Clearinghouse for Derivatives = Good

The reason why the big boys don't want a clearinghouse is because they are able to profit on information asymmetry. A good portion of profits on derivatives is made off of buying CDS, taking a cut, and then selling the CDS to someone else with a lower "premium" payout. So I sell a CDS to Bank A and receive $40,000 per year for every $10M insured. If I can purchase a CDS on the same company for under $40,000, I've just made money risk free. No not really risk free in reality, but it is to these guys. A clearinghouse would stop these transactions because everyone would know that the market price is $40,000.

The reason why there are so many CDS outstanding is because everyone plays the, pass it along and take a cut, game. I can purchase a CDS for $50,000 a year, then I write out a CDS for $60,000 a year, giving me a $10,000 a year profit that is hedged away for risk. My buyer can take my $60,000 CDS and sell his own for $65,000 a year, and get $5,000 in "risk-free" profits per year. And on and on this goes until you get a guy who wants to hold on to the CDS because he actually has the bonds to insure, or you find the biggest sucker who can't sell for a higher markup and is stuck with the CDS.

These type of profits provide no value and are born of inefficiencies that can be eliminated by way of a clearinghouse or exchange that posts the prices of the last trade

Financial Regulation and Credit Default Swaps

CDS isn't involved in just insurance, it's used in CDOs to make synthetic bonds. If I write a CDS on GM bonds, I get paid the "premium" as long as GM doesn't default. If they do default, I must pay the contract amount and I receive the defaulted bonds in return (or I receive the liquidation value of the defaulted bonds back). I also have to put up collateral that pays the risk-free Treasury yield. Add it all together and you have something very much like a GM bond where I would receive interest payments as long as GM doesn't default and if they do, I lose my initial purchase (contract amount) minus whatever I can receive for the defaulted bonds (liquidation value).

The theory is to separate risk from investment. What if I just want to take on the risk of GM bonds without having to actually lend GM money, thus tying up my precious capital? With a traditional bond, I need to loan GM X money for a period of years and I will get X money back at the end assuming there is no default. What if I don't want to tie up that capital but still want to take on that risk? Well let someone else lend GM the money, I'll write a CDS on it and sell it to them. There, they just transferred the risk to me and I didn't have to lend GM any money (though I still have to put up collateral usually). Now that the other guy has a risk-free asset, he can then purchase more bonds up to the risk limit set by the risk management team. That's how it's supposed to work in theory. Of course, in reality his insured GM bond isn't risk free, if I go under, his insurance is worthless.

I think the problem lies with leverage and leverage ratios. CDS can help firms manage their risk without making big capital intensive moves. Selling GM bonds from your portfolio means that you have to find a buyer with the money, and then you're left with the problem of what to do with the money you just got. Where to put it? Why not just buy a CDS contract instead? That way, you get rid of the risk and don't have the problem of what to do with the excess cash.

When risk is being pawned off in an endless cycle, it can become hard to tell exactly how much systemic risk is left. I think I have sold my risk thanks to my CDS purchase, but so does the guy who sold me the CDS because he purchased another CDS to get rid of his risk. Risk keeps on getting transferred, we know that the total risk to the market as a whole cannot be eliminated or reduced merely by transferring, but each person thinks he's OK because he's sold his risk to some other guy who has sold his risk and on and on. It's hard to tell if the guy I purchased CDS from has too much CDS exposure (too overleveraged) because I don't know how many CDS he's sold or purchased since the time I originally purchased CDS from him.

Some limit has to be set for the amount of CDS exposure a firm has given his capital base. That amounts to a limit on leverage. A clearinghouse would make the market more transparent so I can see that there is way too many CDS out there for the CDS I just purchased to be considered safe. Right now there is no way for the individual actor to see the entire whole and the entire whole has a great impact on the individual actor. That is part of the problem. We need to think about the issues and come up with good solutions, I don't think banning CDS is even remotely close to the best solution.

Ratings Agencies: The Monsters Congress Created

It should also be noted that ratings are only important for regulatory reasons. Congress created the game, made these private agencies which are just companies issuing opinions on others, into God-like emperors who pronounce if some debt is worthy of inclusion in a pension fund or not.

Even more important is how AAA securities are treated under Basel and Basel II for capital requirements. AAA securities count 100% towards capital requirements while non-AAA securities start off at 50%. Again, Congress created their own boogeyman through bad regulations. It's important to get regulations right or else very unintended consequences can occur.

People should understand that no large investment or financial management company depends upon ratings to determine risk. Everyone from Fidelity to Paulson with his hedge fund has their own analysts and do their own research. No one except for maybe mom and pop (they probably aren't buying CDOs) use S&P, Moodys, or any agency to determine the risk level of default.

Then why are the agencies important? Because Congress made them so. They're part of the regulatory process thanks solely to Congress. And Congress has frozen out all other competitors, even those who have better track records, only a certain select few ratings agencies can issue ratings that "count" towards regulatory requirements.

Thanks to regulations, it was just too tempting for certain greedy institutions to hold AAA securities that count 100% towards capital requirements and pay a good yield over AAA US Treasuries. The very fact that CDO AAA always yielded more than AAA corporate bonds which in turn always yielded more than AAA US Treasuries shows that the market was aware that not all AAA were created equal. But since regulations treated them equally, we have a little discrepancy that ended up fueling (along with a bunch of other factors) the crisis. Now can people understand why regulations have to be very carefully crafted and the urge to just pass any regulation is probably very stupid?

Government Failure: Another Example

Regulations will not work if the regulators refuse to do their jobs. With regards to the massive $8 billion dollar Robert Allen Stanford fraud, the SEC did just that. An internal report released on the same day the Goldman case was filed (of course), revealed that the SEC knew of the fraud as far back as 1997.

The OIG investigation found that the SEC’s Fort Worth office was aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme, having come to that conclusion a mere two years after Stanford Group Company (“SGC”), Stanford’s investment adviser, registered with the SEC in 1995. We found that over the next 8 years, the SEC’s Fort Worth Examination group conducted four examinations of Stanford’s operations, finding in each examination that the CDs could not have been “legitimate,” and that it was “highly unlikely” that the returns Stanford claimed to generate could have been achieved with the purported conservative investment approach. Fort Worth examiners dutifully conducted examinations of Stanford in 1997, 1998, 2002 and 2004, concluding in each case that Stanford’s CDs were likely a Ponzi scheme or a similar fraudulent scheme. The only significant difference in the Examination group’s findings over the years was that the potential fraud grew exponentially, from $250 million to $1.5 billion.

While the Fort Worth Examination group made multiple efforts after each examination to convince the Fort Worth Enforcement program (“Enforcement”) to open and conduct an investigation of Stanford, no meaningful effort was made by Enforcement to investigate the potential fraud or to bring an action to attempt to stop it until late 2005. In 1998, Enforcement opened a brief inquiry, but then closed it after only 3 months, when Stanford failed to produce documents evidencing the fraud in response to a voluntary document request from the SEC. In 2002, no investigation was opened even after the examiners specifically identified multiple violations of securities laws by Stanford in an examination report. In 2003, after receiving three separate complaint letters about Stanford’s operations, Enforcement decided not to open an investigation or even an inquiry, and did not follow up to obtain more information about the complaints.

It is any wonder why I am so cynical over government control and fixes for our economy?

More Thoughts on SEC vs. Goldman Sachs

Didn't ACA, IKB, and everyone else have the same information on the RMBS in the CDO as Paulson did? That the great Paulson wanted to bet against this CDO was of supreme importance, why? Because he's an omniscient god?

Goldman acted as a broker/middle-man. It's not their responsibility to advise against trades that they don't think will work out well. Imagine if you entered a market buy order for Goldman stock on Monday and it was canceled because your broker thought that would be a stupid move. I'd be furious.

My take is that Paulson thought the subprime real estate market was going to hell and he needed a way to make a bet. So he asked Goldman to find a manager, ACA, that would structure something he could bet against. Paulson could have been wrong, he had no special information on the RMBS he picked along with ACA correct? He was just smarter and better than everyone else who had the same information. The information included credit scores, loan-to-value, etc., Paulson's opinion of the mortgages and of the real estate market isn't relevant. Is he God?

People are looking at this in retrospect with perfect hindsight. I ask you all to come up with a list of 10 stocks that you want included in some sort of "sure to lose money" index. The point is that Paulson had nothing to do with the low yields the buyers were willing to take or the low payments the CDS issuer was willing to accept for writing insurance. The more I understand the situation, the more I think this is totally BS!

SEC vs. Goldman II

I was wrong and Goldman only acted as a middleman/broker in the transactions, they did not directly issue CDS and did not have positions in any of the transactions.

As I read more and more, it seems the SEC is really going to have a hard time proving anything. All Goldman did was find participants, they acted as a market-finder and had no skin in the game. Were they supposed to issue updates on what one of their customers, Paulson, was doing? Or basically say to the CDS issuer, "Hey, don't you know the great Paulson is on the other side of the trade? He's never wrong, and you're going to get taken!".


I think I understand the situation almost completely now. Paulson saw the crisis coming and wanted to bet against housing. But how? There isn't a subprime mortgage index or anything like that so he first had to create a reference index that he could bet against. That was the CDO made up of subprime loans rated Baa2 that he expected would be in trouble. So he asked Goldman to find someone who could act as an asset manager and structure such a CDO so that he could bet against it. Goldman did in ACA. ACA had all the information Paulson did on credit scores and so forth, and subsequent investors would also. After the CDO was structured, Paulson bought CDS on it and he turned out to be correct. Those issuing the CDS had the relevant information, that Paulson wanted to bet against this CDO all along wasn't relevant. It's like if I bought Goldman Sachs tomorrow and I didn't know George Soros was selling me his shares. So what? I'm buying because I see that the SEC has no case, who cares if Soros is selling?

If there is a culprit here, it is Paulson, not Goldman who only acted as broker. Still it is a stretch, Paulson didn't have any information that wasn't available to everyone else. He was just smarter and better.

Analysis of SEC's Case Against Goldman Sachs

Those who want to read the actual complaint made by the SEC should go here. After reading the complaint, the SEC's case can be split into two parts.

PART 1

Goldman mislead ACA, the third party picked to head selection of securities, that Paulson, a person also involved in the selection of securities to be included, would have skin in the game of the final CDO.

On January 10, 2007, Tourre sent an email to ACA with the subject line, “Transaction Summary.” The text of Tourre’s email began, “we wanted to summarize ACA’s proposed role as ‘Portfolio Selection Agent’ for the transaction that would be sponsored by Paulson (the ‘Transaction Sponsor’).” The email continued in relevant part, “[s]tarting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility aroundthe names.”

then

47.
On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction

Considering that what Goldman described was a CONTEMPLATED capital structure, I think this alleged deception will be very hard for the SEC to prove. It's up to ACA to do due diligence as they were hired to do just that, act as a neutral third party analyst for the selection of securities to be included in the CDO.



Later on, ACA's parent company would write insurance on the CDO. The SEC claims that ACA wouldn't have done so if they knew that Paulson had gone short (bet against the CDO since he helped pick the underlying securities. However I think that's a very weak argument as ACA also helped pick and had ultimate say in that they could have refused to put their name on a CDO they didn't like.

61.
ACA’s parent company, ACA Capital Holdings, Inc. (“ACA Capital”), provided financial guaranty insurance on a variety of structured finance products including RMBS CDOs, through its wholly-owned subsidiary, ACA Financial Guaranty Corporation. On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.
62.
ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1.
63.
The super senior transaction with ACA Capital was intermediated by ABN AMRO Bank N.V. (“ABN”), which was one of the largest banks in Europe during the relevant period. This meant that, through a series of CDS between ABN and Goldman and between ABN and ACA that netted ABN premium payments of approximately 17 basis points per year, ABN assumed the credit risk associated with the super senior portion of ABACUS 2007AC1’s capital structure in the event ACA Capital was unable to pay.

Part 2

Goldman did not disclose to investors that the selection process involved Paulson who had a short position against some of the underlying securities or similar securities.

41.
On or about April 26, 2007, GS&Co finalized a 178-page offering memorandum for ABACUS 2007-AC1. The cover page of the offering memorandum included a description of ACA as “Portfolio Selection Agent.” The Transaction Overview, Summary and Portfolio Selection Agent sections of the memorandum all represented that the reference portfolio of RMBS had been selected by ACA. This document contained no mention of Paulson, its economic interests in the transaction, or its role in selecting the reference portfolio.

I think this is the only place where the SEC might have a case. But did Goldman have to disclose Paulson's role? After all, Paulson is just another client of the firm and so does it have to keep track of what each and every client is doing? What if Paulson had entered into short positions with another firm instead of Goldman, clearly then Goldman would not have known (but he didn't). It was known that the underlying securities would be based on subprime mortgages rated Baa2, does Goldman have to reveal that Paulson, who played a part in the selection of the particular mortgages, had a negative view of the mortgage market and bet against those securities?

In the end, a stupid German commercial bank, IKB, decided to purchase $150 million of the CDO in two tranches. They lost just about all of the $150 million while Paulson, who had purchased credit default swaps on the underlying securities, profited. The CDS was purchased through Goldman, which means that Goldman "lost" money as they had to pay out on the CDS. That will add complications to the SEC case, but the SEC claims that the money IKB lost went to Paulson which isn't directly true. IKB lost money through purchasing a CDO offered by Goldman. Paulson made a bet on securities that the CDO was based upon or similar securities and collected his insurance money from Goldman. Goldman "won" with IKB and "lost" with Paulson, it doesn't follow that IKB's money went to Paulson. We'll have to see what happens, but this is by no means an open and shut case.

SEC Has Weak Case Against Goldman

Today, the SEC filed civil charges against Goldman, a short summary from the NY Times reads,

Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.

After reading more details of this transaction, I'm not sure if the SEC has a case or not. ACA knew that Paulson was involved with picking the securities, they exchanged e-mails with him and both negotiated over which securities would be included in the CDO.

On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically. Of the 123 names that were originally submitted to us for review, we have included only 55.”

It seems the whole SEC case hinges on the fact that Goldman did not disclose Paulson had purchased Credit Default Swaps (CDS) on some of the underlying securities from Goldman, and was involved with ACA in the initial selection process. However someone else on Felix Salmon's blog raised a really good issue,

“After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure.”

In other words Paulson bought insurance for the underlying portfolio from Goldman.

If the underlying portfolio fails–or if it were to fail–Goldman will have to post collateral.

If Goldman knew that these are bad securities (implying that at some point it has to post collateral to Paulson & Co.) then why would GS structure them in a way that Paulson wants?

Even if for some strange reason GS did structure it the way Paulson wanted and got a fee in return, how can GS be held culpable, given the fact it is long on the underlying insurance?"

This will be a very hard case and is not a clear case of wrongdoing. Goldman was not an underwriter, they were just the broker in the deal. There's no guarantee that anything a broker sells has to be a "good" security in the eyes of the broker or the seller. It's like a yard sale, the buyer knows that the stuff there is junk in the eyes of the seller, but one man's junk is another's treasure. In the financial world, no one is omniscient, Paulson turned out to be right, but ACA had the opportunity to review the proposed list of securities, made revisions, and agreed to the final list. They could have rejected any of the securities on the list, and in fact did reject 21 out of the initial list as well as pick the replacement securities. It was a negotiation and ACA is a big boy who should have done better analysis (actually it's really the willingness of subsequent investors to accept risk for such a low yield). The fact that these were to be based on subprime mortgages at the Baa2 credit level underscores that this wasn't going to be as safe as a government bond.

This occurred on February 2, 2007: “Later the same day, ACA emailed Paulson, Tourre, and others at GS&Co a list of 82 RMBS on which Paulson and ACA concurred, plus a list of 21 “replacement” RMBS. ACA sought Paulson’s approval of the revised list, asking, “Let me know if these work for you at the Baa2 level.”

The only fault I can see is that Goldman didn't correct ACA's false assumptions that Paulson was long in the fund.

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction…

On February 12, 2007, ACA’s Commitments Committee approved the firm’s participation in ABACUS as portfolio selection agent. The written approval memorandum described Paulson’s role as follows: “the hedge fund equity investor wanted to invest in the 0- 9% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities.”

All the instant analysis on the mainstream news sites don't do justice to the complexity of the issue. It's a good thing there are blogs out there that will provide real analysis from people who understand the business, but that's bad for the SEC as the deeper you look into the case, the worse it appears for the SEC.

Google's Internet Monopoly

A recent op-ed raises concerns over Google's near monopoly position, read on for my response.

http://www.nytimes.com/2009/12/28/opinion/28raff.html?_r=1

AS we become increasingly dependent on the Internet, we need to be increasingly concerned about how it is regulated. The Federal Communications Commission has proposed “network neutrality” rules, which would prohibit Internet service providers from discriminating against or charging premiums for certain services or applications on the Web. The commission is correct that ensuring equal access to the infrastructure of the Internet is vital, but it errs in directing its regulations only at service providers like AT&T and Comcast.

Today, search engines like Google, Yahoo and Microsoft’s new Bing have become the Internet’s gatekeepers, and the crucial role they play in directing users to Web sites means they are now as essential a component of its infrastructure as the physical network itself. The F.C.C. needs to look beyond network neutrality and include “search neutrality”: the principle that search engines should have no editorial policies other than that their results be comprehensive, impartial and based solely on relevance.

The need for search neutrality is particularly pressing because so much market power lies in the hands of one company: Google. With 71 percent of the United States search market (and 90 percent in Britain), Google’s dominance of both search and search advertising gives it overwhelming control. Google’s revenues exceeded $21 billion last year, but this pales next to the hundreds of billions of dollars of other companies’ revenues that Google controls indirectly through its search results and sponsored links.

One way that Google exploits this control is by imposing covert “penalties” that can strike legitimate and useful Web sites, removing them entirely from its search results or placing them so far down the rankings that they will in all likelihood never be found. For three years, my company’s vertical search and price-comparison site, Foundem, was effectively “disappeared” from the Internet in this way.

Another way that Google exploits its control is through preferential placement. With the introduction in 2007 of what it calls “universal search,” Google began promoting its own services at or near the top of its search results, bypassing the algorithms it uses to rank the services of others. Google now favors its own price-comparison results for product queries, its own map results for geographic queries, its own news results for topical queries, and its own YouTube results for video queries. And Google’s stated plans for universal search make it clear that this is only the beginning.

Because of its domination of the global search market and ability to penalize competitors while placing its own services at the top of its search results, Google has a virtually unassailable competitive advantage. And Google can deploy this advantage well beyond the confines of search to any service it chooses. Wherever it does so, incumbents are toppled, new entrants are suppressed and innovation is imperiled.

Google’s treatment of Foundem stifled our growth and constrained the development of our innovative search technology. The preferential placement of Google Maps helped it unseat MapQuest from its position as America’s leading online mapping service virtually overnight. The share price of TomTom, a maker of navigation systems, has fallen by some 40 percent in the weeks since the announcement of Google’s free turn-by-turn satellite navigation service. And RightMove, Britain’s leading real-estate portal, lost 10 percent of its market value this month on the mere rumor that Google planned a real-estate search service here.

Without search neutrality rules to constrain Google’s competitive advantage, we may be heading toward a bleakly uniform world of Google Everything — Google Travel, Google Finance, Google Insurance, Google Real Estate, Google Telecoms and, of course, Google Books. (more)

The reason Google has a near monopoly is because it offers relevant searches and useful services. Other search engines that started to place paid sites at the top of their queries quickly lost market share and are now all but dead. Google has always made it clear what is a paid placement and what isn't. There's a line that everyone can see separating the two and it works well. Their algorithm works well, that's the #1 reason they enjoy such a dominant position. Recently Microsoft's Bing has come up with a search that works either just as well, or nearly as well, but it's interesting that they've not been able to come up with a search that clearly works better than Google. Even so, Bing is gaining market share, though mostly at the expense of other search engines.

Google maps is far superior to Mapquest. Google maps will lead you to Google Street View, which is a great way to look around the neighborhood without having to drive there. I can only imagine the amount of money and resources it cost to photograph every single street and address from several different views and make it accessible.

In short, Google has a near monopoly because it's good, it's better than the competition, and because there are low barriers to entry, it has to keep on being good or else some other startup will take over. Only a few years ago, people were concerned that AOL and Yahoo would consolidate their monopoly positions as search/gateways to the internet. These concerns have proven to be ill-founded. If anything, AOL and Yahoo are fighting for their lives, fighting to keep relevant in a fast moving and very competitive online marketplace. I believe Yahoo finance is still the #1 finance site on the internet because it's the best. Google finance is not quite as good even though it has certain features Yahoo doesn't.

The internet is the last place government needs to worry about monopoly power and unfair competition. Government should be focusing on Ticketmaster and its monopoly of ticketing, this is an obvious monopoly that tries to inhibit competitors and offers very little yet charges outrageous fees that can be easily 50% of the ticket price. Just try and buy a bleacher ticket to a Dodger's game. $8 for the ticket, but add to that convenience fees of $3 and then mailing fees and service chargers of $2.50 and an additional $5.50 is added on a $8 ticket! How they can be allowed to merge with LiveNation is a mystery to me, where are the anti-trust regulators? Where is the Justice Department on this one? It's so obvious it's a joke.

Regulations can only work if the regulators do their jobs. That's why I'm so skeptical about new regulations and new government agencies that will supposedly cure all of our ills. If only they would start doing their jobs and uphold their current duties, I would be more willing to view regulation as a viable and even superior solution. Please do your jobs government bureaucrats! Perhaps we need a regulation that requires regulators to regulate.

New Scandal Over Global Warming Data

Uh oh, leaked e-mails from a prominent global warming research group, the Climatic Research Unit of the University of East Anglia in eastern England, reveal that data might have been falsified, cherry-picked, or made up. Other documents and e-mails reveal that the climate model the CRU uses to predict and make their case for future global warming is so riddled with errors and bad code that it is virtually worthless. The CRU's data and model were major contributors in the UN's Intergovernmental Panel on Climate Change's 2007 report. The UN's report is what the United States EPA relies on most heavily to argue that carbon dioxide emissions endanger public health and thus need to be regulated. It all looks like a house of cards that is about to fall. Here is the link to the CBS News article quoted below.

A few days after leaked e-mail messages appeared on the Internet, the U.S. Congress may probe whether prominent scientists who are advocates of global warming theories misrepresented the truth about climate change.

Sen. James Inhofe, an Oklahoma Republican, said on Monday the leaked correspondence suggested researchers "cooked the science to make this thing look as if the science was settled, when all the time of course we knew it was not," according to a transcript of a radio interview posted on his Web site. Aides for Rep. Darrell Issa, a California Republican, are also looking into the disclosure.

The leaked documents (see our previous coverage) come from the Climatic Research Unit of the University of East Anglia in eastern England. In global warming circles, the CRU wields outsize influence: it claims the world's largest temperature data set, and its work and mathematical models were incorporated into the United Nations Intergovernmental Panel on Climate Change's 2007 report. That report, in turn, is what the Environmental Protection Agency acknowledged it "relies on most heavily" when concluding that carbon dioxide emissions endanger public health and should be regulated.

Last week's leaked e-mails range from innocuous to embarrassing and, critics believe, scandalous. They show that some of the field's most prominent scientists were so wedded to theories of man-made global warming that they ridiculed dissenters who asked for copies of their data ("have to respond to more crap criticisms from the idiots"), cheered the deaths of skeptical journalists, and plotted how to keep researchers who reached different conclusions from publishing in peer-reviewed journals.

One e-mail message, apparently from CRU director Phil Jones, references the U.K.'s Freedom of Information Act when asking another researcher to delete correspondence that might be disclosed in response to public records law: "Can you delete any emails you may have had with Keith re AR4? Keith will do likewise." Another, also apparently from Jones: global warming skeptics "have been after the CRU station data for years. If they ever hear there is a Freedom of Information Act now in the UK, I think I'll delete the file rather than send to anyone." (Jones was a contributing author to the chapter of the U.N.'s IPCC report titled "Detection of Climate Change and Attribution of Causes.")

In addition to e-mail messages, the roughly 3,600 leaked documents posted on sites including Wikileaks.org and EastAngliaEmails.com include computer code and a description of how an unfortunate programmer named "Harry" -- possibly the CRU's Ian "Harry" Harris -- was tasked with resuscitating and updating a key temperature database that proved to be problematic. Some excerpts from what appear to be his notes, emphasis added:

I am seriously worried that our flagship gridded data product is produced by Delaunay triangulation - apparently linear as well. As far as I can see, this renders the station counts totally meaningless. It also means that we cannot say exactly how the gridded data is arrived at from a statistical perspective - since we're using an off-the-shelf product that isn't documented sufficiently to say that. Why this wasn't coded up in Fortran I don't know - time pressures perhaps? Was too much effort expended on homogenisation, that there wasn't enough time to write a gridding procedure? Of course, it's too late for me to fix it too. Meh.

I am very sorry to report that the rest of the databases seem to be in nearly as poor a state as Australia was. There are hundreds if not thousands of pairs of dummy stations, one with no WMO and one with, usually overlapping and with the same station name and very similar coordinates. I know it could be old and new stations, but why such large overlaps if that's the case? Aarrggghhh! There truly is no end in sight... So, we can have a proper result, but only by including a load of garbage!

One thing that's unsettling is that many of the assigned WMo codes for Canadian stations do not return any hits with a web search. Usually the country's met office, or at least the Weather Underground, show up – but for these stations, nothing at all. Makes me wonder if these are long-discontinued, or were even invented somewhere other than Canada!

Knowing how long it takes to debug this suite - the experiment endeth here. The option (like all the anomdtb options) is totally undocumented so we'll never know what we lost. 22. Right, time to stop pussyfooting around the niceties of Tim's labyrinthine software suites - let's have a go at producing CRU TS 3.0! since failing to do that will be the definitive failure of the entire project.

Ulp! I am seriously close to giving up, again. The history of this is so complex that I can't get far enough into it before by head hurts and I have to stop. Each parameter has a tortuous history of manual and semi-automated interventions that I simply cannot just go back to early versions and run the update prog. I could be throwing away all kinds of corrections - to lat/lons, to WMOs (yes!), and more. So what the hell can I do about all these duplicate stations?...

As the leaked messages, and especially the HARRY_READ_ME.txt file, found their way around technical circles, two things happened: first, programmers unaffiliated with East Anglia started taking a close look at the quality of the CRU's code, and second, they began to feel sympathetic for anyone who had to spend three years (including working weekends) trying to make sense of code that appeared to be undocumented and buggy, while representing the core of CRU's climate model.

One programmer highlighted the error of relying on computer code that, if it generates an error message, continues as if nothing untoward ever occurred. Another debugged the code by pointing out why the output of a calculation that should always generate a positive number was incorrectly generating a negative one. A third concluded: "I feel for this guy. He's obviously spent years trying to get data from undocumented and completely messy sources."

Programmer-written comments inserted into CRU's Fortran code have drawn fire as well. The file briffa_sep98_d.pro says: "Apply a VERY ARTIFICAL correction for decline!!" and "APPLY ARTIFICIAL CORRECTION." Another, quantify_tsdcal.pro, says: "Low pass filtering at century and longer time scales never gets rid of the trend - so eventually I start to scale down the 120-yr low pass time series to mimic the effect of removing/adding longer time scales!"

More on cherry picking from this site.

And more evidence of fraud/cherry picking here.

Observations on Bubbles

Bubbles are only obvious after the fact. I thought there was a housing bubble, but I also thought we had a bond bubble too when 30-year Treasury bonds were near 5%. It could be that the bond bubble is still ongoing and will pop soon, or next year, or not at all. Gold is another case. I don't think there is a bubble in gold, the heightened attention paid to it reflects the unease people feel towards the ballooning balance sheets of central banks and the unsupportable budget deficits of certain nations. Yet there are others who think gold is pretty much worthless outside its value for industrial purposes. Is gold in a bubble right now? Too hard to say. Should gold drop to $450 then it becomes obvious and we can look back at the gold bubble and blast the idiots who couldn't see something so obvious. Stock market P/E has been higher than average and in bubble mode since the early 90's, yet even after this meltdown we're way higher.

What I think we need to focus on are the types of events or bubbles that can bring down the financial system. This has to do with leverage and allowable risks to our banks. The dot com bubble hurt, but wasn't as damaging as this crisis because banks didn't stand a chance of going under, they were not exposed enough to the bubble to cause a financial system meltdown. However banks are tied to real estate in a much great fashion, here is where a bubble can do great harm.

In the future, we have to make sure leveraged firms don't have their eggs in one basket and that not all firms that are leveraged are exposed to the same risks. Should all banks start lending out cheap money for margin accounts tied to gold, then the price of gold would have a great impact and could cause a crisis like this one. It's the banks and the leverage that is the problem. If we can eliminate the risk of many banks going under at the same time, then we've solved the problem, crises will no longer be as severe as this one.

Large banks should have higher capital requirements, and lower leverage allowances. Smaller banks will have looser requirements, but the regulator needs to see if they are all betting on the same thing and if that poses a danger to the entire system should the bet turn out badly.

Almost forgot, bubbles are almost always the result of easy credit. Bubbles can't form without credit, in every case I can think of, credit was the hidden accomplice, perhaps even the mastermind that causes bubbles. No credit, not enough "fuel" for a bubble to develop. I think we're seeing a lot more bubbles recently because the FED just will not allow credit to contract, they keep on trying to reinflate the bubble, even now there are calls for more loans and credit to be made available. I think the FED's monetary policy is severely flawed, the default rate in normal times is too low and they refuse to tighten until its too late due to pressure to allow good economic times to continue (the economy is always referred to as bad, no matter what, even when we had below 5% unemployment in order to create pressure for more rate cuts). The FED has to break the cycle or we'll have another bubble shortly, the aftermath of reflating the housing bubble.

Regulations Caused This Crisis

If there is one thing we should learn from this crisis it is the danger of bad regulations and the unseen danger of unintended consequences. The Basel II regulations put a lot of power in the hands of the ratings agencies. These agencies are the only ones allowed "in the game" by law, I'm talking about S&P, Moody's, etc. Go to the link below for the full list of ten.

A Nationally Recognized Statistical Rating Organization (or "NRSRO") is a credit rating agency which issues credit ratings that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes.

http://en.wikipedia.org/wiki/Nationally_Recognized_Statistical_Rating_Organizations

Thanks to the REGULATIONS we ALREADY HAD, financial institutions were eager to separate their subprime debt into AAA securities and left over toxic waste. Unfortunately, those AAA securities weren't as safe as the ratings agencies said they were and became toxic themselves.

Regulations made a protected cabal of agencies free from other competition. Regulations allowed these agencies to affect the capital requirements of large financial institutions. AAA securities count toward capital more than BBB securities under Basel II.

Regulations caused this financial mess, they set the stage and regulators who were supposed to watch over the system failed to do their jobs.

Let's not pretend there were no regulations. The regulations we had didn't work. Government plans and wise thinking failed and turned out to be very stupid instead of wise. This is just another example of government failure and why we should not put our faith in government. Anyone who looks at the facts and past history can see that the government's record is incredibly poor, the government is incredibly incompetent no matter what party is in power. And for those who believe in the superiority of international regulators, Basel II was push upon us by "the international community". Below is an article with links to other articles.

http://www.allbusiness.com/government/government-procedure-lawmaking/7503196-1.html

The long-awaited implementation of the Basel II capital adequacy accord has been further threatened by US concerns over the results of the recently completed quantitative impact study (QIS4). The four US federal banking agencies (OCC, Federal Reserve, FDIC and OTS) have called for a delay in publishing an important notice of proposed rulemaking (NPR), from the summer to the autumn this year, to allow for further study.

Lack of Regulation?

I don't know, we have dozens of government regulatory agencies with thousands of rules and regulations, yet somehow the entire financial sector was unregulated!

Face it folks, the regulations didn't work! The regulators were asleep! This is the problem with regulations and regulators, they often don't work and fail us!

What gave the ratings agencies the power to determine what securities are safe enough to hold in some portfolios?

Oh, regulations!

What made certain institutions purchase only assets that were deemed good enough by the ratings agencies?

Oh, regulations!

What gave these agencies monopoly power and prevented any other company or agency from entering into their business and offering better analysis?

Oh, regulations!!!!



And yet somehow there were no regulations and no regulators?

We have Greenspan's testimony, and somehow the government isn't involved in this crisis? It was a LACK of government? Gee, I guess Greenspan was never appointed by a government official or confirmed by Congress. He was never a part of the Federal government right?

Perhaps a better suggestion would be to craft regulations that work, cut the ones that don't, and be sensible instead of just screaming for more bad regulations.

Bad Regulations Caused This Crisis

Political Calculations provides a great case in point for my skepticism over regulations and regulators. The greatest problem with regulations is their unintended consequences.

An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.

And the greatest problem with regulators is that they often do not act until it is too late. Regulators do not respond well to new technologies and new innovations because they are entrenched in a bureaucracy with a well-worn mode of operation. Going outside the box will put a regulator's job in jeopardy if he is wrong or at the very least, cause his actions to be examined. And if you have a cushy job, why rock the boat and put your generous benefits in danger? If all goes to hell, regulators can always just use the age old excuse that they don't have enough resources or that they need new powers and new regulations to do their job correctly.

I've heard too many people expressing a wish for more regulations recently, without any regard as to how these regulations will work and how they will be structured. We need more good regulations, but that's easier said than done. It's crucial we do not make more bad regulations and most of all, we cannot expect regulators to do a better job than they've done in the past. You can't expect a lifelong C student to become an A student. We have to factor in incompetence. Only then can we determine if the regulation is likely to do more good than harm. So far, only the good part is being examined, with nothing on the harm that regulations routinely inflict.

Need For More Regulation?

We need more regulation, that's been the current mantra heard across the country. But what has been overlooked is that we had regulation and already had regulators who failed us. Warren Buffet explains a fundamental problem with regulation and regulators, we can't assume that they will do their jobs and actually regulate the industries they're supposed to!

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get
them on the Internet, every year. And, in fact, they reported to Sarbanes and
Oxley every year. And they went—wrote 100 page reports, and they said,
`We’ve looked at these people and their standards are fine and their directors
are fine and everything was fine.’ And then all of a sudden you had two of the
greatest accounting misstatements in history. You had all kinds of management
malfeasance, and it all came out. And, of course, the classic thing was that
after it all came out, OFHEO wrote a 350—340 page report examining what went
wrong, and they blamed the management, they blamed the directors, they blamed
the audit committee. They didn’t have a word in there about themselves, and
they’re the ones that 200 people were going to work every day with just two
companies to think about. It just shows the problems of regulation.

QUICK: That sounds like an argument against regulation, though. Is that what
you’re saying?

Mr. BUFFETT: It’s an argument explaining—it’s an argument that managing
complex financial institutions where the management wants to deceive you can
be very, very difficult.

I don't necessarily disagree that we need changes to the regulatory system. The question is in what manner and in what way? As with everything, the details are critical. But it is wrong for us to believe that there was no regulation and no oversight whatsoever and that's what caused the financial crisis. Regulators must be capable and have knowledge of the industry they regulate. They must understand the complex financial instruments in use and be smart enough to recognize a problem ahead of time. That's a lot to ask of a government employee. Especially if that employee is part of a no-name regulator like OFHEO, if you had any talent, why would you work for OFHEO instead of Treasury or a Wall Street firm?

It's failures like OFHEO's that make me question the effectiveness of government and government programs. I know the intent of programs and regulation, but no one seems to look at if the intent can be reasonably carried out, or make adjustments for government incompetence. A government plan or program is usually taken at face value, with very little consideration of the fact that government doesn't do many things perfectly, and is prone to screw up.

There should be regulation that sets up a clearinghouse for derivative instruments. There also needs to be a law that gives shareholders the power to veto any management compensation plan. Basel I has to be changed so that financial institutions have to keep more reserves and cannot leverage as much as they have been. Accounting rules should be reformed to make institutions show SIVs (Structured Investment Vehicles) on their balance sheets if they are obligated to fund them. Regulators like OFHEO and the SEC should be merged into a larger regulator such as Treasury or the FED. Those are large reforms, and I think they comprise most of what we need. But in the end, we still will have to depend on regulators to do their jobs, the financial sector, and the world at large are just too fast moving and changing for hard rules to work. We need good judgment and talent, something government agencies don't always have. But the more important the agency, the more likely we are to have talented people with good judgment working there. Paulson and Bernanke are two such examples, Rice another. Still, no amount of regulation and no government system has been able to prevent financial crises from occurring now and then. We've had financial crises in the past and will have them again in the future. There are some things that are just unavoidable.