Opinion

Felix Salmon

Retiree income datapoint of the day

Felix Salmon
Dec 27, 2009 02:31 UTC

The group of people hit hardest by interest rates are those used to living on interest payments. “The elderly and others on fixed incomes have been especially hard hit,” reports Stephanie Strom. But just how hard have they been hit?

“The unemployment situation and the general downturn in the economy had an impact, but what’s going to happen now as C.D.’s mature is that retirees and the elderly are going to take anywhere from a half to three-quarters of a percent cut in their incomes,” said Joe Parks, a retired accountant in Houston on the advisory board of Better Investing, an organization that works to help people become savvier investors. “It’s a real problem.”

A cut of as much as three-quarters of a percent? Somebody call 911! The median income for households where the householder is 65 and over was just under $28,000 in 2006. If low interest rates have hit that by 0.75%, we’re talking about a drop less than $20 per month. Is that “a real problem”, when Barack Obama is sending out $250 checks to everybody drawing Social Security, just ‘cos he’s a nice guy? I don’t think so.

Low interest rates are one way of trying to bring down the number of people getting laid off, when unemployment can reduce your income by 75%, rather than by 0.75%. Remember that Social Security payments are going up, not down (for no good reason), and in any case there’s no rule saying that anybody has to keep their principal untouched, and live only on interest payments. For that matter, there’s no rule saying that people who live on interest payments have to invest their money in risk-free investments.

The fact is that even if interest rates were 5% rather than 1%, you’d still need a $400,000 nest egg to earn $20,000 a year in interest payments. Right now, the economy is facing much bigger problems than the plight of individuals with $400,000 of liquid cash in the bank. And what’s more, we already have a safety net for retirees — it’s called Social Security, and its generosity is a serious fiscal issue going forwards.

So you’ll excuse me for not getting particularly exercised about the plight of savers in a low-interest-rate economy. If they want higher returns, they can take some risks with their money, and if they want to spend more, they have large nest eggs just sitting there for the spending. They certainly shouldn’t be a serious part of the deliberations at the Fed over whether and when to raise rates.

(One thing worth adding here: it’s possible that Parks misspoke, and that what he meant was that retirees were going to take a cut of up to 0.75 percentage points in the interest rate they could get on maturing funds. But that of course tells us nothing about their total income.)

COMMENT

Not saying it can’t be done, but you’re not likely to be living too well on $28/yr and probably noticing that Social Security isn’t operating with great alacrity or anything that could be termed generosity, these days.

The potential for economic enslavement of the American elderly, infirm and anybody else who can’t stand up for themselves is far too grave to disregard, or even quibble over.

Meanwhile, if this discovery doesn’t set your teeth on edge -

http://www.nytimes.com/2009/12/24/busine ss/24trading.html?_r=1&em=&adxnnl=1&adxn nlx=1261707835-ayU9fzFyp9l+5LL6DbC6aw

- then you don’t have much of a heartbeat. Not for the elderly, probably not for anyone else among the living, unless you include TARP-ripping zombies.

One nation under Goldman, America’s not such a great place to grow old in any more.

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Teflon Buffett

Felix Salmon
Dec 26, 2009 23:32 UTC

Warren Buffett is a lovable, avuncular chap, not one of those axe-wielding CEOs who are feared by employees and idolized by the kind of red-claw capitalists who think that firing lots of people is a major leadership skill. Yet somehow he seems to have fired 21,000 people — 8.6% of his workforce — over the past year. And the cuts are being felt hardest by Berkshire’s poorest employees: some 3,000 textile workers have lost their jobs at Fruit of the Loom in El Salvador.

Alice Schroeder, Buffett’s biographer, explains that Buffett is expert at hiring “bad cops” to fire employees and to insulate himself from any blowback:

At NetJets, Sokol has got an enormous challenge on his hands. The changes he’s making at NetJets are so significant that Sokol’s angry employees apparently took their complaints about him to the press.

Try to imagine Berkshire employees doing that to Buffett. It’s unthinkable, right? Buffett could order animal sacrifices on his birthday and his employees probably wouldn’t complain to the New York Times…

No matter who succeeds Buffett (Sokol, if he pulls off the turnaround) this part of the franchise will be “lost” after Buffett is gone, because it is unique to the way Buffett has arranged his image over the years. Buffett has gone to a lot of trouble to be universally liked. I can’t think of anybody else qualified who can replicate that.

Schroeder explains that being universally liked is a major source of Buffett’s wealth: it makes it a lot easier for him to acquire any given business. Absent Buffett, it’s going be much harder for Berkshire to acquire the privately-held companies that it specializes in buying. And more generally, it’s going to be a practical impossibility for Berkshire to be run by someone as teflon-coated as Buffett. Could anybody else fire 3,000 Salvadorean textile workers and receive essentially no bad press at all?

(Incidentally, if anybody can find the RSS feed for Schroeder’s blog, “Passages”, I’d love to add it to my reader.)

COMMENT

Personally, I have a lot of admiration for Buffett. But I doubt the housebound seniors who aren’t getting their Loaves and Fishes meals any more do, and I have to wonder if that was really necessary. Also, it’s not a linear increase in productivity, since you have a hit to morale.

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Counterparties

Felix Salmon
Dec 25, 2009 05:48 UTC

Treasury provides an unlimited guarantee for Frannie, formalizing what’s existed de facto for decades — Reuters

“The people in charge of most technology companies are disinclined to realize that their success was due to luck” — Baseline Scenario

Bernie Madoff Assaulted in Prison? — ABC

The NYT seems to think that calling a politician by his first name means he’s not feared. Tell that to Rahm — NYT

Merry Christmas!

Why Goldman could go short mortgages

Felix Salmon
Dec 24, 2009 20:50 UTC

Blake Hounshell asks (of me specifically, no less) why “other banks didn’t follow Goldman’s lead when in December 2006 the firm turned bearish on the mortgage sector”.

The answer is that Goldman never had much in the way of net mortgage exposure to begin with, and could therefore turn bearish quite easily. Banks which had tens of billions of dollars of illiquid mortgage bonds on their balance sheets, by contrast, had no real way to put on a bearish bet.

More generally, pure investment banks, like Goldman, always claim to be in the moving business as opposed to the storage business. Today’s NYT story shows that there are limits to how true that is — Goldman had significant long-term mortgage exposure which it hedged by building up a short position in synthetic CDOs. But at least its net position stayed very small.

Competitors like Merrill Lynch, by contrast, found themselves taking enormous amounts of mortgage-bond exposure onto their own balance sheets just because no one else was willing to buy the lowest-yielding tranches of their mortgage bonds. It was that exposure which ultimately doomed the bank. Merrill might have been talking the moving-not-storage talk, but in practice it was acting as a waste dump for all manner of risky paper that the bond desks couldn’t move.

And big commercial banks with investment-banking arms, like Citigroup and UBS, never even claimed to be movers rather than storers: they actively sought out high-yielding triple-A paper as part of their business model. So long as the yields were higher than their own internal cost of funds, they considered such a position to be inherently profitable — and the bigger the position, the more profitable it would be.

There was also a difference in the type of mortgage paper which each bank had in its long portfolio. While Merrill, Citi, et al were stocking up on the lowest-yielding debt, Goldman I suspect had mainly the equity tranches of the bonds it underwrote: the highest-yielding, riskiest paper. Because the equity tranche is inherently extremely risky, even in good times, it’s only natural for any bank owning such paper to want to hedge that exposure.

And this is where I think that Goldman might have gotten a little lucky. Because equity tranches can all go to zero very quickly, you need a fair amount of CDS insurance to hedge that exposure. But once you’ve bought that CDS insurance, it will continue to rise in value as the housing market implodes, long after your original equity tranche has been wiped out.

Let’s say the housing market is at 100, and you have $3 million of bonds which will get wiped out if the market drops to 97. So you hedge that exposure by buying credit default swaps which pay out $1 million for each point that the housing market drops. (This is massively oversimplifying, but work with me here.) If the market falls to 97, then you lose $3 million on your bonds, while making $3 million on your CDS — you’re even. But if the market falls even further, to 70, then you still lose only $3 million on your bonds, while making $30 million on your CDS — gravy! You don’t even need to buy any more insurance to make that extra money, you just need to keep holding the insurance you already own.

On the other hand, let’s say the housing market is at 100 and you have $50 million of bonds which will get wiped out if the market drops past 75. At that point, the temptation is to do nothing at all, since hedging costs money and your models tell you that the market will never fall that far. And by the time that the market starts falling, insurance is so expensive that you can’t afford it any longer.

More generally, if you’re starting from a market-neutral position, it’s easy to go short. But if you’re starting from a large net long position, it’s much, much harder to do that. Almost impossible, really, especially when the market seizes up and there’s no liquidity any more.

And while I’m on the subject, there’s one thing worth adding: that none of this would have happened if Goldman hadn’t been so mind-bogglingly enormous. Goldman could hold on to the short side of all the synthetic CDOs it was underwriting precisely because in some distant other arm of the Goldman empire, a mortgage desk had managed to make money by introducing lots of mortgage-backed bonds onto the bank’s balance sheet. So the logical thing to do was to create a new desk which could make money by introducing lots of mortgage CDS onto the balance sheet. That way Goldman made money on both trades, while its balance sheet was hedged and canceled itself out.

If however there was a cap on bank size, or punitive capital requirements on balance sheets above $100 billion, then those kind of shenanigans would be much harder to pull off. Goldman would then do neither the original mortgage deals nor the subsequent synthetic CDOs, and the world would be a better place.

COMMENT

We know Goldman nearly bankrupted AIG (huffingtonpost…)

With collapsing mortgage markets, insurers were getting in big time trouble. However, some knew how to pull the string …

1. In July 08, SCA a bond insurer settled contracts for 13 cents on the dollar.
2. In Aug 08, Calyon a French bank also involved with AIG, settled financial guarantees for 10 cents on the dollar.
3. Ambac another bond insurer cancelled similar trades for 10 cents on the dollar.

I remember watching CNN with Mr. Bush saying, ‘Hank walks into the room and says we have to save AIG otherwise there will be a financial meltdown’. So to prevent this meltdown emergency meetings happen and AIG gets huge funds.

So compared to the other bond insurers, how much did the Feds pay, 100 cents on the dollar. Goldman avoids 22 billion dollars in losses.

A side note – Hank Paulson had a very successful career with Goldman with an estimated compensation of 35 million in ‘05

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Is there a Goldman CDO scandal?

Felix Salmon
Dec 24, 2009 17:04 UTC

The big story on this slow news day is the NYT’s 3000-word story on Goldman and synthetic CDOs, which now has a formal response from Goldman itself.

Here’s what I think is the most interesting new information in the story:

Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion…

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades…

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

There are a couple of things which jump out, here: firstly that Goldman was structuring synthetic mortgage-backed CDOs as early as 2004, and secondly that it held on to the short side of those deals for years.

Remember that by their nature, synthetic CDOs have equal-and-opposite long sides and short sides. Anybody buying these things from Goldman knew that someone else was betting the opposite way. And they knew that someone was Goldman, at least in the first instance.

Over 2004, 2005, and 2006, and even into the first half of 2007, demand for mortgage-backed credit assets was insatiable. That’s why so many originators started churning out low-quality paper, and that’s why Goldman got into the origination business too, both on the real-money side (although it was never a huge player there) and on the synthetic side.

Goldman’s synthetic CDOs involved it paying millions of dollars in insurance premiums every year to the investors who bought them. Because of the balance of power between buyers and sellers of credit during the boom, the people buying bonds had very little bargaining power, and the people issuing debt had a lot. As a result, private-equity shops were able to issue billions of dollars in cov-lite loans, and the likes of Goldman Sachs were able to put all manner of triggers into their CDOs — things like ratings downgrades — which would stop the money flowing from Goldman to the buyers, and start sending money flowing back in the opposite direction.

Goldman was certainly in a good position here. It had a substantial portfolio of mortgage-backed securities — so substantial, in fact, that it wrote down $1.7 billion on its residential-mortgage exposure in 2008. As a result, it had a lot of appetite for hedges against those securities, and happily held on to those hedges in 2004-7 when they were losing, rather than making, money. It liked holding the position because it had structured the hedges itself, and knew exactly how profitable they might be if and when the housing market turned.

But does that mean, as the NYT article says, that Goldman’s decision to take the short side of the CDOs “put the firms at odds with their own clients’ interests”? No, it doesn’t. In fact, I’m a bit depressed that we’re still having this argument, a full two years after everybody derided Ben Stein for saying the same thing. I may as well simply disinter what I wrote back then:

If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. Caveat emptor, and all that. If I am investing your money on your behalf, then I have a fiduciary duty. But if you’re looking for fiduciaries, you’re not going to find them on the sell side, only on the buy side.

When Stein accuses Wall Street banks of “betraying their clients’ trust,” he’s simply confused about who the clients are, in these transactions. If I’m an investor and I buy a stock from a broker, then I’m buying it because I think the total amount of money I’m paying is a fair amount for that security. I’m completely agnostic about whom, exactly, I’m buying the stock from: if a different broker has the same security for a lower price, I’ll go there instead. And I’m certainly not trusting the broker to assure me that my security will go up rather than down in value. In fact, at the margin I actually like it if my broker is shorting that stock and thinks it will go down in value – because that just means that I get to buy it at a slightly cheaper level.

It’s just ridiculous to think that “basic fairness” means that Goldman should be exposed to exactly the same risks as anybody who it sells securities to. Goldman Sachs isn’t Berkshire Hathaway, investing money on behalf of shareholders. It’s an investment bank: an intermediary between issuers and investors. If an investor buys any kind of financial security, he’s deliberately buying a risk product. He gets all the upside if that security rises in value. But he also gets all the downside if that security falls in value. It’s not the job of any securities firm to bail him out.

The 30,000-foot view of what happened here is that there was an enormous amount of mortgage paper flooding the market over the course of the 2000s. Goldman Sachs, as a sell-side institution which manages its risk book on a daily basis and doesn’t want to take long-term directional bets, hedged its mortgage exposure with short positions it created by structuring synthetic CDOs. The buy-side, by contrast, had an enormous amount of appetite for long positions in mortgages, and it was the job of banks like Goldman to feed that appetite: again by structuring synthetic CDOs. Goldman was killing two birds with one stone: no wonder Jonathan Egol, who was in charge of these deals, did so well there.

When the mortgage market started to turn, Goldman was smart and nimble enough to realize that it could make money on the way down as well as on the way up. That’s what traders do, and Goldman is the world’s largest and most successful trading shop.

Henry Blodget adds another important point:

Don’t forget that everything is obvious in hindsight. Goldman could have been wrong about the housing market, and its clients could have been right. In that case, we wouldn’t be talking about a scandal. We would be talking about how Goldman got greedy and made dumb bets.

The real lesson here isn’t that Goldman did anything scandalous. It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing.

COMMENT

If you create a financial instrument that is based on fraudulent mortgages, how can that be a legitimate financial instrument? Incomes, assets claims, appraisals and many other things all constituted fraudulent false statements. These were the basis for the products in question.

The crises would never have been as severe if fraud hadn’t been repackaged and sold, allowing new fraudulent mortagages to be originated.

Did Goldman know that the loans were fraudulent? They were called Liar Loans for goodness sake! Everybody knew!

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Counterparties

Felix Salmon
Dec 24, 2009 05:25 UTC

Mean-reversion vs momentum strategies: The former is safer, the latter can make you much more money — Kid Dynamite

How Stephen Colbert self-censored his White House Correspondents Dinner speech — The Atlantic

The new wave of oyster farmers — WSJ

Beware anecdotal evidence of microfinance’s success (or failure) — Center for Financial Inclusion

Google News overtakes NYTimes — TechCrunch

Taibbi on the human cost of defense earmarks — True/Slant

Young Bernanke — Time

Dan Gross weighs in (on the side of the sensible) re jingle mail — Slate

Hilarious roundup of local-TV jesus sightings — YouTube

Euphemisms of the day, Dubai edition

Felix Salmon
Dec 23, 2009 19:42 UTC

Maria Abi-Habib reports:

Gulf News, a newspaper part-owned by a senior government minister in the United Arab Emirates, has told its journalists to avoid using the words “bailout” and “default” when writing about Dubai’s debt crisis…

Reporters for the paper, the largest English-language daily in the U.A.E., were also urged to steer clear of the phrase “debt crisis” and asked to “ensure the following politically correct terminology is used” — words such as “financial consolidation” and “fiscal support” — when describing the sheikdom’s economic problems…

“This is a style guide,” said Francis Matthew, the Dubai-based paper’s editor-at-large when asked by Zawya Dow Jones about the memo. “We’re trying to restrict people from using financially incorrect terms.”  

Remember this, reporters! AIG, Citigroup, Frannie, GM, etc etc didn’t get bailouts, they got fiscal support. Or, better yet, they simply experienced financial consolidation. Sounds so much better than, you know, bankruptcy.

(Via the indefatigable Daniel Lippman)

COMMENT

Using establishment political correctness to bail out [sic] the bilge of Dubai World will be like forming a teaspoon-line to keep The Titanic above water.

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Did Oppenheimer’s Core Plus funds rise or fall in 2008?

Felix Salmon
Dec 23, 2009 19:10 UTC

Mish has found something very odd indeed from Oppenheimer Funds. Its Fixed Income Core Plus strategy was marketed to the Illinois Bright Start college savings plan, with disastrous results: parents thought they were making a conservative investment for imminent college-tuition needs, bechmarked to the Barclays aggregate index, which rose more than 5% in 2008. Instead, they wound up in a crazy leveraged vehicle with total losses of 38% in 2008 and more in 2009.

But at Oppenheimer’s website, the information on the Core Plus fund shows positive returns for both 2008 and the year to date. It’s all very odd, and makes it seem that the college fund investments were invested in something enormously different from Oppenheimer’s own Core Plus fund. Either that, or Oppenheimer is calculating its fund returns in a very odd manner. Can anybody get to the bottom of this?

Update: Mystery solved! There are two Oppenheimers. There’s Oppenheimer Funds, which sold the disastrous investment to Illinois; its Core Bond Fund did indeed plunge in value in 2008. And then there’s Oppenheimer Investment Management, which Mish linked to, which also has a Core bond fund, but which is not part of Oppenheimer Funds at all; instead it’s an affiliate of Oppenheimer & Co, the boutique where Meredith Whitney used to work.

COMMENT

Just to amplify Felix, Oppenheimer Investment Management doesn’t actually run any ’40 Act mutual funds of any kind. The “core bond” strategy to which you refer is available only through separate accounts, etc.

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How big of a problem is cybertheft from banks?

Felix Salmon
Dec 23, 2009 18:05 UTC

The WSJ’s front-page story yesterday was clear and unhedged:

The Federal Bureau of Investigation is probing a computer-security breach targeting Citigroup Inc. that resulted in a theft of tens of millions of dollars by computer hackers who appear linked to a Russian cyber gang, according to government officials.

The fallout, however, is incredibly muddy and opaque. Citigroup is strenuously denying that there was any breach at all, let alone any losses; it also said in the original story that the WSJ’s smoking gun — the disappearance of $1 million from a Citibank bank account in Mt Vernon, NY — was “an isolated incident of fraud”.

PCWorld says that the story is wrong:

A source within federal law enforcement who declined to be identified said the Wall Street Journal story was inaccurate and appears to have confused a known 2007 hack of Citigroup-branded automated teller machines with a long-running criminal effort to hack online banking customers and move money out of their accounts.

“They’ve screwed up so many different things,” he said.

ABC has weighed in too, deciding that Citigroup and the WSJ are both wrong, and that “the truth here is somewhere in the middle”, whatever that’s supposed to mean.

Paul Murphy has an interesting theory:

Citigroup, like every major bank in the Western world, is covering up the fact that online fraud — both sophisticated and unsophisticated — is running at epidemic levels. But it can’t be seen to be singled out as an institution with weak controls, where the public at large might be fearful of depositing their money. So it goes on the denial warpath.

But hang on, you say! How about the Citi guy saying: “We had no breach of the system and there were no losses, no customer losses, no bank losses.”

Well, maybe the Russian crooks were siphoning cash out of a Citi customer’s account, using his or her computer. The customer would suffer no loss because the bank routinely makes good on the missing money; the bank, meanwhile, makes no loss because when it discovers a fraud such as this it simply contacts the correspondent bank in Latvian/China/Ukraine/Russian to which the money was transferred and demands it back.

Murphy is convinced that banks are losing billions of dollars to cyber thieves, just because they can’t afford the IT investments needed to stop such theft, and in any case have no assurance that such investment would actually be successful in preventing further theft. All they can do is quietly reimburse any customers who are hit, while keeping the scale of the problem as secret as possible.

It does seem to me that the biggest problem with the WSJ story is not its accuracy, but rather its scope. The paper here concentrates on a single alleged theft, the outcome of which is unclear, even to the reporters involved: one of them, Siobhan Gorman, told Ryan Chittum that she was “in the process of clarifying with sources” what exactly had happened.

But by concentrating on a single instance at a single bank, the WSJ and papers like it force banks into a defensive crouch where they deny that any theft has taken place at all. After all, if Citibank were to say that the story was true, that would make it seem that Citibank was less secure than its rivals. As the original story reported:

U.S. banks have generally been loath to disclose computer attacks for fear of scaring off customers. In part this is an outgrowth of an experience Citibank had in 1994, when it revealed that a Russian hacker had stolen more than $10 million from customer accounts. Competitors swooped in to try to steal the bank’s largest depositors.

I think then it’s important for stories like this to try to make clear whether they’re talking about individual thefts which could and should have been prevented, and which would not have happened at a safer bank, or whether on the other hand they’re talking about symptoms of a much broader system-wide problem. If banks always refund thefts and the thefts are rare and isolated, there isn’t a problem here on a systemic scale, and there isn’t a risk to depositors either. On the other hand, if Murphy is right and cybertheft is endemic, then that poses a systemic risk to the banking system which ought to be addressed in a high-profile manner, in conjunction with regulators who are charged with overseeing the safety of the system as a whole.

COMMENT

The banks don’t really care about cybertheft, beyond the security measures already in practice.

Because as the old saying goes:

“One man’s cybertheft, becomes that same man’s tax deduction.”

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