Opinion

Felix Salmon

The small, light, fill-in blog

Felix Salmon
Oct 21, 2011 22:29 UTC

I’ve been saying for a while that blogs are dead — certainly the one-person, one-voice blog, and also the big splashy expensive blog launched by a new or old-media company. Both I think had their heyday a few years ago. But as bloggish tendencies get incorporated into the broader news business, and as the sharing-and-linking part of the blogosphere moves to social media, something quite encouraging is happening: media organizations are finding it easy to set up small, light blogs which they’re not particularly invested in.

On the basis of 2=trend, I present to you: Overheard, the new blog from the WSJ’s Heard on the Street team; and Occupy Wall Street: The Wealth Debate, from Bloomberg Businessweek. Both are places where shorter-form quick hits can get published without laborious editing; neither are particularly important strategically; but both fill an empty niche in terms of their organization’s coverage in a cheap and effective manner.

This is a lot easier than having to re-architect the broader news outlet to make it more amenable to such materials. All websites have some kind of blog content, so if you need something fast, adding a new blog should be pretty easy. And it doesn’t involve lots of unreliable technology from outside vendors, either, which is always an advantage.

Well done, then, to the WSJ and Businessweek for seeing how blog technology is a good way of powering things which don’t need to last forever, or get lots of traffic — they’re just another part of the big package which the newsroom provides.

I doubt many people will bookmark either of these blogs, but that’s fine — individual posts will get shared socially and placed on the home page, the news will get covered effectively, and that’s all that’s needed. These aren’t throwaway microsites — they’re important to the broader function of the newsroom. But they’re also small enough to experiment and push the envelope with respect to voice and content type. And if certain ideas work well on these blogs, they can always percolate up to the rest of the site over time.

COMMENT

I think that if you are really engaged with social media then blogs come off seeming a bit clunky. Felix lives in an interrupt-driven world where fast and informative updates and insights come from a variety of sources. I think the Toyota Venza commercials (http://www.youtube.com/watch?v=EpeoRIvn xfk, and others) capture this culture exactly. In Felix’s defense, that’s what everyone around him does, too.

I blog, and tweet once every couple of days, and it serves my larger purpose, but I don’t have anywhere near the level of engagement that Felix does. In his world, blogs aren’t cutting edge, and are slow, and he’s ready to move on. Direct feeds into the brain, perhaps?

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The murky world of student-loan statistics

Felix Salmon
Oct 21, 2011 21:15 UTC

I got some very interesting responses to my post on Wednesday about the total amount of student loans outstanding — and I’ve learned a lot about the limitations of official statistics as a result.

The first thing to say is that the New York Fed figures I published for total student loans are not accurate — they understate the truth of the matter. The New York Fed is aware of this fact, and will revise its numbers for Q2 2011 in coming weeks; when it releases the Q3 numbers, they will reflect the new methodology and will be substantially higher than what we’re seeing right now.

And yes, the new numbers will show that student-loan debt exceeds credit-card debt.

But they won’t show student-loan debt at $1 trillion.

It turns out that the $1 trillion number is not new — it appeared in the lede of a NYT story back in April, which attributed the number to Mark Kantrowitz. Kantrowitz, who runs the websites FinAid.org and Fastweb.com. Kantrowitz, described by the Richmond Fed as “a leading resource on student financial aid”, has been pushing his own estimates of student-loan debt for a while; he supplied the data for the chart which accompanied the NYT story, and indeed published a very similar chart back in August 2010.

The USA Today story I criticized on Wednesday was interesting because it’s the first story to come up with the $1 trillion number which doesn’t attribute it to Kantrowitz. Instead, it attributed the number to the New York Fed — but the New York Fed has never published a figure for student loans anywhere near $1 trillion.

Kantrowitz claimed in an email to Reuters that “the US Department of Education has confirmed total federal education debt in NSLDS at over $800 billion”. NSLDS is the National Student Loan Data System, but the Department of Education doesn’t publish numbers for the total amount of debt in that system, and it’s unclear where or when this confirmation happened. Kantrowitz also pointed us to the numbers in the president’s budget for FY 2012. If you want to be daunted, go to this page and check it out: it’s absolutely enormous.

I got Nick Rizzo to try to pull out the line items for the cumulative balance of student loans outstanding. There are two main sources for federal student loans — the Federal Family Educational Loan Program, or FFELP, which is being phased out, and the Federal Direct Student Loan Program, or FDSLP. The FFELP has about $390 billion in total loans outstanding –$77 billion in Stafford loans, $81 billion in unsubsidized Stafford loans, $21 billion in PLUS loans, and $211 billion in consolidation loans. PLUS loans are actually loans to parents, rather than to students, but they still count as education debt.

The FDSLP is up to $220 billion in loans outstanding at this point — $58 billion in Stafford, $59 billion in unsubsidized Stafford, $20 billion in PLUS, and $83 billion in consolidation loans.

Add the two together, and you get to $610 billion. There are a few tiny other loan programs in there as well, but nothing which really moves the needle much past that point.

Still, this is just federal loans. These numbers don’t include private-sector student loans at all, and already they’re above the $550 billion that the Fed claimed was the total of all student loans outstanding in the country.

The Fed knew this — Kantrowitz is no shrinking violet when it comes to sharing his findings — and so they embarked on a quest to find out why their student-loan number was so small.

Now it turns out that the data feeding the NY Fed’s household debt and credit report is bought in — the Fed has a contract with Experian Equifax, the credit-report company. Experian Equifax takes a nationally representative random sample of the credit reports that it runs, breaks out the various different forms of debt in those reports (mortgage, home equity lines, auto loans, credit cards, student loans), and passes that information on to the NY Fed, which compiles the report by extrapolating that data to the nation as a whole. And although Experian Equifax has provided data going back to 1999, the New York Fed has only actually published this data series for less than two years — the first release came for the first quarter of 2010.

When it became obvious that the student-loan totals were too low, the NY Fed and Experian Equifax started looking at the data again. And eventually the culprit was found. There was a bucket of random obligations called “Miscellaneous”, which included things like utility bills, child support, and alimony. And it turns out that if you went burrowing in that miscellaneous debt, there was actually a pile of weirdly-categorized student loans in there.

When the NY Fed restates the Q2 figures, and from Q3 onwards, that pile of student loans will get included in the bigger student-loan figure, where it belongs. And the number will rise, probably by a couple of hundred billion dollars. Not enough to bring it to $1 trillion, but enough to make it bigger than total credit-card debt.

The problem is that when the new numbers are restated, the old numbers won’t be. There’s a lot of digging into formerly-miscellaneous line items involved here, and a lot of very old data which was never provided to the NY Fed which needs to be resuscitated and disaggregated. That’s a laborious process, and one which will cost a lot of money. The NY Fed wants to be able to publish the full series in an accurate manner, but it won’t be able to do that for a while, if ever. For the time being, we’re just going to have a spike in the series at Q2 2011, when it stops being inaccurate and starts being accurate. We won’t be able to tell, for instance, how fast student-loan debt has been growing. Which is a bad thing.

And more generally, it’s probably suboptimal that the best public data series for student-loan debt comes from a sample of credit reports from Experian Equifax. Since the government owns the vast majority of student loans, why can’t it just publish accurate data for total federal student loans outstanding? That would certainly be easier than having to piece such things together from dozens of disparate line items in the annual budget. I suspect, too, that the government also has pretty good data on private student loans, as well. But putting a data series together is a big undertaking: you have to find the data going back quite a ways, and then you have to commit to updating it on a regular basis. I suppose that no one really cares enough to have made that happen, ever — with the result that no one really knows for sure just how much America owes in student loans.

But when the NY Fed releases its new numbers, those will probably be the best we’ve got. Even if they’re flawed.

COMMENT

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Why taxi medallions cost $1 million

Felix Salmon
Oct 21, 2011 19:41 UTC

1021-met-TAXIweb.jpg

What on earth is going on with the price of taxi medallions in NYC? Two of them just sold for $1 million apiece — that’s a 42% increase just since August, when conventional wisdom had it that $705,000 was a top tick and that medallions would soon plunge in value.

Derek Thompson reckons that this is a sign of how great New York’s economy is doing:

It’s all about supply and demand. The tailwind behind medallion inflation is a cap on taxi cab licenses. Even as the economy of New York City grew at a furious pace across three decades, the number of taxi plates stayed basically constant, despite wage growth and population growth and rising demands for cross-town transportation. As a result, their value rose tremendously.

One problem with this theory is that if you look at the chart of medallion prices, it doesn’t seem to bear much relation to the strength of New York’s economy. The majority of the rise in price has happened over the past ten years, which haven’t been particularly great, economy-wise. And certainly there hasn’t been any citywide boom in the past two and a half months.

Jacob Goldstein has a similar theory.

Every cab in New York City has to have a medallion. And the city strictly limits the number — currently just over 13,000. So as New York has prospered over the past few decades, the price of medallions has gone through the roof.

The economics of this, however, don’t make a lot of sense. Cabs might get a little bit busier when economic activity picks up, but most of that extra income is taken home by drivers, rather than the owners of corporate medallions. (Corporate medallions are the ones where the owners don’t drive the car; they’re the ones being charted here.) The income from a corporate medallion is pretty steady, and was spelled out in the comments to this post:

The maximum amount a cab leased out to drivers can earn over a year is $82,524. This assumes that the cab had a driver every day and every night and that it never breaks down. The day shift maximum charge is $105. The maximum night shift charge is $129 and that is only for Thursday-Saturday. Sunday-Tuesday is $115 and Wednesday is $120.

You’ve also left out of your calcultions the cost of the car. Let’s call it $27,000 and you are required by law to buy a new one every 3 years.

This is the real reason why medallions are so expensive: good old-fashioned interest-rate calculations.

We’re basically talking about a real income stream, here, of about $75,000 per year. (Let’s assume, for the sake of argument, that the income from a taxi medallion rises at the same rate as inflation.) That’s a real yield of 7.5% on a $1 million investment — which isn’t half bad at today’s interest rates.

Put it this way: how much would a bond paying a real yield of $75,000 a year cost? At the most recent auction, the 29-year TIPS cleared at an interest rate of 0.999%. At a 1% real yield, an income stream of $75,000 a year would cost you $7.5 million.

Now you don’t actually get $75,000 a year if you own a medallion. You have to pay for maintenance, insurance, and workers comp; you also have to pay someone to manage your drivers. But even if you bring the income down to $50,000 a year, that’s still a pleasant 5% yield on your money, and what’s more it’s a yield which behaves much more like a real yield than a nominal yield. Paying $1 million for such a thing doesn’t seem silly to me, especially when there’s a lot of room for capital gains as well.

Of course, there’s risk here too. Any time you see a chart like the ones above, you have to worry that there’s a bubble. Plus, there’s political risk: the mayor can print new medallions, making the existing ones worth a little less (but not a lot less, given that the income from medallions is largely fixed).

That said, medallion owners have a lot of political clout, and historically they’ve been good at making sure that their income is maximized, rather than suffering anything which might reduce it. And when Goldstein starts dreaming of taxi deregulation, he quickly enters cloud-cuckoo land:

The medallions create a textbook example of what economists call rent-seeking behavior: Basically, gaining extra profits without providing extra benefits. If the number of taxis were allowed to increase (and if cab fares were unregulated), the number of taxis would increase and the price of a cab ride would fall.

No! if the number of taxis were allowed to increase, then the number of taxis would increase. Of course. That’s just a tautology. But the price of a cab ride would not fall, because that’s a separate piece of legislation — the price of a cab rate is set at a predetermined rate, and indeed has to be set at a predetermined rate. If you deregulated cab fares, utter chaos would result — New Yorkers would basically have to haggle over the cost of a fare every time they got into a cab.

Goldstein’s not the first person to have this cockamamie idea: Jim Surowiecki said the same thing in 1999. But in order to have a market where prices are set by supply and demand, people need to be able to choose how much they’re willing to pay to take a cab. And you can’t do that when you’re standing on the sidewalk (not in the bike lane, please!) sticking your arm out and trying to hail the first cab to turn up. In order to make that transaction work, the fare schedule has to be set, in advance, by the municipal government.

But I do worry that the way fares are set, too much money ends up going to medallion owners. If fares were brought down, the amount that medallion owners could charge drivers would also come down, and medallion prices would — finally — start to fall. Why does NYC ever raise taxi fares, when the income from those fares ends up going overwhelmingly to a handful of millionaire medallion owners? These medallions, right now, are licenses to print money. That’s why they’re getting extremely expensive. But it doesn’t need to be that way.

COMMENT

I don,t think you know the real reason why the medallions went up in price.The real reason is that you can depreciate the meddalion over 15 years.Which means that if you bought a fleet medallion at 1,350 million dollars then you would be able to deduct off your taxes 90 thousand a year in depreciation.Which for most people with money that would be about 45,000 a year in savings just from that.

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Abolish the 30-year fixed-rate mortgage!

Felix Salmon
Oct 21, 2011 17:03 UTC

File under “Republican ideas which are actually rather good”:

Congressional Democrats remain strongly committed to the 30-year fixed-rate loan, which protects homeowners against a rise in interest rates. But some Republicans, who want to scale back the government’s role in the housing market, have growing doubts about the taxpayer-subsidized loan product.

During a Senate Banking Committee hearing Thursday, the panel’s top Republican, Sen. Richard Shelby, asked a series of questions that critics of the 30-year fixed-rate mortgage have long been focused on.

“What unintended consequences have been created by subsidizing the 30-year fixed-rate mortgage? And what has the subsidy of this product already cost the American taxpayer?” Shelby asked. “We need to take a hard look at this product and determine if the preferential pricing resulting from these subsidies truly creates a public good.” …

Shelby asked another witness, the economist Paul Willen of the Federal Reserve Bank of Boston, to explain why fixed-rate mortgages can be more harmful to borrowers than adjustable-rate mortgages.

“So people who had fixed-rate mortgages from 2005 and 2006 and 2007, most of them are paying 5.5% or more on those mortgages. These are the people with negative equity,” Willen responded. “The people who had adjustable rate mortgages, their rates are under 4.5, and a third of them are paying less than 3.5% on their mortgages. They do that without any assistance whatever from anyone. They don’t have to beg their lender, they don’t have to get a modification,” Willen said.

That’s just one reason why the 30-year fixed-rate mortgage is a bad idea, and it’s not even the strongest one. The real reason this product should be abolished is that it simply doesn’t exist in any free-market system. In order to create it, you need to invent Fannie Mae and Freddie Mac — and just about everybody agrees that those two entities, which have cost the government hundreds of billions of dollars of late, and will probably cost even more going forwards, need to be radically downsized.

The simple truth is that without Frannie, you can’t have 30-year fixed-rate mortgages. Banks would never offer such creatures, and if they did, the interest rate on them would be so high, relative to adjustable-rate loans, that nobody would ever take them out.

A lot of the debate here seems, sadly, to surround the idea that such mortgages should be prepayable. Maybe if there was a prepayment penalty, they’d make more financial sense. But I’m not a fan of prepayment penalties at all — people should always have the ability to repay their loans just by paying back the full amount they owe.

At heart, it comes down to this: the 30-year fixed-rate product is always going to shift a huge amount of interest-rate risk onto the government in one form or another. Even the product’s defenders, like Susan Woodward, understand that:

“The critics of the 30-year fixed rate loan argue that this is unfair for households to get the benefits of reduce risk of fixed-rate loans while the taxpayers bear the risk,” she said in her written testimony. “This criticism forgets that homeowners are taxpayers too.”

No, it doesn’t. It’s true that homeowners are taxpayers. But it’s also true that renters are taxpayers. And homeowners already get far more than their fair share of tax relief, not least through the dreadful mortgage-interest tax deduction. We shouldn’t subsidize them even further by offering them financial products which would never normally exist in the wild.

COMMENT

@CarlOmunificent

Your link doesn’t work, but I get your point.

My point is that such a setup is part of the problem, and each time economy and housing market go down the US tax payer will have to pay a few hundred Billion or even a few Trillion Dollars.

How much in mortgages are open on the USA? I remember numbers in the $12 Trillion range. Let 20% of the owners go underwater, and there are so many “too big to fail” triggered that Uncle Sam has to open his pockets widely (e.g. the US government cannot let any of Frannie go bankrupt).

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The Groupon roadshow

Felix Salmon
Oct 21, 2011 16:20 UTC

Here’s something I haven’t seen before: an IPO roadshow appearing online for the world to see. (Click the link on the left; the link on the right basically just takes you to a copy of Groupon’s S-1.) In fact, I’ve never seen an IPO roadshow pitch before. They’re boring! And, they feature senior executives looking uncomfortable wearing ties in front of a dark-grey background, talking to slides!

But, this roadshow is also very helpful indeed for people looking to understand Groupon’s business. And it includes cohort information which has never been made public before, and which is rather more bullish on Groupon’s prospects than the analysis we’ve had to make do with to date from Yipit.

First, though, it’s worth taking a look at the price tag on this company. As Anthony Hughes reports, the price range indicated here values Groupon at no more than $11.4 billion, with Groupon itself getting a maximum of $540 million in cash. These are big numbers; the valuation is essentially double the amount that was reportedly offered by Google for the company in December, and is 2.3 times the $4.875 billion valuation at which Groupon raised money that month. (Interestingly, Groupon is actually raising less money in the IPO than it did in that round.) Still, the valuation’s nowhere near the $25 billion or even $30 billion numbers that were being whispered a few months ago.

Andrew Ross Sorkin is very critical about all that $30 billion number, talking about known issues surrounding Groupon, and writing:

How did so many Wall Street firms desperate to underwrite the Groupon I.P.O. miss these warning signs when pitching such a sky-high valuation? …

A deep dive into the numbers should have raised alarm bells at the outset about even talking about the possibility of a $30 billion valuation…

If it were to really slow its marketing spending, it is possible Groupon could turn a profit.

Even so, it does not fully explain how Groupon’s underwriters, whose endorsement of the company is supposed to be considered the Good Housekeeping Seal of Approval, originally came up with Groupon’s questionable $30 billion valuation.

Sorkin, here, is saying that Goldman Sachs and other banks, when pitching their IPO services, told Groupon that they could bring the company public at a $30 billion valuation — indeed, that they “originally came up with” that number. And, frankly, I don’t believe him. All conversations about these matters are off the record, of course, so it’s hard to be definitive. And Sorkin certainly talks to many more bankers than I do. But going public really isn’t about the IPO — it’s about being a publicly-listed company in perpetuity. And Groupon has very little incentive to launch at a bubblicious valuation which can only exacerbate volatility over time.

I think that the $30 billion number was never something that bankers seriously pitched to Groupon as a launch-valuation possibility. Instead, it was a number thrown out by people looking at LinkedIn’s first-day pop, and was intended to reflect not the IPO price but rather the level at which Groupon shares might trade in the secondary market, if the market remained frothy. (And even today LinkedIn is worth more than $8 billion, which makes $11 billion for Groupon seem pretty reasonable in comparison.)

As for Groupon’s business, I do still like the model — with the proviso that I have no idea how to place a present value on such a thing, so I take no position at all on what a sensible valuation for the company might be.

And in the light of the numbers Groupon released today, it’s no stretch at all to say that “Groupon could turn a profit”: the company’s total loss in the third quarter was a tiny $239,000 — essentially, the company broke even.

One thing which makes me look more favorably on Groupon now that I’ve seen the roadshow is the company’s cohort data. One of my biggest concerns about Groupon, up until now, has been the idea that its subscribers suffer from “deal fatigue”. You sign up in a fit of enthusiasm, you buy a few deals, and then the novelty wears off and you go back to your old life. That thesis was supported with charts like this one, generated from some of the relatively sparse information that Groupon provided in its S-1.

This chart could show that subscribers spend less and less money over time. On the other hand, it doesn’t necessarily show that. There’s an alternative explanation: basically, that there are diminishing marginal returns to marketing spend. Groupon picks the most valuable low-hanging fruit first, and then as its subscriber base grows, the newer subscribers spend less money than the older ones, bringing the average down. Even if the older subscribers keep on spending just as much as they ever used to.

And that’s what’s shown in two charts from the roadshow. They look at the numbers associated with the subscribers that Groupon acquired in the second quarter of 2010:

As Groupon CEO Andrew Mason explains with regard to the first chart,

This shows the repeat purchasing behavior of a typical cohort of customers; this one joined in Q2 of 2010. You can see that quarter after quarter after quarter, they continue to buy at the same pace.

The first chart shows the quarterly revenue from the customers that Groupon acquired in the quarter; the second chart shows the quarterly profit from those same customers. In both cases, the numbers are remarkably consistent over time — they’re not falling off.

My other big concern is about targeting — Groupon’s ability to differentiate between consumers based on much more than just what city they live in, and to show them deals they’re likely to love. Groupon product head Jeff Holden talks about this around slide 26. Groupon has something called Smart Deals, which tries to implement just that kind of targeting. One way it’s doing that is by getting its customers to click on categories called Deal Types, so that it knows what kind of deals that customer is interested in. And then of course given that customers keep on buying deals over time, it’s easy to see what kind of deals they’re buying, and what kind of deals they’re not.

Holden also gives the best explanation of Groupon Now that I’ve seen — the way it offers yield management for merchants.The idea is that the Groupon app on my phone is a great way for me to save money: I fire it up, and immediately see a list of deals nearby. Merchants can offer or not offer those deals in real time: they can make them better when business is slow, and turn them off when business is already overwhelming. That’s great for both merchants and consumers, who hate turning up to a Groupon-featured merchant and finding it overwhelmed with bargain-hunters.

There’s a rewards system, too. You know those punch-cards at coffee shops, where you get a free coffee after you’ve bought ten? That can now be built in to what the company is calling Groupon OS — all you need to do is allow Groupon to associate you with your credit-card number, and then every time you use that card to buy a certain item, it will automatically show up in the Groupon app. Eventually, you become eligible for a reward. It’s pretty effortless, for the consumer, and it brings an element of addictive gameplay into the shopping experience.

There’s a couple more slides which are relevant too, and directly address my concern that Groupon has to develop a reputation for high-quality deals. It can’t just let its salespeople maximize revenue, as sales people are wont to do: it has to delight its customers, by pointing them to great merchants. And it turns out that Groupon does actually attempt to do just that. One slide talks explicitly about “curation”:

And another (with the dreadful title “operational excellence”) shows the huge number of steps that need to be gone through before and after an offer appears on the site.

I love the way that under “Editorial” there are separate steps for “Humor”, “Voice Edit”, and “Copy Edit”. So there are systems in place here. But the really crucial step is buried somewhere in that “Deal Quality Assurance” circle. Groupon does not have the best reputation for picking only fabulous merchants; it probably needs to work on that a bit.

Overall, then, I think it’s pretty clear that people who think Groupon’s some kind of Ponzi scheme are wrong. There’s a real business here, with a real business model. The big question is whether Groupon can execute. Can it create a much-loved mass-market brand, which people and merchants trust and return to on a regular basis? We will always hear about bad experiences, of course — that’s a statistical inevitability, given the number of deals and employees going through the Groupon system. But will those significantly damage Groupon’s reputation? That’s a harder question to answer. (And it’s worth remembering, too, that for comparison reasons some small percentage of Groupon customers are going to have to continue to receive offers which are not targeted to them. If you’re one of those unlucky few, you might have a much worse experience of the company than everybody else.)

If I had to make a forecast, I’d say that Groupon is going to be around for the foreseeable future, but that the error bars on its future size are enormous. It could just slow down and lose its competitive advantage over its competition; it could, on the other hand, genuinely revolutionize the infrastructure of commerce and even become that thing everybody wants to be these days, a platform.

Like all fast-growing technology companies, Groupon is a risky bet from an investor’s point of view; it’s in no sense a widows-and-orphans stock. Like many consumer-facing companies, it’s probably better for most people to just take advantage of it as consumers. Individuals are much better at judging whether a money-off deal is a good one than they are at judging whether a particular stock is a good investment. But if Groupon’s sales continue to grow at anything like their recent pace, that’s an indication that a lot of individuals will continue to love what Groupon’s doing. And ultimately that’s going to show up on the bottom line.

COMMENT

if this is true you have to wonder how they set valuations at groupon
Did Groupon Value Its China JV Gaopeng at $500m in July? | DigiCha http://bit.ly/r1Zmd2

Posted by niubi | Report as abusive

Counterparties

Nick Rizzo
Oct 20, 2011 23:27 UTC

Germany and France still can’t agree on how to leverage the EFSF — Reuters

The EU considers issuing a temporary ban of sovereign credit ratings — WSJ

Don’t expect a repeat of America’s six-year “productivity miracle” — Bloomberg

A new bill would throw in a visa with every expensive American home sold to a foreigner in an all-cash sale — WSJ

Wall Street posts its worst quarter since 2008 — Bloomberg

Millionaires and billionaires control nearly 40% of global wealth — WSJ The Wealth Report

The NYT paywall seems to be working — Mashable

“are we screwed” — Paul Kedrosky

 

 

COMMENT

How exactly do you ban credit ratings?

S&P: We can’t officially rate Italy anymore but let’s just say that if we did, it would rhyme with me me me shminus. *wink* * wink*

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Is the SEC colluding with banks on CDO prosecutions?

Felix Salmon
Oct 20, 2011 22:44 UTC

Is the SEC colluding with Wall Street’s biggest banks to let them off lightly with respect to their dodgy CDOs? Jesse Eisinger and Jake Bernstein get an astonishing on-the-record admission today, from a Citigroup flack, that might indeed be the case:

The bank says it has settled all of its potential liability to a key regulator – the Securities and Exchange Commission — with a $285 million payment that covers a single transaction, Class V Funding III…

[The SEC] made no mention of the dozens of similar collateralized debt obligations, or CDOs, Citi sold to investors before the crash.

A bank spokesman said the SEC would not be examining any of those deals. “This means that the SEC has completed its CDO investigation(s) of Citi,’’ the spokesman asserted in an e mail.

The SEC, of course, denies this — but it carries the ring of truth. Just look at the SEC’s own list of CDO prosecutions to date: there’s exactly one enforcement action per bank.

And the idea is held more broadly, too — look for instance at Peter Henning’s article on the subject today.

The settlement — in which the financial firm agreed to pay $285 million without admitting or denying guilt — appears to be of little concern to Citigroup investors. They’re likely to be happy that the bank has put the issue to rest.

What makes Henning think that Citigroup has put this issue to rest? As Eisinger and Bernstein demonstrate, Citi had lots of synthetic CDOs — not just Class V Funding III — where someone other than the ostensible CDO manager was intimately involved in choosing the contents, and had a vested interest in picking securities which were extremely likely to fail.

There’s every indication, here, that the banks are doing nod-and-a-wink deals with the SEC. The SEC brings its single strongest case, and the banks agree to a nine-figure fine, on the implicit understanding that the fine covers all their other CDO deals as well. That saves the SEC from having to laboriously put together a separate case for each CDO deal, and it allows the banks to put much of their contingent liability behind them.

But if that is going on, it’s a scandal. For one thing, it’s incredibly unfair to everybody who bought one of the dodgy CDOs which is not prosecuted. Investors in Class V Funding III, for instance, are getting all their money back as a result of this latest settlement. But what about investors in Citi’s other synthetic CDOs, like Adams Square Funding II, or Ridgeway Court Funding II, or even Class V Funding IV? Not to mention the $6.5 billion of Magnetar deals, where — according to all ProPublica’s reporting — Magnetar was intimately involved in choosing what went in and what didn’t. The big sin, remember, in both the Goldman and Citi deals, was one of disclosure: the banks didn’t disclose to investors that the short side of the trade was hand-picking the contents of the deal. And you just know that there were dozens of deals — not just one per bank — where that key disclosure was missing.

Is the SEC trying to protect the banks it’s meant to be prosecuting? Is it quietly agreeing on a one-prosecution-per-bank model? If so, we should be told. And if not, it had better bring prosecution #2 against someone pretty soon. Because right now the pattern is decidedly fishy.

COMMENT

Felix — it’s a settlement agreement, so yes it’s agreed to by both the SEC and Citi. And Citi (or any other company) would only agree to a settlement if they were pretty darn clear that the settlement, for all intents and purposes, ended their liability for such actions with the government.

If Citi thought there was potential for the SEC to go after every single CDO, they would fight it tooth and nail, because — to be honest — they most likely have a decent chance of winning based on the law in many cases. Disclosure cases aren’t easy cases. The SEC simply cannot afford to fight each and every case. So they agree to settle. It’s in the best interest of the SEC and the subject company. If that’s what you call collusion, then, yeah, it’s collusion.

Posted by MrAbeFroman | Report as abusive

BofA puts taxpayers on the hook for Merrill’s derivatives

Felix Salmon
Oct 20, 2011 20:28 UTC

Bloomberg had a story, a couple of days ago, about BofA moving Merrill Lynch derivatives to its retail-banking subsidiary. The story was quite long and hard to follow: there were lots of detours into explanations of what a derivative is, or explorations of what the BAC stock price was doing that day. So let me try to cut away the fat.

Bank of America is being hit with downgrades. And as we saw with AIG, when a derivatives counterparty gets hit with downgrades, it has to post lots more collateral. In BofA’s case, the numbers are very large indeed:

Bank of America estimated in an August regulatory filing that a two-level downgrade by all ratings companies would have required that it post $3.3 billion in additional collateral and termination payments, based on over-the-counter derivatives and other trading agreements as of June 30. The figure doesn’t include possible collateral payments due to “variable interest entities,” which the firm is evaluating, it said in the filing.

On the other hand, retail banks are much safer, because they’re protected by the FDIC. If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral. The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties. And then if there isn’t enough money left to pay depositors, the FDIC will step in and make those depositors whole.

So Bank of America decided to move some unknown quantity of derivatives from Merill Lynch — which doesn’t have an FDIC-insured deposit base — over to its Bank of America retail subsidiary, which does.

The FDIC was not happy about this — it makes it more likely that they will have to pay out in the event that Bank of America runs into trouble. And when the FDIC pays out, that’s a hit to taxpayers, the letter of the law notwithstanding. Jon Weil explains:

The market harbors serious doubts about whether Bank of America has enough capital…

Dodd-Frank lets the FDIC borrow money from the Treasury to finance a seized company’s operations for as long as five years. While the law says the FDIC is supposed to tap the banking industry to pay for any eventual losses, it’s hard to imagine the agency could ever charge enough to cover the costs from a failure at a company with $2.2 trillion of assets

Now it’s worth pointing out here that other big derivatives houses, most notably JP Morgan, have used their retail-banking subsidiary as their derivatives counterparty for years. Now that Merrill is part of BofA, there’s no obvious reason why it should be worse off than JP Morgan is with access to Chase. But Yves Smith makes the case that the two are in fact significantly different:

JPM runs a massive derivatives clearing operation, and a lot of its exposure relates to that. This and the businesses of the other large banks have been supervised by the regulators for some time (you can argue the supervision was not so hot, but at least they have a dim idea of what is going on and gather data). By contrast, no one was supervising the derivatives book at Merrill. The Fed long ago gave up supervising Treasury dealers, and the SEC does not do any meaningful oversight of derivatives. And Chris Whalen confirms that Merrill was and is the cowboy among derivatives dealers.

I’m not entirely convinced by this. I don’t think that JP Morgan’s derivatives operations are particularly assiduously regulated — certainly not to the point that would make the FDIC happy. But I also hate the “everybody’s doing it” defense. The whole point of the Volcker Rule was to stop banks with retail-banking privileges from abusing those privileges in their risky investment-banking operations. And that’s exactly what’s going on here. And as Bill Black points out, the whole thing is dubiously legal in any case:

I would bet large amounts of money that I do not have that neither B of A’s CEO nor the Fed even thought about whether the transfer was consistent with the CEO’s fiduciary duties to B of A (v. BAC).

The point here is that regulators care much more about Bank of America, the retail-banking subsidiary which holds depositors’ money, than they do about BAC, the holding company which owns Merrill Lynch. And the senior executives at Bank of America have a fiduciary duty to Bank of America — never mind the fact that their shareholdings are in BAC. The Fed, in allowing and indeed encouraging this transfer to go ahead, is placing the health of BAC above the health of Bank of America. And that’s just wrong. Holdcos can come and go — it’s the retail-banking subsidiaries which we have to be concerned about. The Fed should not ever let risk get transferred gratuitously from one part of the BAC empire into the retail sub unless there’s a very good reason. And I see no such reason here.

COMMENT

IanFraser, well frankly, Yves Smith is just dishonest. I have difficulty believing that she is unaware that she is making factually incorrect statements, especially given she is strongly financially motivated to make them.

I am also afraid to say that, yes, I don’t trust what I read in any of those publications. Bloomberg, for instance, seems to have just gone downhill since buying Businessweek. Reuters has been dodgy for as long as I have been around, not only in terms of letting the rather homogeneous ideology of the journalists shine through but in employing people with a shocking ignorance of the basics of their chosen field. Ft was always a mix. One of the reasons I like this blog is that it links to original documents – I tend to skip the commentary and read them.

rootless_e, I think this is at the base of the issue of journalism. It might seem there are “thousands of financial journalists” beavering away, acting as a natural overlapping fact checking machine and I am sure they like to see themselves as harden, cynical men and women who take nothing on faith but the reality is that most of them just cut and paste from each other. I have seen over and over, a single dodgy article become “fact” from sheer repetition from other sources.

I wouldn’t mind except there are real consequences for such nonsense. One only has to look at the focus of financial regulation to see how bad “journalism” can impact the world. In particular, the focus on prop trading vs say money market funds or capital requirement vs liquidity management.

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Citi’s Abacus

Felix Salmon
Oct 20, 2011 12:32 UTC

It’s worth reading the full SEC complaint in the case which was settled by Citigroup yesterday for $285 million. For anybody familiar with Goldman’s Abacus deal, it all rings very familiar; in fact, the wording on the Abacus sign can be applied perfectly accurately to Class V Funding III. It’s worth rehearsing in full:

It’s wrong to create a mortgage-backed security filled with loans you know are going to fail so that you can sell it to a client who isn’t aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted upon.

The loans in this case — just like in the Abacus case — were “synthetic”, or made up of credit default swaps rather than actual loans. Wall Street, at the time this deal was done, had run out of actual loans to securitize, and so was forced to create such things by inventing ever more complex transactions. This one, for instance, is a hybrid CDO-squared: it’s a CDO made up mostly of CDSs written on the mezzanine tranches of other CDOs.

Citigroup had two aims when it structured this transaction; one was fully disclosed to its client-investors, and the other was not. The first was to make millions of dollars — $34 million, to be precise — in fees. The second was to put on a $500 million short position in the CDO market. Citi was a big trader in CDSs on CDOs, and therefore could simply have acquired that short position directly, in the open market. But when Class V Funding III was put together, such protection was already very expensive. And the CDOs that Citi wanted to buy protection on were known in the market to be particularly horrible. Probably, it couldn’t buy protection on those particular names at all. And if it could, the price would be prohibitive.

So Citi created Class V Funding III instead. It gave Credit Suisse Alternative Capital a list of the CDOs it wanted to buy protection on, and CSAC did what it was expected to do — it persuaded itself that it could live with having a large number of them in its deal. After all, CSAC wasn’t investing its own money in this dog — it was just managing it for others. And hey, it was AAA-rated! What could possibly go wrong?

Citi, with CSAC on board, then went out to investors and told them that the portfolio had been selected by CSAC — professional! experienced! expert! — and that they could have confidence in CSAC’s selection of securities. Citi did not tell investors, of course, that Citi itself had actually picked most of the CDOs in Class V Funding III, and they certainly didn’t mention that Citi would be holding a $500 million short position in those securities on its own books indefinitely, as a naked-short prop trade. Here’s how the complaint puts it:

The pitch book and offering circular were materially misleading because they failed to disclose that:

a. Citigroup had played a substantial role in selecting assets for Class V III;

b. Citigroup had taken a $500 million short position on the Class V III collateral for its own account, including a $490 million naked short position; and

c. Citigroup’s short position was comprised of names it had been allowed to select, while Citigroup did not short names that it had no role in selecting.

The fine, in this case, is richly deserved, and the money’s going to the right place — the investors who bought into this dreadful deal. I do wonder how many more of these late-vintage CDOs there are, sitting out there and as yet unprosecuted. (I have to admit that I didn’t think of Citi as being particularly evil in this regard; I thought they were more at the incompetent end of the spectrum.) And I certainly hope that if and when there’s some big mortgage settlement with the banks, that the banks don’t receive in return immunity from prosecution on this kind of deal.

COMMENT

simplemind1, also remember buy side are investment advisors. As such they have a legal fiduciary responsibility to the clients. Market makers do not.

Posted by Danny_Black | Report as abusive
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