Financial Innovation

Financial innovation is to innovation as theft is to wages. For both the thief and the worker, there is certainly economic gain from their industry. It is a bit harder to see the broader social benefit from the activities of the average thief than it is find benefit from the productive efforts of the average working person.

The use of terms like 'financial engineering' to dignify gaming schemes and regulatory arbitrage with some quantitative aspects should offend both linguists and engineers. Most derivatives and swap products are simply insurance contracts for which no adequate reserving was undertaken. The fact that the regulatory regime was so weak that it was possible to do this offers no excuse for the organizations that took on the risks without appropriately underwriting and pricing them. Those organizations were, after all, private enterprises with a profit making goal. Some--AIG, in particular--even had the internal expertise to do it right. Instead, for whatever reason, they chose as their business model the casino rather than the insurance syndicate. And, even as a casino, they didn't get it right. They confused their gross with their net, and compensated the coupiers and the dealers out the gross, forgetting the need to payoff the winning customers.

Financial Markets Closed Today

in the United States, but here is the question--are they working, even when they are open?

I guess that leads to two more questions--how do you judge, and which markets? For instance, the market for residential real estate isn't really a financial market, but I'd argue that the market for commercial real estate is. Clearly the equity markets are financial markets, as are the commodities markets, and as are the various markets (formal and informal) in which debt securities, credit swaps and the like a created, placed, layered and, sometimes, traded. That final collection of markets, with so many tailored instruments and so little liquidity is the one about which the biggest questions have to be asked.

Self-professed proponents of the free markets who know argue that we are facing a liquidity, not a solvency crisis don't generally distinguish between the equity markets valuing a financial institution's publicly traded securities, and the swaps markets in which that same institution surveys the landscape in vain for a credible pricing benchmark. But there is a real distinction.

Most commodities, real estate, equities, forex markets, etc., appear to be working just fine. You may not like the action, but they are functional if you judge them by three factors--does the market in question provide adequate liquidity for most purposes, is the price signalling generated by trading activity generally accurate for most purposes, and are the transaction costs reasonable (not optimal, and not frictionless, mind you, just reasonable).

The markets for debt instruments and their derivatives are another kettle of fish. Those markets are the sources of the anomolous price signalling that The Financial Times reports every few weeks--interest rates going negative, corporate default projections in excess of 100% of principle, and so on. In a functioning market, arbitrage would eliminate those before Lex could highlight them in a mocking squib.

Perhaps the best argument for unwinding the casino, and banning further financial innovation for a generation or so, is that it would allow time through custom, practice, trial and error and a generation of practical experience, to develop the norms, procedures and institutions necessary to a sophisticated financial market. That may not be the conclusion a true believer in the free market would promote, but I'm not a true believer in the free markets anymore.

The Politics of All This

First off, who knows if the bank bailout, whether in its current or in some future form, can work? Personally, I have my doubts, but they are grounded more general economic, cultural and political concerns than the specific financial mechanics of any particular program. Leaving those doubts aside, a bailout will work, or it won't work, one or the other. What are the consequences?

The economic consequences of a failed bailout are very bad indeed. But, I'll argue that, for the financial services sector, the political consequences of a successful bailout may be even worse. It is a matter of timing.

The current recession is still gathering steam. More likely than not, it will bottom out, perhaps on the schedule predicted by the all-powerful Fed Chairman, sometime next year, maybe a bit before. But bottoming just means things stop getting worse, more or less. So there we sit, with double digit unemployement, most of the country upside down on its mortgage, our cars are getting older, and so are all the other baubles imported in the glory days. The cult of the CEO is a dim memory. Paris Hilton and the celebutantes an embarassing one. Thin may still be in, but rich won't be.

Meanwhile, TARP has turned out to be a huge success. Banks are again profitable. All the losses from the housing bubble's collapse have been nationalized, but the customer gouging profitability of an oligarchy of regulatorily privileged financial institutions has been re-established.

Something tells me the public perception of all this will not be that Ken Lewis and his ilk were far sighted visionaries deserving of all the wealth bestowed on them by their grateful boards of directors. Something tells me you'll get a nice slow burn that will just grow until it finds an outlet.

Four Good Three Bad

Looking at the Case Shiller numbers for January, here's a down and dirty reaction:

The three worst metropolitan areas in the country to own a house are Charlotte, NC, Portland, OR and Seattle, WA. The four best are Atlanta, GA, Cleveland, OH, Dallas, TX and Denver, CO.

On the eventual level of housing prices, everyone else is free to predict how low they will go.

But the basis for my prediction for those seven markets is as follows:

Those seven cities have experienced relatively mild housing declines to date (all less than 20% at a time when the national average is 30%), so the question is, of the cities that have suffered least so far, which are most likely to get a pass on the national nightmare, and which are most likely to have their worst ahead of them (in other words, which will have relatively less severe house price declines and which will have declines that are delayed, but every bit as severe as those elsewhere in the country?).

When you look at how far back the declines to date have taken price levels in various cities, an interesting bifurcation opens up. In Atlanta, Cleveland, Denver and Dallas, even though price declines have been relatively moderate, housing prices are back to 2000-2001 levels (nationally, price levels have not retreated quite that far). In other words, the bubble has been deflated in those cities as much or more than it has in places like Phoenix, Las Vegas and Tampa (where housing prices have only backed down to 2003-2004 levels). The bubble never developed to the same extent in Atlanta and its peers that it did in Phoenix and such.

By contrast, house prices have also declined 20% or less in Charlotte, Portland and Seattle, but house prices have only backed down to 2005 levels. Assuming those places are as vulnerable as anywhere else to the nationwide correction currently underway, it would appear that it merely late reaching those areas, and that they have a considerable way to fall, if house prices in those cities are to return to levels comparable to those of roughly around the turn of the century. That is, unless there is something that reduces their vulnerability. That doesn't seem particularly likely. Even at the height of the bubble, Portland had a reputation for poor affordability, and, in today's economic circumstances, the dependence of the Charlotte regional economy on the financial services sector has to be worrisome.

Other people can provide a more sophisticated analysis of the national metric. For that, I'm sticking with an unwind, a regression to the norm, an overshoot and then a recovery. Time is the only independent variable and it's going to take time. My little contribution is in noting four good and three bad local markets.

When Do the Wheels Come Off?

Or have they already?

It all depends on what you mean.

With last year's carnage in various financial markets, we've already bought and paid for a grim recession, which we're experiencing this year. No more carnage is necessary in the debt and equity markets to discount a great deal more future discomfort. As a matter of fact, the implied rates of default at which credit swaps are currently trading would suffice to discount a depression, not a recession.

So, higher unemployment, lower real estate prices (residential and commercial), and outright contraction in global levels of economic activity are already priced into the market. But their full impact hasn't yet been felt in the general economy.

That's all well and good at the macro level. At the more personal, individual level, though, the questions are more in the nature of, will my spouse keep his/her job? How far underwater are we on our house? Why is there only half as much in my 401K as this time last year?

Those are the questions of the merely worried. For the roughly 15% of the workforce captured by the U-6 unemployment number, the questions are a bit rougher, on the whole. (Incidentally, if you want to compare current employment to the headline 25% number tossed around for the Great Depression, use U-6, not the lower, headline U-3 figure).

That 15% is the group of people who are in the process of learning just how frayed the social safety net has been left about a quarter of a century of Reagan revolution, new Democrat reform and the Bush family ascendancy. I don't know what a laid off third year law firm associate does, with a six-figure educational debt, and utterly no prospect of replacing his or her $150,000 salary. But it's no wonder rents in Manhattan are plunging.

I think that most of the 282,000 people laid off so far from financial services sector jobs had the resources to keep going for a few months, maybe a year. By and large, they aren't the segment of the population living literally paycheck to paycheck. But, by and large, they are a population segment with very high living expenses, and backing down from the life style, particularly for families, is going to be a very tricky proposition indeed. More than a few DINK marriages will shatter, and when there are kids involved, I dunno. . .

This is going to be the first post war recession in which the impact falls as heavily on the service sector as that of past recessions has fallen on the manufacturing sector. And given wage rates prevailing in the services sector, that means that the impact will be felt higher up the ladder, well into the middle class.

And that is likely to have political ramifications. You can't eat family values or right to life rhetoric. Don't hedge fund managers and Wall Street traders make hate crime targets every bit as attractive as gays?