## The Allowance Experiment, Completed!

Last night completed Day 30 of the “Allowance Experiment,” in which I offered my eldest daughter a daily payment calculated as 10% of her allowance savings, compounding daily.  On day 1, she began with an initial grub stake of \$1.  She received \$0.10 on day 2 (10% of \$1) and \$0.11 on day 3 (10% of \$1.10), and so on.

By Day 30, however, due to the magic of compounding, the daily payment grew to a substantial \$1.44.  At the end of 30 days, she had \$15.86 in the money jar.  That’s a pretty good sum for an 8 year old, because she can buy any ice cream her little heart desires, and \$15.86 is also approximately 1/1000th of the way to obtaining an American Girl Doll.[1]

With this kind of experiment, one must stop after about a month.  Otherwise – because compound interest turns money into kudzu crossed with HGH crossed with a mutant Godzilla[2] – by 6 months of this I would end up paying her \$2.1 million per day, and she would have over \$25 million in her jar.  At which point obviously I’d be asking her for a daily allowance.

Plus with \$25 million in the bank she could afford to purchase approximately 2 American Girl Dolls at the same time.[3]

Unexpected benefits

As I wrote before, one of the beneficial side effects of the allowance experiment – because I required her to do the daily interim calculations of 10%, plus adding up the totals in the jar – was appropriately difficult math for a 3rd grader.  This is smart parenting.

You know what else is smart parenting?  When she messed up the calculations.  For example, when the 10% number she calculated ended up larger than it should have been, I immediately pointed out her error and asked her to try again.  I was not about to pay any more than I had to.

But what about when she messed up the calculations and it worked in my favor?  What about when she asked me to pay less in compound interest than I should?

Well, let me just say that all’s fair in love, war, banking, and parenting.  I mean, you can take the Dad out of Goldman Sachs, but you can’t expect to take Goldman Sachs out of the Dad, now can you?

Plus, as (my guide to all good parenting practices) Jack Handey points out, kids like to be tricked.[4]

The main point, accomplished

All jokes aside, the point of this experiment was not so much to induce savings or to teach basic math, but to viscerally illustrate the powerful force of compound interest.

I asked her if she understood the way in which money grew at an accelerating pace with regular 10% compounding.  She responded with a wide-eyed, “Yes, it gets really big.”

Good girl, my work is done here.

Daddy Can I have an Allowance?

The Allowance Experiment Gets Better

Daughter’s First Stock Investment

Book Review of Andrew Tobias’ The Only Investment Guide You’ll Ever Need

[1] That last number is just a price estimate based on gut feeling.  I haven’t looked it up.

[2] “Kudzu crossed with HGH crossed with a mutant Godzilla” is the name of my new favorite funk band.  Also, I’m going to copyright it as a title for my book on compound interest, so don’t even think of copying it.

[3] Again, all prices are just estimates.

[4] From the parenting guru himself: ‘One thing kids like is to be tricked.  For instance, I was going to take my little nephew to Disneyland, but instead I drove him to an old burned-out warehouse.  “Oh, no,” I said.   “Disneyland burned down.”  He cried and cried, but I think that deep down, he though it was a pretty good joke.  I started to drive over to the real Disneyland, but it was getting pretty late.’

## The Meaning of Jon Corzine

With the announcement that MF Global Trustee (and former FBI chief) Louis J. Freeh will charge Jon Corzine for failing in his duty to oversee the company, the meaning of Jon Corzine shifts once again.

Prior to this announcement, I understood the meaning of Corzine primarily through the following investment aphorism:[1]

“One of the worst things that can happen to you or a client is an early investment that wins big. You will become overconfident of your abilities and proceed to lose much more in the future through imprudent decisions than you initially made on the winner.”

Corzine’s career is the epitome of this wisdom, although he combined it with an uncanny ability to “fail upwards.”  A few salient points in his timeline illustrate his pattern.

The 1994 failure in Goldman’s Fixed Income department

1. He made partner as a government bond trader in the ‘80s, and later managing Goldman’s entire bond trading operation, but Corzine ramped up fixed income risk just when the wrong moment hit.

Interest rates rose sharply in 1994, prompting a bloody massacre of fixed income departments on Wall Street, including an existential threat to Goldman’s survival, due to losses.[2]  Instead of firing Corzine for his astonishing imprudence, the partnership felt it had no choice but to elevate Corzine to Chief Executive, all the better to unwind the level of risk in the fixed income department.  His elevation illustrated another finance aphorism:[3]

“If you owe the bank \$1,000., they own you.  If you owe the bank \$100 million, you own them.”

Corzine, as described in William Cohan’s Money and Power, How Goldman Sachs Came to Rule the World, in a sense ‘owned the bank,’ as the partnership could not afford to lose him due to its exposure to rising interest rates.  He was a massive risk taker in the lead-up to 1994, making extraordinary money in 1992 and 1993.  But when it all turned bad, instead of being fired, Corzine was rewarded with the top job at Goldman, paired with Hank Paulson to temper Corzine’s risk appetite.[4]

Summer of 1998, Long Term Capital Management, and Corzine’s attempted rogue portfolio trade

2. With the August 1998 Russian ruble-bond default and Solomon Brothers’ swap desk liquidation, most of Wall Street faced major exposure to the insolvent Long Term Capital Management, the first Too-Big-To-Fail hedge fund.  The New York Federal Reserve attempted a private sector “bail-in,” requiring cooperation and an infusion of capital from each of the Wall Street firms, via a Godfather-style meeting of the families, hosted by the New York Fed.

Corzine, however, nearly managed to personally blow up the whole bail-in, achieving the rare trick of pissing off not only the rest of Wall Street but the entire Goldman partnership as well.

While the Fed urged cooperation between banks, Corzine attempted a sideswipe of the portfolio out from under the rest of the Street.  He secretly negotiated a purchase of Long Term Capital’s entire portfolio using Goldman’s capital[5], presumably believing the firm could make a profit by taking on the risk of the illiquid trades.

This attempt, ultimately unsuccessful, came at a delicate time for financial markets, suffering unexpectedly large losses on Russia and exposure to LTCM.

Goldman, in particular, had been planning an IPO that Fall, which Corzine’s actions undermined.  The IPO was delayed by market conditions, but also by the frightening style of rogue trading risk which Corzine engendered with his move.  The firm leadership of Paulson, along with deputy heads John Thain and John Thornton, engineered a coup against Corzine’s leadership as a result.

Corzine seemingly never saw a risk he didn’t try to take, which ultimately proved too much for the partnership.  They allowed him to stay nominally in charge through Goldman’s IPO in June 1999, with the understanding that Corzine would be professionally sidelined after that.  His political career began shortly after.

MF Global and lack of risk controls

3. After unremarkable stints as Senator and Governor of New Jersey[6], Corzine landed the top job at MF Global, a medium-sized brokerage.

We now know Corzine continued his pattern of 1994 and 1998, in which he doubled-down and tripled-down on risks, in the face of extraordinary losses.  Although his trading led to huge losses, somehow his ability to fail upwards did not derail his own personal career.

Up until MF Global became the eighth largest bankruptcy of all time, the meaning of Corzine seemed to be about his almost Forrest Gump-like success, in the face of amazing failure.  His Midwestern affable, bearded, demeanor masked an unlimited appetite for investment risk.  Sometimes it worked, sometimes it didn’t, but either way Corzine kept on moving upward.

We know in retrospect that Corzine’s pattern of unrelenting risk-taking continued at MF Global, and that ultimately some wrong-way bets on European sovereign bonds pushed the firm into chapter 11 bankruptcy.

We also know some \$1.6 Billion in customer funds were misplaced in the final days of MF Global, for which I’ve argued Corzine should be in jail.

A new meaning of Jon Corzine

Following the debacle of MF Global, and in the light of the 2008 credit crisis, however, Corzine’s career came to represent something darker and more insidious.

Unlike failed chief executives Dick Fuld of Lehman Brothers, or Jimmy Cayne of Bear Stearns, Corzine actually oversaw the misplacement of customer funds, not just the destruction of shareholder value.

We forgive – mostly – the leaders who drove their firms into the ground through errors in judgment, or risk management, like Fuld and Cayne.  Shareholders lost, but shareholders took equity risk and our system rightly allows for losses like that.

Fuld and Cayne lost personal fortunes invested in their own firms, as they should have, and suffered for the loss in their reputation.[7]

But we should not forgive those who commit the fiduciary sin of misplacing customer funds, like Corzine.

I make a distinction between these so that we do not lose sight of the different types of losses, and the consequences.  It bothered me, up until now, that Corzine was not pursued more aggressively for the loss of customer funds.

Too Big To Fail executives

For me, Corzine additionally offered the ultimate lie to the public about executive compensation.  Namely, if you’re so essential to your business that you deserve, say, \$12.1 million per year in good times,[8] how can you not retain the liability and responsibility when things go horribly wrong?

In what way did you earn the upside profitability, but not deserve the downside liability?

If you’re so good at what you do, then you need to be held personally liable when \$1.6 Billion in customer funds go missing.

All of which is to say that I’m extremely pleased to see MF Global Trustee suing Corzine for his responsibility in the failure of his firm.

MF Global, the firm, was not Too-Big-To-Fail when it went under in September 2011.

Jon Corzine, the executive, until now represented a type of CEO who could earn profits and bonuses in the good years, without suffering personal consequences when things went wrong.

With the latest news, however, I’m encouraged that at least one Too-Big-To-Fail executive will suffer the consequences.

Please also see Arrest Jon Corzine Now

[1] All credit for this aphorism to financial planner David Hultstrom, whose ‘Ruminations on Being a Financial Professional’ is the best collection of pithy and wise investment advice I’ve ever seen collected in one place.  See especially pages 9-12.

[2] Incidentally, I’m not in the prognostication business, but when you look at this simple chart of fixed income over the past 50 years, you see we’re at the very bottom of the rate cycle with very little to go from here.  No risk manager alive has ever dealt with a massive move upward in rates, only short spurts in a secular move to lower rates.  When the trend reverses, it will by U-G-L-Y.

[3] Attributed in different variations to John Paul Getty as well as John Maynard Keynes.

[4] I didn’t work in Goldman’s fixed income department until 1997, at which point Corzine ran the firm as senior partner, along with Hank Paulson from investment banking.  Corzine was the bearded, affable, sweater-vest guy who would occasionally come down to the bond trading floor.

[5] Matched with capital from Warren Buffett’s Berkshire Hathaway.

[6] An associate of mine who dealt with Governor Corzine frequently complained about Corzine’s leadership in New Jersey.  Although in agreement with his political persuasion, he found Corzine unwise politically and inconsistent to deal with.

[7] I actually wish we had more Japanese-style “begging of forgiveness” for corporate failure by chief executives.  The promise of public shaming might help temper risk appetite.

[8] Corzine’s scheduled final executive package, before he wisely offered it back, in the wake of the Ch. 11 filing of MF Global.

## What is Wealthy?

Back when I worked on the bond sales desk at Goldman, many of us talked about what our “Number“ was – the “Number” obviously representing “Fuck You Money.”

“Fuck You Money”, if you haven’t worked on Wall Street, represents the amount of money you’d need in order to professionally disregard anybody else’s needs.  In other words, the amount you need to walk away from your desk, go out the door, and never look back.

My sales partner, and friend, who I sat next to on the mortgage bond desk, kept a spreadsheet on his desktop calculating precisely how close he was at any given point to achieving his “Number.“  He’d been at Goldman (and another firm before that) longer than me, and he stayed about 5 years longer than I did.  Although I never came out and asked him directly after he left GS, I’m pretty sure he made his “Number.”

I left Goldman in 2004, long before earning my own personal “Fuck You Money.”

Sometime after 9/11 happened[1] I was no longer willing to live an unhappy daily life, focusing on delayed gratification, the key factor for me to accumulate enough for my “Number.”[2]

I’ve been thinking about what it really means to be wealthy for a couple of reasons.  One, because its bonus day today at Goldman, and two, because I’m teaching a course this semester on personal finance.

Preparing for this course has pushed me to reflect, before the college students ask me, on the best definition of wealthy.

My answer to them will be something like this:

1. Wealthy can’t be determined by a single, static, net-worth number, because I know that Mike Tyson at one point earned \$30 million per fight and over \$300 million in his lifetime, but subsequently declared bankruptcy in 2003.  For some people, like Tyson, their number is larger than \$300 million, and probably can never be achieved.
2. What I know from the Tyson example is that on-going lifestyle expenses play a big role in determining whether you are wealthy, at almost any level of asset accumulation.  Some people can be wealthy on an accumulated \$3 million net worth, while other people can be poor and bankrupt with \$300 million in earnings.
3. 19th Century English authors Jane Austen and Anthony Trollope tell me a great deal about how to understand wealth, and, in particular, the role of passive income.  At that time in England, the landed gentry earned passive income from family-owned real estate, real estate which would never be willingly sold.[3]  Unlike today, the landed gentry never calculated their net worth in terms of the real estate value, but only in terms of the passive annual income to be derived from the land.  Every hero and heroine of Austen and Trollope novels has an income, known to all polite society and expressed in thousands of pounds per year;  their “Number” follows them around as they seek appropriate romantic matches.  It’s as if they are marriage-seeking Sims with a number floating above their animated-avatar heads.[4]
4. One meaning of wealthy that exists in our popular culture is that if you are wealthy you never need to work again, like landed gentry.  Because 19th Century landed gentry did not work for a living,[5] I like the analogy between the “Number” associated with every Austen and Trollope character, and “The Number” that we think makes us wealthy today.  The best way of knowing whether you’re wealthy, by this analogy, is to compare the passive income you derive from your assets on an annual basis with your yearly lifestyle expense.  If your passive income exceeds your expenses for the rest of your life, guess what?  You’re wealthy!   I specifically urge my Personal Finance students to look at it this way because, like the 19th Century landed gentry, you shouldn’t depend on selling your assets to cover expenses,[6] since that’s a non-sustainable practice.[7]
5. Time, specifically your expected life span, plays a big factor in my definition of wealthy.  If you have enough income or assets to cover your expenses for only the next three years, but you’re only going to live for one more year, you’re wealthy three times over![8]  If your passive income and assets are high right now, but will run out before you die, you’re far from wealthy.  A young person needs far more passive income and assets to cover them for their expected remaining life, while an older person may be much closer to wealthy – by my definition – as a result of having less time on earth.
6. Passive income in modern times rarely derives solely from real estate income, but rather comes from many sources such as dividends, business profit-sharing, pensions, annuities, fixed income interest, and social security payments, in addition to traditional, real-estate derived income.

A More Nuanced Version of being wealthy doesn’t involve saying “Fuck You” to work

Hold on there a moment!  I’m not done yet with my definition of wealthy.  My fullest definition of wealthy adds an important factor to the ‘Do you have enough to walk away from work?’ question[9].   After all, work gives meaning to life.  Work grounds us, puts us in the flow of society, and makes us feel useful to others.  Work in that sense is a good thing unto itself.  So how do I integrate that with my definition of being wealthy?

I think wealthy means not so much having “Fuck You Money,” or reaching your “Number,” but rather having the option to choose work that you would do regardless of the level of compensation.

So here it is, my definition of wealthy: If you have enough assets plus passive income to cover your personal lifestyle expenses for the rest of your life, and that money allows you to work at something you love – without concern for the amount of compensation – then you are wealthy.

Let’s say you love feeding the less fortunate.  If you have enough passive income in excess of your expenses that you could ladle soup to the homeless – even though that service pays you almost nothing – then you are wealthy.

If your greatest joy in life consists of reading novels and writing your memoirs every day,[10] and you can live cheaply enough to make that happen for the rest of your life, then you are wealthy.

If you perform eye surgery for a living, and you live for the joy of returning sight to the blind, and you can afford to do so even if when Medicare cuts your reimbursements to one-tenth of their current level, then you are wealthy.

If you would sell bonds for a living, for the sheer joy itself – the act of efficiently allocating capital or whatever you tell yourself – then you don’t care what your actual bonus is today from Goldman.  So what if you’re down 25% from last year, or you’re up 100%?  Who cares?   You love it!  If you’d do it anyway, and you can afford to do it, then you are a wealthy person.

If, however, you’re working at something, day in and day out, that you would quit as soon as you made enough money, I would argue you’re far from wealthy.  You may be covering your costs and accumulating assets, but you’re even farther from the ultimate goal of wealth than you think.

[2] Also, I wasn’t the world’s greatest bond salesman, so it was going to take me quite a bit longer than some to make my “Number.”

[3] To sell real estate would be to announce to the world that you no longer belonged to polite society, so in effect the market price of most real property was meaningless and incalculable.  Family-owned real estate meant much more than price.  To lose your land due to excessive indebtedness, a common theme of these novels, was to lose your place in the world.

[4] The romantic plot of all these novels goes something like this: “Demure Lizzy Bernnet, with her mere 300 pounds per year, could not possibly hope to make a match with the dashing Mr. Farcy and his 20,000 pounds per year.  She’ll surely need to settle for the homely parson the widower and his modest 500 pounds per year.  But plump narrow-eyed Fanny Bobbins and her 12,000 pounds per year, however, seems to have caught the eye of Col. Wigglesworth and his 1,200 pounds.  Oh how happy the Colonel will be with this match!” etc.

[5] Ah, the English ideal!

[6] Interestingly, 401K and IRA rules mandate that Americans withdraw at least some of their retirement savings from their accounts each year, after age 70, in effect forcing us to sell assets to cover expenses.  The 19th Century English landed gentry do not approve!

[7] This issue gets complicated if you consider leaving wealth to the next generation to be a sign and precondition of being wealthy.  The English landed gentry did.  As an American with “small d” democratic leanings, I don’t.  Those of you who have read my previous posts on tax policy may detect a hint of dismay for tax policy which encourages inheritance as a primary means of “getting rich.

[8] At the extreme example, everyone who is debt free on their deathbed is ‘wealthy’ since they need no more assets or income to cover their expenses.

[9] As a good austere New Englander, I cannot get away from the difference between my home culture and the English 19th Century ideal of not working.  So I need to amend the idea of wealthy so that it does not celebrate idleness.

[10] Like the greatest of all the English landed gentry, Bilbo Baggins, writing the story of his travels as he lives frugally in Rivendell, off Elrond’s largesse.

## Book Review: Money and Power – How Goldman Sachs Came To Rule The World

The book cover – featuring a view of planet Earth presumably from a heavenly vantage point – offers the first hint that William D. Cohan’s plan here is not critical thinking but rather hyperbolic imagery.  Inside he writes a survey not of Goldman, Sachs & Co.’s overall history but rather of historical points selected for potential embarrassment to the firm.

As the consensus choice for the Wall Street firm that escaped the least scathed financially from the credit crunch, paradoxically, Goldman Sachs’ reputation became the most tarnished by its role throughout the 2007/2009 crisis and the years leading up to it.  After a calamity like the Great Credit Crunch, the general public and its commentators need a villain.  And it stands to reason, goes their thinking, that the Wall Street folks who broke even or came out ahead must have been the same ones who both caused the crisis and set themselves up ahead of time to benefit from it.

Cohan and his publisher clearly sought to benefit from this demand for a scapegoat.  Unfortunately Cohan seems determined to find a scapegoat more than he tries to put recent financial events into context that helps explain them.

The first three-quarters of Money and Power, however, did not need to be written, and certainly don’t have to be read.    The majority of Money and Power follows the rise and reign of Goldman’s leaders throughout its history.  He clearly interviewed a wide number of leaders and partners of the firm.  Less impressively, a majority of his chapters rely almost entirely on secondary sources such as earlier books, newspaper coverage of scandals, and feature pieces in industry magazines.  Lawsuits and SEC investigations provide the rare primary source document.

Cohan highlights a few gossipy items of interest, in particular clashes between the firm’s leaders throughout the years.  Given the recent collapse of MF Global, Jon Corzine’s massive risk appetite and his trading losses in 1994 seem particularly relevant.  Also relevant is Corzine’s long-time alliance with Chris Flowers, who installed him as head of MF Global, and earlier became an uncomfortable catalyst of conflict between Goldman’s leaders Corzine and Hank Paulson in the lead-up to the firm’s IPO in 1999.

Paulson clearly provided extraordinary access to Cohan and manages to come out looking the best among Goldman’s modern leaders, a trick Paulson also pulled off with journalist Andrew Ross Sorkin in Too Big to Fail.

If you need an illustration of how Cohan chose headlines over substance, look no further than his Prologue.

The Prologue describes in detail Senator Carl Levin’s (D-Michigan) cross-examination of executives in the Goldman mortgage department in front of his investigatory committee in 2010.  The hearing highlights Levin’s blustering unwillingness to listen to the testimony he’s asking for.  Levin repeatedly cuts off answers, refuses to acknowledge complexity, and grandstands for the cable news networks.

As Cohan tells it, Levin makes the point at the end of his Congressional cross-examination that as a lawyer, Levin knows not to represent both sides of a deal.  To do so, Levin lectures, would introduce undeniable conflicts of interest that would harm his client, his firm’s reputation, and the ethics of law practice.  Levin points out that as a broker working both sides of a CDO transaction, Goldman has badly served its clients and wrapped itself in a web rife with conflicts of interest.

It’s a fine-sounding point, and we can imagine a number of cable news hosts at the time pursing their lips in prim agreement with the venerable Senator’s analogy.

Levin clearly doesn’t get, however, or will not admit to getting, what a broker-dealer does all day.  By definition, a financial broker-client relationship is not an attorney-client relationship.  Attorneys always, or most properly, represent one side of a deal, but financial brokers do not.  There are almost always two sides to the client transaction, and the broker buys from one client and sells to the other client.  Cohan should know this, as does anyone who has ever worked in the securities business, but he doesn’t bother to point out the obvious flaw in Levin’s analogy.

Next Cohan describes the SEC actions against Goldman’s CDO structuring desk, built on the evidence of a pair of emails, one from a senior manager who describes relief at the end of a ‘a shitty deal’-  and the other in which a relatively junior CDO structurer worries to his girlfriend about the end of a financial window for selling his product.  The ‘smoking gun’ found by the SEC was only an empty water pistol, but that did not stop Cohan from describing the actions as if they are solid evidence of wrong-doing and moral breakdown.

Cohan concludes his Prologue with what’s meant to be a shocker about selling shares in Facebook in 2011.  For this, Cohan needs to be quoted in full:

“How could Goldman get comfortable, in January 2011, with offering its wealthy clients as much as \$1.5 billion in illiquid stock of the privately held social-networking company Facebook – valued for the purpose at \$50 billion – while at the same time telling them it might sell, or hedge, at any time its own \$375 million stake without telling them that its own private-equity fund manager, Richard A. Friedman, had rejected the potential investment as too risky for the fund’s investors?”

Now here again, Cohan could prove that he knows how broker-dealers work – but he fails to give the obvious answers to his rhetorical question. First, the investment management arms of broker-dealers do not always, or even often, purchase the same investments as their clients.  Second, broker-dealers frequently have widely different valuations for assets than their clients.  Third, Goldman’s wealthy clients are allowed to, and often do, make purchases that differ, in important ways, from the purchases made by Richard A. Friedman for the firm.

I get the sense that Cohan did a Google search of Goldman just before sending his final book edits to his publisher in early 2011 and decided on one final zinger against the firm.  He should have restrained himself.  The Facebook example is the point where Cohan loses credibility as a financial journalist and becomes an author trying to capitalize on public anger by ignoring his own experience.  It’s too bad for Cohan that the point occurs in the Prologue.

How did Goldman Sachs come to “rule the world?”  It’s a great question, and a book that answered it would be a great book to read.  Unfortunately, Cohan provides almost no analysis to support his title.  Instead he presents Goldman’s history since at least 1929 as a series of scandals, bad behavior, and influence-peddling.

Is Goldman Sachs the real villain of the Credit Crunch?  Cohan effectively surveyed the popular mood and surfed the firm’s history for anecdotes to support this idea.  But there’s almost no comparative discussion in the book of Goldman’s role vs. the role of other Wall Street firms.  There’s also very little in the way of weighing evidence for Goldman’s centrality to the crisis vs. other important actors or explanations.  What we are left with instead is a survey of headlines throughout the firm’s history, and an unwillingness to explain what they mean.  The intelligent but non-insider audience will believe whatever they believed before picking up the book, and that’s a missed opportunity.

We need a book that leads the interested public through the complex issue of who is responsible for the Great Credit Crunch and the Great Recession, but Cohan’s Money and Power is not it.

Please see related post: All Bankers Anonymous Book Reviews in one place.

## Life After Debt, Part II – Weapons Of Mass Destruction

In Part I, I discussed an internal Clinton-era memo in which US Treasury department officials considered the consequences of paying off our national debt, by 2012.

The most frightening ironies of the ‘Life After Debt’ memo are the alternative vehicles the author proposed to replace US Treasuries.

As a finance professional, reading the memo carefully, I almost chocked on my morning coffee at the proposals coming from the bowels of Treasury.  It was like reading a 1930s memo proposing the invention of a nuclear bomb, as that would ensure the end of all future wars.

First, the author considers FNMA and FHLMC (more commonly known as Fannie Mae and Freddie Mac) agency debt as securities for the conduct of monetary policy instead of US Treasury debt.  Since the companies were AAA-rated, fast-growing and as rock-solid as the US housing market (!), this was not an entirely crazy idea at the end of 2000.  Obviously, with the receivership of Fannie Mae and Freddie Mac in 2008, we know in hindsight that a Federal Reserve balance sheet filled with agency debt would have meant a complete catastrophe wrapped in a shit sandwich.  Although it had become an increasingly important staple of Wall Street bond issuance for the prior decade, agency debt from Fannie and Freddie became deeply distressed in the Summer of 2008, and would have ripped a limitless black hole in the Federal Reserve balance sheet.  Needless to say it’s a good thing that did not happen.

But the second suggested vehicle for absorbing impending federal surpluses is the real problem.  The author introduces “[N]ew, very low-risk securities constructed from a pool of private debt securities.”

Knowing what we know now, we should be thankful this idea never took off.  I’ll quote the memo for a fuller description and then explain what the author was getting at:

Such securities would be packaged in a way similar to mortgage-based securities currently issued by Government Sponsored Enterprises like Freddie Mac and Fannie Mae, but would not be as liquidity constrained and would be better diversified against certain market risks.  To package the new instrument, a financial institution could buy a set of high-quality corporate bonds.  It would then offer to sell a coupon bond called the Triple-A Plus bond that pays a fixed annual interest rate for the life of the bond.  The Triple-A Plus Fund would put up its equity capital and take on the default risk of the underlying corporate bonds.  Although not completely risk-free, bonds like the Triple-A Plus bond would entail very little credit risk and would be close substitutes for Treasury securities.  With the advent of such an instrument, liquid and transparent markets should develop, given the value of just such a low-risk security to both private markets and the Fed.

Now, I take great interest in the author’s plan, because it is both prescient, up-to-date for its time, and in hindsight, incredibly stupid.  This theoretical super AAA bond was in the process of being perfected by Wall Street at the time of his writing.  It would have been constructed by pooling a diversified portfolio of high quality corporate bonds, and then offering a fixed rate to the holder who takes on the very-low probability of default.  My sense is the author must have heard of this financial innovation through a conversation with Wall Street structuring professionals, and he then attempted to apply it to solving the problem of what instrument the Fed could use for investments instead of US Treasurys.

The author is right that there was no liquidity constraint on this type of instrument, which is another way of saying, Wall Street could make in infinite amount of it.  The author also correctly notes that “the value of such a low-risk[1] security to both private markets and the Fed” would lead to the creation of extraordinary amounts of this debt instrument.  Finally, and most importantly, the author was also right that the assets were “not completely risk-free,” although plenty of quantitatively sophistical investors believed them to be risk-free up until the period of 2007 and 2008, when they were shown to be financial “weapons of mass destruction.”  The “Super-senior” AAA CDO, comprised of a portfolio of low-risk corporate bonds, was a particular innovation of Goldman Sachs’ mortgage desk where I worked in the years following this memo.

AIG Financial Products (AIG FP) considered the “Super-senior AAA CDO assets riskless, and the income derived from it to be free money.  It was precisely these instruments, described by the author at the Treasury department, perfected in the following years by Goldman Sachs to the specifications of its client AIG FP, that sent AIG into government receivership in 2008.  We can be thankful again that the Federal Reserve didn’t buy these products from Wall Street, as attractive as they sounded in the memo.

[1] !!!!