Teddy Bloggie Blog Blogging

Ah, the free market, where everything is free. It's leading to free stocks and bonds of America's finest corporations. Some of you may have missed the fire-sale of Lehman and Bear Sterns. Don't fret. This Christmas, free GM stocks! Everyone will be able to own a piece of GM. Ongoing free stuff in the free market includes free capital injections from the Fed for qualifying banks. Better than free needle exchanges but the high is still temporary. Free market capitalism met 21st century minimalism and became free capital. Due diligence is overblown and too realistic. We want abstract paintings of blue lines for $200 million. Could I have derivative contracts with no financial backing for $200 billion, Alex? What are Sharks and bankers in formaldehyde.

I've been made honorarily gay by he passage of proposition 8. Fact is I woke up feeling more solidarity with gay people than straight because of the passage of prop 8, which amends the constitution of California to redefine marriage as between someone with a penis and someone with a vagina.

Separate but equal is inherently unequal and so civil unions will never be acceptable to the gay community as a separate but equal legal status, especially in California. This is California!!! The government should not intrude into personal relationships between two consenting adults and should treat everyone the same. The intrusion is especially discriminatory because it is based on physical characteristics, and the government should get out of the business of checking on what type of genitalia people have.

The fact that the proponents used the teaching of gay marriage to children as a scare tactic is depraved. No one is going to be saying "gay,gay,gay,gay,gay" in school. And in any case, who gives a fuck? Isn't school about learning facts? There are whales in the ocean, and there are gay people in the world. Teaching kids about gays won't turn them gay. Being around gay people won't turn them gay. Maybe we shouldn't teach kids about wizards just in case they turn warlock! Gay, gay, gay, gay, gay!

The demographics favor gay marriage in the future, but in order to get society to take a speedier path toward enlightenment, I'm going to say "gay,gay,gay,gay,gay" and patiently explain why this is a pock on California.

Obama 2008!!!

I think part of the problem with financial markets is that transactions are almost costless. That's a problem because it lowers the incentives for people to keep the assets on their books for any length of time. It also diverts capital and talented people into the financial sector when they otherwise would make great mathematicians, physicists or professors.

I think financial transactions should be taxed to reduce that tendency. If it's more costly to buy and sell and day trade, it would make people do more due diligence. Part of the problem with asset bubbles is that people expect the ponzi scheme to go on, but it's less likely if the transactions get stuck in the molasses of government taxation. The taxes can go into a fund that insures systemic risk rising from unfettered asset bubbles. The more bubble-icious the market, the more money there would be to bailout that sector of the economy.

Excellent story on CDS from NPR/This American Life:

"The line between investing and speculation or gambling in financial markets is always a pretty gray one," he says. "And speculation is always a motive."

So, how did we get from one of the safest activities on the planet "insurance" to one of the riskiest "gambling"? There's one key difference between an insurance policy and a credit default swap.

"The way that I first described the credit default swap is, you own the bond and you want to transfer the risk to someone else. But what if I want to buy protection but I don't own the bond?" Berman says.

But isn't buying protection on a bond you don't own like buying fire insurance on a house that's not yours?

"It is exactly like buying insurance for a house you don't own," Berman says. "So it's like you took out fire insurance on your home, and I also took out fire insurance on your home, and a thousand other people took out fire insurance on your home.

"And when that happens, what you're doing is, you're betting on the house."

So, a CDS allows people to get paid off by insuring something they don't own ?" not a house in this case, but a bond.

......

Imagine someone with a hedge fund worth $100 million who wants to make a killing in the credit default swap market. He starts calling and e-mailing all those credit default swap desks and hedge funds out there, saying, "I'm selling protection, who wants to buy?"

Someone calls back and says, "I have a billion-dollar bond from Lehman Brothers, I want to insure." He says, great, "I'll insure your bond if you agree to pay me 2 percent of its value every year." The caller says, "All right." They are in business.

Now, let's review those numbers: 2 percent of $1 billion is $20 million, which the person with the $100 million hedge fund gets every year. So, by signing one piece of paper, he has doubled his money in five years - psyching him and his investors.

That's the upside of leverage: You make profits on a billion dollars even though you only have $100 million.

The downside of leverage is that he is on the hook for up to $1 billion if the bond defaults and he doesn't have a billion.

So there are three big problems with the CDS market as told in this story.

1. OTC instruments are not regulated in terms of leverage.

2. The value of CDS are not marked-to-market. If they were and the CDSs are marked to market, as the seller gets on the hook for more and more money, they would be forced to get out of those positions day-by-day as the likelihood of default goes up.

3. Since the products are not marked to market, you can also get into the situation that as hedge-funds, investment banks, and AIGs of the world hold on to their short CDS positions "gambling for resurrection" instead of living in financial reality. Once the underlying bond actually defaults everyone has to pay up at the same time and instead of a bad financial bet by some investment professionals it becomes a financial meltdown.

So, it seems the solution is to just have CDS traded on a market with a clearinghouse. In fact, it should be a rule that any financial instruments regulated banks and insurance companies invest in or sell should be traded on a market, marked to market, and have a leverage limit.

Update: It seems that CDS have collateral that acts as margin calls. The collateral ratchets up if the firm is downgraded. As Felix Simon explains via this WSJ article:

The WSJ shines a bit more light on what went wrong at AIG today, with a story centering on the chap who designed its risk models, Gary Gorton. In a nutshell, anybody writing credit protection runs two risks: the default risk of the underlying security, on the one hand, and market risk, on the other. It seems that AIG only ever asked Gorton to worry about default risk; no one ever bothered to calculate the risk that CDS spreads would gap out, forcing AIG to take billions of dollars in mark-to-market losses and post many billions of dollars more in collateral.

Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances...

AIG began selling credit-default swaps around 1998. Mr. Gorton's work "helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money" because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton's work didn't address the potential write-downs or collateral payments to trading partners.

Incidentally, AIG Financial Product's Joseph Cassano was kept on as a consultant after he retired in February -- at a rate of $1 million per month.

The WSJ also reports, without citing even anonymous sources, on the subject of Goldman's exposure to AIG, and the amount of AIG collateral that Goldman now holds:

Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG -- most of it before the U.S. stepped in.

Goldman protected itself in other ways, too, since it's not easy getting that collateral:

Late last October, Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and it ultimately posted $1.5 billion. Goldman hedged its exposure by making a bearish bet on AIG, buying credit-default swaps on AIG's own debt, according to one person knowledgeable about this move...

Mr. Gorton attended the Federal Reserve Bank of Kansas City's annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, "The Panic of 2007," which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. "It is difficult to convey," he wrote, "the ferocity of the fights over collateral."

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let's say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you're happy, and making money. But let's say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

As far as AIG was concerned, it was one of the biggest companies in the world, more than capable of weathering any mark-to-market storm -- and therefore all it cared about was default risk, not market risk. But as a result, it took on much more market risk than it was really aware of -- and that market risk ended up forcing the entire company into the arms of the US government.

The lesson, of course, is simple, but hard to learn: it's not the risks you measure which bring you down, it's the risks you don't measure. But protecting against those risks is very, very hard.

I thought the problem was that all of the marking-to-market and collateral calls came at the same time because they are tied to the rating of AIG, and I still think that's the case. If, as the article indicates, that there's very little default risk then it makes sense to bail out AIG, but I'm skeptical that their models are right when evidently the model failed to account for market risk.

The bigger problem of course is that any firms dealing in CDS are now finding it hard to get credit because counterparties can't be sure how much exposure they have to AIG and Lehman Bros. All these OTC instruments are traded in a dark and scary place where it's hard to figure out who owns what from whom. Since you may have some CDS purchased from AIG, I don't want to lend you money in case AIG defaults. In addition the default risk of bonds have skyrocketed so more defaults are coming. No one knows from where or how to assess the risks. When the markets can't put a number on the amount of risk there is, it sits on its hands. Why oh why wasn't this stuff traded on an exchange with a clearinghouse???

Alex sent me an email linked to Laffer's article criticizing the bailout:

There are many more examples, but none hold a candle to what's happening right now. Twenty-five years down the line, what this administration and Congress have done will be viewed in much the same light as what Herbert Hoover did in the years 1929 through 1932. Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity.

It's right I think that the bailout is being rushed, but a slow bailout would be as effective as no bailout. Speed really matters but speed with some point-guard decision making skills would be even better. To me, the injection of money into bank equity seems like a mistake but buying up mortgages seems like a good idea.

Here's my reply to Alex:

Laffer's right that this is going to cost us more than we think 25 years from now. But I like to think of the bailouts (if done right) as your neighborhood fire department. We all pay taxes so that if some three-alarm fire next door erupts, they will be there to put it out. It might cost a lot in terms of paying for 5 guys and a shiny red truck, but it's better than having your house burn down because your next door neighbor was foolish and went to sleep with a lit cigarette and no one's there to stop the fire. It's kind of a similar situation in financial markets. You can stop bailing out the people who took too much risk, but then you'll probably lose your job too when the banks stops lending to the company you work for and people have no money to buy the goods or services you produce. The systemic risk is too great to do nothing and an unregulated financial market with very dispersed ownership and information creates a lot of unchecked systemic risk. Until someone figures out how to solve those fundamental problems of information asymetry and principal-agent (stock-owner/management) problems, we'll have more bailouts in the future.

Low growth, low inflation, low interest rates. The Japanese economy writ large? I think that's what's going to happen for the next few years. The credit squeeze and the fall in home prices is going to shrink the nominal values of everything in the economy. There's going to be a rise in unemployment and a lack of investment, keeping the demand for money and interest rates low. I think I'm going to invest in healthcare because expenditure in healthcare is more inelastic and there's still a tremendous amount of innovation happening in the healthcare sector.

Will these two icons of American industry will go bankrupt in the near future? They have enough cash to burn for another year or so, but I think they're done for. Building what people don't want to buy and financing people they shouldn't finance got'er done. They'll go the way of Studebaker and Packard. GM and Ford have huge finance divisions and the markets are especially unkind to financial companies right now. They must be sitting on a ton of loans that are going bad and getting worse. I imagine those same people who are having trouble with mortgage payments probably borrowed to buy cars. They are now defaulting on car payments and getting repossessed (like the guy behind me at the DMV two days ago). So it might not even be the slumping auto and truck sales that really kills GM and Ford but their no-money-down, 0% financing.

Some people argue that hundreds of thousands (maybe millions) of jobs are related to Ford and GM -- and so they're too big to fail. In many auto-related blogs people say that it's the right time to invest. I wouldn't. Just because they're too big to disappear doesn't mean they're too big to go bankrupt. A government bailout might not bail out the equity holders just as in the case of AIG, and a corporate takeover might not help equity holders either when it's sold for close to zero. I would be really worried if I'm an American retiree of GM or Ford right now because even if they don't go bankrupt, any takeover will only be interested in profitable operations in China, Brazil or Europe. A bankruptcy of GM or Ford will basically mean the recession will be longer and deeper than what we're looking at now. The seemingly virtual world of Wall St. will hit home. The repercussions of bad CDOs will have caused your GM retiree neighbor to stock up and eat canned tuna.

It's young people working an old town
it's ambition combusting in frustrations
it's formal attire, cheap opportunities, and static cling
It's fried chicken chinese food and gourmet everything else

Look at that! Doesn't it look like RMB and dollar held hands, ran as fast as they could, and then lept of a cliff? It makes me think about gravity models of trade...

Inflation in the U.S. has been kept at bay in part because of low tradable prices due to China holding the RMB-Dollar exchange rate constant (increasing the demand for dollars by buying up US treasuries and selling RMB), but it has been creeping up ever since China loosened its unofficial peg to the dollar. It's got a ways to go before RMB-dollar hits about 4-1 based on my own gut feelings of purchasing price parity. But if it keeps going -- the way it has for the last three years -- that'll come very soon. If I were a real estate broker in Malibu or NYC, I'd be learning Chinese or Russian.*

The devaluation of the Dollar also means we're going to be importing inflation (among other causes such as our loose monetary policy to save our banks and increases in commodity prices) and that's why I tell myself that I need my dollars in real assets like old motorcycles.

Also, I feel pretty good about what I said back in May, 2005.

* Because the Europeans are more better well-spoken than we is.

Surprisingly good analogy by David Brooks.

Questions for Dr. Retail By DAVID BROOKS

QUESTION: Dr. Retail, now that the Democratic presidential race has entered its long, bloody slog phase, I figured it was time to get a fresh perspective. Can you explain to me what it's all about?

DR. RETAIL: Why do you bother me with simple problems? Listen, the essential competition in many consumer sectors is between commodity providers and experience providers, the companies that just deliver product and the companies that deliver a sensation, too. There's Safeway, and then there is Whole Foods. There's the PC, and then there?€™s the Mac. There are Holiday Inns, and there are W Hotels. There's Walgreens, and there's The Body Shop.

Hillary Clinton is a classic commodity provider. She caters to the less-educated, less-pretentious consumer. As Ron Brownstein of The National Journal pointed out on Wednesday, she won the non-college-educated voters by 22 points in California, 32 points in Massachusetts and 54 points in Arkansas. She offers voters no frills, just commodities: tax credits, federal subsidies and scholarships. She's got good programs at good prices.

Barack Obama is an experience provider. He attracts the educated consumer. In the last Pew Research national survey, he led among people with college degrees by 22 points. Educated people get all emotional when they shop and vote. They want an uplifting experience so they can persuade themselves that they're not engaging in a grubby self-interested transaction. They fall for all that zero-carbon footprint, locally grown, community-enhancing Third Place hype. They want cultural signifiers that enrich their lives with meaning.

Obama offers to defeat cynicism with hope. Apparently he's going to turn politics into a form of sharing. Have you noticed that he's actually carried into his rallies by a flock of cherubs while the heavens open up with the Hallelujah Chorus? I wonder how he does that.

QUESTION: But why would Democratic votes break down so starkly along educational lines?

DR. RETAIL: The consumer marketplace has been bifurcating for years! It's happening because the educated and uneducated lead different sorts of lives. Educated people are not only growing richer than less-educated people, but their lifestyles are diverging as well. A generation ago, educated families and less-educated families looked the same, but now high school graduates divorce at twice the rate of college graduates. High school grads are much more likely to have kids out of wedlock. High school grads are much more likely to be obese. They're much more likely to smoke and to die younger.

Their attitudes are different. High school grads are much less optimistic than college grads. They express less social trust. They feel less safe in public. They report having fewer friends and lower aspirations. The less educated speak the dialect of struggle; the more educated, the dialect of self-fulfillment

Did you hear the message of Clinton's speech Tuesday night? It's a rotten world out there. Regular folks are getting the shaft. They need someone who'll fight tougher, work harder and put loyalty over independence.

Then did you see the Hopemeister's speech? His schtick makes sense if you've got a basic level of security in your life, if you're looking up, not down. Meanwhile, Obama's people are so taken with their messiah that soon they'll be selling flowers at airports and arranging mass weddings. There's a "Yes We Can" video floating around YouTube in which a bunch of celebrities like Scarlett Johansson and the guy from the Black Eyed Peas are singing the words to an Obama speech in escalating states of righteousness and ecstasy. If that video doesn't creep out normal working-class voters, then nothing will.

QUESTION: Your cynicism is really interfering with my vibe. I don't think you're feeling the fierce urgency of now.

DR. RETAIL: Believe me, those of us who bill by the hour completely feel the fierce urgency of now. As John Edwards would say, this is personal with me.

QUESTION: So does this mean the Democrats are fundamentally divided?

DR. RETAIL: Why do you political people always think in either/or terms? No. Safeway and Whole Foods people shop in each other's stores. They just feel less at home.

QUESTION: So who's going to win?

DR. RETAIL: Observe the marketplace. The next states on the primary calendar have tons of college-educated Obamaphile voters. Maryland is 5th among the 50 states, Virginia is 6th. But later on, we get the Hillary-friendly states. Ohio is 40th in college education. Pennsylvania is 32nd.

But it'll still be tied after all that. The superdelegates will pick the nominee: the party honchos, the deal-makers, the donors, the machine. Swinging those people takes a level of cynicism even Dr. Retail can't pretend to understand. That's Tammany Hall. That's the court at Versailles under Louis XIV.

I disagree with the conclusion. Once it goes to the superdelegates it will be a question of electability because superdelegates, being elected Democrat officials and other party affiliates have in their self-interest more so than the regular voter to pick the candidate that will increase Democratic control in Washington Those who vote Obama will say he's more electable and will bring a majority to the house and senate with him. If Obama loses, people will dismiss Hillary supporters as she wouldn't've stood a chance. But if Hillary loses, Obama superdelegates will commit mutiny. But there's the possibility that Hillary wins, right? What if Hillary wins? Nothing will change in Blue states and no gains will be made in Purple or Red states. Based on these considerations I think the superdelegates will vote Obama in larger numbers than are predicted. And I shop both Walmart and Wholefoods with equal comfort.

This Sci-Am article suggests the right kind of encouragement and mindset are important in overcoming challenges for kids and adults. I tend to agree; although, I've seen some hard working students in my class struggle with conceptual problems while others who just "get" it.

At times, the intellectual hurdle seems too high to them and students think the effort required might as well be infinite; and therefore, they give up before they understand a concept or solve the problem. But it's exactly at those times where a little bit of extra effort can see real payoffs. That's something I've forgotten about lately too and could use the reminder. Note to self:

http://www.sciam.com/article.cfm?id=the-secret-to-raising-smart-kids&print=true

Moon as seen behind the co-op in Davis.

Prior to today, I didn't think the following was possible. What does this have to do with econometrics? I was never that interested in maximum entropy estimation and I don't know much about it, but the following image is maximum entropy applied to image data. Now I'm interested.

Maximum Entropy Data Consultants, http://www.maxent.co.uk/

The following fact by way of Mario Juric:

While most people can see with a resolution of 1?€™, the image on our retina is blurred through a PSF of width as large as 5?€™ due to various effects (the largest being chromatic aberration).

And while we still struggle with finding optimal deconvolution algorithms, the brain happily performs the procedure on a 8500x5400 (43Mpix) image, a few times per second, ~17 hours a day, 365 days a year.
MacKay (2003)
Tidwell (1995), http://www.hitl.washington.edu/publications/tidwell/ch3.html

- From Probabililty Theory: The Logic of Science by E.T. Jaynes

Many people are fond of saying, "They will never make a machine to replace the human mind, it does many things which no machine could ever do." A beautiful answer to this was given by J. von Neumann in a talk on computers given in Princeton in 1948, which the writer was privileged to attend. In reply to the canonical question from the audience "But of course, a mere machine can't really think, can it?", he said: "You insist that there is something a machine cannot do. If you will tell me precisely what it is that a machine cannot do, then I can always make a machine which will do just that!"

I'm staying at a hotel called "Orange Hotel" in Beijing. Sign next to the ethernet plug in my room reads, "Reminder from Orange Man. Please don't view any website includes information of gambling or eroticism. Please don't spread any information against the society."

How long will these signs be seen in China? How long will awkward grammar be seen? 10years? 5 years?

I'd guess 7.5 years, after which they will seem quaint.