Wednesday, December 1, 2010

The Europe's Woes and the solution

It's stiking how much trouble they are in and how no one says what the obvious solution is and, instead, keeps wringing hands about how this is so very complicated.

There are three possible ways the mess gets resolved:

1. They keep doing what they're doing and Ireland, Greece, Portugal and quite possible Spain and Italy default on their debt, causing a worldwide banking crisis all over again that will be too big to salvage even for the Fed.

2. PIIGS exit the EMU and reinstate their national currencies, which massively devalue, while the reinstated Deutche mark massively appreciates causing no end of trouble for Germany (see here).
3. There is a temporary spike in inflation in the Eurozone - let's say 10% for three years or so, which wipes off the real value of everyone's debt burden and causes some amount of economic distress for the savers and bondholders, but not any kind of massive Depression-scale disaster. German inflation would be especially high given that they are closest to full employment, and the result would be that Germany would be less export competetive vs other EU countries (same result as would happen under deflation in those other countries).

You can see that option 3 is clearly preferrable, from the point of view of economic turmoil and the amount of human suffering. And there are of course ways to achieve it, such as the helicopter drops of Euros that Bernanke wrote about but never got around to actually doing. And you can see why it's the solution that will never be chosen: in it, Germany suffers worse than anyone else, while in Option 1 everyone else suffers more than Germany.

Monday, October 25, 2010

What would a "non-artificial" growth look like

There is a crowd of people out there, generally in the Austrian Economics/Hayek/Austerians/"Conservatives", etc. camp that keep complaining about how any growth that we have now is "Artificial" because of the massive government intervention in the economy. This keeps annoying the crap out of me as the alernative to this alleged Artificiality is never presented. So I'm going to piece together what I think this crowd wants to see. They want the economy to grow:
- Without any deficit government spending
- Without debt-financed consumer spending
- With short term interest rates at fairly high levels (4-5% would probably be good enough)
- With CPI at or near 0%
- With the dollar stable or appreciating against all major currencies

That the above is mathematically impossible and in many instances contradictory is, of course, absolutely beside the point.

Friday, October 22, 2010

The must read cognitive science article of the day

Here. I wonder if one could persuade David Gal and Derek Rucker that they are dead wrong about everything.

Personally, I find the implications not entirely new, but depressing nonetheless. Winning arguments is not really about being right, but about pushing the right emotional buttons. Ugh.

Friday, October 15, 2010

Two brief thoughts on the foreclosure mess

My response to this money quote from a piece in the NY Observer worthy of reading in its entirety:

"The problem is they don't deserve to be in that place. They probably deserve to be there less than they used to," the source continued, referring to incomes lower now than they'd been when the loans were made in the first place. "You do need to foreclose, and you need to go back to people living in houses that are consistent with their income levels."
 - Dontcha love how responsibility is allocated here, without even a second thought of any joint culpability for those who made the loans and those who made the loans possible?
 - That last bit, where the people should live in houses that are consistent with their income levels, might be easier to achieve than before: without a clean title to permit unproblematic future transfers or indeed any purchase with mortgage (because no bank will lend without title insurance, and title insurance are getting out of this mess as fast as they can) the house isn't worth very much at all - and pretty soon the market-clearing price of the homes going through foreclosure will be pretty well in line with the people who are currently living in them.

One other little parting thought: I would encourage those whose houses are going through this messy and lengthy process to stay in their homes until all legal options are exhausted. The amount of time it'll take to sort through the mess, you might just be able to establish a clean title by adverse possession. In Florida, that would be take a mere 7 years.

Wednesday, October 13, 2010

The politics of it all

I love this paragraph in today's Peter Baker article for the NYTimes Magazine:

The policy criticism of Obama can be confusing and deeply contradictory — he is a liberal zealot, in the view of the right; a weak accommodationist, in the view of the left. He is an anticapitalist socialist who is too cozy with Wall Street, a weak-on-defense apologist for America who adopted Bush’s unrelenting antiterror tactics at the expense of civil liberties.

The whole piece is a worthy read, even if much ink has been spilled on the subject already. And I don't think I have anything new to say on the matter. On the whole, the politics has become deeply depressing  - there is very little intellectual curiosity once you step outside the blogosphere, and feels too much like we've entered a time when zealotry that only belongs to religions rules politics once again. Or is my memory too short and we've simply never left that time?

Wednesday, July 21, 2010

No ratings - no bonds?

This is a 'shocker'. WSJ reports that the rating agencies stopped slapping AAA on any random bond issuance, because under the FinReg that is about to be signed today, they would be "liable for the quality of their ratings, effective immediately."  This has pretty much stopped securitization dead in its tracks for the time being.

And what of the issuers and the underwriters, who still need to - what's that word - oh, right, "disclose" material information about the issuance? Well, nobody trusts them, obviously. And even if they did, people will need time to get used to the idea of actually reading prospectuses and offering memos as well as doing some digging into the credit quality of the issuer. I say, take your time boys, take your time.

But, sarcasm aside, what is really shocking about this story is this. The fact that people are no longer willing to scoop up some securitized awesomeness because the rating agencies no longer want to rate said awesomeness, leads me to conclude that people were still trusting the rating agencies to do their job, and were willing to buy and price bonds based on ratings.  WHY???

Monday, July 12, 2010

on multipliers

It seems that there Mark Zandi has come to be accepted as gospel truth on fiscal multipliers, at least as far as the left-leaning blogosphere goes. Ok, so according to him the multiplier for extending UI benefits is 1.61. That seems like a pretty clear cut argument to extend unemployment benefits.

Fine. I'm down with that program - do put me in the 'voted yes' column. But I can't get over the short-horizon nature of most of the stimulus programs we've undertaken, and 100% of the additional measures that are being discussed now out-loud. It's all been very deeply unsatisfying. Everything seems to be targeted at the most bang-for-the-buck now - and this applies to the more effective things, like UI insurance, as much as it does to the least efefctive things, like the housing tax credit.  These programs create sharp but short bursts of demand. When the money is gone - we're hitting the brick wall again as the demand has no momentum.  Perhaps in a slump as deep as we have now, you just can't get the economy back into the positive feedback loop of continuous growth with these teaspoons of caffeine - the best you can to is to lift the funk slightly for a few months or weeks, until everyone gets depressed again. Spending accelerates first, but then -  since the deep structural problems aren't fixed, since the consumer is still overleveraged and fundamentally cash strapped and since capacity utilization is still too low to generate business investment - it falls or stagnates like it seems to have now.

And in any event - do we really, and I mean fundamentally, want to drive the economy forward on the back of incessant consumption?  Even ignoring the fiscal impossibility of these credit-financed binges, is the social environment of increasing consumption year in and year out a Good Idea? And why are these questions so rarely asked or talked about?

Suppose, for example, that the relentless drive to give more and more people air conditioners, washers, dryers, dishwashers and cars results in a complete environmental catastrofuck, depriving billions from water and food supplies, creating endless suffering for billions more and wars that last for a few decades?  What do you say then? Do you say that economic growth now and the corresponding low unemployment rate is worth it?

Now, I am not saying "fuck economic growth, we'd be better off just slowly declining back into the stone age." Not me - no thanks: I like me some creature comforts as much as the next guy.  What I am saying is that we need to take a good hard look at the kind of prosperity that we are generating through the choices we make today. And since we happened to be in a situation where the government must play an unusually large economic role to drive growth, perhaps we can kindly ask the powers-that-be to put their philosopher-king hats on for a bit, and think about what it is that we should be spending money on, rather than just relapsing into doling out cash and perpetuating the status-quo of a consumption-driven economy.

But the post is titled "on multipliers." On that, all I have to say is: how short term are those multipliers? I can never believe that over the long haul something like the building of the interstate highway system has a lower multiplier than UI benefits.

Wednesday, May 19, 2010

Open Letter to the President

Yeah, another one of those open letters. Dontcha hate those. Anyway, here it is.

Dear Barack,

I, as all reasonable Americans do, very much appreciate your efforts over the past year and a half to put the economy back on track after... you know what. The challenges have been enormous and the collateral damage from Wall Street's collapse unprecedented. I know you like that word, so I thought I'd use it here.

As an astronomy geek, I tend to think of the calamities of the recent past by analogy to a supernova. The financial sector used to be a hypergiant star that gave energy to its periphery (the rest of the economy) by a fusion of light elements (mortgage, consumer and corporate debt) into progressively heavier elements (ABS, MBS, CDOs, CLOs and then synthetic CDS-wrapped CDO's) until it ran into the "iron wall" and reached a point where fusion consumed more energy than it generated. At that point, this hypergiant exploded in a supernova-scale explosion, doing enormous damage to its periphery with a shower of life-annihilating radiation, while its core has collapsed into a black hole after a liquidity crunch of the Fall of 2008. This black hole is now sucking away our money and energy (including by being the sole preoccupation of our legislators) with no useful output whatsoever. Well, maybe some output, but not very much more than Hawking radiation - barely a tick above the absolute zero.

But enough flowery metaphors. And enough feeding the black hole -- high time to move on. The American Recovery and Reinvestment Act was mostly a good thing but with two large problems: (1) it wasn't big enough and (2) not all of it was all that good. We gotta acnowledge, at least privately amongst us friends, that Paul Krugman and Christina Romer were right about this, at least in general terms. We're gonna need a second stimulus, most likely sometime around this coming Fall, because by then the growth will stagnate to near zero (or even turn negative again), housing prices will resume the inexorable decline and job growth will not be enough to keep up with population growth. But you already know all that and don't need me to spell it out.

The kicker of course, is how do you do a second stimulus amidst such vocal opposition to more government spending? The short story is that Tom Friedman is right too. The long story is this:

1. What. Call it the American Project for Energy Independence. Names are important, and the name above has at least three words that Americans will eat up: "American", "Energy" and "Independence". "Project" is somewhat neutral so feel free to replace it with "Initiative" if focus groups like it better - I just though that you need at least one consonant in there to make it a semi-plausible acronym and couldn't think of anything else off the top of my head. Just don't try to shove "Jobs" in there - too tired and "J" is never good for acronyms.

But I digress, for substance is important too. The substance is that we will wean ourselves from imported energy in 10 years and all fossil fuels (except for some transportation) in 15 years. We will accomplish this goal by setting out on a massive national program to build (1) mega-windfarms (East Coast and the prairie West), (2) geothermal stations (everywhere), (3) solar plants (the desert SouthWest), (5) one nuclear plant per state per decade and, of course, (6) a new grid to carry all that electricity to our cities.  And boy, are we gonna need a lot of manufacturing and R&D! Think of the manpower that we will need for that! And think of the manpower needed for construction jobs. Foget New Deal - we're talking about a WWII style mobilization of resources, without the side-effects of wanton destruction of most of Europe. Unemployment rate should go down to 4% easily.

Next in order of importance are things we will not be doing.
 - We will not be building or repairing highways and bridges - because this sort of infrastructure is as exciting as watching paint dry: we already have something that works well enough and the concept is totally wanting in novelty.
 - We will also not preoccupy ourselves with transportation issues. Car makers are well on the way to making electric cars a mass-produced reality and will only need a small nudge here and there (like further tightening of CAFE standards) to achieve universal adoption. And while high-speed rail is cool and is needed, it can take a back seat for now - we'll get to it in a decade, and hopefully with Maglevs.
 - We will not meddle too much in home weatherization and efficiency. Seriously, "cash-for-caulkers"? Good luck selling that on any scale that matters. Let's just leave markets to do the job that they can do. We can give it some quiet nudges here and there, by, for example, revamping revenue generation schemes for utilities or by slapping taxes on inefficient appliances. But we will not be making this a part of a major national debate.
 - We will not be soliciting bids from private contractors on the vast majority of EPC work: we will just do the job Roosevelt-style and privatize the pieces later. I would even suggest issuing a new style of bond to finance the project -- modeled on war bonds and with the same marketing push behind it. 
 - We will not be engaging in a lenghty environmental review/public comment process on individual facilities, because this is just too important, including for the environment in the long run. Loosing a dozen endangered species is a very small price to pay to avert a catastrophic global warming and we should keep that in mind. Nuclear and geothermal will and should get a thorough vetting, of course, but wind and PV solar should basically sail free with zero review, while solar thermal should only be reviewed from the perspective of impact on water resources. We will need to rewrite the book on agency review process so that the siting and permitting is finished in a year, long before all of the necessary R&D is complete.

2. How.  How to sell all of this to American public, that is. Obviously, a project like that will be terrifyingly expensive. But the people will only care about that if you keep telling us about cost every frakin' minute. I noticed, for example, that when the stimulus debate was presented in terms of the number of dollars that we needed to spend, it immediately started sounding as something of a big and wasteful boondoggle. 1 trillion sounds scary, especially if you can't clearly spell out what it's  for -- and this should surprise no-one. If, instead, the debate was about what we needed to DO, and how great things would be once we had ACCOMPLISHED it, the stimulus would likely be better, larger and far more popular.

So try a different approach this time. Paint a picture of a future in which we do not pay money to countries who don't like us very much or send our soldiers there. Paint a picture in which oil spills no longer happen because we don't pump oil anymore. Paint a picture of abundant and cheap electric energy that will power homes, plants and cars. We need vision from our leaders. Not accounting.
 - If opposition brings up costs and "we can't afford it argument", ignore it and change the topic onto your vision. And mention that the opposition is in the pocket of Saudis, BP and Exxon and is unpatriotic. 
 - If opposition brings up objections to "big government", ignore them, and talk about your vision again. And mention that the opposition is being unpatriotic and wants to put our brave troops in harm's way.
 - If opposition objects on the grounds that this is socialism, ignore them and tell the American public that the opposition is trying to rob them blind by taking money from their pockets and sending it to the arabs.

Don't get me wrong though, costs are important. Just not that important in the long run. For in the long run, this massive project will put our economy on a path to sustainable prosperity by providing long-term employment to a very large segment of our population in the new energy industry and by making American imports shrink while exports (of all the new tech that we are going to build) will grow dramatically. National debts and deficits will shrink just as they did in the aftermath of WWII.  And reduction of CO2 emissions to dramatically lower levels will be a very nice and welcome cherry on top.

 With best wishes,

Econ Skeptic

Sunday, May 9, 2010

EU's Shock and Awe

From Bloomberg article:
Jolted into action by last week’s slide in the currency and soaring bond yields in Portugal and Spain, the 16 euro nations agreed to offer financial assistance worth as much as 750 billion euros ($962 billion) to countries under attack from speculators. The European Central Bank will counter “severe tensions” in “certain” markets by purchasing government and private debt...
This is Shock and Awe, Part II and in 3-D,” Marco Annunziata, chief economist at UniCredit Group in London, said in an e-mailed note. “This truly is overwhelming force, and should be more than sufficient to stabilize markets in the near term, prevent panic and contain the risk of contagion.”

Well, this is more like what the doctor ordered. To be honest, even that large of a package by itself may not be enough, because the borrowing needs of the likes of Spain and Italy are much, much larger than that. Still, it's sizeable, and if I read things correctly, the cap is really quite soft because of ECB's upcoming debt monetization.

The Euro is surging righ now, but this is all wrong. There's gonna be QE in Europe as ECB starts buying up sovereign debt and this should hurt the currency over the next few months, especially if the Fed doesn't resume its own debt monetization programs. The bond yields should start normalizing though, with spreads for the PIIGS narrowing substantially and the fligh-to-safety trades unwinding both for the German bunds and US Treasuries.

Currencies can't all devalue at the same time. So there's bound to be some give and some take. Good news for gold bugs, I suppose - but that's a side show. The real issue is what happens to US trade balance now and whether the slumping Euro puts a damper on the nascent US recovery.

Thursday, May 6, 2010

It's time for "I told you so"s

1. Zerohedge. When it comes to HFT trading, they've been right all along.  This is their "I told you so" moment, and a richly deserved one.  

A minor observation here: recently, Barry Ritholtz has been a staunch advocate of trading with a stop-loss close at hand - I can't be bothered to look for specific entries on his blog, but there were several. So a question: how would that strategy have worked out today. Suppose you had a stop-loss on SPY at 1100 - it would have gotten tripped up halfway through the meltdown and a solid 2.5%+ lower than the eventual close. Don't get me wrong here: I am not advocating trading without a stop-loss either. Rather, in this algo-driven market, I am advocating not trading equities at all.

2. Yours truly. Didn't I tell you that a bailout for Greece does jack shit to help Spain and Portugal? Didn't I? But I think it's worth repeating the fundamental question for further consideration by Europe's "leadership". I take it that the fundamental goal of a Greece bailout was to attempt to stop contagion to the rest of Europe. And I agree that it is a worthwhile goal - nobody wins if Spain goes down in flames. But if you are not willing to go all out and make ECB into the equivalent of US Treasury and Fed combined, why bother with Greece at all? $140 billion is no chump change, and it's all down the drain as Greece will still default/restructure and the rest of the PIIGS are in as much trouble as they've ever been.  If ye Germans are so keen on preserving your mojo of fiscal discipline and punish the profligate transgressors of Maastricht, why not just (a) withdraw from the EMU and reintroduce the Deutche Mark and (b) bail out your banks and your banks only, as necessary?  Let's get this mess over with one way or another - enough of this charade of half measures!

Monday, April 26, 2010

Can contagion in Europe be avoided?

Good post by Felix Salmon here.  The outlook for Greece is indeed depressing. But it's not just for Greece.  What keeps me puzzled is why does anyone think that bailing out Greece and avoiding Greek default make the situation in Portugal and Spain any easier? Consider:

1. If a mere promise of a bailout along the lines of "we will not let a Euro member fail and here is a nice chunk of change in committments to prove it" worked, Greece would already be safe and be able to fund itself in the market. To put it in H. Paulson's terms, they already brought out the bazooka, but it's been mostly ineffective - though probably because the use of bazooka still needs to secure political approval and because caliber is too small.

2. Even if they bring out an unlimited-caliber bazooka for Greece (i.e. Germany somehow agrees to an open ended funding committment), why would that make anyone think that a blank check is waiting for Portugal, Spain and Italy as well, if those three ever need it? It's not like France and Germany have unlimited appetite for bailing out their neighbors, right? Politically, pushing any bailout after the Greek one is going to be much more difficult (go on, try selling another bank bailout to the American public today), so a bailout for Greece means that Portugal is actually LESS likely to be bailed out. Meaning that if Greece is fully contained, Portugal is definitely next up for bond vigilantes.

The key difference to TARP here is that Germany and France have to consider bailouts in succession, while TARP (plus emergency lending by the Fed) was a blanket promise big enough in size to cover all of the major US banks, all at the same time.  The latter requires one-shot political agreement - which is difficult but possible in sufficiently dire circumstances. The former is virtually impossible -- it's political suicide, even if the eventual economic outcome is the same. So the only way to avoid contagion that I see, would be for Germany and France to agree to a creation of an pan-European treasury, fund it with, say, 500 billion of seed capital and authorize it to issue its own bonds backed by full faith and credit of all EMU members. In other words, they need to replicate the federal system.

Thursday, April 15, 2010

It's deja vu all over again...

Greece speads have been blowing out wider again. Back to the levels before the bailout was announced.  What gives? Wasn't the unveiled plan supposed to stop the run by reassuring the creditors that there will be no default - so that, as Hank Paulson would have us believe, once you show that you brought a bazooka out, you'd never actually have to use it?

Well, if that was the plan, we've got some 'splaining to do, because it's pretty clearly failing. 

First, we need to figure out what's actually happening with the market for greek debt, which, alas, I cannot. But perhaps someone else could answer this question: is there widespread selling (and therefore widespread buying just not at prices that Greece can bear) or is the market incredibly shallow such that the brief blips of tightening are immediately offset by another seller who is trying to liquidate his longs.  I suspect it's the latter. I suspect that there are virtually no buyers except a few random hedge funds that are speculating and a central bank or two (paging Mr. Bernanke!). I suspect that there are also not too many sellers at these prices: whatever banks are holding long-term Greek sovereign debt have decided that the better strategy is to hold out and hope for a better price and continue the practice of "mark-to-myth" accounting than to liquidate the positions in full and take an immediate and large hit to the balance sheet. 

So no one's really buying the bonds and no one's really buying the Kool-aid that Papandreu is selling. You can see why too. Take a look at this excellent spreadsheet and see for yourself. At first blush the curve looks kinda primising. And the numbers that result in that curve don't look particularly weird either... until you realize that these are probably fairly optimistic projections on every metric for United States, let alone Greece. To pick out a few obvious examples:
 - The interest rates are way too optimistic. There is no way that Greeks are getting under 5% rates for 2010 and 2011. Just think: the European bailout will cost then 5%. So that's a floor, below which any new debt they raise is highly unlikely to fall. On a hunch - go ahead and plug in 6% for the debt cost in 2010 and 2011 and see what that does.
 - Inflation??? Hasn't Latvia taught us anything? Deflation is what Greece is about to experience, and that's the end of it. Plug in a modest -1% into the Inflation boxes for 2010 and 2011 (let's assume that after that modest inflation will return) and see what that does.
 - Account balance at a mere -3.7% in 2010? How the fuck is that supposed to happen, pray tell?

So we can easily see how the Greek assumptions begin to unravel. And even with the bailout, the fiscal situation looks pretty hopeless. There is just no compelling reason why this will not be just another Argentina, which held stayed afloat for a bit but finally caved in and defaulted.  Unless, that is, one bailout is followed by another... and another.

Wednesday, April 14, 2010

WaMu pity party

Killinger, the ex-CEO and chairman of WaMu, complains that his bank was subject of "unfair treatment" during the crisis, ultimately leading to WaMu being place in receivership. Which, according to him, didn't even need to happen (REALLY???). The hillarity of this pity-party aside, Killinger is an embodiment of the two grave moral vices that have been all but institutionalized:
 - If you ran your organization into ground through fraud and malfeasance (as WaMu did), blame others. Rubin's "everyone is to blame" mantra is a variation on this theme.
 - How the fuck is it still OK for Killinger to keep his $14 million in compensation in 2007 and $21 million in 2008???

Thursday, April 8, 2010

Is Greece about done?

Latest check-up on GGGB10YR reveals further deterioration - the yield is now 7.32%, which is 17bps wider than yesterday all-time wide. The spread to Bunds is now a whopping 424 bps. ZeroHedge reported yesterday that 450 bps is about as much as Greece will be able to stand.  At this rate of deterioration, we will reach that point very soon, possibly by the end of the day or by Monday at the latest. 

A European "Lehman weekend"?

Monday, April 5, 2010

So... what about those jail terms for bankers?

Matt Taibbi does another takedown of the banksterscamster culture we had (have?) in this country. Jefferson County has made headlines before, of course - so how come none of the guys from JP Morgan that were involved in these blatant violations of the Sherman Act and federal and state anti-bribery statutes have been even indicted yet?

Does size matter?

Among the central topics of debate on the FinReg proposals is whether size matters.

Some (or many) think that downsizing TBTF is absolutely essential to the new legislation. The Volker rule which would limit activity is but a step in that direction, albeit an important step. Another, more decisive step would also limit the amounts of deposits that any banking instutution can keep and the amount of aggregate assets that it can have (on an off the balance sheet).

Others, like notably Paul Krugman in today's column, believe that size is not an issue. The basic argument here is that even if the financial institutions are small, in a pinch they'll have to be bailed-out anyway and a run on big banks is neither more nor less likely to happen than a run on small banks. In fact, both the Great Depression (and many bank panics that preceded it) as well as the more recent S&L crisis featured such runs on rather small financial institutions. And, as Krugman points out, it was very likely a mistake for the government to let the banks fail willy nilly during the depression.

So where do I come down on this? The former view - and here is why.

Krugman and others of the same view a missing the point and the problem of bailouts. It may not, indeed, necessarily be the case that we would let a bunch of small banks and financial firms fail in the next financial crisis without trying to prop up the system in some way or another - putting aside whether this is a good thing to do or not for a moment, the politics of the moment usually overwhelm sound thinking in these types of situations.

However, there are key advantages to having a world composed of small instututions from regulatory point of view at the time of a crisis:

 1. When financial instututions are less inter-connected and have fewer tentacles, it is easier for regulators to operate them in receivership without much help from their management. In many cases, this should obviate the need for one of the most puke-inducing part of the AIG bailout where the chumps who caused all the trouble were nevertheless kept on board because they were the only ones who could help untangle the mess they created.

2. The most egregious players could be simply let go of, and made an example of. This did not happen in the last crisis - because the most egregious players were also some of the biggest. Lehman WAS made into a test-case, but that did not exacly ended well.

3. You could even experiment with different resolution regimes and test in real time which one is working better. It is highly unlikely that the whole system will be brought to its knees in a matter of days - what we'd probably have is an accelerating wave of failures that would be spaced out over the course of several months. This was the case in the current crisis - with Bear Stearns being the canary in the goldmine. But because Lehman and other systemically important players managed to put off the inevitable by a few more months through creative accounting, the regulators were basically caught flat footed both by the Bear Stearns failure and by the avalanche of near-failures that followed 6 months later. Imagine now, instead, that we'd have a slow at first but gradually building wave of small instututions going under: regulators would have a much better chance of developing a coherent responce by the time the crisis peaked in the Fall of '08.

Friday, February 26, 2010

Some thoughts on building a better law firm compensation system

The biglaw model has gone through quite an upheaval in the past year and a half. Firm dissolutions, mass layoffs (including the previously sacrosant first-years by Latham Watkins), stealth layoffs, salary freezes and finally salary restructuring away from the lockstep model that is proving to be unsustainable for all but the best-managed shops, especially if you try to keep up with the Cravath-Sullivan-et. al. salary scale.

So what's to be done? Some of the latest moves have been away from lockstep compensation of associates and towards performance-based systems. I won't bother with citing specific examples (which are cited and discussed ad nauseum on Abovethelaw), but the attempts to deep-six the lockstep have ranged from merely making bonuses tied to performance to tying associate advancement through three or four tiers of salary levels tied to performance rather than seniority.  The idea, ostensibly, is to promote competition and to reward talent.

On the partner side, compensation systems had more variety before, and I don't think that general picture has changed. Many firms reward their rainmakers with much higher share in profits. At the same time, there are some very prominent examples of firms that are lock-step top to bottom, with partners in the same class getting the same salary, irrespective of how many clients they bring, irrespective of practice area and irrespective even of where in the world they are located.

So which is better? One the one hand, lock-step compensation undoubtedly fosters a more transparent and cooperative work-environment, where associates are not trying to dig each other's grave, hoard work or to otherwise screw peers, and where partners do not wage turf wars on a constant basis (e.g., which litigation specialist gets the next referral from M&A or who gets that superstar associate under their wing) or reward those who have the brownest noses.  On the other hand, partners in such places lack incentive to bring new business, and associates - especially those who don't plan to stick around forever and are therefore not particularly motivated by the partnership carrot - have no motivation to try harder.

I have a solution to propose, aiming to combine the virtues of both approaches:
1. Separate firms into fairly independent groups by practice area, with sizes generally of 5-7 partners and 15-20 associates. Cap leverage ratio at, say, 4.
2. Lock-step salaries of associates across the board, and lock-step bonuses by practice group.
3. Distribute a percentage of partners profits across the board (e.g., 50%) in lock-step by seniority and the remainer ("Profit Remainder") based on the relative contribution of practice groups to the overall bottom line (adjusted for the group's size). Within a practice group, this remainder would be distributed among the group's partners by seniority.
4. Encourage cross-practice group referrals by additionally allocating 5-10% of the revenues generated through referral to the practice group where the referral originates. This would factor in the calculation of the Profit Remainder.
5. Money-losing practices get zero bonuses for associates and zero Profit Remainder for Partners.

6. Recruit law students on a firm-wide basis, and initially assing associates based on expressed preference after the summer program. Associates would be asked to express 1st, 2nd and 3rd preference. In allocation, observe the caps to leverage ratio for each practice group. Associates are initially allocated to their first preferred group, but if too many want to get into the same practice group, they would be allocated by lottery, with those who don't get in then assigned to their 2nd preferred group.
7. Mandate  rotations after a 1-1.5 years to another practice group. Allocation is done as in step 5.  After completing rotation, associates can come back to original group or stay in the second group, based solely on their choice. If their choice pushes the leverage ratio of any one group above the limit, that group gets fewer rookies.
8. Practice groups can recruit associates laterally at their discretion, so long as leverage ratio caps are observed.

The core idea in the above is that collaboration and transparency is preserved within each practice, but competition is fostered among different practices.

Wednesday, February 24, 2010

Euro Carry Trade???

This is making no sense to me at all.  Bloomberg writes:
"The euro will become a favorite funding currency for carry trades as Greece’s crisis weighs on regional interest rates, according to Deutsche Bank AG."
Huh??? I thought that interest rates go UP if the bond prices go DOWN, as is currently happening to Greece. The safest of Euro bonds (German Bunds) are still yielding slightly above comparable tenor US Treasuries and far above the level of Japanese bonds. Regardless of whether or not Greece defaults, this situation is unlikely to change in a direction that would enable a Euro carry-trade.

At a very elementary level, there are at least two reasons why a currency might experience a decline. One is a carry trade, where short-term borrowing in one currency is used to finance purchases of another, so that instututions and individuals sell the funding currency (driving down its price) and buy another.

The other is when weakness in the economy substantially decreases government revenue, necessitating increasing currency sales (or money printing) by the government itself.

If Euro continues to suffer it will not be because of reason #1.