Tuesday, September 30, 2008


More federal reserve act...

Section 15. Government Deposits

1. Federal Reserve Banks as Depositaries and Fiscal Agents of United States

The moneys held in the general fund of the Treasury, except the five per centum fund for the redemption of outstanding national-bank notes may, upon the direction of the Secretary of the Treasury, be deposited in Federal reserve banks, which banks, when required by the Secretary of the Treasury, shall act as fiscal agents of the United States; and the revenues of the Government or any part thereof may be deposited in such banks, and disbursements may be made by checks drawn against such deposits. [12 USC 391. As amended by the act of March 18, 1968 (82 Stat. 50). Also, in effect amended by Act of May 29, 1920 (41 Stat. 654).

The Finer Points of the Federal Reserve Act

Federal Reserve Act

Section 2a. Monetary Policy Objectives

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]

Section 10A. Emergency Advances to Groups of Member Banks *

1. Authority of Reserve Banks to Make Advances

Upon receiving the consent of not less than five members of the Board of Governors of the Federal Reserve System, any Federal reserve bank may make advances, in such amount as the board of directors of such Federal reserve bank may determine, to groups of five or more member banks within its district, a majority of them independently owned and controlled, upon their time or demand promissory notes, provided the bank or banks which receive the proceeds of such advances as herein provided have no adequate amounts of eligible and acceptable assets available to enable such bank or banks to obtain sufficient credit accommodations from the Federal reserve bank through rediscounts or advances other than as provided in section 10(b). The liability of the individual banks in each group must be limited to such proportion of the total amount advanced to such group as the deposit liability of the respective banks bears to the aggregate deposit liability of all banks in such group, but such advances may be made to a lesser number of such member banks if the aggregate amount of their deposit liability constitutes at least 10 per centum of the entire deposit liability of the member banks within such district. Such banks shall be authorized to distribute the proceeds of such loans to such of their number and in such amount as they may agree upon, but before so doing they shall require such recipient banks to deposit with a suitable trustee, representing the entire group, their individual notes made in favor of the group protected by such collateral security as may be agreed upon. Any Federal reserve bank making such advance shall charge interest or discount thereon at a rate not less than 1 per centum above its discount rate in effect at the time of making such advance. No such note upon which advances are made by a Federal reserve bank under this section shall be eligible under section 16 of this Act as collateral security for Federal reserve notes.

[12 USC 347a. As added by act of Feb. 27, 1932 (47 Stat. 56).]

Section 16. Note Issues

1. Issuance of Federal Reserve Notes; Nature of Obligation; Where Redeemable

Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.

[12 USC 411. As amended by act of Jan. 30, 1934 (48 Stat. 337). For redemption of Federal reserve notes whose bank of issue cannot be identified, see act of June 13, 1933.]

Call it a Comeback

Today was easy. Take it down low on the open after yesterday's bad news. Bleed anybody dry who had the balls to hold through yesterday's debacle. Then rip it in their faces right after they sold at the bottom. Classic example of the most people doing the worst thing at the least opportune time.

Monday, September 29, 2008


In a point that I cannot emphasize enough, the federal reserve has the ability to print money and effectively raise funds ad infinitum (until the whole system falls apart, but thats not going to be now). That means that this vote today was simply a formality; the great and powerful bernanke chose to let the treasury and the congress look like they could handle the bailout (with his blessing, of course). But when our politicians dropped the ball, the US central bank let everyone know who was really in charge.

The fed wields blunt instruments, but they are hugely powerful. As the dollar is the world reserve currency, the fed can create money out of thin air in a way people only dreamed of under the gold standard (GS). They can pump prime the lending markets until the rapture because nervous investors have driven treasury bill yields to historic lows.

Everywhere Dead Bodies

Bombs exploded everywhere. Naz down 9.14%, sp500 down 8.79%, dow down 777. financials took the worst hit, as was to be expected when the ground drops out from under a sector. xlf down 13.18%, some individuals down much more. my boy ntrs down close to 20%.

no one was safe. pot down 15 pts, agu 10, mos 12. oil streaked down 11%. The terror stalked from sector to sector. goog down 11%. bidu 11%. end of world.

the grim grizzly bear reaper slit the bull's throat and paraded its corpse around wall street. then it strangled all the sheep with lengths of entrail.

while the US congress was the catalyst for today's decline (vote ended 13:42:00, take a look at ze chart), the fact of the matter is that declines like this are largely endogenous events with exogenous triggers. The congress rejecting the senate bill was outside the market, in the political environment of an election year. That catalyst found a vulnerable market; punch drunk, bleeding, and reeling with the failure of wachovia.

The Strategy Surreal

If anyone was watching both the vote on C-SPAN and the SPY's today, you could have made a fortune. The second that the nea's surpassed the yea's the SPY's dropped 3.5 points without stopping. While the market was pretty wild, this unexpected trade was the big winner of the day.

Saturday, September 27, 2008

The European Liquidity Mechansim

In the preceding article, we looked at how china's currency manipulation was leading to money creation on a massive scale. Today we will contrast the european method for dealing with the dollars we throw at them.

China is not the only net exporter in the world; it is just the most extreme example. Germany, for instance, maintains large trade surpluses with many nations. Since germany is the largest economy in europe, this means that on a net basis the european union (EU) is one of the largest net exporters to america.

Like china, this means that there is a constant stream of dollars heading into the euro currency zone. Unlike china, there is much less currency manipulation. The european central bank (ECB) does not make it an everyday policy to keep their currency cheap by printing euros and using them to buy dollars like china does with the yuan. This means that the euro has increased against the dollar for most of the past 7 years.

That isn't to say that every dollar sent across the pond is sold for euro's: far from it. As one of the largest markets in the world, the so called "eurodollar" market refers to dollar deposits held by european banks. A great deal of these dollars make their way back to our domestic capital markets in the form of investments in stocks, bonds, and toxic collateralized mortgage obligations (CMO's) like the ones in today's current crisis. That is one of the reasons a US housing bust caused so much pain abroad, both europe and asia were heavily invested in US debt.

Nevertheless, until the US reverses its trade deficit with the EU or the ECB begins a china-esque policy of currency manipulation, the euro will resume its long rise against the dollar.

Friday, September 26, 2008

The Chinese Liquidity Mechanism

In terms of how much liquidity a foreign country injects into the world financial system, countries can be classified using two characteristics: their current account balance and the level to which they manipulate their currency. In trade, a country may either be a net exporter or a net importer. Most countries fall into the exporter category. None more so than China, which maintains a growing trade surplus with the US. As for currency, a more continuous scale can be used: active manipulators on one end and completely unregulated currencies on the other with shades of gray in between. China falls at the extreme end of the manipulation spectrum; they actively manipulate their currency to remain cheap against other currencies like the dollar. China's intention is to remain competitive in export markets by keeping export prices low in terms of dollars. That way more of you will go to target or wal-mart and send your levered cash to chinese exporting firms.

The american consumer sends a constant and growing flow of dollars to firms in china. when the dollars reach the chinese banking system, the domestic banks sell their dollars deposited by the exporters in exchange for yuan on the open market. If unchecked, this exerts a marginal downward pressure on the value of the dollar and a corresponding upward pressure on the value of the yuan. This increases the export price of chinese goods in dollars and makes them more expensive for you to buy at retailers state-side.

The chinese central government wants to avoid such an outcome. They counteract the effect of the domestic banks' currency conversions by entering offsetting positions in the market: printing new yuan and selling them for dollars on the open market. This exerts a marginal upward pressure on the dollar, making both the yuan cheaper and chinese export goods to america. This keeps americans buying cheap chinese shit.

This amounts to money creation on a massive scale. Chinese export firms are awash in yuan that they converted from the dollar profits on exports. Chinese banks get yuan deposits and make domestic loans to chinese firms in yuan. The government prints yuan in order to sell them for dollars. This has the effect of injecting yuan into the world markets, but since the majority of yuan are employed in china, the printing presses increase domestic chinese liquidity even further. The dollars that the central government acquires are then reinvested in dollar denominated assets like US government debt, US corporate debt, US agency debt, oil, gold, corn, soybeans... you get the idea.

Since china actively manipulates its currency, it injects far more liquidity into the world system than a country that allows their currency to appreciate as the result of a prolonged trade surplus. This liquidity has decreased worldwide interest rates, increased the ability of banks to lend in the form of mortgages, car loans, credit card loans and so forth and contributed to the preceding boom we had from 2003-2007.

Thursday, September 25, 2008

A Brief History of Time Part 1: The Beginning of Floating Exchange Rates

Our history begins in 1968 during the Tet Offensive. The rising US government expenditures for the Vietnam war was placing strain on the international monetary system, which at the time was based off of the Gold Standard (hereinafter referred to as GS) and the Bretton Woods Agreement. Under the GS and Bretton Woods, national currencies were either convertible at a fixed rate into gold, or "pegged" to the US dollar. A pegged currency would be actively manipulated by the government to maintain the exchange rate to within +/- 1% of parity with the dollar. The dollar, while still based off its convertibility into gold, became the default reserve currency of the world.

The benefit of the GS was that it was self-correcting. If a country maintained a current account deficit, gold would flow out of the country to those with surpluses. This would contract the domestic money supply, decreasing lending, and pushing the country into recession. This led to a decline in domestic consumption thereby reducing the deficit. An add on effect came from the resulting devaluation in the deficit currency, which made their goods more competitive and helped reverse the current account deficit. Likewise if a country experienced prolonged surpluses, its money supply would increase, leading to increased inflation and a strengthening currency as international money would flow into the surplus currency to take advantage of rising asset prices. This led to a decline in export competitiveness and a reduction in the surplus.

The downsides all stemmed from the fact that it was ultimately the supply of gold which determined the money supply. Unlike today's system, money could not be created at will. Keeping the supply of gold constant, an economic boom would cause demand to outstrip the money supply. The prolonged boom after the end of WWII created what was known as a dollar shortage, because convertibility ensured that the supply of dollars was constrained by the relatively constant supply of gold.

Back to vietnam: by 1968 there began to be widespread concern that increased levels of US military spending was creating a currency crisis and a run on US gold reserves. The US had been maintaining a current account deficit for several years, and as dollars were flowing out to pay for the war, so was gold. Since other major world currencies were pegged to the dollar, the decline in gold reserves began to jeopardize the stability of the fixed exchange rates. As we mentioned earlier, under the GS, a deficit creates negative pressure on the currency of the net importing nation. Normally this would adjust itself naturally by the self-correction mechanism: the dollar should decline and other currencies rise against it. But we were under the Bretton Woods pegging system, which meant that other governments had to spend large amounts of money to maintain the lower exchange rate in the face of a gold run in the US.

Some revaluations were enacted in a piecemeal fashion: the German mark was formally appreciated by 9.29% on September 20, 1969. But the manipulation that governments had to engage in as the US balance of payments deteriorated represented a dead weight loss of productive capacity; the money spent could have been productively employed elsewhere. Moreover government budgets experienced strain as the money flowed into manipulating exchange rates. Since governments have always been huge participants in debt markets, the distortions created by increased government borrowing were transferred to the real economy, and crisis ensued. As Vietnam dragged on, non-governmental actors anticipating devaluation placed extreme pressure on the monetary system.

Finally, during the summer of 1971, the Nixon administration formally suspended the convertibility of the dollar into gold. Thus began the rapid advance of the floating exchange rate mechanism. Under this new system, currencies would float freely against one another. Exchange rates would be determined primarily through market forces, with some government intervention during crises. Most importantly, the supply of dollars would not be constrained by the amount of gold in the world, allowing the government to regulate the money supply as needed.

Stay Tuned for Part II, "Exponential Expansion of Reserve Currencies Under Floating Exchange Rates"


Yet Another Way to Screw the Shorts

Short selling is dangerous. Since a stock can only go to zero and can theoretically go to infinity, a short's upside is limited and the downside unlimited. Shorts can also be outlawed by the government, as many of us found out first hand last friday. Now there is yet another reason it sucks to be a short: it is getting harder and harder to borrow stock.

In order to be compliant, a trader who wants to go short must either be a bona fide market maker or meet the requirements as mandated by the SEC. This means that you have to locate and borrow the stock before you can sell it short. Most brokerages have an easy-to-borrow list and charge little to nothing for the ability to short stocks on the list. Some stocks, however, are harder to borrow and thus carry a higher charge for borrowing them.

The stock you or I borrow to short a stock usually comes from a margin account of somebody who is long the stock with your broker. Because he bought it on margin, technically the stock belongs to your broker, who earns a fee or commission for lending it to you to sell short.

Another source for borrowed stock comes from large pension and hedge funds who want to be both long the stock and earn a return from lending the stock out to shorts. Lately these institutional investors have realized that it is not in their best interest to lend stock for shorting. The thinking is if they do not lend stock out, it will be harder to borrow stock for shorting; the awful thing is that they're right.

Anecdotally I have noticed my borrowing costs increasing since last week. I have also read that big pension funds like CalSTRS are reigning in their stock loan operations hard. The managers of CalSTRS said they would no longer lend stock to the "piranhas" that stalk the markets' murky waters.

Everyday it gets harder and harder to be a short.


How the AIG Bail Out Saved the Airlines Too

Something that has not been commented on in the press as much as it should have was the fact that the AIG rescue package did far more than just bail out their financial products division. It also kept the aircraft leasing subsidiary of AIG, International Lease Finance Corporation (ILFC), out of receivership. This stopped ILFC's 900 planes from going into the hands of creditors. If this had been allowed to happen, it would have thrown the major airlines' operations into a tailspin. As ILFC leases lots of their planes to the majors, a bankruptcy would have derailed flights worldwide at a time when flight operators cannot afford to lose any revenue.

Wednesday, September 24, 2008

Nobody is Trading... We Are All Watching the Bureaucrats on CNBC

It was to be expected that the volatility might compress in the days after the nonsense we went through last week. Add to this the fact that everyone was watching the extensive coverage of the House Financial Services Committee's questioning of the powers that be. If a second day of politicians not knowing how the hell the economy works (why are they on the committee?) was too much for you, the decision to keep trading might have seemed like a good idea. But sideways trade to nowhere is only a good thing for the market makers. One might have been better served by drinking beer and laughing at hapless congressman.

What I find amazing (other than the amount of useless campaigning that takes place at such a gravely important meeting) was the genuine lack of understanding of the world that surrounds these representatives and their decisions. These congress folk continue to be astounded at the "complexity" of our financial markets, fail to recognize that we have the only government who's borrowing costs DECLINE during a market bust, and completely miss that the fed and treasury want to buy up cheap debt assets which will provide a massive amount of cash flow. This is essentially the greatest carry trade ever. Our government borrows (currently) at less than 1% and buys debt products yielding anything from 6%-12%. Any bank would kill your grandmother to get this kind of positive carry.

Anyone testifying in front of congress about financial matters requires a heaping helping of diplomacy and almost infinite patience. There is, however, one representative who understands the market better than his peers: Rep. Spencer Bachus. This guy typifies the scumbag I was mentioning in my rant below. The representative from Alabama made an estimated $160,000 in short term options trades last year. Now I am not in any way saying that I know this guy had insider information.... but it is extremely difficult for me to believe that this man did not posses material information before any other scrupulous trader or investor who was not a member of congress would have. I'm not a member of the House Financial Services Committee, are you? And I know for SURE that Ben Bernanke and Hank Paulson have never shown up at my house on a sunday night to brief me on anything, let alone the largest bailout in history.


Tuesday, September 23, 2008

Beware Specialization in Those that "Serve" You: What Are They Specializing In?

Most politicians are scum. More than that, they're some of the scummiest scum that ever crawled out of the pond (specifically one in china that serves as a phosphate factory's drainage). This is a little thought exercise to explain why.

First think about how we as individuals evaluate the "quality" of a politician. We see and hear them on television and read what they say on the internet. We are able to evaluate how well they speak, and possibly how well they write (although almost everything said or written by a politician really comes from a professional writer). We hear them talk about their policies and voting records. We hear them say how much they care about us.

So what are we really evaluating? Any American would acknowledge that being well spoken and presentable are admirable and possibly monetarily valuable qualities to have. But does this solely qualify them for office?

We read what they write, but that is written by someone else so that any information we can get from that is complete bull$hit.

We hear what they say about policies, but those are CHOSEN by a team of pollsters and back office types who are paid huge amounts by the parties to get their candidates elected. Policies are designed to maximize constituency and easily changed from season to season. If it is a presidential election year then policy is ephemeral; candidates changing policies from station to station. So any policy metric is out.

Voting records suffer from survivorship bias. Candidates drag out records during elections and use them to trash their opponents. They also trot out their own records when it is advantageous to do so. But sooner or later the election has to end and someone has to win; and when they do their good voting record keeps on getting mentioned (by them) and the bad records stop getting mentioned (because the other guy lost and is out of money). So people see the winner in office (that must mean he's good, lacking any other real information), and only hear good things because that's what the party money machine pumps out... eventually all you hear is good about the winner. He's a saint he is.

So that leaves the quality most of us are qualified to judge is speaking skill. This is the only uncorrupted information that we receive... BUT IT STILL DOESN'T TELL US JACK!

I can train a bird to talk. I would probably rather vote for him.

So this means that if someone specializes at speaking, is possibly manipulative, has a good sales team behind him with good writers, and doesn't get caught banging an underage guy with the deacon in a coke fueled rectory rumpus he's a f$#king shoe in for senator.

Still following? One more step:

So you meet someone on the street for the first time and have to bet: do they care about themselves or you more? Bingo: Themselves.

Is it easier to take an opportunity if it: hurts your friend or someone you don't know? Obviously the person you don't know.

So then in a country of 300 million I am willing to bet good money that there are at least 600 motivated, well-spoken, possibly manipulative, well-funded people who care more about themselves than anyone else and doesn't have a clue who you are. I'm betting that some of them are running for president.

All politicians have to specialize at is being a good speaker. They find the political and economic machinery already in place from years of the two party system. Plug and Play Politics: Simply Add Speeches! Now in new colors and action genders!

Hence politicians are scum. QED


The Market is Scared S%^#less of the Senate... and I Am Too

Watching the senate finance committee grill Bernanke, Paulson, and Cox today most certainly did not make me all warm and fuzzy inside. First of all, the market has tanked ever since Cox and crew led a pogrom against the shorts and forced everyone to buy it all back last friday. You can't make money off that however, because (sorry to belabor the point) they outlawed shorts in financials!!! I thought they banned shorting to manipulate stocks upward. Great job there guys, turning our market upside down just to put the shorts out of business. Now we have prices that mean f$@# all.

Add to this sour mood the image today of the senate finance committee burned into everybody's retina: seemingly BALKING at the rescue plan set forth by the treasury, fed, and sec. On one side of the desk you have the most powerful banker in the world saying that the market cannot recover unless we enact this 700 billion dollar rescue and on the other you have sen. D0dd stumping. GET YOUR F#$KING CAMPAIGN OFF THE TRADING FLOOR YOU DIRTY CRIMINAL. This guy is an idiot anyway: he's from connecticut, which last time I checked was the center of the hedge fund universe. Who does he think this bailout is for? The public? Main Street? This is welfare for the rich, plain and simple.

The fact is if the senate harpoons this deal we don't know what kind of hell will ensue. Its no wonder this market can't hold a bid into the close. Keep in mind that my earlier optimism is completely dependent on government intervention in the markets. Without them we would have a good ol' fashion credit starved depression. The drop would have been spectacular. It could still happen, you just wouldn't be able to short it.

Suppose you are a tax collector and you have two types of people to make money off of: bulls and bears. Would you, while the bulls are getting killed and not paying any taxes, shoot all of the bears in the head? Why NO, because then you would have no tax revenue. Then you would be smarter than our government.


What is Worse: Short Selling or RIGGING THE MARKET?

Consider the following example of Zion Bank Corp (ZION) last friday. At 9:28 it was trading approximately $50. By 10:00 it had printed $108, $46, and everything in between. HOW IS IT BETTER FOR FINANCIAL STABILITY TO HAVE SOMEONE PAY $100 AND THEN WATCH IT GO TO $50. I'm sure more than a few people got absolutely destroyed because of the short sale moratorium. Even more lucky gamblers were bailed out after doubling and quadrupling down on losses. Luckily I was not one of either group, but even so I realize that the market has fundamentally changed from a free market to a rigged one.

The risk factor of a company's political importance has to be brought to the very core of our new market models. Economic reality is shunned in favor of betting on blatant market manipulation.


Why Banning Short Sales Screws Everyone

1) It leads to steeper declines

While it may seem counterintuitive, the people who are buying the most during market declines are people who sold the stock short and are buying it back to cover their positions. While shorts want stocks to go down, they become net buyers during declines because it represents an easy opportunity to book the profit out of a short position. The presence of these short buyers exerts a marginal pressure upwards on the stock price. Without these buyers (because they outlawed shorts on financials), longs who want to sell find less of a willing market to sell into. This means that there is less buy-side liquidity for any given market decline. Thus long sellers have to push the price down further to attract the same amount of buyers as before the ban.

2) It leads to steeper rises and worse buy prices

Normally when the market is presented with a bid that seems too high any participant can sell to that buyer (be it a long sale or short sale). With shorts banned only someone who is already long the stock can sell to this "too high" bid. This is by necessity a smaller number of people than before the ban. Thus for any given rise in price, there are less sellers attracted now than before the ban. Just as the absence of short buyers led to steeper declines and worse prices for sellers, the lack of short sales means that buyers have to push up the price higher to receive the same amount of stock as before the ban. This means that when you buy a financial during an upswing, you are paying more for it than you would if there were short sellers.

3) It causes dislocated prices

Markets are interconnected more than in any time in history. Computer based statistical arbitrage traders push stocks that have nothing to do with each other economically around as though they were competitors. These trades are based off of identifying and enforcing statistical correlations among large portfolios of stocks. A stat arb trader relies on being able to go both long and short at a moments notice. The ban on short sales has thrown a wrench in their trading systems, which leads to crazy price movements as the programs attempt to adjust to the new world order. This has led to extremely dislocated prices since last week: stocks will move points in seconds, effectively establishing two prices for a stock at once. While this has been a bonanza for traders like me, we must all realize that this severely hurts the systemic health of the system: who is going to want to invest when they get completely screwed (by multiple percent) on their price within a few seconds?


PS: while I am aware that banning shorts causes a certain marginal decrease in selling, as a trader I assume that most short selling is done on the way up and not used to pound stocks into oblivion. The only time a short seller can make a stock go down is if there are already an imbalance of long orders to the sell-side. A short seller who tries to single handedly push down a stock will get his face ripped off. Lets face it, shorts are sometimes the ONLY buyers of stock on the way down. They support the market on declines and regulate its exuberance on rips.

An Altogether Appropriate Admonishment

Some Notes on Determinism vs Probability

There is an irresistible force within each human that compels them to find reason in the randomness around them. This is why people come to read blogs like this one: to glean some truth out of the game of deception that is Wall Street. But how we describe events determines how valuable the lessons we learn from today eventually become.

In trading, ways of describing the world come in two forms; there are those that try to provide discrete causal explanations for a particular market event -- this is known as determinism. These explanations are consistent in logic and view each event as a unique combination of forces. The other form -- probability -- takes a different approach, considering each event as the summation of a number of random variables. These probabilistic explanations are less satisfying on the surface. They make no causal claims about today's event, they merely say that there was "a 60% chance of the market rising today given treasury bond yields and what the nikkei did yesterday." Unlike determinism, the probabilistic mind makes no attempt at causality, he merely counts the past and extrapolates into the future, knowing all the while that relationships are bound to change. The probabilist makes use of causation, but not as a one way street. He knows that when oil goes up there is a good chance airlines are going down. But he does not say that airlines went down BECAUSE of oil.

A determinist and a probabilist will view the same event in different ways. Suppose we flipped a coin fifty times without knowing whether the coin was fair or not. If the results show 30 heads and 20 tails the determinist might conclude that the coin was indeed biased to come up heads. Or he might say that there was an error in the flipping method that we used. He has no way to find out the quality of his theory, as it is generated ad hoc to explain the 30 heads. The probabilist will say that if the coin was fair he knows there is a 4.19% chance of getting 30 heads exactly and moreover, we would only get 30 heads or more about 10.1% of the time (see chart). He will do another statistical test and will most likely conclude that he too thinks the coin to be unfair and biased towards heads.

Risk Affine Market Wisdom Cumulative Binomial Distribution with 50 trials @ p = 0.5

If both parties are not allowed to examine the true state of the coin (as is often the case in the market if we replace "coin" with "company") then the two approaches can produce numerous different explanations and not have any real idea which is true. The determinist could say that since he couldn't examine the coin it could be any of his explanations that led to the bias. The probabilist will tell you that on one hand it could happen even if the coin was far, but on the other an outcome with greater than 30 heads would only happen 10% of the time, but on the other hand...

This example should highlight both the usefulness and the pitfalls of using either approach by itself. The solution comes in the form of a judicious combination of the two philosophies and an iterative approach to model building. One must use both models together while using how the models respond to repeated experiments; each time refining the models to reflect new information.

If we further assume that our two coin commentators can repeat the fifty tosses, they can use their combined knowledge to come up with a better explanation of events. Suppose the coins again show a bias with 30 heads and 20 tails. The determinist will be cock sure about his explanation. The probabilist will say that the odds of that happening twice (if unbiased) are 0.16%. He will calculate that the probability of the 30/20 split is maximized when the probability of each coin toss going heads is about 60%. After two experiments, both approaches conclude that the coin is likely biased.

Determinism also provides a useful tool for the imagination of the probabilist, and visa versa. Combing the cannon of possible causal explanations may lead one to examine a relationship that would have never been considered under either approach alone. Likewise, knowing that market participants follow probabilities intensely could lead to a deterministic explanation if the numbers change rapidly.

Through a combination of these two approaches one can overcome a great deal of the downsides inherent in a single strategy. Take this lesson to heart, and always remember that its never as complicated or as simple as it looks.


Monday, September 22, 2008

The Levered Elite

How Government Regulation Robbed Retail Equity Investors of their Right to Borrow and Gave it to the Investment Banks... (who $%^&ed it all up)

After the stock market crash of 1929, the federal government enacted what is known as Regulation T (Reg T), which effectively limited any participants ability to buy stocks on margin (with borrowed money from a broker). Currently you can purchase four times your capital for intraday transactions and two times for interday. Of course, if someone other than your broker handed you a million dollars as a loan for speculation/investment, you could deposit it alongside your personal capital in a brokerage account and still be in compliance with Reg T margin requirements while in effect having much higher leverage. But there isn't anyone lining up to loan you money to speculate. For an investment bank, however, it is a different story...

During normal market conditions, an investment bank usually has loads of people willing to lend it money. Since these lenders are usually investors themselves (not brokers) they are not covered by Reg T and thus the investment bank may use the proceeds of these loans to speculate in equities. As was already mentioned in the moral hazard section of the glossary, this combined with other loose regulation to allow investment banks to buy assets worth 60 to 70 times the value of their capital.

When market conditions turned sour and lenders stopped throwing money at the banks, it was exactly this level of gearing (leverage) that led to such precipitous declines in asset prices. If you buy a stock for cash and it rises 10%, you make 10% on your capital invested. If you're levered up 60 times and the investment rises 10%, you make 600%. The same is true on the downside, however, and being geared up over 50 times means all you need is a 2% move to wipe you out. This is why banks were indiscriminately selling stocks, because they were all levered up way too much to handle anything but rising asset prices across the board. Once intraday traders smelled blood in the water, the forced selling came in earnest as stop after stop was uncovered.

To understand how this epic amount of borrowing was allowed to take place we have to skim the dense surface of a subject known as financial mathematics. This allowed investment banks to calculate a likely amount that they could expect to lose/earn in the event of certain market conditions. This practice is known as the Value-at-Risk (VAR) model. Statisticians make assumptions about a particular asset's distribution of returns in order to predict, for example, how much a bank could lose during a complete market meltdown. Of course if your assumptions turn out to be wrong, your VAR model will be wrong. Why does this matter? Because of the interwoven nature of banking regulation and financial math.

There has been a push since the early nineties to tie how much a bank can borrow to how "risky" its assets are. Lacking any other way of quantifying risk, regulators and practitioners alike have embraced the VAR model. This would all be fine and just if the models actually worked; but they don't. The reason is that the results these mathematical models pump out are HIGHLY DEPENDENT on what data is used to estimate them. The data that banks and regulators used to define risk was from the last thirty years (most of it from the last ten), which was largely a time of uninterrupted credit expansion. The models were thus completely inadequate for predicting what would happen in the event of a liquidity drought. Most models in the literature don't even take into account the idea of liquidity; being a hard to quantify it was simply left out.

If you are looking for someone to blame in this mess, blame the investment banks who hired physicists to run trading desks. I'm not joking. There are entire programs at well respected institutions that make it their business to turn 40 year old engineers into quantitative traders. As a result, people who had never traded a share in their lives were tasked with running billions of dollars. These financial children were given the keys to the family flatbed truck which was then loaded with gold. They were told to drive 200 mph at what they thought was an even bigger pile of money and when they all rolled over at credit crunch curve we act surprised.


Some Notes on Bail Outs, Numbers, and the Long- vs Short-Term

Re: Bail Outs

Last week the Fed organized an $85 billion loan to American International Group (AIG). The loan allows AIG to post collateral against billions in claims from their financial products division. This doomed unit underwrote credit default swaps (CDS's) and other credit derivatives; it has almost single handedly brought down one of the largest insurers in the world. Given the Fed's predilection for stabilization, they had no choice but to extend the loan after the prospects of securing financing through a non-sovereign banking consortium deteriorated yesterday. Letting AIG go into bankruptcy would have been disastrous. To understand why, lets look at how insurers work.

Insurance companies underwrite policies against certain risks occurring. During "good" times, insurers collect premiums, pay out a small percentage of claims, and invest what's left in stocks, bonds and the like. This makes insurers as a group some of the largest investors in the world. AIG is one of the largest of all insurance companies, which means it owns at lot of financial assets.

If AIG had not received the $85 billion loan from the Fed, it would have been forced to start liquidating these assets until it had raised the necessary collateral to cover its derivatives losses. Since the market was already depressed to begin with this easily could have led to an all out rush for the door, with investors selling anything and everything. We saw a shadow of what could have happened last monday and wednesday.

Of course, the Fed is expanding its balance sheet by selling more treasury bills. This would be a problem if foreigners didn't eat our sovereign debt as quickly as the government can print it. But for now it seems the Fed has unlimited scope, especially with the dollar not deteriorating at any real clip Holding short term interest rates firm at 2% (instead of cutting) was perhaps the cause of this dollar strength.

Moreover, investors were so spooked by last wednesday's market action that they drove 3-month treasury bill yields negative. This means that people bid the price of a 3-month T-bill so high that buying it will actually earn you negative interest: YOU PAY THE GOVERNMENT TO LOAN IT MONEY.

The Fed either has the smartest people in the room or the luckiest, and which doesn't matter; I still want to stand next to them. This means that the government, even if yields go positive, is financing this AIG bailout for almost nothing. They are lending to AIG at approximately 12%. This might very well be the best trade in history. That's a positive carry of .12 * $85 billion = $10.2 billion per year. If AIG defaults the government will repossess one of the best property-casualty insurers in the world.

As former fed governor Wayne Angell said last week: "THE FED'S BALANCE SHEET IS INFINITE." This is especially true now that investors don't even demand interest to loan our government money...

Re: Numbers

It always amazes me the double reversals that can take place after numbers. Take the price of oil last wednesday after the 10:35am announcement of inventory data, which traded immediately down reversing an earlier gain, only to reverse again throughout the rest of the day; it was even so bold as to make a new high. The same thing happened last tuesday in the S&P 500 after the Fed rate decision was announced at 2:15pm. The market immediately tanked, only to spend the rest of the day going higher.

It has been my experience that opposing the knee-jerk reactions people have after numbers is the closest thing to a free lunch in this market.

Re: Long- vs Short-Term

Finally I want to stress the importance of planning long term and living short term. Planning long term goals and thinking about where the world is headed are noble pursuits, and it can bring us comfort to feel that we know where we're going. But we must remember
the Keynes quip that "in the long run, we're all dead," in addition to the fact that the short term can bankrupt you well before the long term saves you.
This doesn't mean you should ignore the long term, far from it, only that you should always be aware that in a market like this (especially if you are
using leverage) you must always be containing your short term losses. The moves have been so volatile
that you could be completely right long term, but blow out your equity waiting for it to happen. In this market it is best to dump any position that isn't going your way immediately and wait for a clean move that you nail from the beginning. In a market where there exists so much opportunity, there is no point in sticking to a bad trade and wasting your money.


Our Market is Actively Manipulated by the Government, Relax...

It strikes me that despite the current mood of death and despair that stalks the market, we should all wake up and smell the negative real interest rates! So let's lever-up, get LONG, and quit all this belly-aching about a "credit crisis." The government just bailed out the debt holders which means credit and moral hazard will rain from the sky, eventually. So while prices are getting smashed I will lever up and buy.

The dollar has been rallying to its high against currencies far and wide. This means despite the losses we feel so acutely in this country, foreigners who bought at the lows are still making dough. So blow out the trade gap, and give them all the cash, because our people can print more of it just as fast. Pump it into their banks and strengthen trade ties, they all have to buy our debt not to let their currencies rise. Thus they will lend it right back to us and we will do it all again, and I will multiply my position by ten.

Remember Rothschild: "Buy when there is blood in the streets." I will go further. Wait 'til it runs into the Hudson, the Thames, the Rhine. That's when you will know it is time. But it is when the bounce has started in earnest that you must push your credit furthest and watch asset prices soar higher than the burj dubai.

But when bank profits wax fat and real estate agents are telling YOU to buy this stock and that, this is the time to pull your position back. Cash in and check out, buy some puts if you must-o... because trying to short the top is an easy path to bust-o.