Author: James Kwak

Mysterious Facebook Problems

By James Kwak

Sometime this morning all of the links from our Facebook page back to the blog stopped working. According to Facebook, “Facebook users” had identified the page as being “abusive.” I didn’t find out until this evening, when a reader emailed me. (I don’t spend a lot of time on Facebook.) When the problem started, it also applied to all of the older links from Facebook to the blog. The problem did not seem to affect links from the Facebook page to 13bankers.com.

Then, in the last half our, the problem went away, and now all the links work.

I have no idea what happened. For background, this is what usually happens. New posts on this blog go into the RSS feed. That feed gets polled periodically by Twitterfeed, which takes the title of the post and the URL (compressed using bit.ly*), appends “#fb”, and creates a new tweet from our Twitter account. (The 13bankers.com feed gets treated the exact same way.) Then the Selective Tweets application for Facebook monitors our Twitter feed; whenever it sees a tweet that ends with “#fb”, it posts it to the Baseline Scenario fan page in Facebook.**

The fact that the links to 13bankers.com continued to work seems to absolve Twitterfeed, bit.ly, and Selective Tweets. However, I have enough software experience to know that things are not necessarily that simple.

So the possibilities seem to be:

  1. Facebook doesn’t like bit.ly — doubtful.
  2. Facebook doesn’t like anything being promoted by Selective Tweets, as suggested by one commenter — quite possible. This could be a flaky problem, meaning it comes and goes.  (It does seem like the problem appeared briefly on April 23 as well.)
  3. Facebook has some kind of algorithm that says, “if the same site gets posted too many times using something that looks like an automatic process, it’s probably spam.” But this seems doubtful, since we are far from the biggest blog that auto-posts to Facebook.
  4. A bunch of pro-Wall Street activists (are there such people? aren’t they called “lobbyists”?) figured out how to report to Facebook that baselinescenario.com is really a religious cult indoctrination site, and therefore someone at Facebook (or some program) shut off access to the site.

If anyone knows, or has better theories, please comment. If it happens again, someone please email us at baselinescenario at gmail dot com.

(Incidentally, ours is not the first blog this has happened to. This happened to Cake Wrecks, a blog that highlights really, really bad cakes.)

* Actually, I told Twitterfeed to use Snip instead of bit.ly, but for some reason it’s using bit.ly. But it’s been using bit.ly since long before this problem started.

** I don’t use the main Twitter app for Facebook because, at the time I was setting this up, it didn’t allow you to post your tweets onto a fan page, only onto your personal Facebook page.

Download the Blog – New and Improved!

By James Kwak

I finally came up with a better way to create a downloadable blog archive (always available via the “Download the Blog in PDF” link under Navigation in the right-hand sidebar). Now the archive is up to date (through April 2010) and you can download it in PDF, Kindle, or EPUB format. And it has clickable bookmarks for each individual post.

Thanks go to Joss Winn, Martin Hawksey, Feedbooks, and Yahoo! Pipes. See the archive page itself for a technical description.

Why Do Harvard Kids Head to Wall Street?

By James Kwak

That’s the title of a post a couple weeks ago by Ezra Klein, in which he interviewed a friend of his who went to Wall Street after Harvard. Having seen this phenomenon from a couple of different angles, I’d say the interview is right on. This is how Klein summarizes the central theme:

“The impression of the Ivy-to-Wall Street pipeline is that it’s all about the money. You’re saying that it’s actually more that Wall Street has constructed a very intelligent recruiting program that speaks to the anxieties of the students and makes them an offer that there’s almost no reason to refuse.”

When I graduated from college, I had no interest in investment banking or its close cousin, management consulting. But I went to McKinsey for reasons that were only slightly different than those of the typical Ivy League undergrad; after getting a Ph.D. in history, I discovered that I was unlikely to get a good academic job and was pretty much unqualified for anything else, and McKinsey was one of the few places that would hire me into a “good” job with no discernible qualifications (other than academic pedigree). Now that I’m at Yale Law School, where maybe 15% of students (my wild guess) come in wanting to be corporate lawyers but 75% end up at corporate law firms (first job after law school, not counting clerkships), I’m seeing it again.

Continue reading “Why Do Harvard Kids Head to Wall Street?” →

Who’s Got Those Pitchforks?

By James Kwak

The Huffington Post Books section is hosting a discussion of 13 Bankers; there are links to all the posts so far here. Mike Konczal, usually of Rortybomb, weighed in with a post that included this chart:

People from the 90th to the 95th percentile make about 11% of total income; people from the 95th to the 99th percentile make about 15%; and people in the top percentile make about 23% (in 2006, presumably). But mainly, look at the way that black line shoots up relative to the others since 1980 (along with financial sector profits and per-employee banking compensation).

Continue reading “Who’s Got Those Pitchforks?” →

The Role of Government

By James Kwak

Last week Simon gave a talk sponsored by Larry Lessig’s center at Harvard. Afterward there was a dinner and then another question-and-answer session. Jedediah Purdy (another person to write a book while at Yale  Law School; he is now a professor at Duke’s law school) asked a question that I have rephrased as follows (the words are mine, not Purdy’s; I may have also distorted his original question so much that it is also mine):

“You’ve criticized the government for withdrawing from the economic and particularly financial sphere and allowing private sector actors to do whatever they wanted. Do you think the government should simply act so as to correct the imperfections in free markets? Or do you see a positive role for government in determining what kind of an economy we should have?”

Continue reading “The Role of Government” →

Update on ABACUS

Read the “synthetic, synthetic CDO” post first if you haven’t already.

The reasonable counterargument, for example here, is that because these are derivatives, there logically speaking must have been someone on the other side of the trade from the buyers, and the buyers should have known that — who that is doesn’t need to be disclosed. I think this is true to a degree, but not to the degree that Goldman needs it to be true.

Take an ordinary synthetic CDO. Back in 2005-2006, a bank might create one of these because it knows there is demand on the buy side for higher-yielding (than Treasuries) AAA assets. To do this, the CDO has to sell CDS protection on its reference portfolio to someone. That someone could in the first instance be the bank. But then the bank’s “short” position goes into its huge portfolio of CDS, which may overall be long or short the class of securities (say, subprime mortgage-backed securities) involved.The bank is constantly hedging that portfolio via individual transactions with other clients or other dealers, so there’s no one-to-one correspondence between the long side of the new CDO and any specific party or parties on the short side.

Let’s say for the sake of argument that the bank, prior to the new CDO, was exactly neutral on this market. The new CDO makes it a little bit short. So the bank will go out and hedge its position by finding someone else to lay the short position onto. But first of all, there’s a good chance it will divide up the short position and hedge pieces of it with different people. Those people may be buying the short position not because they want the subprime market to collapse; they might be partially hedging their own long positions in that market. Second, there’s an even better chance that it won’t sell off exactly the short position it just picked up from the CDO; it will buy CDS protection on a bunch of RMBS that are similar to the ones it just sold CDS protection on (which ones will depend on what the market is interested in), so in aggregate it comes out more or less the same.

So ultimately the “short” side of the CDO gets dispersed between the bank’s existing CDS portfolio and the broader market. So yes, there must be a short interest out there that is exactly equivalent to the long interest. But there doesn’t have to be a party or even an identifiable set of parties who have exactly the short side of the new CDO and want it to collapse, let alone a party that helped structure the CDO because it wanted to be on the short side. There’s a big difference between the market as a whole and one hedge fund.

Now, are things different with a synthetic synthetic CDO, as I have called it? Maybe. The pro-Goldman argument would be that ABACUS was so highly structured — basically, each tranche was a single complex derivative with a long side and a short side — that the long investors must have realized that there was a single party, or a small number of parties, on the other side. But that doesn’t necessarily hold. Just like a synthetic CDO, Goldman could have whipped this thing together because it thought it could sell it, and Goldman could have planned to hedge it the usual way — partially with its inventory and partially through a lot of small transactions dispersed throughout the market.

As always, I draw on Steve Randy Waldman.

ABACUS: A Synthetic, Synthetic CDO

By James Kwak

I actually suspected this, but I haven’t had the time to look at the marketing documents. But thankfully Steve Randy Waldman did. I don’t think I can improve on his description — these things take hundreds of words — but here’s a quick summary.

An ordinary CDO is a new entity that raises money by issuing bonds in tranches, uses the money to buy some other bonds (say, residential mortgage-backed securities) and uses the cash flows from those bonds to pay off its own bonds.

A synthetic CDO is similar except instead of buying the underlying bonds, it sells credit default swap protection on those bonds (the reference portfolio) and uses the premiums from the CDS to pay off its own bonds. (The money it raises by selling those bonds is usually parked in low-risk securities so it is available to pay off the CDS if necessary.)

ABACUS was different. There was a reference portfolio. But instead of selling CDS protection on all of those bonds, Goldman said (to paraphrase), “Imagine we sold CDS protection on all of those bonds. Then imagine we used those CDS premiums to issue bonds in tranches A-1, A-2, B, C, D, and FL. The derivative I’m selling you is one that will behave exactly as if it were an A-1  (or A-2) bond in that scenario — even though we’re not actually selling all of the tranches.”

Continue reading “ABACUS: A Synthetic, Synthetic CDO” →

Rewarding Teacher Performance? Resist the Temptation to “Race to Nowhere”

This guest post is contributed by Kathryn McDermott and Lisa Keller. McDermott is Associate Professor of Education and Public Policy and Keller is Assistant Professor in the Research and Evaluation Methods Program, both at the University of Massachusetts, Amherst.

On March 29, the U.S. Department of Education announced that Delaware and Tennessee were the first two states to win funding in the “Race to the Top” grant competition.  A key part of the reason why these two states won was their experience with “growth modeling” of student progress measured by standardized test scores, and their plans for incorporating the growth data into evaluation of teachers.  The Department of Education has $3.4 billion remaining in the Race to the Top fund, and other states are now scrutinizing reviewer feedback on their applications and trying to learn from Delaware’s and Tennessee’s successful applications as they strive to win funds in the next round.

One of the Department’s priorities is to link teachers’ pay to their students’ performance; indeed, states with laws that forbid using student test scores in this way lost points in the Race to the Top competition.  A few months ago, James pointed out some of the general flaws in the pay-for-performance logic; here, our goal is to raise general awareness of some statistical issues that are specific to using test scores to evaluate teachers’ performance.

Using students’ test scores to evaluate their teachers’ performance is a core component of both Delaware’s and Tennessee’s Race to the Top applications.  The logic seems unassailable: everybody knows that some teachers are more effective than others, and there should be some way of rewarding this effectiveness.  Because students take many more state-mandated tests now than they used to, it seems logical that there should be some way of using those test scores to make the kind of effectiveness judgments that currently get made informally, on less scientific grounds.

The problem is that even if you accept the assumption that standardized tests convey useful information about what students have learned (which we both do, in general), measuring the performance gains (or losses) of students in a particular classroom is far more complicated than subtracting the students’ September test scores from their June test scores and averaging out the gains.  We’re concentrating on the statistical issues here; there are other obvious challenges in test-based evaluation, such as what to do for teachers who teach grade levels where students do not take tests and/or subjects without standardized tests.

Continue reading “Rewarding Teacher Performance? Resist the Temptation to “Race to Nowhere”” →

What Did Robert Rubin Think About Derivatives?

By James Kwak

First Bill Clinton said he got bad advice from Robert Rubin on derivatives. Then a Clinton adviser issued a statement essentially taking it back and blaming Alan Greenspan. (Jennifer Taub discussed some of the substantive issues on this blog.) Dan Froomkin asked Rubin, who said, “I thought we should regulate derivatives; I thought so when I was at Goldman Sachs and I thought so afterwards.” But Froomkin points out that Rubin was part of the team that suppressed Brooksley Born’s attempt to regulate derivatives back in 1998.

Brad DeLong defends Rubin, although it seems like a somewhat lukewarm defense. DeLong’s point #3 is: “Brooksley Born and her organization are the wrong people to regulate derivatives.” (That’s a statement of Rubin”s thinking at the time.)  Norman Carleton, a Treasury official at the time, also defends Rubin with two posts on his blog that spell out DeLong’s point #3. In the first post, he says that Rubin favored regulation but was concerned with giving the CFTC jurisdiction over the OTC derivatives market. In the second, he explains the issue (legal certainty of existing contracts, something I don’t really want to get into here, so go read the argument there) and concludes with this logically plausible but somewhat bizarre argument:

“Rubin had proposed to Born that, instead of the CFTC asking questions about the need for regulation of the OTC derivatives market, the President’s Working Group on Financial Markets issue the questions.  Born point blank refused this suggestion, thus pushing Rubin into Greenspan’s camp, much to the relief of ISDA and other Wall Street groups lobbying on this issue.  They knew they had a problem with Rubin.

“Brooksley Born was so sure she was right in her legal position that she could not compromise in face of the practical and political realities.  While, not to make too fine a point about it, she has been proven right and Greenspan wrong about the dangers of the OTC derivatives market, Greenspan was the better politician.  History might have been different if Born had agreed to Rubin’s suggestion.”

Continue reading “What Did Robert Rubin Think About Derivatives?” →

The Best Thing I Have Read on SEC-Goldman (So Far)

By James Kwak

Actually, two things, both by Steve Randy Waldman.

Part of Goldman’s defense is that it was in the nature of CDOs for there to be a long side and a short side, and the investors on the long side (the ones who bought the bonds issued by the CDO) must have known that there was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does. Since a synthetic CDO by construction mimics the characteristics of a non-synthetic CDO, the same thing holds. (While the credit default swaps that go into constructing the synthetic CDO have long and short sides, the CDO itself doesn’t have to.) Here’s the conclusion:

“Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading ‘against’ short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors.”

Waldman follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its own fee). The point here is that Goldman could have simply put Paulson and the buy-side investors together and had Paulson buy CDS on RMBS directly — but that would have affected the price of the deal, because Paulson wanted to take a big short position. So instead, they created the CDO (a new entity) and then drummed up buyers for it, in order to avoid moving the market against Paulson. The advantage of thinking about it this way is it shows what the function of a market maker is and how that differs from the role Goldman played in this transaction.

The posts are long, so sit back and enjoy.

Update: Nemo points out that I misinterpreted Waldman’s post, and Nemo is right, although I think I got the substance of Waldman’s point right. Here is what Waldman says:

“There is always a payer and a payee, and the payee is ‘long’ certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. . . . The existence of a long side and a short side need imply no disagreement whatsoever.”

So I was clearly wrong when I said, “a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does.”

But — and I don’t think I’m engaging in sophistry here — Waldman’s underlying point is that even though there is a short position, that doesn’t mean that the long and short investors have diametrically opposed interests. That’s true of stocks, and it’s also true of CDOs. And so it’s disingenuous of Goldman to imply that buyers of any CDO always know that there is someone who is actively betting on it to go down in value.

Clinton Confesses: Rubin and Summers Gave Bad (strike that) Excellent Advice on Derivatives

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here).  Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.

What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.

Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).

Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.

Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”

Continue reading “Clinton Confesses: Rubin and Summers Gave Bad (strike that) Excellent Advice on Derivatives” →

The Discount Rate Mismatch

. . . or, how finance is like quantum mechanics.

This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.

Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk.  We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight.  Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . .  In fact you’ve probably never even heard of it, and neither have I.

What is the Discount Rate Mismatch?

It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments.  And by investors, I do not just mean individual retail investors or hedge funds.  I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.

It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals.  This strategy sometimes works.  And, sometimes, it does not – as Orange County well remembers.

Continue reading “The Discount Rate Mismatch” →

SEC Charges Goldman with Fraud

By James Kwak

Press release here. Complaint here. The allegation is that Goldman failed to disclose the role that John Paulson’s hedge fund played in selecting residential mortgage-backed securities that went into a CDO created by Goldman. Here’s paragraph 3 of the complaint:

“In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)

Continue reading “SEC Charges Goldman with Fraud” →

We’re Big . . . and We’re Connected

By James Kwak

MBIA, the big bond insurer, is actually headquartered in Armonk, New York, about forty miles from Wall Street, and it’s not quite one of the swaggering elite. But it plays its own crucial role in the financial system, insuring municipal bonds as part of a tight oligopoly. Then it recently expanded into writing credit default swaps on mortgage-backed securities and collateralized debt obligations, raking in profits during the boom while loading up on exposures that would almost kill it during the financial crisis.

But when it comes to attitude, MBIA wanted to be every bit the financial oligarch. Bloomberg has an excerpt from Christine Richard’s upcoming Confidence Game, which tells the story of hedge fund manager Bill Ackman’s short position on MBIA. (Here’s a previous Bloomberg story on the topic.) There isn’t much in the excerpt, but there is this choice quote from MBIA CEO Jay Brown, as recalled by Ackman:

“You’re a young guy, early in your career. You should think long and hard before issuing the report. We are the largest guarantor of New York state and New York city bonds. In fact, we’re the largest guarantor of municipal debt in the country. Let’s put it this way: We have friends in high places.”

(The next year, New York attorney general Eliot Spitzer began investigating Ackman for market manipulation, but Ackman was never charged with anything.) It doesn’t get much more clear than that.

(Disclosure: I knew Bill Ackman a long, long time ago. We took calculus together in high school; I was a sophomore and he was a senior. And I vaguely recall helping him with it. Nice guy. Yes, he had gray hair in high school.)