Big day tomorrow in Massachusettes.

I lived through one of these case studies some years ago. A senior VP with no technology background was given a performance objective for the coming year: put together a web application for the bank’s investment customers. That was about the extent of the mandate. It was the 1990’s, after all, and top management knew the buzzwords but not much more. The team started off with her trusted subordinate who actually had real expertise. Some of the next hires doomed the project. For example, one manager was hired for her generic management skills, but had no idea what her staff was doing. She tried taking a basic HTML/Intro to Web Development course but dropped it before the mid-term. Any request from the business users was treated as a divine law, regardless of what it would take to implement it or what it would do to the rest of the project. You may be familiar with the “big red button that you just have to push it and it does everything.” This beast, like the chupacabra, has never been seen in the wild or captured alive. Despite everything, we wrote the data dictionary, got the data imports right, designed and built the database, made the GUI, tested everything, and got as many things done well as we could during the breaks between screaming sessions. Phase 1 was implemented and the external clients loved it; I had a contract with one of the clients later, and they didn’t know how they would manage if the plug were pulled. When they found out I had worked on it and could show them some tricks and tools, that was as close as I have ever come to being a rock star. When the bank was later acquired by a competitor, this client gave the new owner an earful about shutting it down. Back at the bank, internal customers and other IT groups hated it. It was either too much trouble to learn, too disruptive to the way they were doing things, or represented a turf invasion. For example, we were denied licenses for a software development tool because it was already being used by another IT department which would not let us purchase additional seats. Most of the team, top to bottom, was laid off while phase 2 was being developed, although a few managed to get to other parts of the organization.

Looking back, it’s clear that the job got done despite management, not because of it. It’s not the first or last time that I’ve run into management by self-destruction. Clearly, the team had gone around the bureaucracy to find out what the ultimate client needed, and built that instead of what they were told to do. IT people are naturally self-organizing anarcho-capitalists. Maybe the lesson is that if you find yourself herding cats, you should either get yourself some sheep, or at least ask yourself if the cats might have reasons for going in a different direction.

A possible remedy comes from the Internal Revenue Code, which starts with this:

§ 61. Gross income defined
(a) General definition
Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.

The definition is broad enough to encompass just about anything that could be construed as income; that is, anything that would result in the improvement in the economic situation of a person or entity. Cash need not be involved. Income can be recognized, and taxes must be paid, on the unrealized gains of certain derivatives (§ 1256, § 988), on bonds that do not pay anything at all until they mature (§ 1272), and even in some situations where you pay too little for something (§ 1274). This is a marvelously flexible idea, and suggests that we can close our budget deficits not by raising the tax rates, but by discovering and taxing previously undiscovered sources of income.

No one would quarrel with the idea that an elective office is worth something. After all, if a salary must be paid to the occupant, that in itself is recognition that there is some value in it. And yet, salary does not seem to be the motive for seeking office. An ordinary congressman is likely to raise funds for election and re-election that can be orders of magnitude higher than the salary. The current base rate is $174,000 per year, or $348,000 for the two-year term. A successful campaign for an open House seat will run you about $2 million, give or take. The most expensive race, the NY 20th, involved over $11 million. Clearly there is additional value involved, value well in excess of the nominal salary.

All that money has to come from somewhere, and it has to have a purpose behind it. Something for nothing makes the news when it happens, because it doesn’t happen often. If it the money were just meant for the betterment of mankind and the relief of the downtrodden, it would have gone to the Salvation Army. If it were meant simply to recognize and reward public-minded citizens, it would not have gone to someone already drawing a salary for being public-minded. No, value for value is the usual way, and I think it is reasonable to assume that someone is paying good money so that a politician will do, or refrain from doing, something within the power of his office. In other words, the congressman is receiving “compensation for services, including fees, commissions, fringe benefits, and similar items.” Why not tax it?

You may object that the contributions are not made directly to the congressmen, and therefore should not be imputed to the congressmen. While I am not a lawyer, I believe that there are circumstances where the IRS can consider the economic reality of a transaction, rather than its formal legal arrangement. You could set up a trust, for example, with yourself as beneficiary and serve as the sole trustee, but if you failed to include the trust’s income in your own tax return, the agents of the federal and state tax authorities would be after you with sharp implements to separate you from your personal property, including any organs worth harvesting. In this case, the situation is clearly someone selling services and someone else paying for those services. There is no exception in the Internal Revenue Code for services that may be illegal, like prostitution, or merely disgraceful, like running for Congress.

We might even consider applying an excise tax on top of the income tax. In theory, at least, the taxpayers are entitled to the honest services of their congressional representatives. Since we have been essentially outbid for those services, a 100% excise tax on congressional salaries might be in order. It would also be worth looking into some of the more clever ways of buying and selling congressional services. Bargain purchases of real estate, as was the case of the former junior senator from Illinois and the current senior senator from Connecticut, are a well-established way of exchanging value for value without the vulgarity of cash-filled envelopes. There are no limits to human ingenuity in avoiding taxes, and it would probably be impossible to find and stuff up the mouse holes faster than the mice can gnaw. Why not just simplify the calculation? It could be a model of tax simplification.

Box 1. The congressman’s net worth at the end of his term of office
Box 2a. The congressman’s net worth at the beginning of his term of office.
Box 2b. The congressman’s declared income during his term of office.
Box 2c. Add box 2a and 2b.
Box 3. Subtract box 2c from box 1. Add this amount into the congressman’s adjusted gross income.

If the funds raised from these provisions prove inadequate, we might explore other ways of calculating income from political favors. I have discussed the taxation of the value received by the legislator, but what about the value received by the donor to the legislator? Surely he will realize a gain on his contribution. Perhaps the congressman’s or the lobbyist’s income should include the dollar amount of harm done to the electorate; that is, it might include whatever additional expense the taxpayer has to cover as a result of the buying and selling of favors.

I hesitate to call for additional provisions in the US tax laws, onerous as they are, but these are desperate times. Of course, part of the reason the times are so desperate is that government is bought and sold like lap dances. Really, the only way to ensure that government is not bought and sold is to make sure the governing class has little or nothing worth selling, because otherwise someone will surely buy. What they sell is their ability to order us about and to make us pay for whatever glistening utopias with which they might replace West Virginia.

Here is some encouraging news: “On April 29, 2008, Franken released a statement noting that he will pay about $70,000 in back income taxes in 17 states dating to 2003″ (link). Since Timothy Geithner had to pay only $34,000 in back taxes, Franken is about twice as qualified as Geithner to handle the fiscal affairs of our country. Senate Appropriations Committee, here comes a fellow who knows which end of a calculator is up, if not much more. Maybe someone can teach him what those symbols on the buttons mean.

My grandparents came here because their continent had gone insane. May they rest in peace, never having known what happened here later.

I was speaking, of course of the New England textile industry. After a bit of industrial espionage, American entrepreneurs copied and improved British manufacturing techniques. In 1793, the English immigrant Samuel Slater built a mill in Rhode Island to use the Arkwright method pioneered by his former employer. Francis Cabot Lowell toured British plants, memorizing as much as he could during the day and sketching and writing at night in his room. He and his associates raised money in one of the first public stock offerings, and built a mill in Waltham, Massachusetts, in 1814. The mill took in raw cotton, and using water power, produced finished cloth. It was profitable from the first, and it looked promising as a venture on an even larger scale. Lowell died three years later, but his partners named their new planned industrial city for him.

The siting was brilliant at the time. It took advantage of an existing system of canals around the falls and rapids of the Merrimack River, and was connected to Boston by the Middlesex Canal. The high point was in the decades after the Civil War, and then Lowell began to decline. The decline had been gradual at first, but the inescapable fact was that there was no longer any compelling reason to make cloth there. Water power was not available when the river froze or flooded. The mills were converted to steam power, then to electric power from coal and hydro, but the cost of hauling in coal by railroad put them at a disadvantage (Fall River and New Bedford, having good harbors, held out longer). When the Great Depression came to Lowell, it just never left. There is an excellent write-up of Lowell’s industrial history here.

The Wannalancit Mills, seen from across the canal, showing the water intakes. It is now used for office space.

End of story? Not quite. Lowell is still no garden spot, but there was a bit of a revival in the 1970’s and 1980’s. The region was part of the high technology boom, and although Silicon Valley was the eventual winner, there were enough people with ideas to support a decent high tech industry. With financial services, health care, and biomedical companies in the area, some of the old mill owners’ houses are being refurbished.

This was the “campus” of Wang Laboratories. It is now an office park. Someone in there could be cooking up the next big idea.

The point is that no amount of money could have saved Lowell’s textile mills. Once the initial advantage of water power was gone, the end could be delayed but not avoided. Neither the human nor financial capital was destroyed, in the end. First, manufacturing spread throughout New England, and then to the Midwest, as the principles learned in Lowell were applied to other industrial processes. Farming was never a good idea in the acid, rocky soil of New England, and this was the start of the shift from agriculture to manufacturing in the Northeast. The mills were profitable for many years, and the profits funded other ventures.

Francis Cabot Lowell’s company, the Boston Manufacturing Company, closed in 1930. At that time, the industries that would take its place were not even imagined. Would they have ever come into existence if money and effort were still being used to keep the mills alive? Detroit is in about the same situation that Lowell was in around 1900. If General Motors closes (as seems inevitable), people will still drive cars. After all, we still wear clothing long after the Lowell mills closed. There just may no longer be a compelling reason to make those cars in Detroit.

(Previous: Failure, Part 1)

Update, courtesy of Michelle Yang again: I missed it, but there was another demonstration today across town, down by the water at Christopher Columbus Park in the North End. The harbor has been getting cleaner in recent years, even to the extent of supporting living fish. The tea dumped there today is not likely to harm them. This second demonstration was sponsored by the local FM talk radio. There was even a third gathering in the morning on the Common. Unfortunately, I was unable to attend that one, either. I spent the morning struggling with extensions for Massachusetts income taxes. Let me just point out that (1) if you put a telephone number in the instructions, you should probably do better than have the answering machine tell callers that they cannot use that number; (2) if you require your victims to use the website and forbid them to use paper forms, it is not really a good idea for all your site search results to point to the paper forms; and (3) if a CPA with web development experience can’t figure out what is going on in your website, your website probably sucks and your web developer should be firmly disciplined. “Bad codemonkey! No donut!”


The gathering was moved from the State House steps (the gate was closed and locked) to the Common. You can see the State House across the street and the the back of the memorial to the Mass. 54th Infantry directly behind the tree.

That’s the Prudential Building and the John Hancock Tower in the background.

Barney Frank represents the 4th Massachusetts congressional district. Barney, you’re doing a heck of a job.

Discuss the role of civil society when it is healthy, and the role of the state when it is weak or damaged.

Notes on the cartoon: Oswald was originally drawn, but not owned, by Walt Disney. A few tweaks and a change of species later, Mickey Mouse was born. Take a good look at the mice on drums in the band – it was probably an in-joke. Also, check the credits: Tex Avery (Bugs Bunny) and Walter Lantz (Woody Woodpecker), among others.

He must have been pretty good at it, though, because they promoted him and brought him back as a gunnery instructor. Nevertheless, he says he hated every minute of every day of the war. That may have saved his life, because they were offering early discharges to anyone who would sign up for the reserves; but he had decided that once he was done, he was done. It was 30 years before he would get on another airplane. As he said later, it was much nicer when no one was trying to kill him. The guys who took that offer went to Korea a few years later. Instead, Dad came back to the states to serve out his full enlistment, weighing 135 lbs., bright yellow from the malaria drugs, and bearing a heartfelt dislike of authority. All seven of his kids seem to have inherited that last characteristic.

Thank you, Dad, and good-bye. I hope we always have more like you when we need them.

Credit default swaps are sort of like insurance. One party offers, for a fee, to guarantee a certain bond against a “credit event,” usually something like a default, missed interest payment, restructuring, etc. If that happens, the insurer (seller) pays the difference between the bond’s face value and what it is worth after the event. In the case of Lehman Brothers, the company’s bankruptcy means that the sellers of the CDS will have to pay about $91 for every $100 of par value insured, since those bonds were selling for $8.65 per $100 par value at auction on October 10. Because there is no central market or clearing house for CDS trading, no one has a complete story on who will be paying and who will be trying to collect. The gross notional amount of credit default swaps on Lehman Brothers debt is believed to be approximately $300 billion to $400 billion. One hopes that the net amount is a lot less, maybe less than $10 billion after offsetting positions are netted out. One hopes, but one does not know.

(Update 10/19/2008: SEC Chairman Christopher Cox has a piece on the CDS issue in the New York Times.)

Some of the big net sellers of insurance on Lehman’s debt include AIG, which has already been taken over by the federal government, and also MBIA and AMBAC. You may recall that these latter two companies were involved early in the crisis because they were in effect guarantors of other companies’ debt, and they had their own credit ratings reduced by S&P and Moody’s in January 2008. Will they have the money? They have been trying to reduce or offset their exposure, and soon we will see how well they succeeded. In the case of AIG, where the government has sunk $123 billion into the company, how will the public react if large portions of that taxpayer money are dealt out to politically unpopular CDS holders like hedge funds and foreign investors?

If we get through 10/21, we can look forward to a similar but smaller situation on 11/7, when Washington Mutual’s credit default swaps settle. Then we can start to deal with the credit default swaps on asset-backed securities, including the huge amount related to Fannie Mae and Freddie Mac. Somehow, I don’t think the $58 trillion credit default swap market (a little more than the annual gross world product) is going to stay unregulated much longer.

Some predictions:

• Credit default swaps will soon be regulated similarly to futures. They will be traded on exchanges, instead of in private contracts, and traders will have to meet capital requirements and margin restrictions. The EU and the SEC are already working on proposals.
• Financial regulation is probably going to have its most comprehensive restructuring since 1934. The SEC has been late in recognizing and reacting to problems in the financial sector, and of limited help in solving them. They are likely to be merged with the Commodity Futures Trading Commission, and not likely to assume much of the authority that Treasury and the Federal Reserve have exercised.
• If the Lehman Brothers settlements go smoothly, the worst of the credit crunch will likely be over. The economy is probably already in a recession, but we cannot get out of it without fixing the credit markets.
• The US and the UK are probably going to lead the recovery, but it’s not going to start soon. The north-south split in the Euro zone will worsen. Oil producers still have some pain in store for them, which may in turn cause them some domestic political problems. Hugo Chavez, you are about to get the world’s worst margin call.
• The wild card is what Congress will do with Fannie Mae and Freddie Mac. Weigh the damage these entities can do to the economy against the campaign contributions and great jobs they offer to politicians, and you can see where there could be a problem. It’s bigger than just Barney Frank and Chris Dodd.

Sources (some require registration):
Seeking Alpha
Roubini Global Economics
Wall Street Journal
Financial Times

Beowulf said “We must mourn our friends later; they have died, but we have not yet avenged them. While we live, we win whatever victories we can; so now let us hunt the monster, whether its trail lead through the middle of the earth or the bottom of the sea.”

The monster is hiding, but heroes are hunting it.

Sry!

Maybe it’s unfair to judge a candidate by his supporters. If it were just one or two, I might go along with that. In this case, though, there is a whole ward of drooling loonies who think Obama is their kind of guy, and Obama’s campaign furnishes them with a soapbox and a microphone.

Mortgage-backed derivatives are not new. Some 20 years ago, FNMA introduced the REMIC (Real Estate Mortgage Investment Conduit). These were pools of mortgages that were split into various tranches or classes of maturity and quality, which were then sold separately, similar to the way today’s collateralized debt obligations (CDOs) are sold.

There were some important differences between this first generation and its descendants. I would like to point out some of the differences, since they may highlight the reasons behind the collapse.

When REMICs were issued,

• The mortgages in the pool had to conform to the agency’s standards, or they could not be used. The agencies had minimum debt payment to income ratios, minimum down payments, maximum loan amounts, and other requirements designed to make sure the borrower could repay the loan.
• FNMA used to use only “seasoned” mortgages for the pool. This meant that the homeowner had been paying the mortgage for a couple of years. Any obvious payment problems, flipping, or serial refinancing had been largely taken out of the pool. Prepayments and defaults were reasonably predictable.
• FNMA had a much-disputed soft guarantee from the federal government. None of its debt was issued with the “full faith and credit” of the government, unlike a Treasury bond, but it was generally believed that the government would step in if there was a question of default or bankruptcy.
• You only owned what you bought. It was always possible to buy on margin, but the buying and borrowing were separate events. Too much leverage would draw scrutiny from your lenders.

By contrast, here is how CDOs, including bundled sub-prime mortgages, were handled:

• Sub-prime mortgages were almost all originated by mortgage brokers. Low initial “teaser” interest rates permitted loans to be made to people who could never afford the payments at a market rate. While there were there were supposed to be requirements to ensure creditworthiness, fraud and misrepresentation were widespread. It was always understood that a sub-prime mortgage was risky; soon it emerged that some of the mortgages did not even meet the lax standards supposed to be in place.
• Sub-prime mortgages and other loans were bundled and securitized almost immediately, not seasoned. The volatility of the first few years of a loan was incorporated into the securitized asset. We now hear that the problem became obvious when the adjustable sub-prime mortgage rates reset after two years.
• Non-governmental CDOs automatically have counterparty risk, the risk that you cannot collect from the other party to the transaction. If you follow the process from the original mortgages, to the bundling and securitization, credit enhancement, and credit insurance, there are quite a few parties involved. If something goes wrong, the mortgage broker is likely judgment-proof; the bank doing the bundling and securitization is liable only for gross negligence or actual knowledge of fraud by the broker. MBIA and AMBAC, the companies issuing the credit enhancement (essentially a guarantee), are themselves in financial difficulty and may not be able to fulfill their obligations. Credit insurance, in the form of credit default swaps, is only as good as the counterparty to the swap. ACA, one of the largest issuers of credit default swaps, is unable to make good. Its creditors, including Merrill Lynch, have already reserved for losses from ACA. (MBIA and AMBAC are also credit default swap dealers.)
• Credit default swaps began as a way of reducing risk. In a credit default swap, one party buys insurance against default on one of its debt holdings. The other party (the one issuing the insurance) receives a regular stream of payments while the contract is in force. If a specified “credit event” (bankruptcy or missing a payment) happens, the insurer must either buy the defaulted bond at par or make up the difference in the bond’s value. The volume of the credit default swaps market, in notional value, is now greater than the par value of the underlying bonds. This indicates that there is more speculation than insurance in credit default swap activity. Hedge funds are significant buyers and sellers of credit default swaps. In theory, the buy and sell side are balanced. In practice, if one party cannot meet its obligations, the others who cannot collect may not have the liquidity to meet their own obligations.

The holders of CDOs are suddenly coming to realize that they are pretty much on their own. The insurance and the guarantees they had relied upon are very much in doubt, and they have no idea what exactly they own and whether it is any good. Until they figure that out, they cannot sell it, and no one will buy it. Their holdings are illiquid, and if they can be valued at all, there is a huge liquidity discount on top of a newly-discovered risk discount. Banks and other holders have had to write down the values of their holdings and take the losses against their earnings.

The thing to watch in the next few weeks is the hedge funds. They do not have the same stringent valuation and reporting requirements as banks or other public holders. The only hedge funds we have heard from are those associated with banks. Let’s hear what the others have to say.

]]> http://chicagoboyz.net/archives/5509.html/feed 6 http://chicagoboyz.net/archives/5347.html http://chicagoboyz.net/archives/5347.html#comments Wed, 21 Nov 2007 01:08:06 +0000 Mitch Townsend http://chicagoboyz.net/archives/5347.html One reason the effect of the US subprime loan crisis has spread so far and so quickly is that financial institutions have many ways of participating in the debt market other than issuing or buying debt instruments. Most of the financial news I have read omits explanations of how it happens, other than generic references to “derivatives.” Here are some of the other ways to have a loss without touching a mortgage.

Credit default swaps are a very common form of derivative. They work this way: A bond holder who is worried about the creditworthiness of the issuer can purchase a credit default swap from a bank. The bank is essentially agreeing to act as a co-signer on a loan. If the debtor defaults, the bank pays off the principal to the bondholder. In return, the bank receives a periodic fee calculated as percentage of the loan. The discounted value of the cash flows from the fees goes on the bank’s books as an asset. If the debtor’s credit deteriorates, the asset’s value goes down, since it becomes more likely that the bond will go into default. Credit default swaps can also be aggregated as investments. Investors, especially hedge funds, may buy either side of individual or aggregated credit default swaps without owning the underlying bond.

Ambac, MBIA, and other companies offer their guarantees (for a price) to bond issuers which might not be able to attract investors otherwise. This guarantee improves the quality of the bond by acting as insurance for bond buyers. These bond insurers are big issuers of credit default swaps, and they are under pressure.

Collateralized Mortgage Obligation (CMOs) These are mortgages with different maturities, rates, and risks, bundled together and sold as securities. Mutual funds are big buyers of these securities, so this is where the individual investor is likely to see the problem in his own pocket. The CMO’s value is determined by estimates of the rate of prepayment or default of the underlying mortgages; when it becomes clear that these estimates have become too optimistic, the value of the CMO drops. CMOs are one type of what are generically called asset-backed securities. Other kinds would include Collateralized Debt Obligations (based on commercial or consumer loans), and mortgage-backed certificates (pass-through mortage pools, with or without a government guarantee). Problems in one part of the credit markets are likely to affect other types of asset-backed securities as well.

Those are just the direct effects. The indirect effects are widespread. The subprime mortgage problem will result in less credit available to other borrowers, regardless of their qualifications, as lenders try to conserve their capital. The financial markets as a whole have begun to doubt whether they even understand the risks of the mortgage-backed securities they already own, which makes new mortgages or other asset-backed loans difficult to sell. Some banks have had to keep mortgages in their own portfolios that they were unable to sell, in part because investment banks have been unable to find buyers for the CMOs they have packaged. The uncertainty itself is an additional risk factor depressing prices. Share prices of financial firms will be a while in recovering.

Their uncertainty, unfortunately, is well-founded and too late. While the immediate trigger for the current crisis was the resetting of adjustable-rate mortgages, the problem was a long time developing. For years, mortgage originators other than banks have been lightly regulated. There is no question that some of them have misrepresented the financial health of the borrowers. The newspapers are full of stories about applications being changed, with borrowers’ income magically doubling, and complacent or complicit appraisers inflating the value of real estate. Most of it is not fraud, however; just bad business practice. I know of one couple who got a primary mortgage for 80% of the purchase and borrowed the 20% down payment on a HELOC (home equity line of credit). They did not even have to pay for primary mortgage insurance. They also have about $50,000 debt on various credit cards and a couple of car loans. Personal bankruptcy or mortgage default would finish their careers in accounting or financial services, so they may hang on and pay it. In fact, they’re current and paying down the debt. You have to wonder, though – what else is out there? Until that question gets answered, the pain will continue.

Update
Right after I thought I had finished this, Freddie Mac, an enormous mortgage finance company, announced a huge loss and indicated it will need to raise capital. Freddie Mac and Fannie Mae were originally established by the federal government, although they are nominally independent and sell shares to the public. If either of these entities has to stop processing loans, there will be no loans processed. Two other things to note:

• Freddie Mac and Fannie Mae’s securities are not guaranteed by the US government. However, they have always been understood to carry an implied guarantee, at least as far as their bonds are concerned. That’s you and me, folks.
• Neither Freddie Mac nor Fannie Mae deals with sub-prime mortgages. They do, however, trade in derivatives related to interest rates and credit. These results indicate that write-downs of asset-backed securities are moving up the quality charts to investment-grade issues.

]]> http://chicagoboyz.net/archives/5347.html/feed 2 http://chicagoboyz.net/archives/5076.html http://chicagoboyz.net/archives/5076.html#comments Sat, 14 Jul 2007 14:22:24 +0000 Mitch Townsend http://chicagoboyz.net/archives/5076.html “We have not released giant badgers in Basra, and nor have we been collecting eggs and releasing serpents into the Shatt al-Arab river,” Major David Gell told reporters.

Cue the Monty Python references.