it’s well established that larger firms in all sorts of industries have a lower risk premium than smaller but otherwise similar firms. According to Ibbotsons Valuation Yearbook from 2008, the risk premium for the largest 10% of firms is 34 bps below the CAPM rate, and for second largest 10%of firms is 68 bps above it*. So using a standard valuation handbook, firms in the largest decile should borrow at 102 bps below the rate charged for the second largest group of firms. You hardly need to appeal to a too big to fail premium to explain a 78 bps gap between the rates charged to large banks and small banks.Read Adam Ozimek's interesting blog post on Modeled Behavior, "Who Knew Banks Were Too Big To Fail, And Does It Matter?"
New McKinsey research shows that the challenge of reducing total debt levels relative to GDP is a global problem that is only just getting started. Leverage is still very high in some sectors of several countries, including the United States. History also shows that deleveraging episodes are painful—on average lasting six to seven years—and exert a significant drag on GDP growth in the early stages.From "Deleveraging: Now the hard part: The challenge of managing the enormous debt burden weighing on global recovery is only just beginning" by Susan Lund, Charles Roxburgh, and Tony Wimmer in the January 2010, McKinsey Quarterly. Weblinks to the executive summary and the full report are available in the McKinsey Quarterly article.
In the aftermath of the earthquake in Haiti, many Americans are reaching for their cellphones to make a donation via text message.
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The American Red Cross, which is working with a mobile donations firm called mGive, said Thursday that it had raised more than $5 million this way.
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The mobile donations are part of a larger surge of money flowing to the relief effort. The Red Cross said it had collected nearly $35 million as of Thursday night, surpassing the amounts it received in the same time period after Hurricane Katrina and the Indian Ocean tsunami.
Great article John.
Investing is not rocket science. There are two simple rules. There is no free lunch and do not put all your eggs in one basket.
Sophisticated Investors always had the choice to place funds into US Treasury Securities, which are highly liquid and which have a low risk of default. You do not need to hire an investment manager and pay a high salary to put all your funds into Treasuries.
Pension funds, mutual funds and other sophisticated investors hire investment mangers to take risks to attempt to achieve returns higher than the returns from US Treasuries. The only way to get a higher return is to take risks. Those additional debt risks include extra defaults and more concentration in a single sector (residential mortgages), i.e. less diversification. (Mortgages also have prepayment risk, but that is a different kind of risk and does not result in a loss of principal.)
Sophisticated investors knew they were taking risk because they knew the expected return was higher than a US Treasury or a GNMA of the same maturity. If the return were not higher, they would not have bothered buying the mortgage related securities from Goldman. These investors also know the risk of placing too much money into a single sector (housing), and a single product (non-government insured mortgages). Only the most inexperienced and stupid fund manager thought there was a free lunch. They did not have to read the documentation to know that there was risk.
The credit rating is irrelevant to most sophisticated investors except to the extent some are restricted by law from investing in categories below a certain rating. If the sophisticated investor relied on the credit rating to determine his investments, then the problem was with that organization for not going out and hiring experienced investment managers who understood risk and who knew what questions to ask. The credit rating in the aftermath of this financial crisis is being used as a memo to file to CYA since there has been a lot of Monday morning quarterbacking, but the managers knew what they were doing despite their claims of denial now. The investors are just trying to deflect blame from themselves for their stupidity.
Despite what those who are unfamiliar with the process think, institutional sales people, from Goldman and other firms, are used to tough questions about their products. Buyers know these products are complex. Sophisticated investors usually have to get approvals from a committee or a least a head person to buy. Salespeople and analysts from Goldman and other firms are willing and often do talk to clients to answer any questions. Sensitivity charts are prepared to show what happens under different scenarios, such as if interest rates go up, down, defaults are below, above x, etc. If a selling firm cannot answer a reasonable question, such as how will your product perform if defaults go up by x percent or house prices decline by x percent, there is always a competitor who will be glad to get the business, especially to take it away from Goldman, do the analysis and sell the product to you. Otherwise,, the buyer should and can just walk away from the product and invest in something else. Many products fail to sell because sophisticated investment buyers are not convinced it met their needs, is sufficiently analyzed or understood by the selling firm.
Philip Angelides, chairman of the Financial Crisis Inquiry Commission, doesn’t get it.From "How Lloyd Blankfein’s Brilliant Answers Befuddled The Financial Crisis Commissioners" by John Carney.
...Angelides has a world view that is overly constricted by the ideology of regulators. His intellectual world cannot contain “good products” that result in huge losses for their buyers. Blankfein [CEO and Chairman, Goldman Sachs] tried many times to get the chairman to open his mind. It remained decidedly closed.
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A structured credit product—whether its as simple as a mortgage backed security or a complex CDO—is not necessary flawed if it produces losses. Even enormous losses. Indeed, it might be perfectly well-designed but still deliver the buyers losses.
The point of creating structured financial products is to create exposures to certain risks and opportunities. A mortgage backed security, for instance, might be designed to expose buyers to subprime mortgages. If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it.
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When Goldman was selling the financial products, it wasn’t necessary telling the buyers that these were great investments. It was telling them that they were investments that would give them the exposures they were looking for. If you were bullish on the mortgage market and a skeptic of the Bubble Thesis—a thesis that Goldman had very publicly embraced—then buying mortgage backed securities from Goldman was a way to put that bullishness into action.
Angelides, the former California state treasurer, just has too much of paternalistic world view to understand that it is possible to sell a financial product without believing the buyer’s rationale for buying it.
This really is the heart of the matter. Angelides thinks it is wrong for Goldman to underwrite financial products that create exposures it does not want for itself. As long as Goldman wasn’t lying to clients or over-hyping the financial products—and so far, no one has shown any evidence of this—there’s nothing really wrong with what Goldman was doing. If sophisticated investors want to take on risk, they should be permitted to.
For example, over the entire period from 1967 to 2005, median real household income — that is, money income adjusted for inflation — rose by 31%. For selected periods within that long span, real household incomes rose even less, and those selected periods have often been cited by the intelligentsia to claim that income and living standards have "stagnated." Meanwhile, real per capita income rose by 122% over that same span, from 1967 to 2005. When a more than doubling of income is called "stagnation," that is one of the many feats of verbal virtuosity.From "How Media Misuse Income Data" by Mark Perry on Carpe Diem.
FDIC Board Seeks Comment on Incorporating Employee Compensation Structures Into the Risk Assessment System:
Board Approves Advance Notice of Proposed Rulemaking
FOR IMMEDIATE RELEASE
January 11, 2010
Media Contact:
Andrew Gray (202-898-7192)
Board Approves Advance Notice of Proposed Rulemaking
The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved an Advance Notice of Proposed Rulemaking (ANPR) seeking input on whether certain employee compensation structures pose risks that should be captured in the deposit insurance assessment program.
"A broad consensus of academic studies agrees that poorly designed compensation structures can misalign incentives and induce risk taking. I share those concerns. The recent crisis has shown that compensation practices that encourage excessive risk can create significant losses in the financial system and the deposit insurance fund," FDIC Chairman Sheila Bair said.
The ANPR includes a broad set of questions designed to solicit information on the types of structures that should be encouraged and on whether and how employee compensation should be factored into the risk-based pricing system. The ANPR will go out for public comment for 30 days after publication in the Federal Register.
"I believe this ANPR suggests a good approach by targeting compensation structures, rather than levels of compensation. It contains no features which would limit the amount of compensation paid to employees. And I feel that the supervisory efforts underway can be strengthened by the FDIC's effort to provide incentives for banks to achieve higher standards," Chairman Sheila Bair said.
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the massive rise in uncertainty associated with this policy ferment [health care legislation] is sufficient to impede measured economic performance because it is rational for businesses and individuals to delay investment and hiring decisions until the uncertainty is resolved.From Deja Vu? by Craig Pirrong on Organizations and Markets blog.
When they got a number that was too high above Millikan’s, they thought something must be wrong—and they would look for and find a reason why something might be wrong. When they got a number closer to Millikan’s value they didn’t look so hard. And so they eliminated the numbers that were too far off, and did other things like that.We have seen clear evidence in the released emails that there was scientific intimidation of the scientists who produced results different than the accepted results of global warming due to man-made CO2 emissions.
". Each segment is approximately seven minutes in length.There are more boom and bust cycles in commercial real estate (certainly on a regional level) than residential. Bank CRE lending went bust in the mid to late 1970s (money center banks had severe commercial real estate loan problems then), the late 1980s (Bank of New England among others had tremendous problems) through early 1990s (purported reason for Chase-Chemical Bank merger) and now.The above is a comment I posted to Arnold Kling's post, "Commercial Real Estate Prices: What Inference to Draw?" on EconLog.
Residential housing did not go through the same severe post WWII boom/bust cycle until now. The S&L collapse of the 1980s was due mostly to a mismatch in funding. Using short-term rates to fund long term fixed mortgages and when short-term rates rose, legacy fixed rate mortgages on the S&L books produced losses instead of profits. There was not a similar housing price collapse or excessive residential mortgage defaults that caused the S&L problems.
It would be astounding in this economic downturn if CRE did not show a severe downturn. Commercial real estate developers seem to always overbuild in good times, suffer huge losses in bad economic times and take the banks with them. Their philosophy is if you build it they will come and I will build it if you give me the loan until banks stop lending to them, call in the debt, and they file for bankruptcy or restructure their debt.
CRE difficulties are on a distinct cycle that follows the ups and downs of the economy. The cycle is separate from residential and just happens to overlap this residential housing crisis.
I think the fundamental question is if the economy had not gone into a recession would the housing market have collapsed any way? If it were in a bubble then it did not need a recession to burst and housing would have crashed anyway. Maybe it would collapse later than it did, but it was inevitable.
If the early effects of the recession started and caused the housing collapse (lower productivity, increased unemployment, lower HH income, lower than expected growth in HH income, higher oil prices) then the recession is the prime mover. There may have been feedback and amplification from the concurrent housing collapse, which made the recession worse. In this scenario, the housing bubble is a side issue to the recession causes and is only an issue for why it was not contained and limited in its effect.
We could just be in the unfortunate situation of having two bad economic things occurring at the same time. A housing bubble burst and a recession. In which case, more work needs to be done on the cause of the recession, why it became so severe and on what the Fed missed that allowed the recession to happen. That is a different focus that preventing future bubbles.
There has not been a coherent and clear understanding of why the housing collapse caused such a severe recession (certainly in employment and consumer demand). A homeowner that defaults or walks away from a mortgage, frees up the excess amount of the monthly payment over renting, a lower priced home, or moving in with someone else and consumer demand should not decrease. Even those that foresaw the bubble collapse never expected the economy to collapse as much as it did.
I think we are dealing with two different issues that just happened at the same time. Something akin to a flood and a war, both horrible if they happen at the same time, but neither causes the other. The housing bubble burst and something else caused severe unemployment, a consumer demand collapse and a recession.
Determining Winners and LosersRead the complete post here.
Here’s how our categorization of states works—we classified states as “High Benefit” if the percentage of uninsured is above the national average and as “Low Benefit” if the rate is less than the national average. We then classified states by whether they would be “High Cost”—the top half of the distribution—for each of the financing approaches.
As Exhibit 1 shows, the states most likely to “win” as a result of health care reform are Arkansas, Idaho, Kentucky, North Carolina, Oklahoma, Tennessee, and Utah. All of these states have a relatively high number of uninsured and all are in the bottom half of states in terms of cost under both financing mechanisms. States with a high proportion of uninsured residents also included Arizona, Florida, Nevada, Texas, and Wyoming, but those states are above average in terms of the costs they would bear under each financing option.
Among the states most likely to “lose” are Delaware, Nebraska, and New Hampshire as well as the District of Columbia. Each of these states has a relatively lower-than-average proportion of uninsured residents, and each would fall in the “High Cost” category under either of the financing options. There are four states—Alabama, Indiana, Michigan, and Rhode Island—that while also “Low Benefit” are “Low Cost” as well.
The winner-loser status of the remaining states depends on the financing mechanism used. Under scenarios of taxing higher-income residents, six states (Alaska, California, Colorado, Georgia, New Jersey, and Virginia) would “lose” in terms of cost but would benefit in terms of expanded coverage. Another nine states would be high-cost and low-benefit under either of the financing options. With a tax on high-premium insurance policies, nine states would fare the worst; these states would be both “Low Benefit” and “High Cost” under this scenario.
President Obama told top Democratic House members on Wednesday that he favored a tax on insurance companies offering more-expensive healthcare plans as a means of extending insurance to millions of people who are not covered, according to a person familiar with the meeting.Read "Obama favors 'Cadillac tax' for healthcare" in the Los Angeles Times by Peter Nicholas.
Left out of Andrew Martin's story ["How Visa, Using Card Fees, Dominates a Market"] is the role the FDIC and the House Financial Service Committee played in maintaining the high interchange fees and decreasing competition.Above is the comment I posted on Felix Salmon's Reuters Blog, "The interchange-fee rip-off" about Andrew Martin's New York Times article, "How Visa, Using Card Fees, Dominates a Market" on debit card interchange fees.
In 2005, Wal-Mart filed an application with the FDIC to buy a Utah based Industrial Bank. Wal-Mart stated in its application and press releases that it wanted to own the bank to save on transaction fees from debit cards, credit cards, etc.
Knowing the competitiveness of Wal-Mart, it would use its transaction fee savings to lower prices, which would have put tremendous pressure from competing merchants on banks, Visa and MasterCharge to lower their transaction fees.
Unfortunately, for the consumer, the FDIC, the Democratic controlled House Financial Services Committee and the Independent Community Bankers Association opposed Wal-Mart's application. The FDIC did not approve the application.
The reason fees are high in banking products and services is that our banking regulators and Congress do not want low cost competitors in the banking industry and stop the competition that would lower consumer costs. When voters complain, they pass price fixing legislation, but do nothing to solve the underlying problems.
The tight regulation of the consumer banking industry leaves little opportunity for real price lowering competition. If Congress and the banking regulators allowed the consumer banking market to be competitive, prices would go down and services would improve.
