Tuesday, September 30, 2008

Financial Regulation through Patents

One reason this meltdown has been so bad is because every financial institution has been affected. They all are exposed to instruments linked to mortgages, and all are severely leveraged. I have seen numbers that there are $1 trillion in mortgages tied up in this meltdown, but that there is $62 trillion in paper linked to the performance of those mortgages. Leverage.

Now imagine if only Bear Sterns was exposed. Lehman, Merrill, Goldman, etc. had no exposure. Or only exposure as a counterparty to Bear. Would we be in this mess? No. There would be diversification across the industry.

Convergence of strategy, mimicry of products, and correlation of assets magnify and to some degree create unsound market conditions. One firm develops a hot new product, e.g. Mortgage Backed Securities or Credit Default Swaps. It rakes in great returns and collects huge fees. Everyone else copies that firm, drives down the margins, and over saturates the market. That particular market collapses, and people move on to the next hot new financial product.

Now let's re-imagine that only Bear Sterns had a particular mortgage backed financial product, and further that no one else could sell that product. Get rid of convergence and mimicry and reduce correlation. But how can do this?

Business Method Patents.

Yes, the much laughed at Business Method Patent. So now, when Bear develops its great new financial product tied to mortgages, they patent it so that no one else can copy it. Goodbye convergence. Goodbye correlation.

Three great things come out of this: (1) Other firms have to develop their own products, encouraging competition, (2) The market for this product is effectively capped, and (3) If this product tanks (or the market underlying the product tanks), damage to the macro-economy is limited (because the market has been capped).

As always, the devil is in the details, e.g. defining the product in a narrow enough sense that it doesn't cover all products tied to mortgages but broad enough that it reduces convergence and correlation.

I will try to check with an inside source at the USPTO for his or her thoughts.

Sunday, September 28, 2008

Bailout Mysteries (probably) Solved

As I previously blogged, two looming questions in the Bailout are: (1) how to value the assets the Treasury will purchase and (2) who are the beneficial counterparties to the nominal bailout beneficiaries. 

The Treasury has put forth its answer on the former (greater than market prices) and the answer to latter is apparently Goldman Sachs.  

In a story by Julie Creswell and Ben White in today's NYTimes, it was reported that:
Goldman was A.I.G.'s largest trading partner, according to several people close to A.I.G. who requested anonymity because of confidentiality agreements.

So, under my theory, it is Goldman as opposed to A.I.G. who is being bailed out because without the infusion of Treasury money, A.I.G. would not be able to settle the contracts it had with Goldman, who would then be unable to settle contracts it had with (insert name), and so on....

In other words, systemic risk (this is one of the positions of the Treasury).

Just a reminder that every derivative contract has a winner and a loser, and that a lot of the money the government plans on investing in the losers will be transferred directly to the winners, including, apparently, Goldman Sachs.  

Wednesday, September 24, 2008

All Bailout, All the Time

The best concrete proposals for limitations and conditions yet.

James K. Galbraith and William K. Black at TheNation.com provide 8 points to consider.

Naomi Klein on the Bailout

Naomi Klein (The Shock Doctrine) posted a column at CommonDreams.org that captures a lot of the spirit surrounding the bailout, at least from those who think that Main Street should not bail out Wall Street.

A choice quote reflective of a lot of public sentiment:
This spectacle necessarily raises the question: if the state can intervene to save corporations that took reckless risks in the housing markets, why can't it intervene to prevent millions of Americans from imminent foreclosure? By the same token, if $85bn can be made instantly available to buy the insurance giant AIG, why is single-payer health care - which would protect Americans from the predatory practices of health-care insurance companies - seemingly such an unattainable dream? And if ever more corporations need taxpayer funds to stay afloat, why can't taxpayers make demands in return - like caps on executive pay, and a guarantee against more job losses?

Bailout Evaluations

Rebecca Christie and Jody Shenn reporting on new developments in the mortgage backed securities bailout at Bloomberg.

Essentially, Bernanke and Paulson plan on paying greater than "market" rates (currently at "firesale" prices because there is no private market) for the securities.

From the article:

The government can help restore liquidity to the banking system by buying depreciated assets at "a price close to the hold-to-maturity price,'' rather than the price they would fetch in the market today, Bernanke said. He also warned the economy will contract "if the credit markets are not functioning.''

Seidman [Note-William Seidman worked extensively on the S&L bailout], who also served as Federal Deposit Insurance Corp. chairman, said a 1990s attempt by Japan to halt that nation's banking crisis failed because the government offered prices that would have drained companies' capital.

The Upshot: Valuation will be for above market rates.

Monday, September 22, 2008

Sirota on "Bailout Bill"

David Sirota (channeling Naomi Klein and Tom Frank) raises five questions about the propriety of the Bailout Bill over at InTheseTimes.

He primarily raises the issue of lack of oversight/writing an effectively blank check which is hot on some of my listserves. With action imminent, we will see where everything falls when the dust settles.

For my two cents, the major questions beyond oversight are: (1) how will the paper be valued and (2) who are the counter parties who are the actual beneficiaries?

On this last point, take the example of AIG. Apparently it has large losing positions in a large number of credit default swaps. The government is taking an 80% stake in AIG, thus "bailing it out." But who holds the winning end of these swaps???? To me, it seems that these are the people who are being "bailed out" (along with anyone who has retirement money in AIG) as the alternative would be for AIG to go into bankruptcy and let the counter parties try get their money from the bankruptcy trustee. Instead, AIG gets the money it needs to settle the swaps.

The upshot: Who are the beneficial counter parties???

Friday, September 19, 2008

Mortgage Backed Securities Bailout

David Stout in the NYTimes today, "Paulson Explains Need for Plan to Buy Mortgages"

Paulson reasoning that this needs to be done, and is far more than a rescue of Wall Street, but is needed to protect ordinary people:
“Their retirement savings, their home values, their ability to borrow for college” and their chance to find and keep good jobs depend on it, he said.

The plan seems to be for Fannie and Freddie to purchase toxic Mortgage Backed Securities, and thus create a market where there really isn't one.

This may actually be a brilliant plan for intervention. It helps address one of the underlying problems of the credit market turbulence--large institutions were unable to liquidate their holdings--at all (partly because there is really no way to accurately value the paper). In steps the government (through Fannie and Freddie), and suddenly there is a market for this paper, and the institutions can liquidate their positions--instant liquidity!!! This is great, as credit has tightened, and everyone needs cash to operate.

Where the rubber hits the road is the valuation of these assets. This is also where it will be determined if this is a bail out of irresponsible firms or a measure to protect macro-stability. If the government pays too high a price, it will in effect be providing free insurance to the firms who made the bad bets in first place. This issue is extremely problematic because one of the reasons there is no private market for this paper is there have been few people willing or able to value the paper. So, if no one in the private market has been able to, how will the government undertake this task????

The upshot: It's a great idea for the government to buy this paper, but what is the appropriate discount???

Tuesday, September 16, 2008

McCain's Financial Regulation

As reported in the NYTimes, the McCain campaign has laid out a four point financial regulation plan:
  1. All financial institutions must have a "safety and soundness regulator,"
  2. Greater consumer protection, e.g. easy-to-read mortgages,
  3. Improved corporate governance, e.g. putting executive compensation to a shareholder vote, and
  4. "the last piece is sort of the systems stability issues."
Not much substance, especially on the "systems stability" issue. It would be interesting to see how the specific example in No. 3 would be implemented--what happens if shareholders vote "no" on the compensation package?

No. 1 is primarily aimed at setting up a regulated derivatives clearing house, with the idea that:
You can’t possibly assess the safety and soundness of an institution if you can’t get clarity each day with where they stand in their net positions versus the people they’re trading with.

No word on what accounting method other than mark-to-market would be used to net daily positions, or what the actual role of the "safety and soundness regulator" would be.

Would the bailiwick of the CFTC be enlarged?
Create a new agency? Go DHS and merge the SEC and CFTC under the Fed?

As with all election proposals, everyone wants to see more.

Thursday, September 11, 2008

UPDATE Freddie/Fannie CDS

Follow up article by Ms. van Duyn at the FT.

Wednesday, September 10, 2008

The more things change.....

.....the more they stay the same.

Two stories highlighting this principle.

First, Russian strategic bombers land in Venezuela. Apparently payback for the missile bases in Eastern Europe, Russia comes and plays in the U.S's backyard a la Cuban Missile Crisis.

Second, forget free trade and non-discrimination. The Pentagon has re-opened bidding on the lucrative refueling project which had been awarded to a Northrop Grumman/EADS (Airbus) consortium. The Pentagon has decided to reopen it to Boeing, a U.S. corp. EADS is the European competitor of Boeing in the most profitable export industry in the world. The back and forth in aviation industry trade disputes is legendary (including European claims that U.S. military contracts were disguised subsidies), and looks to continue despite all rhetoric.

Tuesday, September 9, 2008

CDS triggered by US action on Fannie, Freddie

Aline van Duyn at the FT has a piece of reporting on the effect of US intervention at Fannie and Freddie.

Apparently the act of being placed in "conservatorship" is equivalent to bankruptcy, and triggers many of these "insurance" contracts. The International Swaps and Derivatives Association (ISDA) is working on a protocol to address the situation.

This protocol will likely allow adherents to amend the documentation of their contracts, most likely (if past practice rules) to take advantage of some auction pricing mechanism.

Depending on the specific documentation (I haven't seen any) there could also be disputes over whether the "conservatorship" was actually a triggering event. Whether something actually constitutes a triggering event can be a notoriously tricky question.