Kevin Drum

Stupid Ratings Agency Tricks

| Wed Dec. 24, 2008 12:35 AM EST

STUPID RATINGS AGENCY TRICKS....In an obvious effort to avoid being tarred and feathered by an angry mob, Wall Street apparatchik Noah Millman engages in a lengthy self-criticism session tonight regarding "structured finance" — you know, mortgage securitization, credit default swaps, synthetic CDOs, and all the other financial weapons of mass destruction that have helped melt down the world lately. "I thought it would be of interest," he says, "to relate two stories from my long career in structured finance, one that may help explain why, if you asked me in 2004 or 2005, I would have staunchly defended structured finance technology as having real social benefit and why, by a couple of years later, it was clear to anyone looking honestly at the business that something had gone very wrong."

Yes! It would be! And all kidding aside, we've actually seen very little about this stuff written by the people who actually engineered it all. So it really is interesting.

Noah promises to tell us about the "promise and peril" of structured finance, and the "promise" part has to do with the way CDOs and CDS helped make it possible for banks to expand lending in the dismal wake of the Enron/Worldcom/dotcom bust in 2002. That's fine, but let's be honest: it's not what we're interested in, is it? We want to hear about how structured finance destroyed the planet. So let's skip right to the "peril" part.

And it's pretty good. Noah tells the story of the constant-proportion debt obligation, aka CPDO, a cute little invention of the end stage bubble industry. In a nutshell, here's how it worked: the issuer bought up a bunch of BBB securities, and every six months they sold off both the poor performers and the good performers, replacing them with more BBB securities. The idea was to keep the yield roughly the same over time, but since they lost money on the junk and made money on the good stuff, on average they came out even. Or even took a small loss, what with fees and all. So why bother?

Enter the rocket scientists. Even BBB securities are unlikely to default in the short term, which means that the CPDO is basically pretty safe since it sells stuff off every six months. And since it's safe, the issuer can borrow lots of money against it to invest in longer-term bonds. That's called leverage, my friends:

And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you've got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

....When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it's an outright fraud. You're practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious.

The moral of this particular story is: back during the bubble the ratings agencies were idiots. And today, they might even be worse. Read the whole thing for more.

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Blago Update

| Tue Dec. 23, 2008 7:22 PM EST

BLAGO UPDATE....In a turn of events that should surprise no one, Barack Obama has investigated himself and discovered that his staff engaged in no wrongdoing in the Rod Blagojevich affair. According to investigation czar Greg Craig, the accounts he received from staff members "contain no indication of inappropriate discussions with the Governor or anyone from his office about a 'deal' or a quid pro quo arrangement in which he would receive a personal benefit in return for any specific appointment to fill the vacancy."

The reason Craig uncovered nothing wrong is almost certainly because nobody did anything wrong. Unfortunately, investigating oneself isn't likely to convince anyone who doesn't want to be convinced in the first place, which makes me think there really ought to be some way for prosecutor Patrick Fitzgerald to weigh in on this. I guess the rules don't allow it, and rules are rules, but still. In the Valerie Plame case, he at least released enough information in the charging documents to allow people to draw their own conclusions about who did what to whom, and perhaps, eventually, he'll do it this time too. It really doesn't seem right to just leave this hanging forever.

The Decline and Fall of the Newspaper

| Tue Dec. 23, 2008 2:51 PM EST

THE DECLINE AND FALL OF THE NEWSPAPER....I was going to write a post about the subject du jour, namely whether or not newspapers could have done a better job of reacting to the rise of the internet, but via Matt, I see that Tim Lee has pretty much done it for me. Nickel version: Yes, it would have been great if railroads had converted into airline companies, if IBM had taken PCs more seriously, and if newspapers had embraced the web, but that kind of thing is really, really hard to do. That's why it so rarely happens. Cannibalizing your own business is almost impossible for both institutional and economic reasons, and knowing that you're in the generic transportation business, not the train business (or the generic computing business or the generic information business) isn't nearly as profound an insight as some people think. Anyone who thinks differently needs to run an actual business first and then report back on how they did converting its core business into something brand new.

In any case, I have my doubts that there was ever a long-term business model that could have successfully transitioned newspapers onto the web. Sure, the print news media could have done more — though simply asserting that newspapers could and should have been way more awesome isn't very helpful — but the advertising revenue just isn't there to support the kind of reporting infrastructure that the print version of newspapering supported. This isn't for lack of trying, either. Everyone and his brother has tried to figure out a more lucrative web-based advertising model for news, and so far no one has succeeded. Bright ideas are still welcome, of course, but most likely even the best newspapers will eventually die off and be replaced by something entirely different. I'm not as convinced as some that the replacement will be as good, but I suppose old fogies have said that before too more than a few times. We'll just have to wait and see what our brave new bloggy/twittery/decentralized news biz manages to deliver.

Twitter Followup

| Tue Dec. 23, 2008 1:44 PM EST

TWITTER FOLLOWUP....Via James Joyner, Michael Arrington writes on his blog that he thinks Twitter has ruined uber-twitterer Robert Scoble's life:

I asked Robert how much time he actually spends on those services. He monitors them all day, he said, hitting refresh over and over on both (he doesn't use desktop clients to manage the services, and he says he doesn't like real-time streaming feature on Friendfeed). In addition to watching all day, he says he spends at least seven hours a day, seven days a week, actually reading and responding directly on those services.

That's 2,555 hours over the last year....It is an addiction.

What is the cost of this addiction? Well, I'll put his family life aside, that's his business. But his blog has clearly suffered. He now posts only a few times a week, sometimes sporadically writing multiple posts in a day but often skipping 3-4 days in between. A year ago, Robert wrote multiple posts, every day. I used to read his blog daily, now I visit once a week.

As an aside, I'll note how amusing it is that in the same way that people once complained that blogging crowded out "serious" long form work like books and magazine pieces, people are now starting to complain about Twitter crowding out "serious" blog posts. The worm, she does turn.

Anyway. I created a Twitter account a couple of days ago after I posted about it, since I figured that was the only way to get a better sense of what it was all about. So far, I've tweeted twice, so obviously I haven't exactly embraced the form. But in a way, I think Arrington's post captures one of the problems with Twitter: like Facebook, it doesn't really make too much sense unless you spend a lot of time with it. It doesn't have to be 2,555 hours a year, mind you, but both Facebook and Twitter strike me as things that are perhaps moderately useful if you use them occasionally, but potentially highly useful if you're logged into them constantly and use them as primary tools for keeping in touch with people. That's unlike the blogosphere, where most people pick three or four blogs to follow and read them once a day for 20 minutes or so, and it's one of the things that makes these services hard to "get" unless you're totally committed to them.

Of course, I could be full of hooey here. But that's my take so far.

Sand in the Gears

| Tue Dec. 23, 2008 1:11 PM EST

SAND IN THE GEARS....Dean Baker explains to Ezra Klein why so few economists predicted that the economy was headed for disaster: there's not much risk in agreeing with the conventional wisdom and being wrong, and there's not much reward in bucking the conventional wisdom and being right:

[W]hat would an economist expect to happen in a situation in which option one carries no risks and reasonable expected rewards and option two carries enormous risks and only moderately higher expected rewards? In short, the incentives in the economics profession, just as in finance, strongly encourage a lack of original thinking.

Actually, I think this is too simplistic. There are some exceptions, of course, but even the economists who saw the housing bubble for what it was mostly didn't predict that its bursting was going to cause a massive global credit crunch and the biggest slowdown since the Great Depression. In fact, to a large extent, we still don't quite know why the reaction to the housing bust has been so severe. So there's a genuine question here that's worth diving into in more detail.

Still, I think Baker is basically right, and it's worth keeping in mind how the incentives work in the finance industry. Suppose, for example, that everyone on Wall Street knows there's an investment strategy that will pay off big 19 years out of 20, but implode in that one remaining year. What's the right thing to do?

Obviously, the answer is: follow the flawed strategy. If you don't, and everyone else does, then within a couple of years you'll either get with the program or you'll be out of a job. Even in the absence of any kind of fraud or collusion or mass insanity, following a strategy that you know will be disastrous 5% of the time is simply too profitable to pass up.

Given that, what should be the role of the government in trying to prevent systemic meltdown? Regulations that target fraud are useful, but remember: even if everyone is purer than Caesar's wife, they'll still be forced to follow the flawed strategy. They can't afford not to, and unless they're smart enough to predict precisely when the 5% of disasters will take place (and few are), the collective result is some kind of periodic meltdown.

My own guess is that the answer is a set of regulations that slow things down. Something that throws just a little bit of sand in the gears of the global finance machine and prevents bubbles from growing quite as quickly as they otherwise might. Baker has proposed a small fee on financial transactions, for example, and that seems like the right kind of idea. I've long thought that very modest capital controls might also be a good idea, even for advanced economies. In the mortgage market, requiring even a small down payment plays the same role.

I think one misconception that's become awfully popular recently is that the current meltdown is a "black swan" event, a perfect storm that happens only once a century or so. But I think Paul Krugman has made a persuasive case (in both the original edition of The Return of Depression Economics and the new one) that the kind of bubble related disaster we're seeing now is simply a common feature of the modern, global, hyper-fast, hyper-unconstrained financial market. The only difference is that it's mostly affected only small countries in the past couple of decades, and now it's worked its way all the way up the food chain — and if we don't introduce a little bit of institutional deliberation and constraint into the system, this won't be the last time we see it. Given the limitations of human wetware, after all, there may be such a thing as a financial system that's too efficient.

Saving the Lada

| Tue Dec. 23, 2008 12:10 PM EST

SAVING THE LADA....The government plans to bail out the country's big automakers and the public is unhappy over the deal. Old news? Sure, except it's happening in Russia too:

The dozens of demonstrations that have cropped up across Russia in recent weeks haven't been particularly big. However, they have been significant as the first notable show of widespread dissent in the near-decade since Prime Minister Vladimir Putin cemented his hold on power.

Organizers say they will keep up the pressure unless the government reverses its decision to raise taxes on imported automobiles.

....The tax hike, which will be determined for each vehicle based on a complicated formula, will drastically increase the cost of foreign cars and trucks. Vehicles older than 5 years will be slapped with a duty of at least 70%, making their importation unprofitable.

This dynamic is playing out everywhere: governments all want to bail out their auto companies, but not every auto company can survive. There's just too much vehicle manufacturing capacity in the world, and there has been for a while.

However, this story also suggests that, against all odds, it may be the consumers of the world who prevent a mass outbreak of new beggar-thy-neighbor tariff rules. National governments understandably feel a lot of pressure to protect their local industries, but it might turn out that their publics don't really agree. Americans don't like American car companies all that much, it turns out, and Russians don't like Russian car companies either. Siberians would rather buy a Toyota than a Lada.

This might not turn out to be case for every industry, of course, but I wouldn't be surprised if it restrains central governments from going too far down the protectionist path. Imports are just too popular with the unwashed masses.

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Shoeing the Prez

| Tue Dec. 23, 2008 11:35 AM EST

SHOEING THE PREZ....I agree with Daniel Davies that tossing shoes at George Bush and tossing pies at Tom Friedman are both basically funny things, not worth getting a stick up your butt about. Just have a laugh, don't let it get out of hand, and relax.

Following up on that, however, he admits: "Although seeing Bush get shoed was a laugh, it's a nervous sort of laugh for anyone who is worried about the possibility of President Obama being assassinated, which I know that a lot of people are. And statistically, they're right to be worried. Roughly 10% of all US Presidents ever elected have been assassinated (4 out of 43), which is roughly as high a death rate as street drug dealers." Then, with a few heroic assumptions and the help of some geeky friends, he quantifies the job-related mortality rates of being president compared to, say, being a member of Hezbollah or the King of France. Turns out that being president is more dangerous. Read the whole thing if you want to know how much more dangerous.

Guantanamo Update

| Tue Dec. 23, 2008 2:08 AM EST

GUANTANAMO UPDATE....In the Washington Post today, Peter Finn reports that European countries, which have had an obviously fraught relationship with the Bush administration over Guantanamo and the legal treatment of terrorist suspects in general, is looking forward to working more closely with Barack Obama on these issues. In particular, they may be willing to accept the resettlement of Guantanamo detainees into their countries:

The Europeans want a clear commitment to close Guantanamo Bay and an acceptance of common legal principles in the fight against terrorism, including those regarding the treatment of suspects, European officials said. A series of meetings between the United States and the European Union on a legal framework for combating terrorism has considerably narrowed differences on the application of human rights law, refugee law and humanitarian law, said Amado and John B. Bellinger III, a legal adviser at the State Department.

The Europeans also want Obama to agree to transfer a small number of detainees to the United States before they attempt to sell a resettlement program to their own citizens.

....Guantanamo Bay currently has about 250 prisoners, according to the Pentagon. And some European officials said a number of governments are considering the logistics of resettling a majority of the 60 prisoners already cleared for release by U.S. authorities.

The Pentagon has not identified the 60, but a study released by the Brookings Institution last week found that as well as the Chinese Uighurs, the group includes detainees from Yemen, Tunisia, Algeria, Uzbekistan, Iraq, Saudi Arabia, Egypt, Libya and the Palestinian territories. The Brookings study found that these prisoners "concentrate at the less dangerous end of the spectrum."

The whole story is a little hard to follow, which is probably because nothing even close to definitive has been settled yet. Mostly it's just a feeling that EU countries are looking forward to a more constructive relationship with Obama than with Bush, and may be willing to make some compromises on their end to start things off on the right foot.

It's all very mushy at this point, but obviously good news regardless. The question of what to do with Guantanamo detainees that nobody wants is a genuinely difficult one. If the EU helps out here, it makes it a lot more likely that Guantanamo will be shut down sooner rather than later.

Department of Labor

| Mon Dec. 22, 2008 8:58 PM EST

DEPARTMENT OF LABOR....Victor Davis Hanson is unhappy with Barack Obama's choice to head the Department of Labor:

I'm sure that the labor secretary nominee Hilda Solis is a bright and savvy politican. But a labor secretary is supposed to reflect some balance between labor and management, one that seeks to hammer out compromises in the best interests of the nation. Her record, however, is exclusively pro-union without exception or doubt.

Maybe my memory is just getting fuzzy as I get old, but I sure don't remember very much conservative concern with "balance between labor and management" when George Bush chose Mitch McConnell's wife to be Secretary of Labor eight years ago. Do you?

Let's see. Before her appointment, Elaine Chao spent four years as a fellow at the Heritage Foundation. She campaigned tirelessly with McConnell against the Employee Free Choice Act. Her choice to head up OSHA was a partner at one of the best known union-busting lawfirms in the country. Under her watch the NLRB reclassified 8 million workers as "supervisors," primarily in an attempt to throw a wrench in unionizing efforts. New overtime rules wiped out time-and-a-half for 6 million workers. The probability of union organizers being fired went up by more than half.

Now, that's about what I'd expect from an administration that's exclusively pro-business without exception or doubt. But after eight years of that, it's a little rich to complain when a liberal president nominates a Secretary of Labor who's actually pro-labor. Less whining, please.

Domestic Spying

| Mon Dec. 22, 2008 2:44 PM EST

DOMESTIC SPYING....Over the weekend Dick Cheney made a point of saying that congressional Democrats were fully on board with the NSA's domestic spying program during the 2001-04 period. This may or may not be completely true, but there's plenty of evidence that it's mostly true: the NSA program really was approved on a bipartisan level. Spencer Ackerman comments:

Cheney might not be acting in good faith, but he's nevertheless pointing to something barometrically significant. In Washington, the phrase "bipartisan" is supposed to cash out to something like "legal" or "wise" or "no longer controversial" or "kosher." The Germans probably have a word that's a more acceptable translation. In any event, that's self-evidently foolish: lots of people can make mistakes and lots of people can make venal decisions, and it's not a function of belonging to one political party or the other. Cheney doesn't get off the hook if Nancy Pelosi is on it with him. Naturally, what I imagine Cheney's doing is warning the Democrats off creating an independent commission into the abuses of the administration, lest it go after them too, but that's all the more reason one should be created.

Agreed. Unfortunately, there appears to be literally no one who has any incentive to do this. Not Republicans, not Democrats, not Bush loyalists, and not Barack Obama, who voted for the wiretapping bill earlier this year and really has no reason to want this to continue to be an issue. Unfortunately, this whole issue is probably destined to fall quickly down the memory hole.