FinReg for Dummies: derivatives

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If I hear the term ‘complex financial instrument’ without any further elaboration one more time, I am liable to throw something at the television. I wish that I could use my Wii remote to launch tomatoes at news anchors who seem to believe their motto is, “We report. You go look it up.”

How can we possibly think we stand a chance of adequately regulating the financial sector when no one can even explain exactly what it is we are regulating?

The most blatant example of things-we-should-fear-but-need-not-understand is derivatives. Given the scarcity of descriptions that go beyond, “they’re complex,” I imagine you’d be hard-pressed to find one non-banker that can explain them.  Yet they are central to this regulation, so let’s try to break it down.  Deep breath…

A derivative, at its most basic level, is a financial instrument that derives its value from another asset, hence the name. There are various types of derivatives – options, swaps, futures, etc. – but they all share this common trait; they cannot exist without the presence of some other underlying asset.

In contrast to what Congressional theatre would have you believe, derivatives are fundamentally valuable to the process of mitigating risk. The easiest way to explain this is through commodity futures, a type of derivative that allows someone to buy something tomorrow, at a price determined today.  Many businesses could not survive without these arrangements.

Take orange juice futures, with oranges being the underlying commodity.  If you are an orange juice producer, the sustainability of your business is highly susceptible to the price of oranges.  So if you are worried that Florida might have some of the coldest temperatures on record, as it did this past winter, you might be willing to pay a fee lock in a price, just in case.  Because if the frost settles, and the orange crop yield is cut in half, prices will go through the roof.  Your gross profit margin will drop and you may fail to recover all of those fixed operating costs.  Without a degree of certainty, no OJ producer would make the investments necessary to get from harvest to glass.

Orange juice producers thus use orange futures to protect against the uncertainty of the weather.  All the other derivatives, no matter how complicated, are similarly used as protections against uncertainty in the underlying assets.  CEOs are paid in stock options because shareholders are not certain management will increase the value of the underlying stock.  Businesses that invest in other countries use currency swaps to protect against uncertainty in the value of the underlying foreign currencies.  Banks use interest rate swaps to protect against fluctuations in underlying interest rates.

But if derivatives are so important to the process of mitigating risks, why are they most often associated with speculation?  The fact of the matter is that for derivatives to do their job of mitigating risk, someone has to take the other side of the bet.  Our orange juice producer cannot protect against his uncertainty without someone on the other side willing to bet that it will be a perfectly normal winter.  It’s all speculation, but one person’s nay-saying is another person’s insurance.

As you likely have heard, credit default swaps were at the center of the financial crisis.  They are very similar to insurance, in that they pay out to the buyer in the event of a negative outcome.  Their good side is that they allow lenders to insure themselves against the default of their borrowers, but again, the counterparty tends to put us on edge.  Whoever takes the other side of that bet is essentially speculating that the borrower will default.

But when we talk about regulation, the issue is not the speculation, it is transparency.  Most derivatives are not traded on public exchanges, but instead are traded “over-the-counter“.  What this means is that no one aside from the two parties involved in the trade know the terms of the trade, which is where we ran into problems in the financial crisis.  In the absence of the transparency seen on public exchanges, no one understood who was exposed to who or how a domino effect of defaults could tear through the economy.

This is why getting derivatives regulated on exchanges is so important, because it could actually help stave off crises by bringing all the relevant information to light and allowing for some insight on future risk.  One of my finance professors used to say, when vacationing in Florida, he would take changes in the price of orange juice futures over the weatherman’s forecast any day.  Sure enough, orange juice futures shot up in the days leading up to those unusually cold days in Florida.

The argument that has been made is that, if more derivatives had been openly traded, we would have had a much greater understanding of the risks facing the housing market.  If Paulson’s bets against the housing market (the ones at the center of the Goldman Sachs fraud case), had been more transparent, other investors would have picked up on his insights.  As more and more followed suit, investors would have become much more skeptical of the housing boom.

In Congress, both sides of the aisle seem far too ideological on the topic.  Democrats would love to limit derivatives trading, but that ignores the value they hold for individual businesses as well as their potential to foreshadow risks.  Meanwhile, Republicans pretty much don’t want to allow any regulation of anything, and have been particularly protective of derivatives, likely because over-the-counter currently earns their supporters higher fees.

The central plan of the bill is to get all derivatives onto regulated exchanged, and all trades to go through a central clearinghouse to assure investors have enough capital to cover their bets.  To me, that sounds good.  Any efforts to reach beyond that will limit the benefits derivatives offer.  Any efforts to keep certain derivatives off these exchanges will increase the risks of limited information.

I find that I like my financial sector like I like my democracy: all-inclusive, because more information is better.  The more trades that pass through a central clearinghouse, the more we are able to deal with problems of uncertainty.

Perhaps there’s a derivative for that.

Posted on May 15th 2010 in news

Biking with Android

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Android finally brought me bicycling directions on Google Maps.  I let it take me on a tour across Brooklyn today.  It works quite nicely for stop, check where I am, and move on, but I’m yearning for the day it becomes my perfect biking GPS.  It’s not quite there yet.

First, you can’t navigate with bike directions in the way you can with driving directions, which is unfortunate.  I can’t imagine it would be that difficult to replicate that functionality, so I suspect it won’t be too long, perhaps in the Android 2.2 update, code-named Froyo.  In the meantime, I’m gonna be ready.  Project: $5 Handlebar phone mount, courtesy of Lifehacker.

[this is crucial, as texting while biking is set to become a problem.  Last summer, I watched a kid texting on his bike run right into a parked car and clip off the rear view mirror.  Dude just kept going]

It also won’t be a complete experience until I can drag and drop points on the route, like you can on the web, with real-time adjustments to the route.  When that hits, I’ll be ready to roll, phone strapped to the handlebar, grabbin’ speaker phone conversations as the street names pass under me on the navigator.  Sweet.

One cool thing now is that you can add the terrain layer on your directions and check out where the hills are around you.  But it doesn’t do much for me; it basically had all of Brooklyn flat.  Park slopes don’t count.

All in all, though, I am just pleased to have it.  It is pretty on-point with choosing routes and finding all the bike lanes around the city, miles of which have emerged over the past couple years and bumped NYC up to the second-most bike friendly city in states, according to National Geographic.  Loving it.

Posted on May 13th 2010 in news

Financial Regulation for Dummies

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I consider myself of a former finance dummy.  I studied social sciences in college and worked in non-profit.  I had no clue about how financial markets worked until I enrolled in business school and started taking courses in the unknown, mostly out of curiosity.  After two years of coursework, I now feel like I have at least a proper foundation to start thinking about how the world of finance should be regulated.

But the scary reality is that most of the people charged with writing the financial regulation bill never bothered to take the class.  When Senator Levin went on his public tirade against Goldman Sachs, it was clear that he didn’t understand the difference between trading and making markets.  Yet the public and Congress are clearly moved by these theatrics – shortly after the Senate hearing, the financial regulation bill began moving forward, all of a sudden buoyed by that ever-elusive relic, bipartisanship.

Regulating finance is enormously difficult because it’s never about individual actors.  Sure, there is the occasional Bernie Madoff and Fabulous Fab Tourre, but they don’t bring down entire markets.  These are serious collective action issues, which makes them all the more difficult to regulate.  Imagine if the government tried to regulate trending topics on Twitter.  Though I would welcome it, I really doubt they could find a way to stop those damn Justin Bieber tweets.

I worry, because no regulation founded on fundamental misunderstandings can ever be effective.  So I will attempt to do my part, with a brief series to explain what I think are the most important elements of financial reform: derivatives, the ratings agency, the resolution trust authority, and the consumer financial protection agency.  As someone with no ties to Wall Street, I only hope to demystify these things in a way that both recognizes the risks involved as well as some of their benefits.

so stick around.  derivatives are up first…

Posted on May 13th 2010 in news

Immigration in perspective

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One of the things that drives me absolutely bonkers about debates surrounding immigration is how devoid it is of historical perspective.  Anti-immigration advocates that argue for more control over immigration universally tend to overlook the historical reality that the relatively recent existence of immigration controls is the only reason one can even speak of an increase in illegal immigration.

One common argument you hear from anti-immigration advocates is that, yes, we are a nation of immigrants, but that our ancestors came to this country legally.  But the fact of the matter is that the concept of “illegal” immigration did not exist until the end of the 19th century.  Prior to 1875, the United States allowed a virtually unrestricted flow of immigrants, with the only requirement for legality being physical presence.  Basically, as long as you found a way to set foot in America, it didn’t matter how you got here.  You were a legal permanent resident.

And 1875 didn’t change much except bar the entry of convicts and prostitutes.  You have to go to 1921 to find the first time the United States ever put any real limits on the number of people allowed to enter the country (shocker: it was motivated by xenophopia, the law actually attempted to implement proportional immigration quotas by country in order to keep the existing ethnic balance intact).

So for all those that claim that their ancestors came legally, before you go praising their virtues, keep in mind that they didn’t really have much of a choice; there was no such thing as illegal entry.

Now imagine what the situation would have looked like if we had today’s limits on entry.  The majority of our nation’s ancestors might never have been allowed in.  Though I have a hunch that, with the hope that their future generations might grow up in America, some of them might have hopped over a fence to make it happen.

Posted on May 12th 2010 in news

Breakin’ from break

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There are few feelings I can describe as pure relief, and finishing exams is one of them. I’m chillin.

They took me out of commission for a little, but now I’m back to the BB. And there is so much damn stuff to talk about. FinReg. Supreme Court. Innovation funds. Oil. Open Source. Immigration.

stay tuned.

Posted on May 11th 2010 in Uncategorized

Small enough to matter

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[Image source: Grassroots Economic Organizing]

A familiar seed grows amidst the ‘too big to fail’ trees in our financial forest:

After months of anticipation, the East River Development Alliance (ERDA), a non-profit organization established in 2004 to help public housing residents by expanding their economic opportunities, [has] finally opened its Federal Credit Union (FCU) – the first to be chartered in New York City in 10 years.

According to ERDA, three out of 10 people in the Ravenswood, Queensbridge, Astoria and Woodside Houses – which will be served by the new credit union – currently lack bank accounts.  [The credit union] will help change that, ERDA says, by providing public housing residents with a means to build capital, manage their money and achieve their financial goals. Proponents also believe the FCU’s presence will spark economic development in the area.

A credit union is a cooperative financial institutions that is owned and controlled by its members and operated for the purposes of promoting thrift, providing credit at reasonable rates, and providing other financial services to its members.  I call them familiar because they’ve existed for quite some time – the first credit union in the U.S. was founded in 1909 and they’ve been under federal supervision since 1934, backed by the full faith and credit of the FDIC.

The ERDA credit union launch ties in quite nicely with my recent thoughts on microfinance, particularly with respect to its lack of freshness. Here is a centuries-old system of community-based finance, owned by its depositors – sounds an awful lot like a Grameen Bank.  Yet for all the fanfare that has surrounded microfinance, people often overlook the credit union as a tested tool for financial reform in this country.  ERDA’s is the first credit union chartered under the Obama administration, and the first established in New York City in over 10 years.

So props to ERDA for reminding us of the tools we have!  As we contemplate how to regulate institutions that are too big to fail, it’s quite reassuring to know that we might also promote those that are small enough to matter.

* on a related note, check out Raghuram Rajan’s radically provocative thoughts on why deposit insurance should only exist for community-based financial institutions, via Ezra.  It’ll make you go ‘hmmm.’

Posted on April 29th 2010 in news, OrgWatch

OrgWatch: WikiLeaks promotes transparency, among other things

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The founding idea of WikiLeaks is beautiful in its simplicity, an anonymous repository for government and corporate officials to leak things of critical importance to the voting public. Like wikipedia, anyone can put forth content into the public dialogue, and the organization goes to great lengths to protect its sources.  The organization has facilitated leaks around the world, including the Climategate emails and the Palin email hack.  As The National is quoted on their website saying, “WikiLeaks has probably produced more scoops in its short life than the Washington Post has in the past 30 years.”

But a recent leak may have gotten them in the hot seat.  The video below, entitled “Collateral Murder” by WikiLeaks, is of a 2007 Apache Helicopter Attack in Bagdhad that resulted in the deaths of civilians, including two Reuters news employees.  The issue was that many observers did not find that this constituted a war crime, and found WikiLeaks’ editorializing to be particularly distasteful and misleading.  You be the judge [Warning: it is tough to watch]:

The official Pentagon story is that there was small gunfire in the area, though the founder of WikiLeaks, Julian Assange, disputes that in this interview with Stephen Colbert, who may or may not have stepped out of character to condemn the slant:

The Colbert Report Mon – Thurs 11:30pm / 10:30c
Julian Assange

Colbert Report Full Episodes Political Humor Fox News

I am empathetic to the critiques made of WikiLeaks; to call it “Collateral Murder” inserts a deliberate subjective opinion onto a purportedly objective piece of media. But what is funny about the whole thing to me is the fact that we accept this kind of sensationalist editorializing in virtually every other journalistic output. Rarely do the loud, outlandish lower graphics on Cable News channels match the objectivity demanded by the profession, and try picking up the New York Post any day of the week. Why should we begrudge Assange for trying to “achieve the maximum political impact” for what is nothing more than a leaked video in a case where the Pentagon was being particularly secretive?

Colbert gets him on this, because the video is slightly edited, but it is light years away from the chopped up 30-second clips that might squeeze past a TV news editor’s desk, if they actually aren’t too PG to show it. However, the fact that only 1 in 10 watched the whole thing should raise some eyebrows about the powerful impressions made in those first two minutes.

I am reminded of a critique I once read about the use of exclamation points by Lewis Thomas, who noted, “If a sentence really has something of importance to say, something quite remarkable, it doesn’t need a mark to point it out.”

I applaud the effort to make transparent the pain and suffering and collateral damage that comes from wars, especially those fought on false pretenses.  That effort is certainly of importance.  It shouldn’t need any slant to point that out (and we all know cable news will jump right in to fill any voids in that department).

So, do you think WikiLeaks crossed a line?  Would it have hurt their effort if they had simply added a question mark to the title, and let viewers and politicians and lawyers make their own judgments?  Is WikiLeaks really a threat to national security?

[Props: Andrew Sullivan]

Posted on April 16th 2010 in news, OrgWatch

On Microfinance

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I worked for a microfinance organization, so it’s a little strange that I have not come around to talking about it yet, but a recent New York Times article touched on all of issues surrounding microfinance that I have been pondering.  So I guess its time for me to confront my opinions.

Microfinance has been hailed by Muhammad Yunus and many others as the elusive formula to improving the lot of the world’s poor.  It is thought that providing small loans to poor people will allow them to pull themselves out of poverty by virtue of no longer having working capital constraints on their entrepreneurial ventures.

One must first consider that lending to poor people is not, in and of itself, a novel idea.  People with capital have always been there to lend it to those who don’t have access to it, and to take profits off the top.  We called these people loan sharks, and have long stigmatized them in film.  They sit in dimly lit rooms and finance a protagonist at a time of desperation. Later, when the loan goes sour, they use violent methods of collection.

There are certainly these sorts of loan sharks out there, but that is not the whole story.  Some are just moneylenders, respected members of their communities, attempting to fill a capital gap because banks, the “formal” arbiters of small business finance, refused to lend in these communities.  The banks considered it too costly to reach these borrowers, and the interest to be earned off of their small balances, has not traditionally been worth the effort.

Enter microfinance.  It has always been an attempt to “formalize” the practice of small-scale lending, to provide safe and affordable access to capital to the segments of society forced to rely on predatory lenders.  And formalize they did.  MFIs simply institutionalized the practice of community lending that existed, which is why many people remain so skeptical.  The interest rates still appear predatory and there are still rumors of abusive collection practices.

The question of whether or not small loans, in and of themselves, can eradicate poverty is hotly debated.  After much internal debate, I have come to the conclusion that, financially speaking, it is simply not feasible.  Even the cheapest microfinance organization is lending at well above 20% APR and thus for this sort of small-scale entrepreneurship to be sustainable, microborrowers would have to be earning above that.  Now, imagine what Compartamos borrowers would have to earn.

But not even the largest, most efficient corporations in the world are capable of consistently earning returns like that – the market average is, at best, 10%.  If it were indeed the case that microentrepreneurs could consistently earn 30-130% on borrowed capital, we’d all be hawking handmade goods on the street and selling fish out of the back our cars, and you can be damn sure that banks would be lending to us.  This is why the interest rate question is so important, because if you can’t earn above the cost of borrowing, the only options are then deeper indebtedness (i.e. more microlending) or bankruptcy.

But I am still a huge proponent of microfinance.

The way I see it, microfinance is the stepping stone between the bottom of the pyramid and the true engine of wealth building, savings.  Microfinance has introduced millions to formal financial services, and as MFIs struggling to become self-sufficient have turned to collecting deposits, they are introducing people to the real consumer benefits of banking, saving.

In the future, we will see that MFIs simply laid down the distribution channels, proving that the poor demanded financial services and that they could be reached affordably – that was the true innovation. And as mobile technology and other innovations bring down the cost of banking to the poor, the logical conclusion of the story, like it or not, will be the transformation or consolidation of MFIs into the traditional banks.  MFIs may survive as full-time distributors, selling loans and receivables between banks and borrowers, but the net effect will be the same, JP Morgan and co. trolling around the bottom of the pyramid.

The reason this scares people is that they think banks will profiteer off of the poor.  But one should remember that banks are heavily regulated with respect to the interest rates they can charge; the same cannot be said for all MFIs, especially non-profit ones.  If there is any reason that banks and MFIs can get away with charging exhorbitant interest rates, it is because the local usury laws permit it.

This is not a question of greed and profit margins.  It is a question of democracy, the will of the people and the rule of law.  It is about what interest rates we as a society are willing to accept.

At the end of the day, if we get the laws right, we will have expanded access to financial services to all corners of the globe, with regulated lending and the opportunity to save open to all.

And isn’t that what we truly want?  Because think about it: if the end of this story is not about savings, are we not just creating another generation of debt-addicted citizens?  Are we not just blowing up another lending bubble?

[The caveat of all this, of course, is financial literacy and how  well we educate ourselves on the responsible use of financial services.  This is not limited to the poor.  It should be a mandated part of high school curriculum for all]

Posted on April 14th 2010 in ideas, news

Non-profit Millionaires

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Did you hear that the CEO of the Boys and Girls Clubs of America made $1 million dollars in 2008?

A group of Republican senators, led by the Senate Finance Committee’s ranking member Sen. Chuck Grassley, R-Iowa, sent a letter…criticizing the non-profit organization’s use of tens of millions of dollars in federal funds that it receives every year.

[...] the letter specifically cited [CEO Roxanne] Spillett…for raking in $988,591 in total compensation in 2008, according to IRS filings.

That’s right.  A million dollars.  It seems pretty astounding that an organization dedicated to public service and opposed to distributing profits can get away with paying someone a million dollars, especially one that boasts on its website that its “efficient use of resources has won national recognition.”

I have to admit, I am empathetic to the idea of paying competitive salaries to non-profit executives.  The work is as hard, if not harder, than that of any other sector and you are forced to deal with its ambiguity of success.  With evidence-based funders and impact/efficiency critics (myself occasionally included)  questioning the difficult-to-measure outcomes of your efforts, it can seem pretty thankless.  Anyone not particularly keen on having their good intentions judged, or carrying any significant education debt, will undoubtedly consider if their efforts might be better compensated in the private sector.

And one should at least consider the scale of this organization.  BGCA operates over 4,000 clubs nationwide, with over 50,000 employees, and serves over 4 million kids each year.  Spillet is essentially paid $0.25 per kid – not a bad price to pay if she is able to successfully fulfill her mission: “To enable all young people, especially those who need us most, to reach their full potential as productive, caring, responsible citizens”

But a million dollars?

For argument’s sake, lets dig a little closer into the numbers:

[...] of Spillett’s total compensation, $360,774 was her base salary, which the organization said had not changed since 2006. She also received an “incentive based on performance” of $150,000 as well as benefits, expenses and contributions to deferred retirement plans totaling $477,817.

The numbers still seem shocking, but perhaps there is potential in “incentive based on performance.”  If folks in the non-profit world want to justify this kind of compensation, it seems to me the best way is to tie it to impact.
Its essentially what the private sector does when it buries the bulk of executive compensation in stock options.  Pay for outcomes, not just leadership.

The key is transparency.  Unfortunately, we have no idea what Spillet’s incentive was based on, but I’d guess that if people knew that her compensation came as a result of increasing the rate at which teenagers graduate high school and earn college degrees, they may not be as appalled by the prospect of paying her a quarter per kid to do it.


p.s. Not to be a hater, but BCGA and others could at least take 1/1000th of these salaries and build decent websites?  No one is gonna want to miss out on the impending iPad fundraising bonanza.

Posted on April 9th 2010 in news

Google’s authoritarianism and China’s democracy

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[Image Source: FakeSteve]

We’re often told to take Google’s “Don’t be evil” slogan with a grain of salt.  It’s a corporation, after all, with a fiduciary responsibility to its shareholders and thus allegedly constrained in its effort to promote non-evil causes.

So how do we explain Google’s decision to leave China?  Some thoughts are rounded up:

Sarah Lacy at TechCrunch speculated they are trying to save face after failing to capture share:

Does anyone really think Google would be doing this if it had top market share in the country? [...] Google has clearly decided doing business in China isn’t worth it, and are turning what would be a negative into a marketing positive for its business in the rest of the world.

Parsa Sobhani, joining voices on WashPo, say it is just pure strategy:

While much of the media point to the ['do no evil'] slogan as the basis of the power play, one can see that the self-censorship policy simply doesn’t align with [Google's] business vision…to make information universally accessible and useful.

Danny Sullivan scoffed at the hypocrisy:

But bottom line, it was still a business move, to me. If Google just wanted to help people in China get good information, it could have spent the past four years helping to construct ways for people in China to bypass their government’s firewall. Or the past four years arguing that the US government and US-based businesses should follow its lead in staying out of China.

And Matthew Forney and Arthur Kroeber, opining at the Wall Street Journal, say its all about trust:

The reason is simple: Google’s business model requires that its consumers trust that their information will be absolutely secure. So when Google says it will “do no evil” and will never compromise on its principles or its technologies, the world must believe it.

Whatever your take, the irony of the whole thing is that Google would not be able to promote democracy in China were it not for its own fundamentally authoritarian governance structure.

When the company went public in 2004 they created a dual-class voting structure that basically gave Larry Page and Sergey Brin unbridled power and authority – outside shareholders cannot override their decisions.  Amalie Tuffin explained at the time:

Google and its selling shareholders are selling Class B common stock, having 1 vote per share in the offering; Google’s founders, its CEO Eric Schmidt, and certain others will retain Class A common stock, having 10 votes per share, after the offering. In the initial offering, only about 10% to 15% of Google’s shares will be sold to the public and thus Google’s current owners would initially retain control in any event. However, this dual-class stock structure will allow Google’s insiders to retain effective control over Google long after a majority of the company is owned by the public.

Consider the implications.  Could any other company operating under the traditional rules of delivering returns to shareholders afford to walk away from the 1.3 billion-person behemoth that is China?

Google’s IPO precedent may be replicated by Facebook and others.  And as social networking companies become increasingly important to democratic movements, we may yet see more of this sort of corporate activism in the future.

What are your thoughts?  Purely strategic?  Just business?  Hypocritical? Is Google’s stock structure fair to shareholders?  Or is it a chance to break free of corporate constraints on social responsibility?

Meanwhile others have been inspired – Dell is moving factories out of China and GoDaddy stopped registering websites on the mainland.

To keep a pulse on the availability of Google services in mainland China, click here.

Posted on April 6th 2010 in news
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