Dump Your Gold ETFs

In one of my earliest posts, I suggested that if you're really buying gold for the "end of the world" scenario, you have a problem: Gold ETFs look and act like hard currency.  A sheet of paper may be exchanged for gold, on demand.

Today the Wall Street Journal picked up the story from federal court in North Carolina of Bernard von NotHaus who has been convicted of producing hard currency.  He's going to federal prison, and they're taking his gold.

Your GLD is at risk.  Don't say I didn't warn you!

The Other Mortgage Bailout

I'm ashamed I missed this one: We're already backstopping another mortgage bailout.

I've written before about my opposition to various schemes that force all taxpayers to take on catastrophic risks of loss that only benefit people who live in high risk areas, (like a plan to let the national flood insurance program practically give away hurricane insurance, or another great idea to force all of us to take on earthquake and hurricane risk.)

A recent report by Aon Benfield, one of the largest insurance brokers quantifies the earthquake risk Fannie Mae and Freddie Mac take.  That's right, neither agency ever required borrowers to have earthquake insurance.  That means all those mortgages in California, guaranteed by the two agencies, would be covered after the Big One, without even the indignity of the governor having to beg for a bailout!

How much is at stake?  Insurance companies typically look at a one in 250 year loss as an extreme (but possible) measure of risk.  Aon pegs the loss to Fannie and Freddie in a 1 in 250 quake at $33 billion.  That's right: Fannie and Freddie stand to lose $33 billion in an earthquake--not counting any credit losses! 

For fun, let's put that in the context of Fannie and Freddie three years ago.  (Yes, I'm assuming their quake exposure hasn't really changed in three years.)  At year end 2007, Fannie Mae had $44 billion of equity. Freddie Mac had $26.7 billion.  So, it's probably not far off that the combined entities had only about 2x the capital that they could have lost in a single, major earthquake.


Again, according to Aon Benfield, (not just me!) a reasonable commercial insurance company doesn't risk more than a 20% loss in book value in a 1:250 event.  So, the mortgage giants were taking risk as if they were a combined $168 billion book value insurer of earthquake risk, when they had less than half.

I know, like we need another reason to declare Fannie and Freddie insane exercises in risk taking...

Money Market Deja Vu

Almost one year ago, I wrote about the deception of money market funds.  Money market funds were under serious scrutiny then, because their manipulated price of $1 makes them appear to be less risky than they really are.  One year ago, the mutual fund industry refused the idea of letting money market funds vary around $1.  Why reveal that these investments that look like bank deposits actually have risk?

Today, the Investment Company Institute came back with a new suggestion: Set up a new "bank" that stands prepared to buy assets from money market funds when they cannot meet the liquidity demands of their investors.  Again, we're talking about making a risky investment look not risky.

Why is this called a bank??  Two very good reasons.  First, money market funds aren't bank deposits.  Bank deposits are secured, at least in theory, by FDIC insurance.  So, if money market funds could say their investments are "protected by a bank" it will make them sound less risky, right?  Second reason to call this "beast" a bank?  This beast is a financial guaranty company, and if there's one thing we've learned from the financial crisis, it is that financial guaranty companies don't work in a time of massive systematic shock!  (Here I talk about this problem more generally.)  So, let's call it a bank instead of an insurance company.

However, the real question remains: Why would we, the public, want to establish a financial institution that cannot possibly cover its own risks in a serious financial crisis, so that the mutual fund industry can more effectively hide the risk of money market funds?

Questions You Never Thought You'd Ask

Hold on to your hats:  Are more efficient markets really that good for us?

I know, I cannot believe I wrote it either.

Let's be precise.  If we define "efficient markets" as a full complement of Arrow-Debreu securities, (these are securities that have a payoff of one in a single, particular state in the future, and pay off zero otherwise..pause and think about this...that's a whole heck of a lot of securities!) then we can accept the fact that "efficient markets" is a theoretical construct.  All we can strive for are "more efficient" markets by constructing more an more useful securities.  Useful being the operative term.

Why are a complete set of Arrow-Debreu securities useful?  If we had them, we could hedge anything.  Because we don't, we can't always hedge.  This means messy states of the world will exist.  Think May's "Flash Crash".


In this story, we learn about one after the fact solution to the Flash Crash.  A husband and wife pair of market micro-structure experts, working with a high frequency trading practitioner at Tudor, have developed a measure called VPIN, for "volume-synchronized probability of informed trading."  Apparently this measure predicts movements in volatility, and could have predicted the Flash Crash. 

The researcher at Tudor has applied for a patent on the measure, with the logical next step of a futures contract on it.  We can only assume options on VPIN follow shortly thereafter.  The VIX (volatility index) followed a similar securitization path.

So, how could I be opposed to such a securitization, which only serves to reduce market inefficiencies?  Safety measures have consequences.  Sam Peltzman's research on seat belts tells us everything: Drivers who wear seat belts drive more recklessly. 

Since the Flash Crash likely had roots in lousy liquidity, I find the situation ironic.  Design securities with lousy liquidity to hedge a liquidity driven crash!  

How do I know VPIN based securities will have lousy liquidity?  No one wants to be long VPIN risk.  In a very simple sense, this means you lose a whole bunch of money when a disaster hits the equity market.  (I wrote here about hedging catastrophic market events.  Providing insurance for truly catastrophic events requires massive amounts of capital and very high fees: you have to be certain you'll have capital after the event happens, but at the same time you have to be paid enough to have your capital doing nothing at other times so you don't lose it in the crash.) 

There are no natural buyers of VPIN risk.  (Who wants to agree to lose money in a liquidity driven crash?)  Lot's of sellers means some combination of lousy liquidity and horrible volatility imbalances in options of VPIN...until someone constructs futures (and options!) on VPIN volatility!  That way market participants magically hedge the VPIN illiquidity!  You see where this goes?  Rinse and Repeat.

We'll keep hiding the risk in more and more esoteric derivatives, but the risk doesn't go away.  As much as it pains me to say this, I can't quite see how more securities really makes us better off.

We Are All Tony Hayward

In case you've been under a rock, or an oil slick, Tony Hayward is the embattled head of BP.  And no, I am not about to attack you and your carbon footprint or personal oil consumption.

Richard Epstein writes in the Wall Street Journal yesterday that BP should not have liability caps:

A tough liability system does more than provide compensation for serious harms after the fact. It also sorts out the wheat from the chaff—so that in this case companies with weak safety profiles don't get within a mile of an oil derrick. Solid insurance underwriting is likely to do a better job in pricing risk than any program of direct government oversight. Only strong players, highly incentivized and fully bonded, need apply for a permit to operate.

Basically, if you have everything to lose, you act more responsibly, and you buy more insurance.  (And, your non-"catastrophic loss scenario" return on equity falls.)

In seemingly unrelated news, the GAO released its latest report on individual state natural catastrophe programs.  (Here's the summary, and the full report.)

For me, the highlight of the report: Florida's hurricane programs cover $2 trillion of risk.  Yes, that's trillion, not billion.  I am not making this up.  How do you imagine the state of Florida covers that risk?  You and your wallet.  I've written about this before, whether it's a special program to bail out all our high risk friends, or the lunacy of making the money losing National Flood Insurance Program cover hurricanes too.

So, Epstein argues that liability limits amount to free insurance.  If you know you can't pay out over some limit, then insuring about that limit comes at a price of zero.

Too many people will argue that without liability limits, or without free insurance from the government, "companies won't function," or "homeowners can't live."  That's just not true.

However, I have two questions that maybe I'll investigate further, and I'd love Epstein's thoughts:

• Why do we have limited liability companies because that too amounts to free insurance?
• How do you avoid private insurance and reinsurance companies becoming systematic-disasters-waiting-to-happen because, as I argue here and here, they cannot possibly hold capital to cover their risks?
  

Making BP Pay, Kicking The Habit, and Future Predictions

President Obama says he's going to make BP pay.  Pay for everything.

I'm going to take him at his word for this.  Seems like a reasonable outcome, politically speaking.

Let's consider the tobacco settlement as a good precedent.  Tobacco products had done, and continue to cause, irreparable damage to state finances through medicare and other costs.  In addition, every state in the Union depends on significant cigarette tax to fund god-knows-what programs.  (I love designated funding.  Sure, we don't like gambling, but the gambling benefits the children!) 

The end result: State and local governments depend as much on tobacco sales in the US (if not more) to fund their entitlement programs than the actual manufacturers of tobacco products depend on them for their profits.  Let's face it, state fiscal crises hit faster and harder without tobacco manufacturing and sales in the US.  As taxpayers, we cannot afford to kick the habit.

At some point, in the not-so-distant future, all BP efforts to produce oil from the gulf will focus exclusively on funding programs in Texas, Louisiana, Alabama and Florida.  (Let's hope not Georgia up to Maine, but maybe...)  At first, these will look like "good" works: cleaning pelicans, protecting turtle eggs, etc.

Not long after, this will involve special training programs to spouses of Tallahassee hot dog vendors who lost their jobs as a result of tourism dropped in Miami.  BP's new role as a key funding mechanism to state governments will ensure that the quantity of offshore drilling will rise, and the quality may even fall.  As taxpayers, we won't be able to kick the habit.


BP has died.  Long live BP!

Earthquakes and Credit Rating Agencies

Credit rating agencies have been under intense heat for a long time.  Recently, Congress has joined the action.  For those unaware, the issue surrounds (mostly) AAA ratings.  Triple A bonds, investors believed, had "very little" risk.  The problem, however, results because no one knew what that meant.  But, it's worse than that: Even if investors knew what that meant, we won't live long enough to know if the agencies were right.

The business of underwriting catastrophic risk, like earthquakes and hurricanes, faces the same problem.  How can you tell if someone is good or bad at pricing risk?  The events they price happen (thankfully) truly infrequently.  So, when they lose money, are they wrong or unlucky? 

Suppose you know for certain that an event has a one in 500 year chance of occurring.  The event happens next year.  That's unfortunate luck.  You could be great a pricing such risk.  In fact, you could have been paid superbly to take the risk.  However, you lost.

Now, complicate matters ever so slightly, but reasonably.  You think the event happens once in 500 years.  But, maybe it's one in 400, maybe it's one in 600.  You can't be sure.  (Ask someone who didn't get a D in his first undergrad statistics class to tell you how many years it will take to know whether it's one in 400, 500 or 600. ) Now, if the event happens next year, you don't know if you were unlucky and right or unlucky and wrong, no matter how much premium you collected to take the risk.

What does this have to do with AAA rated bonds?  All we can say for sure in 2010 is that an incredibly rare economic catastrophe happened in 2008 and 2009.  We can't really say how rare with any degree of precision.  Worse, the rating agencies never even declared default probabilities for different bonds.

Where does that leave investors?  It's actually pretty difficult to say the rating agencies did anything wrong based on outcomes.  Bonds defaulted.  An incredibly rare event happened, but we don't know how rare.  And, bonds defaulted.

Do I defend the rating agencies?  No, I dare not.  Fault the rating agencies for their processes.  Do not fault them for defaulted bonds and observable outcomes.

Where's My Insurance Bailout?

In a previous post I wrote about the joys of HR 2555, which seeks to create a federal program to protect the voters who live in catastrophe prone areas.  Sponsored by a Floridian, logically.  This disastrous piece of legislation implies that it would allow for better risk sharing by introducing the government into the hurricane and earth quake insurance business.  Who foots the bill?  You, lucky readers, who don't live in those high risk areas will eventually pay the price for your fellow tax-payers folly.  Maybe they'll let you stay in the beach house for free?

The new kid on the block, HR 1264, sponsored by Gene Taylor, a congressman from Mississippi, seeks to allow the National Flood Insurance Program to sell hurricane insurance too.  Taylor failed to pass a bill he introduced after Katrina that would have allowed people to retroactively buy flood insurance from the federal government.  No, I did not make that up!  I hear the new commercials: "GEICO could save you fifteen percent or more, especially if you call shortly after an accident."

Panic Investing And Profiting From Disaster

Not long after Passover, it's nice to see the James Altucher in the WSJ attempting to help people profit from a nice list of several plagues.  I'm a fan of contemplating disaster.  Most friends think I spend too much time on the topic.  This piece stinks like rotting corpses after the death of the first born.

The first fundamental problem: Free insurance rarely exists.  Making money when something out of the ordinary happens, especially bad things, typically requires losing money when things don't go wrong.  Why?  I've written more about this here, but the basic idea follows because you want to insure against the vary same things others want to insure against, which means (a) you want someone else to hold risk you don't like and they probably don't like it either, and (b) your insurance requires your counter-party tie up capital waiting for the event. 

Second fundamental problem: He suggests public equity market hedges for all his risks.  Public equity markets, all prognostications aside, operate pretty darn efficiently.  This means two things: First, often equity prices reflect expected economic growth, in the broadest sense.  Second, equity prices reflect a risk premium, or how much investors will pay for a dollar of future earnings potential.  Neither of these factors really change in response to the ills of Altucher's world. Acute disasters don't matter in the long run.  Big, long run disaster expectations efficiently work their way into prices.

With those two warnings, let's look at his suggestions....

HR 2555...The Secret Health Care Bill?

HR 2555, the Homeowners' Defense Act of 2009, seeks to establish a federally backed risk pool for catastrophe exposed states.  The bill's sponsors (from Florida!) allege it will save money at the same time addressing the exorbitant insurance costs in several states.  Here's a summary.  This idea sucks...unless you live in Florida.  They think the market lacks risk pooling.  They're wrong.  The market, in Florida at least, lacks sense.

For most people, homeowner's insurance reflects unexpected events: accidental fire, theft.   For catastrophe prone areas, homeowners insurance reflects expected events with unknown timing.  Your homeowner's insurance on the coast in Florida must reflect the fact that your house will very likely be destroyed prior to the end it's useful life.  You may not live there, but your insurance company must prudently evaluate that risk, and reflect it in your price.

Of course he saw it coming...

I'm am completely sick of hearing he saw it coming...nothing about this individual in particular bothers me, but we hear this refrain all too frequently after outlier events.  Making proclamations that unlikely disasters will happen is easy because, well, talk is cheap.

Making piles of money (John Paulson, anyone?) doesn't even prove the point, but it's a step in the right direction.  At least he placed the bet.  Betting that disasters will happen when the bets are cheap takes skill to price, luck to get right, and errors don't come cheap.

The problem remains, however.  If we're talking about rare events, we can't see enough to differentiate luck from skill.  How long do we need to watch an investor to see if he can accurately predict one in fifty year events?  In financial markets, were correlations run very high, the answer, sadly, is a long, long time.

Where does that leave the academic in the SEC?  Sadly, I suspect ignored, with no authority, and a somewhat bigger audience than I have...but he won't be as entertaining!

Give Well, don't Guide Star, and how to respond to Haiti

In this post, I propose hedging catastrophe risk in emerging markets via reinsurance transactions.  I argue it's cheap because most emerging market catastrophes are uncorrelated with developed market catastrophes, and they are small risks, relatively speaking.  I argue it's more efficient because it prevents crowding out of more effective, higher success rate development aid programs. (Let's be realistic: Search and rescue teams in Haiti are not "free" in any sense of the word.  Their cost per lives saved, unfortunately, is very high.  We'd save many more lives buying mosquito nets.)

This brings me to the Red Cross, and my suggestion to them.  Millions of people of generously texted their $10 to the Red Cross, a genuinely generous act.  However, they should know there is no guarantee most of these contributions go to Haiti.  I for one don't think that matters.  However, I'd imagine many of these contributors want their money to be for disaster relief.

What, in theory, could the Red Cross do?  They could take these contributions and buy catastrophe insurance on other potential emerging markets disasters.  They will very likely occur.  They will stretch the resources of the Red Cross and others.  They will crowd out longer term projects that may be substantially more cost effective.

Hedging catastrophic risk exposed foreign aid

Several days ago, I posted a comment here that talks about hedging foreign aid.

Most developing countries have very low insurance penetration.  This means, typically, if they suffer a catastrophic loss, their insurance recoveries amount to very little.  Developed economies can and should address this problem.

Reinsurance markets (these are the markets that serve insurance companies, not people) have developed many tools to sidestep what is called "follow the fortunes" doctrine.  This insurance practice says insurance may only pay off on actual losses.  Historically, anything else was referred to as "gambling" and would provide nasty incentives to those gamblers.  However, buyers of "insurance" even if they don't bear the risk of direct loss, are unlikely able to affect the severity of an earthquake, for example.

Attempting to prevent financial disasters is too costly

What does it mean to prevent financial meltdowns?  Suppose you could buy an insurance policy against a financial catastrophe.

Let's keep this very simple, for a concrete example.  Suppose you want to buy a binary security linked to GDP for one year.  Such a security pays the holder $1 if U.S. GDP drops by 10% or more in a calendar year, zero otherwise.  That's what we'll define as a financial meltdown.  The price of this security is the insurance premium for one year of financial disaster protection.

Suppose a household needs $1 million of this security to hedge their exposure to the risk.  This $1 million payoff presumably must cover (the net present value of) losses to financial assets, employment income, real estate, etc. if such an event occurs.

In addition, the buyer of the insurance must be confident that the provider of this protection will be able to pay off the $1 million if the event happens.  That's a serious concern.