Thursday, April 29, 2010

A problem with regulators

Regulators have interests, too - interest in looking like they've been acting appropriately. They are just as invested in keeping big problems hidden in the hope that they'll go away, so they look like they're doing their jobs.
The European Central Bank is aggravated at ratings agencies for downgrading Greece, Portugal and Spain in anticipation of a Euro debt contagion crisis (after, as one blogger pointed out, everyone got mad at them for NOT downgrading mortgages in anticipation of a mortgage crisis). Not exactly what the financial reform bill has in mind when it hands over more power to regulators.
More regulation doesn't fundamentally change the fact that regulators and politicians are inherently bad at figuring out what's going on and acting upon it.


The Arizona law is disgracefully immoral and the Slate article is stupid... but this should tell us something about the danger of setting a context-specific precedent. The Supreme Court has this precedent to look at when it's looking at the Arizona law. I've heard a lot of you arguing for context-specific precedent on a lot of issues (largely related to measures targeting better outcomes for historically-oppressed groups - women, minorities, etc), so hopefully this gets you thinking outside your box a little bit.

Tuesday, April 27, 2010

What I want to see out of Financial Reform, v 1.2

The financial reform argument is very strange - it's a hard enough problem to solve for people who actually get the banking system. It's almost impossible for Congresspeople.

That said, I do have a list of things I'd like to see and a list of things that I think will be problematic. You'll notice some trends - I'd much rather see a system where the consequences for bad behavior are strongly negative but not destabilizing (numbers 1 and 3 on the ideas I like, for example), issues are made transparent (number 2, 8 and 9 of what I like), markets are more equal and less prone to manipulation (4, 5, 7, 11, 12, 13 in what I like) and destabilizing regulations are avoided (6 and 10 , and also sort of 5 and 7 on things I like, and 1, 2 and 3 on things I don't). In other words, make sure that people acting in their own interests contribute to a stable system - the definition of decentralized. I dislike a system that requires regulators to be smart (2 and 4 in stuff I don't like) or risks political pressure (12 on things I like, 4 and 5 on things I don't). I'd rather see a degree of corporate efficiency and competition that benefits consumers (1 on things I don't like.).

In other words, this is a thoroughly "conservative" approach to the banking system - not conservative in the political spectrum sense, but conservative in the "let's keep things that we know definitely work, instead of throwing babies out with bathwater". The Democrat vision of centralized and regulated everything is something I definitely don't agree with.

Ideas I like:

1) I think I really like pre-funded bailouts and living wills. Every bank would determine how it would be broken up, in real time, with mandatory and frequent regulatory reviews. Unlike the other "regulation" forms, this is something which the government actually should be decent at. Each bank would have to fund its own pre-funded bailout pot, because otherwise there's an incentive to take extra risk and be bailed out by your competitors, which is even better than getting bailed out by the government. They'd also have to be structured so they don't encourage banks to rely on them  - perhaps banks pay a substantial interest rate on the funds they draw from their pot, and once the fund is used, banks can't book any positive earnings until the pre-funded bailouts are replenished to the levels they should have been at.

2) I love the idea of contingent convertible debt, as proposed by Mankiw, in which banks issue debt that is converted to equity of a regulator deems them insolvent, would be tradeable, and thus provide an excellent leading indicator of bubbles. It won't be perfect, but it will be generally pretty good, and can tip off regulators where to look.

3) I've mentioned an accelerating bailout tax before. I've never seen anyone promote it other than me. More here: Any bailouts paid will have interest rates that accelerate over time - a bank caught up in a storm, but no worse than its peers, would hopefully be able to recover reasonably fast, and so while they'd pay for their bailout, they'd recover. The really irresponsible entities would eventually default on their bailout interest and die, but it would happen with lots of prior warning and after everyone's recovered a bit.

4) I like that flash trading was banned because it was unethical. If flash trading is gone, dark pools aren't nearly as necessary and should probably go, as well.

5) I think the short-sale uptick rule should come back.

6) I think mark-to-market rules need reforming. People don't like the idea that mark-to-market can accelerate a liquidity crunch, but it can. In many cases, market is not representative of actual long term value (esp in a liquidity crunch, because long term value and spot value diverge). Accurate representation of value is good, but mark-to-market isn't necessarily that much better at that than historical.

7) I'd love to see some way of reducing high-frequency trading. High frequency trading has little merit (expounded here:  I've mentioned a "high-turnover tax" before, and I still think it will be a good both in reducing HFT and also making Wall Street as a whole a little less schizophrenic. Again, I haven't heard anybody promoting this. Another idea I have heard elsewhere is to tax cancelled transactions - UHFT are the biggest creator of cancelled trades, by far, and this could deter them.

8) Putting things on exchanges if possible is not the panacea everyone thinks but it is a useful step in cases. It will certainly reduce the opacity of the system somewhat, which is a good thing. It also alleviates, somewhat, the "too interconnected to fail" problem. This is not the case for more specialized derivatives, but for some standard ones, it is a big improvement - you just need to worry about the exchange's viability instead of everyone's individually.

9) Similarly, forcing all contracts to be on-balance sheet would be helpful. This would entail increasing what actually gets counted in capital regulations. In a sense, there is a "shadow banking" system which should be brought into the open.

10) Reduce the role of the ratings agencies in official calculations. The ratings agencies are being demonized by everyone, and probably unfairly - they did a bad job, but according to AK Barnett-Hart's masterful thesis, there doesn't seem to be a statistical link between who pays the agencies and how everyone is rated, implying that outright corruption wasn't an issue. Additionally, there are places where their ratings don't have a great substitute. All that said, relying on two or three (largely young) analysts for the valuation of an entire class of securities is probably not so smart. Ratings should be a piece, but not all, of how these things are regulated.

11) Subsidized and lenient mortgages need to go. Down payments on Federally-subsidized mortgages need to go up. If the government is paying for you, you'd better be responsible.

12) No way this will happen, but a Fed and an SEC that are more independent of the whims of Congress would help avoid the "Phil Gramm/Barney Frank" effect, where stupid congressmen assert that whistleblowers are wrong because they're enjoying the party (Phil Gramm famously proclaimed that the Fed call for higher rates was ridiculous because tech stocks were still undervalued in February 2000 and higher rates would hurt urban teen employment, and Barney Frank argued that for affordable housing, it'd be fine to "roll the dice" a little bit with subprime mortgages at Fannie and Freddie.)

13) I'd like to see corporate board reform tacked onto the bill. It's nominally related in the public eye, even if it's different from a true economic or legal sense. This would entail a lot of what is listed here: and here: The biggest factor is to force the board to think like owners instead of like the CEO's buddies. The CEO should not be allowed to be the board's chairman, the boardmembers should probably not be paid and they certainly should be forced to have large personal positions in the company. Proxy voting (anyone who doesnt vote is voted by the board) should not be legal. Elections should be frequent, with publicity for board challengers, and compensation formulae should be a) public and b) very long-term. If this means paying the CEO after he or she is gone, fine, but the CEO should get paid based on the results of that year's accomplishments over the next few years, instead of just a snapshot-in-time approach. We might consider punishment for litigation (probably excluding patent litigation, which is more benign).

14) Mandatory waiting periods for consumer lending. 7 days to back out, for example, would be extremely useful in reducing rash decisions and would force people to take time to look at documents and understand them.

15) Some sort of mechanism for getting banks to hold onto junior tranches of deals they originate. This is not to loan against, but to incentivize more responsible underwriting. This would have to be done carefully to minimize distortion of deals to create high reward, low probability option value.

16) A close look at annual fees vs mutual fund loads. Reducing annual fees in exchange for increasing back-end loads to mutual funds and hedge funds would prevent "churn" and chasing performance, which have the effect of driving people into strategies just as they begin to overheat, worsening bubbles. A "lockup" period once you enter a fund would be an inferior version of this, but increasing the cost of churn without increasing the cost of funds - as would happen if annual fees were partially replaced with back-end loads - would be particularly useful. I don't know how this would be implemented but I imagine it would not be too difficult. This is a third piece of this list that I haven't heard anyone promoting.

17) More radically, I'd be interested to see what would happen if we re-widened spreads from pennies to nickels, or partially ECN-ed the market, where matching and execution are not continuous but instead execution happens at certain predetermined points (perhaps every minute, or 5 minutes, or something like that) and only matching can happen in the interim. These would help to reduce a lot of the egregious HFT and flash trading practices.
18) Making the market circuit breakers time-dependent. Clearly, a 10% drop in 10 minutes is more serious than a 10% drop in a day - see May 6, 2010.

19) Coordinating the networks so when a primary exchange closes down or a circuit breaker is tripped, the secondary exchanges close, as well. This should apply both to closings due to volatility and also to coordinating market opens and closes, because executions on a secondary exchange before the NYSE opens can often disadvantage retail investors in a way that is not fair.

What I don't want to see:

1) I think "too big to fail" is stupid and potentially harmful, and the idea of capping bank size or splitting big banks will worsen things, not improve them. here's why: and especially this:
more here: <- more about bank size than prop trading
and the followup here:

2) Clearly, there needs to be some look at capital regulations, but tighter capital regulations will be very hard to implement well, because they often have some sort of unexpected negative consequence (Basel II capital regulations reduced the number of banks that took junior equity slices of the products they created because it made them not count in the capital structure, even though the bank having a junior piece made the actual structuring of the products more risk-averse). Reducing the opacity of the system and increasing what actually needs to get counted in capital regulations is not a bad start.

3) A pure transactions tax or a bank tax seems to have perverse effects and could even work to worsen crises. More here: (also linked above) and here: (also linked above)

4) I am very torn on the Consumer Financial Protection Agency, because I see it as a blunt instrument of Congressional political games.

My main concern is that if, for example, Congress decides it wants student loans offered for lower rates, student loans will get offered for lower rates regardless of whether that's a sensible level to offer them at. When they start defaulting badly, the taxpayer ends up paying. It thus becomes a mechanism of shadow redistribution at the whims of whoever is in control of Congress.

I don't believe consumers are quite the "victims" everyone says they are - firstly, people are on some level responsible for their own financial choices, and while I can see getting caught up in the moment with things like credit cards, if we can't hold people responsible for purchasing a house with a degree of intelligence and foresight as to their own ability to pay, then we're functionally arguing for no responsibility for anyone. There's also the issue that the consumers took the banks for a ride this time, not the other way around - banks lent consumers all the money required to buy a house, then consumers couldn't pay it off and left the bank with a depreciating asset. The banks lost the entire value of the house; consumers just lost a credit rating that'll go back to normal in 7 years.

That said, there are places where consumer financial protection is valuable. Credit card companies used to target kids, for example, and charge interest rates bordering on usury.

On the whole, I think I'd rather see that kind of power in a much less centralized, Congress-dependent entity.

5) I don't want to see Congress try and regulate what sort of derivatives can and cannot exist or be held by various different entities. China illegalizes shorts and foreign investing, so they have an asset bubble in stocks. Illegalize certain actors from doing things and at best you'll increase the cost of capital, and at worst you'll create a massive, massive imbalance. This, sadly, seems to be a major part of the Democratic approach. Financial innovation has value, despite uneducated media complaints about "zero-sum transactions". see here: For a quick example, think about an airline and a refinery. Both are highly capital intensive and highly sensitive to price movements of gasoline, but airlines do badly if gasoline goes up and refineries (usually) do better. The downside risk for refineries and airlines (potential bankruptcy) is a lot worse than the upside risk (a little extra profit that'll get competed away quickly enough) is good. Thus, if they engage in a hedge, where refineries pay airlines if gas prices go up and the converse if they go down, they're both better off. You have a zero-sum financial transaction with a substantial economic benefit. Thus, derivatives aren't riskier than not having derivatives, it's just that the types of risk change (from gas risk to counterparty risk) into something much more difficult to measure. If you overestimate how much risk you've reduced, that can cause a crisis because you take on too much risk elsewhere. That doesn't, however, mean that derivatives should go away just cuz they're harder to measure.

More on Financial Regulation

David Brooks gets it right today. Quotes:
"The second big event in Washington this week is the jostling over a financial reform bill. One might have thought that one of the lessons of this episode was that establishments are prone to groupthink, and that it would be smart to decentralize authority in order to head off future bubbles...

But, alas, we are living in the great age of centralization. Some Democrats regard federal commissions with the same sort of awe and wonder that I feel while watching LeBron James and Alex Ovechkin.

The premise of the current financial regulatory reform is that the establishment missed the last bubble and, therefore, more power should be vested in the establishment to foresee and prevent the next one.

If you take this as your premise, the Democratic bill is fine and reasonable. It would force derivative trading out into the open. It would create a structure so the government could break down failing firms in an orderly manner. But the bill doesn’t solve the basic epistemic problem, which is that members of the establishment herd are always the last to know when something unexpected happens."

He mentions something that Mankiw has mentioned before, which is that financial institutions should be forced to issue contingent convertible bonds - in other words, financial firms issue bonds that would be converted to equity when they are deemed to have insufficient capital by a regulator. The important part of this is that traders could buy, sell and short these bonds, and thus you'd have a leading indicator of banking problems.

I LOVE this idea.

I'll add it to the "what I want to see out of banking regulation" list.

Links I thought were awesome: Trains that don't stop, online dating, the budget, medical innovation, financial reform, and work ethic

It has again been a long time since I posted links. I found these very interesting.
The bullet train that never stops at a station. This is one of the coolest concepts I've seen in a long, long time.

The economics of online dating.

Arnold Kling's Long-Term Budgetary solution. Basically, raise the age of eligibility on Social Security to reflect increased lifespan, and voucher Medicare w government provided catastrophic care insurance. Simple and sensible. I go back and forth between fixed dollar medical care vouchers and vouchers for competitive health insurance that cover large variety of different subsets of conditions. On the one hand, people feel the need to use up their vouchers (FSA, anyone?), which would increase spending, and they also have more downside risk for each individual (you're not covered no matter how sick you are beyond your voucher if its not catastrophic care). On the other hand, vouchers don't make you predict what care you'll need. Perhaps there's a decent hybrid of the two.

Medical Innovation has been the single largest factor in reducing cancer mortality - more than an order of magnitude more important than incidence. (As a measurement, the average person - that average includes all the people who won't get cancer - will live 3 months longer from birth as a result of the medical innovation solely between 1996 and 2006).

Arnold Kling on the Financial Reform Bill. He doesn't like it - no exit strategy for subsidized mortgage credit (one of the factors that got us into this mess). No change in the role of ratings agencies, no way to ensure that regulators are able to analyze independently and finally, a consumer financial protection agency to "protect consumers from banks" when the banks were actually the ones who needed to be protected from consumers.
An incredible insight into what determines successful outcomes - in this case, what made Tom Brady go from a backup freshman quarterback to one of the best quarterbacks of all time. It started and ended with a legendary work ethic. There's a much broader point to be made here about inequality of outcome vs inequality of opportunity.

I'd point out that the top tier quarterbacks in the NFL - Brady, Brees and Manning - share this and only this trait - their legendary work ethic. They are some of the least physically gifted quarterbacks in the NFL (If I recall correctly, Brady's 40 entering the draft - 5.2 -was slower than mine from sophomore year in high school, and I am definitely not a professional athlete. Manning's not exactly a blazer, either, and Brees may be the shortest starting quarterback in the NFL.). I'd point out that even Payton Manning - whose "bloodlines", exposure to football from a young age and family connections should have made it unnecessary to work so hard if they mattered that much - has a similar work ethic, which is why he and Brady are the two best, as opposed to the much more naturally talented quarterbacks littering the NFL as failures. Brees is the same way. Chris Simms, on the other hand, has the same bloodlines as Manning, and just as many physical gifts, but hasn't succeeded in nearly the same way.

Compare that to JaMarcus Russell or Michael Vick or Alex Smith or David Carr or any other of a legion of quarterbacks with every measurable under the sun - tall, strong arm, accurate, big/hard to tackle, often fast, etc - but with no work ethic. They litter the side of the proverbial NFL streets.

This isn't limited to football - Larry Bird used to actually show up at the Celtics' gym before the janitor arrived to turn the lights on, so he started shooting in the dark. Ray Allen takes 300 shots per day before the start of practice, and is infamous for needing to correct everything he does wrong in real time - like, at halftime he goes and takes shots from all of the places on the floor he missed shots from until he feels confident he can repeatedly make them. Jordan's work ethic was so legendary it spawned an MVP season from someone else (Barkley) because Barkley saw him at the Olympics and realized he'd never be able to win an MVP unless he started amping up his workouts to Jordan's level. Supposedly, LeBron had the same Barkley experience when at the Olympics watching Kobe.

Contrast this with Michael Beasley or Derrick Coleman or Gerald Green - superlatively talented players with differing levels of success

This leads to two points: a) Denver's decision to trade up for Tebow instead of Clausen makes more sense (McCoy, maybe a different story, but not Clausen), and b) more generally, for those not interested in football or basketball, it's not just about "luck" and "connections". The three best quarterbacks of this generation were the hardest working, and that anecdotally applies to most other fields - it certainly applies to investing, at the very least, and computer programming (read "Outliers"). I've heard a lot of people argue for equality of outcome as a mechanism of measuring fairness because outcome is "largely based on luck and socioeconomic starting point". I call bull. If outcomes are unequal, figure out why, first, and address the underlying cause, not the symptom of outcome inequality.

If you're still skeptical, why have the socioeconomic progression of various minority groups been so different? "Racism" is the common answer, but most Americans cannot tell the difference by sight or name between various different Asian ethnicities, but there is a wide disparity in outcomes there. Cultural factors and historical factors in survival are where it starts to get interesting. (Again, I'd suggest "Outliers").

Monday, April 26, 2010

Learning functional forms: The Crazy/Hot Scale

Annetta passed this along. It could teach much about functional form specification. And it's awesome.

Expats give up citizenship - a leading indicator, along with immigration issues

The fact that this is increasing so sharply should serve as a leading indicator, as should the well-documented issues surrounding foreigners in American colleges going home in larger and larger numbers. I predict that within the next 5 to 10 years, brain drain will become a substantial concern for the well-being of the US. The question is how we respond - I'm sure we'll create a whole slew of complicated tax breaks and incentives and "opportunity credits" to fund people to do higher education in exchange for agreeing to stay here after graduation.... but these things work less effectively for higher income people than they do for low income people, largely, because these things usually have absolute limits on the dollar value taken and absolute dollar amounts are less impactful for higher income people. Higher income people are much more educated, which means that what ultimately probably has to happen to stop brain drain is a partial regression of the tax code while it's still attractive to remain here (if too many higher income people leave, you'll have to reverse the flow instead of stopping it, which means much, much higher regression).
Note that regression, here, implies the reverse of progressivity - as in, less taxing the rich and giving to the poor.
The problem, of course, is that it's going to be hard cutting ANY taxes if budgets stay so high. Spending will need to come down even more in order to make that regression possible.
The alternative is settling for a Europe style future - no growth, slow decline into fiscal problems. Of course, Europe has benefited substantially from the presence and innovation of America without paying for it. Unless China or somewhere else in the developing world all of a sudden becomes a much more innovative engine than they have been, our "Europe" future is a lot less bright than actual Europe's last 40 years have been.
On a related note, the Arizona bill - functionally allowing law enforcement to demand to see papers whenever they want in order to deter illegal immigration - is a) a disgrace to American values and b) I do not see how this is Constitutional, and I hope the high court takes it up.

Wednesday, April 21, 2010

On Unions and Standards-Based Education

A friend said:
Look, teachers' unions are probably even less popular than auto workers' unions in this country. I get that, and it's tough to defend them on some fronts -- except to recall, ohbytheway, that fighting for its members is the sole job of a union. To me, criticizing teachers' unions for demanding cushy contracts is like criticizing a defense lawyer for doing her job even when the suspect isn't provably innocent. (And frankly, folks need to remember that we're talking about teachers -- they don't get cushy contracts, except perhaps in a few districts in wealthy liberal states like NY and CT.) Teachers get kicked around quite a lot; it's an often miserable and thankless job that forces you to put up with dumb administrators, dumb students, AND dumb/angry parents; and when students screw up, it's somehow always their teachers' fault. I don't understand the vitriol against teachers' unions, except that everyone's looking for someone to blame and the blame never goes home.
I also don't understand the teacher-centric focus on education, i.e. the Duncan-Rhee-etc liberal technocracy, that says that teacher performance is the determining factor in educational improvement. I especially don't understand the logic behind the standards-based reform policies. (Note: "standards-based" is a term with very particular meaning in the industry: i.e., the district or state or whatever lays out very specific standards for how the classroom will function and what the teacher will cover. The California system puts out all kinds of these standards, massive PDF docs with standards for the curriculum, social development, discipline, whatever. Most of it is bureaucratic bullshit. I've read them.) If teacher performance is what matters -- and a really great teacher can advance students beyond their "potential" by whatever means -- why the hell does it make sense to implement standards-driven curricula and standardized-testing-to-death measurements? That chops off the top end of the distribution just as much as it (might, maybe, possibly) chop off the lower end! Hamstringing the great teachers -- like my AP Lit teacher, who ignored the curriculum entirely and just taught us well -- by forcing them to adhere to bureaucratically-mandated policies developed by career administrators who haven't spent any time inside a classroom. It's bullshit.
And don't get me started on standardized testing. In NC, which has drunk less of the KoolAid than most states, elementary school students lose a full 24 days a year to standardized testing -- that's almost 14% of their time in class! They get "benchmark tests," which ruin the educational day, once per quarter of each semester (i.e., 8 times a year), and there are 3 tests (reading, math, science/other stuff) per round of benchmarks. That's FOURTEEN FRIGGING PERCENT of their school days dedicated to standardized testing!
And most of all, it isn't clear to me that school policies, or schools as institutions, or even really great teachers, can ever be a one-size-fits-all corrective to every social problem. I've said this a million times in a million different education arguments: schools feed a much bigger social and economic system, and the demands of that system will condition how schools perform and how students are motivated to succeed within them. I think most people have the causal arrow pointing in the wrong direction.
The thing that baffles me the absolute most is this.  How many of us do you think would have chosen this new liberal technocratic way to educate ourselves? Our siblings? Our future children? (lord forbid some of us reproduce...) When I teach my baby sister, I don't hand her a standardized test and reach for what a California bureaucrat thinks she should learn. I tell her to read books and write down her thoughts and learn to love learning. It's not about digesting specific quanta of information, it's about figuring out how to engage with material you don't yet understand. Small-group education, hyper-focusing on reading and writing skills (not comprehension and multiple choice questions!), figuring out what's interesting to the student and using that as a case study to teach bigger things -- that's how you teach effectively. That's how my mother taught me, that's how my good teachers taught me, and that's how I teach whenever I have the opportunity. And I think everyone on this list would say the same damned thing. But why is it different for everyone else? Why do people think that moving forward with a system based on lists of specific tasks and standardized testing is a good idea?
Riddle me that, homies.
BTW, I think TFA and KIP and the charter school movement and others are all tied up in this too. I'm not a huge fan of them either."
My response:
I agree with you more on the standards-based education/teacher-centric education than I do on the union characterization, so I'm going to start with the unions.
So, there's an issue with the union characterization. Yes, a union's job is to fight for its members. The issues are twofold: 1) does it really benefit union members in the long run to turn labor, who should be the backbone of an industry, into the leech that slowly kills the industry? It benefits union leadership, and it benefits older (more influential) workers who won't be around when the check comes due, but it's not obvious that it'll help the rest of the members. Seriously, if you look across the private sector (I exclude the public sector only because they don't have a reasonable comparable, not because they're better - if anything they're worse cuz nobody cares enough to negotiate hard with them), firms that rely heavily on union labor stop innovating and die slowly because they have a) less money to reinvest, b) less incentive to grow because so much of any marginal growth is going to the unions anyway and c) less management attention on things other than negotiating with unions. You think anyone other than the oldest autoworkers are particularly happy their predecessors ran the big 3 into the ground?
2) Should they even have a union? A union is a great thing when a) supply of labor far exceeds demand, b) labor is relatively unskilled and thus workers are fast to train and fast to replace, and c) when safety regulations are a concern. In these conditions, companies can quite easily just cut costs on wages and working conditions, so unions prevent companies from exploiting workers' need for tonight's dinner by ruining their health or safety down the road. When any one of those three situations is not present, unions end up making the whole process very unbalanced for the short-term benefit of the older members of the union and at the expense of the younger members and the rest of the American people. Teaching probably doesn't meet a single one of those characteristics - it's hard to treat a teacher unfairly from a workplace-environment point of view because a school can't just replace teachers easily.
Thus, my issue with teacher's unions is not that they fight for cushy jobs for teachers, it's that they are even allowed to exist. If firms colluded to extract as much as possible from labor, they'd have their faces sued off. Why should labor be allowed to collude, especially when it's harmful to everyone else?
Public sector unions are even worse than private, because largely, a public sector union cares more about winning for their members than the people they're negotiating with care about winning for their superiors. This goes beyond just working wage stuff... these union benefits include things like "we are only allowed to do this particular work, and if you want us to do anything else you have to hire more people".  A friend of mine works for the DoT and says they get nothing done, ever, because every department is jockeying for their own special role. How is that a beneficial thing? Same goes for the treatment of incompetent teachers. It'd be a lot easier to move away from teacher-centric education if it weren't so damn hard to get bad teachers out of the classroom. Why, exactly, should teachers have tenure? I understand why it's useful for academic researchers - you don't want them fired for what they're researching - but while there's a case to be made for academic freedom in the classroom, it's a far weaker reason for tenure when you could just deal with that with some sort of fast-process third-party arbitration. Similarly, why should a union dictate the maximum number of students that can be in a classroom? I'm all for smaller class sizes if it helps you learn, but the fight between the "stand and deliver" guy and his teacher's union because he wanted to take more than the maximum 35 students into his epic calculus class was absolutely ridiculous.
I'm a little torn on standards-based education and teacher-centrism. It's definitely counterproductive for good teachers to teach to tests. It's definitely productive for awful teachers to teach to tests - it's like the test pulls teaching towards an average or slightly below level. I agree - it's probably not good enough.
There's something valid about the idea that it's not just the teacher's fault. Organizational theory tells you that organizations with a plus leader can do amazingly well, but for the organization to be really sustained, it needs to be sustained by a culture and a structure that doesn't require an amazing leader. That probably goes double for something like teaching, which a) probably attracts a less managerial subset of educated people and b) in which you'll definitely have a wide distribution of natural ability for the simple reason that you're hiring so many people.
That means that hiring the right people is critical, training them appropriately is critical, but also that the way in which they teach - the structure, as much as the material -  is critical. I think standards-based education is ultimately meant to reduce the importance of the teacher on the classroom - just not implemented very well.
The strange problem with education is that everything we know about organizational theory says to hire only people who will be happy and motivated and work hard, and then decentralize and let them largely manage themselves. In the absence of that as a possibility, have a central mastermind committee (preferably with the ability to ensure it remains a mastermind by finding good replacements) and have them set very streamlined visions. You can't really do either of those with education because you a) can't just "fire" the bad apples from school and b) it's way too big and diverse to have a streamlined vision.
I'm way out of my element here, but I guess this is how I'd take [your comments and extend them].
I've always been a fan in the workplace of the "10% or 20% of your time is your own" principle, and continue to believe that students should be allowed to study anything they're interested in, at all, as long as they can make some sort of semi-regular presentation about it to educate the rest of the class.
Elementary schoolers should probably not be tested as heavily as they are - maybe a couple days to see where they're at to make improvements (it's hard to know where you stand with no data) but the level of testing in elementary and even middle school is probably out of hand. You also don't want to just hand out degrees to people who aren't capable of thinking in an educated way, so testing for graduation makes more sense.
It's tough. The Fryer paper is really interesting - when you pay kids to do things in their control, they do them, to good results (for example, paying them for attendance, or especially paying them for reading and reporting on books). It'd be interesting to see if you could have "student centered learning", where teachers set the boundaries of what they're allowed to study, they choose something, build it with the help of the teacher, and then present it, with the teacher grading on effort and accuracy and handling the disciplinary stuff. At some point you'd have to start teaching a more structured curriculum - 98% of high schoolers would choose the absolute least effort way to do a math presentation, for example - but at least at the younger ages, it's not a terrible way to get kids engaged with learning.
Then again, my teaching experience is limited to first grade sunday school, and first graders love everything, so perhaps I overstate the ability to get older kids motivated enough to work on anything. Again, I'm out of my element here, just musing.

Fixing Executive Compensation

Executive compensation was under heavy fire a while ago, and came up today in a debate with a friend.
The level of executive compensation has been rising over time. It was argued that this is a leech of society, just as much as unions are (which I'll blog about soon). The issues with executive compensation actually parallel those of unions, a little bit, so I'll reference unions near the end.
The first point to make about executive compensation is the more general, less problematic one: why are they so high, and why are they rising?
Executive compensation is subject to positional externality. Most commonly, this is the "keeping up with the Joneses" effect. If the Jones family buys a Volvo, you need a Mercedes to be the nicest car on the street. When you buy a Mercedes, they need a Maserati to be the nicest car on the street. In order to take the number 1 position, the stakes keep getting higher and higher until it's no longer worth it to compete.
This is also observed in higher education. It used to be the case that well over 60% or 70% of jobs could be gotten right out of high school; now, a much larger percentage require a college degree. Part of this is the "technocratization" of society - everything is more complex, so smarter workers are more important - but part of it is also a positional externality effect. If you and I both apply for a job, and you have an associate's degree and I don't, then you get the job. To top you, I need a bachelor's. To top me, then, you'll need a master's.
This also happens with firms. As firms compete to take the number one spot in a market, they need the best management. In order for me to have the best management, I need to pay the most. Then my competitor has to respond by paying even more to get even better management (or lure mine away!). And I need to respond, etc. until it's no longer worth it to pay more for better executives.
Thus, it should be reasonably apparent that the more competitive the environment, the higher executive pay climbs. The US is generally considered to be the most competitive marketplace in the world, thanks to free market principles, a high level of technology and overall education. To succeed in America is much more difficult than succeeding in most other countries, because there are so many people with talent. This is a good thing, generally, and results in innovation. There's a reason why the much-more-competitive US has outgrown a number of lower GDP per capita countries, flying in the face of every major macroeconomic model that predicts country convergence (you slow down your growth as you get bigger). Setting aside the fact that I think country convergence is a very limited theory that's used in a number of inappropriate contexts, the US' competition level has benefited us all immensely.
Competition has led to a number of things. The higher level of competition means we have the highest executive compensation in the world. We do, in fact, get what we pay for. The US scores highest in the world on the majority of metrics related to management performance. This is especially due to the tails - we have a lot more superior managers, and we have almost no genuinely incompetent CEOs, because their companies die or fire them way too fast. Compared to other countries, this lack of a lower tail has been very advantageous for stability and growth.
The US has also almost certainly been getting more competitive over time as people acquire more skills, which means you should see management performance rising as superior CEOs have to stand out even more and the benefit of having a superior CEO continues to rise. Compensation rises in lockstep. This seems, empirically, to have happened.
Thus, the idea that CEOs in America should be paid exorbitant sums of money is not intrinsically a bad thing. CEO can be a very, very hard job at a large company, both in terms of how difficult it is to succeed at it and also the brutal lifestyle (the hours, the travel, the scrutiny, the legal liability, etc).
CEO is not a particularly secure job - the average CEO tenure is about 8 years. You compete, or you get fired. You're paid by your shareholders to perform, and you rarely have another shot at a top job if you don't succeed. Your pay in your tenure has to last you. This is another reason why compensation ends up high - it's a job with absolutely no security.
This is complicated slightly if it's hard to tell who is a good CEO and who is a bad CEO, and there are asymmetric returns to a good CEO and a bad CEO. If talent isn't obvious but you gain more from a good CEO than you lose from a bad one, you see pay rise as people pay extra for an extra shot at "winning" by finding a good one. This explains a lot of Wall Street pay - a rainmaker can make your firm, and if you're wrong it's not catastrophic. Conversely, if you lose more from a bad talent than you gain from a good one, pay gets deflated. Music or movies come to mind, where it's hard to see who has the necessary charisma to do well, but finding a new star isn't as helpful (you could just hire someone you know is good for 10 million), as flopping is bad (hundreds of millions of dollars lost), then you don't pay very much to people who you're not sure about, which is why there are so many starving artists.
Everything we've talked about until now is highly compatible and perhaps even a prerequisite for a dynamic society - you WANT competition, competition is good, and you want talented people working hard to succeed, because people benefit from that. Even for CEOs who don't have large ownership stakes, talent is good. Alan Mullaly comes to mind - he took over Boeing, turned it around, and it went from serious distress into the largest and most important aircraft manufacturer in the world. He is now doing the same thing for Ford. We all benefit far more from Mullaly's success than we lose by paying him - in employment, in technology, in economic progress, etc. As part of a loosely-defined social contract, everything up until now is a good thing.

(EDIT: I've been thinking about this more. Classical positional externalities are generally considered negative things - keeping up with the Joneses by having both of you spend on things that don't matter is clearly welfare destroying. However, this case is not a typical positional externality, because if high wages widen the pool of potential CEOs and raise the expectations for what they will be able to accomplish, then the positional externality effect can actually be positive, in the same way that having another superior salesman in an organization can make his/her teammates work harder and become a better overall sales staff- a status that is no longer positional. If better people want to become CEOs - actually a concern, because of the long hours, travel, high stress, short job tenure and legal liability of the CEO position - and they work to reach a higher set of expectations, that's a good thing. Especially given that it's almost impossible to preserve rank-ordering with any externally-administered "solutions", and it's a side effect of a very beneficial process - competition - it's on net a good thing.)

However, job security has value, so if you gain job security, it's not a good thing if your pay stays as exorbitantly high. This is where executive compensation has a problem, and also how it compares to unions.
You see, executive compensation is also set by corporate boards. Corporate boards are ostensibly elected by shareholders, but the way corporate boards work right now in the US, executives themselves can serve on boards, executives can influence the salary given to boardmembers, boardmembers don't need to think like owners, and any shareholder who does not vote his or her shares has his or her shares voted by the CEO and the board.
Needless to say, this creates a reciprocity between the CEO and the board that can be very destructive for shareholders. The board can set whatever "targets" it likes to help the CEO get paid. Shareholders largely care about the price of their stock, which means that as long as the stock is doing well, the shareholders won't demand the CEO be gone. Thus, a CEO doing a bad job but who is the beneficiary of a rising stock price can remain in power. Thus, you're adding a job security to being a high-paid CEO that isn't good - it keeps bad CEOs in power, removes accountability and victimizes shareholders who let themselves be lulled by short-term results.
THIS is a destructive situation - a bad CEO should be fired as soon as a better prospect is there to replace them. The effects of competition get delayed by a number of years, which hurts everyone. It's not neverending - a bad CEO will eventually be fired when the company runs into trouble - but it can take a while. Society pays for this delay.
Unions are the same way - good employees should be paid well, and probably have a number of perks. Bad employees, however, should not be protected at the expense of taxpayers, consumers and shareholders.
The union problem tends to be bigger for the simple reason that the CEO's hold on the board is looser than a union's hold on a company or government organization. CEOs will eventually get fired, while union concessions have a tendency to grow until the company starts dying - which, in the case of a government organization, is an almost-never kind of event. So unions swell as a problem over time, while executive compensation is a much more constant problem.
That said, the board-executive reciprocity situation is still a negative one. I've listed a number of factors here:  The biggest factor is to force the board to think like owners instead of like the CEO's buddies. The CEO should not be allowed to be the board's chairman, the boardmembers should probably not be paid and they certainly should be forced to have large personal positions in the company. Proxy voting (anyone who doesnt vote is voted by the board) should not be legal. Elections should be frequent, with publicity for board challengers, and compensation formulae should be a) public and b) very long-term. If this means paying the CEO after he or she is gone, fine, but the CEO should get paid based on the results of that year's accomplishments over the next few years, instead of just a snapshot-in-time approach.
I'll write more about unions later, but for those looking for a primer on the executive compensation debate, this hopefully is helpful.

Tuesday, April 20, 2010

More on Moral Hazard

This is a follow up to this:

Another friend responded:
"I think something is wrong with your use of 'nationalization.' The British nationalization of RBS and Northern Rock was basically to demand controlling equity from the most distressed banks (RBS & NR) in return for bailouts. That's what Krugman is talking about. It most definitely did not crater the British economy depression-style. I'd say more the problem is the government as owner has been too passive and left too much of old management in place."

I responded:

That's what Krugman now claims to have talked about. That is not what Krugman was talking about [though controlling equity is pretty close to nationalization anyway]- I listened to his speeches and read his blog through the entire crisis, as painful as it was to listen to his blathering. [I cite links later in this post] He advocated the government stepping in and taking over Citigroup and BofA, and changing the managements directly.
The British example is a bit different... Europe's banks in general (I believe including Britain) actually were much worse off than the US banks were. Britain didn't have as much of a choice of what to do - for a number of reasons - but it's still a much crappier outcome. Setting aside for a moment the political pressure to be populist rather than intelligent in your lending decisions and bank policy, it dilutes the ownership of existing shareholders, and subjects them to a de facto government management with way less experience and incentives that aren't profit-related. More shareholders flee, driving down the value and requiring more government capital. You'd require way less government capital if you distance yourself from the actual management of the firm and just set the incentives right.

The US substantially did this - they took large common and preferred equity stakes in the heavily bailed-out firms (they still own some ridiculous percentage of Citigroup and GM, for example), just without major management interventions. They didn't walk in and try to reorganize the place themselves because they didn't want everyone who was still employable elsewhere to leave (then the banks would NEVER turn around). They also gave the bank an avenue for buying out the US government when it was able to stand on its own two feet again, which the British mechanism, I believe, is having more trouble with, though you're welcome to correct me. The securities pay a rate way above market - the government is in fact extracting its piece of flesh, as it should be, which is why the government is a) getting paid back at a much higher rate than anyone thought, and b) is actually $10 billion in the black on the bailouts. In fact, it's looking more and more like the only government bailouts that WON'T be profitable in the very end are GM and Chrysler, whose bailouts were more political than actual. AIG is the farthest away but the CEO promises it'll happen, and they're making progress. In sum, the US bailouts have been way smoother than Europe's for the most part, and you'll see them continue to outperform for a lot longer. Again, Geithner's direct interventions have been largely magnificent - how often do you hear me say that about a politician?

Also, I don't know why you say the government has been too passive in punishing managements - almost all the firms the US took into true receivorship had the majority of people leave (remember the AIG bonus debate? The part nobody realizes is that almost every recipient of a bonus had left between the payout of the bonuses and the announcement because they saw the writing on the wall.). The US had significant trouble getting anyone qualified to take over firms they took into receivorship (Fannie, Freddie) because nobody wanted to get paid half the amount to "manage" a company with perverse political incentives and get blamed for running it into the ground. In those cases, the firms threw out the babies with the bathwater in cleaning house, both intentionally and unintentionally. The more responsible companies (Goldman and JPM, etc) don't need their managements changed from the top-down; they were fine from the get-go.

You can't just wipe out GM's upper management because nobody would have any experience and nobody would know exactly what the company had and didn't have. The banks are 10x as complicated as GM. You'd just kill the company. There have actually been some great case studies done that show that the vast majority of successful CEO transfers of power come from within, because so many people from without don't have a great sense of what makes the company tick. There are exceptions, certainly (Alan Mullaly at Ford has been the best thing to happen to Ford in 50 years) but you don't really want a "clean house", more of a shift in thinking.
His response:
Hmm. What I took Krugman's argument to be was that the government should send a warning to the managements of banks by firing the top management when a bailout was required. In other words, punish both management and shareholders to avoid moral hazard. In general, I think the problem with what Geithner's done is that he hasn't done anything to prevent 2008 from recurring in 2018. So it looks good now, but it might end up going bad unless the regulation reform really changes the game.
Re: Britain, the big problem they had wasn't relative strength of the banks, but that Britain doesn't actually have an FDIC. So you could have a 30s-style bank run on retail banks in the UK. Nationalization had to both protect the London financial system and the depositors. [A decent point, I hadn't thought of it.]

It'll be interesting to see what happens with the FDIC-equivalent in Dodd's reform bill because of the risk of a big systemic crash. Would they really have been willing to wind down Citigroup, AIG, etc. in 2008 even if they had the authority?
I responded:
This is a hodgepodge of reactions I had to your email. There's a few parts of it, feel free to skip what you're not interested in.

1) Krugman's temporary nationalization plan, which is also relevant to the British plan.

2) Geithner's progression of steps (rescue to repair)

3) What we should be looking for specifically in the financial reform "next step" to Geithner's plan

4) More on Krugman and moral hazard for managements

5) Balancing dynamism with safety in any sort of financial system overhaul generally.

1) Management punishment was a critical component of Krugman's argument, though it wasn't even close to all of it - his plan was to wipe out functionally everyone - shareholders, management, and a large number of the creditors - if the government had to step in so that the government gets basically all the upside along with the downside. He understands that this means the government functionally takes over the whole system via the crowding-out mechanism from above, and he's fine with it, largely because he underestimates the difficulties associated with the government pushing out all private backing (that's more consensus than provable fact). The level of train wreck would have been incredible. Have you watched Iceland at all? As a quote posted on someone's blog, "Iceland's last wish: to have its ashes scattered all over Europe." Their system was in much worse shape, they didn't have much of a choice, but they're in a boatload of trouble. Their currency has collapsed to the point where McDonald's actually pulled out of the country because they couldn't offer food cheaply enough to be competitive.

2) Geithner's solution wouldn't yet stop a 2018 crisis because his solution isn't done yet - Geithner very rationally went about this with the idea of "fix the problems now, prevent future problems once we're out of the woods - it's not like they can really get themselves into many new messes in this weak a state anyway." That's exactly how moral hazard in this situation should be treated, and China notwithstanding, that's probably a reasonable assessment of the banks' situation for the last year and currently. We all want all the solutions laid out at once, but that probably wouldn't have been good - especially not if it were discussed publicly, because people would still panic - a particular criticism of a progressive "remake the world in one go" mindset. The next step - financial reform - will hopefully correct some of the issues for next time, as long as people can avoid the idea of "punish for past" and focus on "prevent for future" (doing both isn't easy because often the ideas are opposed - for example, with a bank tax). It's hard to know how successful that'll be because there are so many proposals for financial reform floating around that nobody knows what'll end up in it. If they do, I certainly haven't seen it.

3) In case you're interested in how I'll be judging that next step, I think I really like pre-funded bailouts and living wills - i haven't spent a ton of time working through the consequences, they'd have to be structured so they don't encourage banks to rely on them (perhaps once the fund is used, banks can't book any positive earnings until the pre-funded bailouts are replenished?) - and I really do think an accelerating bailout tax would be good, though I've never seen anyone promote it other than me. I like that flash trading was banned because it was unethical, I think the short-sale uptick rule should come back, I think mark-to-market rules need reforming, I'd love to see some way of reducing high-frequency trading. Putting things on exchanges if possible is not the panacea everyone thinks but it is a useful step in cases. I think "too big to fail" is stupid and potentially harmful, and the idea of capping bank size or splitting big banks will worsen things, not improve them. Tighter capital regulations will be very hard to implement well, because they often have some sort of unexpected negative consequence (Basel II capital regulations reduced the number of banks that took junior equity slices of the products they created because it made them not count in the capital structure, even though the bank having a junior piece made the actual structuring of the products more risk-averse). A pure transactions tax or a bank tax seems to have perverse effects and could even work to worsen crises. Oh, and while I'm playing judge and jury via email, this SEC investigation into Goldman looks initially like a very weak and possibly politically-motivated case based on early details, and I'm surprised that they chose this molehill as a basis to attack Goldman instead of the actually unethical drama over how Goldman helped Greece hide its debt.

4) And because I'm not done with Krugman (again, hodgepodge, sorry):

just searching for "nationalization" on krugman's blog yields all of these:

among many, many others - i got sick of copy and pasting.

However, this one stands out:

The banks in fact did earn their way back to adequate capital ratios, which wouldn't have been a given under nationalization.

Punishing management is fine as a threat ex-ante, because it changes behavior for the better. Enforcing a clear threat is reasonable. Implemented after the fact with no warning beforehand, it just drives talent away from the firms that need it most. Not everyone at Citi or Lehman, etc. is an idiot. You'd be cutting off your nose this time for no particularly good reason - it's clear you're going to change these rules for next time anyway.

5) Finally, and most generally, the notion that "another collapse like this" can be avoided is questionable, no matter how you structure regulation. There will always be irrational people making bad decisions (the banks in this case), there will always be a few unethical people trying to make a quick buck (the predatory lenders/mortgage brokers like Countrywide, and a bunch of the "houseflipping" consumers), people will always be overoptimistic about their ability to pay (consumers more generally) and the government will never focus perfectly (both Congress and the Fed over the last decade). This happened in the tech bubble, this happened in the junk bond mania of the 80s, this happened in mergermania in the 60s, this happened with stock trusts and all that in the 20s, it happened with Dutch tulips, it happened in Japan in the 80s, it happened in Spanish real estate concurrently with us, it happened in Dubai, it's happening in China right now... it's hard to have a dynamic economy that isn't prone to some sort of excess.

It raises the question of how far you should be willing to go to avoid this type of collapse. You could bring the US back to the banking system of the early 1800s and never have a bank collapse, but you'd probably end the US as a dynamic economy in the process - both because of reductions in credit availability and risk hedging/risk management, and also because the decline in the money supply to tighten capital controls would implicitly just end up being some absurd asset tax (the government functionally would be issuing a 1 time tax of 75% of assets across the economy - it's not direct, but to print the money that's what would happen).

The availability of credit from post WW1 til 1929 or 1980-something til now has fueled a lot of very real growth that wouldn't have happened in a more regulated, less dynamic regime. It lends itself to collapses like we had now, but that doesn't mean we're better off than we would be if we hadn't had that expansion and partial collapse. The US did a lot of growing and credit spawned a lot of very worthwhile innovation, and when we recover, it will hopefully continue to do so. Even Japan, the worst case scenario (which I don't believe will happen to us because of structural differences in the ratio of consumption : investment - maybe to China moving forward?), I don't think they'd trade their 60s, 70s and 80s growth to take back the last 20 years of stagnation. They still need to fix their economy (and they've done an awful job of it) but avoiding that bubble probably would not have been optimal. Paul knows more about this than I do, I don't know if he's still reading. That's something not enough people pay attention to with financial reform.

You want some sort of cost-benefit analysis - how do we minimize the size and impact of a collapse without sapping the system of its dynamism. There are certainly improvements to be made, but a conservatism (in its most literal sense - conserve the parts that have been working, which is most of it) is useful. Focusing only on minimizing downside isn't necessarily the smartest system, either.
(btw, decent point on the FDIC equivalent. Hadn't realized that was the case. I'm guessing Britain probably implements it, and the US probably increases the cost of FDIC insurance. There are other structural reasons why much of Europe nationalized but my specific knowledge of Britain is far more general than yours, I'm guessing.)

Public Losses and Private Profits? A step-by-step explanation of Moral Hazard

From a friend:
"The Banks on Wall Street came back roaring... with robust profits in the quarter.

The Government did make money on the investments it made in rescuing them.... but of course, nowhere near the amount to compensate for the $$ spent to rescue the economy.

Welcome back to the world of public losses and private profits,  heads I win, tails you lose.  Now that the market is back.... guess who's taking home the profits? 

Not the taxpayer. Moral hazard avoided? Hell no.

This would have been averted if the government took a direct equity stake, dollar for dollar, and recapitalized the banks as necessary  (as Krugman and others were arguing for)"
My response:
a) it's accounting profit, not real profit, because they over-recognized losses in the last couple years so they wouldn't need to take writedown after writedown. On a cash basis they're still way below anything they ever saw before the crisis. See here: . It walks through an example of precisely how it can look like banks are making lots of profits when they're actually still taking massive losses in any sort of economic sense.

b) The $ spent to rescue the economy is not all on the banks - we would have had a recession anyway, the question is how deep, and OPEC is a significant contributor to it as well.
c) Krugman and his supporters are backpedaling off of the nationalization position as fast as possible because as time has passed it has become more and more apparent that it was very, very dumb. It probably would have cratered the US economy, in the great depression sense. Krugman has come out and denied that's what he meant - seriously. Geithner handled TARP extremely adeptly, and nationalization could not have exceeded what happened in its best case scenario. Although there's no way of checking this, I'd bet dollars to donuts nationalization would have been way, way worse. Here's why:
Moral hazard has become the buzzword of the crisis, and thus is being used in every single context of reform right now where perhaps it shouldn't be. Moral hazard, for those of you who don't spend a ton of time on this, is the idea that if you create a safety net, it makes people act less responsibly. The best example is car insurance - if you have car insurance, you drive less carefully than if you didn't because you know someone else is picking up the losses. It's been observed in the driving context, it's been observed in unemployment (you work less hard to find a job while you still have unemployment benefits, with a spike in effort 2-3 weeks before they run out), it's been observed in health insurance (obesity and smoking rates are actually higher among the insured than the uninsured), and, in certain cases, it applies to financial firms. The best case I can think of is Long Term Capital Management in the late 90s.
The problem, however, is that it's never particularly appealing to apply measures to combat moral hazard when the recipient is in the state where he/she needs help. Nobody wants to deny the unemployed guy unemployment benefits, nobody wants to deny the guy with a heart attack health insurance, etc. This is entirely understandable. The better way to apply anti-moral hazard measures is when times are still good - make it clear that they won't be reimbursed if things go sour, and they'll be more careful to ensure things don't go sour.
That's the first problem with the "moral hazard" movement - they're trying to yank the health insurance from the guy just as he begins to need it, so you get the worst of both worlds - the guy lives unhealthily because he thinks he's covered, and then has to pay out of pocket when he really needs the help. It is undoubtedly better to bail out the banks than not bail out the banks, because not bailing out the banks collapses the country. You just don't want them to get into a situation where they need to be bailed out. Thus, applying "anti-moral hazard" mechanisms when they're weak (as they still are) is cutting off your nose to spite your face.
Deniz's response will be (and should be) "what about using them as an example so it doesn't happen next time?!". I'll come back to that in a second, because it's usually true to some extent, but there are some unique factors that apply to banks.
The major difference between a bank and a guy driving a car or eating badly is that banks can sometimes get into situations where they're all riding the same wave. If Bertha gets into a car crash, it tells you almost nothing about whether Ursula will get into a car crash. There are many circumstances, however, where banks all are riding in the same figurative car, so when it crashes, they're all in trouble.
When this is not the case, Deniz is entirely right - Long Term Capital Management was an isolated case, and thus should have died to teach future people a lesson. However, sometimes they really are all in trouble at once. Of course, just because they're all in trouble doesn't mean they're all in equal trouble - some (Citigroup, for example) were more irresponsible, while others (Goldman, for example) were far less irresponsible, which is apparent in their respective conditions.
The other unique feature of a bank is that a bank is entirely worth what people think it's worth. This is a weird concept.
If every person in the world decides Coca-Cola is a crap company and it's going out of business, and they all sell Coca-Cola's stock, it doesn't really matter (as long as Coca-Cola isn't trying to raise money). Coca-Cola will keep selling Coke until everyone realizes "wait a minute, they're not so bad after all", the equity will come back, and Coca-Cola will still exist as a company just as strong and vibrant as before.
However, a bank is a special case - a bank is worth only what its shareholders and creditors think it's worth. If every bank shareholder decides a bank is worth nothing and sell the stock down to 0, then the credit gets downgraded, it needs to come up with a lot of money to fill out its legally-obligated ratio of "cash to loans of each type" etc, and if it can't do that, it dissolves. Bear Stearns failed for this reason - it was weak, and maybe it would have died anyway, but Bear was still profitable when it failed! Usually a company can go for a long time being unprofitable as it borrows against its assets - think of how long GM has sucked and how long it took for GM to finally hit bankruptcy... Bear hadn't even turned unprofitable yet, but because everyone was worried it would, it died. That's the risk of being a bank - you're subject to sentiment as well as reality.
I hope a thought is beginning to crystallize as you're reading this: "If all the banks have the exact same problem, and the first one isn't rescued, then people lose confidence in the rest of the banks, and they all die". And yes, that is exactly the problem.
Hank Paulson, Bush's treasury secretary, would have gone down as the second worst treasury secretary of all time (Andrew Mellon, Great Depression) if he hadn't come up with TARP, for this reason: he let Lehman Brothers fail, making it quite clear that anyone who bothered to buy common equity - basically, normal stocks - would not be protected. I actually know a coalition that had been involved in trying to save Lehman Brothers 4 months before the government stepped in by providing common equity. They were wiped out. You'd better believe that when they were asked to do so again for another bank after Lehman Brothers failed, they declined, and the FDIC had to step in.
Thus, people stopped putting money into the common equity of banks. Then Paulson prematurely seized Fannie and Freddie (they may not have died at all), but to make things worse, not only did he wipe out the common equity, he wiped out the preferred equity - another kind of stock these things sell, making it clear that anyone who bothers to provide capital to banks through preferred equity would lose their shirt. Two weeks later, he wiped out WaMu, and not only cratered the common and preferred equity but half the creditors, too - you couldn't even lend money to a bank in debt form and have any confidence that it would be repaid. The next day, the corporate bond market froze and the stock market lost 25% that month. The seizure of GM and wipeout of the creditors there (which was so drastically unnecessary and favorable to unions at the expense of creditors that I believe it's in court now to see if it was unconstitutional, and it's at least a 50/50 chance that it was) just reinforced that not only the banks will be crushed, but everyone else, too. The entire market seized up. (This, btw, was all before unemployment even started rising, so you can blame a sizable chunk of unemployment on Paulson's attempted enforcement of the moral hazard principle).
Thus, when you enforce moral hazard on one bank, and all the banks are in the same boat, you basically tell people, "don't support the banks cuz you'll lose your shirt if they get into trouble". You ensure that the government then has to step in for EVERY bank, which is way, way more expensive than just bailing out the most irresponsible banks.
As you can see, moral hazard works differently in a collective system than in an individual-by-individual system.

So how do you make sure it doesn't happen again? You need a way of ensuring the banks don't get themselves into trouble without throttling them and making it impossible to provide credit. You also have a situation where regulators can't even begin to figure out how to do that effectively.
 My solution was an "accelerating bailout-outstanding" tax. Basically, anyone is welcome to a bailout if they need it, but the longer it takes them to repay it, the higher the interest rates get (and the faster they rise). Many companies don't need to take a bailout (JP Morgan, Goldman, etc). Many would need one but just because the market cratered, not because they were especially irresponsible, which means that as soon as the market comes back a little bit they can repay it (a large, large number of banks right now). Really, really irresponsible groups won't be able to pay it back early, end up paying colossal interest rates after a few years and die when they can't pay it back. However, presumably, their deaths will have been long since understood by the market, and they'd be dying during stronger conditions, so you don't rock the boat too much by letting them die.
By doing this you avoid the need for regulators and the Congresspeople who control them to actually understand what bubbles are going on (Sen. Phil Gramm argued in like February 2000 that deflating tech stocks was dumb and they were undervalued, not overvalued. Rep. Barney Frank argued in 2006 that it was ok for Fannie and Freddie to take a little extra risk in subprime mortgages because affordable housing was really important and it wouldn't have significant negative consequences anyway.). You also ensure that companies in general work to not become the most irresponsible member of their group, which kind of ensures everyone's in a reasonable bound.

Monday, April 19, 2010

Goldman speaks out

It seems that the SEC releases failed to disclose a number of key facts released by Goldman today, and this certainly makes the case seem more political than substantive. I am assuming Goldman is not releasing any outright lies, because if it did, it would functionally end the firm.
For reference, ACA was the largest of the long-side investors, and IKB was the smaller long-side investor. Paulson was the short-side. This means that ACA and IKB were betting on the securities going up, and Paulson was betting on them going down. ACA is most commonly listed as the allegedly defrauded party. All bolding is mine.
It seems that this complaint is based almost entirely on the way in which Goldman disclosed or referenced Paulson's interest in this transaction as a short on the portfolio in its entirety. From Goldman: "The SEC does not contend that the two professional institutional investors involved did not know what they were buying, or that the securities included in this privately placed transaction were in any way improper. These institutions were very experienced in the CDO market."
more: "ACA had the sole right and responsibility to select the portfolio and it in fact did so. As part of the process, ACA received input from other transaction participants. ACA had served as portfolio selection agent or collateral manager for numerous other transactions, and no doubt was accustomed to an interactive selection process."
also: "IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 [RMBS], which it stood behind as the portfolio selection agent and the largest investor in the transaction. The offering documents for the transaction included every underlying reference mortgage security. The offering documents for each of these RMBS in turn disclosed detailed information concerning the mortgages held by the trust that issued the RMBS. Any investor losses resulted from the massive decline of the broader subprime mortgage market, not because of which particular securities ended up in the reference portfolio or how they were selected." [I wonder about this last piece... is it provable? If so, that exonerates Goldman completely]
ACA "evaluated every security in the reference portfolio using its own proprietary models and methods of analysis. ACA rejected numerous securities suggested by Paulson & Co., including more than half of its initial suggestions, and was paid a fee for its role as portfolio selection agent in analyzing and approving the underlying reference portfolio."
Goldman didn't benefit from the transaction. Goldman's intermediary position left them holding a long piece - shorted by Paulson's fund - which meant Goldman lost $90 million on the transaction on a $15 million fee. Paulson (or perhaps some other unnamed short investor) earned the $90 million.
Goldman also says it never claimed to ACA that Paulson was taking the long side, and that confidentiality rules prohibit them from telling anyone purchasing a security who is on the other side.
Again, I look at this and see the only issue as being that there is a difference between structuring a portfolio of long securities where each has an individual short investor attached and structuring a portfolio of long securities that another party is shorting in its entirety. Given ACA's role in selecting the securities used, it seems like no matter whether Goldman improperly disclosed Paulson's interest as the short on the entire synthetic CDO, this is actually a bit of a mountain out of a molehill kind of case. Should Goldman have been required to tell ACA, who was very experienced in this market, that the synthetic CDO they constructed was being shorted in its entirety by another experienced participant and thus the interactive portion was with one party instead of lots of parties each shorting an individual piece? Maybe Goldman did screw up part of the disclosure and may have to pay for it, but this doesn't look like outright fraud - more like a very, very minor issue that wouldn't have hit the headlines (and perhaps wouldn't have even been prosecuted) if the public didn't hate Goldman Sachs so much.
To quote the Wall Street Journal this morning, "Is that all there is? After 18 months of investigation, the best the government can come up with is an allegation that Goldman misled some of the world's most sophisticated investors about a single 2007 [synthetic CDO]?" (source: Taking it further, after all of the allegations of criminal misdealing, the best they can do against Goldman is a civil complaint?

Friday, April 16, 2010

The greatest sport ever

I usually keep it to policy or economics or something along those lines, but I had to post this: It's worth going to ESPN just for the pictures...

Editors note: This excerpt from "Sports From Hell: My Search For The World's Dumbest Competition," by Rick Reilly, delves into the game of chess boxing.

There is a sport -- chess boxing -- that sounded just so deli-ciously dumb I almost didn't want to know what it really was. I just liked saying it, "Chess boxing."

Questions poured forth:

1. Was it two guys sitting at a card table in the middle of a boxing ring playing chess? And maybe one of them goes, "Check." And the other guy looks at the board, scratches his chin, and then just cold- cocks the guy with a roundhouse right, sending him backwards -- bishops and queens and mouthpiece flying -- and adding, "You sure?"

2. Could a guy cheat in chess boxing? Cornerman: Ref, check his glove! Check his glove! There's a rook in there!

3. Can you think of two things that have less in common? I know! Let's combine scuba and baking? Bowling and colonoscopies?

4. The two do have one thing in common: Participants in both disciplines rarely have sex before a match. Of course, chess players don't have it after, either.

5. Could the ref step in and call it if it's getting out of hand?

Ref: That's it! Fight's over! He just tried to move his knight diagonally! We're finished here!

The truth, though, was nearly as dumb. Chess boxing involves two combatants alternating six rounds of chess (four minutes) and five of boxing (three) until one of them is either checkmated on the board or knocked out in the ring, or time runs out on the chess clock. In that case, whoever is ahead on the cards of the judges is the winner.

Does that make any sense?

Anyway, I set out to meet a real, live chess boxer and see a real, live chess boxing match. We decided the best of the European chess boxing seemed to be in London, where a former Channel 1 BBC reporter named Tim Woolgar was attempting to promote -- and win -- the UK's first sanctioned chess boxing match.

There are things you figure you'll never see in your life as a sportswriter and one of them is a regulation- size boxing ring next to four waterproof chess boards, full of pieces, with fighters alter-nating rapidly between knocking each other's blocks in and knocking each other's queens off. But this is what I came upon at the Islington Boxing Club in north London. Three men were on one side and three on the other, each sweating like B.B. King onto the boards, trying to clear their eyes so they could make their moves and punch their speed chess clocks. Each player had twelve total minutes of time to make his moves in the allotted six rounds of chess. If the player ran out of time, he lost the match. Suddenly, a buzzer would ring and they'd all put back on the one glove they'd taken off, and climb into the ring and start punching each other.

Q: What wears one glove, chases queens, and isn't Michael Jackson?

A: A chess boxer.

Alternate answer: Woolgar, a square- jawed babyface with bangs and rectangular glasses. In the ring, his feet were anvils, but his punches jackhammers. Which was funny, because when he talked about his style, he saw himself as a kind of British Muhammad Ali.

"I like to dance, stay out of reach, and hammer with the jab, like Ali," he said.

And I think I look a lot like Brad Pitt.

As a youth, he was decent -- his record was 1-1. At nineteen, his trainer said he either had to turn pro or quit. So he quit and went to college. "Too bad, though," he rued. "I have a very strong jaw. I used to ride my bike to school and had no basket for my satchel, so I'd carry it in my mouth. I can take quite a punch because of that, you see."

Of course, it's hard to tell if he's lying. He promotes himself as thirty- five in chess boxing when he's actually forty-five. The bastard -- he actually looks thirty.

The chess is far more brutal than boxing, Woolgar says. "Boxing is the sport of gentlemen. In chess, there's no quarter asked nor given. We have a champion, Frank Stolz. He lost his crown to a nineteen-year-old when he blundered his queen. I know Frank would've rather been knocked out cold than do what he did, to lose his queen. It was humiliating for him."

Chess genius Bobby Fischer used to find great pleasure in "the moment when I break a man's ego." It's a truism: Men prefer their nose broken to their pride.

The best boxer of the six was a kid named Sascha (the Flascha) Wandkowsky, an unemployed German student who rides his bike to the gym every day, practices his chess and his English, and scares the bejeebers out of anybody who has to face him in the ring. In his last bout, he disfigured a British guy. "He concede," Sascha says in his spotty English. "He had a little broken bone in his face, I think. Just leettle. But he was bleeding all over the board, so he stop the fight."

Those annoying little broken face bones.

"My chess is good, but I always make mistakes," says Sascha, who is just a beginner in chess.

Me: Well, that figures, because you're probably tired from the boxing.

Sascha: No! I make them in the first round, before the boxing!

So his strategy is to stall on the board and attack on the canvas. He will take as long as he can over each chess move, figuring he will rearrange your cerebellum quite quickly in the ring. Generally, the ref will nudge you if you haven't moved in twenty seconds, DQ you in thirty or forty. If Sascha the Flascha can get a guy in the ring for at least two rounds without doing something really stupid to lose the chess first, he usually wins. "In my second bout, I am almost out of time. I am at 11:50 and he had only use only fifty seconds. I managed to have only ten seconds left when the four minute bell go off. This poor guy he must put on his glove and come back to ring. And then I knock him out, I really knock him out."

But why couldn't a person who never plays chess -- like Mike Tyson -- simply stall for the first round of the chess and then knock his opponent out colder than a flounder in the first ring minute? I put this to the club's best chess player, a five-six brainiac named RajKO (get it?) Vujatovic, one of 200 actual chess masters in all of London.

"Well, he could," RajKO declared. "He would just have to get through the first four minutes of chess without doing something so completely stupid that I was able to mate him before we got into the ring. And that'd be very, very stupid. I think I'd need at least into the third round of chess to defeat a simple beginner, unless he just had no idea how to stall."

And in the ring?

"I'd just have to run," RajKO said.

I wanted to test this theory, but Woolgar's insurance wouldn't allow me to box. So I played RajKO in chess just to see how long I could last. I know as much chess as I do Swahili. I only know how the pieces move. He beat me in about six minutes -- thirty-one moves -- thus proving himself wrong. He could've defeated me in only two chess rounds and he'd need only to survive one round in the ring with me. Although I was an idiot about it. I was taking five seconds between moves, not thirty, so it all went much too quick. But considering that in his sparring sessions, he sometimes threw both fists at once, I think that's all I would've needed.

After the boxing, the six combatants went back to the board and proceeded to sweat all over it. The pawns were nearly drowning. It was a rubber board, but still. I asked Woolgar how often he cleans the boards, which looked like something that should be sent immediately to the Centers for Disease Control. His answer? "Uh, never."

A lot more matches end by rook than hook, and there's a reason for it. It's much easier to topple a king onto the board than a man onto the canvas. It takes some real skill and strength. These guys don't have it. It's mostly a lot of, "Ow! That hurt!" and keeping the distance of a Cessna between each other.

It's hard to explain how awful most chess players box, but this may give you an idea: The two best chess players -- RajKO and a very skinny Chinese guy named Doug -- began sparring. They both employed the seldom-seen double-punch strategy. RajKO was closing his eyes when Doug threw a punch, which never got past RajKO's gloves. He had them both in front of his face and yet Doug wouldn't go for the body. Nor would he extend his arm fully when punching, nor turn his fist into the punch. His salvos had all the power of a man on his deathbed reaching out for one last brownie.

Hanging over the ropes, trying to give them pointers, was the London senior lightweight boxing champ. He'd come up from below just to help out a little. He hollered at RajKO, "Try the jab!"

And -- get this -- they both stopped and looked at him. Just stopped boxing, turned to the guy, and said, "What?" It's the equivalent of a coach yelling at his running back to "Hit the hole!" and the running back suddenly stopping -- ball in hand -- running over to the sideline, and saying, "Say again?"

The real boxer just buried his head in his hands. At one point, Doug got a punch through RajKO's double-fisted closed-eyes wall and bopped him on the nose. The receiver looked surprised and his eyes watered a little. He dropped his hands and rubbed his nose. Doug looked like he'd just shot a bunny. He apologized and then actually reached out and rubbed Raj's nose, too. I thought the boxer from London was going to cry.

Afterward, there was this exchange:

Me: Who would be the greatest chess boxer in history?

RajKO: Pound for pound? You'd have to say [world chess champ Gary] Kasparov.

Me: What?

RajKO: Yes, he trained his body with a boxing trainer and he could beat any normal player, like Lewis or Klitschko, in twenty to twenty-five moves.

Me: He'd get murdered in the ring.

RajKO: And don't forget, he gets a five-minute rest between boxing [while playing chess], so he could run.

Me: He'd get turned into a lot of lumps.

Against this backdrop, Woolgar stood out like Halle Berry at a fat farm. He was devoting his life to this. He was running five miles every day, followed by two hours in the gym and an hour of chess. He was pretty good at both. He'd better be. Two years of work were coming to a head very soon in one scary night.

Quiz: Which strategies are boxing and which are chess?

  • • The LaBlanche Swing
  • • The Frisco Crouch
  • • The Texas Tommy
  • • The Philadelphia Shell
  • • The Spanish Exchange
  • • The Pin and the Fork
  • • The Indian
  • • The Turk

A: The first four are all boxing, the last four all chess.

Also: Somebody needs to make a chess boxing movie in which the bent-nose mafia mook comes into the pre-fight locker room and says to the fighter: "Listen up. Da boss wants you to go down in the fifth."

The terrified chess boxer argues, "No! I can't!" "Yeah, you can," warns the mook. "Let him take yer queen. And no funny bizness, or you'll be movin' pawns witch yer elbows the rest of yer life!"

At last, the big night arrived -- the first chess boxing card in British history. More than 150 people crowded into a place called the Bethnal Green Working Men's Club in East London, which isn't a strip joint but a kind of blue-collar nightclub.

Inside was the largest paying audience for a chess match in the UK since Kramnik vs. Kasparov in London in 2000, even outselling -- yes -- the club's recent Mexican wrestling event.

By dinnertime, Woolgar was as nervous as a quart of coffee. He was not only the promoter, manager, ticket agent, media director, and technical advisor, he was also half the main event in the heavyweight division. He'd sunk a silo of his own money into this. Worse, he was up against a brute with a broad back and long arms named Stewart Telford, who once owned a 5-5 record in amateur heavyweight bouts. Telford worked with juvenile offenders, so you got the feeling he'd be able to hold his own against a very polite, false-aged ex-BBC producer.

It was only a two-fight card. Sascha the Flascha opened against a fireplug Dutchman and didn't disappoint. Sascha took him out in the seventh round -- on the chess board, no less -- although it took the in-house bonehead commentator thirty seconds to realize Sascha had checkmated him. OK, so it's a new sport. We're still trying to iron the wrinkles out.

Eventually, it was time for the main event. Telford came out first in a Tyson-like black cape with two guys in white vests escorting him. He seemed to have hit a few too many donut shops on the way to work over the years, and immediately you could tell that Woolgar, who came out by himself to Guns N' Roses, was more fit.

First round is always chess, so the two gladiators went through the traditional donning of the... headphones? Yes, huge headphones to help them concentrate and avoid hearing advice yelled from the crowd. What was playing in the headphones? "Choral music, with sounds of the ocean," Woolgar said. Funny, I just can't see Mike Tyson listening to ocean sounds minutes before he fights, can you? More theagullth, dammit!

The two felt each other out on the chessboard for the first four minutes -- each safely castling their kings away -- with nothing much coming of it, and soon the bell rang and they removed the board, table, and two chairs from the ring in order to let the punching begin. The inebriated crowd was much louder than anybody would've thought. And perhaps spurred on by it, the two started brawling. All the caution and tiny steps on the chessboard were gone now, replaced by two palookas whaling at each other like Dublin bar patrons. Telford greeted Woolgar's face with a hook very early on, leaving him with a nice mouse above the eye.

"He kept lining me up where the spotlights were blinding, then coming in with lightning-fast hooks to the temple," Woolgar recalled. "He caught me a couple of times and rocked me, but I managed to respond with a perfect right uppercut which landed on his jaw and made him think."

In Round Three, the best thinking on the chess side was done by Woolgar, who took charge of the middle and even captured a piece. It's a very odd thing to hear a lot of lusty Brits roar for a captured pawn.

When the two went back to the ring for Round Four, one could hear Woolgar's corner telling him to "Make him miss! Make him miss!" Woolgar heard and obeyed. "I just stayed slightly out of reach and watched various fists whizzing past my jaw but not connecting," Woolgar remembered. Maybe it was fear, but his leaden feet seemed to be lighter and he was no longer absorbing leather facials.

By Round Five (chess), it was clear Woolgar was the Doberman and Telford the pork chop. He was starting to dominate the sixty- four squares. He looked in command of the whole night. Prepare the crown. But then, in Round Six, a very odd thing happened. Woolgar started listening to the suddenly bloodthirsty crowd.

"F*** him up, Timmy!" somebody hollered.

"Knock his f***ing head off!" another screamed.

You know how rowdy chess boxing crowds can get.

Somehow, Woolgar was flummoxed by it. He remembers thinking, "That's not the sort of thing I want to hear at my fight!"

Although exactly what he was expecting them to yell, he had no idea. "Some sort of sporting soundtrack from an old Basil Rathbone movie perhaps," he says. "You know: 'Jolly good show! Oh I say, what a corker!' " And while he was wondering how his chess boxing event had turned into an NHL game, Telford planted a straight right- hand flush in his kisser. While Woolgar's head was snapping back, Telford added a fierce left hook on his temple for good measure. Woolgar started hugging Telford then like he was Bela Karolyi, hanging on for dear life. Soon as the ref separated them, another right hook came, which Woolgar ducked and followed with a combination to Telford's ribs. The bell rang. It was a great round and nobody could remember anything like it in Fischer vs. Spassky.

The doctor and the ref examined the swelling under Woolgar's eye, but let the bout continue. Which meant he had to go play chess with one eye, one glove, and a spinning brain. Luckily, Telford's mind was also moving at the speed of cold honey tipped over. The two of them made only three moves in four minutes. It was the Stupor Bowl. Perhaps even the ref was woozy, because he did nothing to speed them up. Suddenly, they were back in the ring, and this time Woolgar was on the counselor like freckles on Opie. He pummeled him in the corner, against the ropes, with his back to the lights, everything. The crowd was beside itself as the bell rang.

As they sat down for chess and Round Nine, Telford's brain must've been on sleep mode, because, by expert accounts, he played chess like a poodle on Xanax. "Twice in five moves he was oblivious to the long-range diagonal threat of the Black queen," RajKO wrote breathlessly of the match later. The second time, 2:23 into the round, Woolgar delivered checkmate.

All of which led to a deliriously happy chess boxer named Tim Woolgar accepting his honor as the Great Britain Chess Boxing Organization Heavyweight Champion of the World from Great Britain Chess Boxing Organization director Tim Woolgar. It was a very easy picture to take. One guy. Plus, nobody thought to make up a belt.

Telford admitted later that his strategy was to play chess slow and box fast. "He took some pretty clean, hard shots," Telford admitted. "He wobbled a few times, but didn't give up."

Satchel in the teeth, my friend. Satchel in the teeth.


Overall, I believe chess boxing has a bright future, provided it adopts immediately the following change: The chessboards themselves should have little tiny boxing ropes around it.

And be cleaned at least once a decade, for sure.