Pfizer, MBIA, and the Ratings Agencies

This is a pretty thought-provoking article from Mish's Global Economic Trend Analysis blog: http://globaleconomicanalysis.blogspot.com/2008/02/mbia-maintains-highest-rating-pfizer.html.

The only reason I can see for not downgrading MBIA while Pfizer gets the axe is simply because of the fallout that would take place if MBIA, which truly relies on its credit rating to operate, was no longer able to insure bonds (ignoring the fact that they have so little cash that they probably couldn't cover many defaulting bonds at this point anyway). But is trying to forestall a potential blowup really the best thing for the economy or all those MBIA-insured bonds? After all the lack of insight/intelligence/due diligence on the part of the ratings agencies when it came to CDOs, I would think that it would behoove them to become ruthless in their ratings, to show that they really actually do what they claim to do.

Something drastic needs to happen with the way ratings agencies are currently run, since they seemed to have not learned anything from the whole CDO mess. If investment banks are required to have so-called "Chinese walls" in place to prevent improper conduct on the part of analysts and traders, maybe something similar should be instituted with the ratings agencies where those doing the actual analysis and rating are unaware of how much the agency has been paid by the company seeking the rating, or if they have paid at all. It may be hard to implement something, but since the ratings agencies seem unable to handle their responsibilities, as evidenced by the Pfizer/MBIA ratings, something should be done.

Misguided Derision of Black-Scholes

I just finished reading an article by Michael Lewis, of Liar's Poker fame, where he essentially blames Black-Scholes as the reason for catastrophic market failures, from 1987, to LTCM and even the current subprime debacle. I think he's gone a little far however.

Black-Scholes is a model which is supposed to give fairly accurate predictions of option prices. The problem that Lewis failed to understand is that the formula, in and of itself, is not necessarily faulty. The problem is that people have come to expect and use the model to actually price different securities instead of predicting the movements that result from dynamic variables.

This would not be the only time that traders/bankers/fund managers/etc. have used models as a means of pricing things in fact rather than in theory. Consider the write-downs from CDOs and other similar asset backed securities which presented themselves due to the inability to mark-to-market and the ensuing reliance on marking-to-model. In fact, I wrote the following for a research paper on CDOs, with regards to their pricing:

Interestingly, the Marshall-Olkin copula, the so-called “shock model” that accounted for successive catastrophic default events, was found to be a poor model of true market values of CDOs due to the fat-tails it created on the distributions of losses from defaults. This is interesting because the research was done in 2005, and the CDO market has actually trended toward fat-tail loss distributions and catastrophic default events in recent months. Obviously, such strict mathematical models should always be taken with a grain of salt, or at least with the understanding that such models should only be used as approximations for the price of an illiquid security. Instead, many investors (again, in the institutional sense) regarded the prices placed on the CDOs by their models to be the actual value, and in many cases felt that their models were still correct even in the face of a large divergence between the market prices and the model prices [1].

[1] X. Burtschell, J. Gregory, J.-P. Laurent. “A comparative analysis of CDO pricing models.”

It doesn't take college-level laboratory courses to see that theory does not always exactly match actuality or take into account the existence of outlying data points. For that reason, it seems that Lewis is misplacing the blame, at least to some degree. While Black-Scholes, or any market model, certainly comes with limitations and downfalls, it is the implementation of said models that determines their utlimate accuracy.

An Intersection of Engineering and Economics

In going through some of the stories posted on Abnormal Returns, I came across a story from the WSJ Economics Blog and found it interesting that Ben Bernanke and his ilk like to refer to what happened during the Great Depression as a form of a feedback loop. They apparently term the failing of one bank as a detrimental effect to other banks as a negative feedback loop. However, this is incorrect. The negative feedback is what the Fed would want to provide in the form of lower rates and increased liquidity while the compounding effect of cascading bank failures would be the positive feedback. That is, negative feedback causes attenuation of the input, eventually down to zero if it was a true feedback control loop. Conversely, positive feedback would result in the values taking off toward infinity.

This actually got me to thinking about what kind of system this bank data would actually look like, and if you could come up with some kind of control design (P, PI, PID, velocity-feedback, etc.) that would translate into how much to lower interest rates or what other actions should be taken in order to keep banks on their feet longer, thereby avoiding the calamitous outcomes of the Depression Era. Of course, this would require much more time than I would care to put into it. I guess the Fed will have to figure that one out without me.

Economic Stimulus: A Couple Months Late and a Couple Billion Short

President Bush just signed the surprisingly bipartisan stimulus package into effect today. I'll give the government an A for effort, and an A+ for actually doing something expeditiously for once, but I can only muster a D- for the actual package itself.

While I certainly won't send back the $600 check that's coming my way, I also don't plan on spending it the way so many other Americans will. What do you think that money will be spent on? Something like a new LCD TV that is made in Japan from Chinese parts. That is not exactly stimulating the overall economy here in the US. With the influx of foreign capital, especially into the battered banking system, Americans should do something really patriotic and either put that money in a high-yield savings account, invest it in a retirement account, or pay off the over $8,000 (on average) they have in credit card debt. In fact, the $150 billion dollar stimulus package would probably be better spent in reducing the national debt than giving it to consumers. Taking it a step further, for maximal benefit, the government would give all of the money to primarily small businesses as a means of encouraging expansion and capital expenditures, instead of just providing for equipment purchases. Such purchases do not really help businesses in the service sector that saw some awful numbers a few days ago.

Also, the checks won't even arrive until some time in May, meaning that the economy will already be in a recession, if that is indeed the future of our economy...something I'm not entirely conviced on yet.

The fact is, the stimulus package is only about 1% of GDP. That is a drop in the bucket. More than anything, this seems to be a political move in a year when a Presidential election and a slowing economy happen to be occurring.

Not So Super Tuesday

Well, unfortunately the Republican party seems to have been split. Huckabee, unsurprisingly, swept the Bible Belt states of Alabama, Arkansas, Georgia, Tennessee, and West Virginia, most likely stealing quite a bit of Mitt Romney's thunder. Of course, Romney did not turn out too poorly himself, garnering about 7 states to bring him to 269 delegates. Its going to be tough from here on out though, as McCain has about half of the delegates he needs to clinch the nomination.

I'm not really sure what happened. It seemed like most of the conservatives I've heard (personally and calling into talk radio) were ardently against McCain and tended toward Romney over Huckabee. It is disappointing because Americans seem to either be uninformed, apathetic, just plain stupid, or some combination of the three when it comes to voting. The economy has consistently been the key issue for the past few months, yet the candidate who has admitted to having fairly limited knowledge in the way of economics is poised to win the Republican nomination for President. That does not bode well for the Republican party or America.

Which is why I'm supporting Romney. He has the business experience, much of it in taking faltering companies and returning them to their prior glory, that "that other malfunctioning corporation called the USA" could use a healthy dose of. While I've always been of the opinion, unlike so many others out there, that the President and/or Congress have little to do with the performance of the economy, I do believe that they can create incentives to a certain degree that can stimulate businesses and consumers to do things that will make the economy grow. Bush's tax cuts are a good example of this. Businesses and consumers will almost always make better use of money than the government, whether that is measured in return on investment or utility.

Luckily, Romney's pockets are fairly deep, thanks again to his background in business. So, I'm not losing hope yet, despite how far Romney has to go after a fairly disappointing Super Tuesday.

Democrats and the Economy: A Losing Combination

In an article from the most recent Fortune titled "Make the World Go Away," which talks mainly about the recent backlash against Free Trade due to the slumping economy, there is a poll with the following question:

Regardless of which political party you support, which party would do a better job of keeping the economy healthy?

The results? 45% of respondents thought Democrats would keep the economy healthy, followed by 35% for Republicans, 9% for neither, and 2% for both.

Now, before I continue, I think it is impossible for either Democrats or Republicans to have enough control over the economy to determine whether or not it is healthy. All they can control are regulations and taxes. If anyone should take credit or blame, its the Federal Reserve and the actual participants in the economy. That's right, you and me. But, for the sake of argument, let's say that it actually is Congress and the President that help or hurt the economy. I say that if that's the case, you can not logically come to the conclusion that Democrats would be better stewards of the economy than Republicans. I will use the current Democratic Presidential candidates, Barack Obama and Hillary Clinton, and their platforms/rhetoric to support this. In this edition, I'll examine Obama's economic platform, as stated on his website.


OBAMA:

Making Work Pay Tax Cut - This would eliminate the first $8,100 of payroll taxes, presumably for every U.S. taxpayer. How will we then be able to fund a Social Security or Medicare that is already heading towards the red, much less a Universal Healthcare Plan? Obama doesn't seem to understand that you need more revenue to pay for more programs. He seems to want to decrease taxes and simultaneously increase spending.

Eliminate Income Taxes for Seniors Making Less Than $50,000 - While I tend to agree with this, its only because of the first three words. His main idea here is that these seniors have been paying into Social Security for decades with the promise that they would be taken care of. Here's a question: What about all the money Social Security will take out of Generation Y's pocket that we will most likely never see again, unless something changes drastically. The main point from me though is, again, decrease spending before getting rid of revenue that will just pop up someplace else. That, and how many seniors are there really that make less than $50,000?

Simplify Tax Code and Give the Option of Pre-Filled Tax Forms - He wants to simplify the tax code by creating more credits and changing existing loopholes? That's not simplification, that's obfuscation and will just make it harder for people to fill out their taxes. And pre-filled tax forms? Will the Federal Government soon help me balance my checkbook? How about send me reminders to pay the utility bills, or refuel my car? The answer to fixing the problem of not being able to fill out tax forms is two-fold: replace the dense, confusing tax code with something universally understandable (perhaps a national sales tax?) and the acceptance of personal responsibility by Americans.

American Opportunity Tax Credit - This will give a tax credit to offset the first $4,000 of college tuition in an attempt to make college affordable to everyone. There are enough scholarships, grants, and other forms of financial aid out there, that the taxpayer does not need to subsidize college educations any more then he already does. After going to high school in Georgia (where the HOPE Scholarship pays for 100% of tuition for residents of Georgia that attend an in-state public university) such subsidation leads to two things: more people attending college (good), and the high schools making sure nearly all of their students leave with a B-average (a requirement of HOPE, also bad). The point is that not everyone is smart enough to go to college. And even fewer are smart enough for me to want to pay their way via higher effective taxes for myself.

Promote American Business Abroad - Sounds great, but one of the things Obama points out is "Bush's failure" to address China's currency manipulation to the detriment of the U.S. It is a little hard to tell such a nation what to do when they are holding massive amounts of U.S. debt in the form of Treasuries that they could easily dump on the market, REALLY destroying the economy.

Expand Loan Programs for Small Businesses - Again, the solution here is to expand the government by expanding the Small Business Administration. I'm all for small business, but not by creating larger government that will just want to tax away the benefits reaped from the more favorable loans.

Digital Inclusion - Use tax and loan incentives as part of a plan to GIVE HIGH-SPEED INTERNET ACCESS TO RURAL, URBAN, AND MINORITY COMMUNITIES. I couldn't believe it when I read that Obama wants to do this. How about going to the local library? I think most libraries currently have internet. Even if its 56k, its still internet. Why waste taxpayer money on this?

Fund to Help Homeowners Avoid Foreclosures - While there is a ton of blame for the subprime crisis, which led at least in part to the overall housing slowdown, there is still a decent chunk left for the homeowners who took out loans they couldn't afford. Personal responsibility rears its head once again (aka, something taxpayers should not pay for). The fact of the matter is, a large number of these foreclosures were from defaults on second homes (where the original home was put up for collateral), or the homeowner overstated income. Foreclosure is not that bad either. A lot of these people will probably just go back to renting the way they did before they tried to move into a half-a-million dollar house for a $600 monthly mortgage payment. Its not like these people had 90% equity in their home and missed a few payments at the end.

Credit Card Rating System and Bill of Rights - The problem here is with "universal defaults," where credit cards can raise your interest rate for late payment or default with a completely different creditor. If you use your credit card responsibly, this doesn't affect you. That, and this is simply the credit card companies making sure they are being compensated for the default risk that you pose. The credit card use in this country is bad enough without further removing disincentives to reckless use.

Make Corporate Tax Code More Fair and Efficient - Hmm...sounds good, right? All Obama wants to do here is eliminate corporate loopholes "that benefit only a handful of companies." So that means the playing field will be level, but still elevated (as in high corp. tax rates). Wouldn't it be better to make it so that there is no tax code in which to find loopholes?

Eliminate Capital Gains for Start-Up Businesses - Again, those first three words were fine on their own. If eliminating capital gains is so beneficial to start-up businesses, why is it not just as beneficial to the everyday American? Obama should go that extra step.

Ensure Competitive Markets - Here's another one that made me laugh for the following reason: "...the government has a crucial role to play in ensuring competitive markets." I think Adam Smith is rolling over in his grave. The government will end up making markets worse by dictating what it believes to be appropriate levels of production and/or consumption. Competition is all about making a better product or providing a better service than someone else, not having government come in to make sure that every company gets an equal piece of the pie. Also, Obama thinks Sarbanes-Oxley is great, but wants to make sure that compliance is not burdensome to start-ups or small businesses. Well, as long as those start-ups and small businesses are privately held, that will be the case. That will also mean fewer investment opportunities for average investors, as public companies go private to escape the headaches and costs associated with complying with SarbOx standards.

Create Career Pathways for Workers to Move Up the Ladder - Once again, everybody is a winner! Hey America, every one of us is smart and capable of managing other people, taking on massive responsibility, and perhaps even running an entire company! Hate to burst your bubble, Barack, but that's not the case. While America is a place where anyone can succeed if they put the effort forth, not EVERYONE can. Its simple math more than anything: there's only one CEO of a company. Also, factories need those workers out on the floor who have been there for 30 years because they can do a better job than some 22 year-old who's never used the equipment before. And a 22 year-old straight out of college is probably better able to manage and run that factory than the guy who's been on the floor for 30 years because the college grad has been taught how to analyze the whole operation, not just one station to which the factory worker is accustomed.


Increase Minimum Wage - Read an econ text book, Obama.