September 28, 2008

Investment Gambling's Cliffhanging Hangover

This NYT article on credit-default swaps explains a lot. It shows that much of the collapse was due to this market, which is actually simply an insurance against a given financial firms' default on a loan from another firm. Speculators can actually purchase swaps without even issuing a loan to the firm they are insured against. This of course (like short-selling) creates an interest in market failure. And as the market becomes more volatile and investors predict that a firm will not make good on its loans, purchasing swaps against it becomes more and more expensive.

Just to give you an idea, even with the decline, the volume of swaps on the market is three times the debt total. That explains a lot about Paulson and Bernanke's sense of urgency.


And fascinating on several levels. First, the article and chart above show that the swap market dropped significantly at the start of '08. Why? Could it be that many investors decided to be more conservative, seeing the economy in trouble? Or is it--what I suspect is more likely--that swaps were getting prohibitively high (due to market fragility) to be a good investment? Basically, market saturation of default swaps. Perhaps a bit of both?

It's also culturally interesting to reflect on the general attitude toward gambling in this country. We seem to have an entirely dysfunctional or schizoid attitude about it; damning it as immoral in most places, yet encouraging it at the highest levels of banking.

Short selling and third-party default swaps are perfect examples of this. I also, personally think that bank stock should not be publicly traded. The way it used to be until the mid-twentieth century. Interestingly, Goldman Sachs was the last to cave on this and is still the strongest left standing. Evidently, this is largely the result of its continued conservative behavior. Unlike the other firms it continues to hold majority stake in its own stock.

Morgan Stanley is the only other large firm left standing now, and both have chosen to become more-regulated as bank holding companies, which will have to invest more conservatively as traditional commercial banks must. As the last link above states, Goldman Sachs now has only $1 of capital for every $22 of assets, while Morgan Stanley has $1 for every $30. By contrast, Bank of America’s has less than $11 for every $1 of capital.

That seems like a great start.

As a side note, I'm not sure why Morgan Stanley has remained so strong. It could be that it was not so highly leveraged. It also got itself bailed out late last year with 5 billion from a Chinese firm. And managed high-profile IPOs such as Apple's and Google's--the largest in history.

I wish I knew more about how the government plans to regulate Goldman and Morgan now as holding companies. But from what I can tell, this is all in flux right now, as is the general bailout proposal. Another question is will the other smaller bailed-out banks be able to return to lesser-regulated status when the market rebounds?

At least they won't be able to gamble as much, and the government will retain some amount of equity in return for its investment--at least that's what the democratic congressional majority is requiring. Congress could also ban the bundling and reselling of debt, which in a bull market can create an interest in issuing risky loans. That's what Barney Frank, Chairman of the House Financial Services Committee, has been suggesting.

Here's an excellent recent interview with him on Charlie Rose. He's so witty and down to earth. Clearly a formidable intellect and openly gay to boot. It's nice to have someone of that caliber and flare in the mix. Too bad we don't have a whole lot more like him. He's been called the smartest and funniest member of congress.

September 27, 2008

Obama Clearly Dominated First Debate

I'm amazed that so few pundits are realizing that Obama obviously dominated the first debate. Even liberal blogger Josh Marshall initially called it a draw (now, having slept on it, he's starting to come around). The post-debate polls are entirely in line with what I think, i.e. Obama appealed not only to his base, but to independents quite effectively. And McCain only appealed to his base, by simply harping on taxes, spending, and the surge success in Iraq.

As these kinds of debates usually go, there were very few details given or debated. So it's difficult to determine who won on logical grounds. Still, on content Obama was much more truthful, cogent, and candid. He rightfully took McCain to task for his support of Bush's economic policies and mistakes on the Iraq invasion. McCain however, filled his time with mendacious attacks on Obama's record, and misleading claims on his own.

I was amazed that McCain actually derided the "pork-barrel" spending of millions on studying polar bear DNA, when his running mate Sarah Palin did the exact same thing for seals. And McCain painted himself as a defender of veterans benefits, when the Disabled Veterans of America give Obama a much higher rating. And McCain even boasted about being against torture, when the record shows that he caved on this and actually voted to allow it. Interestingly, Obama chose not to mention this, praising him instead for his condemnation of torture.

And let's not forget that McCain trotted out once more the naked lie that Obama voted to increase income taxes on those earning $42,000. That's simply unforgivable as the record shows it's patently false.

Still, the first rule of television is demeanor, i.e. body language, tone, and charisma. And Obama basically destroyed McCain on that all-important aspect, which is key to winning over the weak supporters and undecideds. Much has been said about McCain's unwillingness to even look at Obama, even when Obama was speaking directly at him, and even after Jim Lehrer implored them to speak directly to each other.

This either shows disdain or fear on the part of McCain. And the picture was reinforced over and over again every time Obama magnanimously spoke directly to McCain, calling him "john" in a genuinely human way. This was a real turn off I'm sure to most everyone watching. It shows either that McCain disrespects Obama or fears him, or both.

My take is it's likely to be the latter. McCain knows Obama is the more gifted, charismatic, intelligent, and youthful speaker and this mortifies him. There's also an animal behaviorist weighing-in on this, calling McCain the low-ranking monkey. This is the level at which much communication happens in televised confrontations, and by this crucial measure, I think it's clear McCain showed he was no match for Obama.

And the striped tie McCain was wearing created a distracting feedback effect radiating rainbows down his chest. That couldn't have helped either. I'm guessing by McCain's impulsive style that his suit and tie were vetted about as thoroughly as his running mate. If you haven't seen Palin's performance in her interview with Katie Couric, this is precious.

In sum, McCain came off as tense, repetitive, inferior, and most of all, unsettling.

Obama came off as warm, steady, eloquent, thoughtful, and most of all, reassuring. And that's about as good an outcome as he could have wished for in this context.

September 25, 2008

Choosing Between Rule of Law and Rule of Men

[A slightly shorter version appeared in the Denver Rocky Mountain News, Oct. 16.]

The current mortgage crisis gives us much to ponder. Many see it as part of the continuing historical debate between free-market vs. regulatory systems. And it certainly is. But there's also one undeniable lesson to be learned here regardless of which side of that debate one happens to be on:

This is not a case of just a few bad apples. The entire U.S. investment banking system is corrupted.

To review, we now know all the major investment banks over-leveraged themselves. They bundled and resold mortgages countless times, gambling that even if borrowers defaulted, repossessed properties would, on average, have accrued in value and could thus be resold at a profit. They issued risky loans, often using sub-prime, i.e., adjustable-rate mortgages for first-time homeowners with little chance of being able to pay off the debt when the interest rates increased.

Banks and brokers aggressively issued and traded these loans, knowing full well the real estate bubble would eventually burst. That's plainly irresponsible and shows a deep lack of ethics across the entire industry. It's a sobering realization that should give us pause about the culture of gamesmanship that has become normal on Wall Street.

We can and should discuss solutions, and I certainly hope the Democratic majority in Congress insists on the U.S. Treasury owning that devalued real estate behind much of the bailout. It represents about 20 million mortgages. If we're going to socialize the cost here, we should at the very least ensure that American taxpayers aren't simply reimbursing the bankers while letting them keep the property.

The AIG plan seems like the right one here, since the U.S. Treasury now owns controlling stake in the bank, and might actually turn a profit on its investment. A similar solution should be put in place for the broader bailout scheme. And if the foreign banks want a piece of the action, they can sell their equity to the U.S. Treasury. Those foundering mortgages were sold and resold at the banks' own risk. So if taxpayers are going to take on this debt themselves, they need to have stake in the real estate itself, lest they be holding nothing but paper if the mortgages deflate any further.

Following Warren Buffett's lead of purchasing bargain-basement preferred stock in faltering banks is a step in the right direction. But that's still no guarantee that the stock won't drop down even more. If Buffett wants to gamble with his own cash holdings, that's his right. But the U.S. government should have something more tangible to show for its investment.

Furthermore, there's no reason why it can't just start with, say, 1/3 of the 700 billion, and see what the market does from there. Others might just follow Buffett's lead and shore up the rest. But McCain's idea of incentivizing banks to buy it all by merely ensuring the loans, is irresponsible since it would set an artificial price for the government to have to repay if values continue to plummet.

To me, what's perhaps most interesting about all this is that the flimsy blank-check solution the White House proposes—and rushed at the last minute before the congressional recess—betrays a deep bias toward oligarchy, i.e., rule of the wealthy few. Conservative New York Times columnist David Brooks uses this very term in his first column this week (George Will makes a similar point). Brooks says the proposal is basically what economist Arnold Kling called "progressive corporatism." A system "in which government acts to create a stable—and often oligarchic—framework for capitalist endeavor."


In this brave new world, citizens no longer control any equity whatsoever. They, and their government, are taxed entirely at the pleasure of corporate dictates.

What kind of thinking makes this scenario plausible and even laudable? It seems to be a belief, prominent among Republicans, in near-absolute executive authority. We see it in President Bush and Vice President Cheney's view of their own executive privilege to flout legislation or even the constitution itself whenever it suits them. We see it in Sarah Palin's notion that she is prepared for the presidency because of her "executive experience." As if being a Mayor or Governor is akin to being a Monarch. To them, the Geneva Convention against torture is nothing but a quaint and naïve rule of etiquette.

They really believe in the naked power of individuals to do whatever they deem necessary to get the job done. And that's because they see the swashbuckling drive of the American Dream as the fuel of capitalism and all that ever gets accomplished. This allows them to trust in that drive, forgetting that its power must often be checked for the greater good.

And that's what the laws of our liberal democracy are for. But as Aristotle warned us over 2000 years ago, oligarchs will always seek to replace the rule of law with the rule of men. It's crucial once again that we not let them.