Goldman Sachs is a Symptom.

The Fed is like AIG on Cocaine or a Two-Faced Mutant Pig

April 21, 2010

The Rationale: the Problem is Insolvency, not Illiquidity.

1.1 The policy premise: the prices for bank assets became “artificially” depressed by banks
and other investors trying to unload their holdings in an illiquid market. As a result, they no
longer reflect their true hold-to-maturity value. So… by purchasing or insuring a large
quantity of bank assets, the government (the Fed) can restore liquidity to credit markets
and restore banks.

1.2 The policy error: the “credit crunch” wasn’t about liquidity at all. It is about solvency.
Insolvency can’t be fixed by short-term subsidies. You need liability reduction, asset
appreciation, or greater long-term equity cushion.

Long-term subsidies, like the Fed holding who-knows-what to maturity, equals soviet
communism, as every hooligan knows. Short-term subsidies transfer credit risk, and they
leverage parasitic behavior. Positive valuations assigned by shareholders to equities arise
solely from anticipation of value transfer from firm debt-holders or resource transfers from
US taxpayers. Debt-holder get a piece of this action too if governments overpay for “toxic”
assets backing up their claims. But “everybody” receives more than fair value for their
investments.

So everybody’s happy, right? Umm, no.

1.3 The policy victims: everyone is happy except taxpayers and currency longs.
Government resources that support markets by insuring assets against further loss amounts
to providing an insurance policy at a premium way below what is fair for the risks that US
taxpayers bear. The Fed is just a retrocessionaire with a massive book of correlated tail
risks. Others will be on the stick when they breach treaty.

1.3 With all the slosh, no one knows the extent of the insolvency problem anymore. The
Fed has put a bid under possibly worthless assets. Allowing the secondary market to price
assets without the Fed bid would be the best way to assess the insolvency problem. The
test condition is if asset prices revert back to their “crash” valuations, then those prices
imply that some major US banks are now legitimately insolvent. Bank assets are fairly
priced at valuations that sum to less than bank liabilities.

1.4 For some assets, the crash valuation was right. Securitization will revive in time,
because it is an excellent idea. But the current reboot focuses on supporting the status
quo: lack of transparency, reliance on flawed (understatement of the century) rating
agency designations, and mispricing of underlying cash flows. It is ridiculous to think the
market is going to resume with uneconomic valuations without continued government
guarantees.

Market Crashes as Moments of Clarity

2.1 The world isn’t sure what to make of risk anymore because of the massive distortions.
One year ago the whole world was going up in flames. Now the only thing imploding is
sugar #11. What passes for risk these days is a sterilized construct bounded by
government insurance cover on the downside. You know…the Greenspan put.

2.2 Stalling market crashes isn’t a desirable end in itself. Crashes aren’t any more irrational
than any other trading action. Crashes are just sudden moments of clarity that bring
investors to new “fundamental” valuations. Greenspan putzes and Bernanke variations
don’t short-circuit price discovery indefinitely, they just make transitions to different
valuations even more violent for more and more bag-holders.

2.3 Investors get painful, periodic lessons in risk to enhance survivability. Risk is so much
more real and interesting and wild and painful than the idolatrous constructions people
imagine it to be. Grossly unsuccessful mutations such as central planning don’t last long in
this world. Nature cleans up after herself.

The Fed is fast gestating into a mutation like the five legged puppy, the medically deformed
kitten… the two faced mutant pig. The gene code needed to express it? Simply sustain
institutions unfit for survival, and by implication, penalize those most fit to survive. See
how this works? First governments dilute capital loss by backstopping losses, then the two
instruments of modern economies, central banks and treasuries, transfer the losses to
present and future taxpayers, while at the same time, capital holders get their base eroded
over time through currency devaluation.

Private Sector
Losses

Total Capital
Losses

Central Banks Currency Longs

Public Sector
Losses
Present and
Government
Future
Treasuries
Taxpayers

Crowded Trades are Inbreeding

3.1 The Greenspan put reinforces behavior unsuited for survival, failure after failure. You
can see this in the negative skews of some strategies in the hedge fund space. Skewed
hedge fund returns broken out by Credit Suisse-Tremont sub-indices from 1994 to crisis are
reported below. The skew was calculated based on the monthly returns of each sub-index.
Hedgie Strategy Return Skews, January 1994 until April 2008
Sector
CS/Tremont Hedge Fund Index Weight Skewness
Convertible Arb 1.90% -1.59
Fixed Income Arb 4.70% -3.35
Multi-Strategy 10.40% -1.06
Event Driven 24.40% -3.27
Emerging Markets 8.50% -0.79
Global Macro 13.80% 0.05
Managed Futures 4.00% 0.02
Long-Short Equity 26.40% 0.19
Equity Market Neutral 5.30% 0.34
Dedicated Short Bias 0.60% 0.83
Source: Malliaris and Yan, http://www.haas.berkeley.edu/groups/finance/Nickel11.pdf

In a general sense, skew is a measure of how much more volatility goes up when there is a
significant down swing in prices as compared to a similar swing to higher prices. The
negative skew in this context is just a measure of a crowded trade and the herding of
managers into taking the same trade. So if the trade reverses, a negative skew is a
measure of how much risk-appetite would vaporize as prices drop.

See that some of the listed trading strategies above—statistical arbitrage, convergence
trades, risk arbitrage—that hedge funds employ have serious negative skew. To see what
this means, imagine that a trader tracks over time the credit spreads of a portfolio of bonds.
When a bond’s spread widens, the trader buys the bond. He waits for the spread to return
to its historical levels, sells the bond, and pockets a profit. It works like a charm, except
occasionally the spread continues to widen, and the trader is left holding a distressed bond
and he blows up.

When a bond’s spread widens, this usually means something has happened to cause
investors concern about the issuer. Most of the time, those concerns aren’t realized, and the
spread returns to its past levels. Occasionally, the concerns prove all too valid, and the
spread blows out. In this sense, statistical arbitrage is like selling far out-of-the-money
options. It makes consistent money, but occasionally realizes a dramatic loss. It is a
negatively skewed trading strategy. In the fixed-income setting, the skew can be viewed as
an indicator of a jump to default risk, or extreme rating migration risk forcing a position
rout.

Leverage Magnifies Distortion

4.1 There are ways to hedge negatively skewed returns, like buying index protection. But
you can’t escape leverage in financial markets, no matter how hard you try. A given
investor may not directly leverage assets, but are exposed to the self-amplifying effects of
leverage and fat tails through other market investors. Market volatility is due more than
anything to dumped positions with massive leverage.

4.2 Leverage increases the nonlinearity embedded in all financial markets. That makes the
entire financial architecture much more sensitive to extreme risk. Equity is especially
exposed to the nonlinear effects of leverage. Why? Business law gives shareholders the
right to any residual profits. Bankruptcy law represents the company's exercise of its right
to keep shareholder's money to pay off higher-priority liabilities (e.g., debt-holders,
suppliers, employees, plaintiffs in lawsuits, etc.) This makes stocks subject to extreme
losses. Thus when a debt-laden company experiences a default event, it may be forced into
default with a 100% loss of shareholder's investments.

Forget Being Your Own Central Banker. Be Your Own Insurer

5.1 There is no way to entirely remove risk, simply because time elapse makes prediction
errors grow exponentially. Looking at a morning sky full of dark cloud and thunder makes it
pretty clear that it will rain that morning, but it says nothing about a week from now. Even
those obvious morning forecasts aren’t always right.

Prediction errors grow in part because what you do influences the prediction. Sooner or
later your hard drive will crash or you will screw some measurement up. Further, these
unavoidable errors ensure that there will never be enough observations or simulation times
to back-test to any arbitrary tolerance. Sooner or later certain unexpected patterns emerge
and blow you up.

5.2 Don’t count on elected stooges to reduce your risk. They are working to reduce their
perceived downside risk. It is your responsibility to manage your risk. Here is a rough
schema to conceptualize some risk categories, with hedge ideas that may or may not be the
best.

Onion Risk Management

“Position” Risk: Large Number of Small Independent Risks
Hedge Strategy: Buy Protection Through Diversification

“Skew” Risk: Unavoidably Correlated Event Risks. Risks are Large and Lumpy
Hedge Strategy: Buy Volatility/Correlation

“Leverage” Risk: Highly Event-Driven, Lumpy Correlated Risk, High Degree of

Information Uncertainty
Hedge Strategy: Shorts, Futures, or Buy Puts to Create a Long-Short Position

“Systemic” Risk: Irreducible Uncertainty

Hedge Strategy: Non-Directional Spread Positions

Fed: Part Company with Ivy League and Go to Chi-town

6.1 Professors bearing Doob-Meyer decompositions are not the only way forward, although
the honest, unpretentious, thoroughly decent Philip Protter is the best guy in the world to
get that expertise. There are plenty of reinsurance actuary consultants with hands-on
experience in making tail risk collection a successful business model.
6.2 The banking system doesn’t manage its risks the way the insurance industry does
because their incentives preclude it. Insurance hedging is capital intensive and ROA is
much more volatile. The financial system can’t handle this in its present form.
Securitization is a way to handle this. If you are afraid to take the bid off bank assets
because of life-support concerns, float a CAT-like bond on your balance sheet’s most toxic
assets risks and see what market action you get. At least you’ll get some measure of risk
pricing.

The skeptic can say: “So the Fed is like AIG overdosing on Viagra and cocaine. They have
a printing press, so who cares? Taxpayers won’t know what hit them.”

6.3 This is too short-sighted a view because everything eventually breaks down. The best
trading system doesn’t make you the first to dump crashing securities. Correlations break
at the worst possible time. Assumptions are violated: “Sorry, those stochastic processes
weren’t stationary after all.” Printing presses can’t print fast enough, or they spit out
product of such poor quality no one can use it. When the breakdown does happen, order
itself becomes chaos. Transferring risk doesn’t make risk go away. On an elemental level,
one aspect of risk is uncontrolled motion (gamma). Death is the only escape.