Friday, August 31, 2007

Time for a Tobin Tax ?

James Tobin was a Yale economist who won the Nobel prize.  He suggested a small tax on currency trading to reduce speculation after Richard Nixon ended the Bretton Woods system in 1971.  See wikipedia for more details.

Maybe it is time to revive his idea and extend the tax to all trading, not just currencies. This will help reduce speculation on all assets. If people are so smart, why can't they make up their mind?

The money raised should be earmarked for the US military. The rate should be set so thatit exactly covers all military spending. This way we can exactly account for what the military costs.

We could also reduce the income tax. Raise the standard deduction such that the revenue lost by the income tax would be gained by the revenue raised by the Tobin tax. Exact offset.

This would also reduce paperwork because many more would not have to file at all. Why make Joe Sixpack file a return when he pays little taxes anyway? Cut down administrative expenses.


Thursday, August 16, 2007

Debt: A Downward Spiral into a Depression?

> If I were holding debt now, I would be a little nervous.

Absolutely. Much debt will not be repaid. From Shakespeare's Hamlet, 1603:

LORD POLONIUS:
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

> What bothers me about the debt market is the lack of consumer savings. Savings in America has been negative in recent years, which means that banks books are relying on trumped up reserves, mostly betting on borrowers credit,

People are irrational and do not realize how poor they are because the are so puffed up with debt.

> and a Fed to bail them out.

The Fed will probably have to do something. But if they inject cash, that might stimulate inflation -- contrary to Bernanke's stated career goals. He may have to swallow the bitter pill to ward off a depression.

> With business dependent on consumer spending, the vicious circle could cause some dismay when consumers stop the buying spree that they are now on.

They will no longer be able to get second mortgages, or even first mortgages. They will not be able to spend as much, so corporate profits will be hurt. People will lose their jobs, leading to even less spending, etc. etc.

> Consumer savings is long term. Credit cards, easy borrowing and high paying jobs with varying salary is short term income. What happens when businesses start laying off?

Layoffs will probably occur. People cannot afford to spend so much money on junk. They are at their limits. They will not be able to pay even the minimum. and will go bankrupt.

> Banks without cash for lending are then dependent upon a Fed to bail them out, and I don't mean the liquidation of Treasuries that banks hold in their reserves. These are already phony figures as one writer put it, with bank reserves now made up of commercial mortgages that are in trouble. It could get ugly.

We are at the edge of a cliff. I don't know if they will be able to liquify the system enough to ward off a major crash. There is too much debt and too little cash left to prop up prices. Maybe the Chinese will come over with their money to bail us out, or Indians or British. But they are already sitting on lots of USA assets and may not want to risk putting more. Indeed they may want to get out of dollars and into gold or something that is not crashing.

There are so many irrational players with tricks up their sleeves it is hard to figure out how bad it can get.

I would probably bet we are in a 5 year bear market on houses and maybe stocks. And a severe recession and restructuring.

I think the powerful players are engineering the crash. The rich will get richer and the poor will get poorer. Like when Kennedy sold out at the top and came in at the bottom of the market in the 1930s and amassed great wealth. History repeating itself.

Sunday, August 12, 2007

Mortgage Backed Securities; Subprimes

Mortgages allow borrowers to buy houses and savers to invest in assets that pay off over long periods of time. Supposedly mortgages involve less risk because people do not like to lose their homes. Government provides enormous incentives to housing and real estate finance because it is widely thought that both home ownership and also saving in the form of longer-lasting assets is a good thing. Usually the investor is working and saving for retirement so does not need the mortgage payments as income but wants that money to be reinvested. Because of the risk of default on individual mortgages, those mortgages are bundled into portfolios of mortgages. Because of the mismatch between the timing of mortgage payments and the need for cash inflows by the investor, the cash payments are divided up in various ways by various market participants to reduce the mismatch. If the mortgage contracts are correctly written there should be little reason to change the contract provision or ownership over the life of the mortgage. Funds will outflow from the borrower and inflow to the lender at the agreed on time.

Into this already complicated scene walks the "hedge funds" and assorted traders. They cannot increase the returns on mortgages because nobody will overpay their mortgage. They cannot decrease risk of mortgages because they have no impact on the probability that people will repay their mortgage. They also cannot decrease risk because they have no impact on the probability that people will retire and need their retirement money sooner or later. Indeed, many hedge funds and other traders are highly levered and might go bankrupt and fail to pay the institution that has promised to pay the investor. So rather than decreasing risk they may be increasing risk. Last week the Federal Reserve supplied $38 billion of reserves to help shore up the financial system due to subprime defaults. This is in addition to the large subsidies they give to housing in the form of tax deductions, subsidies to FNMA GNMA, increased road repairs due to housing related transport, and so on.

It is difficult to find a social purpose for very much trading of mortgages after those mortgages are issued. Only costs. There seems to be little role for hedge funds or many of the other middle men who stand between the saver and the borrower. Properly designed contracts should not need to be traded over the life of the contract. The borrowers make their monthly payments over the 20 years. That money should be spent by retirees or reinvested so that when the investor retires that it will be there for them. There is no need to trade the mortgages after they are issued, usually. Occasionally somebody may retire sooner or later than planned and need money sooner or later than planned. Occasionally a borrower will default. These events should be rare and might trigger a small amount of market trading.

Another more serious problem is that some mortgages nowadays are poorly designed, containing features that might result in increase in the mortgage payment. Even worse, these risky mortgages are often given to borrowers who are least able to handle the increase in mortgage payments. Examples are subprime borrowers with mortgages including zero down, balloon payments, ARMs, Option ARMs, minimum payments below the amortization rate (negative amortization) and so on. When payments increase the borrower very well may not be able to pay it and will default on the mortgage. Thus the borrower and lender lose what they entered in the transaction to achieve in the first place. It would seem that as loans are granted to less credit-worthy borrowers that the contracts should be more simple and not allow any increase in payments over the life of the loan. The opposite of what we see now.

If any customer wants a mortgage that does allow any payment increases over the life of that mortgage, then before that mortgage is given, the customer should be required to take two college classes. The first class is on personal financial planning. The second class is on mortgages, real estate finance, and real estate law. These classes are to insure that the person is aware of the mortgage details and that the particular kind of mortgage they are being sold is indeed the best available for their particular situation. These classes must be reasonably thorough with difficult exams. At least 15% of the takers must flunk the standardized national final exam to show that the exam is rigorous. Of course all banking personnel must take that exam each year to make sure the exam is carefully written and graded. Then they should take more difficult exams to make sure they are current in the kinds of mortgages available and the computer technology available to help borrowers make informed decisions.

If well-informed people make mistakes then they have nobody to blame but themselves. A proper education program would eliminate charges against financial professionals for "predatory lending" and taking advantage of people by arcane, sneaky tricks in contracts.

Sunday, August 5, 2007

Volatility Surfaces



Efficient capital markets are supposed to reflect the information available about the expected trajectory of the economy and the payoffs of assets. A booming stock market indicates that investors think there will be good earnings and strong company health ahead. Bachelier assumed in 1900 that stock prices followed Brownian motion when he developed the first option pricing formula. Mandelbrot showed in 1963 that stock price distributions had fatter tails than what normal Brownian motion would imply.

Nevertheless Black-Scholes developed their famous formula assuming normal Brownian motion. This understates risk and thus understates the value of long option positions. The Black-Scholes formula guesstimates must therefore be adjusted to get reasonably valid option prices that can be used for trading. This fudge factor is called the "Volatility Surface." It is discussed in a recent book by Gatheral, and in earlier books by Natenberg and others. The first image is a typical volatility surface for S&P500 options.

The second image shows the actual empirical diffusion of the S&P500 near futures contract in Chicago from the beginning of that contract history until the early 1990s. The bell curve looks bimodal or trimodal because we had to arbitrarily tack the long tails into the end cells for visualization. There is historically a fairly large probability of large stock price moves. The figure is understood as follows: Stock prices start at the initial point where all the probability mass is concentrated on the last historical observation. Then after 1 day prices might be a little higher or lower than that last historical observation. As you progress forward for 2, 3, 4 ... days the bell curve diffuses out so that after 100 days the stock price may be considerably different than the stock price most recently observed.