Synthetic Lehman

We're living life after Lehman. Consider the doctrine of unintended consequences, or maybe simply unforeseen outcomes. Thank God it's Friday and before climbing into the weekend, take a moment to reflect.

Who would have thought, that merely because the principles-based UK regulatory scheme differed from the rules-based US approach, that hedge funds using the New York office for their prime brokerage needs would skate through intact, while those using the London office would become general creditors in the bankruptcy administration, dying at cents of the dollar (pence on the pound?) and of a long wait to get anything at all?

Oh well. Live and learn. Nothing like experiencing a risk to bring it into focus. And a string of hedge fund failures doesn't clog the plumbing or involve systemic risk, right? We can all live the market volatility, right? Something tells me we all have a lot more living, and a lot more learning, ahead of us.Before we move on to more living and learning, though, the Lehman scorpion's tail has one more sting. In some murky backwater, we're having the settlements of the synthetic CDS exposures referenced to Lehman credit but not part of the CDS settlement of CDS written on the bonds themselves at .0841 or whatever it was. Apparently the the notional amounts of the synthetics was about 4x that of the stuff that has been run through the system. Of course, the ISDA assures us that those positions are continuously marked. I guess that means that this is only a liquidity problem and doesn't raise systemic solvency concerns? Very reassuring, that.

But, for the survivors, on to Iceland. Then, coming up soon on a screen near you, General Motors.

Here comes Quantitative Easing . . .

and there go the American automakers.

The Fed has to give the quantitative easing a shot. It didn't work in Japan, and it probably won't work here, but kid yourself not, they've got to give it a shot. No arrow left quivered.

The endgame, though, remains unchanged. The financial services sector in the developed world has decapitalized itself in the last five years. Mark to market accounting may be delivering the bad news, the bad news itself is simply the consequence of having gutted the credit culture of lender-borrower relationships and replaced it with a transactional focus (and a compensation structure based on transactional activity). Incidentally, that is eerily similar to the Enron fiasco--replete with a cast of characters all vying the be recognised as the smartest guy in the room.

Once through a patch of quantitative easing, but fairly early in the next administration, I think we'll see an unbelievable expansion of the current pilot program in the commercial paper market. In other words, if the private sector continues its failure to deliver the financial services required by the general economy, public entities will step in the fill the void. How and in what form remains to be seen.

Meanwhile, the endgame for the American automakers is even closer in time. The next hundred days, according the a senior executive at GM. I wonder if he's a finance guy or a car guy (to use the Detroit vernacular)? That comment was a little forceful for a finance guy. With the orphaned retiree medical benefits of several million voters mired in a bankruptcy reorganization, in about 101 days that should provide the dynamite charge required to pass healthcare reform approximating universal coverage.

In terms of the general economy, I'm not sure what happens if General Motors and Chrysler fail. I assume the initial reaction would be denial and an opportunity to reorganize under current management (as opposed to going straight into liquidation a la Lehman Brothers). If not, it's one thing to buy toxic assets, and another entirely to start stockpiling the output of original equipment manufacturers who've lost their biggest customer to bankruptcy. Where do you store all the cylinder heads, leather upholstery, and fender panels?

Prediction Markets

Economic impact of an Obama victory: too early to tell.

But pragmatism and expertise will be the principal ingredients of the government's policies, flavored with egalitarian anger and populist desire for revenge. On the whole, better than the stew of ideology and grandstanding, similarly flavored (perhaps substituting xenophobic paranoia for egalitarian anger), that would have come from McCain and his crowd. On the whole, I'd rather have Volker, Geithner, Summers and Krugman taking the hand off from Paulson et al. than Phil Gramm, Carly Fiorina and the B list academics in the McCain Palin camp.

Since the entire blogosphere is obsessing on the election, I get to comment, too, off the economic topic. Here you are:

A. Prediction Markets: 1; Bradley Effect: 0.

B. A couple of years ago U.S. military recruiters were given a hypothetical choice between doubling of their recruiting budgets and having the example of the Bush twins enlist in the military. Overwhelmingly, they responded that the example of the Bush daughters in the service would be more help to them in their recruiting efforts than doubling their budgets. Of course, those children of privilege were never at risk of facing the rigors of basic training, much less harm's way.

In terms of its effect on the Arab street, a President Obama is tantamount to the nuclear option.

Black Swans and Factoids

For the last month, I've been wandering around noticing the absence of new car tags on the road--those paper temporary tags the dealer gives you to drive off the lot and keep your car legal for the 30 days or so it takes to get the permanent plates. Then, over the weekend, in Parking Structure 3 in downtown Portland, Oregon, I spotted paper tags on a brand new Subaru Forester. So much for that particular Black Swan.

Yesterday car sales numbers came out. Today the analysts are parsing the numbers, making sense of a situation that can only honestly be summed up as, 'it's really bad for anybody in that business, but who in their right mind would buy a new car today?"

So, I guess I stop going around telling people I haven't seen any new car tags since I can remember, and start going around quoting the reported numbers and using my annecdotal evidence (a single new car tag) to buttress my point. It's no longer a Black Swan, but it's a factoid. (That in itself may be the problem with Taleb's commercially very successful molehill).

Absence of evidence is not evidence of absence. On the other hand, evidence itself doesn't mean much without taking into account measurement error, calibration assumptions and equipment design tolerances.

Jekyll and Hyde

After tomorrow, the howling from Washington should get louder. Frustrated congressmen, told by policymakers they trusted, that Wall Street needed a bailout to keep lending and keep the economy out of the ditch are now finding that the banks have taken the money, and, well, that's about it. They've taken the money.

And they haven't resumed lending, and the economy still appears to be headed for the ditch. Worst auto sales since 1945, according to General Motors. So Barney Frank plans hearings.

In a nutshell, the problem with the banking system is that it has two sides. One is the predatory trading culture of the proprietary desk, the hedge funds, the sharks and their lumbering prey--family offices skinned through fund of fund managers, yield chasing brain dormant European institutions whose managers' knowledge of English didn't make it past the letter A, repeated three times, and such. That world is blowing up. But it's social utility, even in good times, is obscure.

The other side of the banking system is the prosaic, utility like servicing of the needs of individuals, consumers and savers, or businesses, whether large or small. That's the side that we need. For individuals, it's providing car loans to school teachers, insurance policies to young families, and the like. For companies large and small, it's providing cash management services, export/import letters of credit, working capital lines and such.

Imperfectly, the Glass Steagall Act segregated the two activities. Glass Steagall was out of date. There was inevitably a certain amount of mixing things up. But since regulation really took hold in what the convicted felon Conrad Black used to describe to Bush 43 as the 'Anglosphere', those activities have become hopelessly intertwined. The very idea of an 'originate to distribute' business model blended the two. Haven't heard much about originate to distribute since the distribution end of things got all gummed up and the originators turned out not to have the, er, capital, to hold what they had in the pipeline.

Haven't heard much from Lord Black since his conviction, either. I wonder where in the Anglosphere he'll serve his sentence. A Canadian national, who surrendered that citizenship for British peerage, convicted in a United States court. Perhaps Gitmo?

In any event, for his howling hearings, Congressman Frank's first witness should be Phil Gramm.

Liability Structure

Ah, for, a block of prepaid, noncancellable term life policies!

A great deal of ink has been bled expressing angst at the bad loans, dubious securizations, toxic assets and so on currently clogging the financial system. Not as much attention has been paid to the liability side of the balance sheet.

Well, the liability structure of a typical investment banking operation vs. a traditional insurance company is why the crash of the former resembles a plane crash and the failure of the latter resembles a train wreck. (The AIG debacle is such a surprise because it was a capital markets player operating in the sheep's clothing of an insurance company--and now, six weeks on, those involved are still reasonably clinging to the value of the insurance operations as the way over the ever deepening abyss of its capital markets liabilities).

Liability structures are important. By focusing on liquidity instead of solvency issues for the first year of the financial crisis, the regulatory community has radically transformed the liability structures of many regulated institutions. The extent of this transformation isn't fully known and certainly isn't fully appreciated. How it play out remains to be seen. My suspicion is that this development may, in the intermediate term, be more important than the current round of capital injections, particularly in terms of its political ramifications.

Incidentally, the reason the liability associated with a block of prepaid term life insurance is so attractive is that the only way you have to pay anything out is when somebody dies. Unless you've insured a bunch of lemmings (a definite possibility nowadays, given underwriting standards), you don't have to worry about a run on the bank, as it were. One, two, altogether now, over the cliff . . .