Felix Salmon

Whenever there’s a surprise takeover bid at a significant premium to the (formerly) prevailing stock-market price, dozens of journalists and bloggers immediately pull up options-volume data. Much of the time, they discover a suspicious spike in options volume just before the deal was announced. The conclusion is obvious: insider trading!

So many thanks to Baruch for bringing a bit of context to bear on such exercises. His main points: is that options volumes are by their nature extremely lumpy. Just about any options contract, if you look at it, will have occasional extremely large spikes. As Baruch puts it, “the volume of a particular option resides in Extremistan”.

What’s more, the options markets are constantly awash in rumors, any one of which can easily cause on of these spikes. Baruch provides one example: last Friday, a rumor hit the market that Palm would be bought by Nokia. It wasn’t, but that didn’t stop 21,000 options being traded in one day on the $12.50 calls alone. That’s over five times the size of the option volume in 3Com before it was bought by HP.

And one other thing: if you did have inside information that 3Com was being bought by Nokia, you’d make more money simply buying the stock than you would buying the options. The only reason to buy the options is if you simply don’t have the cash to buy the stock.

None of which is to say that there wasn’t insider trading in 3Com, of course. It’s pretty hard to prove a negative. But statistically speaking, if you look at options volumes on every takeover bid which crosses the transom, eventually one of them is going to see this kind of spike, even if there’s no insider trading at all.

As Dean Baker notes, Neil Barofsky’s report on the 100% payments to AIG’s counterparties is the news of the day. It’s sexy stuff, revisiting the dramas of the week of Lehman’s collapse, and of course going into great detail about the way in which the crisis’s designated villain, Goldman Sachs, walked away with billions of dollars of taxpayer money despite saying they never asked for it nor particularly needed it.

I agree with Barofsky that, in hindsight, the payments should have been made at less than par; TED has a good explanation of how that could have happened, given sufficient aggression. After all, it’s not like Treasury wasn’t being run by a hard-charging former investment banker at the time.

But I’m maybe slightly more sympathetic to the Fed than most — or at least I understand how this happened. It shouldn’t have happened, that’s true: for the sake of putting a knife into the moral-hazard trade, some haircut — any haircut — should definitely have been imposed, even if it was only the 2% that UBS offered to accept.

But the government owned AIG, which created the situation that Germans call Anstaltslast: the fact that state-owned companies simply don’t default on their obligations. The government was also battling a major crisis using the only weapon at its disposal: enormous amounts of liquidity. When you’re putting out a fire, you don’t stop to worry that large amounts of liquidity are going to end up where you don’t particularly want them — the important thing is putting out the fire.

So yes, given a bit more aggression and foresight, the Fed could have tried to cram down a haircut onto AIG’s counterparties. But at the time, no one was particularly interested in being harsh to the global financial sector; instead, they were trying to rescue it. With hindsight, it now seems that companies like Goldman Sachs have turned out to be the biggest winners, paying out billions of dollars in bonuses even as the rest of the country struggles with an extremely nasty recession. But that wasn’t particularly foreseeable. And so although I agree with Barofsky that the Fed and Treasury should have been harsher on the counterparties, I do understand why they weren’t.

I was confused yesterday about currency ETCs; after a detailed conversation with Nik Bienkowski of ETF Securities, I think I understand them a bit better.

The answer to my central question about whether you can try to play the carry trade with these things is quite clear: it’s yes. The mechanism is just as commenter Daniel described it: the funds essentially buy currency forwards expiring tomorrow, sell them just before expiry, and roll over into a new short-dated forward. These forwards are extremely liquid, and since that constant rolling one-day exposure in the forwards market does an excellent job of reflecting the differences in local interest rates.

As a result, says Bienkowski, if the Aussie dollar ETC had existed for the past five years, holding it would have returned 4.8% per annum, before fees, over and above whatever you would have got from holding Aussie dollars alone. Fees are 39bp per year, accrued daily, so you genuinely can get a bit of carry out of these things.

So what’s all this about T-bill interest rates? It all comes down to the nature of the derivatives market. If I’m buying a forward expiring tomorrow and then selling it just before it expires, I don’t actually pay cash for the forward in one transaction and receive cash in a separate transaction when I sell it. Instead, the transaction gets netted out. If the currency has moved in my favor, I get paid a small amount of money; if it has moved against me, I pay a small amount of money. If it hasn’t moved at all, I get a tiny amount of money, corresponding to one day’s interest in local currency. Annualize that tiny amount of money, and you’re looking at the carry.

The investors, meanwhile, have put up an amount of money corresponding to the full notional amount of the underlying currency. That money needs to be invested somewhere, so it gets invested in T-bills. Hence the added T-bill interest rate. The T-bill interest rate isn’t large, but it’s the only actual interest paid on these instruments. The local-currency interest, by contrast, is basically an arbitrage condition: the forwards markets always reflect local interest rates because if they didn’t there would be a no-brainer arbitrage there. (This kind of arbitrage can fall apart during something as chaotic as the Icelandic devaluation, which was accompanied by the default of all the local Icelandic banks, but the currency ETCs invest only in G10 currencies, where that kind of thing hasn’t ever happened. Yet.)

The ETCs are dollar-denominated, and they all include either a long-dollar or a short-dollar position. The two facts cancel each other out, so if you’re a UK or euro investor who buys say the long Aussie-dollar ETC, you’re essentially getting direct exposure to the Aussie dollar in pounds or euros or whatever the currency is that you’re using to buy and sell the ETCs.

The ETCs are guaranteed to underperform their index, thanks to those 39bp in fees. But they shouldn’t underperform more than that, since Morgan Stanley has promised to pay the index return. “If Morgan Stanley didn’t pay us the index, they would be in default,” says Bienkowski. On top of that, much of the added complexity of the instruments is essentially designed to hedge precisely that Morgan Stanley counterparty risk.

Bienkowski is a fan of the instruments. “If you want to get access to foreign currency, I think these products are pretty good,” he says. “They aren’t leveraged, they’re not a CFD or a warrant. They’re basically bringing institutional money-market interest rates and spreads to the average investor. “

Thatsaid, currency ETCs are complex, and not easy to understand. There’s language in the prospectus about not buying them without talking to an independent financial advisor, but the fact is that most independent financial advisors aren’t going to be able to understand this prospectus very easily either. (Izabella Kaminska and I are at least as good at understanding these things as most independent financial advisors are, and we got very confused by them.)

If you’re a fan of the UK Financial Services Authority, you might take some solace in the fact that it has signed off on these currency ETCs; they fulfill its listing requirements as debt securities. “We’re bringing the wholesale currency market to a regulated exchange,” says Bienkowski. But the fact is that there’s still a lot of complexity here. In general it’s a good idea not to buy things you don’t understand, and there’s a lot of stuff in the prospectus which is difficult to understand.

On the other hand, historically it has been almost impossible for retail investors to play the carry trade, invest in foreign exchange, or in general diversify into fx as an asset class. If you’re worried that your investment currency is going to implode (be it dollars or pounds or anything else), then buying a few of these ETCs will give you some kind of hedge against that, helping to preserve international purchasing power. The underlying mechanics of them are not particularly pretty, but if you’re going to rely on the continued liquidity of any financial market in the world, the fx market is probably the best one to rely on: it’s incredibly liquid and robust.

Currency ETCs are very new and untested things, and so a sensible investor will probably hold off for a little while longer to see how they do. It might also be interesting to see whether and when a similar product might list on a US exchange. But in principle I can see why these things were invented, and I can also see why a certain class of globally-focused retail investor might be interested in buying them.

Two weeks until Latin America’s first gay marriage! — Inca Kola

49 million Americans lack dependable access to adequate food, the largest number ever — Alea

Alloway sums up what we do and don’t know about those weird Goldman CDO structures — Alphaville

More tales of price-gouging by Verizon from Pogue — NYT

“Duh” news of the day: Study finds eating dark chocolate helps people deal with stress — Epicurious

James Kwak asks why on earth we’re allowing tax-loss carry-backs. It makes no sense! — Baseline Scenario

My contribution to a Newsweek listicle; unfortunately they’ve jumped onto the white-on-black bandwagon — Newsweek

CNN paid Lou Dobbs $8 million to quit — NYP

Newsweek tries to convince NYT that 50% ad drop isnt that bad — NYT

It’s good to be Elin McCoy, living the life sybaritic at the Villa D’Este — Bloomberg

Clay Shirky on ontology, circa 2005. Still very fresh — Shirky

Hedge funds aren’t too big to fail. Even in aggregate, they’ve proved systemically unimportant — Rivast

Lesbians are better parents — Times

Town’s ‘Diana style’ show of grief for dead albino rodent — Daily Mail

Must-read Pinker review of Gladwell and his “cherry-picked anecdotes, post-hoc sophistry and false dichotomies” — NYT

The iq2us website is rather horrible, all flash-based and white-on-black and lacking permalinks, but tonight’s debate was well worth attending all the same. The motion was “Obama’s economic policies are working effectively”, and the interesting thing about it was that it wasn’t a left vs right thing at all.

Proposing the motion we had old-fashioned lefty Larry Mishel, who was joined by Steve Rattner and Mark Zandi. Opposing it were the even more interesting bedfellows of Jamie Galbraith, Eliot Spitzer, and, of all people, Allan Meltzer. An interesting debate was pretty much guaranteed.

The voting was interesting too. At the beginning of the debate, 32% of the audience supported the motion, 29% opposed it, and a very large 39% were undecided. By the end, the undecideds had shrunk to just 12%, the proponents were up to 46%, and the opposition was up to 42%. With an increase of 14 percentage points compared to the opposition’s 13 percentage points, the proposers were named the winners. But it was a very close-run thing, and in my view it was actually the opposition which clearly won the debate, not least because they had by far the best two debaters, in Galbraith and Spitzer.

The arguments for the motion were predictable: things aren’t as bad as they were a year ago, the Obama administration did everything that was politically within its power, and although things are certainly pretty gruesome now, they would be much worse were it not for the administration’s legislation.

The opposition was surprisingly cohesive, given that I can’t imagine Jamie Galbraith and Allan Meltzer ever agreeing on anything. The bailout was an attempt to recreate, at vast expense, the broken status quo ante which got us all into this mess to begin with. Yes, the stimulus and other Obama administration policies were necessary, but they were far from sufficient. And they have overwhelmingly helped the financial-services industry, rather than real Americans, who are still losing jobs at a rate of 200,000 a month.

The revelation was Eliot Spitzer, who was impassioned, fluent, compelling, and clearly enjoying himself. He made some very good points: how come Tim Geithner has managed to get away without ever being forced to justify the decision to pay all of AIG’s counterparties at 100 cents on the dollar? How come no one in the White House seriously pushed for judges to be able to modify mortgages in bankruptcy? How come more effort hasn’t been spent on preventing manufacturing jobs from disappearing, given that once such jobs go, they never come back?

In general, the proponents came across as weak and dry statistics-spewers suffering from a failure of imagination: they couldn’t even conceive of persuading the Democratic Congress to pass anything truly ambitious, even as the opponents were citing precedents from FDR to Reagan. That then prompted Steve Rattner to channel Rahm Emanuel, and accuse Eliot Spitzer, of all people, of being the kind of person who thinks up bright ideas while sitting in the shade at the Aspen Institute.

What’s more, the motion wasn’t whether the current economic policy was the best we could hope for given political realities, it was whether it’s working effectively. And if you’d asked Larry Summers when the stimulus bill was being passed what kind of year-end 2009 unemployment rate would indicate that his policies weren’t working effectively, he would have given a figure much lower than 10.2%. I think we should take him at his hypothesized and counterfactual word. The administration has tried its best, and done some necessary-but-not-sufficient things, but it hasn’t succeeded in its stated aims.

Last year, I applauded Eli Broad for not donating his art to Lacma, and instead keeping it in his own foundation, whence it could and would be lent out around the world. I even suggested that it might make more sense to donate art to the Broad Foundation than to a museum:

Museums tend not to spend any time or effort lending out the works they’re not showing: if they’re asked they might say yes, but they’re not proactive about it. So while they might claim to be driven by the desire to show art to the public, in reality they only really want to do that within their own four walls.

Broad’s new foundation, by contrast, will exist with the stated purpose of truly maximizing the public exposure that its art receives. That’s a proposition which could be very attractive to collectors wondering what to do with their legacy: they provide the art, and Broad will take care of all the paperwork and relationship management. So if you’re buttering up a gallerist, maybe the best thing to do is no longer to hint that you’re thinking of donating your collection to a museum: better that you hint that you’re thinking of donating your collection to Eli Broad.

Of course, this was the charitable view of Broad. The uncharitable view was that he was just another collector with a big ego, who wanted to keep his art for himself and his own greater glory. Now comes the news that he’s playing off Santa Monica against Beverly Hills and a third LA location to build a huge new public monument to himself:

The conceptual drawings for the Beverly Hills museum, delivered to city officials last month, show a much bigger project than the original proposal: a 126,600-square-foot, three-story building with the footprint of an arrow pointing east.

Of that, a museum of about 43,000 square feet and an adjoining 6,100-square-foot outdoor sculpture court would occupy the top floor, compared with the first proposal’s total 25,000 square feet of exhibition space. An additional 67,000 square feet would provide an “archive” for the art not on display and offices for all three Broad foundations — for art, education and medical research.

Inevitably, any museum of this size will overshadow the part of the foundation which exists to lend out unexhibited art. That idea was potentially very powerful and new, but it seems that Broad has retreated to the more boring and old-fashioned paradigm of simply exhibiting his own art himself. It’s now pretty clear where Broad’s priorities lie, and I have no faith at all that his foundation will do something game-changing. A shame.

Philosophically speaking, why don’t we tax corporate interest payments? (Practically speaking, the answer is that it’s politically impossible.) So far, the answers have fallen into three broad categories.

The first one feels like a category error to me, and basically says “the corporate income tax is a tax on income, and a tax on interest payments isn’t a tax on income, so you can’t expand corporate income taxes to include a tax on interest payments”. Well, yes, if you taxed interest payments you’d be taxing something other than income. That’s the whole point. Private equity shops love to load so much debt service onto their portfolio companies that they never make a profit, and therefore never have to pay taxes. This is not something we want to incentivize. There are lots of non-income taxes in the US; this would just be another.

The second two answers are better. Kyle says that it would be almost impossible to build such a law without loopholes: “there are lots of ways to create debt like exposure that appear to be expenses”. And Megan McArdle writes that debt really is a legitimate business expense for certain companies:

Heavy industrial companies need more capital to make new investments, and it can make good sense to match the duration of the financing to the expected life of the asset. That’s accomplished by borrowing money, not floating a new stock issue or trying to accumulate enough retained earnings to keep up with your competitors.

Interestingly, these two objections seem to cancel each other out somewhat. If an industrial company wanted to finance the purchase of a major asset, it could simply sign a long-term lease instead, turning a taxable interest expense into a legitimate business expense. And it would be quite easy to say that leasing companies had to be part of federally-regulated bank holding companies (which would be exempt from this tax), and couldn’t be part of the same corporate ownership structure as the companies they were leasing to.

I agree with Megan that implementing this tax “would make companies that do use debt finance much more risky”. That’s the whole point. We want to move away from over-reliance on debt finance, and towards a world where equity finance becomes much more common and much more boring. If investors want to leverage corporate profits with debt they can do so themselves, by buying stock on margin. But let’s not implement the leverage at the corporate level, where it’s imposed on even the most risk-averse equity investor.

Update: Steve Waldman adds that what we’re talking about is eliminating a tax deduction, rather than imposing a new tax. A useful thing to bear in mind.

Now I’m confused. Back on November 6, the FT’s Denise Law ran an article about a set of new currency ETCs which are going to be listed on the London stock exchange — think ETFs, but for foreign exchange. She quoted Nik Bienkowski, the chief operating officer at ETF Securities, which has created these instruments:

“The benefit of a currency ETC is that it provides exposure to local interest rates. It’s safer than putting money in a foreign bank account,” Mr Bienkowski said.

Is this an interesting new way to play the carry trade? As a good blogger should, the FT’s Izabella Kaminska revisited the subject on Friday, and found all manner of reasons why small investors should stay away from this product. Most startlingly, she writes of the maximum upside from investing in these things, that they have

all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then).

So which is it? Does the ETC provide exposure to local interest rates, or does it pay not interest or dividend at all? The official website for these things says that they “reflect movements in exchange rates between two currencies, plus exposure to local interest rates”, which seems pretty clear. But Index Universe says something rather different:

Each ETC will track the total return version of one of the Morgan Stanley Foreign Exchange (MSFX) indices. The total return index for any given currency pair has two components: a constant (long or short) position in the relevant MSFX currency, achieved by daily rebalancing via a “spot-next” transaction, and an interest component which tracks the one-month US dollar Treasury bill rate.

That’s certainly the impression I get from the official MSFX documentation:

For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily at the One-Month T-Bill Rate… Hence, the daily return on the related MSFX Total Return Index will be computed as the sum of the MSFX Currency return and the One-Month T-Bill return.

There certainly doesn’t seem to be any mention of local interest rates there. And given how much one-month Treasury bills are likely to yield for the foreseeable future, you’re not going to get much in the way of interest on that front, either.

So I’m confused about why and how ETF Securities is claiming that ETCs provide exposure to local interest rates. Is there something I’m missing here?

Update: I understand them now. And yes, they do provide exposure to local interest rates. Or they’re designed to, anyway.

Ultimi Barbarorum’s little-known other author, “Bento”, has a great blog entry up about the iPhone in China. Bento lives in Shanghai, and explains very simply why official Chinese iPhone sales are low: official Chinese iPhones are artificially crippled, thanks to a law banning phones with wifi capability. So the tech-savvy Chinese simply buy unlocked (and cheaper) iPhones from Hong Kong instead, which don’t show up in the official sales numbers.

This dynamic is well-known in Shanghai and across much of the rest of China:

The distribution model is extensive and robust, and in fact most Chinese buy their mobile phones from stalls like this. There are no iPhone shortages, as prices fluctuate to meet demand.

Yet somehow, in this age of universal connectivity, none of the Apple-watchers seems to have known anything about it. Instead they took the official statistics at face value, trying to read all manner of implications into them about Chinese demand for iPhones or the lack thereof.

I’m curiously reassured by this episode: it goes to show that markets really aren’t all that efficient after all, and that information flows in unpredictable ways. And that good bloggers and journalists can still be very helpful in telling the markets something they didn’t know, even if it’s common knowledge in Shanghai.

Nouriel Roubini says the federal government has to be much more aggressive on the unemployment front:

There’s really just one hope for our leaders to turn things around: a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

I’m sympathetic, but I’d note that the low-hanging fruit has already been picked, when it comes to “labor-intensive, shovel-ready infrastructure projects”, with the first stimulus, and I’m not sure that there are actually any left. Instead, might I suggest arts subsidies?

Three cheers to Jim Surowiecki for unambiguously adding his voice to those who would abolish the tax-deductibility of interest payments:

Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked…

As much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile.

The weird thing for me is that when I start banging this particular drum, I always get exactly the same answer: “yes, great idea, not gonna happen”. But is there any intellectual justification whatsoever for making corporate interest payments tax-deductible? I can see an argument for a carve-out for highly-regulated banks, since their entire business is based on making profits from the spread between the rate at which they lend and the rate at which they borrow. But banks aside, why should companies pay lots of tax on dividends, and no tax at all on bond coupons?

In a way it’s depressing: if this were a real debate and Paul Volcker had a remote chance of making interest taxation happen, then surely there would be no shortage of academics and corporate lobbyists making the case for keeping the status quo. The fact that they’re not even bothering is all the evidence we need that this isn’t even going to reach trial-balloon status, let alone get signed into law.

But still, the question remains: if they were to start taking this seriously, what arguments would they use? After all, as Surowiecki notes, the likes of Brazil and Belgium seem to do perfectly well without giving debt this artificial advantage.

The WSJ discovers Bob Hodgson and his debunking of wine tastings — WSJ

The fate of the bluefin — Politics of the Plate

Autocomplete Me

Fox Business is in 50m households, Bloomberg TV in 60m. Neither can crack 35,000 viewers per show — VF

Megan Fox, in verse — Awl

Many thanks to Paul Solman for putting my question to Sheila Bair. Her answer is quite astonishing in its chutzpah:

Solman: Felix Salmon, who blogs for Reuters and does a lot of very interesting reporting, wanted us to ask this: was the Washington Mutual intervention a mistake, given the knock-on effects it seems to have had on the broader community. And more generally, is there anything you would do differently, in hindsight, about Washington Mutual or any other of things that you did?

Bair: I think actually that’s a bit of a myth. WaMu was a liquidity failure. It could not meet its obligations, it didn’t have enough cash on hand to meet the funding obligations it had contractually committed to. That is a basis for closing an institution. And the other option would have been to pump government money in there too, and we’ve tried to resist a lot of these bailouts. So I don’t think that was the right solution. So we really didn’t have any other option.

It was a below-the-fold story. It didn’t even really get that much press play. It was completely smooth. Shareholders and creditors, yes, took significant losses, but everybody else was pretty much protected: the general creditors, even the uninsured depositors were protected. The employees: almost all were kept. So actually I don’t think the WaMu failure had a disruptive impact at all.

Now at about the same time, Congress voted down TARP, and there was a very severe market reaction to that. Those all happened about the same time, and I think that maybe sometimes people get that confused. But the WaMu failure itself was barely a ripple in what was going on with the financial system at that time.

Solman: Felix Salmon’s question is in general, in hindsight, is there anything you would now have done differently?

Bair: Yes, certainly there is. I think we would have tried to tried to dissuade Treasury from making the TARP capital investments…

Just, wow. I don’t necessarily expect Bair to get into the nitty-gritty of the difference between senior unsecured debt and tier-2 capital in a national TV interview. But the fact is that she did have the option of paying off WaMu’s senior unsecured bondholders, and she dismisses that option a little bit too blithely in saying that she doesn’t like “bailouts”. WaMu would still have been a major failure, complete with creditor losses, if she had done that.

And I think she’s simply wrong when she says that hitting WaMu’s bondholders as she did had no disruptive impact. Maybe this is a matter of opinion, since it’s hard to prove a direct causal relationship, but Bair, here, wiped out the senior debt of an enormous commercial bank — the kind of debt which is exactly what Libor measures. It seems to me pretty improbable that she could do that without a pretty significant knock-on effect on interbank markets and on the level of trust between banks. And as we saw at the end of 2008, when that trust disappears, all manner of extremely gruesome consequences result.

Certainly the failure of the TARP legislation to pass the first time round didn’t help things, partly because the markets were hoping that it would rapidly shore up that fast-eroding trust. But the need to shore up trust wouldn’t have been as urgent as it was were it not for WaMu. (And Lehman, of course, but that was out of Bair’s bailiwick.)

Finally, Bair, when asked if there was anything she would do differently in hindsight, essentially says no, there isn’t: the only thing she points to is a decision that Treasury made, not that she made. Rather than taking the opportunity to revisit her own decisions, she quickly turns on Treasury. That’s something she’s done many times in the past. When it comes to admitting to human fallibility, she’s still batting zero.

Economics of Contempt defends too-big-to-fail banks:

The point of creating CDOs was to generate a mezzanine tranche, which investors, who had a seemingly insatiable thirst for yield, would gobble up. Goldman (and other dealers) couldn’t place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines)…

As you can imagine, all the risks that a major dealer bank has to manage on a daily basis—the constantly changing level of their exposures, how those exposures all interact, etc.—gets extraordinarily, mind-bogglingly complicated. The major banks all made huge investments to develop the technological capacity to manage those risks, and it’s pretty clear they didn’t invest enough in their risk management systems. There are only two banks that I’ve seen that clearly did make the necessary investments in risk management (Goldman and JPMorgan, not surprisingly). So there are undoubtedly economies of scale there.

There are two problems with this. Firstly, the two banks which made the necessary investments in risk management were not the two biggest banks. Neither Goldman nor JP Morgan is small, of course — but Citigroup and Bank of America, both of which had woefully insufficient risk-management systems, were bigger still, and saw none of those “economies of scale”. There’s no indication that bigger banks are better at risk management than smaller banks; in fact, bigger banks tend to have more places in which they can hide nuclear waste from senior management and the board.

EoC also implies that bigger banks are more likely to be able to mark their assets to market; again, that’s not really true, as a glance at Citigroup will tell you. The key variable here isn’t size, it’s the quantity of illiquid assets that a bank is holding. (Loans, which are the bread and butter of commercial banks if not of Goldman Sachs, are by their nature illiquid.)

And then there’s EoC’s point about Goldman holding illiquid CDOs on its balance sheet and then hedging the associated risks in the CDS market. Is that something Goldman can do because it’s big, or is it a mistake which Goldman made and which it’s unlikely to repeat? Let’s ask Goldman CEO Lloyd Blankfein, who recently gave an interview to Peter Lee of Euromoney (behind a firewall, unfortunately):

We think there should be a much, much higher return for holding illiquid assets. Right now, our asset quality is a lot higher, we’re carrying more liquidity and the bar just got higher for carrying anything else. But for the right profit opportunity, we would put more illiquid assets on our balance sheet.

Super-senior CDOs are never going to provide that kind of profit opportunity. Goldman’s shenanigans in the CDO market were an aberration, and were not something societally useful which sprang from being large. In any event, there’s really nothing in EoC’s argument which couldn’t apply to banks with only $100 billion in assets, say, as opposed to $1 trillion. As James Kwak notes, economies of scale top out long before bank size does; beyond that, it’s all moral hazard.

I got two smart responses to my assertion that there’s no safe haven for investors these days. Jared Woodard at Condor Options responded with 1,500 words on how investors in an S&P index fund can buy put options to protect their downside: “any hedging at all is better than none,” he writes. Meanwhile, maynardGkeynes left a much shorter comment:

TIPS are both easy and obvious.

Of the two, I prefer the TIPS. Why gamble in the stock market at all, if you don’t need to? Jared’s options strategy is akin to buying insurance that your bet won’t pay off, without stopping to wonder why you’re making the bet in the first place. The main advantage to the options strategy is that if things really blow up, and there’s a major stock-market crash on the order of 60% or so, you could actually end up making a profit. But I think an investor who was invested in TIPS during such a chaotic time would be perfectly happy with her choice.

There are two small problems with the TIPS strategy. One is that the tax implications of investing in TIPS can be extremely complicated, and taxpayers might want to consider the cost in accountancy fees before going down that road. The second is that it doesn’t scale: the whole point of financial markets is that they turn savings into investments, and we actually want people with savings to be willing to take a little bit of downside risk.

In that sense, Jared’s strategy of buying long-dated puts and selling them six months before expiry is better. It brings with it most of the upside associated with stock-market investments, it helps move money into equities (which, over the long term, is something society prefers to having it create bubbles in the debt market), and it helps the investor sleep at night with regards to black-swan events. What’s more, it involves a little bit of work: that’s a good thing, since investing shouldn’t be brainlessly easy. On the other hand, it also involves a significant transfer of funds from the Main Street investor to Wall Street, which always makes money on options trading.

Still, both strategies are worth considering for people with investments. In general, I’d recommend the TIPS approach to people who are likely to be able to make money the best way, by earning it: in that case TIPS are a safe place to put your hard-earned cash. (Especially if you are very unlikely to move abroad, and aren’t worried about a falling dollar except insofar as it feeds through into inflation.) On the other hand, people who are looking to earn money through capital rather than labor will probably not be happy with the modest return on TIPS and might be happier with Jared’s approach.