Baseline Scenario

(c) 2009 F. Bruce Abel

Especially read "More on Goldman and AIG:"


The Baseline Scenario

· Is It 1999 All Over Again?
· More on Goldman and AIG
· Data on the Debt
Is It 1999 All Over Again?
Posted: 25 Nov 2009 07:17 AM PST

The New York Times’ Bits blog has a post on Trefis, a Web 2.0 startup that apparently makes it easy for you to create your own valuation model for public companies. They give you starter models using public information, and you can then tweak the assumptions to come up with your own valuation. The pitch is that this puts the tools used by research analysts and professional investors in the hands of the retail investor. “Perhaps these new tools will put some added pressure on the sell-side professionals – many of whom are notorious for creating overly optimistic takes on the companies they follow.”
Or maybe they will make retail investors think they have an advantage that they really don’t. Advantages in stock valuation have to be based on superior information, which you can get by doing lots of market research (like some old-fashioned hedge funds do) or by having privileged access to company insiders. Superior information can include superior forecasting ability, so if you have some ability to predict the market size for routers better than anyone else, you can make money from it. But neither of these are things you get from models; they are things you plug into models. I’m sure the founders of Trefis don’t see it this way, but this feels to me like a great way to lure people into individual stock-picking, and thereby a boon to stock brokers everywhere.
Update: The post also links to an article about KaChing, which makes even less sense to me (except as a smart business idea that preys on people’s willingness to believe in the existence of stock-picking genius). According to the article, hundreds of thousands of investors manage virtual portfolios in KaChing, which effectively grades them according to risk-adjusted return and other criteria. Then you can subscribe to someone else’s portfolio, so that you make the same trades that she does (there is a monitoring mechanism to make sure that people are putting their money where their mouth is, according to the article), for which you pay an investment management fee to KaChing and presumably a brokerage fee to KaChing’s partner.
This is what confused me. Marc Andreesen, an investor in KaChing, said, “The concept is great — the ability to tap into not just the wisdom of the crowd, but to be able to identify and invest with the particular geniuses in the crowd that stand out.”
Market prices already reflect the wisdom of the crowd. If you create a small crowd and it doesn’t agree with the market, which crowd do you go with? As for particular geniuses, isn’t this just a clever way of marketing the coin-flipping phenomenon?
This is clearly why I will never make money investing in stocks.
By James Kwak


More on Goldman and AIG
Posted: 25 Nov 2009 06:51 AM PST

Thomas Adams, a lawyer and former bond insurer executive, wrote a guest post for naked capitalism on the question of why AIG was bailed out and the monoline bond insurers were not (wow, is it really almost two years since the monoline insurer crisis?). He estimates that the monolines together had roughly the same amount of exposure to CDOs that AIG did; in addition, since the monolines also insured trillions of dollars of municipal debt, there were potential spillover effects. (AIG, by contrast, insured tens of trillions of non-financial stuff — people’s lives, houses, cars, commercial liability, etc. — but that was in separately capitalized subsidiaries.)
The difference between the monolines and AIG, Adams posits, was Goldman Sachs.
Apparently while all the other banks were paying monoline insurers to insure their CDOs, Goldman wasn’t, because the monolines refused to agree to collateral posting requirements (clauses saying that if the risk increased and the insurer was downgraded, it would have to give collateral to the party buying the insurance). Instead, Goldman bought its insurance in the form of credit default swaps from AIG, which was willing to agree to collateral posting requirements, as we all now know. This is one way in which Goldman was smarter than its competitors. Another way, which we also all know, is that at some point in 2007 Goldman began shorting the market for mortgage-backed securities — which would given extra incentive to make sure that they were fully insured.
Until, suddenly in September 2008, it turned out that maybe Goldman wasn’t that much smarter than everyone else, when it seemed like AIG might not be able to post the collateral it owed. And so:
“I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation i can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.”
There’s more.
Yves Smith points out (in an update) another possible difference between AIG and the monolines — AIG’s business in swaps allowing European banks to reduce their capital requirements, which meant that big European banks had a lot of exposure to AIG.
Another difference might be timing — AIG hit the fan at the same time as Lehman and a week after Fannie and Freddie were taken over. Another difference might be raw size: even if the monolines together were as big as AIG, that’s precisely the point — their problems could be spaced out over time, allowing the markets more time to adjust, while AIG would go bankrupt in one big lump.
By James Kwak


Data on the Debt
Posted: 25 Nov 2009 03:00 AM PST

So far, my foray into the world of the national debt has consisted of this:
Don’t try to scare people with hyperinflation unless you have some basis for doing so.
The recent deterioration in the projected debt situation is mainly due to the financial crisis and recession, not some kind of runaway spending under the Obama administration. (See Econbrowser for the deterioration over the last eight years.)
One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.
Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.
Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.
The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.
So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.
As for me, this is far from my area of expertise, but the first thing that comes to mind as far as a solution is some kind of binding commitment (or at least as binding as out government can make it) to raise taxes (or undo the Bush tax cuts) when the economy has fully recovered according to some objective metric like the output gap. That and, of course, fixing the health care system.
Updates: Whoops! Link fixed. Also, a reader says I should include the caveat from Chinn’s post:
“These estimates were obtained using data that spanned a period without extraordinary Federal Reserve credit easing, and in the face of an unprecedented financial collapse. And, the relationship is not precisely estimated.”
This implies that the model may not be accurate. On the broader issue, it’s not as if quantitative easing is a secret, nor is it a secret that it’s going to end sometime in the next few years. So this isn’t something that investors in 10-year bonds don’t know about.
By James Kwak