Thursday, February 19, 2009

The Spiral: The Director's Cut

the end'tis the end for Going Private and, though those with the taste for more of my musings can find them heretofore on finem respice (it is still in beta, be gentle to it), I thought it fitting to give you all the end of The Spiral as a little parting gift.  YouTube seems so, pedestrian, however, so, instead, attached below is the full, Directors Cut of "The Spiral" including the brand-new final chapter.  Caution: It is not for the faint of bandwidth.  The Spiral was, without a doubt, the number one generator of email commentary and I'm pleased to tie off this particular "loose end" in the last entry of Going Private.  The series also generated a number of reader questions, answers to most of which I typed up some time ago in a piece I planned to post with the finale.   You will find it below.  Hopefully, it has been worth the wait.

Q. What inspired the connection between Hitler and the credit crunch?

A. Actually, it was less about the personage of Hitler, or Himmler and the like and more about the tone of those times.  There is this latent, and eventually very blatant, desperation and despair in Oliver Hirschbiegel's original 2004 film "Der Untergang."  This group of supposedly brilliant and rational people, stuck in the Führerbunker, awake for 18-20 hours a day, constantly at odds with this unbridled enthusiasm, unwavering loyalty, indeed the cult of personality that surrounded National Socialism.  I think insomuch as Der Untergang is about the painful conflict between rationalism and this charisma driven mysticism, it is a perfect analogy for the credit crisis.  You have this unwavering belief that modern portfolio theory and Gaussian distributions, are realistic models of the world all the time.  That asset prices can only go up.  Forever.  And there is this huge confirmation bias built into the system.  I mean, when you have people repeatedly ignoring five, six and seven sigma events, instead frantically pointing to a model based on efficient markets theory, what's the difference between that and the National Socialist wonk who insists, "Aber, das ist ein Führerbefehl!" ("But that is an order from the Führer!")?  Interesting, that there was actually a word in German for an order from the Führer. Today we might call it a "normal distribution."

But it was always the people, not the models that were at fault.  I listened to these CDO managers just insisting that their structure couldn't possibly fail, all evidence to the contrary, and I couldn't help but think of Hitler's absolute conviction that Army Group Steiner, SS Obergruppenführer Felix Steiner's almost entirely fictional force, would attack the encircling Russians and "make military history."  That, on top of the fanatical, myopic loyalty of his senior officers.  You get these situations where the likes of Generalfeldmarschall von Rundstedt, tasked with telling Hitler the Eastern Front was about to fold for want of gasoline, comes out of that meeting eight and a half minutes later convinced that they will win a decisive victory.  If that's not a rather direct parallel to some of these senior managers in finance over the last 18 months, I don't know what is.

Q. Don't you feel some twinge of remorse at casting Dick Fuld as Hitler?

A. Well, two things.  First, "the firm" in the clips is not necessarily Lehman, or Bear Stearns, or any other bank in particular, though I do poke fun at some of the institutions that loom large in finance, Harvard, Goldman, The Treasury, Cain.  Second, I think it is easy to see the image of a banker you are looking for in the characters because, for good or for ill, they all act like bankers to some extent.  Really, the characters fit alarmingly well.  I think that's why it works.

Q. I take it you've gotten a lot of reader mail since posting the series?

A. People seem to overestimate the amount of mail I get quite a lot.  What I have noticed is that there is this class of financial Schadenfreunde who not only are eager to delight in the woes of others, but who are inclined to exaggerate (or even create) the Schaden themselves.  I have gotten a couple of emails from people enthusiastically convinced that I am a left-leaning anti-capitalist because all they have seen of my blog is the videos, and they write in the erronious belief that they have found a kindred spirit.  Of course, it is quite a shock to them when I refuse to agree with them that were are in, for instance, the down-cycle of the latest 50 year Kondratieff-wave, or that Kondratieff-waves or any other 20-50 year cycle indicator is worth the paper it's printed on.  The reaction can be quite violent.  An email exchange that started off with "love the blog, genius stuff, hey, what do you think of K-waves" turns quickly into "you fucking poser snob" when I won't join the "it's all coming down on our heads because of the reverse rainbow formation in my chart" crowd.  Ironically, these are people who are replacing one dogma, modern portfolio theory, with another less academically grounded worldview- macro-technical analysis.  Ugh.

Q. Where did you get the idea to subtitle "Der Untergang?"

A. Of course, I wasn't the first person to re-subtitle "Der Untergang."  Not by a long shot.  So it leaves something to be desired as an "original work."  Lots of readers seem to enjoy pointing this out.  What can I say?  I stand on the shoulders of giants.

Q. So you don't think the sky is falling?  Isn't "The Spiral" about how bankers blew it for the rest of us?

A. I think capitalism eventually punishes the consistently reckless.  I think capitalism eventually punishes those possessed of fatal doses of hubris.  With respect to both of these, I include central planners dedicated to e.g., the "American Dream of Home Ownership"- and these are far more sinister as they ply their myopia from the moral high ground.  At least capitalists don't try to tell you the urine on your head is rain.  All of these fantasies, from Gaussian distributions to price controls and "fairness," are excuses to be consistently reckless.  Any time you hear someone telling you "this time it's different" run, do not walk, away- and head straight for your broker to buy deep out-of-the-money puts.  Western equity investors have been spoiled beyond recognition.  I mean, if you really just want prices to go up all the time (except on certain commodities, because that would be bad), and you want to beat the stuffing out of short-sellers, why not just institute price controls on everything?  Either admit that you want a system based on bullshit that always does what you want (or what the ruling class wants), or a system based on free markets.  You don't get to have both free markets and endlessly appreciating asset prices.  You are not entitled to an eight percent return every year.  You should not be able to sue someone when you don't get it or get bailed out when you blow your fortune on opaque securities that not even a forensic accountant understands.

The Spiral isn't about bankers destroying wealth.  The Spiral is about the consequences of buying into the fantasy that you can have "soft capitalism."  Or "capitalism lite."  You can't.  It will bite you and everyone else on the ass if you try- no matter if you are a banker, a mortgage broker, a regulator or a legislator.

It has been a great pleasure writing Going Private these three years, mostly because of the many readers I have communicated with.  Thank you for that.  Enjoy the Director's Cut before Typepad decides that I am using too much bandwidth, and I will see you, I hope, on the new blog.

Download The Spiral (The Director's Cut) [00:35:20 - 178.9 MB .mov file]

Some administrative notes:

Sometime in the next few days the equityprivate -commercial at- hushmail address will be set "whitelist only" to stave off spam.  If we've talked there before, it will probably still work for you.  Be this as it may, you should use the new email address listed on the new blog to contact me.  I will be phasing out hushmail slowly.

I will leave Going Private up as a reference as long as it seems prudent to do so.  Eventually, the entire site will be shifted to an archive on the <em>finem respice</em> domain.  That day, however, is months (years?) away.

The removal of a link to the Director's Cut of The Spiral is probably a much closer event.  Act now, supplies are limited.

Finally- Some interesting statistics: After three years and almost twenty days, Going Private houses 445 posts, 9 comments and 89 "trackbacks."  As of this writing the blog has had just over 2.5 million page hits and, near as I can tell, around 1,500 direct links point here.  I have no idea where this ranks among blogs, except that it probably isn't very high given Going Private's particular niche.

Acta est fabula, plaudite!

Thursday, February 05, 2009

Dare Ye Inquire Concerning Such a Wretch?

out of harms way I have always had a certain unquenchable lust for the lost works of Sophocles, member of The Three, and of whom only seven works survive the looting of the Library of Alexandria- though we have cause to believe he crafted many, many more.  I like to think some nimble librarian, or patron of the library stole away to the shelf where his works were kept and slipped away with just as many (seven) as he could fit in the folds of his clothes.  But in this, I am likely a romantic.

His most recognized works, marvelous as they are, will forever be incomplete as they represent single samples of his four volume treatments.  Before the world of finance, when such things were more apt to cause me wonder, I thought after what other commentary on sovereignty, The State and power we might have seen from this great tragedian, if only his other works were available to us.  Freud notwithstanding, Oedipus Rex is, after all, primarily about The State, power, executive arrogance, willful blindness and the consequences thereof.  But, and this is key, I think most of all, Oedipus Rex is about a total disregard for the inevitability of reality, and, it is this point, as it happens, that leads me to my present subject.

I find it intensely interesting that a number of commentators have alternately attempted to blame and exonerate the Community Reinvestment Act (hereinafter the "CRA") for complicity in the alarmingly complete inflation of the real estate bubble and, in effect, the current credit crisis.  It takes only a few readings of the most prominent (or at least the most prolific) of these authors to discern a woefully inadequate coverage of the context and history of that act, its predecessors, and the regime of mortgage regulation that they spawned.  This particular perspective, that is to say the stubborn focus on a single piece of legislation in the midst of a vast and interlocking series of statutes, rules and regulations ceaselessly built up over three decades, permits the easy (and, indeed, somewhat smug) dismissal of the CRA with the continually repeated line: "The foreclosure statistics do not support such an argument."

Early on in the development of my thinking in this area I wondered why foreclosure statistics should necessarily falsify the thesis that the CRA (or the twisted, multi-branched family of mortgage regulation that preceded and accompanied it) bears some of the responsibility for the present malaise.  We do not, after all, have to write a mortgage down to levels even remotely near salvage cost to see tremendous losses once it has been securitized.  This becomes particularly obvious when we remember that, prior to about eighteen months ago, mortgage backed securities were generally regarded with Madoff-like confidence.  Any break from the norm would easily cause a panic.  Could, therefore, a pool of mortgages suffer from such a serious confidence blow that their value would be written down to pennies on the dollar without the consummate spike in foreclosure rates?  To what extent would pools of low FICO loans be written down independent of any reference to foreclosure rates?  Surely, wise investors will use the only real metric they have for the cash flow prospects of these assets: the borrowers' ability to repay, no?  In this connection, insofar as every piece of historical data about foreclosures seems to have been fairly useless in averting the present crash, how likely are current or past foreclosure figures to have any impact on careful students of this market?  None, I would argue, where smart players are looking to guess where the next spike in foreclosures will hit.

This question only served as the seed for a different question: How did we come to find ourselves in the molasses-like regulatory pool in which we presently swim?  What came before during and after Fannie and Freddie?  When did it become so routinely fashionable to tamper with the mortgage market that, even when shown the facts as plain as day, otherwise bright and skeptical minds refuse to see any issue with an entirely backwards incentive and capital structure developed over thirty years by the legislature of the United States?  Alarmingly, there was very little work on this topic to be found.  That too made me curious.

It turns out it all began in the 1960s, with a series of slow changes that, typical of the beginnings of massive upheavals, passed unnoticed.  What followed in the 1970s and particularly the 1980s was a literal hockey-stick curve of mortgage regulation, legislation, incentives, grant programs and the seeds of a centralized financial-industrial lending policy that brought us to where we are today.  Make no mistake, there is no simple cause for the present crisis.  There were, however, simple seeds.

To be certain there is much blame to go around.  This author will attempt no defense of the various "big banks" that participated in the fiasco that is our current real estate market.  Be this as it may, it bears mentioning that no one was complaining fifteen or even twenty years ago, when the trouble started.  Banks are only the most visible and current culprits. Their bad tidings, however, would not hardly be interesting but for the worst laid plans carved laboriously out of the wood of populist pandering for more than twenty years.  Unfortunately, now the flames of said pandering have been fanned, and today apparently we think that forcing Citi to break their $50 million contract for delivery of a Dassault Falcon 7X in some kind of pathetic retroactive spanking delivered by this nation's chief executive behind the Congressional woodshed, makes some kind a difference.  (I suppose, however, Citi could at least have bought American and acquired a Gulfstream).

If you are looking for big catalysts, and most astute Going Private readers are, there are a number of fairly convincing candidates.  To understand how big, however, one must understand the nature of the environment before The Community Reinvestment Act.  What no one bothers to mention today is that the CRA broke the firewall of a long trend in the regulation of mortgage lending in the United States.  Prior to that act, legislation like Title VIII of the Civil Rights Act, the Fair Housing Act of 1968 and the Home Mortgage Disclosure Act of 1975 focused on the prohibition of rank discrimination and used disclosure as a means to impose fairness on the mortgage market.

Without a doubt, these were areas that needed addressing, and for the most part, I find the means these statutes employ reasonable and appropriate.  In fact, it doesn't take long to see that the Home Mortgage Disclosure Act of 1975 looks nothing like legislation when viewed through today's frosty glass.  Consider:

The Congress finds that some depository institutions have sometimes contributed to the decline of certain geographic areas by their failure pursuant to their chartering responsibilities to provide adequate home financing to qualified applicants on reasonable terms and conditions.

The purpose of this title is to provide the citizens and public officials of the United States with sufficient information to enable them to determine whether depository institutions are filling their obligations to serve the housing needs of the communities and neighborhoods in which they are located and to assist public officials in their determination of the distribution of public sector investments in a manner designed to improve the private investment environment. (12 USC § 2801).

The act continues:


(1)  Each depository institution which has a home office or branch office located within a primary metropolitan statistical area... shall compile and make available, in accordance with regulations of the Board, to the public for inspection and copying at the home office, and at least one branch office within each primary metropolitan statistical area... in which the depository institution has an office the number and total dollar amount of mortgage loans which were (A) originated (or for which the institution received completed applications), or (B) purchased by that institution during each fiscal year (beginning with the last full fiscal year of that institution which immediately preceded the effective date of this title).

(2)  The information required to be maintained and made available under paragraph (1) shall also be itemized in order to clearly and conspicuously disclose the following:

(A)  The number and dollar amount for each item referred to in paragraph (1), by census tracts, for mortgage loans secured by property....

(B)  The number and dollar amount for each item referred to in paragraph (1) for all such mortgage loans which are secured by property....

(Much detail about statistical area definition elided)

The act goes on, in typical legislative fashion, to describe in detail at once great and burdensome, the various definitions and requirements and accessibility issues surrounding these disclosures.

It is pretty hard for any libertarian or otherwise free-market-disposed party to argue against this sort of thing.  Perhaps one might make the argument that market information is being disclosed to competitors, but really, and particularly in the context of 1975, this is a difficult position to cling to without a certain amount of self-deception.

I also want to highlight part of the finding of the Congress used to support the passage of this legislation.  Specifically:

The Congress finds that some depository institutions have sometimes contributed to the decline of certain geographic areas by their failure pursuant to their chartering responsibilities to provide adequate home financing to qualified applicants on reasonable terms and conditions. (Emphasis mine).

Everything you ever needed to enforce equality in lending is contained in this simple description.  I submit that, despite the fact that the "Finding and Purposes" section of most legislation is fluff, a lot of thought went into this particular passage.  Or, alternatively, the importance of this sort of thing simply occurred more readily to the Congresses of old- 1975 seems very old to me, your mileage may vary.

Consider the components here:

1. Adequate home financing...
2. ...to qualified applicants...
3. ...on reasonable terms and conditions.

This is pretty reasonable stuff, really.  There is a particular genius in public disclosure and transparency statutes, sunlight being the best disinfectant and all.  It recalls a period, some years before my birth, where there was a sort of basic trust that, once exposed to the hot glare of public scrutiny, market actors would clean up their act.  Government had to do little.

I think this very artful and elegant. Unfortunately, we have come a long way since 1975.

Enforcement for the act was provided for directly in the statute.  To wit:

For the purpose of the exercise by any agency referred to in subsection (b) of its powers under any Act referred to in that subsection, a violation of any requirement imposed under this title shall be deemed to be a violation of a requirement imposed under that Act. In addition to its powers under any provision of law specifically referred to in subsection (b), each of the agencies referred to in that subsection may exercise, for the purpose of enforcing compliance with any requirement imposed under this title, any other authority conferred on it by law. (12 USC § 2807).

Responsibility for promulgating regulations related to the act ultimately fell to the Federal Reserve Board.

Again, this is pretty reasonable stuff.

There are some other interesting provisions, including the requirement of an annual report to Congress on the utility of the effort (12 USC § 2801) and a requirement for the aggregation of the data (12 USC § 2809).

In essence, the statute was a fairly obscure reporting statute known intimately only to the growing breed of back office administrators we would today recognize as "Compliance Professionals."  Its effect was less obscure.  While the average man on the street might have been unaware of its existence, interested parties, in particular activists concerned with civil rights, now had the tools necessary to crunch data and root out discrimination in effect (if not discrimination in intent).  The phrase "The data in the study come from the Home Mortgage Disclosure Act" is so rampant in the relevant literature today it seems obvious what impact the statute has had.  A quick cross-reference search of the "Home Mortgage Disclosure Act" and the name of any prominent civil rights leader makes it obvious that the data liberated by the act became the go-to ammunition for taking on lenders.

In this connection, there is no doubt that the practice of "redlining" (named for the unfortunate map fallen into the hands of investigators that outlined in red the areas to which a financial institution which shall remain nameless would not lend under any circumstances) was a serious issue at the time.  Ironically, however, we have come full circle and then some.  Cases like Hargraves v. Capital City Mortgage Corp. (140 F. Supp.2d 7 (D.D.C. 2000)) have successfully argued against "reverse redlining," wherein courts have held that artificially pumping funds into a given area on the basis of race (perhaps with the expectation of forcing foreclosure) is, in fact, "predatory lending" and just as bad.  Of course, we have the Home Ownership and Equity Protection Act (15 U.S.C. § 1639) to eliminate this practice.  No word yet on its success.

One cannot help but feel a little sorry for the General Counsel of a mortgage lender at this point, situated as she is between a legislative rock and a judicial hard place.  This quote from Hargraves is priceless:

Redlining creates the market conditions in which reverse redlining thrives. It should come as no surprise that the United States recently settled a case charging Chevy Chase Federal Savings Bank with redlining the exact areas that Defendants are now accused of targeting for predatory lending (140 F. Supp.2d 7 (D.D.C. 2000)).

Observant Going Private readers may point out that once you legitimize the practice of legislative underwriting, the regulatory world and the slings and arrows of the tide of public opinion get intensely confusing, and fraud works easily in both directions.  An astute practitioner once told me "fraud expands to fill the envelope," meaning that such schemes are ever-present and, like expanding gas, always pushing gently to discover the limits of their freedom.  Another friend of Going Private, a former counter-narcotics analyst, put it much more succinctly.  "We are just squeezing the Jell-O."

I will hardly argue that Hargraves was wrongly decided.  I merely note that the dilemma Congress has created solves few of the issues of the day and creates parallel problems just as bad, if not worse.  Rather, most certainly worse.

But, context being critical to the discussion, let us dial the Wayback Machine to 1989.  1989-1990 was an amazingly prolific period for federal intervention in housing and mortgage matters.  Right next to the Global Warming Prevention Act of 1989 even the most cursory of searches returns a literal spew of bills including:

The HUD Reform Act of 1989: To ensure competitiveness in procedures for approving applications for housing assistance and to provide for refinancing of mortgages, loans, and advances of credit under the lower income homeownership program of section 235 of the National Housing Act.

The Homebuyers and Renters Relief Act of 1989: To increase the affordability of homeownership for first-time homebuyers and promote the development of low-income rental housing.

The Housing Opportunity Zones Act of 1990: To remove legislative and administrative barriers to the production of new and substantially rehabilitated housing that is affordable to lower-, moderate-, and middle-income families.

The Department of Housing and Urban Development Accountability Act of 1989: To prevent abuses of the process for selection for housing assistance under programs administered by the Secretary of Housing and Urban Development.

The Community Housing Investment Partnership Act.

The Recycling of Existing Assets for Cost-Effective Housing Act of 1989: To authorize the Secretary of Housing and Urban Development to make grants to States to establish revolving funds to assist low- and moderate-income homebuyers and renters.

The Low-Income Housing Credit Act of 1989: To amend the Internal Revenue Code of 1986 to improve the effectiveness of the low-income housing credit.

The Low Income Housing Preservation Act of 1989.

The Housing Affordability Act.

Homeownership and Opportunity for People Everywhere Act of 1990 (The "HOPE" Act).

Really, who could vote against this?  Consider:

"There are authorized to be appropriated for grants under this title $96,000,000 for fiscal year 1991, $260,000,000 for fiscal year 1992, and $400,000,000 for fiscal year 1993. Sums appropriated pursuant to this subsection shall remain available until expended."

The more observant of Going Private readers will expect the re-introduction of the HOPE Act any day now, submitted, no doubt, concurrently with the Community Housing Affordability and No Gains to Equity Act (the "CHANGE" Act).

Fair Lending Enforcement Act of 1990: To amend the Equal Credit Opportunity Act and the Home Mortgage Disclosure Act.

The Housing and Community Development Act of 1989.

The Housing and Community Development Act of 1990.

The Community Housing Investment Partnership Act.

The Homeownership Assistance Act of 1989: To authorize the insurance of certain mortgages for first-time homebuyers, and for other purposes.

The Home Mortgage Overcharge Prevention Act of 1989: To amend the National Housing Act to limit the amount of interest paid by a homebuyer upon the prepayment of a mortgage insured under the Department of Housing and Urban Development single-family mortgage insurance program.

The Neighborhood Mortgage Lenders Accountability Act: If any examination of an approved mortgagee by the Secretary (including an examination under subsection (d)) discloses that the mortgagee has failed, in the determination of the Secretary, to meet the lending needs of the community served by the mortgage (as determined by the Secretary under subsection (a)(1)) with respect to residential housing lending, the Secretary may, in the discretion of the Secretary, require that the mortgagee, for continued status as an approved mortgagee for purposes of this Act, develop and submit a plan for remedying such deficiencies.

This bill should ring some alarm bells:

The First-Time Homebuyers Assistance Act of 1989: To authorize the Secretary of Housing and Urban Development to establish a demonstration program to insure mortgages with no downpayment for moderate-income first-time homebuying families.

But, I think it is this bill will likely be the favorite of the typically irreverent Going Private reader:

The Homeownership Through Sweat Equity Act of 1989: To authorize the Secretary of Housing and Urban Development to carry out a demonstration program of providing grants to housing development agencies to acquire abandoned and vacant housing for rehabilitation and rehabitation by homeless and low-income families.

And finally (take note here):

The Fair Lending Oversight and Enforcement Act of 1989: To require lenders to compile and make available mortgage loan and commercial loan information necessary to assess compliance with nondiscrimination requirements.

Granted, most of these examples are taken from the House that, by design, is intended to literally spew forth legislation to later be picked apart and duly considered (and probably rejected) by the slower, sager, more above it all Senate.  Even so, I feel like I might be able to discern a pattern in the legislation habits of the 101st Congress.  380 bills from this period contain the word "mortgage."

Why the most basic search of the Congressional Record cannot be made evidence of the almost pathological obsession of the United States Congress with intervening in the mortgage market is somewhat beyond me.  How anyone can claim this environment even remotely proximate enough to "free markets" to use as leverage the current crisis in their indictment of capital markets literally tries the patience.   Also beyond me is the reason the CRA has become the condicio sine qua non of the argument.  It is beyond daft to argue, in light of these facts, that the present market ills are the sole responsibility of any given administration or any given party.  The simple fact is that in a rare, multi-decade fit of bi-partisan cohesion, Congress has been digi-copulating the mortgage market for so long and with such enthusiasm that, Plato-like, it stopped occurring to anyone to wonder if that was really such a good idea.  Be this as it may, waking up every morning to be crowned with a baseball bat, familiar as it may be, still results in a headache.

What is insidious about the entire matter, and as is typical of the most destructive legislation, the caustic cloud of mortgage assistance masks itself under the guise of righteous and "fair" redistribution goals.  It is the nature of the beast that any political animal arguing against these, no matter what the logic, will find herself lonely and out of work.

...to be continued.

[Art Credit: Charles François Jalabeat, Antigone Leads Oedipus Out of Thebes (1849), Musée des Beaux Arts, Marseilles]

The Departure of the Volunteers

to return perhaps?It is with no modicum of sadness that I announce that my next entry "Dare Ye Inquire Concerning Such a Wretch?" will be the very last non-administrative entry on Going Private.  It has been an amazing journey, most keenly highlighted when, on occasion, the fancy catches me and I peruse my own archives and think back to the creature that was your author "in the beginning."  It seems wonderfully arbitrary and capricious to end matters on the week of Going Private's third birthday- and that makes it sort of elegantly beautiful.  So much so, in fact, that one might even consider it an homage to the Congress of the United States.  I do, in any event.

Originally, I planned to pen a retrospective of my favorite Going Private pieces, but, in the end, this seemed like quite a lot of work for very little gain.  What could readers past and present care which were my favorites, or which I thought the most cogent or prescient, or even daft? (There are quite a few of this last description, actually).  And, really, what use have readers for the self-referential indulgences of authors? (To my shame, there are quite a few of these, in Going Private as well).

But something unexpected happened during my slow saunter to the door.  To wit: You filled up my inbox four times in as many days.

Certainly, a proud author never thinks she intends to fish for compliments from her readership, but I suspect I might have been a bit guilty of such in announcing so publicly my intention to close Going Private.  Whatever the nuances and motivations, the last week produced more reader mail than I had seen in the 5 months before.

Thank you for that.  (And the many excellent and humorous suggestions about the fate of my "message in a bottle.")

Some readers even sent money via Pay Pal.  (This struck me as odd, considering, so far as such donors knew there was no future utility in such a payment.  A parting gift?  Perhaps?  Surely some behavioral economics Ph.D. has a paper in there somewhere).  Of course, I have to politely refuse such offers, as accepting money into my Pay Pal account would have the side effect of identifying me.  The gesture is not, however, lost on me even if I cannot accept.  (I may have to find time to ruminate on the tangential point that anonymous Tip Jars are a thing of the past owing to IRS regulations).

Whatever the character of expression of the individual readers who emailed, it was a humbling experience to find one's work so rewarding to others.  It also instills a sense of obligation to one's "public," and this brings me to my last point:

Though Going Private is at its end, I have endeavored to give its readers a new forum, should they wish to join me.  And while the next post is the last for Going Private, it is the first for my next project.  It will be different.  Some readers may be annoyed.  Others charmed.  I really don't know.  I'll announce it here, without particular fanfare, and it will be there that I hope to see you again.

-ep

[Art Credit: Francois Louis Joseph Watteau, The Departure of the Volunteers]

Thursday, January 29, 2009

Is There a Future for Going Private? (Hope and Change Notwithstanding)

VermAs long-time Going Private readers will no doubt be aware, the blog ebbs and flows with my workload, interest and the size of my intriguing, alarming or amusing stories backlog.  Given the fact that Going Private is only days away from its third birthday, and has been in the midst of a down cycle, I thought it a good time to revisit the blog, and to ask the question: "Is it worth it to continue any longer?"  This is not an easy question to answer by any means.

I have recently, gotten a flurry of offers to place advertising on the site.  In my experience, this sort of thing hints that a blog may have peaked, and the long, winding, downhill road towards "selling out" may be around that next bend.  Interestingly, hate mail has increased proportionally in the same period, some of it so caustic and vile that even Laura the Debt Bitch would blush on absorbing the prose.  I am still working on a model that explains both of these on the theory that they are both somehow related to the credit crunch.  The second seems to fit nicely in that model, the first, not so much.  Either way, I generally respond to the ad requests by quoting insanely high prices for the right to corrupt this space- very much in line with my personal, inflated valuation of it and therefore likely to be prohibitively expensive for any buyer.  I'm not sure if I am pleased or alarmed that recent offers have not been deterred either by my initial high price or by my totally gratuitous and subsequent doubling of that price.  In past I have remained committed to keep Going Private ad-free despite these inordinately large offers.  It really looks and feels much purer that way and, since the blog has been a labor of love and despite the very poor risk:reward ratio on the returns I get from writing it, I never really expected it to generate revenue, aside from my occasional experiments with the "tip jar."  As an aside, in the past, if nothing else, the value of the tip jar is that it has managed to guilt me away from closing the blog on those few days a year when it seems pointless to maintain it any longer.

Rumors of a book deal for this author were actually something other than baseless, but heretofore I have declined to pursue any sort of publishing, for reasons probably beyond the scope of this forum, except to say that I feel like a book deal would have detracted from the purity of the blog, which has always been about providing free content on the subject matter herein.  This choice, of course, pushes the risk:reward ratio the wrong way.

The landscape of private equity has also changed.  In one sense it is the best of times for private equity right now, but there are a very few, that is a vanishingly small number of firms who managed to keep their heads down over the last 18 months, and managed not to succumb to the temptation to buy assets at their top with mounds of leverage and are therefore are well positioned today, though they likely sacrificed a ton of LP money in the bandwagon months leading up to the crash.  Careless firms are imploding, a flight to quality ensues, and LBO firms are in their element now, baring a much longer winter for credit markets (which I do not foresee).  There are bargains galore out there, and snatching those up and making something of them is what LBO firms do best.  Where matters got out of control it was when this basic premise was ignored and the massive returns to large firms spawned dozens or hundreds of copycats, none of which really seemed to understand what LBO firms actually do well.  Unfortunately, that has poisoned the well for the few firms still "fighting the good fight."

One difficult lesson to learn in the last 12 months was how shallow even what I will call "pure" LBOs are.  In essence, the VP and Associate tier of a firm must face an almost Faustian bargain.  Partners are directly incentivized to close deals, as these are often the metrics on which partners are compensated, and any carry, even that in a flagging firm, is value (albeit illiquid) in the bank.  Set this against the VP and Associate corps, who are a force designed (in theory) to scuttle deals, to find that one reason not to do this deal, and to save the firm from these mistakes through their careful and complete analysis and due diligence.  Given the expense of diligence, LBO firms start looking at a company with the premise that it will be a good investment.  The onus is on the due diligence team to pop that expectation bubble.  It grows hard to imagine how such an incentive structure can result in much good.  It takes a VP or Associate of incredible testicular fortitude, no matter what her gender, to tell the advocate Partner- who is possessed of a massively powerful personality and got to be the advocate Partner in the first place because of some personal connection or interest in the deal- that the target firm stinks like the primate house during a zookeeper strike and that the employees have been throwing feces at each other with about as much gusto for several years- yet this is what is expected of them.

I am aware of only two firms that have sought to rectify this dynamic.  One, with which I am most intimately familiar, actually gives large bonuses to members of the due diligence team who discover a risk, oversight or problem during diligence that scuttles a deal.  This has the dual effect of encouraging Associates and VPs to look for such "gotchas" much harder, and to make it hard for the Partners to take out their frustrations on the newly recognized Associate who won what this firm calls the "Saved Our Bacon Award."  All this is a somewhat drawn out way to express the simple fact that the financial work in an LBO firm is less than an intellectually stimulating environment for the middle-class employees- at least after the initial novelty has worn of in the first 12-18 months.  Searching for dirty laundry and running through the same basic DCF template over and over again gets trying.  But then, I suppose it is my mistake for having carried a distinctly modern mind (in that it tends to grow restless and wander) into a doggedly repetitious business.

A recent increase in exposure for me, and the blog, has also caused some problems, and increased the risk that the single most essential factor in my continued work on the blog will collapse, that being my anonymity.  It was with the best of intentions that I agreed to talk on one occasion or another to the press.  Unfortunately, those interactions were a bit more risky than I had bargained for.  Suffice it to say that I would do that much differently in the future.

Finally, my interests in finance have drifted quite significantly since I began this little adventure 3 years ago.  There is little reward in LBOville for the ability to identify and capitalize on original and novel investment ideas.  The kind of skills that LBOs demand do not, after a sense, require much creativity.  It was not quite a year ago that Armin quipped to me (with what now looks like alarming foresight) that I would eventually "outgrow private equity."  Interestingly, this was also the entry ("Cascades Are a Poor Excuse for Stupidity") where I quipped:

It strikes me as quite tortured to label a market actor who possesses so little actual information about the contemplated transaction that he or she might be caught up in a cascade as "rational."  Particularly where, as here, the costs of an erroneous decision are extremely high and the decision is not forced.

Reviewing this yesterday against the backdrop of recent hate mail branding me a staunch adherent of Efficient Markets Theory, the Chicago School, a Republican, (I am none of these) and everything else that frustrated permabears believe is wrong with the world this week, it occurred to me that I either have utterly failed to convey my position on these matters, or a large portion of my readership (or my vocal readership) hasn't bothered to read a damn thing I write.

Perhaps more importantly, I find myself spending more time thinking about matters like market efficiency, or more accurately, market inefficiency, the consequences thereof along with ways to capitalize thereupon.  Posts like Death of Cook, Bourgeois Pigs, Why Social Investing is the New Tech Bubble, Loan Baby, Loan, Dual Class (Corporate) Citizens, Fairing Up General Aviation, Escaping Modern Debtors Prisons, Anatomy of a Meltdown, and most particularly Liquid Reflections, Liquidity Feedback Loop, Deep Debt Impact, Kierkegaard, Scientologists Private Equity, There's No Such Thing as a Risk Free Lunch and Liquefying (and then Liquidating) the Illiquid, have become my favorites.  (I will only admit to Tick Tock, Tick Tock being a favorite under enhanced interrogation methods).  Without being too self-congratulatory, reading over many of these suggests a level of prescience that I am not all together comfortable with, but leaves me just curious enough about to want to write more of them.  Given the current environment of anti-capitalist, anti-finance fervor, I suppose this shift wouldn't be particularly popular.  But then, perhaps that's exactly the reason to do it.

There are other reasons to keep writing.  Recent changes in, shall we say, the "regulatory and political environment" seem to suggest a wealth of material for Going Private to chew on in the future.  The rather spectacular disintegration of a daughter company or two (and the wild success of a few as well) have also presented plenty of fodder- as have some recent antics of Laura the Debt Bitch, to the extent those topics remain interesting.

But I fear that what I will tend to pen going forward will look less like the early years of Going Private.  Less LBO discussion, more views on inefficiency and the like.  More "hedge fund like" ideas.  It concerns me that this will give the lie to the title of the blog "Going Private," and pull the focus away from the central early center of gravity for the blog and the central motivation for its creation: illuminating the world of leverage buyouts.  Readers may or may not enjoy this, I simply do not know.

I also have some reservations about continuing on the Typepad platform.  While Typepad has been wonderful most of the time, recent and not-so-recent changes revolving around limitations on what can be displayed and how much of it can be displayed have soured the management over here on the prospects for Typepad.  Clearly, Typepad is a victim of its own success, and has had to moderate its customer's access to "CPU intensive" features, like displaying more than a month of "recent posts."  This is rather annoying when you sometimes only post 1 or 2 entries a month.  If I continue, it will be on a different platform.  This could be amusing, however, as it would certainly be time for some redesign and to inject some variety into the blog, if continuing is a good idea at all.

This presents several questions:

1.  Should I bother to continue?
2.  Is it worth the headache to port the entire blog to a new platform?
3.  If not, should the old blog just use its last entry to point to the new blog (if there is one)?
4.  Did anyone pick up the anonymous message in a bottle I dropped into the sea off the coast of Tortola?

I have no idea.  Especially about #4.

[Art Credit: Johannes Vermeer, "The Astronomer," (1668), The Louvre, Paris]

The Occasional Solace of Hate Mail

it came in the mailI often quip that reader mail is one of the things that keeps me blogging.  It is, but sometimes not in the way that I would expect.  Going Private has in past, and continues to be, an occasional lightening rod for some of the more spoiled of capitalism's children.  Insofar as much of my writing centers on the fact that there is no such thing as a unicorn that defecates skittles, the delicate sensibilities of many a market-must-go-up-at-any-cost "capitalist" are torn asunder.  This provokes a good deal of amusing (if not particularly illuminating) hatefan mail, written, doubtless, on a high end PC with 30" flat panel monitor bought on credit.  I suppose the consoling feature of letters like these is that they suggest that the enemies of capitalism are mostly a poorly read collection of rabble, confined to intellectual debate on the level of "you are an idiot."  If this is true, there may be hope yet.  I can only guess that the urge to mail things like this to me is very much like the religious types who promise me "I will pray for you," upon learning that I think their anthropomorphic vision of god is a freshly steaming load of unicorn skittles.

Acting on the theory that these works, and my replies to them (which, fortunately or unfortunately, tend to sink somewhat to the level of the original author), have some entertainment value, I reproduce for you one of the most recent editions to my collection of trite hate mail (and the reply thereto):

On Thu, 29 Jan 2009 09:47:08 -0600 Paul <xxxx@yahoo.com> wrote:

Just wanted to say I just read your blog post "Death of Cook" and I found myself feeling a bit emotional afterward. 

I admired very much the point -- which I think hasn't been made nearly enough in this debate -- that Friedman's key insight was that freer markets bring power to keep repressive regimes at bay, of from forming in the first place. 

But now that entire economic world has collapsed, leaving the Chicago School with as much credibility as the alchemists or the flat earthers or Phil Gramm, it must be so difficult for the devotées such as you to deal with the fact that what you've studied and come to believe in is now just so much intellectual rubble, which no amount of desperately grasping at any government entity you can to try to hurl blame at, as you do with Fannie Mae or the Fed, can make go untrue. 

Or as PK puts it, now that you've paid your tuition, you've learned you've invested your education with Bernie Madoff.

It's palpable in your post how bitter you are.  I'm genuinely sorry about that, and only hope that as you move on in life, you can find somewhere to utilize your talents in a less futile way than defending the decaying corpse of a dead School.

-L

Dear "Paul" (who signs his emails with "-L"):

Your email is long on glib cliche, very short on fact and totally lacking in analysis.  While I am not sure if these effects were intentional (at first I thought your piece a clever bit of satire, until I got halfway in) they do make your writing remarkably unremarkable in the way it absolutely typifies comments of this kind.

While I understand that attacking markets and finance is what all the cool kids are doing today, doing so with something that approaches compelling and reasoned argument is (as you demonstrate here) rather more difficult.

The fantasy that the markets that melted down were anything remotely resembling "free markets" has created a lot of masturbatory material for the new socialists (and worse).  It is, however, totally divorced from fact and as a consequence you might have to work to get some of that genetic material out of your hair.  (I'm told baby shampoo works wonders).  Given that you fail to address these aspects of my missive (odd since I spent a lot of time and "ink" outlining them) I must conclude that you either:

1.  Have limited reading comprehension skills (public schools perhaps?);
2.  Did not read the piece in any detail (ADD?); or,
3.  Have avoided these points because they derail your position (basic cowardice).

None of these bode well for your intellectual prowess.  Or maybe you were just too lazy to pen a thoughtful reply.  It is, of course, a great conceit to cram useless blather into the inboxes of strangers.  It is a bit of time hijacking.  Be that as it may, I try to reply to such nonsense where possible.  Call it a weakness I have: the inability to pass up the opportunity to discipline other people's insolent children.

If the most fundamental misunderstanding of the issues at hand here were not enough, you attribute to me views which I do not hold, positions I have not defended and associations I do not maintain.  This, given the tenor of the rest of your note, doesn't really surprise me.

I am indeed, as it happens, bitter.  Bitter to watch the new political class rise to power in a miasma of anti-capitalist rhetoric, to watch the renewed belief that the correct "super men" will fix the problem by adjusting the levers of the economy to suit them (as if this hadn't caused the crisis in the first place) and the cult of personality that accompanies such fantastic and feverish belief.  (Already members of the Cabinet are forgiven their felonious transgressions because there is "important work to be done").  In a sense, your prose here is a perfect example of this twisted mindset.  You attack a school of which you demonstrably have little or no understanding, and rely on cliche and stereotype to brand those with views divergent from your own.  In short, you have no meaningful intellectual insight whatsoever to offer.  That you are typical of what lurks out there in the dark, vengeful and misguided malice of public opinion does leave me bitter.  Bitter, and revolted.

But, thankfully, there are tools like the NASDAQ index of bailed out companies, credit default swaps, short selling and put options so that those of us paying attention can bet heavily against this new regime (and by this I mean both sides of political system), and, sadly, against the prospects for the United States for the next five years.  So far that's proving among the most profitable of endeavors, even matched against the obscenely high remuneration of Private Equity.  If you had really been reading my stuff for some time you would have noticed that I saw the train coming back in 2007.  Many of us did.  At the time I invited readers to bet against the system.  I hope some did.  You, clearly, were not among them.

Yes, I'm afraid the palpable glee for the misfortune of finance professionals- that jealousy driven joy that literally oozes from your prose like so much thickened bile, is also based on a fantasy: that I join the many bankers and finance professionals who languish in the aftermath of heavy handed government intervention in the real estate market.  Some of us, you see, saw it coming.  Some of us, you see, do not now live in oversized and now negative equity homes for which we overpaid at the height of the market with easy credit.  Some of us didn't surround ourselves with flat-panel displays bought at the expense of large balances on 18.5% APR credit cards.  Some of us, in short, were paying attention.

Interestingly, no one had many complaints about Wall Street, or the like, when they could buy $750,000 in house at 6.2% with $60,000 in income.  You enjoyed with great enthusiasm the trappings of the bubble on the way up, so it is not surprising that you will point anywhere at all to avoid looking in the mirror now that it is on the way down.

It is good that you seem to enjoy the way of things to come, because you are going to be enjoying them for a long time.  Not so for those of us who planned carefully and have carefully collected the wherewithal to leave, if (god forbid) it should come to that. 

Yes, it is good that you seem to enjoy the new socialist paradise that awaits you- because you are going to be stuck with it for some time.

Thanks for taking the time to write.  Reader mail is what reminds me that the blog is worth writing.

-ep

Wednesday, December 24, 2008

Death of Cook

death of cookNormally, I am one of Barry Ritholtz’ fans, often indulging “The Big Picture”’s expansive prose and deft selection of this chart, that graph or the other political-economy cartoon that collectively has its finger right on the pulse of this week’s market week after week.  I fear, however, the tenure of my fandom is at an end, perhaps belatedly, now that I have absorbed his piece “RIP Chicago School of Economics: 1976-2008.”

Mr. Ritholtz’s Pre-Christmas missive gores Milton Friedman, citing a winding Bloomberg article by John Lippert, whose Chicago beat for Bloomberg often has him penning obiter dicta that includes the latest gossip relating to the Pritzker family, and their glowing approval at the selection of cousin Penny Pritzker as Obama’s national campaign-finance chairwoman, the climbing murder rate in Obama’s “backyard,” and the controversy over the Milton Friedman Institute at the University of Chicago.

The Bloomberg piece “Friedman Would Be Roiled as Chicago Disciples Rue Repudiation” might be forgiven the forced alliteration of its title (certainly I’ve penned worse puns during my tenure at DealBreaker), but granting it the status of some sort of indictment of the “Chicago School” is pushing very hard on the slack rope that is the article’s prose.  When the only real Friedman-indicting quote one can extract from University of Chicago faculty is from emeritus professor of anthropology Marshall Sahlins, who has, conveniently, rebelled violently against homo economicus for decades, it is difficult to find some revelation, some newly discovered and conclusive epitaph for Friedman therein.

Sahlins has much to lose in the homo economicus debate, as do most social scientists who struggle to salvage idealistic concepts about the self-determination of mankind, and its ability to shape itself through the naked will of cultural change alone.  (Certain European political movements in the not-so-distant past come to mind as apt comparisons).  A concept so crude as the economic self-interest of man might put to the torch the noble (and vanity appealing) idea that culture alone defines the stature of a people, after all.

Of course, in many instances the Sahlins school of thought results in rather more absurd intellectual cul-de-sac, drawing Sahlins himself into arguments rationalizing, for instance, the Death of Captain Cook via the necessity to recognize the unique cultural morays of the islanders who killed him.  Much simpler to just admit that Cook was an imperialist conquistador who bit off more than he could chew- but this would not allow for an expansive discourse on the otherwise marginalized relevance of the Lono deity cycle of the Hawaiian natives, an exploration of its importance in shaping modern history, the morality of Western claims of discovery, and the impact of culture clashes (or simply the boost to sales of Sahlins’ University of Chicago press publication on the topic).

If Cook himself prompted the fatal rage of natives, could their Lono deity cycle be of any interest?  What would this mean for cultural study, to reduce this shining example of the importance of cultural understanding (which may have saved Cook had he only appreciated the cultural proclivities of the islanders) instead to a tale of conquest, greed and the execution of imperialistic tyranny?

As an interesting aside, in 2004 when a piece thought to be the original “Death of Cook” by John Cleveley the Younger was discovered depicting Cook as anything but a peacemaker in the fray that eventually took his life, it struck a resounding and final note in that particular debate, as European painters and Western intellectuals had been attempting for over 300 years to recast Cook as something of an innocent in the events that lead to this death.  Perhaps this is one of the earlier examples of "white guilt," and being forced to admit that much of Western gains during the era were, in fact, the consequence of imperialist conquest was simply too difficult to face for the then cultural elite of the era.  It is significant, I think, that their reaction was so revisionist.

It is a common complaint echoed in criticism of these social sciences that they often engage in highly circular argumentation.  In the case of Sahlins that looks very much like “Assume the natives had a very unique perspective, since that would explain their actions in this case, they had a very unique perspective, and we cannot ignore their unique perspective- to do so would be to ignore the absolutely critical role of unique cultures in the understanding of reality.”

Uh, sure.

Unfortunately, the Sahlins approach also characterizes modern attacks on homo economicus and free markets.  At the heart of it, and my criticism, is what I can can only see as a worldview reminiscent of the Aristotelian-Ptolemian Earth-centric view of the cosmos, which is, not coincidentally, of similar psychological appeal.  This “homocentricism,” the concept that mankind has the ability to impose his cultural-moral will upon the environment wherever it chooses, is the master of his domain and is granted by divine right this power, is comforting and gratifying in that it suggests, erroneously in my view, that mankind has some agency in larger events.  It soothes and obscures the pain that is looking into the wide abyss of the cosmos only to come to the consequent realization that we are infinitely small, fragile creatures doomed to a cycle of consciousness under a century in length, of vanishingly small significance when compared to the time scale required to observe anything remotely interesting about the universe’s development.

As a species we can barely manage to protect ourselves from the flashes of temper of a planetary body characterized by phenomenal geologic stability compared to its cosmic peers (250,000 people on average lose their lives to natural disasters each year, events that also cost on the order of $100 billion per year) much less live long enough to escape the earth and reach out beyond anything other than the coldest, bleakest, emptiest space.  Of course it would be appealing that we might shape human interaction, the progress of nations and development (ultimately hinging on the effective and efficient allocation of resources) by will and intelligence alone.

Even this small measure of comfort, however, is a lie.

Coming, as this movement does, from the social science world, it can properly be viewed as an attempt to fill the void left by atheistic rationalism, at least insofar as that movement has gelded among intellectuals the soft comforts religion, or the belief in some grand design and larger purpose for mankind, formerly afforded.  Surely, then, there must be some foundation of thought to salvage the homocentric view of the universe?  Despair is a poor motivator, after all.

This urge, to find the agency of mankind, is compelling, and can be very, very dangerous.  In reality, however, there are no short cuts and homocentricism is a short cut, as is the reliance on culture as an agent of change.  I think, in some sense, this is a consequence of postmodern views of culture.  The “all expression is art, all expressers are artists” interpretation (one with which I violently agree in other contexts) also has the consequence of making all thought culture, and all thought worthy of attention.  Combined with the school of thought of, e.g. Sahlins, we are quickly thrust into a world where no concepts are irrational, inclusion is the most important feature and any hint of closed-mindedness is decryed.  The rise of the politically correct movements and the “tolerance at any cost” of multiculturalism (often flying in the face of all reason) presents a stark example of the effects hereof.

Paradoxically, any mass inclusion mandate has the effect of stifling any skepticism, even rational skepticism.  Criticism of any concept (no matter how absurd that concept) is framed as some form of bigotry or discrimination.  An attack on the belief systems of the holders of absurd thought.  Inter-tribal strife (even the modern version) is attributed to a lack of mutual understanding, and some fault on the part of the victim (the Captain Cook) for failing to understand the quaint, but critically important and valid beliefs of the perpetrators.  (Failing to accept the stoning of women for alleged adultery, for instance- or to respect the conquest driven precepts of certain interpretations of centuries-old religions).

It with this background that we arrive at Mr. Ritholtz’ piece.

Ritholtz’ principal claim appears to be that the Chicago School has been debunked, and its demise late in the coming.  Sayth Ritholtz:

A long Bloomberg piece, Friedman Would Be Roiled as Chicago Disciples Rue Repudiation, discusses the tarnishment of the Chicago school of thought.

Its [sic] long overdue. From the efficient-market theories, to the concept of man as rational profit maximizers, much of the edifice that is was the Chicago school of economics is based on a foundation that is false, disproven or otherwise questionable.

Ritholtz describes his introduction to neoclassical price theory, and classifies it as “authoritarian, a worship of a form of mob rule outside of the usual legal channels.”  He continues with:  “The view that regulation and other government intervention is always inefficient compared to a free market has now been made laughable.”

He then, disingenuously in my view, sets up his detractors thus:

Watch the comments for the cute little protests from law students who never practiced a day in their lives, and the biz school kiddies who never executed a single trade.

I had occasion to study with Fama, and Friedman, both skewered in the Bloomberg article, and while my law school experience seems long past, my business school experience seems less so.  Perhaps I meet Ritholtz’ pre-emptive definition of the trite detractor as a consequence, but it seems hard to take such ex ante ad hominem attacks seriously.  I suppose I expected more from Ritholtz.

This is not what agitates me about the Big Picture piece, however.  Rather, it appears Ritholtz has fallen prey to kind of the homocentric appeal that leads to arguments that free markets are some sort of authoritarian assault on what would otherwise be a fair and just democracy.  How else can we explain a line of argument that calls a “hands off” approach to economics “worship of a form of mob rule” and suggests them undemocratic and anti-representative?  It would seem Mr. Ritholtz’ would prefer a purely representative government.  One need look only as far as California’s recent passage of Proposition 8, amending the state constitution to ban gay marriage to realize that the gridlock of “absolute democracy” is folly, and that a pure democracy is far more authoritarian and reactionary than most dictatorships.  This is particularly so when the majority begins to realize they can vote themselves largess, collected by force, from the whole of society, all legitimized by the sanctity of “majority rule.”

Underpinning these lines of thinking is the absurd notion that individuals are entitled by right to happiness and prosperity.  That the role of government is to create fair results, rather than a fair system.  The United States Declaration of Independence itself managed to avoid this particular tar pit, and did so quite consciously.  It is the “pursuit of happiness” that is enshrined in that text.  It is due process that is afforded the individual, not a favorable process.

Perhaps Mr. Ritholtz, and modern free markets detractors, misunderstand what the Chicago School actually stands for.  Certainly, it was popular to paint the movement in draconian terms.  Friedman was, and still is, attacked rather viciously for his involvement in Chilean development during the tenure of Pinochet, but these criticisms misunderstand both Friedman’s involvement in Chile, and the nature of his belief in free markets.

If the Chicago School stands for anything it stands for the power of free markets to undo authoritarian political systems.  That Ritholtz gets this exactly backwards and then confounds his error so severely rises to the point of totally discrediting his missive.  Friedman pointed out that any economic system other than Laissez-Faire capitalism, of necessity, requires the use of coercion and force- not least to compel the collection of taxes.  He also pointed out that free markets, including the free movement of labor and goods, would always dissolve central control of economies, and make draconian leadership impossible.  To see Friedman’s espousal of these concepts in Chile as anything but his efforts to peacefully undermine statism and authoritarianism is akin to willful blindness.  Can we, after all, ignore the effect those forces had on the oppressive regime of the Soviet Union and the Warsaw Pact, both dismantled by free markets with barely a shot fired?  Friedman always stood for the premise that freer markets resulted in freer individuals.

Neither I nor Friedman have advocated anarcho-capitalism, though erecting this straw man is a typical tactic for Chicago School detractors.  Government clearly has a role in fostering fair markets, but beginning to make markets a little bit “more fair” for a particular constituency quickly exceeds the Chicago School brief.  This particular detail is often lost on Chicago School critics, as it is on Ritholtz.

Similarly, it has become fashionable to point fingers at people and (more disturbingly) at theories, like Black-Scholes (ironically both people and theories) thought to represent the Chicago School as responsible for the current collapse.  Eric Falkenstein “The World's Most Dangerous Mean-Variance Optimizer” nicely parries these attacks with specific reference to Nassim Taleb by wondering how we can any more blame Black-Scholes than the Fisher equation, or even rational thinking as a whole for the present credit crunch.

Moreover, blaming the current economic crash on the Chicago School is about as rational as chastising Shakespeare for Nicholas Hytner’s production of Henry IV.  The structure of the market in mid to late 2008 bore such little resemblance to anything the Chicago School represented that it seems near impossible to even mention the two in the same paragraph without straining the prose to such an extent as would grate even a Bloomberg reporter’s literary sense.  That hasn't stopped anyone though.  Consider:

In late 2007 we had billions upon billions of dollars flowing to prospective home-owner borrowers who, in any other circumstance, could not possibly have been thought worth the risk.  These outflows were facilitated by two massive entities, both seriously politically beholden to the legislature and stuffed with senior managers selected primarily for their ability to raise capital for political campaigns or otherwise service the then-current, ruling political class.  The pervasive and stated objective of these entities was to lower the cost, in the short-term, of “The American Dream of Home Ownership.”  Effectively, a group of legislators decided that home prices were too high, and lenders too risk averse and resolved to correct this "unfair" market result.  This they accomplished only too well.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 gave the power to dictate the particulars of home ownership incentives that would bind the GSEs to the Office of Federal Housing Enterprise Oversight, created within the United States Department of Housing and Urban Development by the same act.

Step back and consider this for a moment.

Billions of dollars was forcibly injected into the housing market for the least qualified borrowers in the form of massive and artificially created demand from Fannie and Freddie as dictated by the wisdom of less than a dozen senior members of the political class in the United States.  In 1996 that amounted to $48 billion in mortgages for otherwise unqualified borrowers that probably would not otherwise have been written.  By 1999 Freddie was penning deals to be the exclusive purchaser of loans written by third parties (Norwest was the first such entity).  Underwriting standards, and their natural check on risk, were never to be particularly connected to the mortgage process again.  This was hailed as a great victory for the Dream of Home Ownership.  By 2000 HUD set Fannie and Freddie to purchase $2.4 trillion (that’s not a typo) in low-grade loans over the next 10 years with significant penalties if they failed.  The GSEs knew the fist of an angry legislative god would descend upon them like no fury they had heretofore experienced if they failed in their appointed task.  How do you think they reacted exactly?

Step back and consider this for a moment.

A small administrative cadre was centrally setting the level of demand and liquidity flow for a major portion of the country’s economy, and, in a cruel multiplier effect, was therefore indirectly setting prices that influenced all the actors in that sector.

By the end 2000 GSEs held 1/3 of all multi-family mortgages.  The speed alone by which these entities captured a 33% market share of a multi-trillion dollar market should have raised eyebrows.  Does anyone really think this possible in a business formerly posessed of such slim margins without a major market distortion?  By now both GSEs were also buying “NINA” loans.  (No income, no assets).  No, I’m not kidding.  That too was mandated.

It bears mentioning during this period that competitors, unable to function in a market this skewed, complained bitterly that the GSEs were distorting their ability to profit, and that they were, in effect, using government subsidies to advertise their services to prospective homeowners.

Let’s put this into perspective.  In what other context would any system calling itself a "free market" ever permit this?  What would we think if the United States government poured advertising dollars into a government sponsored entity producing computer operating systems in direct competition with Linux, Apple and Microsoft?

Those protesting were shouted down with the rationale that the advertisements were not direct to consumers, but rather merely there to educate consumers about the mortgage process, and that the detractors were only looking to increase the cost of home ownership (which, in fact, they were).  No, I’m not making this up either.

The GSEs going public exaggerated the results.  The likes of Countrywide now had to compete with Fannie and Freddie for investor capital.  Their own returns on equity would now be held up to the skewed standard of the GSEs, which showed greater than 20% returns on equity for almost two straight decades, fueled by ever increasing mandates and capital to buy-buy-buy the worst mortgages on the market.

Unsurprisingly, the risk models employed by non-GSE firms made it difficult if not impossible to make a buck when the GSEs were siphoning off anything and everything at reduced rates.  To compete in the distortion, firms like Countrywide resorted to rather creative tactics.  Countrywide Mortgage Investment was created by Angelo Mozilo, for instance, to collateralize Countrywide Financial loans outside of the mortgage size bands dominated by Freddie Mac and Fannie Mae.  Mozilo and Countrywide can hardly be blamed.  Unable to compete in any market where Fannie and Freddie were participating, their business had to evolve into something different.  CMI later evolved into the failed IndyMac, whose abysmal standards for lending have now become the subject of FBI investigations, ironically for doing exactly what the legislature was mandating the GSEs to do, ignore underwriting standards to boost low-income home ownership.  IndyMac took it somewhat further, and forged documents, among other offenses, or did they?  Do we really think no one in the underwriting department of the GSEs did the same?

Post 2000 and 2001, in an environment of historically low interest rates, the impact on the housing market, particularly the low end of the housing market, was predictable.  It ballooned.  The primary cause for low interest rates?  Another anathema to the Chicago School, intervention by the Federal Reserve to recover from the dot-com collapse and 9/11.

As a consequence of the boom, GSEs, and everyone else, had to put all the mortgage paper somewhere.  Technically, their mandates ran afoul of capital regulations.  There was literally no way that the number of loans they were being compelled by statute and the regulatory urgings of HUD to buy could be kept on their own balance sheets.  That should have been the cap right there.  And if not for the dire consequences of missing their targets, it might have been.  There is only so much mortgage risk you can keep on your balance sheet with the capital requirements then in place.  They were eased repeatedly, but not enough to allow the GSEs to satisfy their political masters.  Eventually, they would run afoul of the simplistic regulatory capital requirements that burdened them.  Enter Wall Street.  "Of course, we can solve that problem."  We will just securitize it all.  Faced with daunting requirements, Fannie and Freddie had little choice, and, therefore, either did anyone who had to compete with them.  It should be pointed out that this, in itself, was entirely within the sort of conduct permitted by the regulation of the time.

Here is where the story seems to throw otherwise rational thinking beings: The market was doing exactly what it was supposed to do at this point.  Exactly what it was supposed to.

You had legislators and executives from both parties (Newt Gingrich was an adviser to IndyMac, for instance) telling the market “I want a huge spike in debt-funded home ownership for low income households short-term, and here are positive and negative incentives to accomplish that.”  The Federal Reserve is telling the economy “Nope, nope, no recession today.  I want lots of borrowing, and, since I’m making your returns of safe instruments vanishingly small, I want that cash to flow into more speculative instruments.”  Paradoxically, regulators were also telling everyone in the market “You better watch how much risk you hold in any one entity.”  The market dutifully complied.  Homes “owned” by poor quality borrowers skyrocketed in the short-term, just as our brilliant leaders wanted them to.  Underwriting became divorced from the mortgage writing process because none of the incentives created by government intervention rewarded careful underwriting and several incentives created by government intervention explicitly penalized careful underwriting.  What exactly did everyone expect?  Disneyland?

It is telling that Barney Frank seems to have emerged as one of the leading central controllers somehow qualified to save us all from this mess.  That Congressman Frank is enjoying anything other than ignominious ostracization as an utterly failed and deposed elder statesman for his role in destroying the mortgage economy and everything connected to it (i.e. everything) is a testament to the inability of society to select competent leaders.  This, in itself, should serve as a cautionary tale to Chicago School detractors.  Alas, denial ain’t just a river in Egypt.

It should also be recognized that when individual entity risks started to escalate, the market, again, did exactly what it was supposed to do.  Exactly.  It created mechanisms to transfer that risk from risk averse entities (that aversion artificially mandated by unsophisticated risk and capital limitations) to risk seeking entities in the form of securitization.  And when clever Wall Streeters realized that 200 pieces of mortgage paper rated B could be mashed together and their lack of default correlation would permit the likes of Fitch, Standard and Poor’s and Moodys to throw a AAA rating on the aggregate, well, the market was doing just what we told it to- considering we required large institutions to meet particular credit standards in their portfolio, and because we measured those standards by the woefully inadequate analysis pawned by the ratings agencies.  Specifically: a centrally mandated metric for risk, created by the legislature and enforced by regulators, specifically: the blessing of the ratings agencies, was the centerpiece for evaluating the risk in institutional portfolios.  Make no mistake, the regulation of the day not only endorsed reliance on the poor models employed by the ratings agencies, it mandated it.  In retrospect, could anything look more daft?

The entire system was geared to spike home ownership among poor quality borrowers in the short term and delay any reckoning as long and as completely as possible.  Further, it was designed by the legislature with woefully simplistic measures for risk and utterly naive means of enforcement.  The entire premise was the vain search for a free lunch.

Not only does the Chicago School not shoulder any of the blame for this travesty, but even the most basic student of the Chicago School and neoclassical pricing theory could have predicted it without breaking a sweat.

I’m no PhD candidate, but I was musing about the liquidity surge and its likely effects, twice as far back as March, 2007, and again in August, 2007 (I even quoted a comment left by a The Big Picture reader in that piece) and yet again in September, 2007:

First, as liquidity pours into opportunities, the number of favorable risk-reward opportunities dries up, pressing liquidity ever lower on the risk-return scale.  Second, as asset prices are driven up by the competition for assets, the returns available to higher risk assets diminish.  (The risk premium narrows).

These two effects drive liquidity seeking the same level or returns into increasingly risky assets.  These effects are, as I pointed out, complicated by the structural need for particular risk tranches to service structured products or the issuance of instruments in securitization transactions (CDOs and such) that depend on efficiency frontier portfolio design.  These instruments can, therefore, create an "artificial" need for high risk assets and drive these asset prices up, even as their quality diminishes.

In the present example, and in the words of a CDO manager I quoted before: "I gotta keep accumulating collateral, and I gotta issue the liability against that collateral."  This, in turn, drives loan origination into overdrive and so reduces the oversight and loan standards that less than qualified borrowers are given a pass where they otherwise never would have.

I closed the August piece with this:

What are the lessons for the Going Private reader?  The combination of unaligned incentives (both on the intra-institutional and inter-institutional level), overheated first order liquidity (cheap cash), fickle second order liquidity (as distinguished from true liquidity), and a time lag between liquidity supply and performance feedback for that liquidity, should present strong, structural arguments that, when carefully examined, result in legions of smug looking Going Private readers sunning themselves while floating on liquid(ity) in their new yachts.

Again, I don't make the case here that I am some genius investor.  Merely that even a young girl with a newly minted MBA, a student of the Chicago School writing a private equity blog in her spare time could see what was happening.

Clever investors (e.g. Paulson & Co.) took the time to dig deep into the structures and made small fortunes allocating capital effectively as a result of the crisis.  Of course, these investors, the only ones actually exercising any intellectual calories, are now symbols of the evil profiteering of otherwise innocent market actors.

Now, what sort of myopic intellectual arrogance does it take to blame the results of this borderline criminal bit of statism on the facts that Moodys, Standard and Poor’s and Fitch used Gaussian distributions and correlation modeling to assign their ratings, and that these ratings were the crux of regulatory requirements on institutions?  Well, I submit, the kind of myopic intellectual arrogance that Mr. Ritholtz’ piece displays.  At the heart of it is the conceit that we (the United States) can tame the cycles of the market with the force of our will.  That if only we had the right leaders, these crises would be avoided.  If only we hadn’t deregulated so far.  Of course, no proponent of these positions seems to have any real grasp of how regulated and artificial mortgage markets were at this point- but that takes some work to uncover through the miasma that is today's political rhetoric on the subject.  That, in short, is too much work to try and understand.

The belief that we can reject the cold hard reality described in neoclasical price theory and therefore the Chicago School for a much warmer, fuzzier world is a very appealing one.  We would love a world where we can spike low-end home ownership at will.  Where anyone can enjoy the two car garage stuffed with a pair of new SUVs, and the adjoining macmansion adorned with numerous flat screen TVs, unlimited cable and a perfectly manicured lawn.  Where everyone can live outside their means indefinitely.  Where everyone has a right to insurance.  Cheap insurance.  Where everyone can build inside the bounds of a 50 year floodplain, demand “affordable” insurance for their delusional misunderstanding of their place in the natural world and look to the rest of society to compensate them if the insurer’s premiums (regulated by state mandated risk models to keep them low) are insufficient to cover the rebuilding bills.  A world where 30 minutes study is all that’s required to invest your life savings in a single instrument you selected after reading a glossy brochure on the premise that it is your god given right to make 14% annual returns, and where making a poor selection in that due diligence process is cause for your immediate bailout.

And this is the world that the anti-Chicago School desperately needs.  The world where investing isn’t hard.  Where there is an entitlement to returns.  Where, rather than do painful fundamental analysis, we can rely on simple models that tell us with flawless precision to invest every single dime of our capital in the care of the greatest Sharpe ratio known to man (Bernie Madoff).  Or on three-letter ratings from this or that agency.  In short, a life that rewards intellectual laziness lavishly.  After all, if the world is cruel and cold, and humans are powerless to sway the tide, then what role is there for great leaders?  Great leaders to bring us limitless and effortless prosperity.  Great leaders to punish the evil-doers who gave us imperfect models with fines, perp-walks and, yes, prison.

And this is the ultimate danger of these lines of thoughts.  To adopt a theory that central control of economies is effective, one must believe in omniscient central controllers.  This leads nowhere other than to a cult of personality and unfaltering belief in a perfect leader who will tame markets, be he named Marx, Reagan, Greenspan or Obama.

It is the dogged skepticism of the Chicago School that results in its opposition to such notions.  But, like other criticisms of homocentric thinking, it is doomed to be attacked and decried with the sort of criticism that populists often take advantage of: It is cold-hearted and unmoving.  It requires of us real work.  It requires us to admit that capitalism is hard.  That there are no free lunches.  That merely voting for the right leader and hoping for the best is not sufficient.  And, like the Copernican model, which should have put forever to rest the notion that mankind is the center of the cosmos, it fails to give mankind’s vanity its due.  Copernicus was infinitely lucky not to live to see the publication of his works as he no doubt would have been killed for them.  It would be a pity if the same might be said of Friedman in twenty years.

Our need to remake Cook, rather than face the baser reality of the time in which he lived, and the fact that his conquests, and those of adventurers like him, most likely resulted in more efficient allocations of resources and in large measure the historically remarkable prosperity we now enjoy, is both understandable and dangerous.  The same can be said of the propensity to demonize models in a vain attempt to soften the world.

When I was learning about Gaussian distributions my professor admonished us after every example he gave.  “Do not use this blindly in the real world.  It will turn around and bite you.”  Gaussian distributions were useful much of the time, he warned, often enough to lull you into a false sense of security.  The real world, he cautioned, looks far more like hydrodynamics, and wave theory.  Guided most often by Gaussian distributions, enough so to allow prediction accuracy 99% of the time, until chaotic seas make nonlinear Schrodinger equations more apt and (out of "nowhere") a rogue wave sinks your 99th percentile hull design as easy as you crack an egg for breakfast.  The world was likely overlaid by more than one model, he suggested.  One, which rules most of the time, calmly predictable and familiar, and one (or many) that lurked just beneath, waiting to show itself in all its fury when conditions were right.  Woe to the practitioner who failed to heed this warning, one he echoed for the nth time, sternly before the final (one of my last).  That practitioner is doomed.

That professor, by the way, was Eugene Fama.

Art Credit: John Cleveley the Younger "Death of Cook," (1784) National Maritime Museum, London.  (Discovered, 2004 in private British collection).

Monday, September 22, 2008

The Spiral - Part IX - Paulson

will 20,000 liters be enough? Part IX of the Going Private miniseries "The Spiral." With the Chairman and CEO missing in action, the margin calls come in.  A team of bankers meets secretly as they prepare to gut The Firm.  The complicity of certain regulators leaves a foul stench in the air as the Firm's negotiators prostrate themselves before the presence of a Wall Street luminary.  The offers are low.  Very low, and turmoil threatens to destroy what is left of the Board of Directors.  Despondent, one mistress resorts to an old habit for consolation.

paulson.mov [3 minute 30 second, 59.3mb quicktime H.264 movie]

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