Thursday, March 31, 2011

Detroit Implodes

One of the more striking findings in William Easterly's writings about Third World Aid is how little is learned, just the continual call to double down: it was just not enough or to the wrong people. Similarly, when Detroit recently announced they lost 25% of their populace over the past decade, the solutions sounded the same: double down. A friend of mine drove me by his childhood home in Flint Michigan and every corner strip mall highlighted two products: lottery tickets and alcohol. His old home now had security bars around its first floor windows.

There are two obvious features about American inner cities and neither are talked about very much (see the NYT discussion, no mention). First, most have long and deep Democratic political rule. That is, not only the mayor, but the police chief, school superindendent, and every other head bureaucrat is a Democrat. Five of the 10 cities with the highest poverty rates (Detroit, Buffalo, St. Louis, Milwaukee, Philadelphia and Newark) have had a Democratic stranglehold since at least 1961, and most dangerous big US cities are strongly Democratic. Why isn't this relevant?

The other feature is these cities are predominantly black or Hispanic. Few can even mention this without being called a racist, and most important writers have legitimate reason to avoid even being accused of racism, which can cost you your career (meanwhile, Spencer Ackerman, who was caught red handed advocating the racist libel as a progressive strategy, has been unaffected, highlighting its potency). So, as a non-professional, I'll ask: Why are these minorities performing so poorly when concentrated?

Honest Italian-Americans ended up greatly benefiting from the collapse of the briefly-lived Italian American Civil Rights League in 1971. These were the people who would say with a straight face they didn't know what the word 'mafia' meant. With the danger of being accused of racism removed, the federal government during the Reagan Administration hammered the Mafia and left it a shell of what it once was. Since the Mafia preyed most of all on their co-ethnics, that was a huge win for Italian-Americans. This issue is not whether or not one group is more prone to nefariousness than any other. The issue is that if any group is exempted from criticism, the temptation for members of the group to do bad things increases. We all have urges that are worthy of criticism, but if we can arrange matters so nobody is allowed to criticize us, then the temptation to give in to those urges can be overpowering.

American minorities don't need money, pity, or special rights, they need temperance, diligence, thrift and other bourgeois virtues, exactly what their community leaders are telling them are orthogonal to their position. The last thing you should tell someone in really bad straights is that his problem is the indifference, if not cruelty, of others, because it doesn't help him.

Democrats and black leaders bear most of the blame for the Detroit, and this should be a teaching moment. Yet, I see no such re-evaluation, and so I have little hope for American Cities, which I assume in a generation will be like the favelas of Brazil, places the police won't even go.

Tuesday, March 29, 2011

'The Spread' is Absurd, So is Life

In college debate there's a strategy called 'speed and spread', where a speaker speed reads the broadest number of arguments possible in their allotted time. Watching high school and college debates use this, it seems absurd. The objective is to present the maximum number of arguments in a debate round, hoping that a few unrebutted points seem like concessions to judges. Quality and consistency, are not priorities. I suppose in debate the judges merely read the arguments, because it seems impossible to process these statements (see below).

I thought this was silly until I was in court. I was being accused of appropriating some unspecified intellectual property, and several intimations were made in the original complaint but they were not exhaustive. The problem is that litigation is very expensive (IP lawyers are $500/hour), and there's an opportunity cost because as long as you are accused of appropriating undescribed IP, no one with any money would dare hire or work with you. So, you want to get it done. However, they can say 'you took the idea of investing in low volatility stocks', and by the time you mention you did this at a prior job, they then say ' a particular way', and add on several other items, such as the concept of 'mean variance optimization', etc. You can knock these down one by one, but the longer you play the more you lose.

The judge, meanwhile, looks at every allegation piecemeal, so that they aren't penalized for making absurd allegations, they just hope at least one remains viable. My lawyers then leveled some counter-arguments I found were irrelevant, but they noted you never know what arguments work, that is, which might resonate with the judge. Restricting one's counter-suite was suboptimal. Real life was an absurd spread debate I had to play.

I was reminded of this watching this testimony on how to reform the governmental housing system, and one Janneke Ratcliffe made several remarkable assertions, including that low-down payment mortgages on some subset of loans did above average over the past decade, implying to her that low down payments were not a problem. I'm sure there is such a subset of loans, but in the context of the fact that default rates are multidimensional this is unsurprising--you can find subets of fat men who are actually quite healthy, but on average at the margin obesity is not healthy. The point is, she made an assertion to some atypical finding, presented it as a fact that was dispositive of her assertion, and it sat out there as evidence because no one could, in the time presented, review and rebut it.

If you ever watch a speech by Noam Chomksy you'll note his discussion crosses political science, economics, sociology, history, and mentions several disparate facts in each of these domains. The key to being persuasive seems to be to have an argument that is irrefutable, because no fact is essential, and they are so disparate facts no one can refute a significant proportion of them definitively. That is, appearing to have a fusillade of facts is overwhelming. So, the big issue (eg, anarcho-syndicalism? Capitalism is evil?) is promoted via thousands of supporting facts. You don't have enough time, and no one has the breadth, to evaluate all of them, and merely refuting a finite subset leaves open the logical possibility he's correct on his big point.

If you look at debates about taxes, the stochastic discount factor, global warming, or whether the moon landings were faked, you'll find yourself unable to counter some point that helps the opposing view, reality has too many dimensions. The paper Fact-Free Learning explains this pretty well (AER, Dec 2005). The idea is that most 'facts' are really statements about relations between datapoints. As there are an infinite number of relational facts, you can’t expect to know them all even if you know all the basic data points, so certainly you can't easily rebut them all. So everyone knows only a different subset of the relations, which gives them different ‘facts’. There's no simple way to reconcile them, because there are so man facts, each supportive in their own way.

Any expert merely knows a lot of facts relevant to his prejudices, and it's not hard to make a case for anything, which is why a good lawyer always helps. It also explains why people don't converge on the truth, because once you are a valued advocate for X, the payoffs from others who like X are surely better than recognizing that X is, in fact, false (plus, presumably after so many years most of your friends and colleagues are X-lovers).

Monday, March 28, 2011

CFPB to Start Big

A months-long internal investigation of 500 loan files by the Federal Reserve found no wrongful foreclosures, members of the Fed's Consumer Advisory Council said earlier this month. Zero out of 500. The Fed's report defined "wrongful foreclosures" as repossessions of borrowers' homes who were not significantly behind on their payments. But consumer advocates stated that didn't matter, because "That homeowners were not delinquent has never been our contention," said Rashmi Rangan, a member of the panel and the executive director of the Delaware Community Reinvestment Action Council. "Our contention is that many of these foreclosures were avoidable."

In other words, they could have written down the loan and kept the delinquent borrower in their homes. Heck, why require anyone to pay back their debts, just think of the Keynesian stimulus!

A new regulator, meanwhile, is not encumbered with lots of banking experts. The CFPB, Elizabeth Warren's new financial regulator, is excited to make a bang in home lending. A power point leaked to the HuffPost shows that the CFPA notes banks saved $20B by not applying 'special servicing of delinquent loans'. Presumably, given foreclosed loans were found to all be truly delinquent, this would merely add more signatures and busy work to what is a fact. Somehow, I don't see how adding costs to the intermediation process helps anyone, but that's why I'm not in charge.

The CFPB presentation notes that it could 'require 3.0 million principal reduction modifications over six months , exempting government FHA and VA loans. Why any private bank lends to homeowners any more is an interesting question. The CFPB notes 'servicers fund write-downs (make investors whole)', as if the problem with banks is they have too much money. That will really get the economy going.

With all the financial problems in the pipeline, I'm almost hoping the CFPB does something this bone-headed right out of the gate, because creating a big mess early is probably the best thing they can do. That is, if they did something subtle it would probably be worse because it would take longer to fester.

Sunday, March 27, 2011

Ambiguity Aversion and Panics

The rise in 'information sensitivity' across a broad cross-section of formerly informationally insensitive assets occurs due to fears of adverse selection, of buying an asset that is being sold because insiders know it is toxic. Yet it's interesting that when this occurs assets generally sell below their 'fair value' or 'net asset value' as they were in the winter of 2009, and people don't jump in and sieze this opportunity as they usually do.

Why the sudden risk aversion? Is it just because they are less wealthy? It's not clear less wealthy people are more risk averse than the more wealthy people. Is it just because they recently lost money? Consider the known fact that people would rather bet on future events than on past events of equal uncertainty, because not knowing what happened undermines competence. In experiments, a lottery ticket is worth a lot less after the drawing for most people even if they don't know what the true number is, and seemingly the seller does not either. People shy away from processes about which they think they have insufficient, as opposed to probabilistic, information, even if framed identically (eg, both with a 50% chance).

This 'ambiguity aversion' increases with the perception that others are more competent and more knowledgeable. If people choose an ambiguous option and receive a bad outcome, then they fear criticisms by others who will note they should have known better. Such criticisms are easier to counter after a pure risky choice, when a bad outcome is more easily explained as bad luck, than after an ambiguous choice. This explains the enhanced ambiguity aversion. Such social effects are called the fear of negative evaluation (FNE), basically, the fear of being evaluated a fool with hindsight.

If a bad outcome were to result from a prospect about which an agent had relatively little knowledge his failure can be blamed on his incompetence. A bad outcome resulting from a pure risky prospect, on the other hand, cannot be attributed to poor judgment. All possible information about the risky prospect was known, and a failure is simply bad luck. The key is, ex post, will you look like a sucker, or just unlucky? Investment managers can live with bad luck, but their reputation is essential and they can't be seen a fool.

Applied to the recent recession, consider that by the summer of 2008 we already had failures of Bear Stearns and Fannie Mae, two venerable institutions. It was not clear what the essence of the problem was--CDOs? Complexity? Banks? Mortgages? Copulas?--so investors simply knew that something was rotten, and it seem probable that some people knew what was going on, leaving one in the proverbial position of the guy at the poker table who doesn't know who the sucker is. This causes everyone to get alligator arms and jump into the least risky thing they can think of--the dollar, US Treasuries. With investment down, profits plummet, leading to a general recession.

A key point is that when spreads on Junk bond and Asset Backed Security spreads went well above any conceivable expected loss, we know it's a good time to invest because poor performance is never as bad as implied via risk-neutral probabilities, and it's better not to think of this as a 'risk premium' but rather an opportunity driven by people's ambiguity aversion.

Thursday, March 24, 2011

Spending Other People's Money

Walter Bagehot noted that 'the most melancholy of human reflections, perhaps, is that on the whole, it is a question whether the benevolence of mankind does more good or harm.' One reason I'm against the increase in government spending is because I find government to be a really bad manager, which is what you should expect when there's no bottom line that disciplines the process. Within a profit-making company hard decisions to fire someone or discontinue some activity are made all the time because of necessity. Without this necessity, these hard decisions aren't made at every level.

Case in point, Madonna put up $11MM to start a school for girls in Malawi. It has been abandoned after they spent $3.8MM on nothing:
"Despite $3.8 million having been spent by the previous management team, the project has not broken ground, there was no title to the land and there was, over all, a startling lack of accountability on the part of the management team in Malawi and the management team in the United States,” he said. “We have yet to determine exactly what happened to all of that $3.8 million. We have not accounted for all the funds that were used."

At least here, with a direct line between the financier and the project, it was stopped. If it were US federal money it would be considered 'stimulus', and thus a success.

Wednesday, March 23, 2011

CalPERS Rosy Assumptions

CalPERS, the pension fund in charge of California's $230B portfolio, recently noted they rejected adjusting their expected return over the next 10 years from 7.75% down to 7.5%. That 'saved' them $400MM this year! While you shouldn't quibble over things like 0.25%, understand they basically expect a 5% real return to their investment portfolio.

Here's data from 1990 through June 2010 on Calper's performance vs. some common benchmarks:

Avg. Ann Return
SP500 5.8%
Gov't Bond7.2%

Now, over this historical period interest rates declined from 8% to 3%, which added about 2% to the annual returns (asset prices rise when you decrease the discount rate). That isn't likely to repeat. At best rates will be stable, but probably they will increase. This will drag down not only their bond returns, but equity as well (bond and stock returns generally positively correlated). Thus, they are anticipating the same 5% return over inflation that occured with the one-time secular interest rate decline these managers experience over their working life (which tends to make one think it's simply a given).

Either someone invents cold fusion, the Mayan alien astronauts bring us all sorts of manna when they return in 2012, or we will monetize our debt to pay for all these off-balance sheet liabilities. I'm betting on the latter.

Tuesday, March 22, 2011

DeLong and Krugman Don't Get It

For a wealthy, high status man, Krugman sure sounds angry much of the time. Here's his response to those who don't buy DeLong and his solution of more government spending (on what is not important, highlighting how absurd this solution is):
if you’ve reached the point where you don’t pay attention to anything that might disturb your orthodoxy, you’re not doing science, you’re not even pursuing a discipline. All you’re doing is perpetuating a smug, closed-minded sect.

Yet merely two weeks ago Krugman was bragging about how pointless it was for him to hear from those he disagrees with:
Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously.

A principle is something you apply to your own disadvantage, and so I wouldn't call 'balance' one of Krugman's principles. Because he never engages in real arguments but rather ad hominem and straw men, his adversaries are unpersuaded, which makes him even angrier.

If you read Brad DeLong's post that Krugman is referencing, you see this gem by DeLong:
I firmly believe that I am right. I firmly believe that I am right almost as firmly as I believe that the sun will rise in the east tomorrow.

It's a strange lack of self awareness to find one's certainty interesting to others, because of course everyone believes he in right, otherwise he wouldn't believe what he believes, but it seems DeLong and Krugman simply think everyone else is merely a duplicitous shill or moron.

Let's consider what 5 generations(!) of Harvard book learnin' can do to one's cognitive ability, as Bradford DeLong lays out his diagnosis and cure for our economy in powerpoints, indistinguishable in tone and substance from an earnest senior thesis in this Lecture. I put his PowerPoint statements in bold, my comments in non-bold.

Sources of the Downturn:
1) Irrational Exuberance

My problem with this is it is all ex post. Of course we invested too much in housing and everything related to it. But why? Every recession involves discovering one invested too much in something that was unwise: oil, commercial real estate, technology, cotton. That phrase doesn't explain anything, it is true by definition for a recession.

2) Overleverage
ORLY? Then why were relatively low-leveraged commercial banks like WaMu, Wachovia, and National City also destroyed? The ridiculous levels of leverage at investment banks may have been high, but on average they weren't much different than in the early 1990s. The performance of banks in the recession was pretty independent of their leverage (see here). As recessions are invaribly financial events, they necessarily imply 'overleverage'. Again, this doesn't explain, it is true by definition for a recession.

3) Misregulation.
Here DeLong focuses upon the lack of capital for investment banks, which was incidental to the general glut of housing that would then ripple through the economy. He neglects to mention that these same regulators were threatening banks that did not comply with new 'innovative' underwriting standards pioneered by Bill Syron to increase home ownership among the 'traditionally underserved communities'. Once you create all this crap it has to go somewhere, which is why I think low underwriting standards are the dog and leverage/CDO/copulas are the tail. Today the FHA dominates (90%+ share) the under $300k mortgage market because they are the only one giving out loans on 3.5% down payments, highlighting they still don't think this had anything to do with the 2008 crisis, so it's not like giving them more authority back it 2005 would have lessened the amount of NINJA loans--probably the reverse. Leverage, meanwhile, would not have saved Lehman, Bear, or Wachovia at any conceivable level of regulation people were talking about if you try to estimate some kind of relation between leverage and financial performance.

Consequence: flight to quality. Excess demand for high-quality assets.
Again, true by definition in a recession.

This produces a 'general glut": shortage of demand for goods and services.
Well, when you discover 5% of your workforce is engaged in unsustainable activities, they are now unemployed, have no income, and need to find new work. Their reduction in consumption and savings will adversely affect other sectors, but it is hardly 'general', rather highly specific.

Total spending Y=C+I+G+GX-IM falls short of the amount needed for full employment.
This is backwards. Full employment was at an unsustainable, nonequilibrium level due to all sorts of wishful thinking about giving away homes to poor people and thereby giving them all sorts of neat demographic qualities just like homeowners. People involved in this unsustainable activity now need new jobs, and it will take some highly decentralized introspection to reposition these workers in their best niche.

The Right Cure for the Great Recession
Regulatory Reform

Frank-Dodd? What part, exactly? The Home Affordable Modification Program? Most of this bill just gives regulators greater authority to do something, and like the CFPA, they are busy creating a bigger bureaucracy but thus far nothing really meaningful, which is my 'best case scenario'.

Goverment spending when the private sector stops:
Well, DC has already turned this dial to '11', pushing our deficit to Macedonian levels. Further, the idea that 'government spending' and 'private spending' are substitutes is ridiculous: one pays for the other, an important distinction.

DeLong then mentions the importance of providing liquidity, ie, monetizing the deficit, Fannie and Freddie's losses. The Romans often tried to solve fiscal problems debasing their currency and it never worked, and led them to angry reactions as seemingly greedy merchants would then have the gall to raise prices. Perhaps they just needed to double down?

Cure for the Great Recession: Fiscal Policy, ΔG.
He then lists the standard Keynesian Multiplier, which posits government expenditure as a free lunch via the fact that the money is then spent by someone else, who spends it again, etc. The net effect is to spend $1, create $2 in income, which taxed at 40% pays for itself like a dewdrop in terrarium. There's just one problem: where do you get the $1 in the first place?

As per confronting his critics, he ignores anything about his model and simply criticizes their solution, which is a caricature of Milton Friedman circa 1981. There aren't many hard core monetarists out there arguing the solution to our problems is a monetary growth rule which would eliminate all recessions, but the whole point is simply to set up a straw man and smash him down.

My alternative to DeLong's solution--which has been applied vigorously over the past 2 years without effect--is to reduce the size and scope of government. People left to their own devices will innovate, find their best niches, and create wealth without ethanol and wind programs. Such activities are sustainable because they come from myriad voluntary decisions by other free men, not someone spending someone else's money on a project for someone else, the ultimate in whimsical expenditure. Consider that the economy grew to its heights without much guidance just fine (look at the US up to WW1, the Asian Tigers, China post-1978, Adenauer's West German), and precisely because no one person understands it is why top-down solutions hinder growth.

In the 1987 movie Broadcast News, the insufferable Jane Craig (played by Holly Hunter) is remonstrated by her boss:
Boss: It must be nice to always believe you know better, to always think you're the smartest person in the room.
Jane Craig: No. It's awful.

As Krugman's dyspeptic disposition highlights, being certain you know better can not only be bad epistemologically, but make you feel bad too. This is usually because such people unfortunately '100% believe' their misconceptions of their opponents, and then become frustrated when these straw men don't spontaneously admit to being frauds and fools.

Monday, March 21, 2011

Inflation 6.6%?

Larry Kudlow reports:
Respondents anticipate prices to climb 6.6 percent over the next year. That’s double the 3 percent inflation registered in the December survey.

As the 30-year US Tbond yield is only 4.48%, and the 3-month yield is only 0.16%, if this happens, bond and Eurodollar markets will tank. I was shocked, but then I read the fine print, and this was a survey of 800 regular Americans, in other words, people who probably don't even know what the current inflation rate is (around 1.6% for CPI's latest year-over-year number). Among experts:
The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.88 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

If actual inflation, and economist expectations, are still around 2%, right now things are stable. But it still seems like we are drinking shots of Everclear until we become excitable, at which point there's a brief period of exhilaration, and then all sorts of pain. If economists do miss this it will be like their disastrous experience in the 1960s, where they were blindsided by the increase in inflation that decade. There were many stories of economists who then worked on macro-models and were sure inflation, and thus bond rates, would decline. They kept rising, and the next decade it only got worse.

Fed economist Eric Swanson notes a similarity between the 1960s "operation twist" and the current Fed initiative, QE2:
This paper undertakes a modern event-study analysis of Operation Twist and uses its effects to estimate what should be expected for the recent quantitative policy announced by the Federal Reserve, dubbed “QE2”. We first show that Operation Twist and QE2 are similar in magnitude.

Let's hope it's not too similar.

Sunday, March 20, 2011

N.R. Hanson's Theory Ladenness

I remember being really impressed by Popper's writings on falsification, but over time I think it's much more of a goal than a description of science. Feyerabend did a good job of highlighting that in practice there's no demarcation between obervation and theory, and as no theory is consistent with all the facts (in part because all the known facts are rarely true), you don't simply falsify theories and reject them. But then I read N. R. Hanson's Patterns of Discovery, written in 1958, and realized that Hanson really discovered this Feyerabend point first.

Note the picture to the right. It's a bear climbing a tree. Once you have that 'theory' in your mind, you see it instantly, but without that information you see, I dunno, some bugs climing a string or something. This is an example of observation being 'theory laden'. Observation of x is shaped by prior knowledge of x. People see different things because they focus on different aspects of what is there, which invariably is multidimensional and so ambiguous.

I find it really fun to see where a good idea comes from, and like to find the original sources. It reminded me of how I was really impressed by Tyler Cowen point that we try to fit our lives into stories, but life isn't like a story, it's more like a run-on sentence. That's a really profound point, but it seems Kurt Vonnegut made that exact same point earlier!

Hanson sounds like a really interesting guy. He played trumpet at Carnegie Hall, was a hot fighter pilot in WW2 (famously looping the Golden Gate Bridge), designed the unit's logo, was a boxer, and died at 42 in a plane crash, with ten books in progress, including a history of aerodynamic theory.

Sunday, March 13, 2011

Definition of Rationality

Many think irrationality is when people make a decision that with hindsight was really dumb, like making a bad investment. A good definition of rationality I found in Gilboa and Schmeidler's nifty treatise A Theory of Case-Based Decisions:

An action, or sequence of actions is rational for a decision maker if, when the decision maker is confronted with an analysis of the decisions involved, but with no additional information, she does not regret her choices.

Stated differently, a decision is rational if it is immune to logical introspection, but no new or different assumptions. Thus, you could show someone not following Bayes's rule they are wrong in real time if all they understood was logic, which is independent of empirical data. People who think 'shy librarians' are more common than 'librarians' are thinking irrationally, whereas people who think tax cuts are good/bad for the economy are rational as long as they understand how their assumptions relate to their conclusion.

Many of Kahneman and Tversky's famous behavioral biases are not robust to instrospection, and people realize that anchoring, framing, and representativeness biases are 'wrong', and thus change their opinions upon learning about their errors.

Interestingly, this implies that bees, lions, babies or morons can never be rational, because they don't understand logic, their instincts simply dominate in certain cases. But that's not most people, so if an educated group of adults believes something, and defends their beliefs vigorously, it's rational even if it's wrong.

You could not show people that NINJA loans were toxic back in 2003--there were academic conferences that basically all agreed Alicia Munell was right and Stan Liebowitz was wrong, so smart people all agreed that the historical data showed trivial mortgage risk from such changes (See Papademetriou and Ray, 2004, which highlights no doc, teaser rate, low down payment loans as efficient and just). We now know they were wrong, but the point is, they argued about this in academic journals, and they all agreed previous underwriting standards were discriminatory. Thus, it wasn't irrational, just wrong.

That's important, because it's trivial to prevent irrational bubbles, but rational ones are by definition immune to greater examination.

Saturday, March 12, 2011

Libertarian Test

It seems the government wants to put some bureaucrat in place of you actually knowing your own DNA! Alas, it isn't obvious that Democrats or Republicans are against this lame political intrusion. Do I have enough official credentials to know my BMI? My height and weight? The formula for the BMI? My IQ?

From GNXP:
In the very near future you may be forced to go through a “professional” to get access to your genetic information. Professionals who will be well paid to “interpret” a complex morass of statistical data which they barely comprehend. Let’s be real here: someone who regularly reads this blog (or Dr. Daniel MacArthur or Misha’s blog) knows much more about genomics than 99% of medical doctors. And yet someone reading this blog does not have the guild certification in the eyes of the government to “appropriately” understand their own genetic information. Someone reading this blog will have to pay, either out of pocket, or through insurance, someone else for access to their own information. Let me repeat: the government and professional guilds which exist to defend the financial interests of their members are proposing that they arbitrate what you can know about your genome.

Tsunami Caused by Global Warming

What I find so interesting about these guys is they spend a large fraction of their time discussing the big problem of people whose beliefs are predicated on bias and politics as opposed to 'objective facts' (surprisingly, this is a problem primarily for people who disagree with them):

Thursday, March 10, 2011

No Biased Coins

Many introductory probability courses involve 'biased' coins. The authors of this paper argue this is the unicorn of probability theory: everyone has heard of it, but no one has seen it, because it doesn't exist!
Dice can be loaded—that is, one can easily alter a die so that the probabilities of landing on the six sides are dramatically unequal. However, it is not possible to bias a coin flip—that is, one cannot, for example, weight a coin so that it is substantially more likely to land “heads” than “tails” when flipped and caught in the hand in the usual manner. Coin tosses can be biased only if the coin is allowed to bounce or be spun rather than simply flipped in the air

Wednesday, March 09, 2011

Crash Casualty: Diversification

Just as hard cases make bad law, economic crises create bad ideas. Mainly, the idea that you can have growth without cycles if you have more governmental meddling, which is wrong on two counts: sufficient governmental intrusion causes stagnation, and governments cause more crises than they prevent. But the current big bad idea is that complexity, and anything related to it, is toxic.

One of the pillars of finance was that diversification is one of the few free lunches in economics. Institutions and policies that increase diversification are good things, and assets that increase the number of things (states of nature) you can bet on are good things, because they allow you to hedge or simply lower your aggregate portfolio volatility. Since the 2008 crisis, that intuition seems to have flipped: diversification is complexity, which creates problems we can't anticipate. Complexity is bad. Never mind that a supposedly simple 'stock' actually owns the residual cashflow from a convoluted set of networks, financial contracts, and specialized efficiencies that generates an income statement, making a mortgage CDO relatively simple by comparison.

The Black Hole of Finance | Santa Fe Institute

Case in point, this Sante Fe lecture by MIT physicist Seth Lloyd on financial black holes, which are exacerbated by leverage and scope (ie, derivatives). He prominently mentions Glass-Steagall as a cause, as if there were any evidence that this matter other than it happened in 1997. Europe basically never had a Glass-Steagall, and during the 2008 crisis, investment banks who took great advantage of Glass-Steagall did the same as those that did not. But, that's boring. The statistical quantum mechanics of gravity implies negative energy(?). Supposedly this makes galaxies susceptible to runaway instabilities such as gravitational collapse when they collide. The analogue in economics is negative assets, debt. The model identifies a phase transition from positive to negative specific heat: when gravitational or financial systems pass through this phase transition, they become unstable. It all follows from the fact that assets=liabilities, and the fact that larger entities get greater leverage (big banks can lever more than small banks).

A lot of econophysics involves a model that creates stochastic patterns that look like bubbles or random walks, but that's not the same thing as explaining what's going on unless it can actually predict or price something.

Assumptions ultimately drive the results, and it's rather unfortunate we are taking a step backwards, and now associating diversification with instability as opposed to stability. A quaint fondness for the halcyon days when citizens would understand everything in their daily life, like that of the early American Indians, or life on the prairie for early settlers. This seems related to to unit banks--where banks had no branches, and only lent to the local economy--or locavore eating, and such longing for complete understanding of our life seems a human universal.

Civilization advances by extending the number of important operations which we can perform without thinking about them. Consider the pencil, which no single person can make. Most of us don't understand how our TV works, how to make beer, or where our toilet water goes, and that's a good thing. Specialization and trade increases our efficiency, and gives us the wealth we often take for granted. To think that Joe Sixpack should understand all financial instruments, and how they maximize social welfare, is naive atavism.

The problem wasn't complexity, it was that everyone thought aggregate housing prices would never decline significantly. My 11 year old understands that. With hindsight, it was incredibly stupid, but it wasn't a complex mistake. Currently our government is monetizing a deficit that appears endless, and the result will be nasty. The first symptoms will probably show up in some obscure derivative, but that won't be the cause.

5 Myths of Social Security

Most lists have 10, but for some reason, things pertaining to Social Security contains 5. Here's the Liberal's "5 myths", including this gem:

The Social Security Trust Fund isn't full of IOUs, it's full of U.S. Treasury Bonds. And those bonds are backed by the full faith and credit of the United States.

Here's the conservative take.

Accounting that would be illegal for a private company is pretty hard to defend. The present value of the Social Security deficit is around $7 Trillion. I can see QE3 coming, as the Treasury will probably just issue more debt that will be bought by the Fed. Problem solved!

Tuesday, March 08, 2011

Heat Players Cry

I was amused to see on SportCenter ESPN mocking Miami Heat players for, supposedly, crying after losing to the Bulls. I had a coach who once told me there are two good reasons to cry: if someone you love dies, or you just lost a big match/game. I still think it's a decent rule (provided you were a competitor, not a spectator)

Monday, March 07, 2011

What is Low Risk Investing?

I went to a wealth conference for high net worth individuals, because I knew one of the brokers (I'm not a high net worth individual). This firm is a global brand with $540B or so under management. He spoke in very simple terms, as if these people knew about as much about markets as your average person who reads the paper. The lead speaker tried to explain their Dynamic Asset Allocation strategy, that purported to lower risk. It did this by basically emulating a put option, also known as Portfolio Insurance, reducing equity exposure in draw downs (Leland and O'Brian and Rubinstein famously did this with a lot of money, exacerbating the the 1987 stock-market crash). It's not a bad tactic, but seems rather fragile, as such a rule clearly would have helped in 2008 as the increase in volatility occurred prior to the big drawdown in the second half of 2008, but other than that the time series data generally shows that such a rule merely lowers one's return.

But I was most interested that the practitioner insisted this lowered volatility, specifically drawdowns, and did not lower returns. It seems that lower risk is only tolerable if it doesn't hurt returns, because they were very clear about this.

Another interesting point was that changing equity or currency exposure was mainly done via overlaying with a hedge, as opposed to exiting positions, because this had lower tax implications. This highlights that having different taxes on assets based on how long they are held, or whether the return is dividends, capital gains, or interest, just increases financial complexity. The more the government tries to favor the kind of investment they like, or more likely increase taxes on areas with less political support, creates more derivatives, more trades, and only helps the middleman. If one really hates how much the average Goldman Sachs employee makes (which somehow represents all Wall Street, if not all 'bankers'), they should stop trying to direct investment via tax policy, and treat it all as ordinary income.

Sunday, March 06, 2011

Simpson's Paradox

Last week, Paul Krugman argued that kids in Wisconsin outperform kids in Texas, which to him implied this was due to the collective bargaining rights of Wisconsin educators (Texas does not have those).

IowaHawk noted this finding isn't what it appears. As he notes:
white students in Texas perform better than white students in Wisconsin,black students in Texas perform better than black students in Wisconsin,Hispanic students in Texas perform better than Hispanic students in Wisconsin.

So, on average Wisconsin outperforms Texas, but within each ethnicity, Texas outperforms Wisconsin. As ethnic performance varies predictably across all states, ignoring the ethnic composition of states is really misleading, and is why my state, Minnesota, appears to do so well on these simple measures.

It's the old Simpson's Paradox! It's a really fun issue that pops up often, and good to be aware of because it's one of those cases where an omitted variables bias is at work. That is, the effect of x on y shows a significant coefficient, but when you include another variable, the coefficient on x goes to zero or even changes sign. This usually shows up in a simple cross-tabulation, and it's good practice to always be looking for other variables that could affect your findings, because if you are trying to make money like I am, it's good to know the truth (if your a partisan shill it's a minor annoyance).

Here's my application of Simpson's Paradox to the CAPM, something I go over in Finding Alpha (this is from Chapter 1 of my videos):

One could also adjust for price and also find this gets rid of the positive relation between beta and average returns. Much of the apparent relation between price or size and returns, meanwhile, is the result of measurement errors such as the delisting bias and the problems of geometric averaging (I know CRSP says they got rid of the delisting bias, but there's still a huge low-price premium in their data, and that's obviously not obtainable, as evidenced by the failure of low-priced funds that were popular in the late 80's--now gone).

Monopolies for Everyone

Monopolies enjoy above average profits because barriers to entry prevent competition from lower prices down to their marginal cost. This reduces output, and raises prices for consumers, a suboptimal outcome. We all know that business monopolies are bad for the economy, even if they would help individual companies.

Yet, many still think that if only everyone can be in a union, all would be well. Political scientists Jacob S. Hacker and Paul Pierson argue in the Washington Post that not only are unions good for their members but also that unions promote a strong middle class. Krugman and other liberal economists see attacks on unions as harmful to our nation, especially through its affect on inequality. Unions have monopoly power because the federal government gives them the power, not the right, to be the sole bargaining agent for workers in a plant or company, even if many of the workers don't want to be represented. That an economist like Krugman would see such monopolies as a good thing highlights the fact that economics does not constrain or guide one's thinking, merely provides another way to frame arguments.

That the inefficiency of union monopolies is still disputed is one reason I don't take economics so seriously anymore. You can always find some convoluted reason why some partial equilibrium result generalizes, and so basic economic insights like the inefficiency of monopolies, trade restrictions, or taxes that favor debt over equity. It makes me think, what's the point of economics if these easy issues are still debatable?

Friday, March 04, 2011

Remember Liberaltarianism?

Brink Lindsey and Will Wilkinson tried to convince liberals to adopt their libertarianism, as they were frustrated by Republican social conservatism and foreign policy. I too don't like social conservatism and expansive foreign policy, but I still vote Republican, because like the Tea Party, there's a greater general desire to shrink government control among Republicans. Smaller government ultimate means less medling of all sorts, and as Milton Friedman noted, it's the lesser of two evils if you have to choose one. Republicans are less adverse to gays than Democrats are to God and guns.

The vilification of the billionaire libertarian Koch brothers by the Left highlights this big idea is going nowhere. As David Bernstein notes:

The Kochs would appear to be the perfect liberaltarians–they support gay marriage, drug legalization, opposed the Iraq War, want to substantially cut military spending, and gave $20 million to the ACLU to oppose the Patriot Act (compared to a relatively piddling $43,000 to Scott Walker’s election campaign).

It’s not surprising that some demagogic “Progressives” would nevertheless choose to try to demonize the Kochs to defend the Democratic money machine that public employee unions represent (update: though note that the attack on the Kochs began last Summer). What is, if not surprising, at least a bit depressing, is how few prominent liberal commentators have spoken out against the ongoing attempted Emmanuel Goldsteinization of the Kochs.

Indeed, Hans Bader points out that even the ACLU, as noted a major Koch beneficiary, has helped organize anti-Koch rallies, though the Kochs involvement in small government economic issues seems rather far removed from what is supposed to be the ACLU’s core agenda. So much for liberaltarianism.

'Emmanuel Goldsteinization'. Heh.

Thursday, March 03, 2011

Markets Learn, Governments Don't

Back in the housing bubble, the Community Reinvestment act required banks to meet community needs as a prerequisite for obtaining merger approvals from federal bank regulators, and by giving consumer and community groups the right to challenge these approvals the CRA provided these groups with leverage to bring banks to the negotiating table. Within a decade after the CRA was enacted, many banks created separate "community reinvestment" divisions that were often staffed by liberal individuals who sympathiszed with the aims of the community reeinventment movement. Indeed, some of these individuals had themselves been cummunity activitists who were recruited by banks to serve as liaisons with community groups. Activists pressured banks to invest more money in specific urban neighborhoods. Banks forged partnerships with community development corporations. See an Urban Studies professor's fawning praise for this result back in 2003 when it seemed like the model of good governmental activism.

The result was a disaster. Not that this was a sufficient condition, but it surely contributed to the debacle in a bad way. The lesson is yet another example of the law of unintended consequences. Trying to do good via indirect methods is very dangerous because the economy is a complex system, and when bad things happen as they often do, there's no accountability, no one in the political system got booted out of office for championing NINJA loans, while investors took it on the chin.

So I found the Federal Communications Commission's press release approving the Comcast's acquisition/merger of NBC Universal as just more of the same:

As part of the merger, Comcast-NBCU will be required to take affirmative steps to foster competition in the video marketplace...Comcast will make available to approximately 2.5 million low income households: (i) high-speed Internet access service for less than $10 per month; (ii) personal computers, netbooks, or other computer equipment at a purchase price below $150...we require Comcast-NBCU to increase programming diversity by expanding its over the-air programming to the Spanish language-speaking community, and by making NBCU's Spanish-language broadcast programming available via Comcast's on demand and online platforms."

As Canada and Belgium know, encouraging language diversity is a bad thing, not a good one, as it doesn't help the minority language speakers, but merely adds to the resentment they feel and separates them further. There's nothing worse than government policy implemented via the back door like this, because it isn't free, it just adds to the already large amount of red tape that piles up on businesses.

Wednesday, March 02, 2011

The Parable of the Light Bulb

I will always remember an existential depression I had when I was about 12 years old. We were on vacation in our family truckster and I was just thinking to myself for hours looking out the window at the scenery going by. I came to the realization that life was meaningless, and I just felt incredibly depressed for the next couple of hours. While I generally just avoided the issue growing up, eventually I reconciled my nihilism using the standard rationale that we create meaning by finding interesting things to do and doing them well--World of Warcraft, baking, discussing philosophy, parenting. This puts your life into a network of interactions valued by others--perhaps only those in the future--that makes your life part of a story as opposed to a random sequence of events.

There's a danger there, that your activity is actually like using a narcotic, something that over time producers less enjoyment because of its irrelevance to others; no one wants to be the guy who spent his whole life becoming expert in something later found to be a dead end, not valued by anyone. This is a nontrivial problem for academics who receive the weak signal of peer enthusiasm, as fads are just as common in academics as in financial markets, and many times I have heard people working on abstruse theory note that Riemann's geometry might have seemed irrelevant at the time, but a half-century after his death it proved very useful in Einstein's General Theory. Yet most geometries aren't so fortunate. I actually think most academics are doing this, as I doubt women's studies professors, string theorists, or those doing Global Warming research will find their output valued, but any middle aged practitioner has the equivalent of golden handcuffs and can't reject his life's work. It must have been awful to have been a 50 year old Marxist in 1989.

But, perhaps the problem with finding the right game to play well is even harder than I imagine, basically needing a lot of luck. Recently, I Stumbled Upon this interesting riff. Here's an argument that the solution may not be within us:

A light bulb sits on a store shelf for several weeks, is bought, taken home, and put in the cabinet for months and months. Alone and in the dark, in a way, it could feel that life, alone and in the dark, is a stupid, futile, pointless exercise.

When, however, it is taken out of the cabinet and plugged in to the socket, all of a sudden it becomes useful; it serves a purpose, and all of the parts and pieces work together harmoniously to serve as a conduit for light. It is now doing what it was designed for, it is performing the job it was built for. This might be the same as what can happen with human beings.

If this is the case, then the whole aspect of "creating" meaning does not work. It would be like the lightbulb taking up yoga or canvas painting in an effort to "create" meaning. While this might work for a little while as a temporary distraction and amusement, the light bulb would not experience permanent relief until it became plugged into the socket, or performed the exact function it was built for.

The question we should all be asking: am I just a closeted yogi lightbulb?

Tuesday, March 01, 2011

Low Vol Presentation in NYC March 16

Above are the total return charts for low and high beta stocks, where portfolios were created using 100 stocks out of the top 1500 non-ETF US equities. You can see that high beta stocks are outperforming, low beta underperforming, by a couple percent relative to the S&P500.

The latest low vol conference is at some New York financial club on March 16, $50 at the door. That's not close to me, so I won't be going, but looks interesting.

Time: 5:30 PM – 8:30 PM
Venue: Patrick Conway's Pub & Restaurant (downstairs), 40 E 43rd St (between Madison & Vanderbilt), NY, NY – ½-block from Grand Central Station.

Speakers are:
Ruben Falk, Senior Manager, Capital IQ, "Leveraging Minimum Variance to Enhance Portfolio Returns"

Yin Luo, Managing Director and Head of Global Quantitative Strategy, Deutsche Bank Securities, "The Puzzling Relationship between Risk and Return - Defensive and Offensive strategies".

Interestingly, Falk seems to emphasize how to layer this onto a value play (see here). He suggests low volatility investing 'works' (ie, dominates the indices) because of 'leverage restrictions', the Frazzini and Pedersen argument. Lou of DB, meanwhile, highlights "although they have some intriguing properties, low risk is not necessarily one of them". He's one of the coauthors of the white paper I discussed last week, and I think this refers to the fact that his MVP had some bad returns in the last financial crisis. But his white paper had a rather nuanced view of the data I found almost nonsensical, such as when DB wrote "the strategy does not actually position itself so that low-volatility stocks outperform; instead it aligns itself so that lower risk portfolios outperform." I don't think the MVP portfolio, with short positions, is the essence of the anomaly, rather, the simply flat to negative beta/vol relation to returns. As I said, I think they're gilding the lily.

GAO Report Finds Redundancy, CFPA to improve SEC/CFTC/Fed/FDIC/OCC/OTS/OFHEO

The CFPA was set up with a carve-out of Federal Reserve revenue, and thus is a new perpetual bureaucracy that will somehow do what the other regulators and various state insurance regulators were supposed to do but did not. The solution to a conspicuous disaster is to simply add another regulator. A recent nonpartisan GAO report noted wasteful redundancy in federal programs, as reported in today's WSJ:
The U.S. government has 15 different agencies overseeing food-safety laws, more than 20 separate programs to help the homeless and 80 programs for economic development.

If they wonder how these things happen, the new CFPA is a good example.

Simon Johnson, former chief economist (!) at the World Bank, took time to defend Elizabeth Warren and the CFPA. Johnson is infuriated by the mockery of some groups, such as Congressman Bachus's statement that "If you like TSA at the airport, you'll love these guys." He has all the naivite of a child, or MIT macroeconomist.

Johnson notes:
please remind all members of Congress, regarding their oversight role during 2000-08, that despite everything Countrywide did, including the horrible way it treated consumers and the many apparent deceptions in its practices, Angelo Mozilo walked away a rich man

Just like Henry Cisneros, Franklin Raines, Bill Syron, Jamie Gorelick, Robert Rubin, Herbert Sandler, who got rich(er) off the housing bubble and paid no price. You simply can't say Mozillo was doing something 'horrible' because it was what the government wanted: more loans to poor people. He didn't sneak anything by our regulators, he outlined his strategy at a Harvard speech in 2003 and government and academics thought it was a great idea.

Thus far the CFPA has merely highlighted they will be at least as bureaucratic as any other agency, as they note their mission to educate the public (I can't wait for their The More You KnowTM adverts to make TV), community affairs (surely essential), research (you can never have enough government research), Fair Lending and Equal Opportunity (which led to the last boondoggle), and tracking complaints (the old suggestion box, something that existing agencies could never have accommodated). Their first step will probably either be really lame (eg, adding places to initial on mortgage applications), or really destructive (making something consumers want illegal, thus driving it to less scrupulous markets as in pay-day lending).

Regulators can do good things, as when they outlawed Lawn Darts. In this case, they could not just allow but require hedge funds provide their returns and assets under management, so that investors are not duped into some fad based on selectively hinted returns released to the press and repeated by unskeptical reporters. They could also take over the job of monitoring the performance of the rating agencies, so that there's a consistent and unbiased set of data on what various ratings mean (currently, the agencies do this themselves, and often do not report sub-categories like munis, government debt, or asset-backed securities). Yet, I'm sure other agencies have the ability to do these things, and for some reason do not, so I'm not optimistic.

My guess is they will simply give their agency some sort of sign-off authority, which will make them feel important, and not do anything but cost money. It could be worse.