Talking Points Memo has an interesting insight into why AIG was bailed out.

 Derivatives claims are not stayed in bankruptcy. (Yet another brilliant innovation from the 2005 bankruptcy reform legislation.)

If AIG were to go down, derivatives counterparties would be able to seize cash/collateral while other creditors and claimants would have to stand by and wait. Depending on how aggressive the insurance regulators in the hundreds of jurisdictions AIG operates have been, the subsidiaries might or might not have enough cash to stay afloat. If policyholders at AIG and other insurance companies started to cancel/cash in policies, there would definitely not be enough cash to pay them. Insurers would be forced to liquidate portfolios of equities and bonds into a collapsing market.

In other words, I don’t think the fear was so much about the counterparties as about the smoking heap of rubble they would leave in their wake.

If this is true, this is probably the single biggest flaw in the 2005 bankruptcy reform legislation.   Frankly, I’m kind of shocked by the possibility that a relatively small lobby group could get such a favorable piece of legislation passed.  One would think that the bond holders of the world would freak out when their claim was suddenly reduced to the level of equity in the event of a derivatives blow-up.  Bravo to the International Swaps and Derivatives Association, though, for getting themselves super-senior status and the ability to make a claim on assets even as the claims of other creditors are stayed by bankruptcy laws.  If I ever needed to hire a lobbyist, I’d probably try to poach their talent.

Michael Lewis has an incredible article up at Vanity Fair detailing the story behind the collapse of Iceland. I like it because it gives some cultural context to what happened– I know the economic reasons Iceland collapsed, but that really doesn’t make it clear why it happened. One of the best parts is this metaphor:

Yet another hedge-fund manager explained Icelandic banking to me this way: You have a dog, and I have a cat. We agree that they are each worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners, but Icelandic banks, with a billion dollars in new assets. “They created fake capital by trading assets amongst themselves at inflated values,” says a London hedge-fund manager. “This was how the banks and investment companies grew and grew. But they were lightweights in the international markets.”

That pretty much describes the world asset markets over the past few years. People feel wealthier because the notional value of their assets goes up. They don’t seem to even consider what the liquidation value of those assets would be. Consider retirement, for instance. If a large cohort like the Baby Boomers were to retire, the simultaneous sale of assets would push the prices of those assets down. The traditional approach to saving for retirement therefore falls apart during transitions between cohorts of vastly different sizes. If another bank bought the billion-dollar cat in the metaphor for two billion dollars, would it be conservative for the bank that bought the dog to value it at merely one billion dollars (and thereby meeting the GAAP definition of conservatism)? Of course not! In this instance, book value dramatically overstates the value of the asset. In a lot of ways it doesn’t seem right to group financial assets with tangible assets. Accounting statements should come with some sort of sensitivity analysis or probability distribution. Of course, this is likely to be done poorly, but as long as companies had to state their assumptions, investors could back out realistic values.

In November 2003, Shearer learned that Kaupthing, of whose existence he was totally unaware, had just taken a 9.5 percent stake in his bank. Normally, when a bank tries to buy another bank, it seeks to learn something about it. Shearer offered to meet with Kaupthing’s chairman, Sigurdur Einarsson; Einarsson had no interest. (Einarsson declined to be interviewed by Vanity Fair.) When Kaupthing raised its stake to 19.5 percent, Shearer finally flew to Reykjavík to see who on earth these Icelanders were. “They were very different,” he told the House of Commons committee. “They ran their business in a very strange way. Everyone there was incredibly young. They were all from the same community in Reykjavík. And they had no idea what they were doing.”

Ha!

In early 2006, for instance, an analyst named Lars Christensen and three of his colleagues at Denmark’s biggest bank, Danske Bank, wrote a report that said Iceland’s financial system was growing at a mad pace, and was on a collision course with disaster. “We actually wrote the report because we were worried our clients were getting too interested in Iceland,” he tells me. “Iceland was the most extreme of everything.” Christensen then flew to Iceland and gave a speech to reinforce his point, only to be greeted with anger. “The Icelandic banks took it personally,” he says. “We were being threatened with lawsuits. I was told, ‘You’re Danish, and you are angry with Iceland because Iceland is doing so well.’ Basically it all had to do with what happened in 1944,” when Iceland declared its independence from Denmark. “The reaction wasn’t ‘These guys might be right.’ It was ‘No! It’s a conspiracy. They have bad motives.’” The Danish were just jealous!

Ian and I were actually talking about this today. You should be wary of people who claim that any disagreement with them is disingenuous. Paul Krugman, for example, has a bad habit of claiming that anyone who disagrees with him must secretly agree with him (after all, he’s always right! j/k), and therefore be claiming he’s wrong as part of a sinister agenda. This obviously isn’t the case.

Then Lewis makes a statement that I disagree with wholeheartedly

One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.

First, shorts have no motive to keep their thoughts to themselves. If I think the market will plunge soon, I’ll short as much as I possibly can, then stand on the roof tops shouting out why I think the market will plunge. The worst worst worst thing a short can do is keep quiet. If the short keeps quiet, the price keeps climbing and makes their position less tenable.

Second, shorts weren’t the ones who caused the problem. The barely sentient people who thought that housing prices would always go up, who thought that normality is a fair assumption for the stock market, who believed in the myriad of idiocy that permeated our financial markets are to blame. Why on earth would you blame the few people who saw it coming and were confident enough to do something?

Third, this assumes that rational argument would have done something. I spent hour telling friends not to buy a house while the boom was still on, spent hours trying to convince people that it wasn’t a good time to buy stocks, but people don’t listen.  Not only do you not know whether the other person is correct about a future event happening, the constant feed of evidence proves them wrong.  For example, if you told someone that housing was a bubble in 2004, the next 2-3 years would have been evidence suggesting they were wrong.

So what do you do?  You find a way to profit off of your knowledge.

Icelanders—or at any rate Icelandic men—had their own explanations for why, when they leapt into global finance, they broke world records: the natural superiority of Icelanders. Because they were small and isolated it had taken 1,100 years for them—and the world—to understand and exploit their natural gifts, but now that the world was flat and money flowed freely, unfair disadvantages had vanished. Iceland’s president, Olafur Ragnar Grimsson, gave speeches abroad in which he explained why Icelanders were banking prodigies. “Our heritage and training, our culture and home market, have provided a valuable advantage,”

The inevitable self-justifications.  Lewis utterly savages this view.  If this were the case, why would it take 1100 years for people to realize it were true?

“We’d like you to explain our financial crisis,” she says. “I’ve only been here three days!” I say. It doesn’t matter, she says, as no one in Iceland understands what’s happened. They’d enjoy hearing someone try to explain it, even if that person didn’t have any idea what he was talking about

That’s actually really sad.  As bad as it would be to have the economy crumble around you, it would be just awful to not know why.

There’s a charming lack of financial experience in Icelandic financial-policymaking circles. The minister for business affairs is a philosopher. The finance minister is a veterinarian. The Central Bank governor is a poet. Haarde, though, is a trained economist—just not a very good one. The economics department at the University of Iceland has him pegged as a B-minus student.

Wow.  Just ‘wow’.

Haarde has his story, and he’s sticking to it: foreigners entrusted their capital to Iceland, and Iceland put it to good use, but then, last September 15, Lehman Brothers failed and foreigners panicked and demanded their capital back. Iceland was ruined not by its own recklessness but by a global tsunami. The problem with this story is that it fails to explain why the tsunami struck Iceland, as opposed to, say, Tonga.

Another self-justification.. this one preventing them from learning from their mistakes.  Not a good sign for the future.

The other, more serious problem was the Icelandic male: he took more safety risks than aluminum workers in other nations did. “In manufacturing,” says the spokesman, “you want people who follow the rules and fall in line. You don’t want them to be heroes. You don’t want them to try to fix something it’s not their job to fix, because they might blow up the place.” The Icelandic male had a propensity to try to fix something it wasn’t his job to fix.

Insane that a culture would leave a people basically unemployable.  It’s one thing to fix things on a fishing vessel that you completely understand, but a whole other thing to start tinkering with a finely tuned production facility.  Michael Lewis actually managed to get the following exchange, which pretty much sums up Iceland’s problem:

“You spent seven years learning every little nuance of the fishing trade before you were granted the gift of learning from this great captain?” I ask.

“Yes.”

“And even then you had to sit at the feet of this great master for many months before you felt as if you knew what you were doing?”

“Yes.”

“Then why did you think you could become a banker and speculate in financial markets, without a day of training?”

“That’s a very good question,” he says. He thinks for a minute. “For the first time this evening I lack a word.” As I often think I know exactly what I am doing even when I don’t, I find myself oddly sympathetic.

I just can’t believe that a bunch of ex-fishermen were given enough capital to cause this kind of problem.  Utterly insane!

The whole thing’s worth a read.

I recently came across an amazing working paper by William White at the Bank of International Settlements and was waiting until I had enough time to say something about it. Written back in 2006, the paper savages the prevailing view of monetary policy, and suggests that it will basically lead to the kind of problems that we’re facing right now. Essentially, the paper argues that the asymmetry inherent to Fed’s monetary policy will lead to bubbles, and an increasingly ineffective monetary policy. The whole thing is worth a read, but I want to go over some of my favourite parts. (This might kind of suck because I’m barely awake, but the paper is nonetheless worth reading).

A further problem arising from the conventional approach is that, as imbalances accumulate over time, the capacity of monetary policy to deal with them could also become progressively reduced. A combination of raising rates less in the booms than they are lowered in successive busts could eventually drive policy rates close to zero.

This is from pretty late in the paper, but I thought it was the most interesting insight of the paper. It certainly is true. One of the biggest reasons monetary policy has been so ineffective is that it started from such a low level. Of course, one could argue that this was a result of the massive decrease in macroeconomic volatility we’ve experienced in recent years (the great moderation).

Nevertheless, to date there has been a marked unwillingness to tighten monetary policy in response, except to the degree seemingly warranted by the estimated direct effects on overt inflation. As noted above, the arguments commonly used are that “bubbles” in asset prices are hard to identify, and that “pricking the bubble” would demand interest rates so high as to damage other, unaffected parts of the economy. Yet a convincing counterargument is that the indicators considered by policymakers should extend well beyond asset prices. Rather, it is the combination of rapid credit growth, rising asset prices and unusual (unsustainable) patterns in the composition of aggregate demand that should elicit a monetary response. The former two series point to the probability of a subsequent problem or crisis, while the latter two give some idea of the prospective associated costs should the problem materialise. For example, an abnormally low rate of household saving (say due to intertemporal optimising facilitated by modern financial markets) implies the need for future retrenchment, which could materially slow spending. Similarly, an abnormally high rate of corporate investment could imply unprofitable outcomes, with subsequent negative effects on the demand for both capital and labour.

A tightening of monetary policy in the face of a combination of these indicators would, at the least, moderate the intensity of the upturn and, in turn, the subsequent damage. Moreover, the recognition that the monetary authority was likely to react in this way might also lead to changed behaviour on the part of economic agents. This could reduce the degree of inherent procyclicality in the system. While this might seem far-fetched, such a response would be very similar to that which followed the decision of central banks to pursue the objective of price stability. Expectations of inflation became much better anchored as a consequence, and the need for sharp policy responses much attenuated.

I think this is a really profound insight: Greenspan’s cop-out about asset price bubbles being difficult to identify ignores the fact that even if one cannot clearly determine whether something is a bubble or not, one can look for unsustainable consumer/producer behaviour and make policy accordingly.

Of course, there are limits to this argument. The massive decrease in consumer saving over the 90’s and 00’s were largely a result of low interest rates and small risk premiums. Consumers didn’t save much because the reward for saving was too low. Of course, the Federal reserve could tighten monetary policy and thereby boost interest rates, but doing so wouldn’t necessarily be an optimal policy. First, the massive amount of savings coming from Asia would reduce the Federal reserve’s ability to significantly impact risk premiums in both American and international markets. Second, raising interest rates would cause a further increase in the value of the US dollar, thereby having a negative impact on America’s trade deficit (resulting in Asian countries having even more US dollars with which to bid for American assets, thereby further decreasing risk spreads). Further, the final result of this policy would be more worldwide savings. If the original problem is that there is too much worldwide savings, pushing Americans to save more won’t necessarily fix the problem. (Of course, raising interest rates in the US will make leverage more expensive, eventually decreasing the overall money supply in the US, but investors would have/did substitute for a cheaper source of funding: the Japanese carry trade– so it isn’t clear to me whether the eventual result would have been more or less savings/leverage).

Third, and pertaining more to well developed financial markets, lower interest rates can enhance the “search for yield”. This will particularly be the case for financial institutions (like insurance companies and defined benefit pension funds) that must hit predetermined hurdle rates. This both induces investors to purchase increasingly risky assets, and to use increased leverage to raise rates of return on equity. Such behaviour becomes manifest in reductions in risk premia on lower-rated paper and sovereigns, and on the increased availability of low cost finance to support venture capital investments and to purchase asset-backed securities.

I think this points to something a lot of people seem to forget about the time before the housing bubble collapsed. Risk spreads around the world were almost completely compressed. I remember trying to find a class of asset that was underpriced, and not being able to find anything, anywhere. There was so much money sloshing around the globe that the price of risk was nearly non-existent.

whether growth will prove sustainable remains an open question. One possibility is that the cumulative monetary stimulation seen to date will eventually culminate in overt inflation. Recent sharp increases in energy and commodity prices could provide a foretaste of such an outcome. With the short-run Phillips curve now seemingly flatter than before, reversing any shift upwards in inflationary expectations might be costly and necessitate a more significant tightening of monetary policy than is currently expected.

Another effect of this cumulative stimulation has been an upward trend in household debt ratios in the United States and in many other countries, accompanied by a trend downward in national savings rates, both to new historical records most recently. In China, in contrast, domestic investment has been drifting up and now stands at a record high proportion of GDP. Moreover, in global asset markets, many risk premia have also descended to record lows even as house prices have risen to record highs. Global current account imbalances are also at unprecedented levels, with those countries having the largest external deficits generally exhibiting the largest internal imbalances as well. Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously.

A further problem arising from the conventional approach is that, as imbalances accumulate over time, the capacity of monetary policy to deal with them could also become progressively reduced. A combination of raising rates less in the booms than they are lowered in successive busts could eventually drive policy rates close to zero. Once at the zero lower bound, the Japanese experience indicates that the power of monetary policy to stimulate the economy is much reduced. Should the economy then turn down, with inflation initially at a very low level, the possibility then arises that a more disruptive form of deflation might emerge. Were that to happen, it has been suggested that an even more “unconventional” monetary policy stance than that applied in Japan would be called for, with all its associated uncertainties. That this was the end point to which the conventional way of conducting policy almost led us would, in itself, seem a powerful argument for further refining the basic framework.

 

Isn’t this almost exactly what ended up happening? Inflation started rising, the Fed raised rates, and multiple simultaneous markets collapsed. Since asset-price imbalances built up over time (housing bubble, compressed risk premiums across pretty much the entire globe, etc), monetary policy has largely been useless in dealing with these problems.

Moreover, while most Keynesian models assume a relatively smooth adjustment from one equilibrium to another, the Austrians stressed growing imbalances (cumulative deviations away from equilibrium) and an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it. The underlying reason for this last observation is that the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.

Behold! The rise of Austrian economics. Well, maybe, if they can get rid of the ridiculous gold bugs, etc.

Seriously, though, I think the amazing thing about this paper is that it hits on so many of the issues that ended up coming to fruition when the housing bubble crashed. Because the author was able to predict with such accuracy, I think maybe we should give his prescriptive measures a bit more thought. I won’t bother quoting them here, but he basically suggests we allow for mild amounts of deflation to get rid of the asymmetry in monetary policy, while actively trying to reduce macroeconomic volatility by attacking asset price bubbles.

Randomly came across this on Google:

http://www.bcsc.bc.ca/uploadedFiles/BCPortfolioChallenge.pdf

I’m surprised they haven’t updated the pdf!  That competition was a couple years back.

Charles Platt, a New York Post reporter, decided to go undercover at Walmart in order to gain some insight into how the Arkansas-based behemoth operates.  What he found was pretty cool:

Having pledged ourselves, we encountered the aspect of Wal-Mart employment that impressed me most: The Telxon, pronounced “Telzon,” a hand-held bar-code scanner with a wireless connection to the store’s computer. When pointed at any product, the Telxon would reveal astonishing amounts of information: the quantity that should be on the shelf, the availability from the nearest warehouse, the retail price, and (most amazing of all) the markup.

All of us were given access to this information, because - in theory, at least - anyone in the store could order a couple extra pallets of anything, and could discount it heavily as a Volume Producing Item (known as a VPI), competing with other departments to rack up the most profitable sales each month. Floor clerks even had portable equipment to print their own price stickers. This was how Wal-Mart detected demand and responded to it: by distributing decision-making power to grass-roots level. It was as simple yet as radical as that.

We received an inspirational talk on this subject, from an employee who reacted after the store test-marketed tents that could protect cars for people who didn’t have enough garage space. They sold out quickly, and several customers came in asking for more. Clearly this was a singular, exceptional case of word-of-mouth, so he ordered literally a truckload of tent-garages, “Which I shouldn’t have done really without asking someone,” he said with a shrug, “because I hadn’t been working at the store for long.” But the item was a huge success. His VPI was the biggest in store history - and that kind of thing doesn’t go unnoticed in Arkansas.

He was invited to corporate HQ as a guest at a management conference. “It was totally different from what I expected,” he told us. “I thought it would be these fatcats talking about money, but no one even mentioned money. All they cared about was finding new ways to satisfy customers. I met everyone including the chairman of the company.”

The idea of Walmart giving employees a great deal of autonomy continues later on.

 My amiable, laid-back department supervisor had been doing this kind of thing for 15 years. When I asked him why, he took a moment to process the question. He had to think back to other employers he’d worked for in the distant past. None of them, he said, had treated him so well.

What exactly did he mean by that?

His answer lay in the structure of the store. “It’s deceptive, because Wal-Mart isn’t divided into separate stores like a mall,” he said. “But really, that’s how it works. Each section is separate. This is - my pet store! No one comes here and tells me how to run it. I could go for weeks without a supervisor asking any questions.” Here was the unseen, unreported side of the corporate behemoth. Big as it was, it was smart enough to give employees a feeling of autonomy.

I love the idea of Walmart as an integrated mall.  It allows customers the ability to check out at one location, saving time and transaction costs.  It is a far more effective use of space.  At the same time, by giving employees autonomy and a reason to be proud of their record, it still somehow manages to keep the advantage of independent stores in a mall.  Beyond that, employees having the autonomy to order is just amazing.  As the author points out, Walmart has a pretty new-economy ethos.  I was initially shocked to read that employees got to see profit margins.  In retrospect, it makes sense, though.  They likely won’t make deals on single items, and even if the information leaks, it probably isn’t a big deal.  Even if you knew Walmart’s profit margins, you’d need to find a way to compete with them at a better margin– unlikely.

It is interesting to watch as the financial crisis begins to tear Europe apart. Eastern Europe has been hit hardest, but the bad times are quickly moving westward. For the sake of this post, I am going to consider Russia a part of Eastern Europe (sorry everyone in Eastern Europe, haha).

Ambrose Evans-Pritchard neatly details the spread of the crisis:

Not even Russia can easily cover the $500 billion dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36 percent of its foreign reserves since August defending the rouble.

“This is the largest run on a currency in history,” said Mr Jen.

In Poland 60 percent of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly — by lenders and borrowers — it matches America’s sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.

Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74 percent of the entire $4.9 trillion portfolio of loans to emerging markets.

They are five times more exposed to this latest bust than American or Japanese banks, and they are 50 percent more leveraged (IMF data).

Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico’s car output fell 51 percent in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.

The leverage problems facing European banks may even be worse than Evans-Pritchard suggests. John Mauldin’s latest newsletter states:

But European banks may be in far worse shape. Bruno Waterfield of the London Daily Telegraph reports to have seen an eyes-only document prepared by the European Commission for the finance ministers of the various EU member countries. The problem revealed in the report is an estimated write-down by European banks in the range of 16 trillion pounds, or about $25 trillion dollars! The concern is that bailing out the various national banks for such an unbelievable amount would push the cost of government borrowing to much higher levels than we see today.

(…)

Part of the problem is that European banks were far more highly leveraged than US banks. Some banks were reportedly leveraged 50:1. And they lent money to Eastern European projects and businesses which are now facing severe financial strain and plummeting local currencies.

If true, the $25 trillion dollars needed to bail out could overwhelm European economies. Consider that Europe is starting from a lower place than America. Structural problems like labour rigidity, 7-8% unemployment, huge debt-to-GDP ratios, and inefficient tax structures plague Western European countries. If you go into a recession with 7-8% unemployment, and labour laws that will make it incredibly difficult for businesses to downsize or cut wages, things aren’t going to turn around quickly. Combine that with the sheer size of the crisis and the small amount of borrowing room left, and social unrest breaking out, and one has to wonder if the Europe at the end of the crisis will be the same as the Europe we see today (there already is a great deal of speculation that the euro-zone will collapse, or that countries will withdraw from it in order to default on their debt obligations).

The one thing I enjoy about this crisis is that Europe is getting its just desserts. At the start of the crisis, European leaders fell into fits of schadenfreude.

ONE by one, European leaders have lined up to hail the triumph of welfare over Wall Street. “The idea that markets are always right was a mad idea,” declared the French president, Nicolas Sarkozy. America’s laissez-faire ideology, as practised during the subprime crisis, “was as simplistic as it was dangerous,” chipped in Peer Steinbrück, the German finance minister. His Italian counterpart, Giulio Tremonti, claimed vindication for a best-selling book that he wrote about the dangers of globalisation.

It would be wrong to exaggerate Europe’s sense of self-righteousness over Wall Street’s fall. This week governments in Belgium, France, Germany, Ireland and the Netherlands all scrambled to bail out troubled banks, confirming how exposed Europe’s economies are to knock-on effects from America. Even left-wing editorialists in France, quick to sneer at degenerate American capitalism, have tempered their glee. “There would be something comical, even pleasurable, in watching the frenetic agitation of the banking world”, wrote Laurent Joffrin, editor of Libération newspaper, “if millions of jobs were not at stake, not to mention the economic balance of the planet.”

I’m guessing that Europe is less now it turns out that the far more regulated banks in Europe might be in a far less vainglorious mood these days. It’s no surprise that the more highly-regulated banks of Europe are doing worse than the poorly regulated American banks. Regulators are like bad military generals– they always fight the last war. After Enron, people were alerted to that kind of scheme and were therefore less likely to let a similar occurrence happen. The jail time that Enron and Worldcom executives got scared current executives– there’s no point in going to jail for money you could get honestly with almost the same amount of effort. Regulators should have taken the accounting scandals as a sign that corporate America was infiltrated by a bunch of sociopaths. They should have looked out for other kinds of fraud. Instead they passed a bunch of poor-constructed laws that have done little but push new IPOs from New York to London. Good job!

Bad regulation is also sometimes worse than no regulation whatsoever. Check out this video from 5:20-6:20. Madoff uses the SEC’s reputation as a way to put investors at ease. If a market is highly regulated, investors will feel less need to do their own due diligence to detect fraud. Of course, this isn’t an argument against regulation at all levels, just that if a government decides to impose regulations on a market, it becomes incumbent upon that regulator to thoroughly enforce said regulations. I don’t mind the SEC regulating the stock market, I oppose it choosing to regulate and ignoring when evidence of wrongdoing is handed to them on a silver platter.

Europe should never have been so smug, because there is no inherent benefit to regulation. Regulation only makes a place better if that regulation passes a cost-benefit analysis, if it is properly enforced and has penalties commensurate with the harm caused by infraction. Further, the cost of high regulation and government intervention has weakened Europe to the point that the current crisis could have the severest of repercussions.

Felix Salmon links to a pretty cool graph assembled by one of his readers.  It reconstructs the volatility of Madoff’s returns, and strongly hints that Madoff started smoothing returns early on, long before his fund went Ponzi.

 

(Large version here)

Salmon’s conclusion:

In other words, Madoff was never fully legitimate — or at least, looking at this chart, he seems to have been pretty illegitimate from at least 1995 onwards. But he might not have been actively stealing his clients’ money until he blew up at the beginning of this decade, and subsequently moved from being a dishonest fund manager to the operator of a fully-fledged Ponzi scheme.

Dean Baker of the Guardian has a pretty cool article up about an interesting statistical turning point that the US has hit. 

You probably didn’t see this in the newspapers, but real wages rose at an incredible 14.8% annual rate over the last three months. The basic story is straightforward. While nominal wages have continued to grow at a modest 3.2% annual rate, prices have plummeted, hugely increasing the value of the paycheques of those workers lucky enough to still have a job.

This pattern is not likely to continue. Price declines will almost certainly slow, and rising unemployment will dampen nominal wage growth

(…)

Put simply, real wages rose because house prices and stock prices crashed. The collapse of the housing bubble destroyed more than $6tn of housing bubble wealth, while the plunge in the stock market eliminated more than $8tn in stock wealth.

He then details how oil prices, car prices, hotel prices, etc have crashed recently. 

If you think of all the trends that are coming to a head right now– huge negative wealth effect from the financial markets, deflationary effect from the drop in commodity prices, the impact of increasing unemployment, changes in currency prices affecting import and export prices, etc.. and then think that for just a brief moment, people living off a wage/salary with little savings in the stock or housing markets found themselves a lot better off awhile the world crumbled around them, you have to admire how cool of a turning point it is. 

Happened by an interesting paper that explores the effects of the repeal of the uptick rule– and surprise, surprise, shorting isn’t the source of all evil.  The paper basically finds that getting rid of the uptick rule didn’t send the markets into chaos.  As a fan of short selling, I hope they don’t end up re-instituting the uptick rule.  I can’t see what value it offers.

In this paper, we study the July 6, 2007 elimination of the uptick rule that had limited short sales on the New York Stock Exchange. Some stocks were already exempt from the uptick rule due to an SEC pilot program begun in 2005, and we use these pilot stocks as a control group ostensibly unaffected by the regulatory change. The remaining stocks were affected by the repeal, and we use these non-pilot stocks as the treatment group. We find no significant stock price effects when the repeal is announced in June. When repeal takes effect, shorting increases markedly in both pilot and non-pilot NYSE stocks, and short-sale orders on average become more aggressive in both affected and unaffected stocks. Repeal causes market liquidity to worsen slightly, and short sellers on average become much less contrarian. One might worry that this switch in trading style by short-sellers could have contributed to the bout of volatility experienced by U.S. stocks in late July and early August 2007. But we do not find any evidence that this more aggressive shorting activity destabilizes stock prices in any way, and in fact short sellers seem to be even more important contributors to efficient share prices after the uptick rule is removed.

The repeal of the uptick rule in the summer of 2007 is the only recent regulatory move in the United States that makes life easier for short sellers. As stock prices have continued to fall through 2008, restrictions on short sales have tightened in the United States and across the world. In fact, recent regulatory changes have been nothing short of breathtaking. In July, the Securities and Exchange Commission (SEC) issued an emergency order restricting naked shorting (where the short seller fails to borrow shares and deliver them to the buyer on the settlement date) in 19 financial stocks. After the emergency order expired in mid-August, the SEC returned on September 17 with a total ban on naked shorting in all U.S. stocks. One day later, following on the heels of a similar announcement from the U.K.’s Financial Services Authority, the SEC surprised the market with a temporary emergency ban on all short sales in approximately 800 financial stocks. On the same day, the Commission announced that all institutional short sellers would have to report their daily shorting activity, and the Commission announced aggressive investigations into possible manipulation by short sellers.
Among all this regulatory activity, the SEC has up to now maintained its ban on short sale price tests. However, given political pressures, it would not be surprising to see some sort of price test re-emerge. For example, Erik Sirri, director of the SEC’s Division of Trading and Markets, said on October 6, 2008 that the SEC is considering bringing back the uptick rule, stating, “It’s something we have talked about and it may be something that we in fact do.” We have not considered any of the costs that exchanges, broker-dealers, and others would incur to comply with a new rule. But the findings in this paper, particularly the results for non-pilot stocks, indicate the likely effects on market quality and shorting activity if the uptick rule were re-imposed.

Two posts from Market Movers give a chilling testament to the SEC’s inefficacy. The first talks about the woman who cleared Madoff:

In one of the longest news articles I can remember reading in the New York Post, the SEC’s Meagan Chung — the woman who investigated Bernie Madoff in 2005 and cleared him of fraud — tries, unconvincingly, to defend herself. Instead, she comes across as even less competent than we thought:

[Said Cheung:] “If someone provides you with the wrong set of books, I don’t know how you find the real books.”

Unbelievable!  She’s literally saying that the SEC has no way of enforcing its rules unless the people it is investigating provide proof of their wrongdoing!   What value does the SEC then provide?  It doesn’t catch things like Enron where information about the fraud is publicly available in financial statements, and it can’tcatch things like Madoff?  Where does that leave the SEC, then?

The second post posits a method the SEC could have used to uncover Madoff’s Ponzi scheme.

If you’re looking for a Ponzi scheme, you only really need to ask one question: is the money there? Madoff at this point was admitting to the SEC that he was running billions of dollars, so the SEC just needed to ask to see the money. If the SEC got in return statements from Madoff’s own brokerage, then that implicates not only the investment-advisory group on the 17th floor, but the main brokerage as well, including Madoff’s brother and sons.

In the case of Madoff, it should have been even easier, since he claimed to be extremely liquid and mostly invested in Treasury bills whenever there was a down market. Where were the Treasury bills? Did it not occur to the SEC to ask?

The bold is mine.  Now, I realize that the SEC is largely captured by the people it seeks to regulate.  Even then, the SEC still can’t let massive fraud slip by– doing so would infuriate the public, resulting in more stringent regulation and possibly putting the SEC beyond capture.  The financial institutions that have captured the SEC clearly don’t want that to happen.

Since, even when captured, a regulator still has an incentive to root out the worst frauds, I’m at a loss to explain why the let Madoff continue.  Felix Salmon is entirely correct– the way to detect a Ponzi scheme is to look at assets.  Madoff could have produced fake books with assets, but there are ways to verify.  You can’t, as Meagan Chung suggests, detect fraud when only looking at fake books.

Was Chung representative of the SEC– were they just using people’s books as given, not seeking independent corroboration?  Or did the SEC ignore Madoff because they liked him, or because he was so respected?  In either case, what value has the SEC brought to the market in recent years?