Finance and the Public Interest

“In an abusive naked short transaction, the seller doesn’t actually borrow the stock, and fails to deliver it to the buyer. For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.” “What the SEC Really Did on Short Selling”, by Christopher Cox (SEC Chairman), Wall Street Journal, July 24 2008, P. A15.

As the debate continues over the wisdom or lack thereof of Congress having given Treasury Secretary Paulson a blank check to keep Fannie and Freddie afloat over the next 18 months, a point that seems largely overlooked is that there was only one realistic alternative.  Either Congress could explicitly provide a financial backstop such as the one just enacted, or the Federal Reserve could later ride to the rescue a la Bear Stearns should the need arise.  After all, there is widespread agreement that Fannie and Freddie are too big, and at the moment too important, to fail, and that taxpayers are ultimately on the hook.

It’s official.  After the administration’s protestations to the contrary last week – read my lips, no new bailouts – this morning Treasury announced a plan to inject “billions of dollars in loans and investments” to shore up Fannie and Freddie.

“We’re structure experts, we’re not underlying-asset experts.”

-- Moody’s employee

How exactly did the credit rating agencies assign ratings on collateralized debt obligations backed by mortgages? In “Triple-A Failure” in the April 27 issue of the New York Times Magazine, Roger Lowenstein explains in detail how Moodys rated one such issue, which Lowenstein calls “Subprime XYZ”. Lowenstein’s article is notable for the insight it provides into Moody’s ratings process. The ratings agencies were not the only culprit in this crisis, but they played an important role, and the Lowenstein article helps to elucidate that role.

Reporter: But now I’m asking you: When will we know?
Henry Hurt: Blackout lasts for 3 minutes. If they’re not back in 4, we’ll know.
--Apollo 13

When will we know that the credit crisis is over? One way to tell will be by looking at the market for credit derivatives. Credit default swaps (CDSs) permit investors to buy or sell insurance against the event that a specific company defaults (or more generally, experiences a “credit event”). The buyer of insurance pays a quarterly or semiannual premiums to the seller. In return, the seller promises in the event of default to pay the buyer the loss in bond value due to default. When CDS premiums are high, it is a sign that investors are worried about a default.

”Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”. — John Maynard Keynes

Is the Black-Scholes option pricing model responsible for the current credit crisis? The writer Michael Lewis (whose writing I generally admire) answers “yes” in “Inside Wall Street’s Black Hole” in the March 2008 issue of Portfolio magazine. He pins the blame on papers written 35 years ago by “academic scribblers.” He doesn’t blame Alan Greenspan, borrowers, lenders, ratings agencies; or investment banks. He blames professors. I don’t think this is one of Lewis’s finer efforts, but since he is highly regarded and widely read, it seems worthwhile to consider what he has to say.

The Pension Benefit Guaranty Corporation (PBGC) has just announced its intention to double its investment in equities to 45 percent of its $67 billion portfolio.  This decision flies in the face of responsible financial management, which in this case calls for avoiding equities entirely, or even better, taking a short position in the stock market.

PBGC’s decision to gamble for solvency is such a bad idea, and is motivated by such perverse institutional incentives, that I’d like to commemorate it by making it the topic of this first blog entry.