Undercapitalized firms do not pay dividends, they suspend the payment of dividends. Lawmakers foolishly did not require by law that banks receiving capital from the government to suspend share buybacks and dividend payments until lending is resumed at normal levels. It is not hyperbolic to say that at a least part of the current implementation of the “rescue package” is a direct transfer payment to the shareholders of these companies. These firms would rebut, if they suspend their dividends then it would signal weakness to investors. Well, these are the same firms which were verging on bankruptcy only weeks ago, so signaling weakness would not be informing the markets couldn’t figure out on their own. On the other hand distributing dividends will certainly lower their capital bases and most importantly reduce their ability to lend. If you’re not mad, you should be.
October 30, 2008
October 28, 2008
The worst is not over yet. There last shoe has yet to drop. Hedge funds are supposed to be the for only the rich, key words “supposed to be”. However, as with everything about our economy, they too are highly intertwined in the markets. If they fail the ramifications will be indiscernible for the failure of any other financial institution. Their demise will have similar contagion effects to retail banks. Worse, hedge funds are often leveraged at very high levels. If underlying asset values increase, then the value of the fund goes up by a multiple of that value. However, like all things in life, you can’t get something for nothing, what goes up twice as fast falls twice as fast as well. Therefore, given that the stock market has fallen approximately 40% recently, any fund that was leveraged by more than 2.5 times would be insolvent. If this were the case why haven’t we heard about more failing funds? Well, many of these such funds have withdrawal timing constraints. For many of these funds, the timing of this withdrawl window will be quarter end (yeah Christmas gift). And when investors in these funds start pulling funds out it will be a self fulfilling, the more investors who want their money, the faster the funds will have to liquidate positions at large losses. So what’s the big deal? The only people that are going to be wiped out will be rich kids with trust funds right? Wrong!
Pension funds are supposed to have the fiduciary duty to conservatively manage assets to better ensure the likelihood of fully vesting assets for their pensioners come retirement time. In spite of this duty, many pension funds have invested large sums of money in hedge funds. This is not news either, see this 2005 NYT article, which discusses this idiotic investment risk. Furthermore, all of the selling from these hedge funds to meet the flood of people pulling their assets out of these funds will leave stocks at even lower levels.
So that’s the bad news. Is there any good news? Perhaps. If sensible regulation can be inacted, then some good may come of this. I don’t advocate regulating except in the case when industry’s actions impose externalities. One of my greatests concerns with the financial system has been that financial institutions have learned, because government has taught them, that the federal government and fundamentally tax payers will always backstop their excessive risk taking. In financial terms, the public is writing the financial system a put option, but charging no premium for the risk we bear. I don’t know about you, but when I want to recieve auto insurance I have to pay a premium. Similarly I think it is reasonable to charge financial institutions who leverage themselves at excessively high levels to pay the tax payer for the additional risk they add to the health of the financial system.
The banking crisis could have been avoided if the banks carried enough equity capital to absorb their loses. The banks did have enough total capital to absorb the loses. When equity capital runs out, the bank is insolvent, and in normal circumstances would go through bankruptcy precedings. This would mean the debtholders become stockholders and the original stockholders are wiped out. This is why investors require a higher rate of return from stock than corporate debt. Since you don’t have time to go through bankruptcy preceedings during a banking crisis the logical regulation is to require banks to hold enough equity capital to absorb a very large loss of capital. But even with a large amount of equity there is still a small possibility of catastrophic loss and furthermore capital isn’t free. So somehow you would like banks to be capitalized with a high amount of equity capital for the people writing the put option to be compensated for its expected value. The first part is justified by the “Capital Structure Irrelavance Principle”, which despite an onslaught of attacks by economists since it was originally postulated in 1958 by Modigliani and Miller has proven very robust. The theorem in a nutshell states that the rate of return from a firm is not affected by the form of financing (debt or equity). Since equity makes sense for the public good in the case of banks, lets not suggest it, lets require it. That is the first line of defense, but even if we follow this prescription there would still be residual risk. I suggest using VaR modeling, we determine an appropriate value for the implicit put option for financial firms. Some might call that a tax, I don’t care, I call it an insurance premium.
October 22, 2008
October 19, 2008
It’s autumn and the leaves are changing. Across the street from where I work is a very large park with which I thought would make for some nice landscape HDR images of the leaves turning at sunset. I processed the images entirely with free open source software using GIMP, UFraw, and Qtpfsgui.
October 18, 2008
I had read about a third party open source firmware that has been developed for many of Canon’s point and shoot digital cameras. One of the major additional features the CHKD firmware provides is the ability to save and download RAW image files from the camera. RAW is mostly useful when you intend to do significant post processing where the lossy nature of a JPEG would not have sufficient bit depth. SInce RAW file format images are straight readouts of the image sensor, they contain much richer information. One of the interesting post processing steps you can due is called High Dynamic Range. This is where you take several images of the same scene at a range of EVs and process them with an algorithm which dramatically increases the contrast of the image. I tried my hand at a HDR image and was quite pleased with the results.
October 13, 2008
There has been a lot of criticism of the “rescue plan” retitled from the “bailout plan”. Although I was reluctantly in favor of swift action to avoid systemic risks to the real economy, I was still ill at ease over the adverse fallout to the incentives that drive rational and socially beneficial economic behavior. If we recapitalized banks through the purchase of distressed assets, then the banks who wisely avoided these assets are punished for their conservatism and maybe worse, teaches the finacial markets that overleveraging will not be punished. I read an article by Luigi Zingales, which I think skillfully solves the issues with recapitalizing banks and stabilize housing prices and at the same time pareto improving for all parties with the exclusion of the shareholders of banks that made poor risk management decisions.
October 9, 2008
It arrives tomorrow, a brand new shiny Lenovo SL300. I will try to write a review if I have time.
|Shipped To:||MAYFIELD HEIGHTS, OH, US|
I ran the Portland Marathon last weekend. The result was far below my expectations (4:20), but rather than disappointment I rather feel a great determination to try again to best the result. If I can simply avoid blowing up on the last three or four miles I should be able to break 4:00 hopefully. That will have to wait a while as I already have a busy schedule over the next month. I am sitting for the MFE section of the third Actuarial exam on November 4th and then traveling to China for for almost three weeks.