Felix Salmon

Over at my old Time.com stomping grounds, Adam Cohen has written a fascinating article about the movement to have the federal minimum wage declared unconstitutional. This goes hand-in-hand with the emergence of the minimum wage as a campaign issue in the midterm elections. My question: Why do people care so much?

For much of its recent history, the federal minimum wage hasn't even been all that binding. State minimum-wage laws have led to higher pay, or companies paid more on their own. According to the Labor Department, only 980,000 people made the federal minimum wage last year. Even when you add in the 2.6 million workers who made less (people like tip-collecting waitresses and teenagers just working for the summer), you still only wind up with 4.9 percent of all hourly-paid employees-- and just 2.9% of the total U.S. wage-earning workforce.

Yes, it's true, in Econ 101 we all learn that price floors disrupt the most efficient allocation of resources in a marketplace. When it comes to low-wage workers, that leads to companies hiring fewer people than they would otherwise, leaving some folks who want jobs without them.

But those who make it beyond one semester of economics find out that the world doesn't always work the way a rudimentary model would predict. In fact, in recent years economists have struggled to find explanations for real-world situations in which higher wages do not, in fact, lead to lower employment. One theory: a higher wage forces employers to invest in their employees and figure out ways to make them more efficient (i.e., valuable). As Richard Florida likes to argue, boosting efficiency in low-wage (mostly service sector) jobs is exactly what we should be doing right now.

But I digress. Back to my original question: Why do people care so much about an economic policy that doesn't seem to have much of an impact on the economy? One reason might be because of the anchoring effect of the minimum wage. Even if only a few people are earning the minimum wage, its existence still sends a signal to the market that this is about what it should cost to hire an unskilled worker. That tinkers with the expectations of both companies and workers. Or, what I might be quicker to believe: talking about the minimum wage—whether you want to increase it or abolish it—is a proxy for saying "I care about struggling workers," or "I don't want government telling business what to do."

The problem with using the minimum wage to have this debate, though, is that no matter who wins, the victory will be hollow. If we want to help low-income families, we could do a lot more than change a wage many of them don't make anyway. And if we want to minimize government intervention in free enterprise, we might choose a battle that is meaningful to companies outside of such a narrow range—half of all minimum-wage workers have jobs in the leisure and hospitality industries.

Although maybe saying that just goes to show how naive I am about politics. Maybe in that realm the best battles to fight are the ones that are the least likely to change the status quo no matter what the outcome is.

Nelson Schwartz links the big lawsuit against BofA/Countrywide directly to the mortgage bond scandal I’ve been banging on about:

The legal battle turns on the question of whether the banks properly represented the loans they put together into mortgage-backed securities when they sold them to investors. If the banks ignored evidence that the underlying mortgages did not conform to underwriting standards or they lacked the proper paperwork, the banks could be obligated to buy the troubled mortgages back.

Schwartz also reports that this legal trade is attractive enough that vultures are circling:

Hedge funds like York Capital and Moore Capital have been jumping into the game recently, buying up bad debt in the hopes it will eventually be bought back…

“Any hedge fund with a distressed desk is contemplating this trade,” said one analyst.

There’s a whole bunch of different things going on here, but the key development is that bondholders have managed to get organized, and they’re taking the battle not only to otiose trustees, but also to loan servicers.

The key number here comes right at the top of the letter sent to BofA/Countrywide:

The undersigned are the Holders of not less than 25% of the Voting Rights in Certificates issued by the Trusts listed on the enclosed Exhibit A.

Once that 25% level is reached, bondholders have all manner of rights, which are now being put to good use. For one thing, they’re allowed to file exactly this letter: a notice of nonperformance, telling the servicer in pretty strong language to buck up and start doing its job, or face a massive legal action.

Isaac Gradman says there might be a problem here:

These efforts may well fail for an additional reason that was cited as a basis for Bank of New York’s refusal to comply with Patrick’s earlier request – the failure to provide evidence of a specific breach.

But I’ve also heard that the 25% number is crucial on this front, too. If you own 25% of a securitized issue, I’m told, you can force the custodian to hand over the underlying, individual loan documents — exactly the same documents that Clayton and other due diligence companies examined before the bonds were issued. At that point, it becomes a lot easier to find specific breaches and to make BofA’s life a legal nightmare.

The position of BofA here is hilariously complex and conflicted. BofA owns 34% of BlackRock, which is a lead plaintiff in this case. (BlackRock manages the mortgage bonds which the Federal Reserve inherited as part of the Bear Stearns bailout.) BlackRock, in turn, is suing Countrywide (owned by BofA), the loan servicer which has clearly not been doing its job:

Although there are tens of thousands of loans in the RMBS pools that secure the Certificates, the Trustee has advised the Holders that the Master Servicer has never notified it of the discovery of even one mortgage that violated applicable representations and warranties at the time it was purchased by the Trusts.

In other words, Countrywide has an obligation to tell the bond trustee whenever a loan turns out to be in violation of the bond’s representations and warranties. But Countrywide has never done that. Why? The answer is obvious: the minute that it did so, the trustee would force the servicer to put the loan in question back to the originator. And the originator is — you guessed it. Countrywide.

Essentially, BofA is suing BofA so that BofA can be forced to put bad mortgage loans back to BofA.

Yves Smith reckons that the winner here is likely to be BofA — that the lawsuits (which, remember, haven’t even been filed yet, and won’t be for at least 60 days) will probably be settled for a relatively modest sum. But I’m less sanguine.

For one thing, Smith says that the plaintiffs will only be able to collect on loans which have gone bad and where they can show damages. But the bondholders might want to force BofA to buy back even performing loans, if they got thrown into the pool without conforming to the relevant standards. Calculating BofA’s loss on such things won’t be easy: after all, if those loans continue to perform, then BofA would ultimately make a profit on them. But given the ongoing foreclosuregate mess, there’s a very real chance that even performing loans will end up in strategic default.

The big picture I think is that a lot of the risk embedded in mortgage bonds could shift from bondholders back to the investment banks which underwrote them. In a just world, the bond trustees would be leading this charge, but they’re not, so the cause has been taken up by the bondholders themselves, who are only now beginning to organize and to become familiar with all the legal avenues that the various players can explore.

It’s entirely possible, of course, that obstructionist lawyers for BofA and the trustees will manage to block these suits and keep all those toxic bonds in the hands of bondholders. But mortgage-bond owners are becoming increasingly aggressive and activist, and they’re comparing notes with bond insurers who are also in a very similar situation. The investment banks, BofA foremost among them, might win. But the fight is going to be long and hard and expensive, and is going to make them look very bad indeed. They might well find it more attractive, all things considered, to negotiate a settlement, write a ten-figure check, and move on.

The Boston Globe has a Local-Boy-Made-Controversial story about Marty Peretz (it was in yesterday's paper, but I just got around to reading it today). There's nothing much new in it, but it got me thinking about the changing division of labor in journalism and how it hasn't worked out equally well for everybody.

Peretz is in trouble for making some sweeping and denigratory generalizations about Muslims in his blog, and then not-quite-apologizing for it. I would imagine that Peretz has held similar opinions for decades. But he's only started getting himself into big trouble for them in the past four years: that is, since he launched his blog, The Spine. Until then, Peretz was mostly judged in the context of the institution that he bought in 1974 and has been editor-in-chief of ever since (even while selling his majority stake in 2000 and then repurchasing it in 2009), The New Republic. In that context, he came off pretty well. As Eric Alterman wrote a few  years ago in an otherwise critical account of the Peretz era at TNR:

I think any honest reader would be forced to admit that for many if not most of these years, The New Republic was, despite everything, a truly terrific little magazine.

The main reason: Peretz knew how to hire, and keep, talented people. Here's Alterman again:

"Try, try very hard not to hire anybody who isn't smarter than you, and wiser," Peretz says he promised himself. In this, he notes, he succeeded. He might have added "and more liberal." For in the days when the neoliberal Kinsley and old-fashioned social democrat Hertzberg traded off the magazine's editorship, literary and political giants did indeed walk the TNR hallways. Just 28 and still in law school when he initially took over the magazine, Kinsley's contrarian nature and inimitable example would prod not only The New Republic but an entire generation of pundits in the direction of Mickey Kaus/Jacob Weisberg–style smart-ass neoliberalism.

So as the head of an institution, Peretz was (at least until recently) undeniably successful—even if, like Alterman, you didn't like the direction in which he pushed that institution. As a writer and thinker, though, he was always something of a dud. I was an enthusiastic reader of TNR in the 1980s and early 1990s, but I learned to skip the magazine's "Diarist" page whenever Peretz wrote it. In a magazine characterized by intellectual sparkle and surprise, Peretz's dispatches, mostly devoted to Middle Eastern affairs, were leaden and predictable. But so what? They were just a few pages a year in an otherwise great magazine. And look at all the brilliant people Peretz hired!

Since 2006, though, Peretz has had a blog. This allows him to share his opinions as often as he wants, without the intervention of smarter, wiser TNR editors who in past years might have protected him from his most intemperate and infelicitous phrasings. It also allows him to reach readers who probably aren't interested in the rest of TNR's content. That is, Peretz has to a certain extent been allowed to break free from his organization. Similar new freedoms have been granted in recent years to lots of journalists, myself included, and many of us have found it wonderfully liberating. Heck, Peretz probably finds it liberating too. But it's done permanent damage to his reputation. For 90% of the people who've ever heard of him, he's now that anti-Muslim fanatic, not the guy who hired Hertzberg and Kinsley and did what he could to promote the career of the young Al Gore. He was far better off and more valuable as part of an organization—an organization that he happened to own—than as a mostly independent pundit.

Why do I go on and on about this? Not to defend Marty Peretz, but to observe that institutions have been getting short shrift lately, especially in the world of journalism. And for sure, a lot of existing journalistic institutions are deserving of no shrift at all. But the idea of journalistic organizations in which people specialize, in which editors keep writers from making fools of themselves, in which cranks have a place as long as they're good at something, isn't entirely archaic. We're not all cut out to be freestanding journalistic brands.

Update: Jack Shafer e-mails to point out that Marty Peretz was writing loopy stuff, and occasionally getting called a racist, back in the 1980s and early 1990s too. But he has  definitely taken it up a notch or three since he started blogging, and he never got into the amount of trouble then that he finds himself in now. Also, I failed to mention my favorite Peretz controversy of the past year, when he approvingly quoted from a Tunku Varadarajan Daily Beast column that compared John McCain to Liza Minnelli in a way that reflected poorly on both, then issued a bizarre apology the next day for "slighting ... her and her gifts."

Remember back when the big banks were telling us that re-regulating consumer finance with legislation such as the CARD Act and Dodd-Frank bill would severely disrupt the banks’ business models, and lead to horrible outcomes for ordinary Joes? Well, in Bank of America’s event-packed earnings call this morning, executives laid out how, exactly, the company’s consumer finance business has been forced to change in response to the new regulatory environment. From the press release:

As a result of the legislation and other changes in the environment, the company is changing the way its consumer bank does business, focusing on a relationship enhancement strategy designed to incent customers to bring more business and to make pricing more upfront and transparent. This change moves away from a dependence on penalty fees, which the industry had adopted over the years, and provides the customer with a better banking experience. These changes are expected to result in additional revenue.

So, let’s see. We’re getting 1) more transparent financial products; 2) better banking service; and 3) a boost to B of A’s bottom line. How could Congress have done this to us?!

Granted, the transition isn’t super-smooth. B of A would have reported a net profit today instead of a loss had it not been for a $10.4 billion “goodwill impairment” charge related to a new limit on how much the company is allowed to collect when people use debit cards at cash registers. (“Goodwill impairment” is a kind of made-up thing that you can read about here.)

And I’ll be the first to admit that “upfront and transparent” pricing might very well mean higher pricing, especially for people who are used to getting a free ride when it comes to financial services--like those of us who pay off our credit card balances each month, thereby borrowing at no cost. On CNBC this morning, B of A CEO Brian Moynihan was pretty darn clear: "Instead of charging penalty fees, we'll charge monthly fees.”

Yet, as I’ve long argued, there is nothing wrong with that. If my bank wants to charge me for a service that I am receiving—credit card usage, paper statements, a low-balance checking account—why would I be upset? Just clearly tell me what the price of the service is, and then I’ll make a decision about whether or not I want to buy it. Old-fashioned, I know, but still so beautiful. I understand that many people continue to feel the effects of the recession, and that the idea of paying more for anything right now is a painful one. But, in the long run, it only seems fair that people pay for the services they get.

UPDATE: Kevin Drum digs this post, invoking Hayek along the way. Then one of his commenters smartly breaks things down according to demand elasticity.

Here’s a chart of what tail risk looks like, in the stock market:

The thick blue line is Bank of America stock, hitting a new 52-week low today after reporting losses of $7.3 billion in the third quarter. The thin blue line is financial stocks generally, which are doing much better than BofA. And the thin red line is the S&P 500, which is significantly higher than it was this time last year.

To judge by the headlines, BofA ought to be doing pretty well. Its earnings report today beat expectations, and yesterday it announced that it was going to start foreclosing on properties again, long before anybody expected it would do so. On top of that, it’s the biggest bank in the U.S., with a deposit base of $900 billion—that’s 11.71% of the total U.S. deposit base, making BofA the clear leader on that front and the only bank now to break the 10% cap. With the Federal Reserve throwing free money at the entire U.S. financial system in an attempt to keep the recovery going, and the yield curve sloping upwards in the right direction for easy banking-sector profits, these ought to be good times indeed for BofA.

So why is BofA’s stock in the doldrums, relatively speaking? The answer is tail risk. Part of that risk is regulatory: BofA is too big to fail, and will therefore be subject to extra regulatory scrutiny and higher capital requirements than smaller banks. On top of that, huge swathes of the post-Dodd-Frank regulatory architecture remain to be written in detail, and the risks to big banks on that front are all to the downside, given how deregulated they were up until now.

But the much larger part is mortgage-related: JP Morgan came out yesterday and said that banks could be forced to buy back as much as $120 billion in mortgage bonds from investors. And BofA bears the lion’s share of that risk, incorporating as it does not only Merrill Lynch but also Countrywide.

The mortgage mess hasn’t gone away, and BofA is going to trade at a discount unless and until it’s resolved. That doesn’t mean that the market is pricing in some kind of mortgage-related disaster. It’s just pricing in a very uncertain probability distribution of possible outcomes, some of which are very bad indeed. And since investors hate that kind of uncertainty, the share price is underperforming, and is likely to stay low for as long as the uncertainty persists.

In the UK, it seems, the revolving door from big private banks into a grandee’s public-sector role doesn’t turn quite as smoothly as it does in the U.S. And so sometimes it needs a not-so-gentle shove:

John Varley, Barclays’ chief executive, has broken ranks with the rest of the global banking industry, arguing that the availability of credit should be unaffected by tough new capital rules for banks, which he regards as fair.

He praised both the “substance and timetable” of the Basel III proposals in an interview with the Financial Times, in comments that contrast starkly with other senior bankers…

Mr Varley’s stance is particularly surprising because Barclays is among the hardest hit of Europe’s banks by the Basel III changes to regulatory capital…

Mr Varley’s comments will fuel predictions that when he leaves Barclays, he will seek a significant role outside banking.

He has been linked, by those who know him, with possible roles at the Bank of England, in government or as chairman of a blue-chip company. To make the transition from lambasted banker to a role in public service or the broader corporate world Mr Varley needs a softer image, these people say.

There’s no doubt that if any bank will lend less as a result of Basel III, it’s Barclays: not only is it too big to fail, but it’s also more highly leveraged than most of its peers. Its risk-weighted assets are likely to rise substantially under Basel III rules and its capital commensurately.

Which means that Varley’s comments can be taken one of three ways.

Either Varley is right, in which case the Institute of International Finance and the banking lobby generally are wrong and are being unnecessarily alarmist.

Alternatively, Varley is wrong and is making these noises in a nakedly political attempt to ingratiate himself with public-sector technocrats.

Or nobody really knows what the truth is, least of all Varley himself and one’s view of Basel III is fundamentally a function of your job title, or what you’re hoping that your job title will be.

In any event, it would have been nice if Varley had made these noises back when he wasn’t a lame duck, when he actually had influence in the IIF and among banking-industry lobbyists. One thing you can be sure of: at this point, Varley’s views no longer carry any weight in the industry. As such, there’s frankly not much reason to appoint him to a senior position at the central bank.

The tag line of Client 9 , Alex Gibney’s new film about Eliot Spitzer, is “you don’t know the real story”. But the fact is that we do — or I did, at least.

Everybody knows that Spitzer made powerful enemies on Wall Street as attorney general; that he went on to become governor of New York; and that he then resigned after being outed as a client of a prostitution ring. Spitzer himself is clear that his downfall was his own fault; he doesn’t blame it on Ken Langone, Roger Stone or anybody else but himself.

Yes, the investigation of Spitzer was highly political and was more or less unprecedented on many levels. The Mann Act, for instance, was never before used to prosecute the clients of prostitutes — just as the Martin Act had never been used in the ways that Spitzer used it when going after the big investment banks.

Client 9 is one of those films where almost nobody is sympathetic; as a result it’s not exactly fun to watch. It’s a film of persecutors and plutocrats and prostitutes, starring people like sworn Spitzer enemy Hank Greenberg complaining that after AIG’s collapse, his stock in the company was “virtually worthless, about $100 million”.

Spitzer prided himself on playing the hardest of hardball politics, against the most powerful people he could find. That strategy took him all the way to the governorship of New York: there would have been no job to resign from if he hadn’t made powerful enemies along the way.

Maybe Spitzer’s problem was that he was never very good at cultivating powerful friends who could protect and support him — a skill that another executive horndog, Bill Clinton, has in spades. Maybe he never believed that the Bush administration’s prosecutors would go to such lengths to bring him down. Most likely he didn’t overthink his actions at all. Powerful men rarely do, when it comes to sex.

Spitzer’s now a public figure again, on CNN every night. I doubt he’ll ever again get elected to public office, but he would certainly love to be appointed to an important role in the executive branch at some point. He neither wants nor deserves our sympathy, which is why it’s a bit weird that Gibney takes such a sympathetic tone for much of his film.

Spitzer’s popularity was a function of the fact that he was hyperaggressive, super-determined to go after entrenched and powerful interests. He had successes on Wall Street and he had a major failure in Albany. It remains to be seen whether he’ll have a third opportunity to unleash his righteousness and how seriously anybody will take him if he does.

Apple's earnings announcement this afternoon was something of an epic event. First, the company reported making a staggering amount of money: $4.3 billion in profit for the quarter. Second, Steve Jobs got on the phone and was even more obstreperously entertaining than usual. Third, iPad sales for the quarter were a bit lower than hoped and Apple's stock price dropped 6% in after-hours trading.

That sort of sensitivity to the slightest bit of disappointment is to be expected when a company has been doing as well as Apple has for as long as Apple has. Everybody's looking for the moment when the company's spectacular growth trajectory over the past half decade finally plateaus. As somebody who bought Apple at $14 and sold at around $40 early in the 2000s (I don't own any Apple stock now, except indirectly through mutual funds), I'm certainly not the one to predict when that moment will arrive. But I doubt that the iPad disappointment is any kind of lasting setback.

Why's that? Because I want an iPad, I really do. And I will buy one soon. But Apple has trained me by now to wait for at least the second generation of any new product—it's inevitably so much better than the first. I'm going with the rumors that a new-look iPad will be out by Christmas. If and when that happens, I'll buy. For now, I'm waiting. I'm betting I'm not the only one.

Hello, Reuters readers. Thank you, Felix, for inviting me and Justin to guest blog while you're away. I promise to make the most of my newfound form of procrastination.

Over the weekend, the NYT ran a piece about academics rediscovering the "culture of poverty." The story goes that for decades it was taboo to offer social, as opposed to economic, explanations about why particular people and neighborhoods were poor—unless, of course, you belonged to a certain camp of conservative critic. According to the Times:

The reticence was a legacy of the ugly battles that erupted after Daniel Patrick Moynihan, then an assistant labor secretary in the Johnson administration, introduced the idea of a "culture of poverty" to the public in a startling 1965 report. Although Moynihan didn’t coin the phrase (that distinction belongs to the anthropologist Oscar Lewis), his description of the urban black family as caught in an inescapable "tangle of pathology" of unmarried mothers and welfare dependency was seen as attributing self-perpetuating moral deficiencies to black people, as if blaming them for their own misfortune.

Now, it seems, culture is again fair play. Over the past few years, culture-informed explorations of poverty have been seeping into the research literature. High-profile examples include these Princeton/Brookings papers about unmarried parents and this special issue of The Annals of the American Academy of Political and Social Science (which led to a recent Congressional briefing). Nobel-winning economist George Akerlof goes down this path in his new book, Identity Economics: he and co-author Rachel Kranton argue that students decide how much to invest in their education (i.e., their earning potential) partly by whether they see themselves as fitting into the culture of the "nerd," the "jock" or the "burnout."

I'm all for understanding the nature of poverty, but the culture lens makes me nervous. Maybe that's because right after I read Identity Economics, I read The Trouble With Diversity, by Walter Benn Michaels, an English professor at the University of Illinois at Chicago. One of the main arguments of that book is that there is a lurking danger in turning a conversation about economics (poor people don't have money) into a conversation about culture (poor people have different values and make different life decisions). The big risk: since Americans are loathe to judge one culture as superior to another, we will come to accept poverty as a valid alternative. You're not poor because you can't get a job that pays enough to cover your bills (a failure of education, the free market, etc)—you're poor because you are part of a different culture, which, in diversity-committed America, we all have to respect.

The other thing that worries me about the culture frame is that so much rests on the categories we use to try to capture "culture." Akerlof's nerd-jock-burnout rubric is clear-cut and colorful. But is that where the truly useful information lies?

One of the best things I've ever read about the nature of poverty is Kathryn Edin and Laura Lein's 1997 book, Making Ends Meet. Edin and Lein, a sociologist and anthropologist, spent long periods of time interviewing poor single mothers—most of whom both received welfare checks and undertook some sort of paid work. When deciding the right balance between welfare and work, the mothers certainly took into account which paid better. But they also considered which would allow them to be better mothers by spending more time with their children, and which would provide a more predictable (even if lower) stream of income. Devotion to full-time motherhood definitely reads as a cultural value. But does the preference for income predictability?

If we look at poverty in terms of culture, we might be missing an important part of the puzzle. Let's not forget something else that Daniel Patrick Moynihan once said: “The reason people are poor is that they don’t have money.” Sometimes an economic problem is just an economic problem.

Mathematician Benoit Mandelbrot was not one of those great thinkers who was ignored in his own time. He won lots of prestigious prizes. He wrote acclaimed books. He even gave two TED talks.

But it's curious how little of the acclaim and attention Mandelbrot received over the years, and after his death last week, came from the world of finance. Mandelbrot was, believe it or not, one of the founding fathers of modern quantitative finance. In the early 1960s, he and scholars at Harvard, MIT, Chicago and a couple other places began to explore the meanings of random walks in stock prices. (I spent several years immersing myself in this history for a book; hence my obsessive interest. Here's an excerpt from it related to Mandelbrot.)

In the early days, Mandelbrot was very much one of the random walk gang. He considered Eugene Fama, then a grad student at the University of Chicago, to be his student and protégé. A 1965 article by Mandelbrot in the Chicago B-school's Journal of Business proved that a rational financial market would be an unpredictable one, providing an essential building block for what soon came to be known as the efficient market hypothesis.

Before long, though, Mandelbrot and the finance crowd drifted apart. It was partly just that Mandelbrot was a curious guy, and got interested in other sources of the fractal patterns that he saw in stock prices. But he also felt that "an ominous cloud" was developing in his relationship with the other random walkers. As long as quantitative finance was mostly exploratory in nature, Mandelbrot and the economists and finance professors got along fine. But as soon as the latter groups started trying to develop tools for understanding and managing risk in financial markets, there were tensions. The tool builders wanted to shoehorn market-price behavior into a bell-curve statistical model. That is, they wanted to believe that while price movements couldn't be predicted, price volatility could. Mandelbrot thought volatility was far harder to capture than that. As Paul Cootner, a random walker from MIT's Sloan School, wrote in 1964:

Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil and tears. If he is right, almost all of our statistical tools are obsolete . . . Surely, before consigning centuries of work to the ash pile, we should like to have some assurance that all our work is truly useless.

And so it went. For Mandelbrot, the crucial turning point came with the development—and widespread acceptance—of the Black-Scholes options pricing model in the early 1970s. Black-Scholes and the many financial risk models that have evolved from it (including Felix's friend the Gaussian copula) are all about volatility being measurable and predictable. "When Black-Scholes came out, I said, 'Well, it won’t last,'" he told me in 2005. "'I’ll come back when it’s gone.'"

After the 1987 stock market crash, brought on in part by portfolio insurance strategies built upon Black-Scholes, Mandelbrot began paying attention to finance again, and some financial practitioners actually began paying attention to him. So he made a partial comeback. But the reliance on risk-management systems based on the belief that price volatility can be easily measured and predicted has continued, and it has continued to lead the financial system to the brink of disaster every few years.

So why haven't finance academics and practitioners paid more attention to Mandelbrot's warnings? I think it's mainly that he didn't provide them a handy alternative to Black-Scholes. I can't pretend to fully understand the practical implications of his fractal view of markets (and yes, I've read his book for lay readers on the subject), but it does seem more useful as a critique than as a positive model of market behavior. You can't haul in big consulting fees or create giant new securitization markets with a critique. So the natural tendency of both scholars and bankers has been to hold on for dear life to the Black-Scholes approach to modeling market risk. They get paid well for doing so, after all.

Finally, to switch topics entirely: Thanks to Felix for inviting Barbara and me to procrastinate blog at his place for the next couple of weeks. It should be fun. And it won't normally be quite this wonky.

I’m a big fan of two-handed blogs: there aren’t very any of them, but the ones that there are tend to be fabulous. (Think 2 Blowhards, or About Last Night, or Ultimi Barbarorum, or, of course, Marginal Revolution.) Time.com’s Curious Capitalist blog started off as a one-hander, written by the great polymath Justin Fox (whose book, if you haven’t read it, can be bought here), but it really came into its own when Justin brought in Barbara Kiviat to co-blog with him.

The blog is still going strong, under the auspices of Stephen Gandel and his colleagues, but I miss the old days, and so it gives me an enormous amount of pleasure to be able to say that I’ve managed to persuade both Justin and Barbara to guest-blog here over the next couple of weeks while I swan around South Africa.

Neither of them really has time to do this: Barbara has a huge course load in her new life as a grad student, while Justin is in charge of a monster editorial operation not only at Harvard Business Review but also at its book-publishing arm as well. I’m hoping that, like most bloggers, they’ll take this opportunity to blog as a form of procrastination while putting off their real work.

Many thanks to Justin and Barbara for doing this! I can’t wait to see what they come up with.

I’m going to be spending the next couple of weeks in South Africa, which means I’ll be off the grid (on a plane) for all of Monday, and less-than-fully online thereafter. I’ve invited the old team from the Curious Capitalist—Justin Fox and Barbara Kiviat—to help out with some guest-blogging, which I’m very excited about. But in the meantime, here’s a FAQ on the mortgage bond scandal to keep you tided over, since there seems to be a lot of confusion out there.

I’m hearing a lot about foreclosuregate, MERS, moratoriums, bad title, etc. What does this have to do with that?

Nothing. This is an entirely separate, parallel, scandal. The main area overlap is that it gives investors in mortgage bonds one more colorable reason why they should be able to put back their bonds to the banks who issued them—over and above the fact that they have the right to do that if the mortgages weren’t properly transferred.

So this isn’t about legal title to mortgages. What is it about?

Just like the Goldman Abacus case, it’s fundamentally about investment banks’ lies of omission when it came to the investors who were buying bonds from them.

In that case, Goldman neglected to tell investors that John Paulson, who had helped select the bonds in a CDO, was also short the CDO. In this case, what’s the information that the investment banks neglected to tell investors?

The results of the due diligence tests that companies like Clayton and Allonhill performed on the loan pools the investment banks were buying.

Hang on, back up a minute here. Without waving your arms around like a demented spider monkey, can you explain what you’re talking about?

I can try. A key part of the mortgage securitization process was the way in which mortgage originators like Countrywide—lenders which lent you the money to buy your house—would then get their money back by taking those loans and selling them, in bulk, to investment banks like Lehman Brothers or Merrill Lynch. They’d put a large number of loans into a pool, circulate a document detailing the characteristics of each of the loans in the pool, and then sell the pool to the highest bidder.

But banks didn’t simply pay whatever they bid. Instead, after they won the auction to buy the loan pool, they would hire someone like Clayton to do due diligence on the loan pool, to make sure that what they were buying was what they had been told they were buying. “At the core of our service,” says Clayton, “is the capability to compare electronic file data against data retrieved from source documentation made available to Clayton (i.e. loan files).”

Now, it’s easy to be shocked by what Clayton found when it did its due diligence: it turns out that in many of these loan pools, the loans simply didn’t conform to the lenders’ own underwriting guidelines. But whether you or I find such things shocking is actually pretty much beside the point. The point is that the banks found the findings shocking—or at least they pretended to when they then turned around to the originator and demanded a discount on the price they were paying for the loan pool.

So that’s why the Clayton findings count as material information, right? They were directly responsible for lowering the price of the loan pool.

Right. The banks were willing to pay X for the loan pool based on the electronic file data supplied by the originators, but after having Clayton go in and test that electronic data against the original loan files, the banks were only willing to pay some sum less than X.

But isn’t Clayton’s research just like anybody else’s research—just an opinion about publicly-available information? Investment banks doing a secondary offering of shares don’t need to tell investors about other banks’ buy or sell ratings on those shares, even if those ratings affect the share price.

No, this is different. Because the loan files that Clayton had access to were not publicly available. And in any case, Clayton wasn’t being paid for its opinion. It was being paid to diligently go through a subset of the loan pool, one loan at a time, and check each loan against various underwriting standards. Clayton’s opinion didn’t matter to anyone. What mattered was the new information that Clayton dug up.

What do you expect, that the banks would put all the loan-level information into the bond prospectus? That would make it thousands of pages long! Didn’t John Hintze report back in May that, in the words of his headline, “The Loan Data Was There for All to See”? Anybody could have done the Clayton analysis, and in fact people like John Paulson and Michael Burry did do the Clayton analysis of loan-level data. They didn’t like what they saw, they shorted the bonds, and they made lots of money. So long as the information was public, there can’t be anything wrong here.

Yes, the investment banks, as well as companies like CoreLogic, did make some loan-level data available to investors. But that data, presented in easily-digestible spreadsheet form, was essentially the same as the electronic data that the banks were using to price the loan pool before they sent in Clayton. That data alone, it turns out, if looked at in the right way by someone like Paulson or Burry, was all you needed to short the bonds and make lots of money. But the original loan files which Clayton checked that data against? They were not publicly available, and for good reason: they included things like the borrowers’ names, salaries, social security numbers, and other private information.

Clayton’s report, then, was non-public information: it was the product of looking at private loan files, not semi-public spreadsheets. No one else—not Paulson, not Burry—could do what Clayton was doing, and so Clayton was adding a valuable layer of information to what was publicly known.

Now, it’s true that even when investors knew that Clayton had done these tests, they evinced precious little interest in seeing the results. All they really cared about was the credit rating. And even the ratings agencies weren’t interested in seeing Clayton’s results, which is scandalous in and of itself. But the securities laws don’t say that banks can withhold material non-public information if the investors don’t seem to care about it.

But even if the banks didn’t pass on Clayton’s reports to investors, couldn’t investors have got those reports from Clayton directly? If Clayton was running these tests for the banks, and if it was offering the same information to the ratings agencies, couldn’t anybody have simply bought the reports from Clayton? And if so, that hardly makes the information nonpublic, does it?

That’s a stretch. Investors weren’t even told that Clayton had done due diligence on the loan pool; they were barely informed that any kind of due diligence had been done at all. And even if they did somehow find out about the existence of the Clayton report, it’s not obvious that Clayton would or could have sold it to them. After all, it had been commissioned by the bank, which presumably therefore had control over who could see it and who could not.

And in any case, the investors in the Abacus deal ended up winning a lot of money from Goldman Sachs, even though they had exactly the same information about the contents of Abacus as John Paulson and Goldman Sachs did. What I’m talking about here looks as though it’s clearly worse than Abacus: the investors didn’t have the same information as Clayton and the investment banks had. The banks could have passed that information on, but they chose instead to keep it to themselves. Why? The obvious reason is that they feared that if they made the Clayton reports public, the investors might not pay as much for their bonds, or the ratings agencies might not give them the all-important triple-A rating.

Still, it seems that you’re seeking to punish banks for doing more work on these bonds than they needed to do. The banks were not required to do due diligence on these loan pools. If they didn’t want investors to know the results of the due diligence, they could have simply not done any due diligence at all, and then, according to you, there would have been no scandal. Instead, they spent their own money on hiring the likes of Clayton to double-check everything — and for that you want to punish them?

Yes. It’s great that the banks did the double-checking. But the whole point of double-checking is to make sure that nothing unexpected is lurking in the loan pool. When something unexpected did turn out to be lurking in the loan pool, the banks had an obligation to pass that information on to their buy-side customers. The banks put themselves in a situation where they found themselves in possession of material non-public information. That they did so voluntarily is beside the point; they still had an obligation to disclose it.

Material non-public information, eh? So you’re saying that banks violated Rule 10b5-1 of the Exchange Act?

Yes, but that’s not all. There’s also Section 17 of the Securities Act, which says that banks can’t withhold material facts when they offer securities to the public. And of course Section 15E(s)(4)(A) of the Exchange Act was specifically written to close any possible loophole and ensure that banks will never attempt such behavior again.

So we can expect a bunch of lawsuits around this issue?

From investors, certainly. And possibly from regulators and/or prosecutors too. They’ve been looking at the issue for a long time and so far haven’t taken any action, but times change. The public—left and right—is furious at the banks for seemingly being the sole sector of the economy to emerged unscathed from the crisis they caused. Regulators and prosecutors ultimately represent the public. And a lot of the detail surrounding Clayton’s reports only emerged quite recently, with the FCIC hearings in Sacramento on September 23. It’s possible there won’t be any prosecutions. But it’s equally possible that there will be.

How JP Morgan lent its clients’ money to the doomed Sigma SIV, losing them millions — NYT

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Somebody find me a dish with chicken gizzards, sichuan peppercorns, fish sauce, scallions, and lime — MR

A Xerox Alto sells for $30,100 on eBay — eBay

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Stieg Larsson spent a year with Eritrean People’s Liberation Front, teaching female guerrillas about grenade launchers — Tribune

Benoit Mandelbrot, Mathematician, Dies at 85 — NYT

One company the soaring gold price doesn’t seem to have helped: Cash4Gold — Fortune

Beard Awards Will Not Distinguish Between Online and Print Journalism — NYT

What did Wall Street used to be like, before the Securities Act of 1933? Michael Perino’s new book on Ferdiand Pecora, which I reviewed here, reminds us. For instance, there was National City Bank’s Peru deal.

National City’s South American experts had reported that the government’s finances were “positively distressing”, with the treasury “flat on its back and gasping for breath” and the president surrounded by “rascals”. Yet, inevitably, National City decided to underwrite a series of bonds from Peru. Nowhere in the prospectus was there any indication of National City’s view on the country; meanwhile, National City’s ads stated that “when you buy a bond recommended by The National City Company, you may be sure that all the essential facts which justify the Company’s own confidence in that investment are readily available to you”.

Perino continues:

National City kept right on offering Peruvian bonds in 1927 and 1928, even though one of its own South American experts continued to conclude that he had “no great faith in any material betterment of Peru’s economic condition in the near future”. The political situation, he wrote, was “equally uncertain,” with “revolution” a distinct possibility. Would the public have purchased these bonds, Pecora asked, if that information had been included in the prospectus? “I doubt if they would,” Baker replied.

Pecora did something similar with a bond offering for the Brazilian state of Minas Gerais. National City used much of the proceeds to pay off a loan due to itself, without telling telling investors that it was using their money to exit the very credit they were buying into. And that’s not all:

How Minas Gerais would use the proceeds of the bond offering was not the only misrepresentation in the prospectus. Pecora put George Train, the man who originally urged National City to underwrite these bonds, on the stand. Train, it seemed, was willing to play fast and loose with other crucial facts in order to get the deal done. In 1927, analyzing Minas Gerais’s history of bond offerings in Europe, Train was amazed at the shoddy way the government had handled its obligations. The “laxness of the State authorities,” he wrote in an internal company memorandum, “borders on the fantastic”. His review of Minas Gerais’s history “showws the complete ignorance, carelessness and negligence of the former State officials in respect to external long-term borrowing.” It would, he wrote, “be hard to find anywhere a sadder confession of inefficiency and ineptitude than that displayed by various State officials.” Despite those conclusions, Train wrote in the prospectuses for the bond offerings, “Prudent and careful management of the State’s finances has been characteristic of successive administrations in Minas Gerais.”

I’m quoting Perino at length, here, because I’m getting a lot of pushback from various commenters to my assertion that pretty much every major investment bank in the world withheld material nonpublic information when they failed to pass on to investors the results of the due diligence tests that Clayton did on mortgage loan pools.

Kid Dynamite says that we’re not talking about material nonpublic information here. But of course we are: it’s information, it’s nonpublic, and it’s certainly material, since it resulted in the investment banks negotiating down the price of the loan pool in question.

The Securities Act came into law largely in reaction to exactly the kind of behavior that Pecora uncovered with the Peru and Minas Gerais bonds. The banks knew bad stuff about the bonds they were selling, but they didn’t pass on that information to investors. And so the Securities Act was written to put an end to such shenanigans.

The Clayton reports were much more than mere opinion, like the ratings agencies pretend to be. (And in any case, credit ratings are public information.) Clayton did detailed empirical research on the loan pools, and when the banks didn’t like what they saw, they used that information to their own advantage — by asking for a discount on the loans from the originator.

The whole point of the Securities Act was to ensure that information like that was passed on to investors. That’s why bond prospectuses are so long: they include every conceivable piece of information, and every conceivable risk factor, that might possibly be relevant to the price of the bond.

Yet the MBS prospectuses for the loan pools that Clayton examined didn’t include the fact that Clayton had done due diligence on them, didn’t say what Clayton’s results were, and certainly didn’t disclose that those results had allowed the underwriter to buy the loans from the originator at a discount.

If Ferdinand Pecora were alive today, he would recognize all this behavior — and be shaking his head at the way in which banks simply ignored the spirit of the laws which FDR put into place in the wake of the Pecora Commission.

Did the banks behavior violate the letter of the law? I think there’s a good case that they did; they certainly broke the law as it exists today. But let’s find out! Come on, prosecutors — file some suits, here, and see what happens. This crisis has yet to reach the stage at which people start going to jail. And we need to pass through that stage before it’s all over. So let’s get to it.

Joseph Tauke has a monster 5,600-word excoriation of the mortgage industry. It’s a great read, and it includes a lot of information you probably won’t know unless you’re a regular reader of Naked Capitalism and 4closureFraud. But the most important thing about the story is nowhere to be found in the story itself; rather, it’s the fact that it was published by the Daily Caller, Tucker Carlson’s right-wing website.

The Tea Party wing of the Republican party has never been a big fan of Wall Street, of course. But at the same time, it has also tended to oppose any Democratic attempts to bring Wall Street into line. And it hasn’t made bank-bashing a central part of its platform at all. (TARP-bashing, yes. But TARP was a government program.)

TARP was a bipartisan deal to save the banks, and its outcome is now regarded as desperately unfair: the rich bankers are now back to making multi-million-dollar bonuses, even as most of the country continues to suffer from a weak economy and high unemployment.

So if the Daily Caller’s story is any indication, there might just be a consensus in Congress to gang up on the banks and dole out a bit of punishment for their fraudulent behavior with respect to respectable homeowners.

The big question mark with regard to foreclosure fraud has always been the willingness, rather than the ability, of authorities to prosecute the banks involved. If the political winds change so that regulators have every incentive to sue, you can be sure that they will do so. Given that any indication of friendliness towards banks constitutes political suicide right now, I’d guess that the banks’ litigation risk is higher than it has ever been.

Which is maybe why JP Morgan Chase set aside $1.3 billion in additional litigation reserves last quarter. At this rate, they might well need all of that — and more.