Felix Salmon

Last Friday, Jason Kelly put up a very funny blog entry about his launch of a pair of fictional 100x levered ETFs, with the ticker symbols SOAR and SINK:

Kelly Capital will reset and relaunch the funds at the beginning of each trading day. The company is in talks with the Security and Exchange Commission (SEC) about the possibility of relaunching the funds after lunch should they go bust in the morning session, but the SEC is balking. SEC spokesperson Ben Meriwether remarked, “We recognize the right of investors to employ as much leverage needed to find fortune or ruin in a day, we just aren’t sure of the need to extend that right twice per day.”

By Wednesday, Kelly was depressed enough about the email traffic he got in response that he posted an update:

A full 65% of people expressed an interest in owning products that would “go bankrupt within the course of most trading days.” A stunning 5% thought they already owned them. Only 30% of respondents got the humor.

John Carney picked up the datapoint in a blog entry headlined “Is It Possible To Invent An Investment Product Too Stupid To Find Buyers?” — something I then tweeted.

What none of us appreciated, however, is that products much like these already exist. As Amy Nauiokas Sean Park rightly notes, in the spread betting market, which is huge in the UK and elsewhere, 50-1 leverage is common. IG Index, for instance, gives an example of how a £10-a-point bet on the FTSE can generate a gain of £560 — or a loss of £480 — in one day.

Spread bets don’t exist in ETF form, but they’re essentially the same thing, just much more highly leveraged than any fund. They’re hugely popular in the UK — which just goes to prove that yes, if you offer an insanely leveraged way of betting on intraday moves in stock indices, there’s no shortage of people who will flock to your door. Even in boring old England.

John Jansen reprints some BarCap research on the Miller-Moore amendment, and now I think I understand why so many finance types are so scared by it: they’ve misread it!

Here’s BarCap:

Proposed by Reps. Miller (D) and Moore (D), it would effectively replace existing repo and secured funding with unsecured borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%…

No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount.

But that’s not what the amendment is proposing. Here it is:

An allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

Let’s say you have a secured claim of $1 million on a bank which has been taken over by the FDIC, and let’s say that unsecured creditors of that bank end up being paid only 70 cents on the dollar.

If the BarCap reading were right, the FDIC would first impose a 20% haircut on the $1 million, turning it into $800,000, and then convert it into an unsecured loan — which, at 70 cents on the dollar, would be worth just $560,000. The net effective haircut would be a whopping 44%. But of course this makes no conceptual sense at all, because unsecured creditors would end up being treated better, under this scheme, than secured creditors.

The way I read it, however, the Miller-Moore amendment allows up to 20% of the secured debt to be converted into unsecured debt; the rest of it is untouched. So you retain $800,000 of secured debt, worth $800,000, and now the remaining $200,000 is unsecured debt, worth $140,000. All in all your $1 million claim is worth $940,000 — a net effective haircut of just 6%.

No one likes losing 6% of their money, of course, but that’s a hell of a lot better than losing 44% of your money. And maybe if the sell side begins to understand how Miller-Moore really works, they might be less averse to it.

(HT: Alloway)

What are the consequences of allowing multi-billion-dollar systemically important multinational corporations to report their assets using proprietary mark-to-model tools involving discredited Monte Carlo simulations? I think we all know the answer to that one. But unbelievably, after such shenanigans contributed enormously to the greatest financial meltdown in living memory, the SEC is now set to allow more or less exactly the same thing in the oil industry.

Otto points to a stunning report by oil consultant Alan von Altendorf which spells it all out. Up until now, oil companies needed to actually prove they had reserves before they reported proven oil reserves. Now, however, the SEC is allowing them to use internal, proprietary computer models to essentially pull their “proven reserve” numbers out of thin air (or the nearest friendly Monte Carlo simulation).

Von Altendorf goes into great detail about how such numbers are useless and meaningless, and how the “proven reserve” rules should probably be tightened, rather than loosened, given the number of enormous write-downs in proven reserves which have taken place across the oil industry in recent years.

So what’s the SEC thinking here? Frankly, it’s not thinking at all: this is just another case of regulatory capture. And a sign that, so far at least, nothing has changed at the unsalvageable and dysfunctional institution.

Ira Stoll notes that the Miller-Moore amendment has passed. He calls it the “Bair-Miller-Moore Haircut”, and he doesn’t like it; I, on the other hand, think it’s a spectacularly good idea. This is the meat of it:

Payments to Fully Secured Creditors: Notwithstanding any other provision of law, in any receivership of a covered financial company in which amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund, as determined in the receiver’s sole discretion, an allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

In English, this means that if you’re a secured creditor of a bank which has failed and which the federal government has to pay money to rescue, you are only guaranteed to receive 80% of your money back. Beyond that, you’re treated as an unsecured creditor.

This achieves three important goals.

Firstly, it means that lenders to dodgy banks will actually have to start doing underwriting, rather than simply relying on their security interest. That keeps everybody honest, and will give the system a heads-up when banks start getting into trouble.

Secondly, it means that wholesale lenders no longer have the ability to jump the queue when it comes to seniority. Banks should repay their depositors first, and then their senior unsecured creditors, and then their subordinated creditors, and then their preferred shareholders; whatever’s left over goes to common shareholders. But increasingly the pecking order has been upended by allowing banks to issue secured debt, which in practice ends up being senior even to depositors. In some countries, banks aren’t allowed to issue secured debt at all; this amendment doesn’t go that far, but at least it makes the debt a little bit riskier for the lender.

Thirdly, it means that banks will be forced to look at the big picture when it comes to their assets, rather than simply using them as collateral for cheap and dangerous short-term funding. Writes Stoll:

The provision make it harder and more expensive for banks to raise capital, and therefore, harder to get credit flowing again into the economy.

This is not entirely true. The provision makes it harder and more expensive for banks to raise secured capital — but as we’ve seen, there are lots of other funding sources available to banks. The more unpledged assets that a bank has, the easier it is for that bank to raise both unsecured debt and various forms of equity.

Conceptually, this is entirely what we want. If I have an asset worth $1 million, I can either borrow $900,000 against that asset and pay interest on the loan, or else I can sell off equity stakes in that asset for $1 million. I’m not sure why the former is a better idea than the latter, when we’re trying to deleverage the banks and move to a more equity-based (and less debt-based) world.

Does the Miller-Moore amendment make banks more liable to liquidity runs? Yes, but on the understanding that (a) they only become more vulnerable insofar as they’re reliant on the short-term repo markets, which is something we want to discourage; and (b) they have access to the Fed’s discount window anyway, so it’s not as though all secured funding sources can disappear overnight.

Why does Stoll love secured creditors so much? He says that “the rights of secured creditors took a beating in the Chrysler bankruptcy” — but that’s not true. They still had the right to provide DIP financing themselves (the role played by the government) or even to push Chrysler into liquidation. They sensibly didn’t exercise those rights, because doing so would have cost them an enormous amount of money compared to what they ended up getting. But the rights themselves were untouched.

The Miller-Moore amendment, by contrast, really does hit secured creditors. That’s a very good idea. Next up, let’s allow bankruptcy judges to modify mortgages, too.

Update: One more thought on this subject. Most secured funding for banks comes from the repo market, where banks borrow against securities they own. But what are banks doing holding so many securities in the first place? Shouldn’t their assets mainly be loans, which can’t be repoed?

A classic 2002 Calvin Trillin piece on wine tasting — TNY

How TV works — YT

HFT “is happening because it’s just more cost effective to employ one programmer over dozens of expensive traders” — FT

Elizabeth Warren earns a six-figure salary from COP on top of what Harvard pays her — Bloomberg

Gotta love those ombudspeople. 800 words on whether it’s “Rahm” or “Mr Emanuel” — NPR

BusinessWeek staffer: Bloomberg “seems to be getting rid of voice” with columnist axings — NYT

Annals of famous Belgians: Hilarious Herman Van Rompuy profile — BBC

ACORN conspiracy theory datapoint of the day — TPM

I want a dedicated RSS feed for Heather Horn’s “Screed” columns — Atlantic Wire

Texas Accidentally Bans Straight Marriage — Newser

The Daily Mail news headline randomizer — Qwghlm

Cats for Gold

The semiotics of death penalty attire — WaPo

Simon Johnson’s testimony on TARP — Baseline Scenario

‘Too Big to Fail’ now $13.50, below cost — Amazon

Not generally a fan of listicles, but I like these Weird Error Messages — ZDnet

Jonathan Ford and Peter Thal Larsen on how to shrink the banks — Prospect

Dear Henry,

I’m not annoyed by you! How could I be, when you call me the “king of financial bloggers” no fewer than four times in one piece? I think you’ve created a powerful, innovative, and disruptive franchise in The Business Insider, which employs some very smart people and publishes some great journalism — even if sometimes it’s neither checked nor correct. I’m entirely happy that you’re out there hiring people even as most publications are doing the opposite, and I wish you and your investors the very best of fortune.

My blog entry yesterday was not about you qua entrepeneur; I just thought that if you were going to get into the business of publishing earnings estimates for technology companies — exactly the business you were banned from by the SEC — then it might be worth mentioning the ban as you did so.

In fact, the blog entry wasn’t really about you at all, as you might have surmised from the picture at the top and the lead paragraph, which were all about Michael Whitney. Maybe you could answer my questions where Bloomberg’s Judith Czelusniak didn’t: do you think it was OK for Bloomberg to hire Whitney and not disclose his past? If not, would it have been OK for Bloomberg to hire Whitney if they had disclosed his past?

I suspect that the differences between us are not particularly great, and that we believe that while such episodes aren’t necessarily disqualifying when it comes to hiring journalists, they should definitely be treated transparently. At the margin, the necessity of disclosing such things might well lead media organizations to pick an experienced out-of-work journalist instead: that clearly doesn’t apply in your case, where you’re the hirer rather than the prospective employee.

You say that you’ve disclosed everything in great detail in the past — this is true, and in fact I linked to one such disclosure. I feel that the disclosure should be a permanent thing, easily available to new readers, especially when you start revisiting ground extremely similar to that which you trod as a securities analyst. It’s not a major difference.

I think we’d have a much more substantive disagreement if you defended Bloomberg’s failure to disclose Whitney’s past, or Thom Calandra’s failure to disclose his own past when selling his new newsletter; I look forward to reading your views on them. But as it is, I think you might be overreacting to my piece slightly.

Best,

Felix Salmon, KFB

Bill Gross isn’t earning much interest on his cash: in fact, he’s only earning 0.01%. Tell us, Bill, what’s an appropriate metaphor to explain how it feels to earn such a low interest rate?

My point is to recognize, and to hope that you recognize, that an effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive. Like the American doughboys near France’s Maginot line in WWII – slumping day after day in a muddy, rat-infested pit – when the battalion commander finally blew his whistle to charge the enemy lines, it probably was accompanied by some sense of relief; anything, anything but this! Anything but .01%!

I’m not sure this is entirely fair. Think of the camraderie in those muddy foxholes! Think of all those meaningful religious conversions! Frankly, earning 0.01% interest on your money-market funds is much worse than that!

Or, you know, it could be a sign of how incredibly short memories are. A year ago — even six months ago — people thought that losing 30% or 40% or 50% of your money constituted something extremely painful. Now, it seems, making a small amount of money is analogous to fighting in the bloodiest war of all time.

Kid Dynamite today translates Gross’s column into Sensible, explaining that opportunities paying say 5% annualized become a lot more attractive when rates are at zero than they are when you can get 5% just by investing in Treasury bills. Hence assets yielding anything at all — even stocks — have become pretty popular of late, accounting for the impressive price rise since March. Still, he concludes, “this can only end one way… badly”. People aren’t asking that yields compensate for risk any more, they’re just asking that they pay more than nothing. Which is probably not the smartest manner of allocating capital ever invented.

As for Gross, his best advice is to buy utility stocks:

Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom.

Is that the new Goldilocks Scenario, I wonder?

Update: The quote above — which mangles history in unspeakable ways, as many commenters noted — has been changed on the Pimco website, which now talks about “the American doughboys near France’s future Maginot line in WWI”.

It’s good that we’re moving to an opt-in system for debit-card overdrafts. But in order to get there from here I have a feeling that we’re going to have to dodge a lot of, um, personalized communications from our banks:

SoundBite’s Debit Card Overdraft Opt-In solution can proactively reach consumers through any combination of automated voice, text, and email messaging. Attempts to reach a consumer can escalate from one channel to another — such as from an email to a voice message to a text message — in order to increase reach-ability and response rates.

Maybe this is why the Fed’s model letter included a way for consumers to opt out, even though they’re opted out by default. If you formally communicate with your bank to opt out, will that stop them pestering you to opt in?

Buried in Peter Goodman’s 2,300-word tale of Christopher Hall’s foreclosure woes is a gem of a program in Philadelphia:

Under the rules adopted by Philadelphia’s primary civil court, no owner-occupied house may be foreclosed on and sold by the sheriff’s office before a “conciliation conference,” a face-to-face meeting between the homeowner and the lender aimed at striking a workable compromise. Every homeowner facing a default filing is furnished with counseling, and sometimes legal representation…

Since the administration’s program was begun in March, it has been plagued by complaints of bureaucratic confusion and the indifference of mortgage companies. Many homeowners who have applied for loan modifications complain that their documents have been lost repeatedly or that they have been rejected without explanation.

The Philadelphia program forces an outcome by bringing together all the principals in one room. If the mortgage company proves intractable, the homeowner has the right to request mediation in front of a volunteer lawyer serving as a provisional judge, who relays recommendations to the program’s supervising judge. If the judge finds that the mortgage company is not acting in good faith, she can hold the house in limbo by denying permission for a sheriff’s sale.

This is a great idea: one of the biggest problems facing homeowners trying to come to some kind of a deal with their mortgage lender is that correspondence has a tendency to disappear into a black hole; that they find themselves dealing with an ever-rotating cast of customer service representatives who have a tendency to contradict each other and even themselves; and that constructive conversation, as opposed to a bureaucratic nightmare, is all but impossible.

The fact is that the banks simply don’t have enough trained and qualified personnel to be able to act in a sensible and intelligent manner with regard to each of the loan modification requests which are flooding in on a daily basis. But that’s the banks’ problem, and this Philadelphia scheme forces them to face up to it.

Daniel Indiviglio, I fear, doesn’t understand this at all, and seems to be living in an alternate universe where all bank decisions are entirely rational:

The bank is, ultimately, going to want to do whatever is in its best interest…

A face-to-face meeting won’t change that fact. And if foreclosure is a better alternative for the bank, then meeting in person won’t change that either. It’s a waste of time.

This might well be true: if foreclosure is in the bank’s best interest, then the in-person meeting won’t change that. But there is a very large number of foreclosures which aren’t in the bank’s best interest, and in-person meetings can change those outcomes for the better.

What’s more, even if any individual foreclosure might be in the bank’s best interest, it can also be in the bank’s best interest more generally to slow the whole process down:

In West Philadelphia, Councilman Curtis Jones Jr., one of the sponsors of the resolution, watched his childhood neighborhood consumed by foreclosure, as the homes of working families — their porches once lined with flower pots — were boarded up with plywood.

“It becomes a blight on your entire community,” Mr. Jones said. “It creates an environment that fosters everything bad, from prostitution to drug dealing to wildlife, like raccoons taking over whole houses. One house becomes 10, and 10 becomes the whole block.”

If banks face a situation where a wave of foreclosures can devastate property values, it’s in everybody’s interest to keep even defaulted homeowners in their homes for the time being, if only to preserve the value of the collateral. Schemes such as the one in Philadelphia can help break the vicious cycle of foreclosures leading to falling home prices leading to more foreclosures, and that’s good for all. I’d love to see the Philadelphia scheme rolled out in other cities struggling with this problem.

The indispensable Abnormal Returns has a smart post up on aggregation:

Aggregators, investment or otherwise, are not the cause of the downfall of traditional news gatherers like newspapers. They are simply a sign that people are hungry for information and analysis presented in an efficient manner. For better or worse, that instinct to seek out order in an increasingly complex world is here to stay.

Of course, the news media has been trying to present information and analysis in an efficient manner for centuries: there’s nothing new there. The difference today is that the internet has brought thousands of different news sources just one click away, and so there’s demand for a new layer of editing. Newspapers have always needed editing to put the focus on the most important news, but different readers want different kinds of news and no one editor can be all things to all people.

On the internet there are thousands of people sifting news through their own particular filters, and some of them, like Abnormal Returns, prove to be extremely popular. That’s partly because they’re simply very good editors, and partly because they’re not artificially constrained in the way that newspaper editors are: they can link to anything they like, not just the product of one news shop; and they can ignore important-but-boring stories in favor of the ones that people actually want to read.

It’s almost impossible for newspaper editors and publishers to compete with that — which is exactly the reason why they should instead be embracing it. Either you can encourage people to read your news, or you can discourage them. Everybody needs some degree of help navigating the vast ocean of news and commentary which is produced every day, and no sensible publisher will come to the conclusion that cracking down on invaluable navigators is a good idea. Instead, they should be encouraging them as much as possible. As the late Sy Syms might have said, an educated news consumer is any publisher’s best customer.