Old National Bank and the Brown Swan

Old National Bank (ONB) is a regional bank, headquartered in Evansville, IN, with assets totaling over $8B. As you may remember, ONB gained media attention in May, when it repurchased its TARP warrants from the Treasury for $0.21 on the dollar, giving the taxpayers a $4.6M haircut.

Monday, ONB reported 2009 Q2 non-GAAP earnings of $9.6M or $0.15/share, which was nearly double analyst expectations. $0.15/share for Q2 2009 is about half of what it earned in Q2 2008 and $4.6M of these profits were a one-time occurrence. Nevertheless, Wall Street didn't let such a triviality get in the way:

ONB closed at $11.47, which constituted a one-day gain of over 17%.That seemed like an unlikely return considering the quality of the news, or lack thereof. I converted the daily closing price differences for the prior year to their continuously compounded equivalents and tabulated the results below.

As you can see, the July 27th close was an extreme outlier (>3σ from the mean). Perhaps, the intrinsic value of ONB increased 17% in the course of minutes, but I'd wager that rampant speculation is a more reasonable explanation. Recently, there has been some discussion on the internet as to how a bubble can be spotted before it deflates. It would appear that periodically screening asset prices for this type of situation might be useful and merits further investigation.

The Economist: Modern Economics is Crap

The July 18th-24th edition of The Economist has declared that modern economic theory has been a dismal failure. They cite financial economics and macroeconomics as being particularly worthless, due to the fact that most economists missed the credit bubble and are now clueless as to how to get out of the resulting Depression. Per the article, Nobel laureate Paul Krugman recently described the last 3 decades of macroeconomics as, "spectacularly useless at best, and positively harmful at worst.”


I came to a similar conclusion on 4/17: :

I have to admit that my personal animosity towards economists and finance experts has grown exponentially over the last 6 months. As I delve more deeply into the causes and assumptions that lead to the crash, I find it analogous to peeling an onion, except each layer is made of stale excrement. The recurring theme is the confident assertion that a complex process (derivative pricing, MBS risk, etc) could be accurately modeled without accounting for all inputs. Intuitively, we know this is to be false, since weather forecasts aren't useful more than a few days out. Yet, the finance industry used this reasoning to justify huge risks by proclaiming that trees could, indeed, grow to the sky.

Now, after the gravy train has derailed, we are told that there is a pundit meritocracy that must be navigated in order to hear financial truth. To which, I call bullshit: the baby and the bath water are equally offensive. These clowns have profited from leading us down the garden path twice, now. (Remember the New Economy and the viability of profitless companies claptrap they fed us during the tech bubble?) If we were to send Paul Krugman to truck driving school, the impairment to the common good isn't so apparent. Would society be that much worse off by exiling the source of The Theory of Interstellar Trade and his kind to the open road? Perhaps logistically, but I'm willing to take the hit.

The article attributes economists' inability to foresee the bubble to flawed standard models and that is almost correct. Nearly a year later, I'm still incredulous when I read about how it is nearly impossible to spot a bubble^*. I'd wager that I can produce 50 people who foresaw this crisis, none of whom are economists and many lack college degrees. No model is required to see that $12/hour wage slaves don't belong in $250,000 homes or that "getting upside down" on a car loan is a hallmark of excess and unsustainable credit. The difference is perspective and common sense.

If economics has any hope of restoring its credibility, it must return to first principles. For one, the complexity of the systems that they are attempting to measure must be respected. There is a reason that long term weather forecasts aren't terribly useful. Secondly, new models based on novel ways to misuse the standard normal distribution aren't the solution. Instead, the limitations of statistical techniques should be accounted for early in any future modeling. If said models show flaws under duress, they must be abandoned, with no regard to their eloquence. The implied volatility "smile" of any option chain should have been a damning indictment of Black-Scholes. Lastly, step away from the computer. The economy isn't in there. Nor is it in New York or DC, for that matter. Get in the car and see what 15% unemployment looks like in Kalamazoo. Spend a month working in the service economy for $8/hour and see if your concept of rationality holds. You may be disturbed by what you find, but I can promise you that a bubble will never sneak up on you again.


* Yes, I believe there is currently a bubble in the equities markets.

The 401(k): Welfare For Wall Street.

It is my belief that the 401(k) plan has devolved into little more than cleverly disguised tax designed to subsidize the bond and equity markets. In 2006, after significant lobbying, the financial services industry essentially purchased the Pension Protection Act of 2006 from Congress. Two of the more offensive aspects of the law are automatic enrollment and automatic escalation.

Automatic enrollment allows your employer to withhold 401(k) contributions from your pay without your consent and with no liability for loss. Prior to the first involuntary withholding, the employer is supposed to provide written notice 30 days in advance of the first involuntary contribution. Typically, the default investment, a.k.a. the qualified default investment alternative (QDIA) is a hybrid or target-date mutual fund, which contains significant risk and have generally underperformed. It is very telling that the Department of Labor only allows money market or stable value funds as a QDIA for 120 days, demonstrating that this is a parasitic attempt to divert funds into the equities markets.

Automatic escalation is the practice of increasing an involuntary plan participant's contribution annually. The initial rate is 3% with a 1% increase in each subsequent plan year. The rationale given for automatic escalation is that 3% annual contributions will not generate sufficient retirement savings. In other words, since the involuntary participant has remained asleep the switch for a year, Wall Street might as well press the bet.

If nothing else, the PPA shows the dangers of being a passive participant in your retirement planning. For example, consider a 25 year old who was automatically enrolled on January 1, 2007. Assuming he was earning $45k/year, received a 5% raise annually, and was autoescalated in 1% increments in each subsequent year, his shares of his QDIA, the Fidelity Freedom 2040 Fund (FFFFX), would be worth $3,710 on June 1, 2009. Had he not been autoenrolled/autoescalated, he'd have $4372, which is about 15% more.

I have yet to see it proven that the 401(k) is the best means of retirement funding. Yet, the financial services industry and the government are willing to resort to deceptive and predatory practices to channel more of our discretionary income to Wall Street. Fidelity Investment's response to the PPA clearly indicates that deceit is intentional. In the response, Donna Hanlon suggests that the 30-day waiting period be replaced with a 5-day period because new hires might notice that their wages are being garnished:

Consequently, compliance with a thirty day advance notice advance notice requirement will require these plans to delay enrollment to the detriment of participants' retirement In automatic enrollment plans, this delay may highlight for participants the difference in net pay that participating in the plan entails, with the result that participants may be more motivated to opt out of participation, a consequence that is inconsistent with the policy choice underlying automatic enrollment.

The remainder of the comments provided by concerned parties are posted at the Department of Labor's site: http://www.dol.gov/ebsa/regs/cmt-defaultinvalt.html. I strongly encourage you to read them, since they provide a window into to actual motivations of the retirement fund industry. What I deduced is that nobody involved is terribly concerned with the welfare of the plan participants. If nobody is looking out for our best retirement interests, how long can we afford to remain oblivious?

Bank Failure Friday: 7/17/09

The FDIC reported four more bank failures yesterday::

1. Temecula Valley Bank, Temecula, CA
2. Vineyard Bank, Rancho Cucamonga, CA
3. BankFirst, Sioux City, SD
4. First Piedmont Bank, Winder, GA

Below are the capitalization ratios from the most current (3/31/09) FDIC data:

CIT: Too Cheap To Save

I've not been to MBA school, yet, as I'm awaiting the onset of senility to improve its palatability. Nevertheless, I'm certain that the concept that "It takes money to make money" is readily applicable to modern business. In other words, a company must invest its capital wisely in order to generate future returns. If you are a financial institution that's recklessly lent yourself into insolvency, I can't think of a better investment than the acquisition of a few Congressmen. JP Morgan, Citigroup, Goldman Sachs, Bank of America, Capital One, and Discover all understood this and were allowed to loot the Treasury. In fact, the smarter TARP recipients even kicked back a cut of their bailout booty as campaign contributions, in the time honored pimp/call girl tradition, which allowed them further privileges such as mark-to-myth accounting and unhindered NYSE market manipulation. Apparently, this concept was lost on CIT which explains why it wasn't in the taxpayers interest to save them. After all, CIT only lent to small business instead of companies like Discover, who provide the valuable service of streamlining taxpayer balance sheets with 29.99% late penalties.



From the FEC Campaign Disclosure Database.

Hair of the Dog for K Bank

If you look at the list of Maryland banks that I posted, you'll see that K Bank is one of the more poorly capitalized institutions in the area. K Bank, a regional entity located in the Baltimore metro area, has been afflicted with a portfolio of low quality real estate development loans. Per K Bank's most recent call report, liabilities have reached 94.4% of its total assets, 5.4% of its assets have reached non-accrual status, and 4.4% of assets are 30-89 days late, casting significant doubt on K Bank's ability to survive. In fact, the situation has become so dire, that the FDIC issued a Cease and Desist order on 3/10/09 accusing the bank of unsound practices.

I'm no MBA, but I would think it would behoove K Bank to concentrate on improving the quality of future loans. According to K Bank's website, I would be very wrong:

Failure Friday: More Bank Capitalization Data

In honor of Failure Friday, I have provided the following list of what I believe to be the most troubled banks in the FDIC system. The definitions and rating criteria can be found here and all data is from the most current call reports from 3/31/09. Enjoy.

Doomed

Maryland Bank Capitalization Data

Below is a list of Maryland banks and their associated capitalization ratios as of their most current quarterly report to the FDIC (3/31/09). The relevant ratios are defined as follows:

Tier 1 Capital: Tier 1 (core) capital includes: common equity plus noncumulative perpetual preferred stock plus minority interests in consolidated subsidiaries less goodwill and other ineligible intangible assets.

Risk-Weighted Assets: Assets that have been adjusted for potential default.(residential mortgage multiplier=0.5, commercial/industrial loan multiplier=1.0, cash and US treasuries=0.0, short-term credit,demand deposits=0.20)

1. Total Equity/Assets: Book value.
2. Texas Ratio=(Non-performing assets+REO)/(Equity-Intangibles-Goodwill+Loan Loss Reserves). Note that this is the only metric that accounts for non-performing assets.
3. Leverage Ratio=(Tier1 Assets/Total Assets)
4. Tier 1 Risk Based Capital Ratio=(Tier 1 Capital)/(Risk Weighted Assets)
5. Total Risk Based Capital Ratio=(Total Risk Based Capital)/(Risk Weighted Assets)


MD Banks

Dumbing It Down

At the The Cynical Economist, I found this clip of mathematician Arthur Benjamin advocating replacing calculus with statistics in the public school curriculum:


Benjamin's reasoning for foregoing calculus for the sake of statistics is that statistics is a more pragmatic topic, since risk assessment and odds estimation are daily occurrences. Let's see how it works out for us. Say we go out and measure some continuous quantity like the error in the volume of Foster's in a standard bottle. In the name of science, we are compelled to repeat the experiment often and when we're done we plot the relative frequencies vs. the measured errors:

What we find is that we have a bell curve given by a probability density function f(z). What we really want is the area under the curve for some increment, as this yields the probability that a member of the Foster's population will fall in the increment. How do we get this area? Had we taken calculus, we'd know to integrate f(z) over the interval [a,b] of interest to get the desired probability, F(z)=F(b)-F(a).

You're probably thinking: Wait a minute, for a normal distribution, there is no closed form solution that provide F(z) directly and this is true. Instead, numerical approximations must be employed and this doesn't require calculus. In fact, via a simple transformation, a common Z statistic table or Excel function normsdist() can be employed to simply look up the probabilities sought, without no regard for the underlying math. This is precisely Benjamin's point, to perform statistical calculations, calculus is unnecessary, which is true. The watered down versions of statistics provided by psychology, biology, and business departments prove this daily.

However, there is a significant difference between plugging numbers into a standard formula and comprehending how and why the formula works. To actually understand the formula and its limitations, a student typically needs to see its derivation. This why math and engineering undergrads are required to take mathematical statistics, which is rather calculus intensive.

Benjamin states that this current economic crisis would have been avoided if public schools taught statistics, as opposed to calculus. This is entirely wrong. It was the use of statistics, without the understanding of their limitations, that lead to the gross asset and risk mispricings that contributed to this crisis. Clearly, allowing the dumbed down version of statitistics to become the norm is only encouraging more misapplications of the discipline.