Tuesday, December 30, 2008

Wash Post AIG Story Missing Something

Reading Day 3 of the Washington Post series on AIG, I sense they are leaving out crucial information. For example, the story starts:

The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

Saying "99.85% chance of never having to pay out" is stupid in two ways. One, the spurious precision, reflecting an inappreciation of standard errors (why not say 99.8%, at the very least?). At anyplace I worked such spurious precision would precipitate instant sarcasm, so if this statement stood, there were two guilty parties: the one who said it, and the one who didn't instantly mock the statement. As this is a story being retold, I'm unsure about the credibility of this little scene, because one of the guilty parties seems to be retelling his idiocy. Secondly, there is no time dimension here. I'll assume that is over 10 years, that's a AA- bond, usually very safe but spreads for AA- bonds are not sufficient to cover one's own internal funds transfer pricing (unless they stupidly cost out their funding at their top corporate rate, which may be AAA). So, this never made sense, even without the spurious ratings and not predicting the blow-up in spreads.

There's a seeming conflation between derivatives and swaps with all sorts of CDOs. A journalist would never write a story about how black people should all be put in jail because they commit a disproportionate amount of crime, because it is obviously a ludicrous propositon, but these same journalists will stereotype 'derivatives' as if an interest rate swap is the same as the swap on the Mezzanine tranche for subprime CDOs.

And I love the little arrogance bit: "He told us that in no uncertain terms, that he was -- that all of his people up there were -- smarter than anybody we had at AIG". Every story about financial types blowing up needs some stories about how they were arrogant, hubris leads to disaster, etc. True enough. Indeed, most jerks think they know more than they do, that's one big reason they are jerks. However, in real time, rich and arrogant people will have an infinite supply of toadies looking to get a piece of their business, and any arrogant person running a large business will have a ton of glad handlers, and only time will punish them--they are arrogant because they are ignorant, so they won't be impressed by you pointing out the whole 'Icarus' parable, or that they aren't quite that smart. As we used to say in banking: it's all about spread, volume, and risk--you can't have all three. But, ignorance more frequently begets confidence than does knowledge, and so those who are incompetent will have inflated self-assessments.

In some sense, this crisis is hurting the right people, because those with no money down, who now can't meet there payments on their home, are fine: in the US these loans are no-recourse, so the borrower walks away with nothing but a ding on his credit report, which is probably good for these people. No loss in wealth, just a house they never owned they no longer live in. Those who lost the most money in this crisis, are the right people.

Monday, December 29, 2008

Stuff White People Like

Stuff White People Like creator Christian Lander was at Google Authors, and it's a refreshing story. His site mocks the status climbing world of the stereotypical white person, ever eager to appear more progressive, more environmentally and socially conscious, and most of all more independent than the stupid corporate drones and rednecks they contrast themselves with.

Landon describes creating the website for his friends, never thinking it would be a big hit. I think creative people are best when they just try to please themselves, and if others find their work funny or interesting, great. They are doing what they know, it flows effortlessly because they are doing it primarily for enjoyment, and they have something unique to say.

Sunday, December 28, 2008

Krugman Assumes One Must Act

Krugman writes:
the opponents of a strong stimulus plan don’t really have an alternative to offer.

Here's an alternative: nothing. Like when a nervous mom takes her precious 12-month old to the doctor because he has a cold, the best thing the doctor can do is nothing. Maybe a placebo. So too for the economy.
They don’t even have a really coherent critique; as Brad DeLong points out, if you believe that a surge in private spending would raise employment — and even the critics agree on that — it’s very hard to explain why a surge of public spending wouldn’t have the same effect.

The difference between an increase in private investment spending, and government spending, is like the difference between pushing an old lady down and pushing her out of the way of a runaway train. private investment is the result of millions of individuals making decisions based on their wealth and profit expectation; the other is simply someone spending other people's money to help other people get jobs.

In a complex system, injecting more of an endogenous quantity that is correlated with something good invariably causes feedback effects, most bad, because complex systems tend to be optimized, and so the 'total derivative' in futzing with some input is usually negative (though the first partial often highly positive). This is why we do not suggest one take serotonin supplements, even though higher levels of serotonin are correlated with success and high status. Testosterone is known to have many positive qualities for men, but the best ways to generate a higher level of testosterone is to exercise regularly, including weight training, avoid insulin spikes, get your body fat low, and get good sleep. A bad way would be to inject it into you bloodstream. This is because the latter invites your body to decrease the amount it makes, and the net effect is usually negative.

Similarly, taking money away from some people for make-work projects creates jobs, but these are taking away money spent on something else, so the net is often negative. Further, unlike natural demand, the incentives of the workers are not necessarily so good for 'natural' jobs we would like them to eventually get.

It's funny how many economists do not really believe in the Invisible Hand, except for trivial applications.

What the Government Used to Do

One problem with our government today is that there is so much oversight, there are so many rules and regulations, sensitivities, that the government is pretty timid in actually solving problems. I was reading Temple Grandin's Animals in Translation, and she notes the following example of a successful government program that would be inconceivable today:

livestock were being attacked by screwworms all over the West, Southwest, and Mexico. Screwworms are the larvae of a fray that lays its eggs in open wounds. The wounds can be from anything--a cut, a tick bite, or even a newborn's navel. When the eggs hatch the maggots come out and eat the animal alive. Other maggots eat dead flesh, bu screwworm maggots eat live flesh and they are deadly.
The USDA field workers figured out how to get rid of the screwworms by taking advantage of a quirk in their reproductive system. The screwworm's developmental sequence goes from egg to maggot to pua to fly, and the USDA bred a bunch of screwworms and irradiated the males when they reached the pupa stoage, making them sterile. Then they put the pupae in little paper boxes, like a Chinese takeout box, and dropped the boxes out of airplanes. The flies would come outt of the boxes and mate with lots of females, and the females they'd mated laid eggs that didn't hatch.

The program was a huge success. It started in 1959, the United States working with Mexico, and the last case of screwworm infestation was recorded in Texas in 1982
This was the original biotechnology and it worked. The government saved thousands and thousands of animals, maybe millions,. They just did it; they didn't get everyone's permission. Today the government could never get a program like that off the ground. Some environmental activist would say 'we have to protect these flies', and you'd have people who'd never seen a screwworm in their lives advocating to save them from extinction

It's depressing to note the pathetic incompetence in sub-Saharan African countries, as very little has been built there since the colonialists left. Similarly, much of Cuba is from 50 years ago. Unfortunately, America doesn't measure up to its past either because we are so worried about violating something's rights. No one could ever build the interstate highway system again, or major subway systems. California governor Arnold Schwarzenegger sponsored a bunch of bond initiatives that passed in 2006. But two years later, they still aren't 'shovel ready'. The problem with the government is that people hold it to such a high standard of not hurting the environment or getting buy-in from every locality that failure implies a massive liability, so instead we have redefined government's role, which is now mainly to patch roads, redistribute wealth, and pass laws with all sorts of good intentions like No Child Left Behind.

Wednesday, December 24, 2008

Holiday Cards

I have a lot of holiday cards that say: Happy Holidays! with pictures of 2 kids (Jake and Abby with big smiles), and then inside minimalist text: from John, Ann, Jake and Abby. I have no idea who these people are. I would prefer pictures with parents (who I might know), and a last name somewhere in the frickin' card. I actually enjoy the long-winded recap-of-the-year cards, because these also tell me who the parents are (that's my Freshman year roommate!), and I am interested in their activities.

I'm grumpy after wrapping presents too long. I hate wrapping presents. But I love Christmas. The spirit of Christmas is tit-for-tat at its extreme: my kids pretend to be virtuous for a few hours to acquire lots of loot.

The Madoff scandal is especially poignant at this time of intense religiosity, because some rabbis opined on the affinity scam, where Madoff mainly used his Jewishness to scam Jews, really played off the following reasoning:

In a recent sermon, Rabbi Kalmanofsky described Mr. Madoff as the antithesis of true piety.

“I said, what it means to be a religious person is to be terrified of the possibility that you’re going to harm someone else,” he said.

He was religious, so seemed especially ethical to those inside that religious circle. The nice thing about religiosity is that one believes doing good is rewarded even if no one you know is watching, which while untrue in one sense, is true in some other sense (posterity is always watching). Evil people use pretexts tenable via some well-known principle, in that any evil action is tenable with good lawyers quoting scripture. But if God is watching, knows logic, history, and what is in your heart, such bad guys are screwed! So, if more people believed in the judeo-Christian God, such people would be less inclined to act less in such ways, anticipating God's wrath. Now, there is a trade-off because the phalanx of beliefs includes lots of silly stuff which are sometimes taken literally, but I think Jesus-freaks are much less scary than the common college perception; after all, Newton, Euler, and Gauss were strong deists in their own ways.

Most religious people I know, believing in something I believe is untenable, are better-than-average neighbors, really nice families. Some might think this is lousy, because they should be nice for more rational reasons, but I'm not so harsh in that if your Mormonism or orthodox Judaism makes you an ethical person, I appreciate your goodness irrespective of logical foundations I find bizarre.

So, if my kids translate their greed for presents on this big day, into some sort of grand carrot I can apply throughout the year, I'll use it, and they'll be better for it (plus I get to play with their new toys, which as boys include some cool stuff).

Tuesday, December 23, 2008

Happy Winter Solstice!

Love the feet. My mom would do this to me.

Holidays are no time for blogging. Merry Christmas.

Monday, December 22, 2008

My Book

I see my book that is in the process of being published is listed at Amazon. The description is sufficiently vague that it really doesn't explain why anyone other than my mother should buy the book, but that makes sense because currently a wily editor (actually, a Wiley editor) is doing what editors do. It's my first book, so I'm not sure how this will go exactly, that is, how detailed or substantive the suggestions will be.

It's scheduled for a June release, because I guess the monks who transcribe books are very busy this time of year, and I'm trying to get blurbs from a subset of David Smick's 50 or so admirers (I wasted no time reading it!--Lawrence Summers). I'm obviously excited about it, but given it has several months to release and I don't want to get ahead of myself, I'm not going to say too much about it now, other than it discusses why current models of risk and return are wrong as an approximation, working only for a few special cases. Basically, you see a positive risk-return trade-off from 0 to epsilon riskiness for alpha-less investments (eg, Baa-Aaa spread, short end of yield curve), then a generally flat relationship, and then the lowest returns for the most violently risky assets. Supposedly a spooky risk factor reconciles this with the standard model, but I highlight how absurd this would be even if this wraith were ever identified consistently for more than a business cycle, and how the evidence has been tendentiously presented to support the framework (akin to the Flying Spaghetti Monster's 'noodley appendage' at work). There are some general implications (eg, buy low risk assets), but also more subtle ones. It outlines ways for finding alpha taking into account the petty incentives and information biases of the parties inevitably involved (eg, investors and bosses), with various examples. It was fun to write.

Sunday, December 21, 2008

When Investors Don't Ask Questions

Madoff's returns were clearly too good to reflect the 'split strike' strategy he intimated generated such returns. Further, they could not scale to the size of funds he managed. I suspect many investors thought his purported strategy was clearly a ruse, and that he was doing something illegal, such as front running, or using inside information from his various contacts.

This kind of thing happens quite a bit, though to work, you can't do it with $15B. In James Cramer's Confessions of a Street Addict, he covers his career as a broker for Goldman Sachs, and then a hedge fund manager from 1988-2000. He claims to have generated a 12 year track record with 24% annual return after fees. With an average hedge fund taking out 20% of the pnl, and traders taking out 10%, that would be an even higher 34%. Let's assume he and his traders didn't take the 10% trader bonus because he was not only the head trader, but the general partner. That implies a 30% average annual return for 12 years.

Now 30% is plausible, but he also states in the book he had only one down quarter. If we assume the probability of a down quarter is p, and he traded for 48 quarters (12x4), that means a maximum likelihood estimate for p of a mere 2.08%. If his 30% returns were normally distributed, one down quarter out of 48 is consistent with an annualized volatility of only 4.25%, for a Sharpe of 7.05 (using a simple Sharpe that ignores the risk free rate).

Warren Buffet's Berkshire Hathaway generated a measly Sharpe of about 1.1 over that period. The average of all Long/Short equity hedge fund returns, with survivorship bias, has only a 1.1 Sharpe from 1994 to 2005 (this is an upward bias of the average hedge fund sharpe, since the mean is the same but the volatility diversifies). Given he had some years up 65% and 45% (he mentions these anecdotally, not a complete list), and a maximum drawdown of -38%, it just does not square with a 4% annualized volatility.

I suspect there were at least three things going on. First, these are unaudited results, and he's exagerrating somewhat. Secondly, his strategy of paying lots of money to brokers and getting and giving them lots of information, with only $300 million in capital, might generate some abnormal alpha (though Cramer suggests he mainly trades on fundamental analysis, though his trading horizon seems to last weeks, not years). It's a unique strategy that probably worked well in the 1990's when broker upgrades and downgrades had more patent insider information--brokers would leak their recommendation changes to accounts generating lots of commissions. Lastly, he admits receiving lots of IPOs, and again, back in the 1990s that was pure arbitrage for anyone smart enough to understand the game. The quid quo pro is commissions to brokers for underpriced IPOs to the trader, all paid for by the issuer (because they only issue new stock once, and are afraid of challenging conventions). Again, with only $300 million in capital, a well executed IPO quid pro quo strategy might have been a viable and highly profitable strategy.

But he's clearly not telling near the whole truth when he says in interviews he mainly outperforms by using fundamental analysis, though his investors didn't care. A similar case is Michael Steinhardt, who's reportedly generated a 24% average annual return over 29 years, who like Cramer mentions he pays full commissions for the information, so perhaps there was some dealing going on their (like Cramer, he suggests fundamental analysis is the genesis of his alpha).

Thursday, December 18, 2008

Benford's Law Catches Madoff (error!)

Benford's law, also called the first-digit law, states that in lists of numbers from many real-life sources of data, the leading digit is distributed in a specific, non-uniform way. According to this law, the first digit is 1 almost one third of the time, and larger digits occur as the leading digit with lower and lower frequency, to the point where 9 as a first digit occurs less than one time in twenty. Hal Varian noted this could be used to detect accounting fraud way back in 1972. Here are the proportions of the leading digit according to Benford's law compared to Madoff's numbers (sample size, 171):

lead Benfor st.err. Madoff
1 30.10% 3.43% 40.46%
2 17.60% 2.85% 13.87%
3 12.50% 2.47% 8.67%
4 9.70% 2.21% 7.51%
5 7.90% 2.02% 5.78%
6 6.70% 1.87% 5.78%
7 5.80% 1.75% 4.62%
8 5.10% 1.64% 6.94%
9 4.60% 1.57% 5.20%

Earlier I reported there were errors in digits 2 and 3. Someone noted Paul Kedrosky did a similar analysis and got different results, so I redid the analysis, and got different results! My bad. I do note that the number of 1's is now outside of 2 stds. Out of 173 data points (12 years plus 5 months minus two zeros), I have 70 observations with leading 1's. But, if the mean return is really 0.96 with minimal vol, one could say this naturally violates Benford's law.

I wasn't even drinking last night.

Big Bang Theory Whiteboards

Professor David Saltzberg, an astrophysicist at UCLA, vets the science on "Big Bang", including making sure all the equations on the whiteboards are real and correct.

What Fraudulent Returns Look Like

These returns were from the document Harry Markopolous sent to the SEC in 2005, and while his allegations tend to ramble, his basic points are spot on. Several hedge funds actually merely invested all their money with Madoff unbeknownst to their investors, so Markopolous was able to back out Madoff performance via such a fund (here, Fairfield Sentry Ltd). These are the returns, AFTER the 1% management fee and 20% incentive fee, meaning you can add about 4% to the annualized return to get the return Madoff showed to his investors.

Jan-91 3.08 Jan-92 0.49 Jan-93 0.00 Jan-94 2.18 Jan-95 0.92
Feb-91 1.46 Feb-92 2.79 Feb-93 1.93 Feb-94 -0.36 Feb-95 0.76
Mar-91 0.59 Mar-92 1.01 Mar-93 1.86 Mar-94 1.52 Mar-95 0.84
Apr-91 1.39 Apr-92 2.86 Apr-93 0.01 Apr-94 1.82 Apr-95 1.69
May-91 1.88 May-92 -0.19 May-93 1.72 May-94 0.51 May-95 1.72
Jun-91 0.37 Jun-92 1.29 Jun-93 0.86 Jun-94 0.29 Jun-95 0.50
Jul-91 2.04 Jul-92 0.00 Jul-93 0.09 Jul-94 1.78 Jul-95 1.08
Aug-91 1.07 Aug-92 0.92 Aug-93 1.78 Aug-94 0.42 Aug-95 -0.16
Sep-91 0.80 Sep-92 0.40 Sep-93 0.35 Sep-94 0.82 Sep-95 1.70
Oct-91 2.82 Oct-92 1.40 Oct-93 1.77 Oct-94 1.88 Oct-95 1.60
Nov-91 0.08 Nov-92 1.42 Nov-93 0.26 Nov-94 -0.55 Nov-95 0.51
Dec-91 1.63 Dec-92 1.43 Dec-93 0.45 Dec-94 0.66 Dec-95 1.10
Jan-96 1.49 Jan-97 2.45 Jan-98 0.91 Jan-99 2.06 Jan-00 2.20
Feb-96 0.73 Feb-97 0.73 Feb-98 1.29 Feb-99 0.17 Feb-00 0.20
Mar-96 1.23 Mar-97 0.86 Mar-98 1.75 Mar-99 2.29 Mar-00 1.84
Apr-96 0.64 Apr-97 1.17 Apr-98 0.42 Apr-99 0.36 Apr-00 0.34
May-96 1.41 May-97 0.63 May-98 1.76 May-99 1.51 May-00 1.37
Jun-96 0.22 Jun-97 1.34 Jun-98 1.28 Jun-99 1.76 Jun-00 0.80
Jul-96 1.92 Jul-97 0.75 Jul-98 0.83 Jul-99 0.43 Jul-00 0.65
Aug-96 0.27 Aug-97 0.35 Aug-98 0.28 Aug-99 0.94 Aug-00 1.32
Sep-96 1.22 Sep-97 2.39 Sep-98 1.04 Sep-99 0.73 Sep-00 0.25
Oct-96 1.10 Oct-97 0.55 Oct-98 1.93 Oct-99 1.11 Oct-00 0.92
Nov-96 1.58 Nov-97 1.56 Nov-98 0.84 Nov-99 1.61 Nov-00 0.68
Dec-96 0.48 Dec-97 0.42 Dec-98 0.33 Dec-99 0.39 Dec-00 0.43
Jan-01 2.21 Jan-02 0.03 Jan-03 -0.27 Jan-04 0.94 Jan-05 0.51
Feb-01 0.14 Feb-02 0.60 Feb-03 0.04 Feb-04 0.50 Feb-05 0.37
Mar-01 1.13 Mar-02 0.46 Mar-03 1.97 Mar-04 0.05 Mar-05 0.85
Apr-01 1.32 Apr-02 1.16 Apr-03 0.10 Apr-04 0.43 Apr-05 0.14
May-01 0.32 May-02 2.12 May-03 0.95 May-04 0.66 May-05 0.63
Jun-01 0.23 Jun-02 0.26 Jun-03 1.00 Jun-04 1.28
Jul-01 0.44 Jul-02 3.36 Jul-03 1.44 Jul-04 0.08
Aug-01 1.01 Aug-02 -0.06 Aug-03 0.22 Aug-04 1.33
Sep-01 0.73 Sep-02 0.13 Sep-03 0.93 Sep-04 0.53
Oct-01 1.28 Oct-02 0.73 Oct-03 1.32 Oct-04 0.03
Nov-01 1.21 Nov-02 0.16 Nov-03 -0.08 Nov-04 0.79
Dec-01 0.19 Dec-02 0.06 Dec-03 0.32 Dec-04 0.24

You can read Markopolis's SEC letter here or here.

Wednesday, December 17, 2008

Revenge of the Optimists

Things are pretty bleak now, but one has to put this in perspective. As Flaubert noted, our ignorance of history makes us libel our own times. People have always been like this. Looking back, we think there was little uncertainty in the past, because we know how it ends, and think it couldn't have been otherwise, so FDR defeated Hitler, and Reagan won the cold war (or Hitler started a stupid two front war, and the Soviet Union was doomed). But in reality, there's always a feeling that civilization is like an individual, and so decay and senescence is inevitable. In the thirties, the end of capitalism. In the fifties, a return to the Great Depression, or nuclear annihilation. In the seventies, we were running out of oil and food, and capitalism was imploding. Etc.

So now, credit has backed up because no one believes all those assumption the took for granted, and 'Investment Grade' does not facilitate no-decision lending. But life in 10 years will probably be more of the same. But the economy will come back, and the optimists have been generally right over the past 200 years. It's easy to be a pessimist, because there are a million things that can go wrong, but even Rome took centuries to fade away. I see the US heading towards a Brazil model, with pockets of extreme poverty and anarchy like Detroit and nice gated communities like the suburbs that keep the poor out implicitly through high housing prices. But that will take decades.

I tend to think the permabears who seem so prescient right now are generally cranks. Consider the problem of testing for rare conditions. If an HIV test has a 2% false-positive rate, but only 1 in 1000 people have HIV, then 20 people will get a positive result out of 1000 healthy people, while only 1 actually has HIV. If you get a positive HIV test, you still probably don't have HIV (this supposes you didn't take the test because you just had passive anal sex at a weekend heroin party in Haiti). Similarly, given the false positive rate for permabears, and the relative infrequency of crashes, most permabears were lucky; some weren't, but to sort that out you need to assess their reasoning, not just their predictions. So, listening to these guys is depressing, because they have more credibility now, but while their stature should increase via Bayes rule, it should still be observed skeptically. I'm just hoping the new administration doesn't do an FD Roosevelt and in a rush to do something make things worse, by bringing back cartels and monopolies via card check, bolstering unions.

Tuesday, December 16, 2008

Peter Schiff, Prophet?

I haven't read much by Peter Schiff, but check out these clips of him calling a bear market back in August 2006! This might be cherry picked, but unlike other permabears, he mentions the mortgage market problems with specificity, noting the weakened underwriting standards and teaser rates. I'll definitely pick up his book the next time I'm in my Barnes and Noble.

Madoff Scam

Madoff's fraud is kind of funny because his purported option strategy didn't make any sense. He was buying stocks, trading options on those stocks, and exiting all positions at the end of every month. The latter point is important because clearly he did not have the positions on, and because he didn't show up as an owner of many stocks through standard reports that show end-of-quarter stockholdings, he needed a story, and for some reason people believed he had good reason to be flat at the end of the month. But all this volume, on options, makes it very hard to make money because you often pay 10 cents each way to the market makers in liquid options. But he made basically 1% a month for years with only a few down months with $17B.

One statement indicated that for an account with $500k, he made a sufficient number of trades that if he did this for all his accounts, he would need to have more options than currently are the open interest at the CBOE by a factor of 10! Something is clearly wrong with that business model, because you just apply the logic applied to your account to what you think Madoff is managing, and the implications become implausible quite clearly.

Now, one can understand a socialite, Stephen Spielberg, or a charity, not getting this. But Tremont’s Rye Investment Management unit had $3.1 billion, virtually all the money the group managed, allocated to Madoff. Walter Noel’s Fairfield Greenwich Group had $7.5 billion out of its $14.1 billion in total assets invested with the manager. All together funds of funds had at least $20.3 billion invested with Madoff, who charged no fees to investors, getting paid instead through commissions from his brokerage business for trading the stocks in the accounts! Thus, they were allocating money to a guy whose purported business model exceeded any back-of-the-envelope calculation of plausibility, and it also made no sense for Madoff to be charging zero fees and making it up on commissions. If you have a 4 Sharpe investment strategy, you would make your profits off the investment fees, not commissions.

It's sort of like if someone tells you they can make 30% above the market buying stocks with no risk, or 100 basis points on a Treasury Bond arbitrage trade. There just is not that kind of edge in these markets, unless you are taking gobs of risk. As he suggested he had no risk, the only reason he could do this was fraud. His numbers were off by a decimal point.

For professional investors, either they are very stupid (possible), or more likely they assumed Bernie's business model was a ruse, he was cheating through insider trading or front-running and they wanted in no questions asked. The problem with a Ponzi scheme is they are doomed to end in disaster. I don't know why people do them, because I simply couldn't enjoy myself knowing all these people I was scamming, who were my friends, would soon hate my guts.

Monday, December 15, 2008

Columbus the Risk Taker

From Lester Thurow's The Future of Capitalism (p. 326):
Columbus know that the world was round, but he...thought that the diameter of the world was only three quarters as big as it really is. He also overestimated the eastward and distance to Asia and therefore by subtraction grossly underestimated the westward water distance to Asia...Given the amount of water put on board, without the Americas Columbus and all his men would have died of thirst and been unknown in our history books. Columbus goes down in history as the world's greatest explorer...because he found the completely unexpected, the Americas, and they happened to be full of gold. One moral of the story is that it is important to be smart, but that it is even more important to be lucky. But ultimately Columbus did not succeed because he was lucky. He succeeded because he made the effort to set sail in a direction never before taken despite a lot of resistance from those around him. Without that enormous effort he could not have been in the position to have a colossal piece of good luck.

As Orson Wells noted, "What is confidence? Ignorance, ignorance, sheer ignorance – you know there’s no confidence to equal it. It’s only when you know something about a profession, I think, that you’re timid or careful."

A little delusional overconfidence is surely a good thing, but this is rather paradoxical because most rational people like Robin Hanson preach that knowing The Truth is most important, and one should always be adjusting one's opinions in light of our known propensity to be overconfident (eg, most of us think we are better than average in wit, common sense, our wisdom in politics, etc.). Too much rationality can make one not take chances, because while any business plan is often predicated on a false assumption, they often put one in a situation to succeed. I think the take away is to remember that getting into something plausible that are very good at, will present a lots of unknown option value, so don't be too demanding.

Columbus also had a lot of relevant experience as an alpha producer negotiating with his capital provider. Note that portfolio managers can receive anything from a flat salary, to 50% cut of the profit, to equity ownership. It all depends on one's negotiating power, because if your story is credible, and there is alpha there, this is a free lunch and so investors should be happy to get only 50%. But of course this is all speculative, and often the man with the plan has few rich relatives. Columbus boldly asked for the following conditional upon being successful: he was to be knighted, appointed Grand Admiral and Viceroy (king's representative) of all the lands he discovered, and he would keep a tenth of all taxes levied there. Spain initially refused, so he went to France, and so Spain acceded his demands, and gave him two old ships (Columbus rented a third himself). In the end, his greed cost him, as his wild imaginings made him so unpopular that he king had his own viceroy and admiral arrested and brought home from the West Indies in chains. I suppose that all descendants of Columbus might file suit, asking for one-tenth of all American tax receipts.

Sunday, December 14, 2008

Blagojevich Lesson: Don't Say It

Many are shocked by the Blagojevich scandal because of his brazen quid pro quos: given my campaign $1MM to get the senate seat, give my campaign $50k for a state investment in children's hospitals, give my wife a comfy board seat.

As this article notes:
"People give campaign contributions and expect things in exchange," he said. "It's all perfectly legal."

So it's a given that politicians sometimes indulge in a form of give-and-take.

"Deals are made all the time in politics," said Daniel Lowenstein, a professor at UCLA Law School. "Our system couldn't operate without it."

I think in this case, the veneer of objectivity is a useful line in the sand. We all understand that in business, or politics, making a decision that generates a lot of revenue for someone implies a favor was given, and one is expected in return. But to say that explicitly really takes the situation in a bad direction.

An Extreme Solution to Fraud

Execution! Sarbanes-Oxley is nice, but what we need is something that really gives financial hucksters a reason to behave. China recently executed a businessman convicted of bilking thousands of investors out of $416MM in a bogus ant-breeding(?) scheme, state media reported Thursday. Back in 2007, they executed a former official at the Agricultural Bank of China. I have no qualms with the death penalty in principle, because though the state can and will continue to make mistakes, it would be inconsistent to allow the state to kill people in normal police actions in the process of apprehension, but not after catching them. After all, if the 'potential for a mistake' or 'the state can't morally do that' is the criterion, why let our police carry any guns? Why have a military? I'm not saying it should be used a lot, but given 300MM people, there are probably well over 500 people who deserve death in any one year.

So, perhaps crimes over $100MM in fraud can qualify for the death penalty? Surely they ruin many retirements, and most economists value a life between $4 to $9 million, so I think $100MM is beyond the pale.

Thursday, December 11, 2008

When Quant Models are Complicated

Paul Wilmott, a mathematician by training who publishes a lot on derivatives mathematics, notes the following:

On a one-to-one basis many people working in banks will complain to me about the models they have to implement. They will complain about instability of the Heston volatility model for example. I will explain to them why it is unstable, why they shouldn't be using it, what they can do that's better and they will respond along the lines of "I agree, but I don't have any choice in the matter." Senior quants are clearly insisting on implementations that those on the front line know are unworkable.

And a large number of people complain to me in private about what I have started calling the 'Measure Theory Police.' These 'Police' write papers filled with jargon, taking 30 pages to do what proper mathematicians could do in four pages. They won’t listen to commonsense unless it starts with 'Theorem,' contains a 'Proof,' and ends with a 'QED.' I'll write in detail about the Measure Theory Police at a later date, but in the meantime will all those people complaining to me about them please speak up...you are preaching to the converted, go spread the word!

In my experience as a risk manager any model that most people don't understand is not used for its stated purpose. Thus, most Asset and Liability committees that make decisions about interest rate risk--what duration to take--use simple, arbitrary (eg, 100 basis point) parallel shifts in interest rates, perhaps a twist. A bank might have a quant working on a Heath-Jarrow-Morton type model, usually put out there as a distraction for outsiders such as rating agency representatives, equity analysts, or regulators, lame attempts impress these outsiders as if such high-tech methods are part of the institutional alpha. Creators of complex models that their colleagues do not understand should know they are being patronized, used as tools, and should find a job where either their complex models are appreciated or simplify their models so that their work is actually used.

Thus, the situation described by Paul here seems to me to be a case of some quants who work for someone who is either too stupid to realize they are props, or don't care and simply enjoy their role for what it is. 'Theorems' and 'proofs' may impress referees at academic journals, but unless you work for Bell Labs, this means you are working on things real decision makers do not use directly. Thus, trying to convince such people that they should not use a Heston model, but rather a simpler model, like GARCH, or even an exponentially weighted volatility, is all well and fine, but given their revealed preference for complex, unstable models, there is probably no appetite for using anything coming out of this group anyway, rather, merely to obfuscate. To dumb things down so that such work will be useful might violate the unspoken understanding in the organization where the quants are supposed to create really complicated models merely to impress obtuse outsiders. One should not mention or discuss the 'usefulness problem' directly with anyone, however, just as one does not raise their hand in the United Way drive to say 'if the company is just trying to buy corporate PR with our donations, shouldn't our salaries be adjusted for this?'. To prosper in such an environment one must understand the game being played.

The only times I have seen complicated models used is when both the quant and his boss understand what he is doing. If only the modeler understands his model, and even he thinks it is unstable, you can be sure his work is a pretext. These are great jobs in only one sense--you can work on your next job for most of the day. They are dead ends, because there is an infinite supply of super educated quants who are clueless as to practicalities and office politics. They are also obvious candidates for layoffs in tough economic times.

Tuesday, December 09, 2008

Krugman Highlights Nobelists Limitations

Krugman's Big Idea is outlined pretty well in his Nobel speech. To the extent it truly captures something big, the essence of the idea is as simple as what he presented. The particulars of his academic papers, with their theorems and lemmas are ephemeral, the nature of current rhetoric, because defining a measure space, and outlining that this result only holds when U'(0)=inf and U''<0, is just not essential to his insight.

But consider his idea that increasing returns to scale are important. The obvious policy implication is, there might be situations where one wants to invoke the infant industry argument, to protect an industry that is about to 'take off'. Perhaps. But consider the political issues involved, in that such arguments are often used as pretexts for politicians to distribute monopoly power like patronage jobs. Ann Krueger wrote a very interesting piece in the AEA about this, and noted that while there were some good reasons for adopting tariffs and trade barriers, in practice, it was counterproductive because it merely encouraged wasteful rent-seeking, and the effect of sheltering an industry from competition leads not to a high-flying industrial sector, but a bloated one. Further, infant industries never appear to grow up, so that some industries like textiles and sugar are seemingly stuck in infancy for generations.

Anyway, Krugman took the bait, and put out some heretical books in the early 1990's on why infant industry arguments may work (increasing returns to scale), but then found he was often being used by simple Luddites to increase trade barriers, so wrote Pop Internationalism to point out that free trade is almost always a good thing. In any case, his one Big Idea, is merely one argument for trade protection. Further, it does not address why increasing returns to scale exist. In this sense, his result is a bit like Solow's famous result that productivity growth (the Solow residual), and not capital and labor growth, are the keys to productivity growth. Kind of interesting, but unless you can explain why certain countries have higher productivity growth, not so much. Thus, when a Nobel Prize Winning economists discusses his subject, in the realm of policy he is really a neophyte, because the debate involves many issues, not just one, and often his insight is very parochial even within his field of expertise.

Monday, December 08, 2008

Krugman's Nobel Lecture

If you have an hour to present to the Nobel committee, you lay out your Big Idea. Krugman's presentation here is pretty good. He goes over the puzzle, his solution, and why it is interesting.

Basically, international trade is predicated on comparative advantage, so that regardless of total productivity, if the relative productivity of nations in particular goods is different, there are gains from trade. That is, if I can make a $10 worth of wine in 1 hour, and $20 worth of cloth in 1 hour, and you make $5 worth of wine or cloth in 1 hour, it is best that I make all the cloth, and then buy all the wine from you, and you buy cloth from me. The essence of our relative productivity, presumably, if from differences in resources. But over time trade stopped being 'North-South', that is, from developed countries in the Northern Hemisphere to non-developed countries in the Southern Hemispher (trading hi-tech goods for commodities), to more trade between developed countries. This was a puzzle to standard models, that would expect specialization in more fundamental items, like high-tech and low-tech. This is because technology should spread out over time, so Germany and France should have fewer comparative advantages relative to each other, compared to say Germany and Nigeria.

Krugman points out that if there are increasing returns to scale geographically (with an area within a country), a high tech sector in computers may get more and more productive, while an auto manufacturer may also get more productive, though both are 'high tech' in some sense. Thus, increasing returns to scale are important in explaining the growth of various economic sectors.

This is a pretty good idea. It is simple, but that is not a knock. Indeed, many great economic ideas are simple, such as comparative advantage, the Invisible Hand, search theory, Nash equilibria, or ARCH models. That they can be refined mathematically is merely a plus for insiders, but I think the power of simple ideas highlights that there is probably too much mathematics in economics, because the level at which one can debate and discuss the returns to scale argument is really not aided by set theory, (s,S) inventory modeling, or dynamic programming. The number of really good economic insights--true and important--that are only discernible after learning graduate level mathematics, statistics or economics, is a pretty small set (Arrow's Impossibility Theorem, the Revelation Principle).

Krugman then shows that such economies of scale seem to be diminishing. He presents a graph that shows new US auto plants are outside the geographies where there were increasing returns to scale at one time in this area (eg, Detroit), suggesting that there are no longer increasing returns to scale in certain geographies. The new plants are in the south. What is happening to increasing returns to scale? In my mind, it's clearly an attempt to get away from the UAW, the auto unions, which have made productivity growth near impossible with their onerous work rules and penchant for turning any ephemeral productivity increase into parri passu wage increases. So new manufacturers make sure they are far enough away to make unions less likely. Thus at one level, this Nobel Prize winning economist is still pretty much at 40,000 feet in explaining trends happening on the ground. A good idea, but it put academic economics in perspective.

Sunday, December 07, 2008

Taleb Blames VAR, Merton, Scholes for Crimes

You can't blame Taleb for arguing the same point over and over--he's a bestselling author and much wanted speaker, so supply is meeting demand. But like Naomi Klein, I think he plays into straw man caricatures that are not merely simplifications, but profoundly wrong (when not totally incoherent). In Taleb's case, his latest broadside is courtesy of the Financial Times and Co-author Pablo Triana:
A crime has been committed. Yes, we insist, a crime...Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis....Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”...Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly.

Making the crew at RiskMetrics do a frogwalk is a funny thought (What are you in for, bud? Estimating a VAR for mortgages based on daily data during a period where housing prices were appreciating. Bastard!) Nobel Prize revocation? As they haven't even revoked the Nobel prize to the guy who invented Lobotomies as a cure for epilepsy (Egaz Moniz, 1949) or Arafat's Nobel Peace Prize (a guy who lectured the UN wearing a holster), I doubt Black-Scholes-Merton meets whatever standard is currently being applied.

The idea that LTCM was relevant to Merton and Scholes's seminal model is simply absurd. Long Term Capital Management (LTCM) went down because they became too big in simple trades that were about as related to option pricing as they were to the dividend discount model or the Fisher equation, and eventually the market had them by the balls, because they knew they had to get out at any price, and like Niederhoffer getting busted in 1997, the market will punish you for becoming too big. Thus, the main trades that took down LTCM were a Treasury-Eurodollar trade, a volatility trade (trade on volatility via over-the-counter derivatives), and directional bets in emerging markets. Scholes and Merton were primarily marketing props, not strategizers, and they were punished as investors lost something like 95% of their capital. Thus, perhaps Merton and Scholes let themselves be used by people who took too much risk, but the validity of the Black-Scholes/Merton option model was independent of LTCM's business model. The recent downturn also, is pretty independent of the Black-Scholes/Merton model.

Value at Risk is a broad concept, that basically is a framework that has as its goal estimating a 99% or 95% worst-case-scenario, over an arbitrary period of time (day, week, year). Now, clearly many people underestimated the risk in mortgage-backed paper of all sorts, but this error was not particular to Value at Risk, rather, the assumption that housing prices would not decline, which then lead to errors in your stress test, or whatever you call your 'worst case scenario'. This error was made at many levels, by investors, issuers, rating agencies, banks who warehoused these loans, regulators, etc. Again, Value at Risk is pretty independent of this error, though the error would be reflected in any VAR that had such erroneous assumptions (garbage in, garbage out). Further, Value at risk is pretty agnostic as to method, whether you use data with really fat tails, 99.99% worst case scenarios, whatever you want. Blaming Value at Risk for the latest crisis is like blaming soup, rather than sanitation, for Typhoid Mary.

My argument still stands: he's basically someone who makes the perfect the enemy of the good. Like a communist reveling in the Great Depression, Taleb may take heart in recent events vindicating his worldview, but as Taleb knows, there are always 'lucky fools' who merely were fortunate. I would like to see a risk management report from Taleb, perhaps a page always saying "risk=inf", because of course, we could lose everything in WW3, a new virus, all the banks fail, etc. Every assumption isn't true, so make no assumptions. Be prepared for anything. Go long volatility (especially extreme tails). I don't think that's very good advice, though clearly it worked great this year (and funds he's affiliated have done very well, being long tail volatility).

He is now emboldened by his popular success, and not amending his critique, rather thinking that he has financial academy on the ropes by the weight of his best-seller The Black Swan. Indeed, he notes "So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence." So much for reasoned debate. But regardless of popularity, there needs to be something more specific than his strident calls to stop using Value-at-Risk, option models, and portfolio theory from business schools. What sort of principles are we going to teach? Clearly reality is more complicated than these models, but there are some good ideas in there, and they do have many applications, though one need common sense in applying these tools fruitfully. Perhaps, MBA's should be taught common sense? That is, in some sense, the case-study approach of the Harvard Business School, which walks through various scenarios, with all their idiosyncrasies, and while I think this is very useful as part of a curriculum, it needs to be balanced with boring tools, like learning about covariance and how that affects portfolio risk.

I remember seeing Taleb's syllabus from the course he taught at UMass, and it seemed to be a bunch of papers (half by him) about various behavioral finance items. While any thread this big will have some good pieces, I don't think it could be the basis for learning about finance, or risk management, or pricing. As Eugene Fama says, half of behavioral finance is over-reaction, half under-reaction, about what you expect in an efficient market, but in any case, a risk manager should still understand options, value-at-risk and portfolio theory.

Saturday, December 06, 2008

Paul Krugman's Humor Reveals

Paul Krugman won the Nobel prize, so he got to meet President Bush for a photo. Now, Krugman has been so highly critical of Bush, one wondered if he would behave. But he played nice, and let his wife regale Bush with tepid tales about how her parents hosted his father at a fundraiser back in the day.

Anyway, Tyler Cowen had a caption contest for their picture in light of this backdrop, and submitters offered their snarky hypotheticals. Krugman chose the following as his favorite:
“So then I said to Cheney, ‘Duh! Piecewise continuous functions are always Riemann integrable, so just invert the matrix and use a polynomial distributed lag to eliminate the heteroskedasticity!’ What a lightweight!”

Now, a person's sense of humor reveals a lot about both someone's logical intelligence, and their emotional intelligence. The lowest form of humor is both dumb and mean, like the traditional Polish joke where the punch line is all predicated on the fact that Polaks are stupid (eg, Q: How do you get a one-armed Polak out of a tree? A: Wave to him). But this joke is both dumb--Polish people are generally not stupid, Polish intellectuals include Copernicus, Banach, and Ulam--and mean, because they have basic punch line 'because they are stupid!' It is a good thing that they don't print ethnic joke books anymore (I had a dog-eared Polish/Italian joke book as a 9 year old).

Anyway, Krugman's favorite caption is basically a Polak joke: Bush's stupidity is the punch line. Bush's intellect is contrasted with the intellect involved in advanced mathematics, a contrast so vast it highlights that Bush's intelligence is the polar opposite of that involved in 'piecewise continuous functions'. Like snarking to an obstreperous fat guy, 'listen, skinny...' I doubt any of Krugman's liberal heroes understand the importance of the Riemann integral, or its extensions, the Riemann-Stieltjes integral, and finally the Lebesgue integral. But who cares? Anyone who really understands these concepts understands also they are so parochial as to not indicate much about one's intelligence other than that they had an aptitude and interest to take advanced calculus courses. I would bet JFK, LBJ, MLK, or FDR could not take the derivative of exp(x).

So, if that portion of the joke was overreach, the real punchline is merely emphasizing that Bush is dumb. That's so funny! It is a sign of Krugman's irrational partisanship that he thinks Bush's is dumb, and that this matters. For a politician, Bush's IQ is probably average, estimated around 124, higher than Kerry's or Gore's. This is below the average IQ at top-10 economics graduate programs by a standard deviation, but such is life--there's more to ability, effectiveness, and popularity than IQ. More importantly, it is not true that people who disagree with you are either stupid or liars. Most journalists and academics are Democrats to be sure, but so are most felons and the underclass--do we split the difference?

Even if true, if Bush were stupid, would that be funny? I don't think such humor indicates good character. Intellectual inferiority is a fact, but it is pathetic, worthy of sympathy not ridicule. A leader of a large group is usually of above average intelligence, but not too much so, and so the logic of one's side is not merely an IQ test between their two putative representatives. On any big issue--abortion, evolution, God, taxes, welfare, affirmative action--there are smart, honest, people on both sides. Some sides may be wrong, but neither side is intellectually indefensible, which is why we can't teach wisdom.

Leaders are articulators, consensus builders, ingratiators, and thus Mark Schmitt works as a speechwriter for the much less intelligent Bill Bradley, as George Will worked for Reagan, and Frum worked for Bush. The front-men for any political side is rarely a genius, but that is the nature of leaders--they have other skills.

Thus, Krugman probably believes that those who agree with him are smart, and thus can effectively implement his plans for extensive top-down spending. In this sense, he is consistent, if ultimately clueless Nobel Prize winning economist.

Friday, December 05, 2008

Does Economics Create Wisdom?

Brad DeLong looks at all 'we' have to figure out, and is exasperated:

The Obama administration is going to be rebuilding and reconstructing five major sectors of the American economy. It has no choice--there is no other option. It has to remake:

* Autos
* Housing finance
* High finance
* Energy
* And the big one—health care

On what principles and through what procedures is this extraordinary exercise in structural economic reform policy going to be accomplished? I get how to do the macroeconomics of Obama administration economic policy. I don’t get how to do the structural side…

He might add that we have nettlesome questions about the amount of subordination needed for mezzanine debt in the CDO's for Alt-A mortgages, what price--or is it 'level of price growth'--to set for housing, and how much chromium should be the standard dosage in weight loss supplements.

For me, the key principle in economics is that it studies the unplanned effects of individuals acting in their self interest. Like evolution it appears to be a product of design. Yet, many esteemed economists think that if we do not come up with a 'plan', all the key decisions in the economy won't be made anywhere near optimally, just as a bridge can't be built without a designer. Thus, its hard to say that learning more formal economics is a good idea, because clearly, there are no 'first principles' in this field, it still is merely a field for organizing and articulating your prejudices.

Margaret Thatcher famously told President Gorbachev that capitalism was superior to socialism because unlike Gorbachev, she didn't have to decide how many refrigerators to make this year--the market does that. Faith in the relative superiority of decentralized decisionmaking, by individuals who are not elected, is just as non-intuitive as it ever has been.

Thursday, December 04, 2008

Union Work Rules

The UAW magnanimously announced that they may get rid of the job bank, basically mandatory featherbedding. They also may back off on the demand that $10B go directly to the union's unfunded health care pension. UAW president promises that labor costs will be competitive...in 2010...for new workers. Thus, existing workers keep their comfy benefits, which are much higher than what they would get if Detroit did not have to deal with the union. Given their labor costs are about $72/hour versus $44/hour for the Japanese making cars in the US, I don't see why they shouldn't take a $25/hour pay cut today.

The recent UAW national agreement with Detroit automakers is an inch thick, meaning there are many specifics on who can do what on the shop floor. This makes productivity increases very difficult. The following anonymous commenter outlined how insidious unions are:

I work with the UAW daily. Don't give me any of this "They're protecting 40 hour work weeks and weekends." anymore. I don't even work in a factory (right now). I work in a test facility. All of the mechanics are union. If a bolt breaks or some wiring (CAN lines, 0 voltage) I need to put in a work order to get it done. A 30 second fix will take 6 hours. If you even look at their tool chest wanting to borrow something you'll get written up. Then you have a grievance on your permanent record AND the union guy gets paid double for that time because you went around him.

Oh and a bit about working with the union in factories. You can't touch anything. For example if you're a process improvement engineer and you need to figure out how to improve a process. You need to stand and watch some guy with only a high school diploma do it. You can't touch anything. See a piece of trash on the ground. Leave it (even if it's a safety hazard) if the floor sweeper sees you, you'll have another grievance because you're "Taking his job away".

We have a project going on "Why is this bolt failing" on a certain product of ours. Turns out that it is over torqued at the factory. So management and the powers that be put out an official decree: No air wrenches on X bolt. The union continues to use them. Legally we can't 'take them away' or go into their tool boxes after they leave. So our bolt continues to fail because Joe Blow is too damn lazy to use a proper torque wrench.

And how is it different in a non-union shop? (Coming from my experience in the same company at a different, non-union plant). It's absolutely farking wonderful. I can walk out on the production line. Grab a tool, use it to see how something is done and then go finish my report/project. One day I had to build a proto type. I was all scared because I had just left a union shop. I was out there all timid until one of the guys spoke up "Oh, we're not union." Then he rolls over a tool chest. Gives me a 10 second demo on how to use the overhead crane. And leaves me. At the end of the day he helps me sweep up my stuff. We BS about the project and it was an absolute joy.

And one of the biggest things I noticed is there's no such thing as "That's not my job." (My friends at Toyota point this out readily). If you have one production line down and one that is short of people. You go work on the one that needs people. In a union shop you get "that's not my job." So the workers from line X sit and play cards while the workers from line Y barely meet demand.

Wonder how Toyota and Honda and BMW do JIT (just in time) delivery? You can take someone off of a slow production line (Say an SUV line) and put them on a small car line in a day of training. Most factories are idiot proofed to the point of you don't even need to know english to put bolt X into nut Y and tighten with the wrench.

That's why union sucks and that's why I think they need to be abolished.

It seems more probable that the non-American auto plants will be unionized, given all the nostalgia for the New Deal.

Wednesday, December 03, 2008

What if Moody's Adjusted Their Ratings Earlier?

A AAA rating means about a 1 in 10,000 chance (0.01%) of defaulting, annually. This is very difficult to get at via mere experience, but was plausible because default rates for regular AAA corporate debt for Moody's from 1920-07 was zero. Thus, they figure it was less than the AA rate, which actually had some defaults, around 0.06%, and so seemed a reasonable extrapolation. But a slew of AAA rated paper trading at 50 cents on the dollar basically means that the AAA rating was wrong, rejected, statistically, at the 0.001% level. So if AAA ratings are wrong, how does one adjust them? Is it now 1 in 100 (like a BB+ rating), as opposed to 1 in 10,000?

Such changes in probabilities are not peculiar to finance. Note the the Space Shuttle prior to the Challenger disaster in 1986 had an internal probability of error at 1 in 100,000; after the crash, this was raised to 1 in 50. If this is the magnitude of the default perception change it will take a long time to change, because via bayesian inference the rating agencies will need several years of cross-sectional observations to get these estimated probabilities back near old levels. There is no way to speed this up, such is validation.

Rating agencies used to rubber stamp some types of securities with ratings using deference to the market and path dependence, and so now everyone is skeptical of all of their investment grade ratings. The result is that everyone assumes the worst, and only the Federal Government has a AAA rating, because they can always print money to pay debts. Thus the market now is missing a credible stamp of investment grade (which implies, usually, you can assume its true), everything is trading like its junk (ie, less than BBB-). Even worse, via an ordinal ranking this means that B and BB rated bonds trade like distressed securities. The market is constipated because the secondary market for debt has been shut down, as previously useful ratings are now considered suspect, and our financial institutions do not have the wherewithall to warehouse all the debt in the economy. The New York Port Authority had no bids for AA rated bonds, clearly showing no one believes they are near that quality.

But consider that since this bad mortgage debt was not only rated AAA, but traded as if it were 'risk free' back in 2006. If debt is trading as if it is AAA, if would be very difficult to defend rating it as, say, BB. The market is so big, many people are independently corroborating your judgment. Surely many of them looked at these deals in detail; indeed, probably hundreds of thoughtful people did, including regulators at Office of Federal Housing Enterprise Oversight (OFHEO) and the Fed. The rating agencies were analyzing mortgages the way everyone else, with very different incentives, did. As the market weakened underwriting standards from the 1990's onward, it seemed to make no difference, and academics and regulators were saying these new mortgage innovation were not material. Legislators with a lot of regulatory power implied these were morally righteous changes.

If the rating agency decided in 2006 that the cumulative effect of these changes increased the probability of default from 0.01% (AAA) to 0.50% (BB+), this not only would have been ridiculed, if a convincing case was put forward this would have shut down the housing bubble earlier. But then wouldn't the rating agency then have been blamed for this entire mess? After all, the total amount of bad housing debt is a fraction of the total loss in wealth from this financial debacle, as some unknown accelerator mechanism has destroyed at least 10 times the value of the bad assets at the center of this debacle. Estimates of housing wealth destruction were 'only' around $200B back in March 2008, after the mortgage market had collapsed. Year to date global stock markets have destroyed over $10 trillion subsequently. Now, if Moody's had the prescience in 2006, to see say 50% of this, and caused, say, a $1 trillion mini-correction but avoiding the $10 trillion loss, would they have been congratulated? Remember, you don't get to view alternative time-paths in the multiverse to prove your actions mitigated a disaster, rather, you are left looking like you screwed everything up.

Further, that's all with hindsight. The graph above shows how Investment Grade default rates vary over time (mean about 0.15%). I wouldn't know how to characterize that distribution, with a mode at zero, and some positive numbers that seem to have a non-stationary distribution. Such distributions get funkier with lower default rates. Since low-probability defaults are clustered in time, you probably will not observe the event that will prove you right in your working life. The net benefit to making a change in prospective default probabilities from 0.01% to 0.50% thus would be probably not be something you would expect to 'prove' in your working career at Moody's. Thus, standing athwart history yelling 'Stop!' sounds neat, but in reality that's only realistic when you have no effect, because generally people do not get credit for preventing low probability events from happening.

Given the cyclical nature of default rates, I just don't see how you can design a mechanism to reliably estimate a 1 in 10,000 annual default rate given the diverse set of securities, often novel securities, they are asked to evaluate. We just don't have enough data on comparable issues. Perhaps every new security needs a top rate of BB+ until it generates 50 years of data.

Monday, December 01, 2008

Keynesian Spending Coming

On CNBC NPWE (Nobel Prize Winning Economist) Paul Krugman was giddy about the probability and size of future Federal Spending that Obama has hinted is in the pipeline. The government multiplier, if it worked, sure has not shown itself to increase GDP per capital or alleviate business cycles (Japan had a massive new fiscal stimulus package every two or three years from 1990 to 2005, and it did not work). But in any case, the logic of the government multiplier is rather straightforward partial equilibrium economics. It basically says, since people spend 60% of what they make, when the government spends $1, it actually creates $2.5 via the iteration of following that dollar through the economy (1+0.6+0.6^2+0.6^3+...). Thus, government spending basically pays for itself, because if you tax $2.5 by 40%, you get your initial dollar back!

This only works when we are below 'potential' GDP, which is the GDP if everyone were fully employed at the job of their choosing, which means never in real time (though economists look back wistfully at the 1960's and 1940's). An economic solution without a trade-off is surely too good to be true, and it was, as economies in the West all broke the bank in the 1960's and 1970's, and it just resulted in high amounts of debt, inflation, and lower productivity growth.

The idea that government spending has these multiplicative benefits irrespective of the cost-benefit of the actual government program is ridiculous. Plus, the only way to generate instant spending is not building bridges or roads because of the planning, logistics, and environmental impact issues, so if you have to actually write checks next year, you have to spend it on total patronage featherbeading: white collar bureaucrats who help implement jobs administering social work programs. It would be more honest and less annoying to pay them to join a UAW Jobs Bank (at least those people leave us alone).

Keynes was a good writer and no fool, but that does not mean his biggest ideas are any good. It is rare and admirable to be clever, but rarer still to be that and correct on things that are important. The net net of his General Theory is blather, as if the economy were a hydrodynamic pump; incentives, expectations, government borrowing, and the nature of government spending, did not matter. Tyler Cowen is blogging on the General Theory, but while a seminal work, its also wrong. There are lots of formerly popular theories from the past that don't work, so reading them for historical reasons is pretty unhelpful (like other signature books that were wrong: Coming of Age in Samoa, Silent Spring, Sexual Behavior in the Human Male, The Ego and the Id).

Keynes' Big Point was the dismissal of Say’s law, that supply creates its own demand, as opposed to the new theory, which is that government spending, properly managed, can keep an economy at “full employment.” So what has demand management wrought? Inflationary spirals and their inevitable cataclysms, a rationale for greater government spending, and a general waste of time looking at business cycles at the expense of growth theory. To Keynes, entrepreneurship and wealth creation were descriptions of any investment process whether managed by a politburo, a despot, or an energetic profit maximizer. Nancy Pelosi, Bill Gates--what's the difference? Clever, yes. Wise, no.

Schopenhauer said all truth passes through three stages. First it is ridiculed. Next it is violently opposed. Last it is recognized as self-evident. Conversely with proposed profundities that rationalize the current intellectual zeitgeist: first hailed as revolutionary, next found to have no empirical assertions that are true, and last recognized as merely 'inspirational'.

Many economists think that in spite of the contradictions, and some rather unfortunate wording about 'euthanizing the rentier' (this when Kulaks in Russia were being really euthanized), it was great because it created macroeconomics as we know it, and so could 'handle' the Great Depression. I think prior depressions, and regular recessions, were handled much better pre-1936 than post.

As stated by von Mises (see here):
His contribution consisted rather in providing an apparent justification for the policies which were popular with those in power…His achievement was a rationalization of the policies already practiced.

The Economist's economist, Paul Samuelson, said it best, describing Keynes' The General Theory as follows:
It is a badly written book, poorly organized… it is arrogant, bad-tempered, polemical… it abounds in mare's nests and confusions: involuntary unemployment, wage units, the equality of savings and investments, the timing of the multiplier, interactions of marginal efficiency upon the rate of interest and many others… flashes of insight and intuition intersperse tedious algebra. An awkward definition suddenly gives way to unforgettable cadenza. When it is finally mastered, we find its analysis to be obvious and at the same time new. In short, it is a work of genius.

With that kind of reasoning, we are all merely several beers away from genius. For some reason, really smart mathematicians are highly susceptible to those who seem intelligent but show no doubt, as if they reverse reason that the only way someone as smart as X could believe Y with such certainty, is that Y is true! Much of what we are taught as the high intellectual history of the social sciences is based more on the magnetism and impenetrable self-assurance of thinkers than on minor issues like whether they were right or not.

Sunday, November 30, 2008

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
GOODYEAR TIRE Auto Parts&Equipment GT
CIENA CORP Telecommunications CIEN
AMKOR TECH INC Semiconductors AMKR
WELLCARE HEALTH Healthcare-Services WCG
TRW AUTOMOTIVE Auto Parts&Equipment TRW

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.

Tuesday, November 25, 2008

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.

Monday, November 24, 2008

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?

Sunday, November 23, 2008

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.