Was Wall Street Deriving While Impaired?

In the aftermath of the 2008 global financial crisis (at least I hope we're in the aftermath) observers of the financial markets continue to debate its underlying causes. Some point to executive compensation, which supposedly encouraged excessive risk-taking. Others blame excessive leverage (the most basic form of risk-taking) and finger the Federal Reserve for maintaining artificially low interest rates from 2002 to 2005. Other critics believe that a surge in esoteric and poorly-modeled derivatives allowed banks to pretend that a substantial increase in risk and systemic co-dependence was safely hedged.

But an article in "Science Translational Medicine" offers a simpler hypothesis consistent with lowered inhibitions, excessive risk-taking and impaired judgment: Wall Street was three (spread)sheets to the wind.

Now I'm not suggesting that investment bankers were drinking at work... at least not more than usual. But 100-hour workweeks are not uncommon on Wall Street, and as Bloomberg quotes the study, "Staying awake for 24 hours straight equals having a blood alcohol concentration of 0.10 percent, beyond the 0.08 percent legal limit for driving in the U.S."

You wouldn't give your car keys to a sleep-deprived, cognitively-impaired twenty-two year old, but bet a billion dollars (levered 10:1) on the AAA-rated tranche of a 30-layer, collateralized debt security that he modeled at four in the morning? No problem.

Are You Smarter Than a Fifth Grader?Congressional Edition

From Politico reprinted in its entirety for non-subscribers:

Rep. cries foul over Nets naming rights

"Maybe they should just call it TARP Arena.

Rep. Bill Pascrell Jr. (D-N.J.), wary of taxpayer anger over the AIG bonuses, wants the New Jersey Nets to reconsider selling naming rights to the British bank Barclays for an NBA arena being built in Brooklyn.

Barclays received $8.5 billion in bailout funds from the Treasury Department, and Pascrell believes the $400 million it cost to have the naming rights for the soon-to-be Brooklyn Nets arena should be used, say, for lending to consumers instead. Pascrell was quick to make an exception for the new Citi ballpark the New York Mets are building, because that ball yard was already well under construction under the Citi name before the bailout money was approved.

“I believe that any further payments of taxpayer money, whether through TARP or the Federal Reserve System, be conditioned on the cancellation of any stadium or arena naming-rights agreements that may be in place,” Pascrell said.

It’s worth noting, of course, that Pascrell represents a lot of New Jersey Nets fans quite unhappy about losing their NBA team to Brooklyn."


Actually, Congressman, Barclays did NOT receive any "bailout" funds from the Treasury Department. Nor have they accepted any bailout money from the government of the UK, where they happen to be domiciled. To their credit, they have steadfastly resisted taking money that comes with governmental strings attached; and with each passing day and every congressional comment like yours, the wisdom of their strategy becomes more clear.

True, Barclays received $8.5 billion from AIG, presumably as collateral against or settlement of AIG's contractual obligations under trading arrangements. But to suggest that this is the same as a bailout is just wrong. To further imply that any organization that does business with a recipient of bailout funds is thereby subject to mindless Congressional meddling is either stupid or frightening, depending on how serious you are.

Oh, and Congressman, pretty much all "payments of taxpayer money" are made "through the Federal Reserve System." In fact, when you give a one-dollar tip to the guy who shines your shoes in the Congressional cloak-room, you're using what we in this country call a "Federal Reserve Note". It's actually printed on the top of the dollar bill in capital letters to help you remember.

Perhaps you'd like to regulate what he does with that too?

The Beginning of Wisdom...

"The beginning of wisdom is to call things by their right names" according to the Chinese proverb.

The chart above (click the chart to enlarge) shows the relative frequency of Google searches for "Troubled Assets" vs. "Toxic Assets" over the past 12 months. As the Treasury introduces "TARP 2.0" today, the change in the vernacular reflects a shift from a market view (or hope, really) that the problem was a temporary impairment of "troubled" assets to the acknowledgment that many of the assets at the center of the financial storm are permanently impaired or "toxic". If this view is widely shared, it may actually speed the recovery process as buyers and seller converge on valuation for the assets.

Contrarians may find a bullish signal in this verbal shift.

If you want to update this chart, click here and enter the search terms "troubled assets" and "toxic assets" separated by a comma.

Great Moments in StatesmanshipH.R. 1586

Photo credit Stephen Crowley/The New York Times

H.R. 1586The Law of Unintended Consequences

Well, they did it.

The US House of Representatives, apparently vying for the title of "The World's Greatest Retributive Body" passed HR 1586 - "To impose an additional tax on bonuses received from certain TARP recipients". HR 1586 was designed specifically for the purpose of taxing the bonuses of several dozen employees of AIG, the giant insurance company at the epicenter of the financial crisis.

Look, I'm no fan of AIG. AIG's reckless underwriting of credit default swaps has required a $170 billion injection of government aid to post collateral with counter-parties and extinguish obligations. And I will be surprised if AIG doesn't require more aid before this crisis is over.

So I am as infuriated as any other taxpayer to read that AIG planned to pay out $165 million in bonuses, including bonuses to employees who worked in their Financial Products group, where the credit default swaps were written.

But the speed with which the House has wielded its most powerful weapon -- As Chief Justice John Marshall put it, "The power to tax is the power to destroy" -- is a truly frightening precedent. By levying a confiscatory 90% tax on bonuses paid by firms who have received aid under the Troubled Asset Relief Program, the House has undermined the compensation model of our leading financial institutions, not just AIG. More to the point, it will create a financial hardship for many employees whose banks may not have needed TARP funds, but were persuaded by former Treasury Secretary Hank Paulson to accept them in an act of industry solidarity designed to stabilize the crisis late last year. It will also create financial hardship for many employees who had absolutely nothing to do with mortgage securities, credit default swaps or crazy leverage ratios and who probably earned their bonus. For some, it may mean selling their houses into an inventory-clogged market. For all, it will surely mean a reduction in both their saving and spending, just exactly what we don't need in the current economy.

It was bad enough last month when Deputy Sheriff Barney Fife... I mean House Financial Services Committee Chairman Barney Frank... was chiding Northern Trust for honoring its commitment to sponsor a PGA event in Los Angeles. But HR 1586 is a breathtaking act of power, passion and political pandering that should give pause to any believer in liberal democracy. Look hard enough and you will find federal aid, if only in the form of freedom from federal tax, in almost every nook and cranny of our modern society. Will lesser forms of federal aid be used as a pretext for the House to follow its new precedent of hastily drafted confiscatory taxes to coerce private behavior?

Fortunately, the administration has expressed reservations about the House bill and the public outrage has encouraged some AIG employees to forfeit their bonuses, so cooler heads may yet prevail and this hastily drafted legislation may be rejected or modified.

If you'd like to see how your representative voted, click here.

A Lesson in This Recession?

During economic booms, certain publications and political parties can be counted on to point out that the growing wealth produced by the expanding economy is being inequitably bestowed upon various segments of the population. This (unsurprising) observation usually leads to journalistic hand-wringing, cynical campaign slogans and calls for a more progressive tax code and redistributionist spending programs.

The breadth and depth of the current recession provides an interesting opportunity to observe the results of an experiment no sane policy-maker would ever intentionally conduct.

Last week, the Federal Reserve released its latest triennial analysis of changes in family income and net worth:

Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances

Trust me, you probably don't want to read it all (I haven't yet either) but I'll share one of the authors' observations. The report is based on household surveys conducted in 2007 and focuses on changes in household finances since the 2004 survey. In light of the significant changes in housing and equity prices during 2008, the study's authors also make an attempt to estimate the impact of 2008's market meltdowns through October.

A number of assumptions are required, which can be found on pages A10-A12. The authors conclude, "...these assumptions imply large drops in median and mean net worth since the 2007 survey — 17.8 percent and 22.7 percent, respectively."

These numbers feel about right. From January to October 2008, the S&P 500 declined 34.0% and the Case-Shiller 20-city composite house price index declined 14.5%.

Many commentators get tripped up when confronting means and medians, and politicians are probably responsible for statistics being lumped together with lies and damned lies. So here's a little refresher (page A6) on interpreting means and medians that most students should've had by ninth grade.

"Where a comparable median and mean are given, the gain of the mean relative to the median may usually be taken as indicative of relatively greater change at the top of the distribution; for example, when the mean increases more rapidly than the median, it is typically taken to indicate that the values in the top of the distribution rose more rapidly than those in the lower part of the distribution."

This is equally true in reverse, i.e., when the mean decreases at a greater rate than the median, it is typically taken to indicate that the values in the top of the distribution fell more rapidly than those in the lower part of the distribution.

So by certain conventional measures of inequality, the concurrent meltdowns in the financial and housing markets plus the economic recession have increased "fairness" in the United States.

This is not a headline I expect to read soon.

I make this observation not in defense of the well-to-do compared to the less fortunate. To be sure, this recession is hurting every family at every level. And the hardship at the lower end of the income and wealth spectrum is undoubtedly more palpable and immediate. What's more, the magnitude of federal aid being provided to companies like AIG evokes uncomfortable echoes of the "Welfare Queens" who figured in class warfare debates of the '70s and '80s. It seems we all live in a glass house now; so maybe everyone should put down his stone.

But when this economy recovers, as it certainly will, maybe we'll have learned that although prosperity inevitably benefits the prosperous, it's better (for everyone) than the alternative.

Bumper Sticker

Greenspan-o-Meter - Two Down, One to Go

On December 5, 1996 Fed Chairman Alan Greenspan famously wondered whether stock prices reflected an "irrational exuberance" on the part of investors. This afternoon, The Nasdaq Composite index joined the S&P 500 by closing below its level on that day more than twelve years ago. For its part, the Dow Jones Industrial Average is a mere 2.4% above its level that day, or about one day's volatility in this choppy market.

As it turns out, Greenspan was perhaps too modest about his abilities to spot a bubble. For earlier posts on the same subject, click here and here.

"We Don't Need No Stinkin' TARP Money" - Northern Trust

Northern Trust has released a response to Congressman Barney Frank regarding its sponsorship of the Northern Trust Open, a PGA golf tournament. Congressman Frank, Senator John Kerry and a score of political grandees have been publicly harrumphing about Northern Trust's expenditures on the golf tournament while the US Treasury holds preferred stock in Northern Trust under the Capital Purchase Program of the Troubled Assets Relief Program (TARP).

Northern Trust's basic message is "We're happy to give back the money we didn't ask for.... where should we send the check?"

In his letter to the Congressman, Northern Trust CEO, Frederick H. Waddell, gets the nuance right when he says, "As we have stated publicly, the Northern Trust Open and its related activities were in no way reliant upon Capital Purchase Program funds, and would have occurred even had we not received Capital Purchase Program funds."

Click here for my earlier post on the topic.

At the end of the day, congressional meddling in the day-to-day operations of TARP recipients may be the most effective way of getting the funds back quickly. But it will certainly cause investors -- and possibly depositors -- to discriminate between those banks who can and do return the funds and those who can't. When the Treasury took stakes in the various banks late last year, it apparently cajoled some of the stronger financial institutions into accepting the funds. The Treasury's intent was to characterize the financial crisis as a systemic liquidity issue that could be alleviated by a temporary injection of capital from the government. The Treasury specifically tried to avoid singling out banks that needed the money to avoid creating more concerns among their counter-parties and depositors.

As the Treasury Department put it back on October 14,

"Nine large financial institutions already have agreed to participate in this program, moving quickly and collectively to signal the importance of the program for the system. These healthy institutions have voluntarily agreed to participate on the same terms that will be available to small and medium-sized banks and thrifts across the nation."

With Citicorp trading at $1.27 per share at the moment, maybe the Treasury's desire for benign opacity was naive. But if Northern Trust, JP Morgan, Goldman Sachs and a few others rush to repay the TARP money so they can be left alone to run their businesses, it could have a serious impact on those banks who don't.

This is a pretty serious policy reversal to be driven by a golf tournament.

Addendum: Northern Trust's June 17, 2009 press release regarding its repayment of TARP funds.

Greenspan-o-Meter - February Update

On December 5, 1996 Fed Chairman Alan Greenspan famously wondered whether stock prices reflected an "irrational exuberance" on the part of investors. This afternoon, the S&P 500 closed below its level on that day more than twelve years ago. For an earlier post on the same subject, click here.

While We're On the Subject...

"Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, along with 17 Democrats on the committee, demanded Tuesday that Northern Trust repay what it spent on entertainment during the [Northern Trust Open held in Los Angeles] which ended on Sunday."

"And Senator John Kerry of Massachusetts vowed to introduce legislation to end “the extravagant spending practices” of banks that received taxpayer dollars in the federal bailout."
Link to NYT story

Congressman Frank and Senator Kerry:

By my reckoning, the US federal deficit has soared from around $1 trillion when Congressman Frank first entered Congress in 1981 to $10 trillion today and we're on our way to $12 trillion according to the President's recent budget proposal.

Until the federal government pays back this money, there are a few expenditures I'd like to discuss with you.

In the meantime, I trust that you and your honorable colleagues in the House and Senate -- mindful of taxpayer concern over profligate spending -- are currently using the Metro for your daily commute. If not, you should know the Federal Center station is mere 6-minute walk to and from the Capitol. I know the fare-card system can be confusing at first, but my nephew's third-grade class has been studying the Metro and would be happy to organize a field trip to help you and your colleagues learn the ropes.



We look forward to your continuing vigilance on behalf of the tax-payers.

Quants vs. Suits - Who's to Blame for the Financial Meltdown?

Eric Falkenstein has posted an exceedingly well-written response to Felix Salmon's recent Wired article, "Recipe for Disaster: The Formula that Killed Wall Street" over on SeekingAlpha. Falkenstein nicely captures the interaction between the "quants" and senior management in financial institutions when he writes,

"The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it."

In my experience, the best quants are generally quite keen to identify and debate the risks and assumptions in their models, but too rarely encounter non-quant managers who show the patience to comprehend the implications. If you're rich, powerful and kind of smart, it's more comforting to say: "I don't pretend to understand all this greek, but I've hired the smartest guys to do the math" than to say "I've tried to understand it, and frankly it's over my head."

Felix Salmon's Wired article is indeed worth reading, although the headline is a tad melodramatic. In Salmon's view, the adoption of Gaussian copula techniques to model the risk characteristics of mortgage-backed securities mortally wounded Wall Street.

Over at the New York Times, Joe Nocera seems to think it was a Value-at-Risk spreadsheet that killed Wall Street in last month's "Risk Mismanagement" article.

Perhaps Wired magazine will sponsor a debate between Mr. Salmon and Mr. Nocera about whether it was a VaR model or a Gaussian copula model that buried Wall Street. Nassim Taleb might be willing to moderate.

To Mr. Salmon's credit, his article does discuss what is -- in my opinion -- the single biggest source of failure in these risk management models. Namely, the use of CDS price data as a proxy for otherwise hard-to-track correlations among many discrete and illiquid securities. It was the availability of a real-time price series that apparently made the Gaussian copula function "tractable", but the use of CDS price data appears to have led to models that vastly and tragically oversimplified the real world relationships they were meant to simulate. Moreover, as Salmon points out, the limited history of CDS prices meant that the historical data was largely drawn from a period of benign economic data. Finally, the CDS market ultimately became a speculator's market with the notional value of default insurance dwarfing the underling credits supposedly being insured, which undoubtedly raised the noise-to-signal ratio on CDS price movements and correlations.

Salmon's and Nocera's articles are the most prominent examples of a growing "The model made me do it" set of explanations for Wall Street's current predicament. Unfortunately, the journalistic imperative for a catchy headline and strongly themed story tends to gloss over the more complex human, institutional and managerial failings that are more appropriately to blame.

If you've read this far, and you're truly interested in the subject, I highly recommend reading UBS's confessional Shareholder Report on UBS Writedowns (pdf). This remarkable report from April 2008 describes the causes of UBS's losses related to US residential mortgages, which at that time were a mere $18.7 billion.

What you will find in this report is a board-approved "hurry up" strategy to rectify lagging league table performance in global fixed-income markets, which led to an aggressive market entry into the RMBS market as it was peaking. You will find that internal capital charges were not routinely adjusted for the true risks of proprietary positions, leading to "carry trades" and correspondingly high inventories of ultimately risky securities. You will find that "warehoused" securities held-for-sale were not hedged at all. You will find that dubious AAA-rated mortgage backed securities were hedged based on the five-year default histories of the small handful of remaining AAA-rated corporates during period of strong economic growth. And you will find that compensation policies rewarded traders for current year profits, even if the positions they held proved toxic down the road. What you don't find in this document is "Oops, the models broke" types of excuses.

For anyone interested in the subject, I also recommend Suna Reyent's article on SeekingAlpha as well.

The Equity Risk Premium Puzzle-Who are the Long-term Holders?

One of the unsolved mysteries of modern finance theory is the "Equity Risk Premium" puzzle. In a sentence, the puzzle is why equities have historically outperformed bonds (in real, dividend-adjusted terms) by such a large margin? For an elegant illustration of the concept, see Brad DeLong's 2006 blog post here.

Of course, stocks should deliver a larger return since they are riskier claims than bonds; and the variance of stock returns -- the measure of risk in modern finance theory -- is manifestly greater than the variance of bond returns. But the magnitude of stocks' outperformance is the puzzle, especially in light of the well-known fact that the variance of stock returns can be mitigated by long holding periods. (note 1)

This latter notion is most famously articulated in Jeremy Siegel's "Stocks for the Long Run" and more infamously in Glassman & Hassett's "Dow 36,000".

Barring a quick rebound in the US stock markets, the Equity Risk Premium puzzle is likely to be a hot topic in finance departments over the next few years. And if the US experiences another decade of meandering stock price performance to match the current Japanese experience, it may be decided that there's no puzzle at all. The major Japanese market indices are hovering at the same levels they first reached twenty years ago and are roughly 80% below their all-time highs. The current generation of Japanese investors are probably not scratching their heads over the inexplicably high historical returns of common stocks.

Recent news events may shed some light on the issue as well. Like many universities, Harvard has recently reported that it's endowment shrunk 22%, or $8 billion, in the last half of 2008 and that it may shrink by as much as 30% when illiquid assets such as private equity and venture capital positions are marked to market. Geraldine Fabrikant has covered this story for the New York Times here

"Harvard Endowment Loses 22%"

and here.

"Endowment Director is on Harvard Hot Seat"

What I find interesting in this news is the fact that "Harvard depends on its endowment for about 35 percent of its operating budget..." representing $1.4 billion of endowment income contributed to annual operating expenses according to this letter from Drew Gilpin Faust, the university's president.

"Letter to the Community - February 18, 2009"

Now, $1.4 billion per year equals 3.8% of Harvard's endowment of $36.9 billion as it stood on June 30, 2008. But $1.4 billion per year comes to 5.4% of the $25.8 billion that Harvard's endowment will shrink to if realized losses are in fact 30%. At current prices, I suppose it's possible to construct a diversified portfolio of this size that would generate a pre-tax return of 5.4% without touching the endowment principal; but it wouldn't be easy and, more importantly, the income stream likely would not grow as fast as the operating expenses it funds.

Hence, Harvard is selling off a number of its endowment positions in public and private equity and borrowing in the debt markets to provide short-term cash. On the operating front the university is tightening its belt, suspending some ambitious construction plans and instituting certain pay freezes. The university will undoubtedly be reaching out to the alumni base for increased giving as it celebrates its 373rd anniversary this year.

But if Harvard, whose endowment is managed with a multi-century time horizon, finds its liquidity affected by the current crash in financial asset prices, who exactly are the long-term holders who can ignore the current volatility in stock prices and sit tight for the long term? Insurance companies like, for example, AIG?

There may simply be an insufficient amount of investment capital with a multi-generational investment horizon that is indifferent to market volatility like we're experiencing today. This alone could explain a good bit of the Equity Premium Puzzle. Moreover, the NYT "Hot Seat" article on Jane Mendillo, Harvard's new endowment manager, suggests a related agency issue. Even if Harvard University can take a truly long-term view, ultimately the investment decisions are made by individuals (or committees) whose career horizons are quite a bit shorter than Harvard's. Even if one truly, truly believes that in the long-run stocks will deliver premium risk-adjusted returns, it's no fun to report a 30% decline on your watch.

So for all those young investment bankers who intend to wait out the current recession in business school for the next two years, start reading up on the Equity Risk Premium Puzzle and the Liquidity Preference Function. They should be hot topics for the next couple of years.

**********

Some more comments by RHH on this topic over at Seeking Alpha

Annals of Rank Hubris, Larry Summers Edition

Larry Summers's Billion Dollar Harvard Gamble



(note 1)
Much, though not all, of the data used to analyze the Equity Premium Puzzle comes from US stock returns from the mid-1920's, or in some cases stretching back to the Civil War. This is largely due to data availability and reliability. Some commentators on the Equity Risk Premium Puzzle have noted that returns for US equities over this period may be related to country-specific factors, specifically the evolution of the US from an agrarian, emerging economy into a political and economic super-power. As such, US returns may reflect a "success bias" making them unrepresentative of global equity returns over the same periods. For a good discussion of global equity returns, see "Global Evidence on the Equity Risk Premium" (pdf).

It should also be noted that even 160 years of stock price data represents only eight non-overlapping 20-year observation periods, a relatively small data sample. Likewise, the commonly used U.S. data back to 1925 represents less than five non-overlapping 20-year periods. This means that new, extreme data points can dramatically change our view on the odds of their occurring. This time last year, one could say that a 50% peak-to-trough decline in the S&P 500 had occurred only once in 88 years, and that was associated with the Great Depression. As of today, it's occurred twice.

Alan Greenspan, Market Timer?

Floyd Norris's piece in the New York Times "A 10-Year Stretch That's Worse Than It Looks" is well worth reading.

Click to read article

According to Norris, the 10-year stretch ended January 31, 2009 represents the worst 10-year return (in real terms, including dividends) since the S&P 500 index was created. The compound annual loss in purchasing power was 5.1%.

Further says Norris, "Taking inflation and dividends into account, an investor who put money into the market any time after the end of 1996, and held on, now has less value than when he or she started."

Here Norris misses the opportunity to trot out Alan Greenspan's infamous "irrational exuberance" quote. Over the years, I have asked many sophisticated investors and financial professionals if they remember when Greenspan made the comment. Most give answers between 1998 and 2000, corresponding to the Nasdaq bubble.

In actuality, Greenspan made the comment on December 5, 1996. Closing prices of the major US indices that day (and on Jan 30) are shown here.

It's worth remembering Greenspan's quote more fully. The Fed chairman was addressing the American Enterprise Institute for Public Policy Research on the topic "The Challenge of Central Banking in a Democratic Society." In a wide-ranging speech that briefly covers the history of the central bank, Greenspan raises the issue whether the Fed's goal of price stability should include not just the prices of those goods and services that make up the inflation indices, but of financial assets as well.

"But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?"

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

How do we know when? When the Fed chairman starts talking -- however obliquely -- about overheated equity markets, that's when.

Ironically, Greenspan finishes up with the following thoughts:

"Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown."

Oops.

For the full text of Greenspan's speech, click here.

Did TARP 1.0 Get it Right?

Some good comments from Robert Baird (and follow the links to Yves Smith) regarding the emerging view that TARP 1.0 was the right solution.

For those (like Joe Nocera, NYT) "First Bailout Formula Had It Right" who believe that the intent of the original TARP program was nationalization of bad banks -- or at least bad bank loans -- I say let's deconstruct the words. Someone spent more than a few minutes picking "TARP" among the various pronounceable acronyms that could've been created so there must be some subtext worth examining.

"TARP" stands for "Troubled Asset Relief Program". At the time, these assets were thought to be merely "troubled". Not distressed, not underwater; just a little anxious or, like teenage boys, a bit undisciplined and prone to mischief. The thought was that the government could take them into its custody, perhaps let them spend some time at the spa or in rehab and maybe in a few years they would be restored to perfect health with nary a care in the world.

Now, the growing consensus is that maybe some of these assets are more than a little "troubled" and let's face it, "impaired".

If, as widely expected, the Obama administration comes out with a new program next week, they'll need a new acronym. I suggest "Commercial bank Recapitalization and Assistance Program" or CRAP. The assets acquired by the taxpayers will be known, quite sensibly, as the CRAP assets. That should be easy to remember.


****

BTW, Can anyone shed some light on "TARP"?

Was it meant to suggest a tarpaulin, perhaps in the sense of a being spread UNDER the assets as a sort of safety net? Dictionary.com defines "tarpaulin" as "a protective covering of canvas or other material waterproofed with tar, paint, or wax", which reminds me more of the sheet they pull OVER dead bodies at a crime scene.

Maybe the acronym was more apt than its creators intended.

Weather Report - Perfectly Stormy

Lately, the "Perfect Storm" metaphor has returned with gale-like force to explain all manner of business failures. This buzzphrase hasn't enjoyed such popularity since the collapse of the dot.com bubble in 2001-2003. Most recently, WCI Communities (NYSE:WCI) , a developer of luxury homes and towers in southern Florida invoked the meteorological metaphor to explain its bankruptcy filing.

(Read article from NY Times Dealbook)

And WCI is not alone:

(Read article from TheDeal.com)

As I recall it, a perfect storm is a "100-year" storm, a weather event so unusual that one should expect it to occur only once in a (very long) lifetime. Of late, however, every corporation that runs into a patch of rough water seems to blame a perfect storm of economic headwinds for its difficulties.

It's ironic that Wall Street types use such an extraordinary metaphor to describe the utterly predictable. Notwithstanding the dramatic moderation in the cyclicality of the U.S. economy since 1982, the U.S. has suffered a recession roughly every decade since then. We suffered through the savings & loan crisis in the early 1990's and today -- only fifteen years on -- we are in the midst of yet another real-estate related banking crisis. We've had a bubble market and crash in tech stocks and residential real estate in the first decade of this new century alone. These are hardly once-in-a-lifetime events.

Even more ironic, if the Wall Street whiz kids who created (and the credit agencies who rated) AAA-rated CDO securities had actually understood what it means for a borrower to maintain the ability to pay uninterrupted interest and principal notwithstanding predictably improbable adverse economic events, Wall Street would've avoided much of its current mess.

Consider what a "once in a hundred years" event might look like. World War, perhaps? That's happened twice. Besides two World Wars, the last hundred years have witnessed the rise and fall of the Soviet Union, four different governments in Germany, uncontrolled hyper-inflation of the deutschemark, 25% unemployment in the U.S. and exactly one World Series championship by the Chicago Cubs.

Many statistically improbable events actually do occur in a hundred years, and some of them naturally merit the "perfect storm" designation. But residential over-building in Florida, followed by a collapse in housing starts during a period of tight money ain't one of them.

For another well-written article on the topic, see:

(Long-Term Capital: It's a Short-Term Memory)

What Was Merrill Lynch Thinking?

According to an October 25, 2007 Wall Street Journal article

(Pioneer Helped Merrill Move Into CDOs - subscription required)

Merrill Lynch underwrote $160 billion of CDOs from 2000 through 2007 year-to-date. Assuming Merrill earned an average underwriting spread of 1.25% on this business, they booked $2.0 billion in underwriting fees over these 7 1/2 years. Those are some pretty good numbers even by investment banking standards. And with investment banking compensation at 45-50% of revenue, you can assume Merrill's CDO desk took home some pretty handsome paychecks over the years.

Now Merrill is taking a nearly $8 billion writedown on CDO inventory that they warehoused and couldn't sell. Some think the number will go even higher in the current quarter ending December. At the moment, it would appear that Merrill's approach to CDO underwriting was driven more by league table bragging rights, quarterly profit targets and perhaps a compensation system that ultimately failed to tax the CDO underwriting group with an appropriate capital charge for the risks they took with the firm's money. Ultimately, Merrill was buying the securities it packaged. This looks less like a failure of risk-management systems than a complete lack of one.

To be fair, the development of CDO's helped provide the abundant liquidity that enabled private-equity firms to buy out companies, which in turn, has helped prop up the equity markets. And Merrill seems to have done quite well in its M&A advisory, brokerage and other underwriting activities. So the CDO underwriting business may have contributed directly and indirectly to Merrill's success in other lines of business, mitigating the pain somewhat. Ironically, Merrill seems to have managed its exposure to leveraged finance commitments remarkably well, making the CDO debacle even more puzzling.

More to come on this one.