FI

GSE Bailout and Moral Hazard: Hank Paulson Aims at the Wrong Target

Debt buyers were clearly taking risk with the high expectation of a government guarantee. This is seen in the level of credit spreads. The agents of the equity owners observed this and took advantage of the cheap debt. We can't tell that an equity cram down in these circumstances was unexpected, so Paulson's bailout plan may be growing the moral hazard problem since we may observe an actual bailout instead of an implicit guarantee. When presented with cheap debt, the agents of the equity, even knowing they won't be bailed out, may repeat exactly the same behavior. That the equity has control doesn't mean that not bailing them out has any effect if the cheap debt led to this.

The Fed's Regulatory Reputation Won't Survive Long-Term Scrutiny

Because Bear Stearns had a bank run and primary dealers got Discount Window access, there's been a rush to find regulatory prowess at the Fed. The Fed is justly regarded as an institution with high standards for hiring and performance of personnel. We need to recognize and explain, however, the awful results of Fed regulated institutions during the crisis (they are fortunate they have government backing, or perhaps they are unfortunate if it induced poor performance). We also need to explain the gimmicks intended to seem to address the short-term interbank market which just cost Fed credibility (and the withdrawal of the Bear Stearns 28 day facility after a day). A light moment: In August, Fed officials convened a conference call of major Wall Street institutions to announce that “appropriate” use of the discount window would be seen as a “sign of strength.” This was followed by press releases (sometimes joint) by banks announcing that they had each done their part, with token one time small (and identically sized) borrowings. This was the first step down a constant-slope decline in Fed credibility until the Bear Stearns facility withdrawal, which was a huge jump down.


Regarding http://calculatedrisk.blogspot.com/2008/04/pimcos-mcculley-fed-should-regulate.html

Mr McCulley has something backwards. The worst performers by far were the banks, regulated by the Fed. Bear Stearns demonstrates little on this point since Citi would have had a bank run 6 months before Bear had it not been 2-big-2-fail as well as encrusted with implied government guarantees. Fed regulation has been a disaster.

The connection between access to the Fed window and Fed regulation is a confusion. There can be a division of labor. Central banks intervene in currencies yet treasuries decide when and how much. The Dept of Energy manages nuclear weapons labs but the Dod uses the product and so on. There's nothing wrong with having all operation of Basel and so on centralized in one agency, which should probably be the Fed. But the idea that it's somehow the Fed's money (as opposed to the Treasury's) so the Fed must watch it follows from nowhere.

Regulatory Reform

While it's hard to know for sure what the right regulatory reforms are, a few principles should govern their choice:

1. No regulation should fix a very specific recent market failure since regulations have unintended consequences (biofuels) and the market takes care of such matters anyway. For example, lenders unfortunately won't be lending to people of modest income who can't repay for some time to come so regulatory assistance in this regard isn't necessary.

2. Regulations should carry over to other areas those regimes that operated well in parts of the financial sector. For example, whatever regime governed hedge funds should be adopted for all financial institutions and whatever regime governed banks should be assiduously avoided.

3. Regulators who behave disreputably should not accrue responsibility. For example, the Fed provided a 28 day funding facility to Bear Stearns on March 14, with the clear intent to create market reliance on that. It was withdrawn the same day. This as yet unexplained act of astonishing credibility destruction and lack of wisdom should discredit whoever's responsible for it from having any greater responsibility for the financial system

4. Clearinghouses are good.

Obama's Poker Winnings Are Missing from His Tax Return

Mr. Obama is a well-regarded poker player, for money.
Where are his gambling winnings and losses on his tax return?

Banking Capital Requirements vs Broker-Dealers'

Paul Krugman offers this today:
"The rescue of Bear Stearns, in particular, was a paradigm-changing event.

Traditional, deposit-taking banks have been regulated since the 1930s, because the experience of the Great Depression showed how bank failures can threaten the whole economy. Supposedly, however, “non-depository” institutions like Bear didn’t have to be regulated, because “market discipline” would ensure that they were run responsibly. "

In 2004, the SEC offered dealers the option of going to Basel (bank) capital requirements, which they anticipated would result in a REDUCTION of required capital from the standard SEC rule that applied to all dealers. Several major dealers adopted this including Bear Stearns, Merrill Lynch, Goldman Sachs and Morgan Stanley.

No doubt Dr Krugman will say that the Fed has a sharp eye on all those banks and that's the difference. But you wouldn't know from his remarks that the standing broker-dealer capital requirements were stricter than those for banks. Is there any other formal part of regulation? As we, know dealers are marking to market a larger share of their assets so they are less likely to be fudging capital than banks are.

Malthusian Catastrophes. Here We Go Again

The WSJ had a front page article today on fears of running out of resources. They say water is hard to find substitutes for. The difference in water consumption per calorie or protein unit between meat and grains is enormous. A cultural shift to vegatarianism not only provides a big substitute for scarce water, but also results in enhanced global health. Economics, as usual, can drive this cultural shift. It's nice to have an easy solution to this problem, drive by economics, with ancillary BENEFITS.

Then there is energy. At least in the United States, it is impossible to imagine that in a future of high bandwidth and high resolution video conferencing that people will still spend time in steel boxes commuting to sit in larger steel boxes to do what can be done electronically. Another substitute with ancially BENEFITS (commuting is one of those few things that doesn't exhibit hedonic adaptation).

My favorite quote from the article:
"history is littered with examples of societies believed to have suffered Malthusian crises: the Mayans of Central America, the Anasazi of the US Southwest, and the people of Easter Island."
Pretty powerful stuff.

There is a problem that the very poor are experiencing rapid inflation since they have a very high food weighting in their basket. Perhaps we should focus on how to make them rich enough to afford food.

FT Notes Need for Regulator Who Knows More

I have enclosed below an article in the FT suggesting that if only regulators knew everything that was going on, they would have stopped the subprime excesses.

There are numerous errors of reasoning or fact in the article. Some of them are:

1. "Subprime lending has long loomed as one of the financial world’s less savoury activities, involving as it does the provision of higher interest loans to lower income people, generally speaking." This is an odd one from a business paper. It is hard to know what, generally speaking, is unsavory about lending to credit risky people at credit risky interest rates. The only flaw of the rates it appears is that they were too low for the credit risk.

2. "Everyone involved had the same incentive – to produce more mortgages." Not exactly right. The investors, who were obviously very involved, had no such incentive. The obvious question is why they didn't adequately protect their interests and Mr Silverman would do a service to discuss the reasons for this.

3. "The rating agencies trusted in the procedures of the banks." How does Mr Silverman know this? Could it be that they had no such trust but nevertheless either incentives to act as if they trusted or were not competent otherwise?

4. "What was missing was a proper supervisor – an entity that could observe the entire process and keep it running smoothly." It is hard to know where to start with a sweeping non-obvious claim from an author who has disestablished his credibility earlier in the article. One wonders what exactly such an overarching supervisor would have seen that wasn't already visible to supervisors. For example, large buyers of mortgages such as banks are highly supervised and it wasn't a secret that subprime loans that those banks were buying had 50% not fully documented as to income etc loans, that house prices had rushed up, that LTVs were very high, that there were loans with very low initial rates, and so on. In fact, some of the biggest losers as investors (like Citi) were also functioning as the terrible securities creators. What information were their regulators missing due to their lack of breadth? Yes, we should have better regulators. And I should be taller.

5. Financial journalists are underpaid compared to financial market participants. This is unfortunate since journalists perform an extremely important function, when they perform their function well. Anyone have any idea how I can get a job writing for the FT? I think I could add a lot.





Bigger sheriffs needed

ByGary Silverman

Published: March 21 2008 21:17 | Last updated: March 21 2008 21:17

It has been less than a fortnight since he left the New York state government, but I am already beginning to feel a certain nostalgia for Eliot Spitzer.

I can’t say I particularly miss Spitzer the man. Spitzer’s professional self-immolation – as the alleged “client nine” of a call-girl ring – underscores the questions about his character that surfaced during his years as attorney-general and governor.

But I am developing a hankering for Spitzer the spectre – the presence who became known as the Sheriff of Wall Street. As it turned out, he hadn’t been gone for more than a couple of days before we learnt again that without proper sheriffs, the local cowboys have a tendency towards self-inflicted wounds.

The latest evidence comes in the form of Bear Stearns, an investment bank that collapsed a few days after Spitzer rode off into the sunset. Worth roughly $20bn about a year ago, Bear agreed to be sold to JPMorgan Chase last weekend for roughly $230m – or less than it cost the Texas Rangers baseball team to sign Alex Rodriguez a few years back.

The exact reasons Bear bit the dust could be the subject of debate for years to come. But there can be little argument that it is the latest casualty of a credit crisis that began in the badlands of the financial world known as the subprime mortgage market.

Subprime lending has long loomed as one of the financial world’s less savoury activities, involving as it does the provision of higher interest loans to lower income people, generally speaking. However, it grew rapidly in recent years as bankers pooled payments from these loans to back securities that were sold to investors. Now, owners of these securities have lost billions of dollars and I would argue that’s because free markets, like frontiers, don’t work well without sheriffs to keep order.

The problem in the subprime world was the lack of checks and balances. Everyone involved had the same incentive – to produce more mortgages. Brokers earned fees by arranging the loans and selling them to banks. Bankers earned fees by creating securities from the mortgages and selling them to ravenous investors around the world. Rating agencies earned fees for attesting to the reliability of this mortgage paper.

Eventually, the brokers ran out of legitimate borrowers and began signing up unreliable ones, even people who could not produce a proper pay stub. Bankers quietly moved the mortgages down the bond assembly line. The rating agencies trusted in the procedures of the banks. Investors banked on the rating agencies. Only disaster stopped the subprime machine.

What was missing was a proper supervisor – an entity that could observe the entire process and keep it running smoothly. You would think we would have such authorities in the US but we don’t.

One of the big errors in this regard dates back to the last years of the Clinton administration, when the US enacted financial reform legislation that allowed financial companies greater freedom but kept the existing system of financial regulation.

It was a solution that pleased the bankers and the bureaucrats. Financial firms got to do just about whatever they wanted. But the regulators maintained control of their traditional fiefdoms, meaning different entities regulated different financial services.

This created a problem in businesses such as subprime mortgages, which involved many different activities. No one supervised the whole thing.The regulators were blind men examining elephants. They knew what they touched but little else.

One of the sad things about Spitzer was that he, too, was a creature of this fragmented regulatory system. His role, while dramatic, was limited. As New York attorney-general, he could pursue people who might have broken state laws. But he couldn’t directly address the structural problems that led to Wall Street malfeasance, and, in a sense, his brand of prosecutorial theatre served as a distraction from them.

When Spitzer resigned as governor, there was no small measure of chortling in New York, but, as the subprime debacle and the Bear collapse show, the last laugh could be on Wall Street. We not only need Spitzers here, we need better Spitzers – broader Spitzers – to keep things from getting out of hand.

I learnt as much during my years covering Wall Street for this newspaper. Indeed, as the Bear collapse occurred, my thoughts kept returning to something one of the grand old men of Wall Street had said to me and a colleague during a meeting a few years back.

It was a background conversation, a chance for us to get to know one another, and our Wall Street friend was in fine form, holding forth on politics and joking around. When the time came for us to leave, he looked at us, flexed his bicep and pointed to it with his index finger. “The only thing that matters is this,” he said.

I didn’t argue with him then and I won’t argue with him now. To get things done on Wall Street you have to show some muscle. Our elected government would be well advised to remember that.

Gary Silverman is the FT’s US news editor
Chrystia Freeland is away.

JPMorgan's Change of Price for Bear Stearns on Sunday

Secretary of the Treasury Hank Paulson appeared on a Sunday morning talk show on Fox News and said "The government is prepared to do what it takes to maintain the stability..." This is quite a change in his tone on bailouts (which was the issue at hand at that moment.)

Andrew Ross Sorkin at the New York Times writes that on Saturday, JPMorgan suggested it might pay in the low double digits. By midday Sunday, JPMorgan was "scared stiff" by what it saw in Bear's books and dropped its price to $2.

An alternative explanation is that JPMorgan heard Mr Paulson, their negotiating counterparty, declare his extreme flexibility publicly. I bet that the $30b request from JPMorgan also followed hearing Mr Paulson's prematurely offered remarks.

NY Fed Gives $10 billion to JPMorgan

In order to avoid the moral hazard problem of bailing out Bear Stearns's shareholders, the Fed has given the value of the bailout to JPMorgan's shareholders.

Had the Fed broadly offered the early discount window access plus the $30 billion of NONRECOURSE funding on less liquid assets (otherwise known as a free option), there would have been many takers and JPMorgan, which provides approximately nothing in exchange for this gift, wouldn't have received the benefit. The Fed, having maximised the sale price, could have charge for this benefit by taking a note from Bear Stearns for a few billion dollars.

Put another way,
in order to avoid a payment to Bear Stearns which would create moral hazard in the future, the Fed gave that payment to their friends.

The Fed and Treasury have tremendously smart, civic minded leadership. Why is it that their decisions are repeatedly either lacking in judgment or creativity or even basic good sense?

Michael Lewis in Portfolio.com on Black-Scholes (March 2008)

There are numerous mistakes of fact or reasoning in this piece, which is surprising for someone of Mr. Lewis's credibility.
Examples:
1. $412 trillion of derivatives have no satisfactory pricing model because they rely on Black-Scholes or Black-Scholes like assumptions. This is nonsense. Those mostly instruments that have no option component whatsoever (like interest swaps). Mr. Lewis might note that the largest use of options of any kind, by far, is to provide prepayable mortgages to tens of millions of households.

2. Portfolio insurance was an example of the failure of the Black-Scholes idea. It is true that Black-Scholes assumes no jumps in markets, but Wall St professionals have realised this failing and compensated for it for about 25 years. Further, portfolio insurance and the market collapse of 1987 was an example of what happens when actors FAIL to use options. They had thought they had purchased options, but hadn't. If you sell something to yourself, you can easily be fooled about the price that you're paying as this is about as far from a third-party transaction as possible. Had they actually purchased those options, they would have observed the prices of those options rising with the growing demand for these options. They wouldn't have "purchased" as much and so would not have been as exposed to equities. So perhaps there would then have been no crash. Also, had they purchased these options, some of that risk would have been redistributed to actors who, though they have sold options, don't sell when the market goes down as they aren't "delta-hedging".

3. Housing was thought not capable of declining in price because of a Black-Scholes like mentality. (I think he's claiming this.) "Black-Scholes...gave...[millions of blissfully oblivious people]...the excuse to risk the roof over their head. ... Black-Scholes is no longer just a model; it has evolved into a climate of opinion..." How about another mentality that predates Black-Scholes: Human beings appear to thing that tomorrow will be much like yesterday. So if prices haven't gone down, they assume they won't. And if internet stocks went up yesterday, they assume they will tomorrow. This claim is quite strained.

Regulation Required to Stop a Repeat Crisis?

(rephrasing an earlier post)

Consider how various classes of actors have fared in the crisis (either as contributors or victims). The worst actors are regulated, sometimes highly so. The best actors are unregulated. Here are lists categorized by how they have performed:



Performed Badly

Credit Rating Agencies (regulated by SEC under NRSRO designation)

Monolines (MBIA, etc) (Regulated by State Insurance Commissioner)

Banks and Securities Firms (Multiple Regulators, and including French and German primary regulators)



Performed Well

Hedge funds (famously unregulated; approximately zero blow ups)

Dumb mortgage borrowers fleeced by unregulated mortgage bankers (as a class net received $400 billion of transfers from domestic and foreign regulated institutions )





Note that there are 10,000 hedge funds, with $2 trillion of equity capital, with a variety of strategies and leverage ratios. They are ill-understood and pretty unregulated. Yet there are almost zero credit losses to counterparties and the biggest surprise is that quantitative equity trading (stat arb) had what they would call a 25-sigma one week move and even then haven’t blown up. On the other hand, there are banks and securities firms that may have negative networth on a true mark-to-market basis. And of course we have the credit agencies rating the monolines AAA with a market implied likelihood of default in the next year in the tens of percent.

Classes of Actors and their Performance in the Financial Crisis

In order of performance (worst to best), each as a class:


regulated (via SEC NRSRO designation) credit rating agencies (shocking performance and at the center of it all)

MBIA et al (regulated as insurance companies)

French regulated banks

regulated banks and brokerage firms (shocking or at best embarrassing losses)

US unregulated hedge funds (leveraged, marked-to-market daily, $2tr of equity, 10,000 actors, and no significant credit losses)

dumb mortgage borrowers fleeced by unregulated mortgage bankers (as a class they have net received hundreds of $bn)



Perhaps regulators will act soon and vie for the top position.

The Generation-Long Economic Mirage

from David Leonhardt in the NY Times:

"The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage.
...
But it’s hard not to believe that the economy will pay a price for the speculative binge of the last two decades, either by going through a tough recession or an extended period of disappointing growth."


Real GDP has doubled in the last two decades, some of it from population growth, mostly not. That whole two decades were a speculative binge? Household debt went up a lot in that period but if it stays unchanged from now we still have double the GDP, minus losses due to a recession. That's pretty good for a rich country with high military spending.

Classes of Actors and their Performance in the Financial Crisis

In order of performance (worst to best), each as a class:

regulated (via SEC designation) credit rating agencies (shocking performance and at the center of it all)
MBIA et al (regulated as insurance companies)
regulated banks and brokerage firms (shocking or at best embarrassing losses)
unregulated hedge funds (leveraged, marked-to-market daily, $2tr of equity, 10,000 actors, and no significant credit losses)
dumb mortgage borrowers fleeced by unregulated mortgage bankers (as a class they have net received hundreds of $bn)

I fear that regulators and legislators will soon act and vie for the top position

Brain Drain to Wall Street

I was just reading the WSJ on the survey by Katz and Goldin of Harvard showing the brain drain to Wall St. It is striking that so much brain power has gone into taking advantage of the illusion that yield is desirable (or, put another way, that selling out of the money options is good because "it can never get there"). It's brain power facilitation the systematic (meaning not accidental or randomly wrong) mis-allocation capital. Anyway, I was reading about the brain drain, then I read this in the FT:

"'The debt and the equity markets now both regard these companies as no longer being triple-A, said Andrew Wessel, an analyst at JPMorgan." Does "now" imply that recently this wasn't the case? Perhaps he was misquoted.

Economic Reasoning by Sophisticated Commentators

FT, Wolfgang Munchau, Jan 1, 2008: "The decision by China Investment Corporation to take a $5bn stake in Morgan Stanley is a sign that China is not about to shift investments out of dollar assets into Euros." Why does Mr. Munchau think that China doesn't manage its currency risk separately from its equity risk?

WSJ, WALTER RUSSELL MEAD, of the CFR: "While U.S. import needs are projected to grow significantly, U.S. dependence on Persian Gulf energy is not, thanks largely to expected production increases in the Western Hemisphere and sub-Saharan Africa. U.S. energy imports from the Persian Gulf are expected to remain below 20% of total consumption. The oil market, of course, is global, and if something were to happen to the Middle Eastern supplies, prices would rise world-wide, and the U.S. economy would be seriously disrupted." Why does Mr. Mead think there's anything significant about the source of supply of oil as long as it's foreign. Except for the benefit of long-term contracts, which Mr. Mead doesn't mention, what is the difference to the US whether the price of imported oil is higher because of a disruption in the supply to the US as opposed to the disruption in the supply to others? After that disruption, except for long-term price contracts, each country will import whatever its demand at the new oil price, independent of who was importing from where before. When he refers to "dependence"on the Persion Gulf not growing, what dependents of any import does he mean? How does he manage to display in the second half of the quoted paragraph that the oil market is global, but then not draw the obvious conclusion from it?


NYTimes, Economics Columnist, DAVID LEONHARDT: " 'Overtreated,' by Shannon Brownlee, ... is my choice for the economics book of the year. ...I’m going with Ms. Brownlee’s book because it’s the best description I have yet read of a huge economic problem that we know how to solve — but is so often misunderstood. " This book is about overtreatment in medical situations in the US. Although Mr. Leonhardt is a economics columnist, he doesn't quite mention, or mention if the book mentions, the simple explanation that when people mostly don't spend their own money, they will consume too much. He does note that people don't realise that they are paying through public funds for the excess care, but people might very well realise it but use of public funds and private decisions based on private funds are different things. He doesn't seem to notice this simple but powerful idea.

WSJ quoting Ned Kelly who heads the financial services group at Carlyle: "But in mortgage banking, we're probably as close to the bottom as we're going to get." Is that the same as "we are at the bottom" since at some point we will be at zero distance from the bottom? Perhaps he means that we're as low as we are going to get. (ok, this one doesn't show flawed fundamental reasoning as he perhaps just misspoke, but I thought it was cute so I included it).

Does anyone think that basic economics should be required for graduation from high school?

Are Hedge Funds Dangerous?

We have had a credit financial crisis. Hedges funds are levered and marked-to-market. There have been close to zero hedge fund failures that have cost creditors money. Citibank and Merrill Lynch seem more worrisome.

Credit Losses as a Result of Debt Resale to Remote Investors?

There's a common view that had debt been held by the originators, their incentives would have kept them from making bad loans. No theory is offered as to why the ultimate holders didn't have an incentive also to avoid extended credit unwisely, thought they might not have known they didn't have enough knowledge. But how do we explain Countrywide, Citi, Merrill Lynch, etc? How many mortgage originators are bankrupt?

Buffet, Derivatives and Financial Weapons of Mass Destruction

Mr. Buffet has called derivatives "financial weapons of mass destruction". As we survey the first financial crisis since he made his remarks, it isn't derivatives which are at fault. Rather, it is one of Mr Buffet's companies.

It is ironic that Mr. Buffet has been a large shareholder in Moodys which, along with the other credit "agencies", is at the center of and responsible for the current credit crisis via their at best faulty credit analysis (at worst fraudulent). Who would have owned the CDOs that were rated AAA and AA had they not been so rated? How much less would have been produced? We will never know but as we observe the worldwide propensity to hold these instruments just because of their rating (which was even true for financial market participants like Citi), it's hard to believe that the market wasn't created by the rating agencies.

CFIUS Review of Foreign Investments in US Financial Institutions

CFIUS should seriously examine these investments in order to make sure that national security is protected. If CDO technology were to fall into the hands of hostile powers, the damage that could be done to the United States is immense.

WSJ Finds Failure in Citi's Assumption of SIV Liabilities

Dec 15, 2007:
"Citigroup's bailout of seven investment entities effectively killed one of the centerpieces of the Bush administration's approach to fix the mortgage crisis. If other moves fail, Congress could take a much more aggressive approach."

Citi found itself with sufficiently little need to use the super-SIV that it auto-bailed itself out. Is this a failure of a centerpiece policy or evidence that things aren't bad enough for the super-SIV to be needed?

Press Coverage of the Fed Action

Greg Ip, of the Wall Street Journal, the most eminent of the Fed watching journalists writes, "Officials said reducing or eliminating the spread between the discount and federal funds rate could have drawn an unlimited and unpredictable amount of borrowing, and caused banks to completely abandon the Federal funds market. That would cause the funds rate to plummet and make it hard for the New York Fed to get it close to the target rate chosen for monetary policy purposes."

Imagine that. The unsecured lending rate between banks much below the collateralised rate for lending by the Fed. Why would the unsecured rate be much lower than the secured rate? Are the discount window requirements in terms of counterparty, collateral and margin so lax that banks would pay more to borrow with this collateral than they would to borrow unsecured? If so, that's a story worth telling. If not, perhaps Mr. Ip's sources have it backwards.

Fed Action to Auction Funds for Term

If the Fed's action doesn't incur credit risk to the Fed, they won't be auctioning any funds. The rate for loans for a month collateralised with treasuries is much lower than the OIS for a month and the Fed is requiring that the rates paid on the funds it auctions be higher than the OIS for a month.

So, the Fed is proposing to take credit risk at a price lower than the current market price for that credit risk. That's fine but it would be appreciated if commentators or the Fed would note that instead of talking about "injecting liquidity". The Fed's discount window program was designed to avoid taking credit risk in the extension of credit to banks. If they aren't keeping with that principle, explicit admission would be credibility enhancing.

If the Fed is concerned that 3 month libor isn't as low as they'd like due to the changed relationship to the overnight fed funds rate, why don't they just target the 3 month fed funds (or libor) rate for now, or some average of the overnight and 3 month fed funds rates? It's easy to do and they would be admired for the clarity of their thought and action (not to mention the efficacy of their action). They have been trying with various non-economic methods (jawboning, maneuvers relying on perception changes for their effect) to affect the 3 month rate. Perhaps they should try economic methods.

Mr. Pandit - Citigroup's New CEO

Perhaps the board should have split the company in two and found two CEOs, each with the requisite knowledge. It's been a long time since synergies were claimed between the institutional and consumer businesses.

It's difficult to know whether Mr. Pandit will be a successful CEO at Citi. However, it is clear that his incredible overreach in starting a hedge fund has paid off. Morgan Stanley has precious few alumni who've started successful hedge funds (unlike, famously, Goldman Sachs). That's because the employees Morgan Stanley by and large don't conduct the kind of trading and investing that hedge funds do (it's hard to think of another reason that there are so few successful alumni). Mr. Pandit, nevertheless, coming from a background that deemphasized risk taking in favor of client business, started a sizable hedge fund that was quickly sold to Citi for $800 million. Though the hedge fund is still young, the results are consistent with what one would expect given the modest investing background of the founders. Meanwhile Citi, having bought Mr. Pandit's services by overpaying for the hedge fund, would have been in an awkward position had he left over the selection of someone else as CEO.

One wonders whether, had Mr. Pandit been at Morgan Stanley this year, whether the results there would have been different, or whether he, instead of Zoe Cruz, would have been blamed for the subprime and other credit losses.

Goldman Sachs Practices, Whatever They Are, Are Great

Whenever a firm (or person) has a period of success, characteristics (real or just claimed) of that firm attract compliments as if they caused the success. John Plender of the FT writes that "the culture of partnership...still survives [at] ... Goldman.... That is clear from remarks...by...Goldman's...chief executive".

Goldman Sachs has many more successful, high quality hedge fund alumni than any other firm, created over many eyars. These alumni couldn't be explained by the culture of partnership since they left the partnership. Perhaps they are explained by Goldman's having a deeper trading culture than other firms. In that case, perhaps that explains the firms recent successs, instead of the stories told by the CEO.

Also, it was once thought that splitting the CEO and Chairman's jobs and having a board dominated by outsiders was a better way to govern. Now apparently, as the FT observes, it's good to have a board with lots of management on it since they understand the business (as if management's insights on risk wouldn't be available to a board were they not members) and the combination of CEO and Chairman in one person at Goldmans doesn't appear to disallow their governance's being so good that it's a model for others. (we can discuss whether the effect of 4 out of 12 on the board being current or former Goldmans executives creates an unbalanced board in another note).

Carbon Equivalence not Good Enough

An article by Jeffrey Ball in the Wall Street Journal on Monday, prompted by the UN global warming conference starting in Bali, reports extensively without criticism on the defect in the cap and trade system that while it reduces global warming gas output (like HFC-23, which is 11,700 as potent per unit mass as CO2), it hasn't much affected CO2 output. There is fretting that the market reduces global warming gasses most cheaply per CO2 equivalent unit, without regard to whether actual CO2 production is reduced.

The only way I can make sense of this is that there's an implicit idea that were CO2 reduced, it would be the result of technology improvements that would come in discrete steps of sufficient size that more than the targeted amount would have been achieved or that those improvements would reduce the future cost of improvements in CO2 reduction technology. I don't know of any reason to think this. CO2 is 77% of all CO2 equivalents and is produced in many ways some of which may be much more expensive to affect and via a much different manner than others (eg., nuclear energy works better for electricity than for the current stock of cars).

The article notes that most of the HFC-23 reduction that can be had is already set to be had, so that further reductions will come from other gasses, thus eliminating the problem that the article finds with the reduction's coming from HFC-23 (methane also looks a little overrepresented but not by much).