Felix Salmon

Answers to Four Questions About Financial Journalism

Felix Salmon
Mar 30, 2009 23:27 UTC

Will Ortel, a journalism student at the College of Idaho in Caldwell, Idaho, sent me a few questions about financial literacy for a project he’s doing. They’re good questions, so I’m blogging the answers:

Financial education for the layman is a shambles normally organized towards paying bills on time and managing credit cards. This prompts most Idahoans to think "who is this guy" when I explain what a CDS contract is or how short selling works. Is detailed financial knowledge something that most Americans should have? What is it about financial understanding that makes it distinct from engineering or psychological understanding?

I’m very happy that someone who knows what a CDS contract is or how short selling works is attending journalism school — the world of journalism desperately needs financially-literate reporters. On the other hand, there’s absolutely no need for most Americans to understand these things — any more than they need to understand what makes an airplane fly, or how beta blockers work.

Some people are interested in the world of finance, especially now, when troubles on Wall Street seem to be the proximate cause of the worst macroeconomic recession in living memory. So journalists who can clearly and accurately explain such things are to be treasured. But it’s no weakness not to understand how banks’ balance sheets are constructed, or even what a balance sheet is. People need a certain level of psychological understanding to perform their daily duties, which is why life with autism can be so very hard. And some basic personal-finance literacy is a good thing too. But beyond that, there’s no reason people should be expected to understand the mechanics of Wall Street unless they particularly want to. In that sense, yes, it’s much like engineering.

Coming from the standpoint of protecting small investors from hazy information that they might receive, could you support conceptually the establishment of a test to see who was capable of trading individual stocks and bonds (as distinct from vanilla mutual funds)? Can you think of anything that you would want to put on such a test?

It’s true that individual stocks are incredibly risky things which most people should avoid — much riskier than most hedge funds, which most individuals are not allowed to invest in. But I don’t think there’s much evidence that financially-sophisticated individuals make for better investors. If anything, they suffer from overconfidence bias, think that they have some kind of an edge, and make even bigger bets as a result. Giving people a financial-sophistication test might even be counterproductive in that sense: Americans would barge into the markets armed with their "qualification" to trade stocks, and then proceed to lose a fortune.

The much-heralded blog era has begotten the rise of personal financial journalism, perhaps typified by yourself. To what extent do you think that econobloggers parsing news for lay readers will catch on? Do you see yourself as parsing news for lay readers or providing insightful (and occasionally hilarious) commentary to moderately informed dorks (like me) around the country?

I like the idea of "personal financial journalism" meaning "financial journalism written with a personality" rather than "journalism about personal finance". Econoblogging is exploding right now: when I started the Economonitor blog at RGEmonitor.com in September 2006, one person could pretty much keep on top of most of it. Today, that’s unthinkable, I discover great new blogs constantly, and the best of them can become extremely popular and influential very quickly indeed.

That said, I don’t think that most of them are necessarily aiming at what you call "lay readers": a blog is naturally very conversational, and one tends to like to converse the most with people at more or less one’s own level. So you won’t find too many blogs spelling out what a basis point is, or explaining that bond prices move in the opposite direction to yields. So count most of us in with the "commentary for moderately informed dorks" crowd, I think. For lay readers, sites like The Big Money might be a better bet.

If the audience of a news organization with high overhead demands a Jim Cramer or Ben Stein figure, how can that organization deliver a more responsible figure instead and stay solvent? How would you characterize my optimism that the nature of financial journalism might improve?

Well, I’m on the record as liking Suze Orman: just because you’re a financial celebrity doesn’t mean you’re as idiotic as Ben Stein. And I’m not sure how hiring Ben Stein is likely to improve any news organization’s solvency — he doesn’t come cheap.

But one good thing about the internet is that people can become brands without having to be on the television. And since appearing on TV is a great way of becoming incredibly stupid, then with any luck the age of the internet will usher in a new generation of finance pundits who have made their name by the quality of their ideas rather than the recognizability of their faces.

The much-maligned Gawker Media, it’s worth noting, dispenses a pretty large amount of generally-excellent financial advice on such sites as Consumerist*, Lifehacker, and Jezebel. All of it is vastly more useful than anything you’ll get from Cramer or Stein. So the trend is in the right direction. Stein adds no value for the New York Times, so eventually he’ll be dropped. It’s just sad that it has taken so long.

*Update: As Gari points out in the comments, Consumerist is now part of Consumer Reports, not Gawker Media. I should know.

Why Healthy Banks Shouldn’t Repay TARP Funds

Felix Salmon
Mar 30, 2009 22:09 UTC

I got an interesting response from one reader to my post on whether healthy banks should be able to give back TARP funds. Here it is, with permission; the short version is basically "no".

The TARP preferred shares were extended to the major banks last year with a 5% dividend for the first 3 years, stepping up to 9% after the third anniversary. As orginially written, TARP preferred could only be repaid with the proceeds of equity issuances during the first 3 years. Apparently a clause slipped into the stimulus package gives the Treasury Secretary the option to waive that requirement. I think that TARP money should only be allowed to be repaid if fresh equity is raised from the market, and preferably in the form of common stock.

Let’s look at Goldman as an example of a bank that has expressed a desire to repay TARP funding. A few relevant facts:

1) At $100, Goldman has a $46 billion market cap. Assuming no placement discount, Goldman would have to issue 22% of new common shares to repay TARP, effectively telling the market that GS common shares at $100 are a cheaper form of capital than a preferred yielding 5%.

2) Use of proceeds of the equity deal should be properly disclosed as allowing insiders to enrich themselves with higher compensation without government scrutiny. Beyond that, there is no reason to accelerate repayment within the initial 3 years.

3) Based on the terms Buffett extracted on his preferred, GS could not issue 5% prefs today. Again, how could you justfiy paying a higher dividend on a new pref? Other than to facilitate executive looting, I cannot think of a reason.

4) If Geithner waives the equity issuance, where will the money have come from? According to Bloomberg, Goldman has issued about $22 billion of government-guaranteed debt this year. Given the fungibility of money, couldn’t one argue that the government has allowed Goldman to issue debt so that it could buy back its equity and weaken its balance sheet during a crisis? If markets dip again and Goldman needs help, what would we do?

5) Alternatively, one could argue that Goldman is taking its AIG proceeds to buy back TARP preferreds. I know that their CFO said they didn’t need the AIG bailout given their hedges. At the risk of sounding like Maxine Waters, Blankfein (current CEO) reportedly advised Paulson (prior CEO) during the AIG bailout process. To avoid the appearance of a conflict of interest, perhaps Goldman should voluntarily disgorge its AIG hedge profits since the government made them whole on their contracts (based on Blankfein’s counsel).

6) If Goldman escapes the TARP program’s scrutiny after a waiver, they will have a competitive advantage in recruiting, and other, potentially weaker banks would seek the same waiver. It would set off an arms race to repay TARP preferreds, weakening the balance sheets of large banks. And the primary reason would be to allow executive looting to resume without scrutiny. Again, if we dip again what does Treasury do?

7) Goldman is now a bank holding company but I see little evidence of a stable deposit base or other implementation of a bank holding company business plan. Shouldn’t we evaluate that before we allow them to weaken their equity base?

8) Shouldn’t we have a regulatory structure in place before we allow banks to reduce their capital cushion?

I am a portfolio manager following emerging markets stocks. I have no dog in this fight other than being a participant in equity markets and an American taxpayer.

This all makes perfect sense to me, and can be applied mutatis mutandis to any other bank thinking of paying back its TARP funds too. The government recapitalized the banks with TARP funds because the equity markets were closed. The equity markets are still closed. So for the time being, any talk of paying back TARP funds is surely premature.

OpenTable, Closed Minds

Felix Salmon
Mar 30, 2009 21:02 UTC

I’m a huge fan of OpenTable, and I’ve always imagined that restaurants are, too. They don’t need to spend hours on the phone telling people what’s free and what’s not, special instructions don’t get garbled, and it’s very easy to cross-reference the diner to previous visits. But apparently Raoul’s didn’t get the memo:

I can no longercontinue putting off talking about the back room. I’d prefer it didn’t exist, since I love the rest of Raoul’s. Actually, I’d prefer the ma√Ætre d’ didn’t exist, either.
On my second visit, with tables empty everywhere in the front and middle rooms, he instructed the hostess to take us to the garden. I begged him: Please don’t.
He looked down at us in the French style, and said, “You made your reservation online.” Indeed, my friend had used OpenTable, listed on the restaurant’s website. The ma√Ætre d’ informed us that OpenTable had assigned us to the back room, and that was that. As we were led away, no happier than prisoners in leg irons, he sneered, “Next time you should call.”

Raoul’s is an old-fashioned restaurant — that’s a large part of its charm. But if it doesn’t want diners to use OpenTable, it shouldn’t offer them the option.

I do occasionally wonder, though, what to do with my Dining Rewards Points. I somehow can’t see myself redeeming them on the website, waiting up to six weeks for delivery, taking a Dining Cheque to a restaurant, and then using it to pay for (some of) my meal. It would be great if I could somehow donate them to charity — help treat some non-profit workers to a very nice lunch every so often. But then I suppose more people would redeem them, and the business model might not work any more.

Why Big Banks Should be Smaller

Felix Salmon
Mar 30, 2009 19:37 UTC

James Kwak wants to make US financial institutions smaller:

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities…
Size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities).

Kevin Drum is not convinced:

It still has the flavor of a solution that’s clear, simple, and wrong. After all, Bear Stearns was a quarter the size of Citigroup, and it was considered too big to fail. So just what would the limit be on bank size? $500 billion in assets? $200 billion? Can a country the size of the United States even have nationwide banks with limits like that? And what happens the next time around, when all these smallish banks overleverage themselves and collapse en masse? Are we any better off than we are with a few big banks failing?

I’m with James on this one. Two things are worth noting about Bear Stearns: first, it might have been small by Citigroup standards, but its balance sheet was still enormous. And secondly, it wasn’t considered too big to fail, it was considered too interconnected to fail, largely as a result of its role as a major CDS broker.

To get specific, I think that maybe $300 billion in assets would be a reasonable cap on bank size — there’s very little evidence that banks get any economies of scale beyond that in any case. If they want to be part of a global or even a national network that would be fine — I’m sure such networks would spring up quite naturally, much as they have in the airline industry. After all, the United States managed to go 200 years without any nationwide banks, it’s unclear why it desperately needs them now.

At the same time, the cap on the balance sheet of broker-dealers should be smaller still: the more interconnected you are, the lower the cap, to the point at which companies like the CME, which are far too interconnected to fail no matter how small their balance sheet, should be barred from issuing any liabilities at all.

As for what happens when lots of smallish banks overleverage themselves and collapse en masse, well, you get an S&L crisis. Which is fiscally painful, to be sure, but which can largely be avoided through good regulation and which more importantly doesn’t have anything like the systemic implications of the current meltdown. So yes, we’re better off with one of those than we would be with Citi and BofA both failing.

The problem is a practical one: how do we get there from here. There are no good and politically-feasible answers to that question. So in the real world, TBTF banks are here to stay. But that doesn’t mean we have to like it.

Great Moments in Political Rhetoric: Hannan vs Brown

Felix Salmon
Mar 30, 2009 16:52 UTC

From the European parliament, of all places:

(Via MAI, although I’m late to this, it’s been viewed almost 2 million times on YouTube already.)

One Easy CDS Fix

Felix Salmon
Mar 30, 2009 14:46 UTC

I’ve had my share of disagreements with Arnold Kling on the subject of credit default swaps in the past, but he has a good idea today:

Regulators and accountants could require firms that are net sellers of credit default swaps to translate those positions into bond holdings and put these synthetic bonds on their balance sheets. My guess is that had such a policy been in place in 2000, the CDS market would not have taken off.

My guess is that Kling’s guess is wrong: there were actually very few net sellers of CDS, and in any case for most of this decade the stock market seemed to think that ever-expanding financial balance sheets were a good thing, not a bad thing. But yes, definitely: if you’re a net seller of protection, then the notional amount of credit that you’re exposed to should be considered an asset on your balance sheet, just as it would be if you owned that credit in bond form.

It is conceivable that the the monolines — which were by far the largest publicly-listed net sellers of protection — might have thought twice about continuing their escapades in the CDS market if there would have been such an enormous effect on their balance sheet. Doing so would have brought them more into line with the buyers of synthetic CDOs, who were the other large net sellers of protection, and who invested up front all the money that they could possibly lose.

Kling’s other point is that it’s hard to buy long-dated derivatives on the big exchanges in Chicago: if you want something with a maturity of three years or longer, you need to buy it in the OTC markets. That’s true, but he’s wrong that "it is quite difficult to take a position of any size" in long-dated options: those OTC markets are huge, and in many cases substantially larger than the exchange-traded markets. And they seem to work pretty well, in the absence of massive players like AIG taking large net positions (on the order of hundreds of billions of dollars) in the market.

Why is the NYT Breaking the Web?

Felix Salmon
Mar 30, 2009 05:56 UTC

Websites get old, and need to be redesigned occasionally. That we understand. But the first rule of designing a website is that you make sure you can redesign it without breaking all the incoming links. And the first rule of redesigning a website is don’t break all the incoming links.

The Obama administration broke that rule on January 20, when all links to whitehouse.gov broke at the stroke of noon. And now the New York Times has broken that rule as well, with all links to iht.com now redirecting to a marketing stunt for what the NYT is rebranding as its "global edition".

So for instance if you’re reading my blog entry from May 2007 linking to an IHT op-ed by Ngozi Okonjo-Iweala, you won’t be able to follow that link and read the op-ed. What’s more, that op-ed doesn’t exist on nytimes.com, in any form. The NYT essentially did its best to erase it from the internet, for no good reason.

How did the NYT manage to perpetrate something so utterly boneheaded? And does this mean that those of us who care a lot about our links not dying should start linking instead to organizations which are less idiotic, like the Guardian and the BBC? I hope that the NYT rectifies this error sharpish. Because it’s losing a lot of webby goodwill by the hour.

Extra Credit, Sunday Edition

Felix Salmon
Mar 30, 2009 05:33 UTC

My Manhattan Project: The first-person story of Mike Osinski, whose software fuelled the mortgage-securitization boom.

TR thoughts on ticket re-sellers / scalping: Trent Reznor of Nine Inch Nails explains the economics of concert tickets.

Huffington Post launches journalism venture: Arianna and her friends are putting $1.75 million into investigative reporting. It’s unclear whether the operation expects any revenues, or if it does where they’re going to come from.

Hedge Fund Regulation Doesn’t Matter:
An Artificial Operational Due Diligence Floor
: It’s important that hedge-fund regulation not give investors a false sense of security. Its main purpose is to look out for systemic risk, not ponzis.

More Evidence of Volcker Being Marginalized

South Park – Stan Marsh takes us through the mortgage crisis: Very well done.

How the CDS Market is Going to Improve

Felix Salmon
Mar 30, 2009 04:58 UTC

A Credit Trader has a great post on what he calls "risky annuity risk", an artifact of the CDS market which will go away when all credit default swaps start trading on a fixed coupon. If you like to geek out with the arcana of the CDS market, you’ll love this.

Let’s say you’re a CDS trader who buys $50 million of 5-year default protection on General Motors at 100bp. That means you pay 100bp per year — $500,000 — in return for getting a big payout should GM default at any point in the next five years. Six months later, GM is looking much riskier, is trading at 300bp. You decide to take your profits, so you sell $50 million of 4.5-year default protection at 300bp. You’re now receiving $1.5 million a year, and paying out $500,000 a year, for a net profit of $1 million a year over the next four and a half years. Which adds up to $4.5 million. Well done! You book your $4.5 million profit, and celebrate with some fine Champagne.

But then GM defaults. This is not good for you. Yes, you’re perfectly hedged when it comes to default risk: the amount you owe to the person who bought protection at 300bp is exactly the same as the amount that the person who sold you protection at 100bp owes you. Assuming no counterparty risk, you’re flat, and there’s no problem there. The problem is that your $1 million-a-year income stream has suddenly gone dry. The CDS have all been wound up: you’re not paying $500,000 a year any more, and you’re not receiving $1.5 million a year any more, either. And your $4.5 million profit has disappeared.

This is what ACT calls "essentially unhedgeable jump-to-default risk" — you bet on a credit souring, the credit sours, you make lots of money, but then you hope desperately that the credit doesn’t sour all the way to a credit event, because then you lose most of the money you thought you’d made.

The solution to this problem is to set the coupon on all CDSs at, say, 100bp. In that case, the first deal is exactly the same: you’re the protection on $50 million notional of GM debt at a spread of 100bp, and you pay out your $500,000 per year. But when you come to close out the deal, instead of selling protection at 300bp, you sell protection at the same fixed spread of 100bp. Since GM credit default swaps are trading at a spread of 300bp, however, you’re essentially selling the exact same contract that you entered into six months previously — you’re selling the privilege of being able to pay just $500,000 a year in return for that big payout if GM goes bust. How much is that privilege worth? $4.5 million.

The CDS has become a tradeable instrument, which goes up in price when spreads widen, and which goes down in price when spreads narrow. The buyer of protection always pays the seller $100,000 a year for every $10 million nominal amount, and the seller of protection pays the buyer an up-front sum if the spread is below 100bp. Conversely, if the spread is above 100bp, then the buyer of protection pays the seller an up-front sum.

By moving to this system, CDS traders manage to get rid of that pesky jump-to-default risky annuity risk, and can cash in their gains as soon as they close out their positions. Liquidity in the CDS market should improve, bid-offer spreads should narrow, and volumes should rise. Of course, that’s exactly what all those people who want to move to exchange-traded CDSs want, right?

Update: Alea, in the comments, corrects my misconceptions about how the new system will work: apparently the annual premium will be a thing of the past, and the whole premium will be payable upfront. Which means that the buyer of protection always pays an up-front sum, no matter what the spread.

Update 2: Wait, no, that’s not it, either, the buyer of protection still pays an annual premium, and then there’s an upfront payment as well. Isn’t that what I said the first time? Look, here you go, Markit explains it all in great detail. Look at pages 15-16.