Felix Salmon

On Tuesday, the Federal Reserve released its final rule governing credit card issuers. The whole thing can be downloaded here; it’s a mere 1,155 pages long. And credit card consultant Timothy Kolk has found something rather worrying buried within it.

Here’s the language from page 317:

Consumer groups and a member of Congress raised concerns about two industry practices that, in their view, exercise control over the variable rate in a manner that is inconsistent with revised TILA Section 171(b)(2). First, they noted that many card issuers set minimum rates or “floors” below which a variable rate cannot fall even if a decrease would be consistent with a change in the applicable index. For example, assume that a card issuer offers a variable rate of 17%, which is calculated by adding a margin of 12 percentage points to an index with a current value of 5%. However, the terms of the account provide that the variable rate will not decrease below 17%. As a result, the variable rate can only increase, and the consumer will not benefit if the value of the index falls below 5%. The Board agrees that this practice is inconsistent with § 226.55(b)(2). Accordingly, the Board has revised comment 55(b)(2)-2 to clarify that a card issuer exercises control over the operation of the index if the variable rate based on that index is subject to a fixed minimum rate or similar requirement that does not permit the variable rate to decrease consistent with reductions in the index.

In English, what this says is that credit card companies can’t put a floor on their credit-card interest rates. If you’re paying 12 percentage points above Libor, you pay 12 percentage points above Libor, no matter how low Libor goes. On page 516, the Fed gives an example: even if the terms of a credit-card contract include a floor below which an interest rate cannot fall, that floor can no longer be enforced after February 22.

Sounds great, right? Surely if there’s no minimum interest rate, that’s got to be good for consumers? Actually, no: there’s a problem here, due to the fact that interest rates are very low right now.

Let’s say that I’m a customer-owned credit union, and I want to issue my customers a card carrying a low interest rate of 9.9%. I also want to protect myself in case rates rise a lot, so I put in language saying that the interest rate always has to be at least 3.9 percentage points over the Prime rate. Prime is currently just 3.25%, but if Ben Bernanke were to raise the Fed funds rate past 3%, then the rate on the credit card would begin to rise.

As of February 22, that kind of product will be illegal. The variable-interest bit (Prime + 3.9%) is fine. But if you have a variable-interest credit card, you can’t set a floor any more. Which means that since Prime is just 3.25% right now, the interest rate today would be set at an uneconomical 7.15%.

As a result, if I want to charge a 9.9% interest rate today, I need to peg the card’s interest rate at Prime + 6.65%, and the rate on the card will start rising as soon as Bernanke raises rates by so much as a quarter-point.

Clearly a Prime + 3.9% card with a floor of 9.9% is a better deal for consumers than a Prime + 6.65% card. But the Fed is banning the former product, and forcing issuers into the latter.

The point here is that banks need to charge at least 10% or so on their credit cards, no matter how low prevailing rates are, just because of charge-offs and expenses. That doesn’t mean they always need to charge at least 10 percentage points more than the Fed funds rate, however.

I do think that floors on credit-card interest rates are a bad thing if they’re set so that consumers can’t benefit from falling rates. But right now, when rates are at zero, that’s really not an issue — and banning floors can sometimes make products worse rather than better. I wonder whether the Fed understood this when it put its rules together.

Let’s be clear about this: JP Morgan’s earnings today were very strong indeed. So why are the shares down? Simply because this is one of those instances where the interests of the bank and the interests of its shareholders are not perfectly aligned. Investor disappointment with the earnings is a function of the bank’s loan loss reserves, which are now a whopping $32.5 billion, or 5.5% of total assets. It’s entirely proper that JP Morgan should be treading cautiously when it comes to loan losses these days: the real economy is still very shaky. Shareholders would doubtless be much happier if the bank took a large chunk of those loan loss reserves and reclassified them as profit, but that’s not the responsible course of action.

JP Morgan’s earnings make this morning’s WSJ report — that financial-sector bonuses are going to hit an all-time high in 2009 — a little more plausible. But if you look at the accompanying interactive graphic, something very weird emerges. The WSJ helpfully breaks out each year’s numbers by constituent firms — but looking at the makeup of the 2006 and 2007 pools, the likes of Bear Stearns, Merrill Lynch, and Lehman Brothers are nowhere to be seen.

In the story, the WSJ writes:

The increase in both revenue and compensation is due partly to the industry’s consolidation during the financial crisis. J.P. Morgan, for example, acquired Washington Mutual Inc. and Bear Stearns Cos. Bank of America bought Merrill Lynch & Co. and Countrywide Financial Corp. Those deals inflated revenue and compensation because the acquirers’ financial results now include the purchased companies.

This too implies that 2007 bonuses at Bear Stearns and Merrill Lynch aren’t included in the WSJ’s 2007 bonus pool figures. If that’s the case, then that’s a serious weakness in the data.

I suspect that the exclusion of Bear, Merrill, and Lehman is in fact exactly what’s going on here, and that it’s a function of a problem with many data service providers. It’s quite easy to get public data for companies which still exist, but it’s much harder — for reasons I don’t fully understand — to get public data for companies which used to exist but don’t any more. (Good luck, for example, finding a share-price chart for Chrysler, from back when it was a public company.) Still, if the WSJ did indeed exclude a large chunk of Wall Street’s bonuses in 2006 and 2007, they should make that clear in the article.

I’ve been having an interesting email discussion with Jim Surowiecki of the New Yorker about quantifying the moral hazard trade. If big banks have lower borrowing costs than small banks, he asks, why do we automatically attribute that to moral hazard (the idea that they’re much more likely to get bailed out in extremis) rather than the simple fact that they’re less likely to default? He also makes Jamie Dimon’s point that since the debt of too-big-to-fail banks wasn’t trading at risk-free rates, there can’t have been a moral-hazard trade going on.

The second point doesn’t hold much water. Moral hazard isn’t a binary thing which either exists or doesn’t. So long as the probability of being bailed out by the government is greater than zero, a bank’s cost of funds will fall a little. And even if the probability of being bailed out was 100%, that doesn’t mean that banks could borrow at the same rate as Treasury. As David Merkel points out, even debt with explicit (rather than implicit) government guarantees sometimes trades at a significant spread over Treasuries.

As to the first point, Carrick Mollenkamp comes to the rescue today with the fascinating tale of COFI, an index off which many mortgages are priced. It suddenly spiked on New Year’s Eve, from 1.259% to 2.094%, resulting in an unexpected increase in monthly payments for people with adjustable-rate mortgages.

It turns out that most of the COFI index was based on the cost of funds at Golden West, a subsidiary of Wachovia. When Wachovia was taken over by Wells Fargo, it was no longer eligible to be a reporting member of COFI, and the COFI index went from being overwhelmingly based on Wachovia’s cost of funds to being much more reflective of what smaller banks are paying. And it turns out that smaller banks pay much more than Wachovia did for money.

This datapoint is telling, because Wachovia — largely because of the Golden West acquisition — was a very rocky bank indeed, and was sold as a highly-distressed asset to Wells Fargo. The fact that its cost of funds was so low clearly had nothing to do with its inherent safety, which means that we have to attribute it instead to the moral hazard trade. And indeed the government went to great lengths to rescue Wachovia’s bondholders by forcing a sale of the bank.

Note here that Wachovia’s shareholders were pretty much wiped out in the deal — but that was fine by anybody playing the moral-hazard trade, just so long as the bondholders remained whole. Surowiecki says that “In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end.” Not at all: Wachovia’s executives were very unhappy about the forced sale, but they had no choice in the matter, precisely because the government bailout expected by the moral-hazard types overruled any internal management decisions. Wachovia was not really party to the negotiations surrounding its sale: those essentially happened entirely between the FDIC, Citigroup, and Wells Fargo.

The small banks which now make up the COFI index are safer institutions than Wachovia, but because they aren’t subject to the moral hazard trade, their cost of funds is higher. That’s why it’s no great hardship for Wells Fargo to be paying a 15bp bank tax: it saves much more than that on its cost of funds just by dint of being too big to fail. And there’s a good case that in fact the tax should be significantly higher.

The hip-hop/contemporary art nexus — Slate

Even the Red Cross is talking about “looting”? Shame on them. And the NYT — The Awl

Excellent piece by artist Austin Kleon — 20×200

When a personal finance columnist gets hit with a 703.80% APR — Moneywatch

“Bit.ly is actually a Libyan domain. Probably not the best idea for the U.S. government to use” — NYT

Chinese netizens get around censorship by typing in “May 35″ instead of “June 4″ — NYT

Paul Kiel has an important story today on something I was not aware of at all: banks converting trial loan modifications into… trial loan modifications. This violates the government’s guidelines, but it seems that the likes of Chase and Wells Fargo are doing anything they can to avoid doing what is clearly envisaged in the government plan: transforming all trial modifications to permanent modifications if the trial-mod payments are made in full and on time for three months.

This screams “bad faith” to me. Up until now I’ve reckoned that a lot of the incompetence at mortgage servicers was due to incompetence rather than outright malice, and that they were simply overwhelmed by the volume of distressed mortgages they have to deal with. But there’s no reason at all for them to be asking for updated paperwork from people who have already completed their trial modifications — unless they’re desperately searching for excuses, legal or not, to avoid converting those modifications to permanent status. Shame on them — and I hope that somewhere a regulator with teeth is reading this story and preparing some serious penalties. Otherwise, this obnoxious behavior is only going to continue unabated.

Here’s one more way to look at the new bank tax, courtesy of the equity analysts at Oppenheimer & Co: it basically has the same effect on the banks hit by it as would a 15bp rise in the Fed funds rate. And much like an increase in Fed funds, it’ll simply end up getting passed through to customers in the form of higher loan rates. Which doesn’t mean that lending will fall — in fact, the Oppenheimer analysts reckon that any decrease in lending will be “barely measurable”, and will come about mainly in the form of lower demand for loans rather than less supply of credit from the banks.

Meanwhile, an anonymous “senior industry leader” from the murky depths of the financial-services industry emerges to inform Politico that lending could be hit to the tune of $1 trillion as a result of this fee. Don’t believe it. The reason that the source is anonymous is that he would never say something that bald-facedly ridiculous on the record. Banks already have excess cash on their balance sheets, and they won’t reduce lending by $1 trillion for every 15bp that their cost of funds increases. If that were true, then a 200bp rise in interest rates would reduce lending by roughly 100% of GDP.

It’s right and proper that too-big-to-fail banks should have a higher cost of funds than smaller community banks, given the extra systemic risk that they pose. Even after this tax, they probably won’t, thanks to the moral hazard play. But at least it’s a step in the right direction.

(HT: Weisenthal, Choksi)

The World Economic Forum has released its annual Global Risks report, which kicks off with this chart:

There’s a key explaining what all these numbers are, ranging from 1 (food price volatility) to 36 (data fraud/loss). But the really scary thing, for me, is the pretty clear positive correlation between severity and likelihood: the trillion-dollar risks all have a significant probability of happening, with the most severe risk of all — a global asset price collapse — being associated with a probability of well over 20%.

That collapse in asset prices is #6; #7 (developed-country retrenchment from globalization) is just as severe, if not as likely. #2 is a spike in the oil price, #5 is fiscal crises, #31 is chronic diseases, and #4 is a slowing Chinese economy.

The report is being published in the run-up to the WEF’s annual meeting, in Davos, where the great and the good will try to convince themselves that they’re part of the solution rather than being part of the problem. But frankly there’s really nothing they can do about the biggest risk of all, that asset-price collapse. In fact, given how rich they are, they’re likely to bear the brunt of it themselves.

In the wake of the publication of an extremely high-impact article in Science magazine which says that mountaintop removal mining has enormous environmental impacts which can’t possibly be mitigated, the campaign against JP Morgan Chase’s financing of such activity is heating up again:

JPMorgan Chase has been funding six of the top eight coal mining companies responsible for mountaintop removal coal mining in the United States. Recently, its investment bank underwrote more than $1 billion in new financing to Massey Energy, the largest mountaintop removal coal mining company.

JPMorgan Chase states that its “environmental goal is to make a positive contribution to sustainable business practices by integrating environmental practices into our business model.” Yet, Massey Energy has a deplorable environmental record, having violated the Clean Water Act no fewer than 4,500 times – resulting in a $30 million fine in 2008.

The practice of mountaintop removal mining is egregious in the extreme: the Economist, for instance, has said that “the underlying question is why America allows this practice at all”. And JP Morgan can’t fall back on the “everybody else is going it” argument: BofA pulled all its financing as long ago as 2008, and Wells Fargo has pulled out as well, leaving the field wide open for JP Morgan — which can either charge monopoly rents for such financing, or can do the right thing and withdraw from the field as well.

It makes financial sense for the likes of Massey Energy to destroy the environment in search of cheap coal. That’s what they do. But it’s not JP Morgan’s job to facilitate such activity, in the US or anywhere else. If they want to stop being perceived as evil banksters, they’d be well advised to get out of this business sharpish.

Ezra Klein takes Jamie Dimon at face value when Dimon told the FCIC yesterday that the market didn’t consider bank debt to be risk-free, and that therefore there wasn’t a moral hazard too-big-to-fail trade.

But America’s biggest banks are too big to fail, and there is (and was) a moral-hazard trade. The key here is to look not at the risk-free yield on Treasury bills, but rather the cost of funds for small-enough-to-fail banks. If you do that, as James Kwak notes, you find that TBTF banks have a cost of funds 78bp lower than their smaller brethren.

Kwak concludes, reasonably enough, that the problem with the bank tax is that it’s far too small: TBTF banks are still much better off paying a 15bp tax and having a 78bp discount on their cost of funds than they would be if they had to lose both. In fact, the tax is lower than 15bp, since it’s not paid on deposits: Kwak calculates that for most banks it’ll be closer to 7bp.

Meanwhile, Jim Surowiecki has managed to convince himself that the moral-hazard trade doesn’t exist at all. But he’s looking for it in the wrong place. It’s not bank executives who put on this trade, it’s the institutional investors who lent to the banks. By reducing the banks’ cost of funds, they naturally enabled the banks to take on more risk.

Specifically, because the banks’ cost of funds was lower than the interest rate on the triple-A tranches of subprime CDOs, the banks had a huge incentive to borrow as much money as they could and invest the proceeds in those supposedly risk-free bonds. If the banks’ cost of funds reflected their real riskiness and wasn’t artificially kept down by the moral hazard trade, it’s unlikely that the CDOs would have looked nearly as attractive.

The moral-hazard trade is real, then, and it’s dangerous, and the bank tax doesn’t make it go away. For that, we’re going to have to look to regulatory reform, and specifically to significantly higher capital ratios for TBTF banks. There’s a good chance that will actually happen, but it’s by no means a done deal.

Tim Fernholz links to the official government factsheet on the bank tax, which gives a lot more detail on how it’s structured. One thing that jumped out at me is that something along these lines is actually required by law:

The EESA statute that created the TARP requires that by 2013 the President put forward a plan “that recoups from the financial industry an amount equal to the shortfall in order to ensure that the Troubled Asset Relief Program does not add to the deficit or national debt.”

In other words, TARP recipients should have known all along that this was coming, and it’s a bit rich for them to start complaining now.

Other details in the factsheet include the $50 billion cut-off in terms of total assets: if you have fewer assets than that, the fee doesn’t apply to you. $50 billion is not Too Big To Fail, but it’s still large enough, the factsheet points out, to exclude anything which could reasonably be considered a community bank. The factsheet also makes it clear that the fee will apply to the US subsidiaries of foreign banks as well as to the foreign subsidiaries of US banks. Does that put US banks at a slight competitive disadvantage globally? Yes, but not enough that you’d notice.

It seems pretty obvious at this point that the arguments against the tax are very weak indeed. Jamie Dimon, for instance, has complained that “using tax policy to punish people is a bad idea” — but he’s going to have to spell out his thesis a lot more clearly than that before he gets anybody but the most knee-jerk anti-tax Republicans on his side. (He’s also damaging his chances of ever becoming Treasury secretary, which I’m happy about: the last thing we need is another Treasury secretary coming straight into the office from the CEO position at a major Wall Street bank.)

The only thing I’m mildly worried about is that the fee is large enough to be passed on to consumers, but small enough that they won’t react by moving their money to a smaller bank. My guess is though that the big banks are maximizing the fees they charge already. Might they lend a little less? That’s possible — but, on the other hand, maybe the fee will force them to lend a little more, and hold less money in cash.

Overall, any harm done by this tax will be minimal, while the benefit is likely to reach a good $100 billion or so. I call that a no-brainer.

Jackie Calmes has the broad outlines of the new bank tax, and I like the way it looks: essentially, it’s a 0.15% tax on bank liabilities excluding deposits (which already come with an FDIC fee attached). It would be paid by roughly 50 firms, including GE Capital, and would raise something on the order of $90 billion over 10 years. That’s an average of $180 million per firm per year, which seems eminently affordable to me.

US subsidiaries of foreign banks like HSBC and Deutsche Bank will be taxed; it’s unclear whether foreign subsidiaries of US banks will be as well. The aim of the tax is to ensure that the entire TARP fund gets repaid in full — not just the money lent to the banks directly, but also the money lent to the banks indirectly, through the AIG bailout. The tax is not, however, designed to repay the cost of rescuing Fannie and Freddie.

I like the way the tax is structured: it’s simple, and the liabilities-minus-deposits formula naturally puts more of the onus on investment banks than commercial banks. It also encourages banks to fund themselves with equity rather than debt.

Will the fee be passed on to bank customers? Well, it doesn’t apply to deposits, so retail banking customers shouldn’t be affected, but you never know. If they are, at the margin that might be no bad thing, if it encourages bank customers to move their money to small-enough-to-fail banks and credit unions.

Critics of the tax are certain to focus in on the rhetoric surrounding the announcement, and to denounce it as politically-motivated populism. Which might even be true. But just because a policy is popular doesn’t necessarily make it a bad idea. And this one makes a lot of sense.

Wi-Fi on Acela! — Economist

Jon Stewart on bank bonuses: great stuff — Daily Show

Why wasn’t Pandit at the FCIC hearings? Is the real reason that he’s about to get fired? — The Deal

Time for NBC boss Zucker to go — Gawker

Gawker will pay $100,000 to play with the iTablet for an hour — Valleywag

Does this mean that TheDeal.com is now disappearing entirely behind a paywall? Sad if so — The Deal

What I Learned By Not Getting into a Car for a Year — Time

Malcom Gladwell is no particular expert on financial markets. But he has said, according to Moe Tkacik, that of all the people he has interviewed, he most identifies with Nassim Nicholas Taleb — in a 7,800-word profile which explains just how hard it is to invest in markets when your strategy involves losing money every day and waiting for a tail event.

With a few notable exceptions, like the few days when the market reopened after September 11th — Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. “It’s like you’re playing the piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and the only thing you have to keep you going is the belief that one day you’ll wake up and play like Rachmaninoff.”

So I was very puzzled to pick up this week’s New Yorker to find Gladwell write about John Paulson in very different terms. (The story is behind a firewall; it’s not particularly worth paying for, although the magazine as a whole is a fantastic value.)

Gladwell in this essay characterizes Paulson as “The most successful entrepreneur on Wall Street — certainly of the past decade and perhaps even of the postwar era”. I think this involves a very narrow criterion of what makes successful entrepreneur. Later in the essay Gladwell talks about how “people who work for themselves are far happier than the rest of us”, and in my experience hedge-fund managers — who do after all work primarily for their clients — are not in fact particularly happy people. They might not have a single boss telling them what to do, but the pressures of managing other people’s money are immense.

What’s more, any hedge fund manager playing a version of the negative-carry trade has it much worse than most of his peers. Warren Buffett says that the first rule of running other people’s money is don’t lose it; the second rule is “don’t forget the first rule”. One of the reasons Taleb gave for giving up running money day-to-day was precisely the incredible toll it takes when you’re losing money almost every day. Andrew Lahde, another huge winner from the subprime crisis, also quit the business, citing the way in which the stress of the job destroyed his health. Gladwell himself talks about how successful entrepreneurs will deliberately harm their own reputation if it means improving their risk-adjusted returns. That’s not a route to happiness.

And in any event, although success is often measured in dollars on Wall Street, even Wall Streeters don’t end the analysis there. Is Paulson really a more successful entrepreneur than, say, Charles Schwab, just because he arguably has more money? For that matter, Mike Bloomberg has not only founded a hugely successful company which can run very well without his presence; has also made more money than Paulson. Even if Paulson does count as an entrepreneur, it’s not at all obvious how he counts as being more successful than Bloomberg.

But I digress. The point is that Paulson, like Taleb, is a negative-carry kind of guy. Positive-carry investing can take you a very long way, and indeed it’s the foundation of the entire global banking industry, but it’s negative-carry trades which have the ability to score enormous home runs like Paulson’s. Many big hedge-fund managers avoid negative-carry trades, because they feel too much like a gambling habit: you pay out money every day in the hope of scoring a huge jackpot. That’s not the kind of strategy most investors in hedge funds particularly like, and indeed the likes of Taleb take great care to sell their funds as hedging devices — a place to put a small amount of your net worth for insurance purposes — much more than as absolute-return vehicles.

Paulson is no Taleb: his clients are pretty typical hedge-fund investors, including rich individuals who really hate losing money. Which means that his negative-carry trade — buying credit default swaps which obligated him to pay out millions of dollars in annual premiums, with no income attached at all — was extremely risky, from a business point of view. Gladwell quotes Greg Zuckerman explaining that “the most an investor could lose would be 8 percent a year”, while the upside (as we saw) turned out to be astronomical. But it doesn’t take many years of 8% losses — or any losses at all, for that matter — for clients to pull all their money out of your hedge fund.

Paulson was not actively trying to burst the bubble, in the way that George Soros pushed the pound out of the European exchange-rate mechanism with his legendary 1992 negative-carry trade. Instead, he was just the biggest of a long line of investors who saw that there was a housing bubble and tried to find a way to go short. Those who were right but too early disappeared into the footnotes of finance — if they were lucky to get even that. They learned the hard way that “the market can stay irrational longer than you can stay solvent”. Paulson was like them: he felt certain that the bubble was going to burst, but he didn’t — couldn’t — know when, and he simply had to pray that it would happen before his investors deserted him.

What’s more, there was no guarantee that even if the housing bubble did burst, that Paulson was going to make lots of money. To be sure, he had a lovely model, put together by his colleague Paolo Pellegrini, showing that if house prices stopped rising, subprime mortgages were going to suffer enormous losses. But on the other hand, all the banks and credit-rating agencies also had models, showing that the bonds that Paulson was betting against had almost no chance of defaulting. When your model shows one thing, and everybody else’s models show something else entirely, there’s a very good chance that your model is flawed.

Gladwell’s thesis, in this essay, is that Paulson is actually very risk-averse, rather than being a big risk-taker. “Would we so revere risk-taking,” he asks right before introducing Paulson as Exhibit A, “if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?”

The fact is that Paulson did take bold risks, on factors which were entirely out of his control: When would the bubble burst? How long could he hold out before his investors deserted him? Indeed, Paulson’s strategy had a Ponzi aspect to it, where he would try to make up losses with new investments: “He bought CDS contracts by the truckload,” Gladwell writes, “and, when he ran out of money, he found new investors, raising billions of new dollars so he could buy even more.”

Warren Buffett has described his most recent mega-acquisition, that of Burlington Northern, as a huge bet on the long-term health of the US economy. That kind of bet has made him more billions than even Paulson can dream of, and it’s a bet made in the positive-sum game of the equity markets. Stocks can and do rise over time, and a well diversified stock-market investor has been able to reasonably expect to see some kind of profit over the long term.

Paulson, by contrast, was playing in the zero-sum derivatives markets. In order for him to make any money at all, somebody else had to lose. If I bought a random basket of derivatives contracts and held them over the long term, my expectation would be that I would end up with less money than when I started.

The amount of sheer hubris involved in Paulson’s trade, then, is enormous. He had to have an unshakeable faith in the infallibility of his own models, in a world where no model is infallible. He had to have entirely irrational confidence that the bubble would burst before he ran out of cash. And he had to do all of this with other people’s money: while he was already personally set for life when he entered into the bet, he couldn’t say the same thing about all of his clients, who didn’t necessarily share his shoot-for-the-moon risk profile.

After all, Paulson’s clients had invested their money with a manager whose returns, Gladwell quotes Zuckerman as saying, were solid, careful, and decidedly unspectacular. Did Paulson decide to put them into a risky derivatives trade with a negative carry just because he’d already made lots of money and was now aiming for posterity? I’m sure all those clients are very happy with Paulson today. But if you’d told them about his strategy while the bubble was still inflating, they might have had a very different opinion indeed.

Update: Zuckerman responds, in the comments.

Is there any sovereign credit which looks remotely attractive these days? I feel like a bit of a heel talking about fiscal distress even as the attention of the world is rightly concentrated on much more pressing real distress in Haiti. But the drumbeat is getting hard to ignore.

Alex Dalmady has a good overview of Venezuelan debt, which has been soaring of late and which might yet continue to go up. If you’re a short-term momentum trader, it looks great. But buy-and-hold types have no business being in Venezuela:

Buying Venezuelan debt is like lending money to a wealthy, eccentric and partly insane uncle. You kind of figure he’s good for it, but there’s a good chance he’ll blow his fortune buying real estate on the moon or something and leave you hanging out to dry…

Corruption, deliberate misinformation and ineptness merge together to form an incomprehensible mess. There isn’t an official figure that can be trusted… the Central Bank puts FX reserves at $35 billion. Really?…

Alex concludes that while the opportunity cost of not being invested in Venezuelan debt is hight, a crunch of some description is “inevitable”. And therefore he just avoids the country altogether, which makes sense to me.

He should probably avoid Argentina too, while he’s at it. The debt situation there has never been messier: the president wants the central bank to transfer $6.6 billion into an account ring-fenced for paying private creditors. When the central bank governor refused, he was fired by the president, reinstated by an Argentine judge, and then seemingly confirmed in his decision by a US judge, who has frozen the central bank’s account in New York.

Right now the account only has $1.7 million in it, but as Goldman Sachs analyst Alberto Ramos says in a research note today, “the political and institutional implications of this preliminary court order could potentially be large and eventually lead the government to back off from insisting of getting the $6.6 billion from the central bank”. After all, if the $1.7 million is subject to attachment by holdout creditors, they’ll probably be able to go after any disbursements from the $6.6 billion fund as well.

The Argentine economy minister is still adamant that the country’s bond exchange is going ahead as scheduled, but there’s no way that’s actually going to happen if a puppet is in charge of the central bank or if there’s serious doubt about the ability of the government to get the contents of the $6.6 billion fund to bondholders without the money getting hijacked along the way. Certainly the bond market doesn’t think much of the Argentine credit these days.

Meanwhile, Greek debt is looking increasingly shaky, as Moody’s talks about the country suffering a “slow death” and Desmond Lachman says that Greek might as well leave the euro zone now, since it’s going to have to do so sooner or later in any case, and the longer it waits the more painful the process will be. Further east still, Barclays is reckoning that Nakheel debt in Dubai will ultimately recover less than half its face value. And of course other sovereign nations are having major problems too, from Iceland to the Pequot nation of Mashantucket.

This time last year, Paul Kedrosky and I wondered if 2009 was going to be the year of sovereign defaults. It wasn’t, and things look better now than they did back then: the number of countries with EMBI spreads of more than 1,000bp over Treasuries has gone from 14 to just one (Belize). That move, however, has happened without any real improvement in sovereign fundamentals. As a result, I fear that the main thing the rally has achieved is just to increase the downside of a sovereign-debt crisis, and minimize the upside should the world manage somehow to muddle through.

(HT: Otto)

Andrew Ross Sorkin has got his hands on what looks for all the world like a pro-forma piece of legal CYA out of Goldman Sachs, and is trying to turn it into a story:

For years, Wall Street whispered that Goldman Sachs profited handsomely by trading ahead of — or even against — its own clients.

On Tuesday, a Goldman executive made an unusual admission that, in some cases, the rumors were true.

In an e-mail message to select clients, Thomas C. Mazarakis, the head of Goldman’s fundamental strategies group, acknowledged that his unit often provided investment ideas that the firm had already traded on. Sometimes Goldman has even taken the opposite approach, betting against particular instruments that the group has recommended.

The good news is that Sorkin is enough of a blogger to actually publish the email in question. But weirdly I can see nothing at all in the email saying that Goldman ever trades against its own clients, or bets against instruments it’s recommending. Here’s the relevant bit:

We may trade, and may have existing positions, based on Trading Ideas before we have discussed those Trading Ideas with you. We may continue to act on Trading Ideas, and may trade out of any position, based on Trading Ideas, at any time after we have discussed them with you.

Now it’s conceivably possible that when Goldman makes a trade “based on” one of its Ideas it actually takes the opposite position to that implied by the Idea. But there’s nothing in the email to indicate that ever happens, or has ever happened — which means that it’s very hard to see how Sorkin can characterize the email as “an unusual admission” that sometimes Goldman bets against instruments it’s recommending.

I suspect that Sorkin might be looking at the “may trade out of any position” language — but of course when Goldman trades into a position it will necessarily trade out of that position at some point. Doing so will involve selling what was previously bought, or buying what was previously sold, so yes I suppose that if it’s selling while its clients are buying, then you could say it’s trading against its clients. On the other hand, any time a Goldman client buys a position from Goldman, or sells one to them, Goldman is by definition trading against that client. And that’s exactly what the client wants!

Alternatively, there’s a Clintonian reading of Sorkin’s story, in which it’s literally true but actually doesn’t mean what you think it means. The “unusual admission”, on this reading, is just that Goldman sometimes trades ahead of its clients, not that it ever trades against them. And the bit of the story saying that sometimes Goldman bets against instruments it’s recommended comes not from the Goldman email but rather from previous NYT reporting.

Either way, I think there’s a lot less to this story than meets the eye. The email is clearly legal boilerplate, and not an “unusual admission” of anything at all. Goldman will continue to share trading ideas with its biggest clients, and those clients will judge those ideas on their own merits, rather than entering into them just because they come from Goldman. Sometimes, the clients will decide to trade against the ideas. They’re all big boys, and they make their own decisions.

The idea that Goldman is conflicted because it trades with and against clients is ridiculous — that’s its job. It’s a broker-dealer, not some kind of fiduciary. I do think that Goldman is too big, but I don’t believe it’s remotely constructive to start attacking the fundamental role of any broker-dealer, which is to make markets by trading in and out of lots of positions with lots of clients. That’s one of the few ways in which Goldman actually makes the world a better place.