Wisconsin Post-mortem

Just some brief thoughts that came to mind.

Democrats lost and by a big margin. In a blue state, with large labor union population, with high turnout. About a third (!) of union members voted for Scott Walker, according to some exit polls. What is becoming evident to me is that Democrats fail to play a long game, but Republicans master it. For decades Republicans have succeeded in building an infrastructure that would make a win like this possible. Namely, divide and conquer approach to public unions and general demonization of labor, open floodgates to massive amounts of campaign financing coming from outside groups, limited government mantra repeated over and over for generations that actually sunk in with the population undisputed. Outside Wisconsin there are massive efforts underway to erect voting blocks, like photo ids, because bigger turnout usually favors Democrats. Add to this the conservative Supreme Court and armies of lawyers on call should any election be disputed in court. And generally, conservative have a more cohesive community that picks up its own roadkill (by that I mean gaffe-prone characters) and fiercely comes to their defense, while Democrats are quick to distance themselves from their own gaffes instead of engaging in discussion about what those issues that those blunders expose. I’m really digressing from Wisconsin analysis here, but I felt like touching on this. In short, if you behead a system that conservatives built – it survives, because of the powerful infrastructure behind it (No charismatic leader? No problem – they can pick up a crazy and he/she can actually win). Democrats don’t have that luxury – we’re dependent on having a “Clinton”, or an “Obama”, a person who sucks oxygen out of the room with the charisma, to get people excited and actually come to the polls. Ironically, and to touch of on my previous post, we need a Superman to win, while Republicans, with their powerful infrastructure, can do just fine with a mediocrity.

Occupy SEC article in the American Banker

I helped write this article in the American Banker, except for the calls for “criminal prosecution” part. I really see no criminality in JPMorgan’s trade. I would rather focus on the broader message of the article – superstar treatment of traders, inept SEC and the complexity of trades that requires superhuman abilities to monitor them.

Conservative case for taxes and regulations.

Damn, Joseph Stiglitz beat me to it. I have been working on the related topic of why the top 1% should also be worried about current income disparity.

It’s no secret to anybody that Republicans in Congress in general and the top 1% of earners in particular are no big fans of taxes and regulations. In this post I’d like to demonstrate that this is a rather short-sighted view and, out of their own sheer self-interest, they should be for higher taxes and government regulations.

Imagine, you are a billionaire and the economic reality around you has been rather, shall we say, anemic. But why should you give a fuck? You’re set for life, live in a gated community, have private security, household help – in other words with money you can theoretically shield yourself from daily struggles that the peons face every day. There are many reasons why you should (give a fuck), beginning from the fact that, if you’re a billionaire, your worries are of a different scale, namely, you want to close deals, sell products and make smart investments. None of it can be done in a vacuum. You need a solid consumer base, a partner on the other side of the deal, people who want to buy when you want to sell, the suckers at the poker table if you will! In order to be the king of the hill, you have to have the freaking hill! You have to have a vast and robust middle class whose wages are rising consistently year after year. Henry Ford was no fool when he paid his workers high salaries – so that they could buy his cars. The taxes have been falling for the last 30 years but that did not bring the promised prosperity and jobs to the middle class. Let’s admit that we tried it and it didn’t work.

I must also admit that the game that you played for the last 30 years is spectacular in its shrewd, take-no-prisoners ways: pushing for tax breaks and lobbying for favorable legislation, eliminating competition, skimming consumers. Congratulations, you won. Now you’re all dressed up and ready to play but there’s no one left to play with. Now you’re a lonely player at the poker table with mountains of chips in front of you, wondering why is it that no one wants to come and play with you. Maybe it’s because people have no more chips left. In real poker, as in most games, being the last guy standing is the most optimal and desirable outcome, because there are other tables and other games always readily available. But the point of a real life game is not to win the most chips, but to keep the game going, simply because we only have one table. Besides, taking chips and going home is anathema to any businessman worth his salt: chips are supposed to be working. Now that you have that picture of yourself with all the chips let me ask you: Will the dealer taking smaller rake from the pot (I’m drawing an analogy with smaller taxes here, for those who don’t play poker. The dealer takes part of every pot, a ‘rake’) offer real solution to the lack of players at your table?

Another, more mundane reason why you should support taxes is unpleasant visuals that can spoil your day, if you’re not a complete sociopath. Do you like seeing bums on the streets or on subway trains, or, especially heartbreaking, neatly dressed middle-aged, resumes in hand, standing in unemployment line? Neither do I. Conservatives’ standard solution to this kind of situations and other life’s misfortunes is personal responsibility and charity. I disagree. It’s hard to be personally responsible if you’ve been a victim of forces beyond your control: mental disability for example as is the case with many homeless, or mass layoffs. The problem with charity is that it’s selective and whimsy. While there’s no shortage of charity causes here in New York City, the problem is that they mostly target arts, children and breast cancer. Nothing wrong with this, of course, but you can see how many other areas worthy of charity get omitted because, let’s face it, some of them are not picture perfect. And in a bad bonus year even those “New Yorkers for Children” (my favorite moniker on emotionally manipulative scale, to be surpassed only by “New Yorkers for Puppies”) charities will take a back seat to personal priorities of an otherwise generous and vain Wall Street soul. As for the unemployed, I have yet to hear any conservative to explain what is exactly wrong with government hiring those people for useful projects? Because government is evil?

But we’re way past worrying about the homeless problem. At this stage we need a charity ball for the middle class. I’m afraid that such a task is insurmountable, even to Koch brothers and Warren Buffet combined. There’s only so many maids and drivers that they can hire.

Sometimes I think that I’m more conservative than conservatives because I prefer order to chaos, rules to anarchy, so that I don’t have to spend most of my waking hours solving logistical problems like dysfunctional or non-existent public transport, unsafe drinking water in the tap, malpracticing doctors. Which brings me to regulations.

“I can’t be bothered with that shit”. This is my favorite argument in support of regulations. Do you really want to spend valuable time experimenting in choosing the best vendor who sells the best meat, doctor who practices solid medicine, insurance provider that pays off? Especially if you work 12 hours a day? If we lived in the realm of neighborhood mom-and-pop shops (many conservatives still think that this is the world we live in), where you could just go to the other one down the street if the first one treated you unfairly then you could make that case. But unfortunately we live in towns where only 2 or 3 big vendors exist for any product. What is your recourse against, say, an insurance provider to whom you dutifully paid premiums for several years, and who refuses to pay off if an accident happens? Are you going to follow a classic conservative advice and go to another provider? No, you’re going to call your lawyer. Moreover, if you can do your own “testing” of the quality of meat, how are you going to know the promised quality of products that you have no expertise of measuring, like software, for example? Or how about products which questionable quality you can measure only after you’re no longer a consumer, like bad surgery or faulty car breaks? Or how can you be sure that the guy managing your 401(k) is not a crook? Do you want to spend months doing research, aside from your main job, making sure that the guy you’re entrusting your money to is not the next Madoff? And more importantly, who’s going to enforce business contracts that you enter into? Who is going to help you collect? Nicky Santoro?

Sports have strict rules. That doesn’t keep athletes and teams from succeeding. In fact that makes the game more exciting because it is the ultimate ‘let the best man win’ situation. The beauty of a fair competition is that no particular party has an advantage at the beginning of the game. There are stronger teams and weaker teams, of course, but they all play by the same rules. By the same token, I do not resent the fact that there are rich and there are poor, contrary to conservatives’ cries; I resent the fact that there are different rules for different classes, that the game is rigged.

Conservative insists on being left alone, but who is should provide that aloneness, that peace of mind, that mechanism that makes trains run on time, the streets lit up at night, the garbage picked up in the morning? Hire a guy to do that for you. Let that guy have enforcement powers if someone is out to screw you. Such guy is the government, whether you like or not, whether you admit it to yourself or not.

By the way, speaking of Nicky Santoro. What can be better to conclude my post than this insightful quote from the movie, where Nicky laments on how reckless the Mafia has handled the casino business:

“But in the end, we fucked it all up. It should have been so sweet, too. But it turned out to be the last time that street guys like us were ever given anything that fuckin’ valuable again.”

 

The Skinny on JP Morgan’s $2bn Loss

Well, where to begin? The case is dripping with irony.

In order to discuss the implications of this trade let’s review, with whatever little information we have, the trade itself. The culprit is a trader Bruno Iksil at London’s JPM CIO desk, nicknamed London Whale. The instrument that he was trading is index CDX.NA.IG.9. To translate that into English it’s an index that contains 125 insurance contracts (CDS) on corporate American investment-grade debt (e.g. Alcoa, GE, etc). Figure 9 stands for series – the index is reissued every 6 months and is now at series 18. To understand such “synthetic” trade you have to think of it as insurance. This is what a credit default swap (CDS) is – an insurance. Imagine you have a house, traders would say – you’re “long” house and you buy an insurance contract on it (traders would say that you “buy CDS” or “protection”) to bring down the risk of owning the house. This way your risk is essentially zero (or at least we declare it for the purposes of this article): if the house value goes down you make money on insurance. In trader’s lingo you’ve entered a “basis trade” – a low risk low-return trade. Now, the guy who sells you the insurance (or writing the contract) is going long risk on the value of your house. He collects the premium and he doesn’t want anything to happen to your house. Traders would call this maneuver as “writing protection” or “selling CDS”. You see, you were long risk with your house before you bought protection on it – now you’re flat risk. The insurance seller is outright long risk, but synthetically, because he doesn’t own the physical house like you do. So this index, consisting of a collection of insurance policies, is an easy way for a trader or a money manager to express either positive or negative sentiment, while with the cash bond you can only express positive sentiment. With this index, if you’re bullish on the corporate bond market – you sell protection, betting that the corporate spreads will tighten; and if you are bearish – you buy protection, betting that spreads will widen.

To sum up:

Going long synthetically = selling CDS, aka selling insurance, aka writing protection, aka buying the index. (I know it’s a little confusing: selling insurance = buying the index; the index was structured in such a way so that it’s easier to understand that you’re going long risk)

Going short synthetically = buying CDS, aka buying insurance, aka buying protection, aka selling the index.

Jamie Dimon wants you to think that this trade was a hedge. Why? Because the upcoming Volcker Rule would prohibit banks to engage in speculative activity, that is taking an outright long or short position. But once you have a position and a corresponding hedge (or, as we discussed above, a house and an insurance policy on it) then everything is tip-top. JP Morgan is a deposit taking institution and, together with Citi, BofA, Wells Fargo, is a primary target of Volcker Rule. Of course, the original Volcker Rule did not have any exemptions – it prohibited any sort of proprietary trading; it is JPMorgan’s own lobbyists that pushed for that “hedging” exception, among other things. I just don’t see how Jamie Dimon “hedging” excuse logic works: if he’s trying to point that the trade was kosher but lost money then how many of such “risk-free” trades can be put in the future and dismissed consistently by the top management as “a tempest in a tea pot” before it blows up in their face?  If you lobby to increase speed limit to 100 mph and drive at that speed you are not really breaking any laws, but should we all just feel safer because the rules are followed? And if the accident happens how can you then turn around and blame the rule? You lost money not because you complied with Volcker Rule, but because you used exception to the rule to put trades on that even you didn’t know how to manage. Now he says: “I was dead wrong to dismiss concerns.” No shit, Jamie.

Bruno Iksil was SELLING protection by amassing about $100bn long position in the index. He was on the hook for losses, he was essentially long risk. And he claimed this to be a hedge.

A hedge against what? If he was selling protection, then his original position would have to be a massive short in those corporate bonds (think of it as a “negative house”: you would have to buy the house, or sell CDS in order to bring your total risk to zero). The only way to achieve that original short position in bonds is either through similar index (perhaps a different vintage) or individual credit default swaps. But let’s assume, for arguments sake, without asking stupid questions of why he happened to have that original position in the first place, that it was a basis trade. A minus $100bn in corporate bonds CDS and a plus $100bn of CDX.NA.IG.9. How can one lose $2bn on such a “riskless, Volcker rule compliant” trade? Index price has fallen from about $100.6 at the end of March to about $99.3 in early May, but because I’m in generous mood and for simplicity, I will assume that the index moved just 1% against Bruno.

Source: Markit.com

You would have to have a naked exposure of $200bn to lose $2bn on a 1% down move. So his “hedge” defense doesn’t stand this simple test. Where is it coming from then? Jamie Dimon threw out “Macro hedge” and “economic hedge” explanations out there as well, probably to see which one sticks. (As a side note – I love it how they throw obscure financial terms to the public that are undecipherable to the general population hoping to blind us with the fancy lingo. Are they expecting us to say: “Oh, ok, Macro hedge – that explains everything!” and go on our way?) These are imperfect hedges that are supposedly protecting your portfolio against broad economy moves. With our house example it would be like having a house in NY and buying protection not on that particular house but on a similar house in Indiana or a basket of houses around the country. What’s risky about this sort of trade is that your NY house’s value will fall more than the value of protection on the Indiana house will rise. To make matters worse, in a frenzy to bring your risk to flat again, you start to frantically add on to your hedge to keep up with falling value of your NY house, thus making your final hedge much, much bigger than the original amount. Since Iksil was adding on his position for several months, my bet is that this is what happened: a small initial trade that gotten out of control when hedges didn’t behave in sync with the underlying.

And why such a theory should be far-fetched? Just look at the language that Dimon used to describe the situation.

“The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.”

But this isn’t the end of the story. In fact this is just the tip of the iceberg and things are bound to deteriorate further. “It could get worse, and it’s going to go on for a little bit unfortunately.” – Dimon said.  And if he uses this kind of language – it most certainly will. The reason why things might get worse is that JPM haven’t unwound the position yet. The $2bn is a mark-to-market loss, a paper loss. Considering the fact that The London Whale didn’t get his nickname for nothing – he’s the only game in town in that particular niche of the credit market – trying to get out of that position is like running a herd of elephants through the narrow door. He simply won’t get the price that he wants. And everyone, and by that I mean guys who could possibly take the other side of the trade, the hedge funds, know it. They salivate of the prospect of killing the whale. Nothing personal of course, just business.

I am especially entertained by the hedge funds guys. You know, these are the kind of guys who don’t play by the rules, they want to be left alone in a sandbox, and have their own unregulated brawl with no rules, where only the strongest and the savviest survive. Imagine how surprised I was to read this in FT Alphaville. This is what the hedge fund guys began saying when they noticed that some desk in London was cornering the market:

“The hedge funds got more angry. It dawned on the hedge funds that they had no one to complain to. The hedge funds and banks had lobbied long and hard to keep this over-the-counter market in credit derivatives unregulated. Thus it is unregulated, and they had no one to tell, officially, about what they suspected — that a single player had cornered, and distorted the market by putting on huge trades.

And then they complained to journalists.”

Another ironic thing is that the $2bn loss, according to Barney Frank, is 4 times the amount JPMorgan has claimed the regulations will cost them. But with all those exceptions the freedom to lose money is intact, which I guess is more important for Jamie Dimon. Oh, and did I mention that JP Morgan is a bank, backstopped by taxpayers money in the case of unmanageable losses? Guys, I want you to appreciate the magnitude of the fuckup. 3 senior heads have rolled already 4 days after the news broke. Ina Drew, a CFO with 30-year career with the company, has submitted her resignation several times during the past few days with Jamie Dimon reluctantly accepting it. People don’t just leave the company if this was something trivial as they want us to believe, if it was just a little correctable screw up. You can’t unwind such a position without major losses, you can only put it to book-to-maturity and hope that everyone forgets about it. I think this is the only strategy Dimon has to deal with the situation. Should we hope that our regulators and congress won’t forget about it in an election year?

A post from Cathy O, at mathbabe.org that nicely puts together a line of thought I’ve been conceiving for weeks.

Cathy O'Neil, mathbabe's avatarmathbabe

First, I’d like to say thank you to the people who have been writing me very nice comments about the PBS Frontline special. It’s cool that people dug it, and it makes me really glad I did it. Thanks!

Second, I had a blast with Reno the other night doing her “Money Talks” show. You should definitely check her out soon.

Also, I’m on my way to the third day of a modeling conference at the IMA (which is part of the University of Minnesota) called User-Centered Modeling. I’ll be speaking tomorrow and I expect to be blogging quite a bit on the other talks between now and Friday.

And with that, I’d like to use the rest of my GoGo Inflight Internet service to start a conversation about the libertarian mindset.

By the way, in spite of my annoyingly opinionated personality, I actually love having friends I disagree…

View original post 693 more words

In Praise of Communal Values

Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off.  Franklin Delano Roosevelt.

I’m Russian, let’s just get that out of the way. May 9th is a special day for any Russian. It’s both a joyous celebration of our victory over fascist Germany in 1945 and also a day of reflection and remembrance. To many people it’s the most treasured and most profound, a knot-in-the-throat holiday, as sacred as 4th of July is for any American. Every family has a relative who died or fought in that war. With sadness I watch more and more veterans leave our ranks every year and I contemplate over these special men and women and wonder what I would do if I was born in 1924. Would I have the guts to do what they did, to be on the frontlines, to face an armada of German tanks pacing toward me when I had just a rifle and a grenade? There’s no place of cynicism and individuality on the battlefield. My generation grew up watching war movies and talking to live witnesses of those events, we played “war” and our heroes were young partisans. We grew up picturing ourselves in those situations and admiring real war heroes, just like young Americans grow up admiring comics superheroes. During those games and those daydreams what was always present is the collective spirit. “We’ll show them!” – our thinking went. There was no “I” on our imaginary playground battlefield. Contemplating the victory in World War II (or Great Patriotic War) for a Russian is to invoke the “us” narrative.

Continue reading →

Macro View on Emerging Election Dynamics

Romney seems to have settled on the emerging theme of Obama being a “nice guy generally” but who is “in over his head”. This kind of positioning is supposedly meant to attract voters who like Obama personally but are unsure about his managerial abilities to run the country. What I think is really happening is that various conservative operatives have resigned to the idea that Romney is not going to excite new voters into voting. The scenario that they have assumed in their models is that Romney is a stiff, uninspiring, polenta candidate that simply has to appear on stage, wear a suit and say dull things. That’s all that is required of Romney now. The real job of winning an election will fall onto Right-leaning Super PACs, like Karl Rove’s Crossroads GPS and various political-minded billionaires.  And can we really expect them to spend their hundreds of millions of dollars on a lukewarm message that Obama is a nice guy who’s just not up to the task? I doubt it. There will be a tsunami of crazy shit coming Obama’s way the closer we get to the election.

I, of course, do not underestimate the power of slime. Just recall what happened to John Kerry in 2004. We have to expect more of the “Secret Muslim” and “Where’s the real Birth Certificate” lines of attacks to resurface again among other things. These ads, to be clear, will not be designed to make any new converts, they will be designed to rile up the paranoids to come and vote in droves. So for Republicans these sorts of ops are more of a Get out the Vote (GOTV) exercise rather than converting the undecideds.

I’m not entirely crazy about Obama’s “We Can’t Wait” message because this message is directed at the obstructionist Congress, not at Romney. Something along the lines “A fight for the Middle Class” would be more effective. Obama has to give equally compelling reasons for people to show up at the polling station. “Republican War on Workers” is a more gripping message. First, Obama is already accused of waging a class warfare, so he might as well reap the benefits by talking about decades of stagnating wages and growing inequality gap. Maybe that will bring him some votes from the white working class. Remember when was the last time a presidential candidate talked about growing inequality? Neither do I. And then we’re surprised that white working class is voting Republican every time! I think Republicans are really afraid of this kind of talk, because they have nothing to say against it but the re-recycled and tired message of “trickle-down economics”.

Obama is being accused of so many outlandish things right now that his hands are essentially untied. “If that’s what you think I am” – his campaign thinking should go – “then this is what I shall become”. It’s like buying a cheap bond that cashflows: the downside of the trade has already happened, there’s only the upside left. For instance, those who think that he will take their guns away will not change their minds when shown the facts: they will just think it’s some kind of conspiracy. How much more apoplectic and enraged can they become if Obama really does come and take their guns away?! (I do not advocate it, I merely illustrate the point). Right now those who think he’s not tough enough do not have a compelling reason to walk over to the voting booth, while the Ted Nugent crowd will crawl on broken glass to cast a vote against Obama. Pointing out that Republicans are crazy is useless – everybody knows that. Talking about what is Obama going to do about it – is what people want to hear. And this would involve saying things that will drive Republicans off their rails. This would involve some bare knuckle politics and some strong language. Politically speaking, the coming negative onslaught is a golden opportunity for Obama, a carte blanche; he should be seeking such a battle not avoiding it.

Ultimately the election will come down to GOTV, not converting the swing voters. Romney doesn’t have the skills and personality to do it, so the shadow political groups will do it for him by bringing their voters to the polls. Obama should do the same. The time to reason have passed a long time ago. The opposition is sufficiently nuts.  Now is the time to give people a reason to show up at the polls and vote for Obama. And if he does not fight back he deserves to lose.

Traders also protest free market. But from a different angle.

How about this one?

OTC trading is only good if you’re doing it. If others are doing it it’s bad!

I can’t help but quote from the article:

The protest followed a massive block options trade performed in Eurodollar futures on Thursday. Block trades are privately negotiated transactions performed off the trading floor, but cleared by the exchange, and reported minutes later on the CME website.

The locals were upset because they weren’t able to participate in the trade, brokers said.” (Emphasis mine)