Markets Win

A short post to make fun of AP and deflate Tim Geithner (but just a little) by offering evidence of markets responding ahead of regulators, again.

First, AP. See this article about Geithner's letter to congressional leaders. AP worked in the adjectives "shadowy" and "complex" to describe credit default swaps, obligatory words when trying to scare readers. Here's how complex and shadowy they are: they are puts, or insurance, on an entity's creditworthiness and are traded back and forth between banks, insurance companies, broker dealers and money managers all day every day. Unlike puts on the S&P 500, they are not traded on an exchange and unlike insurance the holder need not have a financial stake in the protected debt (for very good public policy reasons you can't buy insurance on someone else's life or home). They are shadowy in the same way your office is shadowy to me because I don't work there, but would be pretty easy to understand if I did.

On to Geithner. His proposal, in summary, is to create an exchange for CDS trading, just like the NYSE. Terms, reporting, pricing and capital requirements would be standardized and transparent to regulators and participants. It's a very good idea and I commend the administration for advancing it. Off exchange, or over-the-counter, transactions will still occur, as they do with other financial products but they'll have to compete with the very reassuring benefits exchange based trading provides.

However, markets are way ahead of Geithner. Assuredly, Geithner's vision and CME/Citadel's version differ, but in small ways interesting to the industry and few others. The point is, markets saw a need and acted long before regulators (just like in Enron, BTW and, of course, for different reasons). Private enterprise has taken quite a beating in the last year, much of it deserved. But it's this little magic, which gets much less attention and happens, oh, a few million times a day, that will cure what ails us long before the government does.

If Washington doesn't kill it first, that is.

Three Strikes for The Biden Patriot-o-Meter!!

Daschle, Geithner and now Sebelius. Congratulations to Team Obama, a collection of the best and brightest who have collectively skirted almost $250,000 in taxes. As a group, the taxes they've blown off make up the annual income of just one single person Team Obama would like to tax into oblivion.

Also, I love Sebelius calling the taxes she didn't pay "unintentional errors." As opposed to an "intentional error?" Wouldn't an "intentional error" just be a "crime?"

Move Along, Folks, No Expropriation Risk Here.

Without joining those who seek Tim Geithner's head on pike or burning AIG CEO Ed Liddy in effigy and without arguing the legality or propriety of the so-called bonuses dispensed by the company allow me to wax a bit on the implications of expropriation risk. I understand the politics, optics and emotion. As a trader, little makes me angrier in business than a trader's failure rewarded. But as a trader, I also believe only two things separate humans from lower mammals: the sanctity of contracts and opposable thumbs.

However, now that the House has decided to tax some bonuses at some TARP recipients at 90%, we ought to consider the ripple effects. Actually, the House should have considered them before voting, but this is Congress after all where E Pluribus Unum translates not as "Out of Many, One" but "Ready, Fire, Aim!"

When firms invest, among the many things they consider is the prospect of ex post confiscation by government. Want to build a cellphone tower in the Democratic Republic of the Congo? No problem, but if the investor believes, even incorrectly, there's a 50% chance the profit will be extricated without due process, the NPV calculation must factor in this probability. If the assumption is incorrect, over time less pessimistic investors will step in and profit. Provided the less pessimistic assumption stays true, the return requirements will come down, which is good for investors, customers, employees, taxpayers and so on (of course bubbles can form if return requirements come down too much, but that's a different matter and expropriation isn't a good solution).

A simplified explanation for all non-MBA geeks (i.e., those w/MBAs are geeks, author included): Hypothetically, Mr. Cellphone won't invest in any project returning less than 10% net of tax. The tower costs $100.00 and will generate earnings for six years. Given those constraints, the project must produce $142 over those six years or Mr. Cellphone will build elsewhere. As the perception of expropriation risk goes up, up goes required return and down goes the likelihood of investing, down goes employment, down go tax receipts and so on. Rational investors with sunk costs adjust to expropriation risk, too. If Mr. Cellphone has already built his tower and the perception of expropriation risk increases, Mr. Cellphone must decide if it's worthwhile to stay in business or just bailout mid-project (please don't interpret this as a defense of supply side economics. I'm just riffing on expropriation).

Our Constitution's prohibition of ex post facto legislation is a key protection for all kinds of behavior, financial and otherwise. Weakening it, or appearing to weaken it comes at an extraordinary, but often invisible, cost. So, while we pat ourselves on the back for sticking it to AIG's scumbags, consider if investors will bother to determine that a rational Congress meted out a rational response to those who deserved it, or if Congress just makes up the rules as it goes along.