Author: Felix Salmon

Courtney Comstock is absolutely right when she runs a story under the headline “You Know It’s Over When Esquire Magazine Is Telling Its Readers How To Invest In Gold Funds”. In a spectacularly silly article, Esquire’s Ken Kurson extolls the virtues of buying gold-denominated hedge funds, on the grounds that if the hedge fund doubles and gold doubles, then you’ll end up quadrupling your money! Genius.

But to appreciate the fuller expression of Kurson’s genius, it’s worth flicking through his archives. There’s the 2006 article where he says that everybody should invest in credit default swaps, specifically by buying stock in a company called GFI Group:

A few days after its January 2005 IPO, I bought a few hundred GFI shares (GFIG on Nasdaq) for just under 26, and I have since added a couple thousand, picking up more each time the stock dips below 50. (I should mention that GFI’s CEO, Mickey Gooch, has become a friend of mine.) In addition to my belief that this stock could very well become a tenbagger within ten years, there’s something very appealing about investing not just in a company but in a whole new industry.

Today, GFI Group is trading at $4.43 per share. Yes, that’s in the wake of a 4-for-1 stock split, but it’s still well below its IPO price, and Kurson, if he didn’t sell at the top of the market, is now sitting on substantial losses. Of course, that’s the problem with 99% of investment advice, not just Kurson’s: these people are very happy to tell you what to buy and when to buy it (now), but never tell you when you should exit your position.

Kurson also reckoned that the automakers were a screaming buy in 2005, saying that “GM is moving with stunning speed to address what ails its business, and that “the United States government will not allow Ford or General Motors to default on its debt”. How did that trade work out for you, Ken?

But if Kurson is not very good at telling you what to buy, maybe he’s good at telling you what to sell. Let’s see:

An investor should short as many shares of Apple as he can possibly borrow…

I’m short a bunch of AAPL at $65.

Oh well, never mind.

So when Kurson says that “$20,000 will barely buy in five years what $10,000 buys today”, it’s worth reading that in the context of his past predictions. And maybe staying away from the gold-denominated Superfund.

Has Illinois’s Kevin Joyce been reading Andrew Clavell? There’s something quite elegant in its simplicity about this:

Illinois is considering a bill to avoid derivatives abuse by public pension funds, Pensions & Investments reports. The bill, which is under discussion at the Illinois House Rules Committee, will restrict the state’s public pension funds from investments that trade derivatives in non-public markets.

In reality, it’s not the pension funds which are engaging in “derivatives abuse”, but rather the investment bankers who sell the pension funds complex over-the-counter derivatives which make the broker lots of money and which rarely do any good for the end client. As Clavell says,

Let’s assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense…

Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The really elegant part of this bill is that it allows investments in traded derivatives, and therefore gives the sell-side an incentive to find tradable alternatives to their beloved OTC derivatives. If a large chunk of the buy-side adopts this kind of policy, we could achieve by market forces the move to derivatives exchanges which is proving so hard to legislate.

In all the bellyaching about the governance of the biggest banks, and the fact that their boards were spectacularly unqualified to provide any kind of oversight of what they were doing, Goldman Sachs has gone largely unmentioned. But what’s true of Merrill Lynch and Bank of America is true of Goldman too: its executives need some kind of adult supervision, seeing as how they work for their shareholders, rather than just for themselves.

Yet this interview with one Goldman board member, Ruth Simmons, hardly instills in me the confidence that she can or will understand what Goldman is doing, stop them from acting in a reckless manner, or keep a close eye on compensation as she wears her hat as a member of the compensation committee:

Simmons said she originally joined Goldman’s board at the recommendation of Smith’s Board of Trustees around the time that she started a center for financial literacy on campus.

“We had a big push to think about how we could improve the knowledge and ability of women to manage their financial affairs,” she said. “At the same time, there was a good deal of interest in the fact that women have not done so well in the financial sector and on Wall Street.”

Simmons has moved on from Smith, and is now the president of Brown University. But of all the reasons to join the Goldman Sachs board of directors, improving the ability of women to manage their financial affairs has got to be one of the worst: that’s simply not something that Goldman board members do. Instead, they’re meant to represent Goldman’s shareholders and oversee Goldman’s management.

But rather than bring any kind of financial or economic expertise to bear on her job, it seems that Simmons was happy to simply sit back and receive the gift of wisdom in such matters from the Squid:

Simmons said her service on Goldman’s board gave her the economic savvy to take certain risks that she might not have taken otherwise, such as the introduction of need-blind admissions.

This seems to me to be both an admission that she was lacking in economic savvy when she joined the board, and an admission that being on the Goldman board made her more prone to taking financial and economic risks than she was before. Is this really the kind of person that Goldman’s shareholders want representing their interests as an overseer of management?

There’s no indication in the interview that Simmons takes her fiduciary responsibilities to Goldman’s shareholders particularly seriously; instead, there’s a great deal of talk about the effect of the directorship on her and on Brown, not to mention a fair amount of standard-issue ass-covering:

“There are lots of things in a complex institution that go on,” she said. “You’re not in charge of everything that your friends do and every policy that organizations that you’re affiliated with issue.”

It seems to me that the days when Goldman Sachs could fill its board with these standard corporate board types — the college president, the management consultant, the business-school professor, even the long-time chairman and CEO of Fannie Mae — have surely come to an end. It’s made a stab at beginning to reform its compensation practices, and I’m quite sure that’s entirely a decision of management rather than of the compensation committee. Next up, it should get to work on the board, appointing people who will look hard at managerial business decisions, and won’t allow themselves to be snowed by Lloyd. Indeed, he should welcome the extra set of eyes and a few tough questions: it’s good, in his position, to be forced to know what you’re doing and be on your toes.

Faisal Islam does a great job explaining the problems facing Greece, and why Germany is likely to come up with some kind of bailout:

This so-called ‘ouzo crisis’ has emerged from a witches’ brew of concern about 1 Greece’s shaky political economy, including dodgy statistics and historic default record, 2 the short term nature of Greece’s debts and 3 the fact that a large proportion of its creditors are easily-spooked foreign investors…

It would be a total humiliation if this problem could not be sorted out within the single currency area. Besides, what will the IMF tell Greece to do with its currency, which is controlled by the ECB in Frankfurt? So the IMF is not going to happen.

So all along we have been waiting for the point at which the possible systemic damage, the contagion to the other countries would be so acute, that Germany and France would step in. We are here now.

Will Greece be giving up fiscal independence in return for bailout funds or German guarantees? I’m sure it’ll agree to stringent conditions, while claiming that it would have kept to such a plan in any case. The question is what happens when — inevitably — it ends up breaking its fiscal promises, or trying to play silly games to get around them. What will Germany be able to do, in that case, to snap Greece back into line? And do the Germans really want to play the role of Europe’s fiscal disciplinarian in any event?

It probably doesn’t matter: Greece is the Bear Stearns of Europe, seemingly too big to be allowed to falter or default, and therefore it must be bailed out somehow. Of course this sets an important precedent for when Spain and/or Italy find themselves in a similar situation — and it’s likely to make countries like Latvia feel a bit miffed, seeing how much fiscal pain they’ve inflicted on themselves with no bailout to show for it at all. The hazard here is that countries, seeing the Greek precedent, refuse to take tough fiscal steps unless the path is sweetened by Germany and France. This isn’t the end of the euro crisis: it’s only the beginning.

What’s happened to the FT’s online subscription rates? Leigh Caldwell was paying £6.12 per month last December, but then his debit card expired, he lost his FT.com access, and he went back to the site to renew. When he got there, he found that the renewal rate he was offered was more than double what he was paying before: £12.98 per month, for “premium” access.

Since Leigh doesn’t need premium access, he tried to see how much a regular non-premium subscription would cost — and found that it was even more, at £17.50 per month. And the rack rate for the premium online subscription is now £25.99 per month — that’s over $40 a month, or $486 a year. That’s a very large sum to spend on a website subscription.

Given that there doesn’t seem to be a cheaper option, Leigh’s going for the £12.98 deal, at least for the time being; it does at least have the advantage of being only half what other people are being charged. At $20 per month, it’s not an excessive price for a business product. But it does seem as though the FT is orchestrating things so that as many subscribers as possible end up getting the “premium” product — which nominally costs more, but doesn’t always do so in reality. That’s a great way of making people think that they’re getting something really valuable by having access to the Lex column, without depriving Lex of the readers it wants and needs.

That’s two in as many weeks, I think: first Abnormal Returns was bought by StockTwits, and now Footnoted has been bought by Morningstar.

Both of these operations are small, fundamentally one-person shops: bloggy labors of love which have now become part of something much bigger and much more corporate. That’s great news for the founders, who get an up-front payday (my guess is a reasonably modest one in both cases), and, much more importantly, a steady paycheck, health insurance, and corporate support to help grow the site moving forwards.

From the point of view of the corporations concerned, this kind of deal makes a lot of sense as well. Many companies try to build their own blogs, or hire their own bloggers; those franchises can find it very difficult to gain traction in a noisy and fragmented online marketplace of ideas. By contrast, if you simply acquire the cream of the existing crop, you know that you’re getting a first-rate, hard-working blogger who has already achieved exactly what you want and who is truly dedicated to their own blog and what it stands for.

For a long time, when people have asked me how they can become a professional blogger, I’ve told them that by far the best way to do so is to start out as an amateur blogger, just doing it for yourself, and then get picked up by a bigger company. But now there’s all the more reason to go that route: rather than just getting a job offer to do a job created by someone else, you might even end up with an acquisition offer to keep on doing what you’ve loved to do all along.

There’s one more interesting twist to the Footnoted acquisition: it’s one of that very rare breed of successful blogs (Freakonomics being another) which started as a book tie-in and then grew into a valuable online property in its own right. Michelle Leder started Footnoted as a way of publicizing her book; I’m sure she never dreamed, back in 2003, that it would end up being bought by a huge company like Morningstar. Congratulations to her and to Tadas, and here’s hoping that we see many more deals like this going forwards.

Beat Balzli has an intriguing story at Spiegel saying that Greece has been hiding the true nature of its deficits and its debt using clever derivatives dreamed up by Goldman Sachs. I believe it, although the details are sparse:

Greece’s debt managers agreed a huge deal with the savvy bankers of US investment bank Goldman Sachs at the start of 2002. The deal involved so-called cross-currency swaps in which government debt issued in dollars and yen was swapped for euro debt for a certain period — to be exchanged back into the original currencies at a later date.

Such transactions are part of normal government refinancing. Europe’s governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.

But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks.

This credit disguised as a swap didn’t show up in the Greek debt statistics. Eurostat’s reporting rules don’t comprehensively record transactions involving financial derivatives. “The Maastricht rules can be circumvented quite legally through swaps,” says a German derivatives dealer.

According to Balzli, Goldman has no risk on this deal, after selling the swap to a Greek bank in 2005.

How might a deal like this work? Let’s say that Greece issues a bond for $10 billion, which it would then normally swap into euros at the prevailing interest rate, getting $10 billion worth of euros up front. In this case, it seems, the swap was tweaked so that Greece got $11 billion worth of euros up front — and, of course, has to pay just as many euros back when the bond matures. Essentially, it has borrowed $11 billion rather than $10 billion. But for the purposes of Greece’s official debt statistics, it has borrowed only $10 billion: the extra $1 billion is hidden in the swap.

This wouldn’t be the first time that Goldman came up with a clever capital-markets deal to help a European country get around the Maastricht rules: as far back as 2004, Goldman put together something called Aries Vermoegensverwaltungs for Germany, in which Germany essentially borrowed money at much higher than market rates just so that the borrowing wouldn’t show up in the official statistics. And according to Balzli, Italy has been doing something almost identical to the Greek swap operation, using a different, unnamed, bank.

It’s a bit depressing that EU member states are behaving in this silly way, refusing to come clean on their real finances. But so long as they’re providing the demand for clever capital-markets operations like these, you can be sure that the investment bankers at Goldman and many other investment banks will be lining up to show them ways of hiding reality from Eurostat in Luxembourg.

If I may put on my hat as Reuters Blog Ambassador for a minute (really, it says that on my business card), I’d like to congratulate the urbane and loquacious Lucas van Praag for finally jumping into the blogosphere.

A blog entry is pretty much the perfect medium for reacting to a story in the press: you can link to the story in question, quote various bits, and respond to them at whatever length you like. What’s more, from a PR person’s perspective, a blog entry is unfiltered: you don’t have to rely on partisan journalists to communicate what you’re saying in an accurate manner.

Responding via blog is a much better idea than responding via email, as say Citigroup did to my post yesterday on their end-of-the-world insurance. (And in fact I only got the email because I’m in England right now and wasn’t in the Reuters office to take Alex Samuelson’s phone call.) While I’m the kind of blogger who will always append such things to the blog entry in question, not all bloggers do that, and almost no newspapers will semi-automatically give the subject of their articles an unedited right of reply at the bottom of the article itself. What’s more, if you set up your own blog somewhere, then all your responses can be found in one place. (Memo to Goldman: Do make sure you archive all these blog entries at gs.com, rather than just having them up at HuffPo.)

What Lucas did is very smart, then, and I like how he did it as well. For instance:

NYT assertion: “Perhaps the most intriguing aspect of the relationship between Goldman and AIG was that without the insurer to provide credit insurance, the investment banks could not have generated some of its enormous profits betting against the mortgage market. And when the market went south, AIG became its biggest casualty — and Goldman became one of the biggest beneficiaries.”

The facts: As we’ve already said, we were far from the biggest beneficiaries of the mortgage market’s decline. Through prudent hedging, we limited our losses, rather than generating “enormous profits.” AIG was only one of many counterparties with whom we had hedging arrangements.

This more or less speaks for itself, I think. Goldman didn’t make enormous profits in 2008, and it didn’t make enormous profits in mortgages, either. In fact, it made a loss on mortgages, but managed to mitigate that loss by hedging its position with AIG and others. Yes, the short side of the hedge made lots of money, but the fact is that Goldman would never have put on such a large hedge if it didn’t already have an equally large long position in the market. So ignoring the long side of Goldman’s book while concentrating only on the short side is rather disingenuous.

There is an entirely separate question, of course, surrounding the counterparty risk exposure which Goldman had to AIG: Goldman says it fully hedged that counterparty risk, while no one else really believes them or considers such a hedge possible. But that’s not what the NYT is talking about here.

Interestingly, Lucas doesn’t respond to what I think is the heart of the piece: the idea that Goldman managed to exit its short position, thanks to the US government, right at the bottom of the market, thereby maximizing the loss to taxpayers. Maybe he’ll talk about that in his next blog entry.

I’ve been banging on for a while that one key cause of the crisis was the tax-deductibility of interest payments, and the incentive that allows companies to finance themselves with dangerous debt rather than safer equity. But I didn’t realize it was this bad. Pete Davis finds this table in an October 2005 CBO report, at the height of the debt bubble:

It really is as bad as that: companies financing themselves with equity pay an effective tax rate of 36%, while companies choosing debt pay a negative tax rate of 6.4%. How is that even possible? The CBO report explains:

The effective tax rate on debt-financed corporate capital income is negative in part because accelerated depreciation and interest payments generate tax deductions in excess of taxable income, which leads to corporate tax refunds. Taxes paid by savers on interest received do not entirely offset those refunds; again, much of that interest income is received in various accounts in which it is not taxed.

In other words, companies lever themselves up so much that their interest payments are larger than their income, and so they get tax refunds and pay no corporate income tax. This can’t be healthy. And, sadly, it’s not going to change, either, Paul Volcker notwithstanding.

Marco Annunziata has a diagnosis of what ails the PIGS:

Germany has been relying on an export-led growth strategy: With virtually no wage growth over several years, it has rapidly gained competitiveness against most of its European partners, running a substantial current account surplus, which stood at 6.5% of GDP in 2008. As two-thirds of German exports go to other EU countries, it is not surprising that some of them ended up with huge external deficits. With a sharp rebound in international trade now leading the global recovery, Germany sees no reason to change strategy. But Europe, like the U.S., is a relatively closed economy—the bulk of growth for the area as a whole has to be generated by domestic investment and consumption. If Germany continues to compress wages and hence consumption, there are only two possibilities: Either other euro zone members follow suit, in which case the continent will stagnate, or they lose competitiveness, in which case imbalances will be exacerbated. It may seem absurd to suggest that Germany should somehow favor more generous wage dynamics, thereby losing competitiveness, but the alternative at this stage is an unpalatable choice between sustainable stagnation and destabilizing imbalances.

I think that Annunziata has the effects right here, but I do take some issue with his identification of the causes. Yes, Germany is growing through exports, and yes, those exports are mainly to the rest of the EU, and yes, that strategy is succeeding for Germany, if not for the rest of Europe. But no, I don’t think that the key variable here is wages.

It’s true that German wages have not risen over the past few years, but I don’t think that lower wage inflation is the reason for Germany’s export-led success. Germany’s wages are not low, by European standards, and its exports are not cheap. Similarly, “more generous wage dynamics” in Germany would hardly be enough to rescue the PIGS from their plight . Yes, they would mean that German exports get a bit more expensive, but the fact is that German manufacturers aren’t competing with Greek manufacturers in the global market.

As Martin Wolf says, Germany is “the world’s foremost exporter of very high-quality manufactures”, which means that the demand for its goods is highly inelastic. If you want a high-precision medical-equipment component, or high-end music-production software, you want what the Germans are selling, and, within reason, you’ll pay whatever they’re charging — especially when the euro is weak. State-of-the-art optical components aren’t olives, and more expensive machine tools don’t make Mediterranean beach holidays any more or less attractive than they were before.

All of which is not to say that a bit of wage inflation in Germany wouldn’t be a good thing. It’s just that the chief beneficiaries would be the Germans seeing their wages increased, rather than anybody on Europe’s southern fringe. Germany may or may not end up bailing out the PIGS in one way or another. But it can’t do so just by paying its own workers more money.

Justin Fox tried to adjudicate a debate on Friday. In the blue corner is Philip Augar, a British investment banker who wants to go back to a very British form of investment banking (think all those houses with Hogwarts-style names like Rothschilds and Schroders and Kleinworts and Warburgs), where advisory shops make their money from fee income, and leave the trading to the Americans big broker-dealers.

In the red corner is our old friend the Epicurean Dealmaker:

I-banks are underwriters of securities. As such, they *must* straddle the wall between investors and issuers of securities. They see both sides of the trade: market *demand*, and issuer *quality*. If no-one stands there, who can minimize information asymmetry and maximize trust? No-one.

To which Augar replied:

A radical shake up along the lines I suggest is the only way to let the market operate properly so we don’t get mergers that fail to deliver for acquiring shareholders, IPOs that underperform after the first day pop, share prices that move ahead of deal announcements etc etc.

Justin says that he doesn’t know which of the two is right; my feeling is that both of them are wrong. On the one hand, advisory shops have existed for a very long time, and still do exist in the form of such banks as Lazard, Greenhill, and Jefferies. The old-fashioned British way of doing things did seem to work OK, although admittedly it didn’t take long for most of the advisory shops to get gobbled up by the big broker-dealers.

On the other hand, Augar has got to be kidding if he really expects us to start worrying greatly about mergers that fail to deliver for acquiring shareholders, or underperforming IPOs. This is not a debate about poor buy-side investors investing in bad deals and blaming the banks. And in any case M&A advisory boutiques are just as likely to persuade their clients to overspend on an acquisition as their sell-side counterparts are. The question is whether splitting the trading and advisory sides of the banks would do anything to reduce systemic risk, and I really can’t see how it would.

Augar’s bright idea, then, is I think a solution in search of a problem. I’m not convinced by TED’s pleas to keep the two sides of the business apart, but I also see no reason why separating them would do much if any good.

In hindsight, one of the silliest and most dangerous excesses of the Great Moderation was the large number of companies — foremost among them AIG, although there were lots of monoline insurers in the same trade — basically selling insurance on the world coming to an end. It’s a great trade: either the world doesn’t come to an end, and you make lots of money, or the world does come to an end, and it doesn’t matter ‘cos you’re bust anyway.

Now, however, after seeing how that trade worked out, we’re wiser, and no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance. Would they?

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis…

“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” [says Citi’s Terry Benzschawel].

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.

I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days. After all, it was credit specialists at Citi who ended up losing the bank billions of dollars on trades which were meant to be too safe to fail. And this trade is in many ways even worse than the one put on by AIG, because Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.

We learned in the crash of 1987 that when financial markets start selling products which insure a portfolio against catastrophic loss, the very existence of those products can destabilize the market and make it more prone to crashing. And, of course, we learned that such insurance has a tendency not to get paid out on exactly when it’s most needed. But heaven forfend that the market should ever learn from its mistakes.

It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.

(HT: Alea)

Update: Citi spokesman Alex Samuelson responds via email:

I just wanted to make clear a few points:

1. The Liquidity Index (CLX) is a product that we are considering, but have not launched. It is true, however, that we have developed an index to track market liquidity and we have had customer inquiries over the years asking to purchase liquidity protection.
2. In possibly trading the index, Citi would act as a market maker, not a provider of liquidity. Citi would not take any position. We are only exploring the ability to make a market in liquidity by bringing natural buyers and sellers together. This would not be a prop trading business.
3. We believe that the CLX could be a financially useful product in that it meets a marketplace need to be able to hedge one’s risk of liquidity drying up by purchasing liquidity from those firms that are natural providers of liquidity (insurance companies, pension funds, individual money market funds).

Thus, if it moves forward, the product could allow firms that depend on financing to exist to protect themselves from spikes in liquidity and provide a mechanism for people with excess liquidity to profit from that in an easy and transparent fashion.

Update 2: David Merkel weighs in.

Liquidity derivatives are not a reasonable product.  You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.

Warren Mosler has an interesting and provocative remedy for Europe’s current fiscal woes: the European Central Bank should simply print 1 trillion euros, and hand it out, on a pro-rated basis, to all the Eurozone states. This is a per-capita payment: it would be based on population, not on GDP, with the highest-population countries getting the most money.

Mosler reckons that spending would be unaffected, because the Eurozone countries are already up against their Maastricht limits, and that therefore inflation wouldn’t be affected either. More importantly, he says, the Eurozone debt ratios would come down, by say 5 percent of GDP across the board.

The interesting thing is that given recent weakness in the euro, something along these lines — if not quite as explicit — seems to be already priced in, to some degree. I don’t think anybody in Europe is particularly worried about inflation right now; if anything, deflation is more of a problem, especially in the PIIGS.

The big question, of course, is whether and how anybody at the ECB would ever let something like this happen, given its much-vaunted independence. Deflation worries might have to pick up quite a lot before it happens, and even then it’ll be a very tough sell among the European central-banking crowd.

In case you missed it on Friday, it’s worth checking out Tracy Alloway’s post about second mortgages in the US. She makes a very good point about how they’re making it a lot more difficult for mortgages to be modified — but we kinda knew that already. What I, at least, didn’t know was this:

All those second-mortgage-backed CDOs which have gone to zero, causing enormous losses? They’re in that tiny little purple wedge at the bottom. The overwhelming majority of second mortgages, it turns out, are held the old-fashioned way, on the books of banks, credit unions, and savings institutions.

Now this goes strongly against the dominant narrative of the subprime crisis, which is that the originate-to-distribute business model was largely responsible for the disastrous collapse in underwriting standards. Here, there was no originate-to-distribute business model, and clearly most of these seconds should never have been written — but they still were, and what’s more they were underwritten disproportionately by the big four commercial banks. (Actually, I’m not clear on if they were underwritten by the big four, of if the big four have just acquired them through the acquisition of companies like Countrywide and Wachovia.)

What explains the commercial-bank loan officers taking toxic second mortgages onto their own books? I think it’s a combination of factors. Firstly, they believed the hype. Secondly, they were reaching for yield in the Great Moderation just like everybody else. And thirdly, the originate-to-distribute model still existed in a smaller form: the banks were acquiring these loans from mortgage brokers who got paid at close, whether or not the loan was a good one.

None of that, of course, is remotely helpful in addressing the problem today, of what on earth to do with $1 trillion in second mortgages. It would be great if all the banks just wrote them down to zero, but you know that’s not going to happen. And first-lien mortgage holders are going to hate to give the second-lien holders anything at all — what Al Yoon calls “a principal reduction plan where losses are shared”. Some of the bondholders might be asking for that, but I’ll bet you they’re mainly the holders of triple-A-rated tranches, who don’t mind if the holders of lower-rated tranches get wiped out through a loss-sharing agreement. If this kind of plan does go through, expect holders of the lower-rated tranches of first-lien mortgage bonds to scream blue murder, and possibly go to the courts. They’re meant to be senior to the second liens, after all, yet they might well get nothing while the second-lien holders get something. What a mess.

How did I miss the $104 million Giacometti? Marion has a good round-up of the reactions, to which I’d just add that this is proof of the primacy of the fungible. The most valuable works of art are increasingly not unique, but rather part of an edition: the Giacometti is just one of ten, including four artist’s proofs. Hugely-expensive works by Koons are always in an edition; sculptures by Murakami often are; and in the world of painting, where uniqueness is pretty much a given, the most expensive artists — people like Warhol and Prince and Hirst — are often those who paint the same thing over and over again, allowing many collectors to buy essentially the same artwork.

At the same time, there was clearly a lot of auction psychology going on here. I don’t know whether the identical sculpture being sold by Larry Gagosian for $45 million was cast in Giacometti’s lifetime or not — but even if it wasn’t, that doesn’t come close to explaining the difference in price. It’s just that when you get caught up in the heat of an auction — when you have the winning bid, and you think you own the piece, and then someone else comes along to snatch it out of your hands, and you think only about the marginal cost of taking it back — then it’s very easy to ratchet the price of a great piece like this one into the stratosphere.

The previous work to hold the record for most expensive sculpture ever sold at auction was the Guennol Lioness, which sold for $57 million in 2007, despite being only three inches tall. It’s much more unique than the Giacometti, and can reasonably be described as “the greatest sculpture on Earth” by Sotheby’s auctioneer Richard Keresy; no one is likely to say that about cast 2/6 of the Walking Man. But the Giacometti, largely by dint of its existence in ten different places around the world, is a cultural icon in the way that the lioness never could be.

Every so often, people ask me why I allow my work to be reprinted on Seeking Alpha without them paying me — or Reuters — any money. And I think the answer might lie here: the more you replicate something, the more valuable it becomes. And not just in aggregate, either.

Giacometti’s Walking Man resonates culturally in a way that few other artworks do. And if and when its auction record gets broken, I wouldn’t be at all surprised if it was by another cultural icon: a Warhol Marilyn, perhaps, or a Jasper Johns flag. These things are valuable because they’re not unique; because there are enough versions of them that they’ve managed to gain extremely wide currency. I just wonder when the romantic conception of a unique artistic masterpiece might start coming back in vogue.

Update: Gareth Williams comments, quite rightly:

If you were looking to buy one of an edition and the others pieces were all owned by wealthy, discerning people or institutions you would get a degree of comfort that there was some objective value there. In art this is particularly important as objects have no utility value and there is no universally agreed benchmark of quality. In fact, it provides the supreme example of something only being worth what someone’s willing to pay for it.

So the more people there are who are not only willing to pay for a work but have actually paid for identical versions of it, the more validation you have that the version you’re buying is worth something. Some sort of consensus about value has been established and it’s been backed up by hard cash. Ultimately, it comes down to the old saw that there’s safety in numbers.

This weekend’s big NYT story on Goldman Sachs and AIG does not, I think, say anything much we didn’t already know. But it does suggest, I think, that the US government made a big mistake in bailing out AIG rather than nationalizing it outright:

The government would soon settle the yearlong dispute between Goldman and A.I.G., with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for A.I.G. The prices on many of those securities have since rebounded.

The dispute between Goldman and AIG was one over collateral. Goldman wanted AIG to put up ever-increasing amounts of collateral against the CDS which it had written — demands for cash which AIG was unable to meet. So the government stepped in and unwound the contracts near the bottom of the market, paying out Goldman Sachs and other AIG counterparties in full, and locking in massive losses for the insurer.

The alternative would have been to nationalize AIG outright, and imbue it with the government’s own triple-A credit rating. Since many of the largest collateral calls were a function of AIG’s own deteriorating credit rating, that alone would have helped to minimize the amount of cash needed to be put up as collateral. AIG, rather than unwinding all those CDSs, could then simply have held onto them, putting up as much collateral as it needed to, and paying out on them as and when the underlying bonds defaulted. The end result would, with hindsight, have been significantly cheaper for both AIG and US taxpayers.

Now it is true that as part of the AIG bailout, the New York Fed took possession of a lot of CDOs, putting them in portfolios with names like Maiden Lane III, and hiring Blackrock to manage them. As the value of those CDOs has risen, the US government has seen mark-to-market gains on its portfolio. But that doesn’t change the fact that Goldman Sachs bought credit insurance very cheap from AIG, and then sold it back at a very high price to the US government, locking in billions of dollars in trading gains. AIG took equal and opposite losses on those transactions, and ended up passing those losses on to the US taxpayer.

It will be many years before it becomes clear whether or not Goldman pulled off a great trade here, cashing in on its insurance assets at the height of the panic. It’s still possible that the bank would have been better off holding all that insurance to maturity, and collecting a steady income stream over the years as various instruments went into default. But Goldman will tell you until it’s blue in the face that it always marks all its positions to market, and that it doesn’t really believe in holding financial assets for very long time periods.

So at the very least, AIG and the New York Fed should have threatened to call Goldman’s bluff, and said OK, we’ll continue to put up collateral. Goldman would then have had to hand that collateral back over the course of 2009 as the credit markets rebounded, and AIG wouldn’t have locked in any losses at all. But no one did that, because AIG was only 80% owned by the government, and the government didn’t want to provide essentially unlimited liquidity support to a company which still had a relatively large number of private shareholders. Outright nationalization, then, might have been a much simpler — and cheaper, in the long run — way of addressing the situation.

Peter Conti-Brown has a new paper proposing the creation of what he calls a Fat Tail Risk Metric, or FTRM. The paper itself is flawed, and the details of how it’s constructed would need to be reworked from scratch. But conceptually, the FTRM I think is a good idea. Here’s Conti-Brown’s abstract:

The paper proposes a legal solution that will create a more robust metric: require mandatory disclosure of a firm’s exposure to contingent liabilities, such as guarantees for the debts of off-balance sheet entities, and all varieties of OTC derivatives contracts. Such disclosures—akin to publicly traded corporations’ filing of 10-Ks with the SEC—will allow regulators and researchers to approximate an apocalyptic, black-out, no-bankruptcy-protection and no-bailout scenario of a firm’s implosion; force firm’s to maintain daily record-keeping on such obligations, a task which has proved difficult in the past; and, most importantly, will open up a crucial subset of data that has, until now, been opaque or completely invisible.

Conti-Brown’s method for coming up with the FTRM involves adding up a firm’s total netted derivatives exposure; the size of its off-balance-sheet vehicles; and its liabilities. That gives a total-risk measure; the FTRM itself is the log of that figure.

There are lots of problems here. For one thing, netting derivatives exposure effectively eliminates an enormous amount of counterparty risk. For another thing, it’s impossible to calculate: if I write a call option on a stock, there’s no limit to how much my contingent liability might be, because there’s no limit to how far that stock can rise. And off-balance-sheet vehicles are just one of a potentially infinite line of entities which remove a company’s legal liability, but where the firm can still end up paying out a lot of money in practice. Think, for instance, the money which Bear Stearns threw at its failed hedge funds, or the money which banks used to make whole the people who invested in auction-rate securities. Those things don’t look like bank liabilities, or even contingent liabilities, until it’s far too late.

But put all that to one side: one thing which doesn’t currently exist, and which would be very useful indeed, is some kind of measure of the total amount of risk in the financial system. A lot of people had a conception, pre-crisis, of some kind of law of the conservation of risk: that tools like mortgage-backed securities simply moved risk from banks’ balance sheets to investment accounts, and therefore, at the margin, actually dispersed risk and made the system safer. What was missed, however, was the fact that total risk was increasing fast, especially as house prices rose and the equity in those houses was converted into financial assets through the magic of second mortgages, cash-out refinancings, and home-equity lines of credit.

Some types of risk are more dangerous than others, of course: if there’s a stock-market bubble, then it’s easy to see that the total value of the stock market, which is the total amount that can be lost in the stock market, has risen a lot. But stock-market investments are a little bit like houses without mortgages: where there’s very little leverage, there’s also relatively little in the way of systemic risk. It’s rare to suffer great harm from the value of your house falling if you don’t have a mortgage.

Still, stock-market bubbles can cause harm, and it’s worth including equities as part of the total risk in the system, along with bonds and loans. That’s one metric which macroprudential regulators should certainly keep an eye on; Conti-Brown’s idea is then basically to try to disaggregate that risk on a firm-by-firm basis, to see which companies have the most risk and to see how concentrated the risk is in a small number of large institutions.

It won’t be easy to do that — indeed, it will be impossible to do it with much accuracy. But even an inaccurate measurement will be helpful, especially if it becomes a time series and people can see how it’s been changing over time. It’s good to know how much risk is out there — and it’s better to know that financial institutions themselves are keeping an eye on that number, and trying to measure it as part of their responsibilities to their regulator.

I’m in England right now, spending more time going on walks and eating oysters than trying to keep a close eye on financial markets. But the one thing that has been screaming out at me, from the headlines on BBC radio to the front page of the Independent, is the idea that the fall in global markets is a direct consequence of a deepening crisis in the eurozone, and fears that default risk might be spreading from Greece to Portugal and elsewhere.

This is all par for the course when it comes to financial journalism, but that doesn’t make it any less annoying. The fact is that the fiscal status of the Eurozone countries has not changed, and that if people are more worried about such things than they were a few weeks ago, that’s because of the action in the markets, as opposed to the action in the markets being caused by some kind of spontaneous uptick in generalized concern.

It’s pretty clear which way the causality is running: markets fall, and journalists, who believe that there’s always a reason for such things, look around to see what people are talking about. When it turns out that they’re talking about the likes of Greece and Portugal, they have their headlines: “markets fall on eurozone fears” or the like. But if the markets had gone up instead, and people had been having the same conversation, you’d never see a headline saying “markets rise on eurozone fears”.

So it’s truly wonderful to see my very own Reuters come out with a much more sensible piece of analysis on Friday. Here’s Jeremy Gaunt and Natsuko Waki:

Data held by State Street contains no obvious evidence of an institutional exit from euro zone assets; the flows which are occurring appear to be no more defensive than those being seen elsewhere during a period of risk aversion for financial markets around the world…

Recent falls by the euro may be unrelated to worries that worsening fiscal problems in the euro zone’s weaker members could eventually drive them out of the zone.

The euro has fallen about 4.5 percent against the dollar this year. Euro zone stocks have been battered, with the MSCI Europe exUK index down 6.9 percent for the year.

But many of the moves made by big investors have fit in with other trends. MSCI’s all-country world index is down 6.7 percent.

The key here is to stop looking at day-to-day movements, especially in stock markets: they mean nothing. And if you do look at them, whatever you do don’t try to explain them. Stocks are cheaper now than they were last week: if you’re thinking of buying stocks that’s probably a good thing, and if you’re thinking of selling stocks that’s probably a bad thing. End of story. And as for the eurozone, it has big problems today, and it had big problems last year, and it will have big problems next year. Sometimes there’s a lot of chatter about those problems. And sometimes markets move. But let’s not pretend that there’s some strong correlation between the two.

This event — Hank Paulson being interviewed by Jeffrey Immelt at the 92nd Street Y on February 18 — might just have got a lot more interesting:

On Sept. 15, 2008, the day Lehman Brothers declared bankruptcy, Paulson says he was “startled” when Immelt came to his office and told him GE was finding it “very difficult” to sell short-term debt “for any term longer than overnight.” A day earlier, GE sent investors a letter saying its ability to sell commercial paper was “robust.” Immelt, in a statement issued Friday by GE, said he “does not believe” the two discussed problems with GE commercial paper on Sept. 15, or in one previous talk.

If correct, the portrayals in Paulson’s book, “On the Brink: Inside the Race to Stop the Collapse of the Global Financial System,” could spell trouble for GE in court, where shareholders are accusing Immelt and other executives in civil suits of violating securities laws by misleading investors in fall 2008 about GE’s finances and withholding key information.

Now, what are the chances that Immelt will bring up the discussion he had with Paulson on September 15? It would be really amazingly wonderful if the mogulfest turned into a substantive disagreement with millions of dollars at stake, with Paulson standing by his book and saying that Immelt had complained about illiquid CP markets, and Immelt denying the allegation.

But frankly it strains credibility that Immelt would have had a meeting with Paulson on that particular day and said anything else: this was hardly the time to be paying social calls. As a result, I suspect that Immelt won’t raise the subject — just as Paulson, in his book, never raises the subject of his scandalous meeting with the Goldman Sachs board in June 2008. If the likes of Immelt and Paulson had their way, no one would ever ask any tough questions at all, at the 92nd St Y or anywhere else.

(HT: Bishop)

I was expecting Lloyd Blankfein’s bonus to be small this year, but I wasn’t expecting it to be as small as $9 million: a mere 7 figures.

This is a great move by Goldman, not just from an external public-relations perspective, but also from an internal point of view: the small bonus for Blankfein makes it really hard for anybody else in the company to complain that they’re being underpaid.

Goldman is also lucky that the Couric Rule, under which public companies would need to disclose how much their highest-earning employees are making, is still not in force, although it does seem to be on its way. If Goldman were forced to say how many of its employees are making substantially more money than the CEO, and how much the top earners are bringing down, this latest piece of high-profile underpayment would probably feel less impressive.

Of course, $9 million is still an enormous amount of money for any one person to earn in one year, and Blankfein made many times that sum as his holdings of Goldman Sachs stock appreciated over the course of 2009. He’s still comfortably in the realm of the plutocrats. But in a way that’s the point: you don’t need to be paid $50 million-plus to be a master of the universe. Blankfein is one of the kings of Wall Street no matter how much or how little he’s paid. And maybe, just maybe, Goldman Sachs is coming to the realization that its senior executives won’t leave after all if their bonuses are cut to the merely enormous from the utterly obscene.