Market Cap Less Than Cash

This WSJ article notes people looking for stocks that sell for less than the amount of Cash on their balance sheets. Here are current US Stocks with a Market Cap < Cash on Balance Sheet:

Short Name Industry Ticker
FORD MOTOR CO Auto Manufacturers F
GENERAL MOTORS Auto Manufacturers GM
ICAHN ENTERPRISE Holding Companies-Divers IEP
CONTINENTAL AI-B Airlines CAL
GOODYEAR TIRE Auto Parts&Equipment GT
UAL CORP Airlines UAUA
CENTEX CORP Home Builders CTX
US AIRWAYS GROUP Airlines LCC
CIENA CORP Telecommunications CIEN
ASHLAND INC Chemicals ASH
AMKOR TECH INC Semiconductors AMKR
WELLCARE HEALTH Healthcare-Services WCG
TRW AUTOMOTIVE Auto Parts&Equipment TRW
SANMINA-SCI CORP Electronics SANM
ATLAS AIR WORLDW Transportation AAWW
GLOBAL INDS LTD Oil&Gas Services GLBL
LIBERTY-CAP A Media LCAPA
ARVINMERITOR INC Auto Parts&Equipment ARM
RTI INTL METALS Mining RTI

Clearly, those are not 'obvious' buys (Ford?), but nothing is.

The fundamental approach to investing is exemplified by the approach of Benjamin Graham, a very successful early popularizer of this approach. Graham was born in 1894 and started a brokerage in 1926, during the midst of an economic and financial boom. In 1928, he started also teaching a course on security analysis at Columbia. In a very influential book, Graham and Dodd’s Security Analysis (1934), and later Graham’s classic The Intelligent Investor (1949) , a generation of securities analysis’s learned how to evaluate stocks as investments. Sound investing was simply buying stocks below their intrinsic value, and avoiding stocks above their intrinsic value. Intrinsic value was a function of their balance sheet and income statement. Warren Buffett, was the only student in Graham's investment seminar at Columbia to earn an A+, and has tirelessly praised the man and his method. Interestingly, though Buffett wanted to work for Graham right out of school, Graham had a policy then of only hiring Jews at that time. Buffett never held this against Graham, and they ended up working together later.

For example, one would look at the Price/Earnings ratio, compare it to other stocks, to bond yield, and if the Earnings/Price yield was significantly higher than what one would expect on bonds, the stock is good. Other valuation ratios were debt-to-equity, dividend yields, net current assets, book equity, and earnings growth. One applied these ratio into various formulae to find attractive stocks. Graham argued that the market is a capricious popularity contest, but ultimately, true value shines through, so the key is both prudence (knowing true value) and courage (not being dissuaded by short term fluctuations in the market).

He suggested buying companies when they could be bought for a 1/3 to 1/2 discount to intrinsic value (this in a lifetime when interest rates were typically single digit), a safety margin in his investing strategy. In this way, Buffet often says that risk and return are inversely related, because a 'good stock' necessarily has the least risk (eg, if it is selling for $4 and is worth $20, it is a good buy and has low risk). After buying, don’t pay much attention to the market price, and sell out when the business model changes.

While initially Graham favored the simple comparison of book equity, or net current assets, or even net cash, to market value, his approach grew to incorporate dividend growth over the next 30 years. Thus there are a few famous calls where firms were seemingly worth more in liquidation than as going concerns, and these he argued were good buys (thus the list above). After his 1934 volume, the Dividend Discount model was discovered, a way to explicitly handle growth, though this was mainly handled by one of his co-authors, Sidney Cottle, because Graham saw earnings projections as speculative.

Pirates and Global Warming

In a seminal amicus curiae to the Kansas City Council in their Intelligent Design debate, along with introducing the Flying Spaghetti Monster to ethnocentric atheists, Billy Henderson introduced the famous 'pirate effect', which showed conclusively that the number of pirates is inversely related to mean global temperature: hotter earth, fewer pirates.

The recent pirate attacks, such as the takeover of a $100MM supertanker well off the coast of Kenya, should therefore come as no surprise. As shown below in a chart of monthly satellite recordings from 2003-8, world temperatures have fallen drastically in the past year.

As sure as night follows the day, pirate attacks increased sharply.


It would be a mistake in logical inference of the first order, however, to blame 'global cooling' per se, because we all know that global cooling is a direct consequence of global warming, via interactions implied by climate models.

A Pervasive Index Bias

I was amused in this blogging heads video when these guys note that art indices have a huge survivorship bias to them. Don't they all.


Most asset indices are presented by groups with a strong vested interest in the asset in question, which is more so the more illiquid the asset.

There’s a clear bias by all data providers to overstate the returns in the indices they present. For example, Malkiel and Saha (2005) found that no hedge fund data base providers has the last year of Long Term Capital Management in their dataset, excluding the -92% return, and so the indexes exclude the very risks that make hedge fund investors nervous. Malkiel and Saha estimate this bias adds approximately 6% to the annualized returns. Who creates these indices? Usually groups that are allied with the product one is examining. For example, the Credit Suisse/Tremont Index that monitors hedge fund returns is maintained by the following:

The joint venture, Credit Suisse Tremont Index LLC, combines the considerable expertise of Credit Suisse, one of the world's leading global investment banking firms, and the data research group of Tremont Capital Management, Inc., a full-service hedge fund of funds investment management firm.

It is an inevitable conflict of interest where those most knowledgeable, and have access to the best data, will be advocates of this field—one does not become extensively knowledgeable in something one thinks is irrelevant, inefficient, or fraudulent. Often times there’s an arm’s length separation between the index provider and the portfolio managers, but there is no way they can be indifferent: without the market thriving, seeming to offer a good opportunity, their service will not have a long life. After all, it was conventional wisdom that active portfolio managers outperformed passive indices until the 1980’s—for several generations—because the evidence was generally held and presented by the active managers and their industry groups. It was based on the intuitive idea that someone managing a portfolio is obviously better than merely buying an indiscriminate, equal weighting of equities. So issues like using closing prices to calculate total returns, while in very liquid markets a benign assumption, in illiquid markets is a material error.

Complexity of the Subprime Bubble

I just learned about 'Down Payment Assistance programs' that proliferated in housing bubble. In these programs, a home builder (D.R.Horton) giving a “gift” to the nonprofit (eg, Nehemiah Corporation), then gives the downpayment to the buyer, which then qualifies the mortgage for FHA guarantee! The FHA actually presumed this gift money was 'like' a down payment, and so then meant they didn't have much risk. Indeed, the FHA required the builder to make such a donation to the nonprofit to then be eligible for the mortgage support. This is a very complex set of favors that allow all sorts of butt-covering. Often, the house price is inflated by precisely the amount of the 'gift' (around 5%), so this is just a small little escrow for the builder. The Wall Street Journal discusses how this created no-money down mortgages on $480k properties. This program by the FHA was rescinded in October 1, 2008. Interestingly, the FHA has no data on what percentage of the loans it guaranteed were based on this corrupt practice.

That's the kind of program that just guarantees a bad ending. To see the government agencies involved in so much of this, it really defies credulity to think 'more regulation' would have prevented the crisis, as opposed to making it worse. While the FHA does not allow this practice, it still provides loans for people who merely have 3% of the house price to put into a down payment! For those arguing for 'more' regulation, does that mean more of these loans?

Uh Oh

From the NYTimes:

President-elect Barack Obama has signaled that he will pursue a far more ambitious plan of spending and tax cuts than anything he outlined on the campaign trail — a plan "big enough to deal with the huge problem we face,” a top adviser said Sunday

I would like to say I, for one, welcome our new Democratic administration. I'd like to remind them that as a trusted blogging personality, I can be helpful in rounding up others to like their higher tax obligations. While not a traditional minority, like everyone else I am very unique (and live in a swing state).

Tyler Cowen for Guns & Butter

Tyler Cowen is a good blogger because he filters a lot of information and highlights a lot of interesting news. But he is also an incredibly nonjudgmental reviewer, who seems to have hundreds of favorite labor economists, Peruvian painters, Italian novelists, and always sees papers as being at least half full of insight. He's the Paula Abdul of economists, which is fine once you know how to notch down his reviews.

The latest brouhaha about the New Deal, where liberals are trying to re-write the poor growth in the 1930's as the result of restrictive fiscal policy, rather than excessive government meddling, has pitted Paul Krugman, Brad DeLong, against Russ Roberts, among others. So Cowen wrote a down-the-middle argument in the New York Times, where he comes out subtly for both sides in this debate: everyone wins!

He starts by arguing against the New Deal. He's against monetary contraction, agricultural policies (paying to not grow), and the cartelization of industry. This last item, however, is really a loaded term because it could refer to the whole panoply of New Deal intrusions: the Tennessee Valley Authority that nationalized a lot of utilities in the Southeast, the National Recovery Administration (NRA) that tried to set minimum wages and other Labor wants, the nationalized unemployment relief through the Works Progress Administration (WPA), the Wagner act that strengthened the Unions in collective bargaining. He could be talking about merely to one of the more absurd policies within this list, but who knows.

Cowen then cryptically notes the positives of the New Deal:

the truth is that Roosevelt changed course from year to year, trying a mix of policies, some good and some bad ... The good New Deal policies, like constructing a basic social safety net, made sense on their own terms

What could those social safety net policies be? If it were just social security, I presume he would have said social security, so what is in that list? I guess it's take your pick from those policies that were intended to be a safety net within the NRA, WPA that contributed to the cartelization of industry. Pro-New Dealers consider everything part of the 'safety net', whereas anti-New Dealers point to the cartel characteristics, same policies, different emphasis or spin. So, he needs to be more specific, because otherwise this is like saying he is for the 'pro growth/happiness' policies and against the 'mean/decline' policies, which are the same policies seen through a different lens

Like an economist who thinks both the Keynesians and Monetarists were right, the man who sees the truth of each side of an argument sees nothing. Surely, every side has its correct arguments, its principled arguments, but one should step back, and say, net net, that the New Deal was good or bad, not that it was a mixed bag, leaving the good and bad as an ill-defined overlapping set of programs.

Free of Bush

My local paper has a weekly column by well-know raconteur Garrison Keillor. His tales about Lake Wobegon examine the sometimes poignant, sometimes funny, idiosyncrasies of small-town America. But for the past few years his weekly articles in the local paper were nonfictional vents about the Stupid, Evil, Lying Bush Regime. One could feel the hate dripping from his columns, as Bush's existence clearly made him very angry. Now, a couple weeks after the election, his column is about the standard fare of novelists: observations about very picayune issues, nothing about politics. You sense a great cloud has lifted, and he can resume his vocation again, forgetting about national politics now that Chimpitler McWalliburton is a lame duck.

Now, Bush's last 4 years generated very little actual legislation. It is hard to see how Bush was oppressing so many, but a lot of people, especially intellectuals like Keillor, found his presence to be intolerable on a daily basis. It is strange the degree to which the symbolism of someone putatively in charge, but who actually does not affect your daily life much, means so much to so many.

Moderation in All Things

I love Mixed Martial Arts because the combination of wrestling, ju-jitsu, and boxing is a great combination, requiring athleticism and considerably more strategy than any of these sports alone. But I do think the success of anything creates an over-reach, and thus: X Arm. They promote it as a combination ju-jitsu, arm wrestling and kickboxing. The opponents are tied to a podium, with one arm in some kind of arm wrestle, while they whale on each other and occasionally try a joint lock. I'm not sure if it is a joke. Like chocolate-dipped watermelon slices, some good things don't mesh well.

Mortgage Simulation Circa 2001

In this latest crisis, one thing that really intrigues me is the degree to which everyone underestimated mortgage credit risk. I was oblivious, doing other things, but what were those in this sector thinking? I am skeptical of most of those who loudly claim to have foreseen this crisis for several reasons and I won't rehash them. But this piece estimating mortgage credit risk in 2001 highlights a common error in risk management, or econometric analysis:

To estimate the empirical survival curves, we rely on a large and geographically diverse data set from a major financial services firm. Data includes credit ratings for the borrower at the time of loan origination. Inclusion of this important variable helps ensure unbiased estimation of the coefficients of other risk factors, such as current loan-to-value ratio and changes in local unemployment rates. We should also acknowledge data limitations: it only includes loans originated during 1993-1997 time period when house prices in most (though not all) markets were stable or increasing

Sounds great, like they are just modeling cross-sectional risk, dipping their toe in the empirical pool. After all, 4 years, not including any cyclical volatility, that would be irrelevant for modeling a worst-case-scenario, and they realize this.

But then after torturing the data for 30 pages, the authors conclude with:

We find that the current regulatory standards for capital are too high in most cases.

No mention in the conclusion about the lack of a real cycle in their sample data! They knew the data's limitations, but by the end ignored them. In other words, forget about the business cycle--we have a large number of observations! I see this a lot in default modeling, where someone will look at a bunch of daily data on bonds, and say they have 400,000 observations in the default model, ignoring the fact that the ten years of daily IBM data is not 2520 observations, more like 3.

It's a common problem, mistaking the number of observations for degrees of freedom, because the correlation structure underlying the data may actually drastically reduce the degrees of freedom. Making sure your data has the appropriate sample is a big issue in all social science, as often someone will observe how college kids respond to stimuli to predict how people in general respond, assume men are the same as women. Their is no simple cure other than to be thoughtful about the specific application.

Bias vs. Competence

Two weeks ago Arnold Kling had this rather cynical view of the peer review process in academia:

I put no special value in peer review. You can have a peer who discards a paper for purely idiosyncratic reasons, or because he just does not understand key aspects of the paper. More often, you have a peer who approves a paper because it cites his own work favorably, which makes it immune to criticism in the eyes of the reviewer.

He is describing the his frustration with the popularity of certain strains of economic thought that are dictating current research, but to him seem a dead end. Such things often happen because as a field gets more advanced it takes considerable investment just to participate in the debates, but then, after investing a couple years in such learning, one is in somewhat of a dilemma, because noting 'this is all hairsplitting nonsense' both alienates you from your colleagues (presumably, many of whom are friends), and also trashes a lot of your human capital. Thus, many in a position to make strong criticisms tend to merely make inside the paradigm criticisms.

Obviously this is bad, but the problem is current paradigms don't have neat labels that allow us to objectively distinguish between fads and facts. It is the trade-off between the incompetent many versus the corrupt few, the fact that experts are biased, but the masses are ignorant. I think moderation is the key to this debate as any other, and so there will be an optimum in the messy middle. That is, I'm glad we don't have referendums from the general populace, university students, or even the American Economic Association (AEA) on basic arguments. Yet I'm also troubled by the way certain threads within economics become citation circles that waste resources and hurt the economics brand.

As much as scientists like to 'think outside the box', they generally think inside a very small box, the more so the more they think they don't. The box is rarely based on the policy implications, but rather the methodological and presentational protocols they consider appropriate, and like to think of them as the essence of logic and rigor as opposed to bias. All biases are basically held as beliefs about what is true, in the William James sense of those beliefs that you think have the highest Net Present Value. A 'bias' is merely such a belief you disagree with, and although on a meta level we all understand people have biases, we think our beliefs are true, otherwise we wouldn't believe them. I don't know how to fix the problem more quickly than Planck's observation about waiting for the vanguard to die (OK, I do know how, but I think we have to reject that on first principles).

One path to success in dealing with the highly self-interested gatekeepers is going straight to the public, around the bias, but potentially through the ignorant. With the success of Freakonomics, many economists have taken this approach, though I think it's effectiveness is ambiguous. I'm with Ariel Rubinstein when he notes that there is not much economics, as opposed to mere cleverness, in such tomes. Popular economist John Kenneth Galbraith noted he never had a journal submission rejected, but this was because he wrote only books and invited articles, meaning this immensely popular author did not have to mind the academic peer review process. In contrast, I remember TA-ing for the then President of the AEA Robert Eisner and his submission to the main AEA journal (the AER) was rejected while he was President--kudos to Economics integrity! As popular as Galbraith was in his life through his writings and omnipresence as a public intellectual, I don't think Galbraith's ideas have held up very well: check out Industrial Organization journals or graduate textbooks, and you won't find his name very often if at all. For example, Galbraith argued a lot that large firms have a lot of market power over competitors and consumers, but the small size effect suggests being large is not a net advantage, but rather a disadvantage (eg, why couldn't GM crush Toyota in the crib?).

There is some research, however, that did gain a more solid footing outside of economics experts, but gained solid influence in economics. Hernando de Soto's early non peer reviewed work on property rights in South America (The Other Path, published in 1989), really predates future serious work on the importance of institutions and rules, and helped provide valuable empirical support for the overthrow the older focus on monetary and fiscal policy as being the most important issue in development. One might also note that behavioral economics really gained overwhelming momentum outside economics before becoming a mainstay within. That's not really the same as 'not peer reviewed', but it's not 'economics peer reviewed'. Kahneman, Slovic, and Tversky's Judgment Under Uncertainty: Heuristics and Biases, published in 1982, was first introduced to me by a psychology grad student in 1988 who said it was all the rage in her field.

In sum, its a mixed bag, there is no obviously better way than our current system of using specialist gatekeepers.

Whence our Subprime Crisis

HUD News Release from January 19, 2004:

BUSH ADMINISTRATION ANNOUNCES NEW HUD "ZERO DOWN PAYMENT" MORTGAGE
Initiative Aimed at Removing Major Barrier to Homeownership

LAS VEGAS - As part of President Bush's ongoing effort to help American families achieve the dream of homeownership, Federal Housing Commissioner John C. Weicher today announced that HUD is proposing to offer a "zero down payment" mortgage, the most significant initiative by the Federal Housing Administration in over a decade. This action would help remove the greatest barrier facing first-time homebuyers - the lack of funds for a down payment on a mortgage.

Speaking at the National Association of Home Builders' annual convention, Commissioner Weicher indicated that the proposal, part of HUD's Fiscal Year 2005 budget request, would eliminate the statutory requirement of a minimum three percent down payment for FHA-insured single-family mortgages for first-time homebuyers.

"Offering FHA mortgages with no down payment will unlock the door to homeownership for hundreds of thousands of American families, particularly minorities," said HUD's Acting Secretary Alphonso Jackson. "President Bush has pledged to create 5.5 million new minority homeowners this decade, and this historic initiative will help meet this goal."

Senate Hearing on Autos

I was watching the senate banking committee hearing, where the CEOs of the big Three US auto companies, the UAW leader, and an awesome economist named Peter Morici were giving testimony. It was very good, in the sense that everyone gave a clear argument, and with the economist, we had a little debate. Unlike Sunday talk shows, there were fewer bold claims of fact because they knew they were on the record, and so a material and negligent or misleading statement could engender liability. Further, they got a long time to talk, without commercial interruption.

One fact that seems material, is when Gettelfinger, the UAW president, testified that "one industry analyst has indicated that labor costs for the Detroit-based auto companies will actually be lower than those for Toyota’s U.S. operations". That seems wildly at odd with the data below. I suppose if you exclude legacy costs, and costs for existing workers and the union rules and the job bank, that might be true, but that's excluding a lot. Considering the burn rate, I don't see why we have to wait until 2010 for these cost savings to show: if they want our money, why not demand they lower their costs now.


The sad thing is, even given this relatively well-run forum of opinions by experts, they still end up passing legislation they do.

CSI: Greenwich

Andy Lo's testimony (pdf here, video here) in front of Congress included this little recommendation.

The most pressing regulatory change with respect to the financial system is to provide the public with information regarding those institutions that have “blown up”, i.e., failed in one sense or another. This could be accomplished by establishing an independent investigatory agency or department patterned after the National Transportation Safety Board, e.g., a “Capital Markets Safety Board”, in which a dedicated and experienced team of forensic accountants, lawyers, and financial engineers sift through the wreckage of every failed financial institution and produces a publicly available report documenting the details of each failure and providing recommendations for avoiding such fates in the future.

That would be a very fun job--I would love see Lehman or Bear's balance sheet when they failed. Too many times all we have after big disasters are journalist accounts, and they bring their own bias to these stories, as inevitably to get good info they need an insider, and every insider has an agenda. Most investors don't like revisiting their failures, and of course legal risk inhibits discussing events too much, so there's a real bias for the story to die at the very superficial level of some local paper accounts.

Add in the occasional sordid murder subplots (eg, Kissel murders, Seth Tobias), and who knows, forensic accounting could be sexy.

New Deal Was Conservative Fiscal Policy

Here's Krugman trying to spin the prolonged slump of the 1930's on 'balancing the budget'. This insightful riposte to conservatives arguing the New Deal was bad for the economy was seen as 'devastating' by Steve Benen. That really depends on your priors, I guess.

FDR did try to keep the budget balanced, as the Keynesian idea that deficits produced growth was not conventional wisdom for any subgroup for another 20 years (the General Theory was published in 1936, after all). I think such spending does not have an expansionary effect, though I suppose the industry thinks it does by a 60-40 margin. Still, you had an insane number of new government programs and tax increases that could be called typical liberal programs in the New Deal: price controls, Social Security, work relief, unemployment insurance, the cartelization of big business, minimum wages, slaughtering 6 million pigs, leaving fruit in the fields to rot, government-granted privileges for labor unions, government works projects, higher taxes, etc. Only on the budget deficit would the 1930's fall in the category as 'conservative', so that's all the Left has to explain why this didn't work. As a fiscal conservative, I would gladly trade a big budget deficit for lower taxes, spending, and regulations.

Experts vs. Markets in Ultimate Fighting

Tradesports had the UFC fight favoring Lesnar: 52-48. That is, pay 52 to win 100 with Lesnar, as opposed to paying 48 to win 100 with Couture.

Sherdog polled 34 actual MMA fighters, and they picked Couture: 28 to 6.

Lesnar won by TKO in the second, and won the first round on all three judges cards.

Election Recount Highlights Futility of Voting

In Minnesota, out of 2.9 million votes, the difference between the Democrat and Republican is currently about 200. Now, given we had to fill in these bubbles with pens, surely some voters filled in bubbles in various levels of incompleteness, or with X's. That is, say 0.02% filled out their ballots 'ambiguously', a conservative estimate. That means 580 votes are basically an election's measurement error, a bound within which there is no precise, objective, estimate.

The basic analogy is, say you had a bet with an alien being that the mass of the Earth is some number, like 5.95124897564653554×10^49 kilograms. That is, with 50 digits. Now, we need to count every atom, so 'every atom counts'. But more important is not each atom, but the rules on which atoms to count, those entering, or leaving the atmosphere at any point in time. If the number is decisive by one atom, clearly there will be a reasonable argument as to why a certain atom should, or should not, be considered part of the Earth. The decisive issue is not the number of atoms and their ultimate mass, but to the extent we get to measurement error levels, how we handle special cases. Conditional upon an atom becoming decisive, it become irrelevant through other means.

Now, the determination of how to interpret these ambiguous votes comes down to lawyers, and judges, rather than voters. That is, given the number of votes that people can reasonably disagree upon is probably at least 1000 votes, the probability that your individual vote will determine an election is not near zero, but zero. This is because any election with millions of votes that is decided by 1 vote, will be decided by lawyers and judges using tendentious reasoning with a great deal of pretext veiled as principle (and lots of citations). The only scenario where one's vote counts implies legal wrangling will be decisive, the vote being transferred from a referendum to a meta-judgment about how to deal with smudges and the credibility of people who belatedly find votes in their car, etc. Franken has 1250 lawyers helping his recount, and I've read that Coleman has 120. There is no objective reality with a one vote decision, rather, when the vote is within 0.05% (well above a 1 vote difference), who has more effective legal support.

Lesnar in 1

I think Lesnar will destroy Couture in their fight this Saturday, because he has been working on his jujitsu, and plugging that deficiency makes him a really tough fighter. If he wins, the UFC will really get a marketing coup, so I'm sure the fix is in! Lastly, I just can't see how Couture's 45 year old body will handle the 31 year old, much stronger Lesnar.

Tradesports has it 52 to win 100, on Lesnar, so that's pretty much a draw.

Billionaires, not Geniuses

Watching Hedge Fund billionaires testify in front of congress was rather illuminating. They weren't nearly as impressive as their fortunes might suggest, though with the threat of litigation and legislation I can empathize with their being terse. Yet some said enough to make you understand they do not have an understanding of the current situation much deeper than Thom Friedman's latest thumbsucker on 'why we just can't sit down and work this out'. Not that they sounded as emotional and uninformed as some members of congress, but Griffith sounds like your average 40 year-old businessman. He was the only one that commented on Burton Malkiel's suggestion, that CEO's be paid with option that last well after they leave their firm mitigate moral hazard, with the very forceful objection that this would inhibit essential 'risk taking'. Of course, moral hazard is 'excessive risk taking' created by bad incentives, so Griffith left undefined exactly how getting options that might last 5 or 10 years after their tenure, as opposed to 1 year, inhibits risk taking. The whole point of moral hazard is if the horizon is short enough, lots of risk taking is imprudent though rational, thus the longer timelines. I have difficulty understanding why giving people insanely short horizons is so important. I especially do not like it when anyone selling a financial product who's risk has a weighted average life of 7 or 10 years, gets an option with anything less than 7 or 10 years. That's just dumb.

In general, Griffith was least impressive as to his insights. Paulson was rather boring and circumspect, and Falcone pretty much said nothing not written by his lawyer.

Simons didn't say much, but like a math genius, had a highly particular intelligence. He stated it was very important to step in and stop people from getting kicked out of their homes. It was a sop to legislators looking for support for something radical, and reflects a superficial understanding of the current mortgage problem (which is unrelated to his firm's activities), as the current homeowners who are not paying their bills are hardly sympathetic, and prolonging the length of time before the bank repossess the house causes more rot and decrepitude, but Simons has this intuition of an undergrad, of hard-working people who just 'fell behind' in these bad times. Lengthening the duration of the foreclosure process merely lengthens this crisis.

Then there's Soros, a true rich businessman crank. Like many successful businessmen, he has a good understanding of the real world. But also like many successful businessmen, he thinks this is a profound, academic understanding. It is not. Many wise people have a great understanding of life, but that's different than a theoretical, academic understanding, because a scientific understanding is very specific. It is very parsimonious and testable (when good). The number one characteristic of an older person (ie, over 25) learning statistics or modeling is they add too many parameters to their models. Their intuition is brimming with reality, which is insanely multidimensional.

Thus, Soros propounded his theory of 'reflexivity' to the committee, and even though he did not define it, because it profoundly changes the way we look at financial markets, it implies we must replace Basel 2 with Basel 3. If you google 'reflexivity' and 'soros', see if it makes any sense. I have no doubt that Soros is a smart man with great investing ideas, they just aren't the basis of 'theories' or Basel 3. This is why relatively uninspiring men in academia can do so well, because their field is quite different than in business: proving things, creating models to build upon. Often quite useless, they are analytical tools, much more so than the wise advice of some old relative that, while more profound, can't be systematized.

Michael Lewis: Misses Again

Earlier this year, Michael Lewis blamed the option model Black-Scholes for the current mess. This was a bit like blaming arbitrage, or present value functions for the meltdown. Sure these tools might have been used by some in this process, but it was hardly the distinguishing characteristic of the subprime bubble. He is getting better, as he has new piece in Portfolio.com on Steve Eisman, a hedge fund manager who bet correctly on the subprime meltdown. It's a well-written article where, like Malcom Gladwell, he takes you into a story with an arc about staid conventional wisdom shown up by an intellectual maverick.

Alas, it is also profoundly misleading. His thesis is that ignorance and shameless chutzpah is the essence of this crisis and finance in general. While I agree that there is a considerable amount of ignorance and deception in finance, these are not particular to this industry, nor it's main characteristic.

The initial story is about Eisman, who started his career as an equity analysts looking at mortgage lenders in the 1990's, learned they were mainly liars from the very beginning. The problem is recent work has shown that while credit standards declined since 1990 (cowed by cries of discrimination--see Liebowitz), the bad stuff with extra-normal loss rates was all originated after 2004, so Eisman is a bit of a broken clock here, finally correct. The problem is, every salesman omits much, exaggerates much, something that might be characterized a lie. That's what they all do, but that does not mean every firm, every field, is about to crater. Eisman calculated that

All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.

As luck is when preparation met opportunity, he was prepared to find this better than anyone, and the new CDX default swaps allowed Eisman to put this trade on directly right when the market started to really get bad, a trade he had been predisposed towards for 15 years. In other words, Eisman was correct, but his permabear view on subprime mortgage highlights that subprime's essence is not the problem, but rather, the climax of the bubble was the issue. Lewis notes that in the end, investor demand really created these 'liar loans', because there was so much demand that unethical suppliers who knew better filled the need. This is a much more complicated issue, because if in the end, buyers were not doing due diligence, wasn't their demand, the essence of the problem? Where did this demand come from? In the end, this story is like someone talking about a Robber Baron making a fortune in the panic of 1893--interesting, but not the essence of the Industrial Revolution though some would like you to think so (see Hielbroner's Worldly Philosophers extended portrayal of conspicuous consumption and such).

Lewis is back to his old Liar's Poker thesis: finance is a massive con-job foisted on investing rubes, dominated by aggressive, smart (but ignorant) frat boys. Lewis had lunch with the focus of that book, former Salomon CEO John Gutfreund, and he notes Gutfreund confirms he didn't really understand everything they did at Salomon, and his subordinates were greedy and didn't really understand what they did.

Welcome to the real world! Do you think George Bush really understands education? Stem cells? How about FDR's understanding of the economy (this is the guy that invented destroying output to help the economy via farm programs--note that in the 1980's the US destroyed 1 billion oranges. what a legacy)? What about JFK, who used the mnemonic that the 'M' in Monetary Policy was for then current Fed chief McChesney? The point is, most leaders are ignorant about the processes they putatively lead, so the archetype for a leader is a drum major as opposed to inventors like Bill Gates and Microsoft. But then, salesmen are not the most informed on what they are selling, and market makers are often clueless about what drives the long term value of what they are buying and selling, and even Bill Gates now doesn't understand most Microsoft products. A complex market economy means everyone knows a little bit, and if we all mind our jobs, the system works because it has good incentives. Mistakes are made, but with failure, they are corrected.

Thus, Gutfreund's stupidity, and the rash loans made at the end of the subprime bubble, are different kinds of stupidity, and neither the distinguishing characteristic of finance. The natural stupidity of leaders, which I have blogged about many times before (eg, here), is simply the fact that 'know-it-all's are not the preferred leader in any context, because the powerful masses they lead do not want to be dominated, and so they want someone ingratiating who is merely diplomatic, and good at articulating the practical consensus. The ignorance at the end of a cycle is quite different, the orgasmic phase with impossible business models that with hindsight always seem so stupid. These are different problems, and the theme, that stupidity and fluff underlies all finance, is a profoundly misleading insight, that unfortunately seems to stick with Lewis as his one big idea.

Smart People are Nicer

So implies this study, where people who scored higher on IQ tests played "nice" on the first move in the iterated prisoner's dilemma game. Too bad, because this means groups of less intelligent people hurt themselves further by avoiding the positive gains from trade.

Krugman Highlights Limits of Education, Intelligence

Paul Krugman will receive his Nobel Prize next month, and I don't doubt that he deserves it for work I never really studied but sounds pretty well respected in the Industrial Organization area. One must remember that economic nobel prizes are given out, usually, for generating really clever abstract models. If they pertain to reality, that's merely a bonus, not the key. Anyway, we could not agree less, suggesting that learning economics merely helps one articulate your prejudices, as opposed to forming them.

Krugman in rare form, trying to plant some seeds in the upcoming administration:

the truth is that the New Deal wasn’t as successful in the short run as it was in the long run. And the reason for F.D.R.’s limited short-run success, which almost undid his whole program, was the fact that his economic policies were too cautious.

I don't know where to start, other that we disagree on pretty much everything as a matter of fact.
Social Security: Ponzi scheme soon to be over. Started with twenty some workers per recipient, soon to end with inverse odds. Will it still be considered successful, ex ante? Was Enron 'successful' in 1999?
Paying for farmers to take land out of production: This is known as partial equilibrium analysis.
WPA and NRA: make work and officious.
SEC and greater financial regulation: barriers to entry in finance.
Smoot-Hawley: tariffs maintained, but exports declined more than imports (go figure, they all retaliated), so net effect hardly something to be proud of.
Wagner Act: hurt employment, prevented wage adjustments when prices are falling 50%.
TVA and Public Utility Holding Company Act: crowd out private investment (what utility wants to compete with the government that also regulates prices!).

Finally, the tax on retained earnings was primarily responsible for the worst 1 quarter decline in GDP on record in 1937. the 1937 recession was most probably due to a tax over-reach by anti-business Democrats. Unemployment rose from 5 million to almost 12 million in early 1938. Manufacturing output fell off by 40% from the 1937 peak; it was back to 1934 levels. What caused the plunge in output was the tax on retained earnings, which seemed like a good idea to economically incompetent Roosevelt because he assumed he was just taxing money, and unused money at that, which is typical 'assume the economic pie is constant' thinking for redistributionists. See here for a 1937 rationale, and note it mentions Henry Ford by name. Unfortunately, retained earnings are key sources of investment funds for companies, and taxing them was like putting rocks in your transmission (new Fed chief Ben Bernanke did a lot of work in this area).


Then Krugman notes optimistically that patronage-economics expert Rahm Emanuel stated:

Rahm Emanuel, Mr. Obama’s new chief of staff, has declared that “you don’t ever want a crisis to go to waste.”

Because we know that political decisions are much more considered when done in haste? Is exigency ever good for coming to a wise decision?

the definitive study of fiscal policy in the ’30s, by the M.I.T. economist E. Cary Brown, reached a very different conclusion: fiscal stimulus was unsuccessful “not because it does not work, but because it was not tried.”

This from a guy who considers the Reagan era a nightmare, in part because of its deficits. That is, the economy was below potential throughout the eighties in part because sf Reagan's deficits, but the deficits were too small under FDR to really lift the economy. Huh? As per 'not trying fiscal stimulus', we have a lot of data on countries with large deficits, and the data there show no deficit-growth relation.

F.D.R. thought he was being prudent by reining in his spending plans; in reality, he was taking big risks with the economy and with his legacy. My advice to the Obama people is to figure out how much help they think the economy needs, then add 50 percent.

FDR actually proposed a 99.5% marginal tax rate in 1941 on incomes over $100k, but he lost, so it only got to 90% in the 1940's. He tried to do much more, but the Supreme Court would not let him, and so he tried to pack the Supreme court. But according to Krugman his main failing was a lack of boldness? I guess Krugman pines for Huey Long, he would have really made it happen.

Stretching before Exercise?

The New York Times notes that stretching prior to activity actually weakens the muscle:

The old presumption that holding a stretch for 20 to 30 seconds — known as static stretching — primes muscles for a workout is dead wrong. It actually weakens them. In a recent study conducted at the University of Nevada, Las Vegas, athletes generated less force from their leg muscles after static stretching than they did after not stretching at all. Other studies have found that this stretching decreases muscle strength by as much as 30 percent.

When I was young, my athletic instructors prided themselves on promoting slow, long stretches, not the stupid bouncy ones that were common in the 1970's. It turns out we were wrong too, just in a different direction.

Fooled by Randomness

A theme of Nassim Taleb's book, Fooled by Randomness, is that many (most?) successful traders are fooled by the random success of their strategies. With that caveat in mind, we must consider the implications of the success of funds affiliated with Taleb that presumably were long a lot of out-of-the-money options. The funds are up 50% or so this year, which is a stunning return in any market. Unlike other's who 'called the crash', Taleb advises putting money where his mouth is.

But, as Taleb's book argued, financial success is not proof of financial alpha because one year is a data point, not data. Alas, his old fund, Empirica Kurtosis, also had a 50%-ish return its first year, then he called it a 'hedge' not a fund (trader-speak for a bad trade seen in the 'bigger picture'), and eventually packed it up. As I have argued before, I think buying out-of-the-money options is a bad investment strategy because while it might have worked great this year, on average the return to this strategy is very close to zero because the volatility smile makes one pay up for these kind of risks. Indeed, given the current level of volatilities (VIX at 70%), I think the best thing Taleb and his investors could do is say 'woo-hoo!' and close up shop, because the price of disaster insurance is now so high that it is precisely the wrong time to be in this trade. In general, as opposed to the market underappreciating small risks, I think too many investors pay too much for them. Thus, the opposite strategy, as promulgated by Victor Niederhoffer, of selling wings is better over the long run, though I would do neither (alas, Niederhoffer's fund was shut down last year, luckily).

But his success will give him a bigger microphone to reiterate his earlier trenchant insights. I agree with him wholeheartedly that, say, Phillipe Jorion would be a very dangerous choice for any Chief Risk Manager position, as his seminal book on Value-at-Risk displays an insufficient appreciation for estimation errors, an over-appreciation on the value of parametric models, how this information aggregates, or is useful in actually estimating risk capital. Jorion is an academic, and shares their ignorance of various practicalities. But Taleb takes this good criticism, and extends it so strongly I find myself more on Jorion's side than his, because of the immoderate application of an argument, the straw-man caricatures of those who practice risk management apply to no one (eg, VaR is worse than useless, the normal distribution is an 'intellectual fraud').

For example, last week in Bloomberg he noted that “Recent events have proved that all risk management was wrong.” Such nuanced insights are usually confined to bigots discussing ethnic rivals. What I find especially interesting is how someone can make such sweeping generalizations and have such an enthusiastic following among those he criticizes. Clearly, a lot of frustrated risk managers enjoy seeing their betters brought down a notch, but I think such stupid criticisms (and 'all risk management is wrong' is a stupid criticism) are unhelpful, either for navigating the corporate hierarchy or correcting models that aided and abetted our current crisis. You may think you are smarter than your boss, and you may be, but he is probably not a moron. Indeed, he probably has some skills you lack, such as tact, or building coalitions in a complex set of people with different skills and goals. To the extent people error, one should always aim for a better diagnosis than more criticizing the fact that people believe in things that are often innacurate (see: QUOTES FROM THE BLACK SWAN THAT THE IMBECILES DID NOT WANT TO HEAR --all caps in link on web page).

His fans are keen to remind me that by criticizing someone so brave and true to call all sorts of people 'idiots', I am an envious player-hater with a specific DSM listing for daring to criticize the man, and his adherents remind me a lot of Ayn Rand acolytes in college (the Taleban, always true believers). But really, if he thinks all these people are idiots, after your little chat, do you really think he respects your opinion? I don't hate him, though I disliked it considerably when he would send emails to my old boss making bizarre allegations, and think his usage of 'moron/idiot/imbecile' and sweeping stereotypes reflects an unattractive temperament. Now that I don't have a timorous boss I find him merely amusing as he clearly has not acquired any sense of proportion or discrimination in his vast criticisms. As he discusses issues directly in my wheelhouse, I feel obligated to discuss where he is profoundly incorrect to the extent he is not inconsistent--which is rare, to be sure.

As Taleb lamented in an article in The Edge:

Spyros Makridakis and I are editors of a special issue of a decision science journal, The International Journal of Forecasting. The issue is about "What to do in an environment of low predictability". We received tons of papers, but guess what? Very few addressed the point: they mostly focused on showing us that they predict better (on paper).

Jeez, they just wanted to find a better way? Fools! The approach seemingly preferred by Taleb is to criticize from the sidelines those who attempt to model reality at all, while buying out-of-the-money options. In spite of returns to this strategy this year, it is not helpful for one's career as a quant, nor as an investment strategy.

Rahm Emanuel Learned a Bad Lesson on Wall Street

The problem with people who make their fortunes too easily, via inheritance, or political payoffs, is they think everyone who is rich made their money that way. Thus I'm quite unhappy that Rahm Emanuel is the new Chief of Staff, because as a lifelong partisan, he was paid off by after working as a senior adviser for Clinton, going to work for big Clinton supporter Bruce Wasserstein at Dresdner Klienwort Wasserstein. I guess he knew a lot about finance, because he made $18MM in just over two years there. He also had a board seat at Freddie Mac, a job that requires showing up, and he got a couple hundred grand for that in 2001.

It's simple patronage and access, and I presume that strongly colors how he perceives wealth is created.

Making Lemonade

So, it appears they are going to bail out our auto companies big time. From the WSJ:

Some proposals would offer another $25 billion in low-cost government loans, on top of the $25 billion Congress authorized previously...Rep. John Dingell (D., Mich.) emerged from the meeting calling it one of the most productive of his career and said "the end result would be a good one from the standpoint of the auto industry."

Of course, by auto industry he means UAW, because they are really the only ones making money. Specifically,

The UAW is backing a plan to have the government put money into trusts the auto makers and the UAW established to pay for UAW retiree health care.

So the money bypasses the companies, goes right to the union! Sweet.


But, on the other hand, $50B is a lot of money, meaning that even after, say, $20B for union pensions, Ford and GM will be around for a long time as a great short for equity players. There will always be some suckers out they, so they can lend me their shares.

Current Crisis vs. Tech Bubble

I've read about a lot of doom and gloom, and from a stock market perspective they are correct. But the financials, while bad, aren't that bad. Looking at total financial profits, for banks, broker/dealers, etc. with assets above $100MM (about 1000 companies currently), and comparing them to all the technology companies (about 600 companies currently), we see that in aggregate the total losses were larger both relatively (relative to prior profits) and in absolute terms (total dollars lost) in the infamous technology bubble. These are total net income (including extraordinary items). Also, note that in the bubble crash, most tech companies reported losses (ie, 40% had profitability in the depth of the crash), while currently the figure is down sharply, but still most (70%) of companies are reporting positive net income (data through Sep 08, though only about a third of companies have reported for this recent quarter).

So, I'm a bull.

Yea, I Voted

For most people, a great candidate is someone who articulates their personal major policy preferences successfully (it's funny how many truly smart Democrats observe that Bill Clinton is 'really smart' after meeting him; they mean to say, he's powerful and I agree with him). I consider a candidate great if I suspect they vote for things as I would after investing a great deal of time evaluating the proposal. That is, they have my preferences and vision as to how the world works, but are much more knowledgeable about various facts. This may seem self-centered, but my preferences and world-view are based on my best guess on the truth, taking into consideration all that I know, including the arguments of those I disagree with. I don't see many candidates like that, so I just had fun, wondering how many people knew anything about the 40 judges and Water Commissioner we were voting on. I voted for the Constitution Party for President, because I didn't know anything about them, but I'm definitely not anti-Constitution.

As I have noted before, leaders are paradoxically not our 'best and brightest'. They are slightly-above-average people with a patience for protocol and process, who offend the least but are not stupid. In school I remember many groups talking about the excellence of leaders, about how to train leaders, and select them, as if they were like candidates for the Apollo program where you have all these 'best of the best' filters. In contrast, politicians, especially successful ones (eg, read Caro's biography of Lyndon Johnson) are smarmy, insincere, flattering nabobs, the kind of people who adopt a southern accent when campaigning in the south, who speak with great conviction about meaningless platitudes ('I'm for children/change/peace'). I'm more impressed by the character and intelligence of the head of accounts receivable for a mid-sized company, or an assistant high-school football coach.

Where are the Non-Financial Defaults?

While the financial sector is experiencing historical credit quality deterioration in structured finance, the nonfinancial sector is doing pretty well. Note that in June of 2007, as the crisis was already somewhat apparent, Moody's put out a Special Comment (Corporate Default and Recovery Rates, 1920-2008, Hamilton, Ou, Kim and Cantor), they predicted sharply higher default rates over the next year and a half (see above). But what we have seen, is that nonfinancial default rates have remained at historic lows even as spreads have risen to extreme levels. It seems a great time to buy high yield debt, getting recession-like yields, and non-recession defaults. Moody's is still predicting a big upturn in defaults, but it still has not happened in the nonfinancial sector.

Man in the Center: Gary Gorton

The WSJ has a neat article on Gary Gorton, an adviser to AIG. It seems he was paid millions to review various derivatives models for AIG, and this lead them to be a bit more comfortable with their risk than they should have. He wrote a very good article on subprime that he presented at Jackson Hole this year. The article does not give enough information to really understand what mistakes he made, and as AIG failed, we can assume some were made. But Gorton is a thoughtful person, hardly the naive, overconfident geek so many caricature (Warren Buffet's great quote: 'beware geeks bearing formulas').

I think Gorton is best situated to highlight the key issues in this financial crisis, which involved not merely a subprime meltdown, but some sort of accelerator mechanism that lead to a daisy chain of financial firm failures. As the details of the credit default swaps are generally unobserved, it is hard to know what assumption were most incorrect and material.

As with any complex system failing, there were many independent errors that lead to this debacle, and I'm sure it will take a long time to sort it all out. After all, the take-away for a generation after the Great Depression was that people over speculated, and that the New Deal and then World War 2 saved the economy (eg, see Galbraith), and only much later did people focus on quite different factors as the impetus and accelerator of this crisis. In other words, financial crisis are almost never fully understood within a decade of their occurrence, if ever.

Paper Estimates Mortgage Crisis in 2005

Yuliya Demyanyk and Otto Van Hemert estimate the mortgage problems at the end of 2005 (Understanding the Subprime Mortgage Crisis). They find basically that deterioration of mortgage underwriting (higher LTV, ARMs as opposed to fixed income securities, interest-only loans), and find that credit standards deteriorated significantly over the prior 5 years. But I think they really bury the lead, which is that they estimate a doubling of default rates as of the end of 2005 for the next year's new mortgages. Even if I knew that to be true, I would not have anticipated the crisis we observed.

Shiller's Warning: Hardly Useful

In today's New York Times, Robert Shiller notes how groupthink led to the subprime crisis, and points out that while Greenspan notes that the warnings among the experts were rather tepid, the Fed ignored many who were worried about the housing bubble. But I'm rather unconvinced the Fed screwed up, given the incredibly equivocal warnings that Shiller highlights. In his own words:

In 2005, in the second edition of my book “Irrational Exuberance,” I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that “significant further rises in these markets could lead, eventually, to even more significant declines,” and that this might “result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well,” and said that this could result in “another, possibly worldwide, recession.”

Note the ubiquity of the weaselly 'could' word. Anything could happen: Terrorist Attack with Nuclear weapons, Stock market goes down another 40%, goes up 60%. You name it, it could happen. I don't see how noting various 'coulds' is very helpful, because logically, so many things could happen, noting a 'could' is hardly informative.