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The S&P downgrade of Greece and Portugal’s debt ratings whacked U.S. equities yesterday.

Lowry’s notes that the major market averages experienced their worst decline since Feb. 4th, with yesterday qualifying as a 90% Downside Day on the NYSE (94.5% of total Up/Down Volume).

The decline brought both indices to a test near term support.

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SPX DrawDowns Since Prior High

Chart courtesy of Bianco Research

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SPX Still in Up Channel

Chart courtesy of Fusion Analytics

Dr. Clifford S. Asness is founding principal of AQR Capital Management, a highly regarded, top performing quantitative hedge fund. Prior to forming AQR, Cliff was at Goldman, Sachs & Co. where he was Director of Quantitative Research for the Asset Management Division.

Cliff has authored articles on many financial topics including multiple publications in the Journal of Portfolio Management and the Financial Analysts Journal. He has received the best paper award from the Journal of Portfolio Management twice (2001, 2003). From the Financial Analysts Journal he has received the Graham and Dodd Award for the year’s best paper (2003), a Graham and Dodd Excellence Award (2000), the award for the best perspectives piece (2004), and the Graham & Dodd Readers’ Choice Award (2005), as well as the CFA Institute James R. Vertin Award, given to individuals who have produced a body of research notable for its relevance and enduring value to investment professionals.

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Keep the Casinos Open
by Clifford S. Asness, Ph.D.
Preliminary version Last updated: April 26, 2010

In the storm of politician and pundit pique over financial regulatory reform, brought to a crescendo by conveniently-timed SEC charges against Goldman Sachs¹, one refrain is repeated again and again in different forms. Paraphrasing a few:

• Wall Street is just a casino.

• Over-the-Counter derivatives like the Goldman Sachs’ CDOs are just “side bets” and should be banned, or at the very least we should regulate the bejesus out of them.

• These “bets” aren’t “real investments”.

• We should not let people “gamble” in this manner.

However ubiquitous, and now verging on the conventional wisdom, this is still just silly talk.

First, almost all derivatives are side bets. Even the exchange-traded, clearinghouse-blessed plain vanilla ones that the love-to-regulate crowd supports are still side bets. The simplest S&P 500 futures contract is a bet between the long investor and the short investor that is settled up without any stocks changing hands. Even contracts that, in theory, have physical delivery at their end almost never do, and even if they did are still a side bet between the long party and the short party. So, unless you’re planning to ban all derivatives, including these plain vanilla exchange-traded clearing-housed beauties, please don’t complain about side bets and casinos.^{2, 3}

OK, now why are these side bets good for the world? Well, first, I don’t think I need to prove that. To “ban” something (a word statists really love), you need to show it does a lot of harm to those that are not a party to the transaction. Otherwise, again, be quiet and let free people transact (including betting) with each other as they see fit. But, luckily, I don’t need to rely on just my fellow Americans’ love of liberty here. These side bets are indeed generally good for the world.^{4, 5}

This is all fairly standard economics so I won’t spend much time on it. Any time you have a transaction, including a side bet, which both sides enter into voluntarily, both sides must think they are being made better off. In the case where one side is a speculator and the other a hedger (or better, two offsetting hedgers) both can be made better off before and after the fact. The speculator, by making money, the hedger by reducing a risk he feared (e.g., if you buy fire insurance on your home you are not made worse off by your home not burning down). The tough case seems to be speculator-on-speculator side bets. In this case somebody will win and somebody will lose. First, I appeal again for the rights of free people to put their money where their opinions lie. Just because somebody will be wrong doesn’t reduce this right. But, second, this activity still makes society itself better off. If these “side bets” encourage more research, more time and energy, into figuring out whether the current price is too high or too low, they themselves can make prices more accurate.

Consider of course the case of John Paulson and the now infamous Goldman Abacus deal. Now imagine that instead of just John Paulson and only a few others, many people realized how ugly the real estate bubble was going to be, and realized it a few years earlier than when it was actually experienced. If they all tried to put on “side bets” that real estate would fall (and mortgages would default), they would have moved prices. They would have had to entice people to take the other side. The way this enticement works in a free market is by prices changing. In other words, if more people tried to do this earlier, real estate prices never would’ve gotten so high, and mortgage yields never so low. Put simply, a more vigorous, more liquid, more active market for “side bets” like John Paulson’s would likely have made the real estate / credit bubble a less, not more, dangerous event.

Consider the recommendations of Professor Robert Shiller, famed for predicting both the technology stock and real estate bubbles. Shiller has long advocated a futures market on economic news. These derivatives would give us the ability to bet on how strong GDP will be, how high or low unemployment comes out, whether inflation is climbing back, etc. Furthermore, every one of these is a “side bet”. He doesn’t advocate these side bets as he cruelly wants to feed people’s gambling obsessions, or wants to create a new vehicle on which Wall Street can charge commissions. He advocates for these contracts because he knows that legitimate hedgers and speculators, facing economic risk themselves and wanting to reduce it (hedgers), or holding economic opinions and wishing to profit from them if correct (speculators), will use the contracts to make their worlds, and the World, a better place. Risk would be reduced for those who wish it, and through the research of speculators we would gain valuable insight into where the economy is heading (I promise no forecast will be as good as the net of those betting their own money). The “side bets” Shiller advocates here are worthwhile, but no more so than “side bets” on the state of the real estate and mortgage world back in 2007. And they are all worthwhile for the same reasons.

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Okay, its time for a little fun.

Like the cartoon caption contests the New Yorker runs each month, we are going to have our own little contest.

Whoever comes up the funniest, cleverest most poignant punch line for this photo, wins a signed copy of Bailout Nation.

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Note: Modern Arthur‘s witty “Christ, What an Asshole!” answer to every New Yorker Magazine Caption Contest is disqualified . . .

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I have no choice but to post this:

There is talk that the package for Greece will total 120b euros over 3 years which would be much bigger than initially said a few weeks ago. With Germany struggling just to come to an agreement for giving its 8-9b euro portion of the 30b in total the EC said they will commit, its likely that the IMF will dramatically step up with their funding commitment. European bonds, particularly Greece, are rallying off their lows as, if true, the loans would keep debt restructuring talk at bay, for now.

There is a very interesting Bloomberg article on SIGTARP — the entity charged with putting some oversight on the TARP funds.

Almost as an aside, the article notes that “The secrecy that enveloped the [AIG] deal was unwarranted” and “could result in criminal or civil charges.”

The rest of the article focuses on SIGTARP and  its chairman, Neil Barofsky.

As an example, it discusses how Treasury, in response to demands for those same notorious AIG emails, tried to play a little poker with the new agency. Geithner’s Treasury asked the Justice Department “for a ruling on whether Barofsky and SIGTARP reported to Secretary Geithner.” Barofsky called Turbo Timmy’s bluff — and told the Treasury Secretary he reported only to the President, and not to the head of the department he was investigating. (Treasury then withdrew its request).

That gives you a sense of how SIGTARP operates.

Since Congress authorized the $700 billion in TARP funding in October 2008, the Treasury has committed $489.8 billion, and disbursed $380.3 billion as of the end of Q1 2010. So far, institutions have repaid $180.8 billion.

Excerpt:

“SIGTARP has more than 40 agents, including former Secret Service, Federal Bureau of Investigation and Internal Revenue Service investigators, who sport blue windbreakers emblazoned with the SIGTARP seal.

In its late-January report, SIGTARP said that the banks rescued by TARP remained “too big to fail.” They still have an incentive to make risky wagers in order to generate the profits that will reward their executives, the report says.”

The full piece is worth a read . . .

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Source:
Barofsky Says Criminal Charges Possible in Alleged AIG Coverup
Richard Teitelbaum
Bloomberg, April 28 2010
http://www.bloomberg.com/apps/news?pid=20601109&sid=aVHMZwNcj2B0&

1. Wildly bullish sentiment readings. The latest Investors Intelligence survey is now up to 53.3% for the bulls (versus 51.1% the prior reporting week) while the bear camp has dwindled further, to 17.4% (versus 18.9% a week ago). Bullish sentiment rose for the third consecutive week and bearish sentiment has not been this low since January 12. As Bob Farrell’s Rule number 9 stipulates, when all the forecasts and experts agree, something else is bound to happen.

2. Uncertainty over the coming U.S. midterm elections in November.

3. A more hawkish Fed (futures pricing in 40% odds of a rate hike by the November meeting).

4. Tougher profit comparisons in coming quarters.

5. The fading of the fiscal and monetary stimulus. The tax credits expire on Friday, the Fed has already stopped buying mortgage bonds and the pace of new trial modifications under the Treasury’s Home Affordable Modification Program has begun to slow.

6. Fresh uncertainty surrounding banking industry regulation. Goldman is likely the thin edge of the wedge. A proposal is gaining ground on Capitol Hill to force banks to spin off their derivatives-trading operations, which would represent a severe blow to one of Wall Street’s most profitable businesses.

7. Higher tax rates to pay for the massive $1.4 trillion federal budget deficit. The Bush cuts that lowered taxes on high-wage earners and capital gains and dividends are set to expire at the end of 2010. The top marginal tax rate will jump to 39.6% from 35.0%, and the current 15% rate on capital gains and dividends will go back to 20.0% and 39.6%, respectively,

8. Huge overhang of unsold houses. As of March, banks and investment trusts had an inventory of about 1.1 million foreclosed homes, up 20% from a year earlier, according to estimates from LPS Applied Analytics. Another 4.8 million mortgage holders were at least 60 days behind on their payments or in the foreclosure process, meaning their homes were well on their way to the inventory pile. That “shadow inventory” was up 30% from a year earlier.

9. Sovereign debt problems in Greece and spillover to Portugal and possibly Spain.

10. Ongoing commercial real estate, which have resulted in 55 bank failures this year.

11. Underfunded state pension plans.

12. A property bubble in China — the government is now considering introducing new or higher taxes on real estate, possibly a property tax, in order to cool down a booming property market now widely being described as a bubble (prices up well over 10% from a year ago).

Most European bond markets remain under pressure again. Whatever happens with Greece now, the cost of capital is going up for most of the Euro region and that has implications for companies and consumers that borrow in these markets. Death, taxes and easy money, the only certainties in life. Actually the last one is not always the case but REAL interest rates have been negative for 5 of the last 8 years and the FOMC will tell us today that they will remain that way for an ‘extended period.’ They will tell us that inflation is benign, even as the Journal of Commerce index is up 9% from the last meeting at the highest level since Aug ’08 and just 7% from a record high. There will be some coffee talk on selling their large pile of MBS at some point. Unwinding the largest monetary easing in the history of the world will not be easy and the longer the Fed waits, the more rough it will be due to the misallocation of capital they have created, again.

Here is a commercial I want to see someone create, that I’d like to see go viral:

The screen is dark. There is a soft heartbeat in the background

White letters appear on the screen: 1998 Glass Steagall Repeal

Voiceover: In 1998, the Glass Steagall act was repealed by Congress. Since 1932, it successfully kept banks separated from Wall Street (pause) . . . After its repeal?

(Citigroup, Countrywide, and Washington Mutual logos on screen. They shatter and collapse).

Voiceover: Major banks collapsed, causing the worse recession in generations and costing taxpayers billions.
(Heartbeat gets a little louder and quicker).

White letters   Commodity Future Modernization Act of 2000

Voiceover: In 2000, Congress passed the Commodity Future Modernization Act. It made one group of financial instruments — Derivatives — completely free from all regulation (pause) . . . The result?

(AIG logo appears, explodes)

Voiceover: The AIG collapse cost taxpayers $185 billion in bailouts.
(Heartbeat is now louder and faster).

Letters: 2004 SEC permits Wall Street to dramatically increase its leverage

Voiceover: In 2004, the 5 biggest investment houses in the country got permission to lever up (pause) . . . The result?

(Logos appear; Bear Stearns, Lehman blow up; Merrill Lynch turns gray and keels over; Goldman Sachs, Morgan Stanley spiderweb crack — but don’t fall)

Voiceover:  Lehman & Bear — gone. Taxpayers spent billions helping Bank America rescue Merrill Lynch. Goldman and Morgan became bank holding companies.
(Heartbeat is very rapid and loud).

More white letters: 2010 Financial Reform legislation . . . is . . . blocked

(heartbeat stops . . .  screen fades to white light)

Voiceover:  Partisan fighting in Congress is blocking financial reform  . . . but YOU can help move it forward. (heartbeat starts again) Tell your congressman and senator to stop listening to Wall St lobbyists, and pass financial reform NOW.

Because the last thing any of us wants is another financial heart attack.

Lettering:  Please pass financial reform . . . or else.

(heartbeat stops, letter replaced with flatlined EKG)

Lettering:  Call your congressman today  (phone number)

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Logos after the jump

If any of you graphic wizards wants to create it, I have commitments to get it on television . . .

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