price volatility and price drops, would the EU's finance ministers' work over the weekend to enhance the Greece bailout and finish before Asian markets opened Monday?

Circuit breakers do not change the underlying events that increase market and political risks. Circuit breakers are just makeup that hides blemishes without fixing the underlying condition. Short-term price volatility measures risks, rumors, speculation and other indicia of geopolitical and economic concerns of the market. Masking trades through circuit breakers, masks volatility and price drops and hides the riskiness of world events.

Political leaders, central banks, and finance ministers need to see markets unnerved. It motivates these government servants to action. Positive market responses, such as Monday's global market surge, visibility rewards and appreciates these government efforts.

Those that sell shares as their prices sharply drop only to see the prices quickly recover may feel they were unfairly treated by their brokers and the stock market. Market regulators and leaders can decide under what conditions these kind of trades can be voided.

Political leaders dealing with geopolitical and global economic risks need to see markets unnerved with increased short-term volatility. It motivates governments to act quickly and appropriately to the crisis. A positive market response through decreased volatility and increased prices acts as a positive indicator and a sign of an adequate response to these officials.

Market circuit breakers are really just government censorship of geopolitical risk and uncertainty expressed through price swings and drops.

Friday, May 7, 2010

Five Forces Reshaping The Global Economy: McKinsey & Co Survey

An ongoing shift in global economic activity from developed to developing economies, accompanied by growth in the number of consumers in emerging markets, are the global developments that executives around the world view as the most important for business and the most positive for their own companies’ profits over the next five years. Executives also identify two other critical positive aspects of globalization: technologies that enable a free flow of information worldwide and, increasingly, global labor markets.
From "Five forces reshaping the global economy: McKinsey Global Survey results" in the May 2010 McKinsey Quarterly.

Tuesday, May 4, 2010

Using A Reproducible Evidenced Based Scientific Method In Economics

My thanks to Greg Mankiw for posting on his blog the following excellent video of a talk by Esther Duflo. She is one of the leading younger economists today. What distinguishes her from many other economists is that her economics is evidenced based, experimentally reproducible and not purely theoretical or model based.

Many other economists make policy recommendations based solely on theory and models. Esther is willing to use reproducible experimental results in real world settings to make her economic policy recommendations.

Congratulations to Esther Duflo for bringing the scientific method to real world economic problems.

Monday, May 3, 2010

The SEC's Dilemma

The SEC is in an unenviable situation. It will dishonor itself by either winning or losing its case against Goldman Sachs.

The SEC initiated civil charges and a Justice Department criminal inquiry against Goldman Sachs for fraud in the mortgage CDO and mortgage trading businesses.

A criminal fraud conviction of Goldman through a trial or through plea agreement will almost certainly put the firm out of business. Firms in the service and financial industries that primarily rely on their credibly credibility and trustworthiness, as in market making, trading, money management and advisory services, cannot retain customer relationships with governments and top international corporations after a criminal conviction. Goldman will die from a criminal conviction as the public accounting firm Arthur Anderson died. Goldman likely will recover from a civil conviction without a criminal conviction, but it is will require luck and hard work from Goldman Sachs, and there is always the possibility Goldman could fail.

If Goldman goes out of business, without doubt given Goldman's international government connections, multinational corporation business and political relationships, there will be a strong backlash against the SEC and the Justice department. Goldman's punishment will be far worse than the crime, especially since the alleged criminality did not lead to subprime lending excesses, the housing bubble or to the recession. Additionally, Goldman's actions are not deliberate and blatant securities fraud.

Furthermore, it is extremely likely that what Goldman did was common practice on Wall St. and the SEC could make the same warning shot through prosecution of another firm or through a warning letter after one of its industry examinations of common practices in the mortgage CDO and trading areas. Moreover, the SEC will have to answer difficult questions as to why it targeted only Goldman.

If Goldman is found not guilty, the SEC's image of an ineffectual and bubbling bungling securities industry regulator will be reinforced.

The SEC must carefully thread a needle to avoid losing stature as a securities industry regulator as the case against Goldman Sachs proceeds. Goldman is fighting for its existence. The SEC needs to be strong, but not too strong, and the harm against Goldman has to be real but not too great to create a backlash against the regulator. The end has to be a win-win for both parties and it is difficult to see and execute endings that allow the double win.

Both a win and a loss can further damage the SEC's reputation, if it is not very careful. The backlash from a win will be much greater than the SEC has anticipated.