Tuesday, June 7, 2016

Paul Krugman. VSP

Leaders should, I think, bring out the best in people: not just appeal to our better selves but get us to find better, more accurate answers and drive better solutions – that’s simply how you make things better.  Of course, as Paul Krugman often notes, Republican talking heads often, if not always, get their analysis wrong.  What I think is interesting and very disturbing is that Hillary Clinton is getting the same bad quality analysis and positions out of her supporters – chief among them is Krugman himself.  Take this quote from a damning column on Bernie Sanders view on financial market reform:

Many analysts concluded years ago that the answers to both questions were no. Predatory lending was largely carried out by smaller, non-Wall Street institutions like Countrywide Financial; the crisis itself was centered not on big banks but on “shadow banks” like Lehman Brothers that weren’t necessarily that big. And the financial reform that President Obama signed in 2010 made a real effort to address these problems. It could and should be made stronger, but pounding the table about big banks misses the point.” – from Krugman’s “Sanders Over the Edge” column dated April 8, 2016

This is pretty naïve and a totally wrong assessment of what happened.  To understand any trade you need to look at the cash flows and see what motivated investors – in this case it’s the proprietary trading desks that purchased the riskiest tranches or parts of Collateralized Debt Obligations of negative amortization, high credit risk mortgages as well as wrote the Credit Default Swaps on other tranches of similar CDOs.  As a large investor, banks really could not easily participate in the bubble in single family homes – and the prop traders who are paid grossly to chase the hottest assets in town must have felt this acutely.  You could invest in a REIT (“Real Estate Investment Trust”) – but REITs were suffering from lower rents because the market had rushed to ownership.  You could invest in new developments – but then you are taking on an additional development risk.  Can’t really buy individual houses, rent them in the interim till later monetization because the logistics are prohibitive and rents had relatively dropped.  So what do you do?

Buy the riskiest or ‘z’ tranches of negative amortization mortgages of low credit borrowers and write CDS’ on the other tranches of similar CDOs.  From Put-Call parity this buys you a levered position in the underlying single family homes!  This is what the big boys were up to and drove the whole stinking mess to its eventual explosive and devastating demise – and for the uninitiated requires some explanation.  Let’s start with a basic negative amortization loan pool: the initial principal of the loan pool was $100 and increased over a first, teaser year to $120 with no monthly payment and a prohibitive early refinancing penalty.  The initial principal was then split into multiple tranches from the highest rated or safest which received the first claims on any cash received to riskier tranches that have lesser claims to finally the riskiest ‘z’ tranche – which is better  known as toxic waste and normally is stuck with the origination desk that put together the CDO.  Funny thing is this time the toxic waste went to the biggest of the big swinging dicks: the prop trading desks who have never been known to be forced to take anything from anyone.  Wonder how Krugman is certain that Countrywide managed to stick this to Lehman?  Alas, anything is believable if you have to throw Bernie under the bus…

This toxic waste was different you see, it got the benefit of the appreciation in the underlying houses from $100 to $120 in the example.  At the end of the year, the house would necessarily need to be refinanced because the rate was simply impossible for a low credit customer to pay – no, no one was stupid enough to think that someone who would struggle with a 6% interest loan would be fine servicing a 20% loan.  When they refinanced the mortgage, the CDO would pay back for each class of investor.  If there was any increase over the $100 up to $120 it would go to the z tranche – making it a call option on the pool of single family homes and achieving the first part of what the prop desks wanted.  See, a call option is the right but not the obligation to buy an asset for a fixed price to the writer of the option so that any appreciation over that fixed price goes to the buyer of the option.  The prepayment penalty was to stop or at least ensure compensation if the abused homeowner had the temerity to early terminate the option on the prop trader.  The issue prop traders did face was that the cost of that option was high because the less risky tranches wanted significant discounts to finance the $100 principal – and any trader knows that a trade simply gets better as you buy lower. 


The solution is to write a put option on the same pool: it helps pay for the premium on the call option while exposing you to reductions in real estate prices – and you will recall that the prop desks were often after buying all the exposure to these houses.  A put option is the right but not the obligation to sell an asset for a fixed price to the writer of the option so that any depreciation under that fixed price is pushed to the seller or writer of the option.  How would you do that?  Well any decrease below $100 when the pool is sold would go to the riskiest tranches in the CDO – so if you guaranteed full principal to each of the tranches then you were effectively paying out for any decrease in the value of the houses in that year.  This is, of course, the same sustaining a loss if the house you purchased decreased in value.

One more detail: options are most valuable (option premium less payoff at the current underlying’s price) when the underlying’s price is exactly the strike.  So what do you know, these sub-prime and alt-A negative amortization loans did away with the need for downpayment so that the principal of the mortgage would be equal to the current price.  Wow!

Krugman’s take on financial market reform is taken as a major endorsement by Hillary of her position – witness her statements on the subject in the debates.  Hopefully, by now you’ve gathered that Krugman’s analysis is quite deficient in a way he so destroys others on – no models, no real analysis, just VSP (“Very Serious Person”) dribble.  The reality is that where Dodd-Frank fails is that it doesn’t seek to change the landscape but rather to put constraints on some behavior by making banks create living wills.  But is that enough?  You see, as Yves Smith of nakedcapitalism.com so often points out, banks have negative economies of scale.  So if Dodd-Frank was even marginally successful, the big banks would have immediately started to dismantle themselves.  (Poor Krugman, what does he know about economies of scale, he only got the Nobel Prize for his groundbreaking work there.)

The need instead is to bring back Glass-Steagall and forcibly break banks up – and then, create “mono-line” insurers for each category that double as sole regulators.  Separate FDICs for commercial banks, investment banks, insurers, hedge funds without the corrupting influence of the Fed.  The Fed’s role has to be in monetary policy – and it should not be in bank regulation.  As Krugman rightly points out, congressional oversight of the Fed must be limited because of the complexities of monetary policy.  But how can a regulator with an intrinsic need to provide bailouts to the rich and powerful not get reasonable oversight?  And bailouts, of course, really are central to banking.  The House of Morgan was literally founded on one: from losses on making the market in the French bonds it underwrote to pay for the Franco-Prussian War; JS Morgan got lucky he got a bailout from the Bank of England and the French paid out in full on the bonds!  And the victims if banks aren’t bailed out are the middle and working classes who suffer in the sharp, deep recessions and even depressions that they cause. 

This version of FDICs would be different, they would be allowed to price differently based on a public risk assessment of the individual participant which must include its size.  The one for commercial banks would backstop any risk that the Fed took on from lending to the banks.  Keeping the Fed out of regulation and insuring that the FDIC stepped in quickly if a risk did materialize and wiping out equity holders.  Punitive insurance rates for the systemically monstrous institutions is necessary because it insures that the FDIC moves quickly.  It also allows for participants to exist with dimensions that a regulator can understand and without the constraints that would impact the liquidity of the market or the quality of prices.

Krugman’s real point, like many of Hillary’s supporters, is that Bernie is too much like Chauncey Gardener, the main character in Being There.  Is he right because he’s smart and wise or is it just dumb luck?  It’s easy to understand that Bernie’s absolutely right on financial market reform, but he’s also right on foreign policy in a way that is very disturbing to them.  On the key issue of the Middle East, Hillary didn’t just make a mistake on one vote, her whole view of the region is wrong headed: Our Saudi allies / Iran is a terrorist state.  This isn’t from the last election cycle when she had the opposite view on much, it was her view then and throughout the debates.  This is just as crazy and incompetent as Cheney.  Bernie on the other hand has been ridiculed by the foreign policy experts for talking about a grand coalition of Muslim countries; that they argue is completely naïve.  Saudis fight alongside Iranians?  How could he ever be President?  But honestly, if the Wahhabi/Salafist Saudis aren’t forced to make peace with the Kafirs in Iran, are you actually even talking about a solution?  Proof: what made the difference in Michigan: Muslims Americans showing up in mass to vote for Bernie!  He caught perhaps the most important nuance in the Middle East quagmire and made it central to his policy proposal.  But is he right for the right reasons?

The same is true of the welfare state.  What keeps capitalism alive is not stodgy established companies, but the new startups that disrupt them.  Simply find better solutions to problems and get closer to customers’ needs.  They are fairy tales where people quit perfectly good jobs on a whim because they inherently believe their idea for how the world ought to function is better.  They fight the law of the jungle: they ensure that the lion doesn’t always win but the deer does; and when they grow bigger and into lions themselves they too should go down to a new deer.  But don’t these people need a safety net from the society that so benefits from their risks?  This is the guts of what Bernie says, and Hillary’s limited safety net – she sneers at his ideas – is just a way to make sure deer aren’t encouraged too much.  The lions, after all, are bankrolling her.  But does he know why he’s right?

Thanks to Keara Killian who read, reviewed and edited this multiple times.