The Invisible Hand

Today's announcement by Bank of America is the second in a series of recent rational decisions by private entities seeking to address some of the concerns that exist in the markets.

Bank of America to Modify Mortgages, Help Homeowners

Bank of America Corp., seeking approval of its Countrywide Financial Corp. takeover, said it will modify at least $40 billion in troubled mortgage loans over the next two years to keep customers in their homes. The move would help as many as 265,000 homeowners...

While clearly different in many ways than the industry-wide announcement of a privately orchestrated derivatives clearinghouse (discussed here), BofA is also pro-actively responding to the financial crisis facing millions of American homeowners that has had ripple effects across the globe.

A cynical perspective might suggest that these measures are simply an attempt to prevent direct intervention by regulators in a system in obvious need of repair, or perhaps they just want the merger to be approved.

However, if one considers that such a move is not only the right thing to do, but also economically-rational, then it appears more likely that this was purely an example of the free-market working. Private market participants are nimble and knowledgeable, and at least if we take BofA at their word, they sometimes do the right thing.

While helping 265,000 homeowners is not going to solve the foreclosure crisis we are facing, it is surely a step in the right direction. Now let's hope they follow through.

Bad Housing But Good E-Coli

Although this is unsurprising, it is now official that the housing slump is entering into record territory nation wide.

New-Home Sales Fall to Low Last Seen in 1990s

The NYTimes today said:

Buyers vanished from the housing market in March, as sales of new homes plummeted to the lowest level since the housing recession of the 1990s, the government said on Thursday.

Builders are now faced with the biggest backlog of unsold homes in more than a quarter century, a sign that home values may continue to drop.

One thing that the article does not mention is the growing amount of foreclosures that are continuing to squeeze homeowners, reduce the demand from future buyers and create an even greater amount of excess supply.

Lets hope innovation can pull us out of this mess.

On that note, I had an interesting, but random conversation with a researcher this evening who told me about the use of genetically modified bacteria to make biofuel.

Perhaps best known for food poisoning, E-coli, have apparently been modified by scientists to make biofuel.

I never thought I would be blogging about E-coli, or that if I was it would be good news, but sometimes life surprises you in unexpected ways:

Efficient Biofuel Made From Genetically Modified E. Coli Bacteria

Here's hoping creators keep creating.

Intelligent CDS Reform

The WSJ has a great article today suggesting the benefits of a central clearinghouse for derivatives contracts that are currently traded over the counter.

Here is the article: Street Seeks Credit-Default Safety Net: Banks, Exchanges Speed Effort to Launch Clearinghouse to Back Derivatives Swaps

For those of you who have been reading this blog for awhile or have talked to me for more than 10 minutes about the credit crisis, you probably know that my biggest fear for the markets involves a doomsday scenario where a major institution fails, leaving a variety of counterparties holding CDS contracts without anyone on the other side (earlier post: The Fan).

It seems like one step towards averting such a potential disaster is to have more transparency in this very opaque market so that people can have a better idea about what risks their counterparties are taking.

According to the article:

More than a dozen firms including investment banks, brokerage firms and futures exchanges are accelerating efforts to create a clearing entity that would function as the middleman between firms on both sides of a credit-default swap. The clearinghouse would guarantee payment on the contracts it handles, reducing the risk of a catastrophic ripple effect if one or more firms were unable to make good on their trades.

While there are issues around continued innovation (e.g. the creation of new derivatives), standardization (e.g. which contracts would be used), and internationalization (e.g. people could potentially trade elsewhere), this concept sounds promising.

It is also an excellent example of the market offering a solution to a regulatory failure. Let's just hope that the Fed keeps their hands off or at least encourages these sophisticated players as they develop this promising market-based solution.

Former Telecom CEO And Mobile Internet

Today I had the great privilege of having lunch (along with a group of fellow students) with the former CEO of Chunghwa Telecom, Dr. C.K. Mao. He genuinely was one of the most impressive people I have met in a long time, and I don't think I will be able to do it justice in this post.

He had a very clear and calm charisma about him, yet was able to slice through incredibly complex concepts and articulate brilliant answers in a very meaningful and precise way - all in a second language.

The key takeaway from his various years in leadership across a wide variety of sectors both in government and outside was:

Domain knowledge is not as important as having a tool kit that you can bring across various industries. His kit includes "decision making" and "change management". You should develop your own

To communicate big ideas at the transition point in an industry (for Dr. Mao at CHT this was in the transition from landlines to broadband/DSL): get people involved in *doing*: half will get involved and feel motivated, 30 percent will follow their lead, and 20 percent will probably quit or leave the firm.

He also had some very interesting thoughts about the future of mobile and phone services generally, which he sees progressing towards mobile IP-based data-transmission.

As I can attest to by the fact that I am drafting this note on a blackberry mobile device, I strongly believe in the future of the mobile internet. I am convinced that mobile is the future in more ways than one. Our fixed screens will be cool and good for media content, but lots of content will be easily accessible and text/image based along with us all the time. We will be able to interact socially in ways that make holding the device in our hands just part of the way things are done...and you guys will stop getting annoyed at my typing away...maybe that last bit is a bit too far-fetched, but there are exciting times ahead.

Peter Lynch Visits Harvard

The Harvard Investment Club hosted Peter Lynch today to offer some basic advice on investing in public equities. Mr. Lynch is one of the most well known and likely one of the most successful investors in history judging from the track record of his Magellen Fund at Fidelity, which returned 29% compounded over the 23 years he managed the fund while growing it from $18 million to the $14 billion in assets when he retired from the fund in 1990.

He gave very commonsensical sounding yet insightful advice to future investors. The notes from the talk follow below:
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A. Know what you own.

When a stock goes down and you don't understand what the company does, you don't know whether to sell or buy more. Don't buy things that are complicated. He bought stocks like Dunkin Donuts.

Keep in mind, the average stock has had a range of 100% from high to low. If you don't know what you own, you are likely to "turf it" (sell it right before it goes up). People should employ their advantages, and buy stuff they know a lot about.

B. It is futile to predict the economy, interest rates and the stock market. (*ignore this point* ;-))

You just don't know what is going to happen. Predicting the future is a waste of time. If you spend 13 minutes on economics you have wasted 10 minutes. Small economics...asking questions like: how much does aluminum cost? and does a recession impact used cars or new car sales? are a good idea.


C. You have plenty of time.

When WMT went public they were a 15 year old company. 10 years later they were up 10x and after 15 more years 30x more (300x total). There are good companies, but not a lot of them. Fortunately, you don't need to find a lot of them just a few over a career.

D. 10 most dangerous things people say about stock prices:

1. If its gone down this much already it can't go any lower.

One of his favorite stocks went from 15 to 12.5 to 9 all the way to 3. He was still confident thinking that he was "a little early". With a level head, he bought more and ultimately did well on the investment.

2. If it has gone this high, it can't go higher.

This is simply not true. MCD, MSFT, GOOG are all examples.

3. Eventually they always come back.

Sometimes they don't.

4. It is trading at $3. How much can I lose?

All of it.

5. Its always darkest before dawn.

It is darkest before complete blackout.

6. When it rebounds to $10, I'll sell.

Numbers don't matter. They are arbitrary.

7. What me worry? Conservative stocks don't fluctuate much.

Things change. See the electric utility industry.

8. Look at all the money I've lost, I didn't buy it.

Don't look at the ones you miss.

9. I missed that one. I'll catch the next one.

Maybe not.

10. The stock has gone up/down I must be right/wrong.

Don't start buying because stocks go up. There is a 100 percent correlation between earnings and stock performance over time.

E. Avoid Long Shots.

The company says "If this works and that works it goes up 20 fold!" But now...no sales. Mr. Lynch was for 30 on these.

F. Importance of Management.

Management is important, but if you have a bad industry and terrific management, you can't win. But simple businesses don't need much management. Mr. Lynch wants to buy a company that any fool can run, because eventually one will.

G. Be Flexible.

Even when industries are successful, you can still lose. MCD, Outback, etc. made money in the restaurant industry even when it was growing at 2%. Even shrinking industries are OK. An industry not going anywhere but where you have a monopoly makes money. Bankruptcy is OK.

H. When to Sell.

When to sell is exactly when to buy. Always write down the reason why you made the investment decision. What is the story?
Stick by the reasons. If the story changes or you are wrong, sell...unless you can come up with a new story.

I. There is always something to worry about!

The organ in the stock market is not the brain. It is the stomach. There is way too much news now.

Key example was in 1991: Recession was imminent, 1st War in Iraq was starting (big concerns about major losses), Banking system was on the brink, etc. But...it all turned around. You can't get too distracted by background noise.

After Caesar died, the market in Rome probably crashed. In the year 1 BC, people worried about Y0k. In 1999 it was Y2k. People overreact. There is always something to be nervous about.

The news today is the depressing channel and the super depressing channel. But look at Brazil, Philippines, Chile, Eastern Europe...there is good news out there.

--------------

This last piece is music to my ears as I seek to ignore the horrible news coming out of the banking sector today. At least for another day or two we will stay on the bright side...but watch out for that other shoe.

Jeff Bussgang of Flybridge Capital Visits HLS

My VC seminar at HLS had a real treat Monday evening, when serial entrepreneur and venture capitalist, Jeff Bussgang (of Flybridge Capital, formerly IDG Ventures) took time out of his busy schedule to share some of his experiences and lessons learned from his time working on start ups and in the Venture Capital Industry.

Mr. Bussgang, who is an active blogger (visit his blog here) was incredibly down to earth and gave mostly common-sensical sounding but nevertheless insightful advice in plain English. He reminded me once again that speaking with clarity is a sign of true understanding.

My notes from the talk follow below. The post is long, but there are lots of good nuggets of wisdom, first on being an entrepreneur and then on being a VC:

He knew that he wanted to be an entrepreneur from the beginning. Resisted the temptation (and active recruiting) of a V.C. firm who saw value in his undergrad computer science degree and MBA.

Thoughts on Entrepreneurship:


Start-up 1: Athena
In the early 90's (while at HBS) first start up was an app trying to replicate Lotus 1,2,3 for the emerging OS2 platform. It ultimately was not successful, primarily because they were squeezed by IBM.

Lesson 1): Technology is only as good as the platform.
Takeaway: In developing mobile apps today, we should think carefully about choosing I-phone or Android (or other) as the platform. I personally like Android, but Mr. Bussgang suggests I-phone, as the ramp up for Android will be long and unpredictable.

Lesson 2): Be careful who you are beholden to...they were squeezed by IBM because of their total dependence on 0S2.

Lesson 3): Weak team = weak outcome.
Takeaway: Find the right people for the given project.

Start-up 2: Open Market
Again pursuing his passion for entrepreneurship, Mr. Bussgang turned down another rational offer at a consulting VC firms to join a small firm called Open Market. The firm caught the wave and had a $1.2B IPO with $1.8 mm of revenues at the time. When he left in 2000, the firm was still worth $2.0B and had $100mm of revenues.

Lesson 1): Speed wins. Be First. Be Fast.

Lesson 2): Focus is important. Making the incremental improvements from 80% to 90% and on to 100% of quality is hard...but worth it.

Takeaway: Key is to get BOTH sides of the brain working. Be creative and a dreamer, but bring that down to focus and analytics. Be methodical.

Lesson 3): PR vs PE ratio. Keep the news coming.

Lesson 4: At some point the "grown ups" need to come in to run the company.

Lifetime of the company goes from: Jungle, to Dirt Road, to the Highway. And you need different skill sets (and likely different people) at each stage.

Start up 3: UPromise
In another somewhat "irrational" decision, he left a very large sum of unvested stock options on the table to join a company. It had a very attractive valuation though and had a solid team that raised money with 7 people and 20 slides.

Lesson 1: Great People + Great Idea + Great Comps = Great Valuation (comps were trading at 100x revenue at the time)

UPromise ultimately became a $100 MM revenue company. If multiples stayed as high, it would have become a $10B company. In reality, it was still a nice deal with a $300 mm exit in 2006.

Lesson 1: Save TIME not money. (However, time the market. In a down market, take your time).

Lesson 2: Brand is powerful. Difficult to differentiate between "network effects" of something like UPromise, Ebay, and others, but perhaps the early Amazon where network effects were limited shows a pure "brand" power.

Lesson 3: Build a business using "other people's money" in the sense that unlike NetFlix, which must use its own balance sheet to promote its brand, you want to find ways to get others to promote your brand.

Lesson 4: Founder transitions are crucial to consider. Bringing in an outside CEO is sometimes necessary but may rock the boat.

General Thoughts:

Patents don't matter. People, team, and timing trump any piece paper claiming a patent.

Being Mission Driven from the beginning to the end is crucial.

Thoughts on Venture Capital:
Two typical on-ramps to being a venture capitalist:
1) Apprenticeship Model: Join out of school. Work your way up.
2) Entrepreneurship Model: Make VC's money by being a successful entrepreneur. Get invited to join them.

Differences between Entrepreneurs and VC's:
Entrepreneurs are very focused. Narrow and with deep expertise.
VC's don't really execute. They find opportunities and match them with people. A mile wide and an inch deep.

VC industry has changed dramatically since 1999 when there was about $40B of capital available. Today that number is closer to $250-300B.

This means there are more funds, with greater capital bases, making funding small deals uneconomical.

IDG Ventures (now Flybridge) saw this as an opportunity and was launched with a smaller fund to address the needs of smaller start-ups.

The dispersion in VC is massive - even higher than in private equity or mutual funds, which makes picking a great fund even more important for institutional investors. By staying focused, Flybridge can stay in the top tier.

Flybridge is focused on being a true service provider and having a high level of customer service to entrepreneurs. From my perspective this makes a ton of sense.

The reputation market for Venture Capital is highly efficient. Reputation is everything.

In general, the Venture Capital business has had an outsized impact on the world and the economy. Approximately 1,000 partners of venture capital firms have invested in companies that employ 10 million employees and represent 18% of the GDP.

Venture Capital and Entrepreneurship are about as American as it gets. Ben Franklin was one of the first great entrepreneurs and we have not stopped since.

Struggling to Stay Optimistic

I went to a talk tonight on a talk entitled "The Subprime Crisis, Gold, Commodities and Where the Stock Market Goes From Here" given by a few investors with a collective 70 years of investing experience, and lets just say that it makes this blog sound like a cheery story.

The punch line: we narrowly avoided financial markets Armageddon last month when the Fed arranged the bail out of Bear Stearns and the risk is far from over.

The short-seller and 50 year veteran suggested a variety of things, the most tangible of which is to be long gold as a hedge against hyper inflation and further deterioration of the dollar (just his opinion, not advice). (He is also long GOOG and RIMM. Smart old dude).

That said, spending a good deal of my time on Twitter over the last few weeks has kept me in the flow of optimistic and creative ideas...allowing me to keep my head out of the murkiness caused by headlines like:

S&P may cut $57 bln subprime debt, reviewing loss:

S&P said it is reviewing loss expectation for more than 17 percent of U.S. subprime debt deals issued in the first half of 2007

and

US Foreclosure Filings Jump in March: Foreclosure Filings Against US Homeowners Soar 57 Percent in March; Bank Repossessions Surge

Instead, I am starting to focus on signs of an emerging bottom like this:

Wilbur Ross Seeks $4 Billion to Purchase U.S. Banks

Billionaire financier Wilbur Ross Jr., who made his fortune turning around distressed steel and textile companies, plans to seek about $4 billion from investors including Arab sovereign funds to buy U.S. depositary banks.

And remembering, that God Blessed Texas:
Dallas housing market: nation's most stable

A recent PMI Group study reported that the risk of U.S. housing price declines remained low in many areas of the South, Midwest and Northwest. Among the 50 largest metropolitan statistical areas, Texas cities were the lowest and most stable in risk outlook during 2007.

The objective side of me realizes that there is much more pain to be felt before this is over. But we are still a nation of innovators and entrepreneurs. So I will keep dreaming and keeping hope alive.

Hyperbole Or Not

I was having a discussion with a friend today about a paper I am writing on the credit crisis, and he suggested that I remove some of the "hyperbole" from my analysis. He was referring to recent statements by Soros and Krugman, who have both stated that the current crisis is the "worst since the Great Depression".

That got me to thinking that in communicating extreme events or ideas in general it is difficult to avoid sounding "hyberbolic" or far fetched when describing the conclusion or the idea because it is so far removed from the status quo of the audience.

A similar phenomena occurred in a discussion with some friends last night where I was explaining the power of Twitter in the context of idea generation, dissemination and socialization. Those who are barely using Facebook thought what I was saying was extreme, while a fellow "tech-minded" person thought what I was saying was highly reasonable.

Although this problem may be limited to people like me, who tend to think at the edges of our knowledge and technology, I actually think it is more likely a general concern for communicating new ideas generally: if you are far removed from the audiences' understanding, you should build a bridge to walk them to the island of your idea, or run the risk of sounding like a fanatic or dreamer.

I guess this presupposes a desire to be heard by a wide audience. Maybe it is just better to speak and let those who can hear your voice understand and let the rest think it is all hyperbole. Perhaps one day, when the story has unfolded, they might remember some glimmer of the idea and realize it wasn't so extreme after all.

John Doerr of KPCB Visits HBS

In contrast to much of the negative news in the financial markets, there still remains a vibrant and exciting world of innovation in this country, primarily driven by the most extensive network of Venture Capitalists in the world.

One of those VC's, Mr. John Doerr of Kleiner Perkins Caufield & Byers (KPCB) visited us at HBS yesterday.

His talk focused primarily on KPCB's interest in "Green Tech" ventures, but he also offered general advice for entrepreneurs and future venture capitalists. Here are my notes from the talk:

The best way to predict the future is to invent it.

If you can't invent it, fund it. But to fund the future, you first have to find it.

At KPCB, they believe "Green" technology and energy efficiency are an important part of the future.

55 percent of energy in the global economy is wasted, primarily through heat emissions.

3 primary areas of focus for KPCB: Cars, coal, and efficiency.

Cars:
Fisker Automotive: producing a hybrid electric plug in. Gets about 100 mpg. 1 of 3 car companies in the portfolio.

6 renewable fuel ventures. Amyris produces a key compound in anti-malaria drugs. This allows them to construct better fuels - molecule by molecule. Transportation fuels industry is a $1 Trillion market.

Coal:
Biggest area of opportunity with few companies succeeding to date - carbon capture and sequestration for coal power plants is a massive market. Solve this problem!

Big fan of solar. Investment in Miasole a producer of thin film solar-technology. Able to achieve 11% efficiency.

Conservation and efficiency:
RecycleBank: Uses existing technologies such as Rfid. Has been able to increase recycle rates by 50 percent. They incentivize people to participate by giving people points which they can redeem at local businesses. Huge success and growing.

Policy Matters:

Get states to change rules regulating utilities.

Interest in Green-tech is growing with $3B of VC investments in 2006 and $4B in 2007. This number is growing and will continue to grow.

However, Federal investment in green technology is less than 1 day of XOM's revenues.

To solve this problem, we need all the people to make the right outcome the profitable outcome and therefore the probable outcome.

If we are successful, "going green" will be the largest change on planet earth in the history of humanity.

Advice to HBS students:

Hang out in engineering club at MIT. Join a KPCB, Greylock, or Sequoia portfolio company.

Think about ways to do: Green accounting, green marketing, green strategy.

Advice on becoming a great Venture Capitalist:

Most have entrepreneurial experience. V.C. is a service business, so you need to understand your partners.

You have to learn by failing...Like crashing an F16, it will cost $30 mm the first time. Get operating experience. Spend time at MIT.

Definition of entrepreneur:
Do more than anyone thinks is possible with less than anyone thinks is possible.

Restless. Never satisfied.

Difference between Mercenaries (Bad) vs Missionaries (good):

Drive vs Passion.

Pitch vs Big Idea.

Opportunistic vs Strategic.

Focused on competition vs Focused on customers.

Aristocracy vs Meritocracy.

Deferred life plan vs Whole life plan.

Money vs Meaning and Money.

Success vs Success and Significance.

Consumer change:

How will we change consumers minds to get them on board with "Green"?

Consumer change is hard. For example, we still import bottled water from Fiji.

Theory of change:

We will not have a global solution until the U.S. leads. Leadership is up for grabs. All current platforms are unacceptable. Mainstream America does not have a sense of emergency or urgency here.

Politics are non linear.

Alliance for scientific communication. WeCanSolveIt.Org.

Hewlett foundation. Design to win. The looked at 5 regions of the world that matter. Within each region and each sector and figure out what needs to happen. Figure out how to make change happen (i.e. within power industry, utility commissions have power and 20 dudes really matter). Move public opinion and change the laws.

"Brown" companies will retaliate against "Green". Already have with things like: Coal is clean.

Coal and oil companies will do what they need to do to preserve the status quo.

We need to develop a Carbon accounting system. Carbon capture and sequestration will become standard in coal.


Future hope:
His daughter's generation (she is 16) needs to get out of Facebook and into the face of politicians. We have numbed them into a set of career expectations.

The Energy movement is the first grassroots movement that has embraced 10 million people since Martin Luther King. He is glad Al Gore is out there and providing the leadership he is.

Future of Technology (if all his companies are successful):

Browser will be transformed by sites like: Cool Iris. We will have fully-immersive 3D technology.

We will be mobile.

A few hundred dollars will let you spit in a tube and have your DNA analyzed in hours.

We will reverse metastization of cancer.

Green fuels will be made from CO2.

General advice on balancing competing interests:

Measure how much time you spend with each priority.

For him: Family comes first.

Home by 6 p.m. 20 days a month.

Measures how much time he spends with Partners, current CEO's, potential entrepreneurs, and community service (targets 15% of his time).

General Career Advice:

Ideas are easy. What matters in life is execution. It takes a team to win. Think and speak on your feet.

Network constantly. Network each day for 10 minutes.

Find a mentor, ask them to be a mentor. Sustain that relationship.

Take risks. To ask permission is to seek denial.

Integrity is a binary state.

Life is long - its a marathon, not a sprint.

Call your mom once a week.

Spring Is Finally Here

It is hard not to be optimistic on a day like today. 60 degrees and sunny just sets a nice tone. May help to explain the creativity and entrepreneurship of Californians.

Well, it looks like the optimism (or muted optimism) is spreading to
Wall Street with Goldman's head honcho today staying we are in the "third quarter" of the crisis. (here is the Bloomberg Article: Goldman's Blankfein Says Credit Crisis Close to End).

Such confidence is not only helpful to hear in terms of market sentiment, it is also a nice contrast to the more pessimistic tones reflected in the below post as well as that echoed by the IMF yesterday, which suggested that losses will rise from the current $230 billion to close to $1 trillion by the time we are all said and done.

The most pessimistic number I have heard came in my Investment Management class at HBS, where John Paulson, manager of Paulson & Co, suggested that losses will likely reach ~$1.2 Trillion before the end of the crisis. Mr. Paulson (no relation to the Treasury Secretary) made $15 Billion in profits last year for his investors (with returns approaching 700% for one of his funds) primarily by betting against Subprime ABS securities.

Here is an article discussing his success: Trader Made Billions on Subprime. His bearishness not only turned out to be correct, but it was also very profitable.

What the ultimate losses will be in this crisis will come down to a variety of factors, but I don't think one should underestimate the importance of confidence and optimism.

So bring on the sun...or move to California.

Ratings Schmatings

This headline from Bloomberg says enough to explain the content of the article.

Moody's Is Least Accurate Subprime-Bond Rating Firm

Moody's assigns Caa2 or lower ratings to just 12 percent of the 292 bonds underlying benchmark Markit ABX indexes that UBS analysts expect to default. Both Fitch and Standard & Poor's tag 57 percent of the bonds with equivalent rankings, according to a report from the New York-based analysts yesterday. A rating of Caa2 or CCC is eight levels below investment grade.

``Moody's trails badly,'' UBS analysts including Laurie Goodman and Thomas Zimmerman wrote.

The crazy piece of this to me is how this can to continue to persist given all of the recent public acknowledgment of the obvious fact that the rating agencies were a central character in the credit debacle we have been experiencing for the past 9 months.

The recent report by the President's Working Group on Financial Markets is worth a read if you have not yet. (The press release and link to the report can be found here: President’s Working Group Issues Policy Statement To Improve Future State of Financial Markets)

The report walks through a number of causes for the crisis, with the rating agencies playing a central piece in the puzzle.

As their credibility continues to be undermined it remains to be seen what implications will arise. Hopefully this will create more discipline in the initial underwriting of investments, which to be fair, should not fall on the shoulders of agencies but rather should be conducted by the individuals being compensated to make investment decisions.

In the mean time, the story continues to play out with estimates of total expected losses now ranging from:

the ~$150 Billion written down to date by S&P (Subprime Writedowns: Is the Worst Over?)

...to $600 Billion by UBS Financial Firms Face $600 Billion of Losses, UBS Says)

...to $1Trillion by commentators (Brace for $1 Trillion Writedown of `Yertle the Turtle' Debt)

Judging from the Rating Agencies' performance to date, one would likely have to side with the more conservative scenarios of other estimators if taking sides...or maybe they have learned their lesson?

Avoiding Moral Hazard

Let's hope this article from the Brits is more than speculation:

Fed eyes Nordic-style nationalisation of US banks

Apparently Fed officials have been consulting with their Scandanavian central banking counterparts to learn how the Nordics were able to save their own economies through seizing some of their domestic banks in the early 1990s.

Unlike Bear's bailout, which looks like it is giving equity holders $10/share and Bear management a seat at the table, the Scandanavian efforts "purged" management and ensured equity golfers received nothing.

While perhaps further failures can be avoided recent speculation of losses approaching 1 trillion makes such an optimistic scenario unlikely. It seems the fed is pragmatically asking what to do "when" rather than "if" another shoe drops.

More Paulson Common Sense

In another move indicating that Mr. Paulson has experience outside of Washington he appears to be poised to suggest a new set of regulators and consolidated roles among Washington beaurocrats. The moves are discussed here: Paulson to Propose New Regulators, SEC-CFTC Merger and here: Treasury’s Plan Would Give Fed Wide New Power

Acknowledging that part of the cause of the current crisis was a failure in oversight is an honest step in the right direction and suggests hope for the future. The fact that a conservative-minded former business executive with as much credibility as Mr. Paulson is doing this suggests that perhaps even those with a "leave things they way they are" form of conservatism might be willing to listen.

There is no question in my mind that our government needs to innovate if it wants to have a chance to keep pace with the breakneck speed of financial wizardry. By creating a leaner, more well organized, and more focused regulatory body perhaps we can accomplish such a lofty goal in the future and prevent future calamities like the one we have been watching unfold over the last year.

Now if only they would extend their reach to the rating agencies...one can only hope for so much I guess.

Finding A Bottom

A number of you have asked me when I think housing prices will bottom. The short answer is: I have no idea, but most smart people I have asked think it will be 2010 before housing prices stop falling.

Here is a realistic view from Irvine Housing Blog that suggests that in least in the Los Angeles market, it will likely be 2011 before we reach a bottom based on historical S&P/Case-Shiller forecasts.



In any event, there appears to be a lot more pain for individual homeowners left to come. Hopefully some of the liquidity pumped into the system over the last few weeks will help to dampen the blow in the form of more reasonable renegotiations and restructuring with individual homeowners who are facing the prospect of foreclosure.

It seems like it is in the banks' collective self-interest to reduce the excess supply of housing as the wave of adjustments in a wide variety of exotic mortgages continues to play out.

No More Room

Courtesy of Paul Krugman's commentary on Weird Interest Rates

Always, that is, until now. Treasury rates have plunged close to zero, even though Fed funds is still 2.25%. Since open-market operations take place in Treasuries, I take this to mean that the Fed may not actually be able to reduce short-term rates much from current levels — which means, in turn, that conventional monetary policy has been taken off the table.

There does not appear to be much more room for the Fed to move the needle with liquidity.

Desparate For Good News

Goldman, Lehman Reduce Loan Backlog With Discounts

U.S. banks from Goldman Sachs Group Inc. to Lehman Brothers Holdings Inc. have whittled their holdings of leveraged buyout loans to $129 billion from $163 billion at the beginning of the year by offering the debt at discounts, according to analysts at Bank of America Corp.

The decline is a ``ray of hope'' for banks amid a slump in credit markets and a slowing economy, said analysts led by Jeffrey Rosenberg. The firms also have $73.6 billion of high- yield bonds they need to sell, they said.

Apparently people are treating this as if it is good news. I would not take it as such at face value, but any momentum out of the logjam of February is a positive sign.

Greenspan On Uncertainty

Alan Greenspan recognizes in clear terms one of the fundamental problems with our current financial system, as enunciated in the title of his oped: We will never have a perfect model of risk

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

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But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve.

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Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response.

This sentiment is similar to that which motivates my distaste for "quant funds" or other overly complex sets of financial analyses. When building a house the foundation is important, but it can be somewhat imperfect and the house still stands. But when building a tower, one had better be certain that the foundation is secure.

The elegantly complex models of correlations and statistical almost-truths piled upon estimations of human behavior work in times of human consistency. But when people change their minds, or behave in innovative, stupid, or perhaps just rationally greedy ways, it is sometimes hard to predict the outcomes. And as we are seeing, being wrong with a multi-Trillion dollar tower of financial assets on top of our assumptions produces dislocations that can be somewhat painful.

Fear And Distrust

After Friday's Bailout of Bear Stearns, less than 2 days later, it turns out that the Fed has encouraged a deal in which JP Morgan has agreed to completely bail out the company for $2/share.

J.P. Morgan Rescues Bear Stearns

Bear Stearns Cos. reached an agreement to sell itself to J.P. Morgan Chase & Co., as worries grew that failing to find a buyer for the beleaguered investment bank could cause the crisis of confidence gripping Wall Street to worsen.

The deal calls for J.P. Morgan to pay $2 a share in a stock-swap transaction, with J.P. Morgan Chase exchanging 0.05473 share of its common stock for each Bear Stearns share. Both companies' boards have approved the transaction, which values Bear Stearns at just $236 million based on the number of shares outstanding as of Feb. 16. At Friday's close, Bear Stearns's stock-market value was about $3.54 billion

Falling into the "careful what you wish for camp" this quote jumps out:

"Bankruptcy experts said filing for bankruptcy protection wouldn't have been an attractive option for Bear Stearns, partly due to recent changes in the federal Bankruptcy Code relating to financial instruments like derivatives and repurchasing trades. Unlike most parties in bankruptcy, lenders in such transactions aren't stayed or prevented from acting to seize or control the assets involved in those deals."

In other words, the same financial institutions who lobbied to change the bankruptcy code only a few years ago are likely now regretting such a decision as the ability to slow down collateral calls and liquidations with a bankruptcy filing is now a less viable option.

If this doesn't wake up anyone who hasn't been fearing a major catastrophe nothing will.

The Fed has been moving fast over the weekend broading the liquidity back stop announced last week.

U.S. Fed Cuts Discount Rate, Says Dealers May Borrow

The Federal Reserve, in an emergency weekend decision, cut the rate on direct loans to commercial banks and opened up borrowing at the rate to primary dealers in government securities.

The credit markets have been anticipating this over the last month. These charts of the CDX indices express the fear that we are now seeing in equities:





There are many people prognosticating how the system could continue to unravel such as in this article in the NY Times published over the weekend: A Wall Street Domino Theory

This simple quote from the article underpins the biggest challenge facing the markets today: "In a trading firm, trust is everything".

The underlying principle guiding indices like the "consumer confidence" index and the like reflect the fact that our economy and markets are predicated upon a confidence in a world of limited information.

The unraveling of AAA-rated entities and now a blue-chip financial institution call into doubt basic assumptions upon which people's build their understanding of the economy and markets.

At this point I am starting to support the Fed in its efforts to prevent calamity primarily because I feel that the situation has gotten so dire that a lack of action could have brutal consequences...I prefer the "bull" part of my psyche and can't wait for days when it can dominate the discussion again.

Reason May Prevail

Paulson, Bernanke Plan Tougher Scrutiny of U.S. Banks

This is a reassuring companion to the bail out announced yesterday. An honest and clear assessment of the excesses of the CDO market (among other financial innovations) will lead one to conclude that banks, originators, credit rating agencies, mortgage brokers, and borrowers (yes borrowers too) were far to eager to perpetuate the glut of liquidity fueled leverage-consumption in the form of home "ownership" over the last half-decade.

In addition, lax regulation and underwriting by buyers of these products led to an all-too-easy ability for banks to "remove risks" from their balance sheets so as to avoid capital requirements intended to prevent bank failures.

Paulson's public acknowledgment that such an arrangement is simply unacceptable and unsustainable is to be admired as one of tempered admonishment with an eye to constructive reform.

If only all leaders could show such balance in their public decision-making we might be able to avoid future catastrophes like the one we are continuing to witness today.

The Put Is Here To Stay

In case you were on another planet today, the stock market popped the most it has since 2002 after the Fed announced that it is going to bail out bad banking decisions at the expense of the American Taxpayer.

The details are discussed here: Fed's Loan Rescue Sparks Big Stock Rally: Fed Offers $200 Billion to Prop Up Lenders; Wall Street Responds With Huge Rally

The short answer for what this means is that for the first time, the Fed is going to accept mortgage backed securities as collateral for high quality government assets. In plain english: the government is going to take the risk on mortgage-backed securities that no one else is willing to buy.

I understand there has been some madness in the markets over the last few days, with hedge fund liquidations and the like: Hedge Funds Reel From Margin Calls Even on Treasuries. But does that mean that the American taxpayer should step in and bail these bad decision-makers out?

If we are going to use taxpayer dollars, why not actually restructure individual homeowners loans or do more of the stimulus minded stuff like the recent decision to give all Americans a bit of extra spending money?

The reality is: this is only the beginning of the implicit "put" option that the Federal Government has given banks by allowing them to create any kind of securitized vehicle they like without any oversight.

What today's announcement says, and what the market seems to have heard is, "Don't worry, we will do whatever we can to keep everyone afloat". While this might be good to stave off today's armageddon, deferring the pain until another day will only make it fall on another party - and this time the American taxpayer is footing the bill.

Don't Trust Your Model

This article makes me laugh inside: Credit Swaps Thwart Fed's Ease as Debt Costs Surge

The punch line of the article, similar to the signs we have seen at quant hedge funds is that we are not as smart as we thought we were.

In other words, the same over-confidence that led people to believe that they could construct complex derivatives at a ridiculously breakneck pace without changing the nature of the financial system is now leading to models that just don't work. To me this is another symptom of a society that has become to easily convinced by "proof" through statistical regression. Statistics are useful and powerful, especially in the context of scientific and medical research. However, once one leaves the sciences and moves into areas that involve human beings and even more complex systems like international financial markets, the idea that we can build a model to predict the future becomes less believable.

At a very simple level, if it was so easy to predict what was going to happen tomorrow, no one would make money by investing because all of this information would be priced into today's security values. The so-called efficient market hypothesis reflects this basic intuition.

The problem is: predicting the future is ridiculously hard in one person's life, not to mention trying to do it for a group of people, a society of people, or the world markets as a whole. Add in some leverage, a multi-trillion dollar market of obscure and complex derivatives, some people falling on rough times underneath the whole thing, and you are left with a system fluctuating out of control.

What will slow down the volatility and bring us back down to reality? Hard to know, but one thing is clear: don't trust the model.

Saving The Bank

It looks like my intuitions about regulatory capital and bank failures are starting to materialize in a major way at Citi.

This paints a dark picture for those hoping that the fed interest rate cuts would stem a decline in the housing market Citigroup to Pare Mortgage Holdings by $45 Billion

Citigroup Inc., the fourth-largest U.S. home lender by new loan volume, plans to pare its U.S. residential unit's mortgage and home-equity holdings by about $45 billion, or 20 percent, over the next year.

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Paring back mortgage holdings may help reduce Citigroup's capital needs by $4 billion to $6 billion

Plain and simple this is a sign that this staple of the American banking system is under dire pressure to ensure its survival. Combining these comments with rumors the other day that middle east investors are concerned for the bank's survival and the overall situation in the credit market, makes it seem like it will be quite some time before normal conditions return to the mortgage markets putting even more pressure on an already declining system.

This is unfortunate and sad news for homeowners looking to refinance or for those hoping to buy a home as contractions in the supply of capital will only make a dark situation worse.

Let's hope that this is enough to stave off disaster rather than the usual sign of worse things yet to come.

Bankruptcy Filings Surge

More unsurprising but worsening data

Bankruptcy Filings Surge Among US Consumers

American consumers' bankruptcy filings jumped 15 percent in February from the previous month and a steeper rise is looming because of the subprime mortgage crisis, the American Bankruptcy Institute said.

Consumer bankruptcy filings in February totaled 76,120, up from 66,050 recorded in January, the non-partisan bankruptcy research group said.

The February number was 37 percent higher than in the same month a year ago, according to the institute

Home Foreclosures Keep Growing

This is unsurprising for those of us paying attention, although it is troubling nonetheless. Via NYTimes: In Parts of U.S., Foreclosures Top Sales

During January, it was reported this week by RealtyTrac, there were 153,745 initial foreclosure notices sent out in the United States. That dwarfed the 43,000 total sales of newly built single-family homes and amounted to nearly half the total sales figure, which includes sales of existing homes and condominiums.

The pace of this mess appears to continue to increase.

According to this video from a dude at the Harvard Center for Joint Housing Studies, he sees a bottom at no later than December 2009. Many others are thinking late 2010. I heard that billionaire Sam Zell was on CNBC saying we will have a bottom in a few months...he must have been talking about megacap value equities or something.

Buffett Is Brilliant

Just spent some time reading this interview with Warren Buffett, and I remembered some of the best financial advice in the world is available in his newsletters for free:
Berkshire Hathaway Annual Shareholder Letters

My favorites from the post:

“Success is getting what you want, happiness is wanting what you get.” I won the ovarian lottery the day I was born and so did all of you. We’re all successful, intelligent, educated. To focus on what you don’t have is a terrible mistake.

Why do I come in at 7 every morning, can’t wait to get to work? because I get to paint my own painting and I like applause.

If I had been born earlier, I would’ve been some animal’s lunch. I can’t run, I can’t climb. I’d be talking about allocating capital and the animal would think, “Those are the kind that taste the best.”"

Almost always good things come from good behavior. Don’t keep score in life.

After a talk at Harvard, I told them to work for who they admired the most, so they all become self-employed.

Hearing The Music

Have you ever heard Twelve Tone classical music? In undergrad I overly ambitiously signed up for an advanced "set theory" class which met once a week at a famous professor's house, where he served us giant bowls of ice cream and we played "guess this song" with this 12 tone classical music. I guess partly because the squiggles on the board and Cantor arithmetic were over my head, I strained to hear the "good" in this weird sounding mess.

The optimism I have sought in the recent week or two in the markets brings this idea back - and I realize that the music is just plain bad...then and today.

More directly: my optimistic hope that the downside is somehow already priced in, or that maybe we will somehow collectively wave our hands and be OK is almost certainly mistaken.

The simple fact is that although the headlines today are resonating with the doom first expressed here in June and elsewhere much before, they nevertheless are just hinting at the potential for far deeper losses caused by things like further unwinding in the CDO market, the consolidation of failing SIV's on bank balance sheets, and the failure of financial institutions.
I spoke last night with a fairly well statured hedge fund manager who suggested that a bank failure was unlikely. However the more these writedowns continue to mount, the less room regulators have to act.

This article surely is not a coincidence: FDIC to Add Staff as Bank Failures Loom

Maybe that 12 tone stuff was really good and Aleph Naught to the Aleph Naught really matters. Or maybe the music is just really bad and people are finally beginning to notice. Keep listening.

Bad Mortgage Reform - Implemented Of Course

The government has finally acted to address the increasingly bloody residential real estate markets.

In a plan that includes a refund check to taxpayers, the government also agreed to lift the loan limit that Freddie Mac and Fannie Mae can purchase, which basically has the effect of lowering interest rates for loans above the previous cap of $419k up to the new cap which approaches $700k.

BUT

There is a catch: this does not apply to evenly across the board. In a sick twist that will have the effect of basically giving a government guarantee to help prop up those with more wealth in real estate, the loan caps are only lifted for communities where the average house price is greater than the previous cap.

The details are discussed in this article:

Stimulus Plan Aids Buyers of High-Priced Homes

The article suggests rightly that the markets feeling the most pain in the crash are are those in California and elsewhere where the median home does not currently qualify for federal mortgages.

However, the value of these homes also represents the relative wealth in these communities. Sure they are getting hurt now, but they also likely had a greater rate of appreciation in the bubble. They benefited from the excesses of Wall Street originated mortgages, but rather than letting the market correct these excesses with a reversion in prices, the Government is basically using taxpayer dollars (in the form of an implicit backstop for Freddie and Frannie) to bail out these overpriced assets.

Perhaps I am being a bit harsh, but a more equitable solution would have been to increase the cap across the board so that communities that have not yet realized the "American Dream" of ridiculous home values could have any chance to compete with the inflated values seen in the markets that will benefit from this rule.

Or better yet, the government could leave its too-late overly-simplified solutions on the sidelines until it came up with a more comprehensive rescue package like one suggested by Bank of America this week which envisioned the government buying mortgages and renegotiating with current occupants to prevent unnecessary foreclosures and wasted resources. Such direct social service seems to better represent the role of government in trying times like this rather than trying to play master of a market that is badly broken and clearly deeply misunderstood by most.

More Quant Carnage

According to Bloomberg, the mega quant fund AQR is down huge already this year:

AQR Hedge Fund Fell Almost 15% Through Mid-February

Why do these guys who have hired the most brilliant PHD's and built the biggest model continue to fail?

The past is not indicative of the future...especially when you never had credit markets or personal balance sheets like the ones we are facing today.

Don’t need to get any more complicated than that in my mind.

Open Source Credit Risk

This site has some ridiculously arcane sounding stuff on CD*'s. It seems like it is promoting open-source collaboration on what is obviously an important topic in risk management generally, but also for the future stability of the financial markets.

This site description is what got me...cool...now if only he would have developed this a few years ago!

DefaultRisk.com the web's biggest credit risk modeling resource

This is not a vendor site. It is just my own. I have been excited by credit risk methodologies throughout my career (I work at Fitch Ratings with a crack quant team). Although I am the principal author of CreditMetrics® and LossCalc™ (and have a natural affinity for them), I am more of an advocate for the continued study of credit risk modeling. Wonderfully, there are over fourteen hundred researchers featured on this site (see full list)!

"I'm trying to make the world a less risky place;
one credit portfolio at a time!"

-- Greg M. Gupton

What I want is to advance the state-of-the-art of credit risk management ... through YOU. I hope to give you all the tools to understand the strengths and limits of credit value-at-risk models so you can take the best and ... I trust ... create better ones. This site has been under continual development since 2000 and will continue to grow. I'm trying to satisfy two audiences:

Practitioners have a no-nonsense need to address risk in a timely fashion. Institutions hire research people to develop internally (and adapt from external sources) risk measurement and pricing systems to address tangible needs.

Academics have the more strategic, but no less difficult, need to efficiently access the many disparate sources of prior research and to gain insight into current practitioner practice & demand.

More Gagging

For some reason the news is rife with people trying to shut down open dialogue lately.

I have never heard of this site, but the very idea that a Federal Judge ordered them to shut down because of their whistleblower status just strikes me as unAmerican.

Of course the Internet is the friend of liberty and apparently these guys have found a way around the block...

Whistleblower Website Ordered Shut Down

(02-19) 19:03 PST SAN FRANCISCO -- A San Francisco federal judge has taken the highly unusual step of ordering the shutdown of a Web site devoted to anonymous allegations of high-level wrongdoing after it posted documents purporting to describe offshore activities of a Swiss bank.

U.S. District Judge Jeffrey White issued an injunction Friday ordering a Bay Area Internet host to disable the Wikileaks.org site and prevent the organization from transferring to any other server until further notice.

Wikileaks, founded in 2006, describes itself as an enabler of "principled leaking" by government and corporate insiders. Its site was the first to post the confidential Defense Department manual about operations of the U.S. detention camp at the Guantanamo Bay naval base in Cuba, and has also posted rules of engagement for U.S. forces in Iraq.

Despite the order aimed at its domain name, Wikileaks remained accessible Tuesday through its Internet Protocol or IP address, 88.80.13.160, and through so-called mirror sites in Europe that replicate its contents.