Sunday, January 4, 2009

Weekend Reading Recommendations on Financial articles

For our European friends who believe that the SEC exists to protect investors and that the grades of the rating agencies can be relied upon, it may be worth ten or so minutes to read the column by Michael Lewis and David Einhorn in today's NYT.
I would suspect that the SEC may have some interest in stopping an alleged Ponzi scheme by Haitians but it apparently had no interest in investigating Bernie Madoff, notwithstanding being repeatedly informed something was likely to be amiss.  While it may sound good to prohibit employees from going through the revolving door from the SEC to Wall Street, and why would any of them want to bite the hand that will soon enrich them, the problem would be finding anyone to work at government pay who is any good with a restriction of no employment with a regulated firm, or even if it is limited to 2 or 3 years.  Possibly it could be done if knowledgeable people were put in charge of the enforcement division, willing to do it mostly as a public service, retired or near retirement, and fully supported by a SEC Chairman and the SEC who had some interest in protecting investors rather than kowtowing to the firms subject to its jurisdiction.  The ratings agencies are hopeless in my opinion. They will scurry under some rock, claim protection under the First Amendment for what they have done, and just hope that it will all blow over as it probably will.  Here are some of my links to earlier posts discussing the same subjects as contained in the excellent column by Lewis and Einhorn.

The next article originated from staff writers at the Washington Post and was reprinted in the Tennessean this Sunday. | The Tennessean  The same article is available at the WP.The Beautiful Machine  The unit primarily responsible for destroying AIG was the AIG Financial Products unit.   The first part of this three part series examines the early history of this unit, how it was formed by some young men who made a fortune by convincing Hank Greenberg to allow them to use AIG's balance sheet to engage in what these young ones thought was a way to print money. They would take a mere  38% of the profits and would be paid no matter the long term consequences of their brilliance.  But they were not really interested in the money or so they say. In Greenberg's defense, if he had not been sacked for reasons unrelated to this unit, he might not have allowed the Financial Products unit to destroy the company he had spent a lifetime building.  This is just the first part of a three part series, which ends in the divorce between AIG and the young whiz bangs with one of them reportedly receiving a 150 million dollar buyout.   I do not know what the remaining parts will say but some of my posts may give a hint of what is to come. Cure for a Lush: A limitless supply of alcohol?/SYK a short?/WaMu: Just another example Socializing risk and Privatizing rewards
We already know how this story will end. 

The last article is by Joe Nocera in the NYT's Sunday Magazine and it is a little bit on the nerdy side, discussing how much the banks relied on Value at Risk models (VaR)
Part of the SEC's rule change in 2004 that allowed the investment banks to increase leverage above 12 to 1 was based on the belief that the VaR models would allow all of the smart people to manage risks, so no absolute rule was necessary to corral them in the pursuit of profits.  Needless to say, the VaR models did not work so well for reasons that would be obvious to anyone with an ounce of common sense.  It is not just the Black Swan events that are outside the scope of the models.  The model itself causes behavior that undermines its usefulness.  Nocera touches on a point deep into the article that the VaR model would encourage reaping profits from an activity like using a AAA balance sheet to write credit default swaps.  Yes, this is obvious and it makes this article worth a read keeping in mind what happened to AIG.  The employees at its London unit were richly compensated, absurdly so, as in hundreds of millions of dollars per year, to use AIG's AAA balance sheet to reap what turned out to be a mirage of short term profits that quickly turned into a tsunami.  VaR probably sanctioned their activity- even encouraged and rewarded it.    Nocera does emphasize that intelligent human beings have to be in control and he gives an example of what Goldman Sachs did in response to some unusual activity in its VaR models.  

I previously recommended Bary's article in Barron's about the potential fall in the long term treasury bond.  Bary's Column In This Week's Barron's: Another Helpful Column on Bond Investing
I would add that it would be useful to read this story in conjunction with Bary's
A great deal of the soaring U.S. debt, which may increase by 2 trillion this year, is financed with short term debt, much of it maturing within five years. Out of the Frying Pan Into the Fire The figure used in this WP article is that 40% of it held by private investors matures in 1 year or less.   Moody's is not worried but that is not exactly reassuring to me.  There will be a lot of new supply that the market will have to digest.  It will be interesting to see what happens if the dollar starts to fall against the major currencies as the new supply of treasuries need to be sold.  Will the foreigners continue to be so kind to the debt crazed Americans for 2009? 

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