George Soros bet the farm in 1992. Using more than the entire capital of his Quantum Fund, a hedge-fund named in honor of Werner Heisenberg’s “uncertainty principle” (physics will re-appear in this blog), Soros wagered $10bn that the British pound would be devalued. He was right. According to Niall Ferguson, “Soros reasoned that the rising costs of German reunification would drive up interest rates and hence the Deutschmark.” Aside from netting Soros a tidy sum, his bet forced the pound to be devalued and knocked Britain out of the European Rate Mechanism causing interest rates to decline, and shortly thereafter, took Britain out of recession.

Soros is also famous for his concept of “reflexivity” where perceptions shape reality. Essentially, market participants (you and I) operate with a bias. This bias can influence events and “…create the impression that markets anticipate future developments accurately…” However, the “Efficient Market Hypothesis” (somewhat of a misnomer) notes that markets are unpredictable. This is because at any point in time stock prices “…reflect all information relevant to their value, so that their prices change only on the receipt of new information which by its nature is random…this so-called random walk theory is incompatible with the notion of stock market bubbles, since during bubbles investors react to changes in share prices rather than new information…” (see page 330, of Devil Take the Hindmost, A History of Financial Speculation by Edward Chancellor).

Commenting on reflexivity, The Economist states that “once people come to believe that house prices never fall, they will buy too much property – and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares…,” and we know what follows that.

But why do so many “high caliber” (see previous “Revolutionary Road” blog) financiers and bankers make disastrous goofs from time to time? They forget to ask the “Silly Question” (see prior blog) and rely too much on complex, often flawed, mathematical formulas which can only be understood if you happen to know some physics, differential equations and calculus.

Before we proceed, let’s steep back a bit…

Economic historians trace the origin of modern stock exchanges to1602, the year in which the Dutch East India Company was formed. Voyages to the east were lengthy and hazardous, and the invention of the “joint-stock company” was a means of pooling resources and in a sense, spreading the risk – thereby minimizing the risk any one investor would be exposed to. A stock represents ownership of a company. My risk in the venture is limited to the amount of money I have invested.

According to Niall Ferguson, “ownership of the Company was thus divided into multiple partijen or actien, literally actions (as in ‘a piece of the action’).” This was followed by the creation of a secondary market (the Amsterdam Bourse) in which these “shares” could be bought or sold – the first stock market. Although the Romans engaged in financial transactions in the Forum where money could be exchanged, lent and invested.

In Going Dutch, How England Plundered Holland’s Glory, Lisa Jardine notes that the Amsterdam Bourse (stock exchange) “…was a place to charter ships, to insure their cargos, to obtain credit, to make payments, to rent warehouse space and to hire labourers for loading and unloading vessels…The Bourse was also where information of all kinds, from all around the globe, was exchanged and discussed, and turned into knowledge of prices, markets and trading opportunities.”

It is at this point that assessing risk is still rather simple. If I know that only one voyage out of ten succeeds, I have a 90% chance of losing my investment. But what happens as what I invest in becomes further removed from any actual underlying asset or business venture? What is the underlying asset behind a “liquidity put” or a “LIBOR-cubed swap?” From what assets do these financial instruments derive their value?

Like the game of craps where I can place many types of bets on what is essentially one throw of the dice, stock markets began to invent different ways of investing in one venture to appeal to people’s appetites for speculation. This was accomplished through the creation of the derivative, which was born out of speculation. Edward Chancellor observes that “…the Exchange became a crucible for speculative activities. Futures contract – agreements to deliver or take delivery of a commodity at a fixed price some date in the future – were common.” A futures contract is an example of a derivative. Something that “derives” its value from some underlying asset, such as a stock certificate, a commodity such as corn or even real estate.

But how should the price of a derivative be determined? Skipping the next 370 years, in 1973 Fischer Black and Myron Scholes worked out how to use share prices to calculate the value of derivatives in what is now known as Black-Scholes. Their calculations use partial differential equations and Brownian motion (like the theory of entanglement, physics pops up again) and can be seen here.  According to The Economist (In Plato’s Cave, January 24, 2009), ” it is as if you had a formula for working out the price of a fruit salad from the prices of the apples and oranges that went into it…Confidence in pricing gave buyers and sellers the courage to pile into derivatives.”

Myron Scholes went on to work with Robert Merton at Long Term Capital Management (LTCM) in the hopes of turning Black-Scholes into a cash register. In 1998, one year after Scholes and Merton received the Nobel Prize in economics for their work in the development of the derivatives market, Russia defaulted on its debt and the markets bolted for safety, wrecking LTCM. The Federal Reserve Bank arranged a $3.6bn bailout and investors saw their holdings plummet from $4.9bn to $0.4bn. According to Chancellor, Alan Greenspan told Congress only a few weeks before the bailout that hedge funds were “strongly regulated by those who lend the money.”

And here is the flaw in the model – LTCM’s models calculated that the loss it suffered was so unlikely it should never happen. “But that was because the models were working with just five years’ worth of data. If the models had gone back even eleven years, they would have captured the1987 stock market crash. If they had gone back eighty years they would have captured the last great Russian default, after the 1917 Revolution” notes Niall Ferguson.

So this is where we find ourselves. From The Economist again, “…the idea behind modeling got garbled when pools of mortgages were bundled up into collateralised-debt obligations (CDOs)…a typical CDO might receive income from several hundred sources…” making it “…impossible to model in anything but the most rudimentary way…neither could the models take account of falling mortgage-underwriting standards.”

Edward Chancellor, writing in 1999, observes that “financial risks that were formerly well understood have become arcane…new derivatives serve no other purpose than to facilitate speculation – in particular, enabling fund managers to circumvent prudential restrictions on their investments…the former head of the New York Federal Reserve Bank…warned that ‘the increasing complexity of the financial markets could override the ability of the most sophisticated efforts to monitor and manage risk’…the Federal Reserve, however, saw things differently and headed off moves to regulate the over-the-counter derivatives market.”

George Soros addressed “…the desirability of regulation to the House Committee on Banking in April 1994, but the Republicans’ capture of Congress later in the year – assisted by generous campaign contributions from other hedge fund managers – killed off any further moves to regulate hedge funds. Alan Greenspan of the Federal Reserve also lobbied against hedge fund regulation on the grounds that it would only send the hedge funds offshore (where most were already registered in order to avoid the scrutiny of financial regulators).”

 Thinking Around the Bend (Rather Than Outside the Box)  To followup on the physics theme, Soros’ notion of reflexivity is somewhat related to Schrödinger’s cat, a thought experiment involving quantum mechanics and Heisenberg’s “uncertainty principle.” The uncertainty principle basically states that you can never accurately know both a sub-atomic particle’s speed and position (“pairs of conjugate variables”) at the same instant in time. The more accurately you know the position of a particle, the less accurately you can know its momentum. This has something to do with the wave nature of particles, but I didn’t pass my university quantum mechanics class and can’t help you out…Getting back to the cat, to try and explain some of quantum mechanics’ absurd implications, Schrödinger imagined a cat in a box that was both alive and dead at the same time until you opened the box and observed which state the cat was in (by the way, I love cats – we have two of them). The cat has no reality unless it is observed. This prompted Einstein’s famous quote “God does not play dice.” But investors do, and it is not through observations but through their perceptions that investors affect market outcomes – which is reflexivity.

Bankers receiving taxpayer money are complaining that they can’t make do on meager salaries of $500,000 per year. How will they be able to retain talented staff? An article in today’s Sacramento Bee notes that “dozens of California Senate employees have their pay padded by a combined total of several hundred thousand dollars a year through a little-known method not disclosed publicly as salaries.” Although not quite up to banking standards, a spokesperson is quoted as saying “these discretionary funds are used to retain high-caliber staff, who can earn significantly more in the private sector.” 

Well, they’ve all done such a fine job, haven’t they. I mean, the highly paid “talented” bankers and our “high-caliber” legislative staff have been the best that money can buy. Isn’t it time that this fallacy is debunked? What about paying a fair salary to someone who desires to do a good job in and of itself, regardless of pay? There are people in the world who are talented and take pride in the quality of their work. I don’t put in less effort on the job merely because I am paid less than someone else. What would that say about my self esteem if I did? That I can only feel good about myself if I am paid lots of money?

The country needs a good revolution every two-hundred years or so. It is time to test the myth that you can’t get “high-caliber” staff without paying obscene salaries (we’ll test the myth of “too big to fail” in a subsequent blog). Perhaps it is time for another revolution…

Last December, Now On PBS  ran an intriging piece on the role the credit rating agencies played in the housing bubble. The industry has been attacked lately over the poor quality of its ratings of collateralized debt obligations (more on these later). The way forward is not clear.

In a forthcoming white paper, Matthew Richardson and Lawrence White argue that “…financial regulation may itself be the root cause of the problem since the basis of the NRSRO’s authority as the central source of information about the creditworthiness of bonds decreases competition and incentives to innovation.” An NRSRO is a “nationally recognized statistical rating organization.” The SEC (they will appear quite frequently in these blogs I suspect) designates which organizations can be NRSROs. The top three rating agencies are: Moody’s Investor Service, Standard & Poor’s and Fitch Ratings.

Richardson and White note in The Rating Agencies: Is Regulation the Answer? that “by creating a category…of rating agency that had to be headed, and then subsequently maintaining a barrier to entry into the category, the Securities and Exchange Commission (SEC) further enhanced the importance of the three major rating agencies.”

Banks are supposed to be adequately capitalized (well…who knew). One job of the regulators is to review these capital ratios. It has turned out that the Office of Thrift Supervision (a government regulator) allowed IndyMac Bank to back date capital infusions which enabled the bank to show itself in a better position than we now know it was.

Next up – a comment on the bond rating agencies.

Source: “Office let Indy Mac backdate capital,” Financial Times. www.ft.com

Always a favorite, the Economist has just issued its annual currency comparison.

There’s a section (382) in the Internal Revenue Code that limits the amount of loss a corporation can take when it acquires another corporation that has so many losses it can’t use them (net operating loss carryovers). The purpose of this section is to limit trafficking in what are called “loss corporations.” Last fall, the IRS issued Notice 2008-83 which states that banks will not be subject to the Section 382 loss limitation rules.

The purpose of the notice was to facilitate Wells Fargo’s acquisition of Wachovia. The Notice apparently allows Wells Fargo to apply the Wachovia losses to Wells Fargo’s prior year tax returns and claim refunds. Since California follows federal law, the state has already indicated that it will lose perhaps $2bn in tax revenues as a result of this notice.

Some commentators have suggested that the Treasury Department exceeded its authority by issuing the Notice, since the Treasury’s role is to administer tax law rather than change it. However, it has been pointed out that at the time Wachovia was about to tank (that’s a technical accounting term) it was holding billions of dollars in customers’ payroll funds. Had Wachovia failed, many people would have missed their payroll.

Source: “The IRS Bailout of the Bailout,” Thomas Wechter and Colleen Feeney Romero. “Notice 2008-83: The Ripples Keep Spreading,” George White. www.cpa2biz.com

In his book The Ascent of Money ( also a PBS show ), Niall Ferguson reports that mortgages used to be short term affairs, for perhaps three to five years. The principal on the loan was not paid until the end of the term as opposed to now where each payment you make is part interest and part principal. During the Great Depression, foreclosures spiked and the housing industry was devastated.

As part of the New Deal, the Home Owners’ Loan Corporation refinanced mortgages for periods up to fifteen years to keep people in their homes. Next, the Federal Housing Administration was created in 1934 to provide federally backed insurance for mortgage lenders. Four years later, the Federal National Mortgage Association (Fannie Mae) was formed to purchase and securitize mortgages in order to provide additional funds to lenders and home buyers.

Ferguson notes that “by radically increasing the opportunity for Americans to own their own homes, the Roosevelt administration pioneered the idea of a property-owning democracy. It proved to be the perfect antidote to the red revolution.” You’ll recall that it was the Bolshevik Revolution in 1917 that lead to the creation of the Soviet Union in 1922.

Thus, as Ferguson states, “from the 1930s onwards, then, the US government was effectively underwriting the mortgage market, encouraging lenders and borrowers to get together. That was what caused property ownership – and mortgage debt – to soar after the Second World War…”

The process of securitization basically works like this – a bank lends you money to buy your home. The bank then puts your loan, along with a lot of others, into a package which it sells to investors. This provides the bank with more money that it can lend out, starting the whole process all over again. The residential mortgage market is now approximately $10 trillion, half of which has been securitized.

In another of the same series of white papers previously mentioned (What to Do About the Government Sponsored Enterprises?) the authors note that “the structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking.”

Fannie Mae is one such government sponsored enterprise. The white paper authors argue that the current GSE model is flawed, because it introduces systemic risk into the system. The question that is raised (“what is the appropriate reform to be followed?”) is indeed a poser.

Any member of the American Institute of Certified Public Accountants who performs an audit must be peer reviewed. Cutting through the technical jargon, this means another CPA comes in and looks at your work product and passes judgement about whether you are doing your job properly.

Brokerage companies usually must be audited by firms that are registered under the Public Company Accounting Oversight Board (PCAOB) which was created under the Sarbanes-Oxley Act to help prevent fraud (how’s all that working out?). The SEC exempted companies like Madoff Securities from this audit requirement, which means that the firm auditing Bernie Madoff did not have to be registered with PCAOB or be peer reviewed. What we have here is a phenomenal failure of regulatory oversight.

Remember that Bernie Madoff was chairman of the NASDAQ Stock Market for a period of time.

Source: AICPA Issues Briefing