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Monthly Archives: May 2009

Though it may make sense in some countries, I’m not in favor of the state providing for health. But having lived with the mess of the US private medical insurance I do believe that this is one service that the state should provide, and Australia is a good example.

It is unfortunate that in the US, this last year the state has had to bail out some capitalist. This does not reflect very well on some parts of private enterprise.

My opinion is that done properly, there is no substitute for the power of competition. For example, looking at electric cars, competition allows us to know that GM Volt’s 40 miles per charge is a dud, because we know that another management team, Tesla, has achieved 244 miles per charge.

Without competition there is this opacity of internal business management. We really have no idea what is going on in a company, and can only infer that maybe management is good, bad or ugly. It is an information asymmetry.

Competition reduces the risk of this information asymmetry and enables us, without much effort on our part, to quickly figure out which is the better management team. In this case it is obvious that it is Tesla without a doubt. So I would not pay top dollar for the GM management team.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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I read both WSJ and NY Times. One leans right and the other left. Unfortunately, many times the rantings (both legitimate and not) make it difficult to wade through the discussions.

I think an important aspect of corporate governance is mission. When corporations lose sight of their mission and focus solely on profitability as their only yardstick then anything goes.

For example if AIG had stuck to insurance as their mission, their means of delivering profits, and therefore wealth, AIG would be a very strong company today.

Another example is GM (I’m inferring a lot from the news articles and I might be wrong but time will tell).

At some point in their history GM prided itself for its differentiation strategy. It knew of every nook and cranny of the auto market, but today by way of profitability, GM is essentially an SUV/truck company.

GM lost sight of its need, its mission, to satisfy the transportation needs of the American public, and set its sights on profits at any expense. In a sense we can say that GM allowed SUV/trucks to subsidize the other segments of its business.

Worse still, its development of the electric car (in my opinion) is something to appease stakeholders. GM’s electric car, the Volt, is not a serious contender for the consumer market as it does only 40 miles on a charge.  The average American drives 33 miles per day. (So you know why 40 miles per charge!) Note these are averages, so a Volt owner is going to be severely restricted ie don’t sell your first car. The need to keep your first car is going to reduce the potential market even further.

Compare this with the Tesla at 244 miles per charge. So the Volt is a dud.

The same can be said of the banking industry, sub-prime is a dud. And probably securitization as we have know it.

Once you control a juggernaut, making profits by itself is easy, just don’t reinvest in your future and you will look good for a while. In brand management this is called ‘milking’.

Corporate governance needs to deal with two issues, (1) staying focused i.e. missions, and (2) seek a balance or to temper “profits today” with “a future tomorrow”.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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I posted my comments to John Steele Gordon’s article on other forums and found it difficult to stay clear of the political leanings of authors. I am not interested in the political leanings of any author.

I believe if a government, any government, has to step-in to bail out private enterprise on the scale the US is now doing, than we are witnessing the failure of corporate governance in the private sector.

Both sides can fail as pointed out by Gordon’s and myself. And there are no assurances of either success OR failure at the outset.

The Port Authority of Singapore, and Australian healthcare services are two examples of excellent government run services – excellent. The Apollo program of the 1960s is a US-based public sector success, and a tremendous success it was.

I think the impact of point (1) is underestimated in the private sector. Just because a private sector C officer is in the private sector does not mean that he/she runs an organization solely by merit, i.e. political considerations come into play.

For example (without naming names) board members are often selected / approved by whether they will implicitly support the Chairman / President / CEO, and not for their independent views. So you get entrenched blocks. With entrenched blocks leadership goes out the window because leadership is no longer required to keep your position.

To avoid the risk of massive failures, real corporate governance needs to come into play, but how?

Benjaimn T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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In his article Why Governments Can’t Run a Business Gordon raises many good issues, but Mr. Gordon here is a reminder and rebuttal to each of your points:

1. Governments are run by politicians, not businessmen.
Quite obviously I do not know how you would define businessmen. Remember, Worldcom, Enron, Arthur Andersen, Merrill Lynch, Morgan Stanley, AIG…

2. Politicians need headlines.
Using the examples above I can understand why businessmen don’t like headlines.

3. Governments use other people’s money.
How do banks get their funds?

4. Government does not tolerate competition.
Have you forgotten Standard Oil?

5. Government enterprises are almost always monopolies and thus do not face competition at all.
Oh wow, if cutting cost is alien to the culture of all bureaucracies, then private medical insurance must be free by now, right?

6. Successful corperations are run by benevelont despots.
Sorry, I forgot GM had over-looked 50 years of losing market share.

7. Government is regulated by government.
Have you forgotten what happened to Wall St in 2008 with minimal regulation?

 

My point is, blaming the other side either overtly or covertly, is not going to help America.

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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This was sent to us by a university professor friend of ours:

Something to make you laugh while you are busy marking papers….These were some of the answers to a science paper –

Q: Name the four seasons.
A: Salt, pepper, mustard and vinegar.  

Q: How is dew formed?
A: The sun shines down on the leaves and makes them perspire. 

Q: How can you delay milk turning sour? (brilliant, love this!)
A: Keep it in the cow. 

Q: What happens to your body as you age?
A: When you get old, so do your bowels and you get intercontinental 

Q: What happens to a boy when he reaches puberty?
A: He says good-bye to his boyhood and looks forward to his adultery. 

Q: How are the main parts of the body categorized? ( e.g., abdomen)
A: The body is consisted into three parts — the brainium, the borax and the abdominal cavity. The brainium contains the brain; the borax contains the heart and lungs, and the abdominal cavity contains the five bowels A, E, I, O, and U.!  

Q: Give the meaning of the term “Caesarian Section.”
A: The Caesarian Section is a district in Rome .  

Q: What does the word “benign” mean?’
A: Benign is what you will be after you be eight.

Here are responses to some comments.

Bernard commented that there are other factors that need to be taken into account. Correct.

I was looking for a short cut to get a sense of how things will unfold in the next 2 year, because nobody did predict this housing bust or its magnitude, the recession or for that matter that the banks would get into this supersized mess.

Some times when modeling I divide factors into fast and slow variables, (its an art) compared to oil price swings almost everything looks like slow variables, and are in an approximate steady state, then oil becomes the major drive in the short term.

Zachary was curious how much reliance you can put on using average numbers, in particular with respect to arriving at gas costs as a % of discretionary income.

I usually don’t like using average numbers (because I’d rather build fairly detailed models) but in the absence of good publically available data, averages will do. We’ll know by 1Q 2010 how this gas price hypothesis works out.

My bet is that gas cost as a % of discretionary income is a pretty good indicator of consumer spending but needs testing. To get some idea of its potential effectiveness, look at what happened by 2Q 2008. In Denver many people stopped driving cars and switched to Light Rail and buses. The Light Rail, usually not crowded, was packed. Jammed packed.

Another way to look at things is that any policy that increases discretionary income will help restore the consumer spending (and therefore this economy), while that which reduces discretionary income will retard the consumer spending.

To this we can add, an oil price hike just transfers the funds from US government policies to oil producing nations because the effects of the enlargened discretionary income is negated by the increased energy costs.

If you keep enlargening the ‘pie’ you get inflation, if you don’t, you lock down consumer spending. Not easy.

So the ‘answer’ to this recession severity question seems to be not to stimulate consumer spending, but to stimulate industrial growth and job creation.

Any ideas?

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. These musing are not to be taken as an endorsement or disapproval of any persons, entity, goods or services.
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My apologies for this late response to my earlier post on the severity of this recession. I was preparing a paper for a conference. The thesis of my paper is that the experimental data shows that a photon’s probability distribution is not a Gaussian distribution. But this blog is not the right place for it here. You can tell that my focus is in building models that can be experimentally or historically verified by real world data.

OK coming back to this recession. I really hope that the policies that are being placed into effect will turn the economy around, and for this discussion ‘but may be not’. The Dow is at 8440.36 at this minute, and has come up 2,000 from its 6,440.08 low on March 09, 2009. If this upward trend in the Dow holds, this suggests that the economy should turn around 6 to 9 months from March or September to December 2009.

But this 6-9 month lag between the market and the economy is generally true when gas pump prices are below $2.00/gallon (or equivalent).

I view the economy as tessellations of the consumers’ gross incomes, disposable incomes or discretionary incomes. Then one in theory could build a probability distribution of these incomes. Unlike loss modeling where we are looking to the behavior of the tail, in the tessellate model we would cut-off or ignore the 5% or 1% tails, and model how incomes would behave under economic stress.

For example, the gross income tessellate could be used to model tax revenues, the disposable income tessellate to model consumer housing demand and ‘capex’ expenditures, while the discretionary income tessellate would be used to model retail purchases.

Using only averages we can estimate some effects of this tessellate model.

In 2006, the estimated average annual salary of a US small business employee (they account for 50% of the US workforce) was $31,049, and Conference Board tells us that the average per capita discretionary income in 2006 was $9,148. For households with incomes of $50,000 or less, i.e. small business employees, the 2006 discretionary income was $1,900 for the whole family of 2.7 people. This tells us that it is vital to know how to partition the data correctly to get good results.

The average American drives about 12,000 miles per year. At approximately 20 miles to the gallon, this translates to an annualized $1,050 when gas prices were $1.75/gallon in 1Q 2005, and $2,460 in 2Q 2008 when gas prices peaked at $4.25/gallon. (Source: American Petroleum Institute).

Or gasoline cost was up from 11.5% (2005) of discretionary income to 26.9% ( 2008 ) (using 2006 discretionary data for all years).  A sizeable increase. 

But this does not tell the whole story. From a small business employee perspective (50% of US workforce), gasoline costs went from 55% (early 2005) to 90% (mid 2006) to 130% (mid 2008). Definitely not sustainable.

Today (May 19 2009) gas prices are around $2.20/gallon (my guess is that this is on the low side).  This converts to 14.43% & 69.47% of average and small business employee discretionary incomes, respectively.  Or to put it succinctly, 50% of US employees have the discretionary budgets less gas costs reduced to $580 PER YEAR. That is definitely going to ripple through the economy as this is a reduction of consumer spending on other goods & services.

That means the small business employee is already feeling the pinch, and consumer spending of this 50% of the economy has already slowed down again.  We should see this coming through the economy in the next few months.  Also these numbers have not factored the 11 million newly unemployed. My guess is that a second slow down is in the works and should be visible by mid-summer.

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Most forecasters try to be middle of the road, but try to cushion the downside, and ‘enhance’ the upside. The scenario below could become a reality and could lead to an extended recession well into 2011.

1. The raw data suggests that pump prices triggered the house price collapse. The logical cause and effect would be spiking gas prices eliminated many peoples’ discretionary incomes.

2. This reduction in discretionary income rippled throughout the economy as a reduction in consumer spending, a finite budget showing up as reduced demand for goods and services.

3. Therefore, the housing collapse, the mortgage mess, and the banking crisis. But would not have been as severe as it is now if the sub-prime mess was not waiting in the wings.

4. If the Fed/FDIC has underestimated the severity of the banking crisis as Nouriel Roubini  has suggested, we are going to see more bank failures, and further tightening of credit. This may be the case if their methodology addressed mean loss rather than percentile loss (eg CVaR). I’ll research the methodology and will let you know what I think. But don’t get me wrong, I have great respect of Bernake, Bair and Geithner.

5. My crude estimate is that $2.00/gallon is the threshold price for point of inflexion between +ve and –ve economic growth. Gas prices at the pump have exceeded $2.00/gallon. If I am correct we are going to see further slowdown and more job losses.

Therefore, this crude analysis suggests that the Fed/FDIC/forecasters have underestimated this recession severity in the presence of oil price increases, and just may be our recession will last well into 2011.

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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This series of blogs is derived from my discussions on the LinkedIn Quant Finance: What is the best approach to handling CMBS &/or RMBS Credit Risk analysis? discussion forum. Russel explained that “projected defaults” are foreclosures + delinquents, and all his observed FICO scores were above 670.

 I saw FICO scores between 520 and 820, and almost always once a loan became delinquent it would foreclose.

The main reason I did not consider delinquencies was because I had to be sure it did foreclose and the loan age when it foreclosed, and this data was not available for delinquents.

This agrees with your conclusion about delinquencies but our subsequent handling of the data is different.

Your last comment sums it the best, the underwriting standards varied and deteriorated so much that FICO scores were no longer reliable measures of foreclosures. (eg 820 in sub-prime??)

Another possible scenario is that underwritten FICO scores are based on ‘good’ financial standing in a ‘good’ economic environment. But once a person experiences financial stress, FICO scores are lagged indicators with a range of or even an indeterminate set of lag times. Then given the financial stress all individuals irrespective of their original FICO scores, respond similarly to this financial stress.

That is under financial stress the underlying statistical behavior of the financially stressed population is different from the underlying statistical behavior of the population in good financial standing.

So FICO score may actually be good predictors of success, but poor predictors of failure. This is similar to company profitability versus Altman’s Z-scores. This first predicts success, the second failure.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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This series of blogs is derived from my discussions on the LinkedIn Quant Finance: What is the best approach to handling CMBS &/or RMBS Credit Risk analysis? discussion forum.

Here is the problem with vintage per the triangular matrix method. (I gave it that term because nobody else I talked to knew what it was named.) If you look at the Esaki-Snyder report or the Wachovia CMBS 2008 Loss Study, there is this averaging method, that looks like a triangular matrix, to determine the average over vintages by loan age.

It gives one an incorrect shape of loss or defaults over the life of an asset. There is a simple test to prove this. Assume that all defaults (or losses) are constant over the life of the loan say 2% every year. The age-default profile should be a horizontal line. Now say that as the economy improves the defaults decrease by 0.2% per vintage, ie yr 2000=2%, yr 2001 = 1.8%, yr 2002 =1.6%, … but remains constant per vintage through the life of the asset.

You can do the same with increasing rates.

The method is biased because the averaged defaults (or loss) is no longer a horizontal line (the original correct input), and tends towards the value of the oldest vintage.

To make it easier for the reader I have provided the link to the Triangular Matrix Method Test Excel 2003 Spreadsheet. (Note: you may have some problems with IE8, try saving to disc.)

 

 Discalimer: This blog is purely for informational/educational purposes and is not intended to either negate or advocate any product, service, political position or persons.
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