Landscapes Rule

Data suggest people from all cultures tend to like landscapes. These painting have open spaces, with big trees with branches towards the ground, a river, a view between two mountains, animals, flowering and fruiting plants, and lastly, a path that one can follow. Thus, modern artists take note: in 100 years no one will care about your avant guard take on man's inhumanity to man, or his banality, as represented by a bunch of soup cans. It's funny listening to this guy note that people though art demand was much more culture dependent.

Mortgages are Bank Assets!

The TARP is $700B targeted to shore up banks. Everyone understands that we need banks to be healthy in a modern economy. As John Kerry wrote in the Wall Street Journal: "We need to act swiftly and boldly to restore solvency to our financial sector".

Of course, they also feel the need to protect homeowners, so increasing their ability to prolong a foreclosure, if not outlaw foreclosures, is also being applied. This lowers the value of mortgages.

So, the asset at the center of this, mortgages, is pulling down bank balance sheet. Government's great solution is win-win: subsidize the mortgage owners, and also give breaks to those with mortgage liabilities! This is right up there with outlawing short selling in terms of directly addressing the problem.

BSDs Take Note

Many tell all books by ex-Wall Streeters note the macho culture among traders (mainly, market makers and brokers). Get a bunch of 20-something guys in a room all day, and its kind of inevitable. The temperament of traders, as opposed to IT guys, suggests they probably have higher-than-average levels of testosterone.

Clearly macho behavior can go too far, and a civilized society should discourage rudeness because real diversity is about treating everyone as a person with as much dignity as yourself (as opposed to 'celebrating' differences). On the other hand, taking these issues to court is a poor way to handle one's umbrage. Take the case of Ryan Pacifico who is suing Calyon, charging that his one-time boss at the French financial firm mocked him for avoiding meat and wearing snug-fitting shorts during triathlons:

Catalanello's alleged abuse is the meat of the nine-page complaint, which accuses the boss of saying, "Who the f--- cares?" when another trader questioned what Pacifico would eat during an outing to a steakhouse.

"It's his fault for being a vegetarian homo," Catalanello is accused of saying.

"You don't even eat steak, dude," Catalanello is accused of saying. "At what point in time did you realize you were gay?"

It's such an adolescent jab, it would be hard to get too worked up about it. Even if I were gay, I think I would laugh at the sheer immaturity of the comment (does any slam with 'dude' at the end sting?). Best to shrug it off, and order a salad at the steak retreat, with lots of wine. Politeness is two sided: not giving unintentional offenses, and not being too thin skinned.

And wearing snug-fitting bicycle shorts is kinda asking for the equivalent of an office wedgie.

Selection Bias at Conferences

At Davos, several high profile finance executives are missing: John Thain (ex Merril CEO), Richard Fuld (Lehman ex-CEO), Martin Sullivan (ex AIG CEO), Marcel Ospel (ex UBS Chairman), Lloyd Blankfein (Goldman CEO). Now, these people used to go, and used to be listened to. I would think their stock of knowledge is now much greater after adversity than prior, and they have a much more interesting tale to tell. But many think these people have merely been exposed as having been lucky fools who seemed like geniuses because of the bull markets they presided over.

People want to hear from successful people at conferences. They hope to either get a job with him or his successful acolytes, or learn about how to be successful like them. But a successful person is probably not going to be totally forthright about their edge, even if they know it (after Bob Rubin stated that their subprime exposure was a detail outside his scope, clearly many titular leaders are merely figureheads). Failure, in contrast, leads to more particularized soul searching.

It takes a lot of personal confidence to admit to errors, and very few are willing to admit mistakes that are supposedly right in their wheelhouse, right in their area of expertise. But in fact these are the errors that are most instructive, because the errors of a dilletante are not very generalizable, but when John Merriweather screwed up Long Term Capital Management in 1998, and now JWM Partners in 2008, I want to hear what his diagnosis is. What was he thinking? What went wrong, in his opinion? He is not stupid (hate the sin, love the sinner). Errors by experts in their own domain are very, very interesting, much more so than listening to someone who didn't fail last year. After all, they could merely have been timid, or clueless. Putting all your money in cash, or having a monkey randomly going long or short the S&P every day would have outperformed the S&P last year. Noise would have beat most investments last year, so although it is clearly better to have made 0% last year, I'm not impressed. There's a hedge fund that was down only a couple of percent last year, and thinks people will flock to them for their relative performance in 2008. Good luck with that. What's your sales pitch: 'our alpha is not too negative!'

Anyway, it would be a good thing if people who made mistakes were treated with good faith, that their errors were reasonable, and so to that end, listening to their explanation about what they did, and why it didn't work, is truly enlightening. Much more so than Maria Bartiromo talking to George Soros about his silly reflexivity theory.

On the other hand, there is legal liability, and so, discussing mistakes may open one to damages for negligence, and that is unfortunate.

Backtesting Errors

The most annoying part of backtesting is creating a database, which is problematic because most data is meant to show a one-off take of current information, as opposed to cross-sectional data as of January 14, 1998. It's free and easy to see all about, say, IBM's market and financial statement data. But what good is that information if not put into context, and what is the context, other than a historical sense for the relative distributions and correlations, of the past?

Pulling together such data usually involves integrating data from different sources, splicing them together, and making sure you have 'dead' companies. Invariably a data provider insists they have 'all' the data, because for them, current companies are all they can conceive of. So you have to be specific, and ask instead if they have 'dead' companies, such as Enron, WorldCom-MCI, and Bear Stearns. Then there are issues about splits, dividends, that can, if not accounted for, generate illusory patterns.

Anyway, I discovered something I thought was really interesting, but then found it was merely an error. See if you can spot the error. I have a database with financial statement information available at the end of every month. With that record or observation, I have the month-ahead returns, and also information on the trading volume and market cap as of the end of the month.

I looked at earnings day returns, the returns from the day prior to the earnings release date, and the close of prices the day after the earnings release date. To do this, I had to take the earnings report date information, and then take those date-firmID pairs to a database of daily return data. I noted their daily (annualized) volatility is about 150% higher than average daily returns in this period, which makes total sense. Just for fun, I looked at all companies with a market cap greater than $1B, and saw that the average daily return on this date was about 0.2% or so, highly significant. On average the return was significantly positive, but no one noticed because for any one observation there is a lot of noise, and its not so large as to be totally obvious. I looked for companies with greater than $500MM market cap, same result, and was highly consistent over time.

What is the error?

Well, my size filter used market cap data from the end of the month, to look back at the earnings date returns from that same month. By looking only at companies with greater than $1B or $500MM in market cap at the end of the month, it would include enough of those who migrated upward, and exclude enough of those that migrated downward, to generate the 0.2% return, which was entirely due to this bias. That is, there are enough companies moving from $975MM to $1001MM on earnings that get in, and enough going from $1001MM to $975 that are censored, to generate an illusory sample statistic.

I didn't think a $1B cut-off was material, especially because usually this database is used to look for patterns in month-ahead returns where the bias does not exist, so it didn't occur to me. But in fact there was a material selection bias in the market cap cut-off. These things are subtle sometimes.

Deephaven to Close

Deephaven Capital Management was a hedge fund that reached about $4B assets at one time. They announced today they are closing shop, selling themselves for $7MM plus potentially $30MM more (depending on fund performance and how much money leaves), to Stark. They still had over $1B in assets, so as one analyst said, the $7MM is 'paltry'. I used to work there, and as they were kind enough never to sue me I have nothing but nice things to say about them. But they highlight an interesting hedge fund dilemma.

Say a fund is down 35% or so, as many funds were in 2008. If you expect a volatility of 12%, and hope for a Sharpe of 1, it will be 3 years before you make any incentive fees again (the 20% of profits). That's because a high water mark means you only make the 20% after your investors are back to their high water mark. Now, if you own the fund, you are probably wealthy enough to stand 3 years of no cash flow from the basic fund. You probably also get a lot of non-cash utility from owning your fund. Thus, I can see why you still keep it going if you are an owner-manager. In Deephaven's case, they were 51% owned by Knight Capital, meaning, the main owners were not much involved in day to day management, and have other core businesses to manage, ones they actually control day-to-day. So, if you are down about 3 years of expected returns, for an outside owner, it's a good time to exit.

I suspect many funds are facing similar cost/benefit calculations. If a fund is down 30+%, most of those who don't feel a real stake in the action will have a big incentive to shut down, because of these high water marks.

PermaBear Wisdom

When an extreme event comes around like 2008, those who called it are elevated in stature. I think its appropriate they are elevated, but not too much. Many who called the crisis were incredibly vague prior to the problems (Shiller in his 2006 edition of Irrational Exuberance), and many enumerated tens of things that can wrong, and have always been saying so (eg, Noriel Roubini). Here is George Stigler describing the economist Leon Henderson circa 1942 in Memoirs of an Unregulated Economist):

Henderson had acquired a certain fame in Washington when he had been one of the few to predict the crash of 1937. An indulgent public had forgiven of forgotten his identical but mistaken predictions in previous years. I still label the repetition of a prediction until it comes to pass the 'Henderson method'.

Actually, a good doomsayer should predict a massive cataclysm is 'possible, if not probable'. In casual audiences this will work, because it is impossible to tie down, but it emphasizes the bad, so when that event happens, you simply say, 'exactly!'. A more quantitative audience will require actual numbers, so predict a cataclysm in 2-3 years, but here is the secret: always keep the improbable event forecast as being out 2-3 years. Most people who see you again, in a year or so, don't catch the inconsistency, because no one keeps archival real-time databases on prognosticators. As they say, forecast early and forecast often.

As a fund manager this shows up in your historical cumulative return data, which is why someone like Warren Buffet is so impressive. But if you simply disband your fund and start over, eventually, you can generate a nice arithmetic return, because a one-year -97% return can be offset by a 150% return, even if that won't really help the investors you had when you lost -97%.

Geron up 50% on Hope

The WSJ noted:

Geron Corp., a Menlo Park, Calif., biotechnology company, is expected to announce Friday that it received a green light from the agency to mount a study of its stem-cell treatment for spinal cord injuries in up to 10 patients.

Geron (GERN) rose about 50% since Thursday on this news. They have a market cap of around $600MM, and have never posted a profit.

Now, if stem cell therapy was kept down by the unilateral dictates of George Bush, and this artificial constraint is now lifted, one might say this is purely rational exuberance. But there are almost 100 adult stem cell therapies in existence, since 1968! After 40 years, I think we have good reason to think we have picked the low hanging fruit in stem cell therapies. After all, while Bush limited the Federal funding of several embryonic stem cell lines, states were free to fund them (and did), as well as private and foreign governments. In other words, this is not a field devoid of attention.

The difference between embryonic and adult stem cells is mainly theoretical, that because embryonic cells are from prior to much tissue differentiation, they should be more plastic than adult stem cells. In practice, adult and embryonic stem cells behave rather similarly, and the hidden premise of proposals for stem cell therapy is that we needn't understand exactly what is going on because if you just put the cells in the right place they will know what to do (the Proteus Effect), like dropping Doctors without Borders in the middle of the war-torn Congo. These cells sense when something needs help like damaged nerve, cardiac, or pancreas cells, and make replacement cell parts, if not replacement cells.

I have no ethical qualms against using embryonic stem cells, and think Bush was wrong to restrict this research. But I also think he is assumed to have way too much power, because it is not like he stamped out closely related research, and there have always been other areas that would allow and fund embryonic stem cell research. Sure, 'the long-term promise is boundless', which is great upside if ever, but they also 'show a dismaying talent for turning into tumors', which is bad. If California got $4B to spend on this in 2004, Massachusetts got $1.25B in 2007, and nothing has yet come of it, what are the odds this company will figure it out by the time investors get tired? Possible, yes, probable, no.

When a science generates a potential solution and such solutions are touted as if they have never been tried after decades, I think it is probable they don't work (eg, see behavioral finance, fractals in finance, Keynesian stimulus, neural nets, artificial intelligence).

Fedor Awesome

So, Fedor Emelianenko KO'd Andrei Arlovski with a stunning right hand counter to a flying knee in his Saturday Mixed Martial Arts fight. A quick punch and Arlovski was out cold, face planted on the canvas. Truly impressive. Vladmir Putin is a big fan, so I guess we have that in common.

What is funny is that Emelianenko is about 6 feet tall, 230 pounds. He's strong looking, but also looks like he enjoys donuts and beer like the rest of us. He is also unquestionably the baddest man on the planet right now in hand to hand combat. In contrast, consider the archetype of such a man, such as the ultimate Russian Drago (Dolph Lungren) in Rocky 4. Tall, chiseled. Indeed, Arlovski is impressive looking like Lungren, as he is 6' 4'' and very defined.

Big Government's Big Effects

Many big government programs are really destructive, but usually, such results are not on any explicit balance sheet or income statement. Thus, busing kids in cities to alleviate segregation, or build giant public housing that is more generous to single mothers than those with husbands, or create a Ponzi scheme in social insurance, have engendered profoundly bad results for the very people that were supposed to be helped. Nonetheless, current recipients of the aid all like their aid, just as any wayward kid appreciates his current enablers.

With all the gushing about Obama, and how he might spend this $1 trillion dollars in TARP and fiscal stimulus, such numbers are so large they stagger the mind. They numb anyone from applying any real discipline, because almost every state, industry, could get by another year with a mere $10B, which in the scheme of $1 trillion is nothing. And via the multiplier, every state or industry implies you are saving X million jobs.

To see the problems, note that for the past 15 years, every bank merger would have to by approved by regulators, who were keen on making sure these banks were making adequate recompense for red-lining and other policies. Thus, consider this press release from when Washington Mutual acquired Dime bank in 2001:

In connection with its merger with Dime, Washington Mutual recently established a ten-year, $375 billion community commitment which targets funding to low- and moderate-income borrowers, and minority borrowers, as well as direct investments and other forms of support in communities where the company operates, including the greater metropolitan New York area. One of the largest community commitments of its kind, the ten-year pledge will be implemented with the assistance and support of a variety of non-profit community partners.

Now, WaMu hade about $250B in assets at this time. Pledging $375B for low-income borrowers staggers the imagination. If the entire banking sector was making these pledges, how, possibly, could one actually meet this objective without creating a huge system of favors, with vested interests at every level (government, business, nonprofit, regulatory, academic)? More importantly, how could it not end in a huge number of bad loans? That it took so long to implode is the most amazing thing. When it finally blew up, those responsible for the mess would say, like "it was perverse that Freddie Mac and Fannie Mae, the two biggest providers of money for U.S. home loans, have been encouraged to put people into homes that they end up losing." That was Richard Syron, who was head of the Boston Fed when it 'proved' that existing residential lending was discriminatory and too conservative back in 1992, and was rewarded as head of Fannie Mae, where he pocketed $38MM for running it into the ground.

I suspect that with this kind of money flowing out of Washington, we are creating a vast, dysfunctional patronage system that will create a nightmare of make-work jobs that will be around until I'm dead. You just can't increase spending by this much, top down, in an efficient manner.

Keynes and Ellsberg's Paradox

Ellsberg's Paradox is a famous conundrum in decision theory. At the Wikipedia website, they noted a reference to Keynes in the Ellsberg entry. As I have seen just about every idea attributed to Keynes, I figured this was a typical overstatement. But then I check the entry, and lo and behold, I think Keynes articulates the Ellsberg paradox pretty well. From Keynes Treatise on Probability:

The typical case, in which there may be a practical connection between weight and probable error, may be illustrated by the two cases following of balls drawn from an urn. In each case we require the probability of drawing a white ball ; in the first case we know that the urn contains black and white in equal proportions; in the second case the proportion of each colour is unknown, and each ball is as likely to be black as white. It is evident that in either case the probability of drawing a white ball is 0.5, but that the weight of the argument in favour of this conclusion is greater in the first case.

GE May Lose AAA Rating

GE is one of America's most successful companies, and has a large finance division that relies crucially on its AAA rating to get business, and cheap funding. The AAA rating is a competitive advantage that is hard to duplicate. It has paid an annual dividend since 1899, and has not had a year where they lost money in decades. And many are betting it will lose that rating this year.

But the worldwide recession, and potential write-downs in its finance unit, put this at risk. Its implied volatility is around 80 as its price fell over 50% in the past year and realized volatility often hit the 100% annualized level. Its spread to Treasuries out 5 years is about 326 basis points, which is really bizarre, a spread that most junk bonds had in 2006. The biggest risk factor for a AAA company, is showing that it isn't a sure thing on the profit front. This is much more material that the leverage. Indeed, I know many people in financial restructuring, and their pitch is pretty simple: you have 100% equity, why not swap 50% of that with debt, and get the same profits at half the capital! You can buy a big house with the proceeds and still have control, and get about the same dividend. Sure, the interest expense goes up, but not much. I imagine Microsoft will adopt this strategy at some point in the next 10 years (it has zero debt), and anticipating this currently buffets the stock.

In fact, my debt model calculations show that an exogenous increase in debt from 0 to 50% is pretty immaterial on the probability of default for a profit making company, so debt buyers are willing to facilitate such a deal. But it is the income that is key to GE's plumb financial status, and I don't think there is much they can do here. I would hate to see GE issue shares, because I think that would have a second order effect on its debt rating, because it won't help if GE actually posts an income loss next year. It's all income, not leverage, for GE, at this point, and I doubt there is much Immelt can do, top down, to affect this strategically.

Bank Directors Often Empty Suits

When I was at a bank, no matter what level executive you were addressing about some issue, the meeting would often end: "well, get this and that in there, but don't forget to simplify it when presented to my boss." The Senior Vice President would say this about the Executive Vice President, who would say this about the Managing Committee member, who would say this about the COO, who would say this about the CEO, who would say this about the Board.

And they were all kind of right. The higher you go, the less technical, the more the 'leader' has qualities like reputation, great hair, and the ability to spout platitudes as if they were keen insights into the human condition. Most of all, they know that saying very little, or something very vague, can seem really intelligent when you have a lot of power. Recently, Bob Rubin, the banking expert, claimed that subprime exposure at Citi was a technical detail outside the scope of his activities, which highlights that for $115MM Citi was not paying for anything as prosaic as, say, risk management or portfolio advice.

Richard Parsons is going to be the new head of Citigroup. He is a lawyer by training, whose first job in banking was as COO of Dime bank when it was under strong regulatory review during the S&L crisis, and wishing to demutualize (a trick that needs approval from government). He then left to join Time Warner's board, eventually becoming chairman in 2003. He was head of Time Warner, and left in May 2008 after not budging the stock price over 5 years. But he has great political bona fides, with friends among Republicans and Democrats, and was on Obama's economic advisory team. A large corporation, especially one receiving TARP money, needs expertise managing Washington no less than Fannie Mae, which made many of their senior executives very rich via conflating Fannie's self interest with some social good like encouraging home ownership (among people who can't afford homes).

He's no fool, but having such people lead large banking institutions highlights that banking's primary concerns are political, as they always have been. It is implausible to think that any such executive would have the ability or interest to appreciate the massive degradation in residential mortgage lending in the past decade, which is why just about every single large bank suffered similar problems. Given the nature of leaders, if the zeitgeist is for weaker standards, and there are no actual losses, such leaders are not going to put on the brakes. They won't do much of anything, other than 1) try to maintain their fiefdom via takeovers and avoiding takeovers and 2) lobby for favors from the government, such as keeping 'non bank' competitors out (eg, insurance, mutual funds, foreign banks, etc), and expanding the latitude of services they can provide.

Plausible Theories

Many times I hear about theories that seem really good, but further examination shows they don't work. There are lots of feedback loops that are hard to see, and so, many times a theory is really a partial derivative, while reality is full of only total derivatives.

For example, young mammals often play, and countless times I have heard the nature show narrator note that such play is practice fighting when the bear cub/lion cub/etc. grows up. But scientists actually tested this theory by recording the frequency of play fights by squirrel monkeys and meerkats, noted their success fighting as an adult, and found no correlation between either the number of play fights as an infant, or the successes at infant play fighting, and the adult fighting prowess. They also found that play fighting does not address key tactics in real fighting. Infants learn from fighting, but mainly things like coordination, how to deal with surprise, and socialization. Thus, at a high enough level of abstraction, it seemed perfectly reasonable theory, but the closer one looked, it was plain wrong. Animal play is not practice for adult fighting, except in some very abstract sense.

So too, the government multiplier, import quotas, unionizing industries, and all sorts of other great top-down ideas. They work in some very hazy, abstract sense. But you factor in all the opportunity costs, the disincentive effects, the costs spread among many to help a few, and they are all worse than doing nothing. Unfortunately, such theories are so consistent with other objectives (read: redistribution), they are really too good to check.

The Case for Financial Stocks

Financial companies are toxic waste currently, because they are at the center of the recent meltdown. They are not merely symptoms of the excessively foolish subprime crisis, but were active participants, a stunning combination of negligence, stupidity, and greed.

Taleb has stated that banks have lost more money than they have made in their history, a statement that was 'too good to check' I guess. I'm betting this error is a combination of off-the-cuff loss estimates--eg, 1 Trillion USD, which was global not US--and using nominal dollars. Using Ken French's website, out of 44 stock industries with data back to 1926, financials had the 9th highest return since then, Banks 5th. An investor forced to choose sectors in 1926 would have done much better in financials or banks than the average equity investment.

A common bank profitability metric is Return on Assets (ROA). On average, a bank makes 1% on assets, historically. Now, if you look at the entire financial sector, (say using S&P/MSCI Barra's GICS from 5000-5280), you see the average NetIncome/Assets of 0.78% since 1989, including the most recent year. The graph shows the ROA for all US banks since 1984 as estimated by the St.Louis Fed, and this independently corroborates this mean result. That is, aggregate earnings in the financial sector included a lot of large write-offs, but the net for the year 2008 was near zero earnings, not something that returned total earnings for the sector to zero from the beginning of recorded history.

Currently, bank stocks have a forward P/E of around 13, meaning, using the current price, and the estimates for earnings next year, the ratio is 13. But this average ignores the fact that the largest stocks have the lowest P/Es: KeyCorp, National City, Citigroup, Wachovia, Comerica. If all the banks had a forward earnings equal to 0.78% of assets (its historical average over the past 20 years), and the P/E were then equal to the median P/E, the bank sector's market cap as a whole would rise 150%. That is, if all banks earned 0.78% of assets going forward, and if they all had P/Es of 13, the total sector market cap would be $519B for the top 50 US banks, not $204B. This is an example of what Warren Buffet calls a 'low risk' idea, because the expected return is so great, you have to have a lot of wrong assumptions to underperform a benchmark of say, 12% annual return.

Now, on the other side, are people like Paul Krugman, saying that many of these banks are technically insolvent because their assets are market too high (his example is Citigroup). I think these banks have been written down aggressively in part because the new regimes want to have a new base to benchmark against, and the failures of the past are already the fault of prior regimes (they wish to assert, anyway). So, if you are a new CEO of a troubled company, or just acquired a troubled company and have access to the US Federal Government's $700 TARP funds, you want to write down as much as possible. I don't think they are holding back, but I can see how smart people, at 30,000 feet, think this is all so obvious.

Historically, stock market losing sectors show a strong rebound after falling greater than 50%, as financials have recently done. Not that they make it all back, hardly, but they have good returns their first year out of the crisis nonetheless. Biotech in 1992, Oil in 1980, the Nifty 50 in 1972, Japan in 1990, Tech in 2002. Things don't go down forever. Of course, the future may not be like the past, but I think it is our best guess going forward. The financial decline has been going on since May of 2007, and I think the worst-case-scenario is already baked into financial market prices.

They Didn't Use the Seat Cushions!

For decades, the preflight instruction would mention using the seat cushions as a flotation device in case of a water landing. I have yet to hear about this tactic actually working, or even tried. The guy who sold the industry on this for his company should be in the Marketing Hall of Fame.

Experts are Curmudgeons

The word 'corny' comes from the way mawkish stage scenes would pay off in the Midwest where the corn is, even though jaded New Yorkers found them hackneyed. I was reading a negative review on Slumdog Millionaire, and it highlighted the strangeness of the movie reviewing profession. It reminded me of a bad review of the teen vampire movie Twilight. I'm a middlebrow moviegoer (I liked both movies), having gone to enough to find the car chase scene in the latest Bond movie not very suspenseful, but I still like it when the guy gets the girl, or the bad guy gets eviscerated by his nemesis's nephew (note to self: don't kill Bruce Lee's uncle).

If one is paid to watch movies, it is very important to keep a perspective on your audience. Thus, after one sees the 50th high speed car chase, or woman falling down while the zombie is chasing her, it becomes boring. Such reviewers want to see scenes that are new, fresh, and have some resonance. But your average movie goer has nowhere near this amount of experience watching movies and so might appreciate these scenes, because it is not a cliche to them. This 'problem is not just in movies. Those who have never heard classical music find Eric Carmen's hits "All By Myself" and "Never Gonna Fall in Love Again" beautiful melodies, which they are, whereas the music expert might dismiss these as stolen riffs from Sergei Rachmaninoff. There is an inevitable difference of opinion between an expert of any kind, and popular expositions in his field, because experts dominate reviews, whereas dilettantes dominate the audience.

I find Nassim Taleb's observations on statistics and models banal (see here), his hope for the potential for Knightian uncertainty or fractals naive. All models are wrong, some are useful. Fractals and knightian uncertainty are not wrong, but in part because of this (they can't be wrong), they are pretty useless. I have not met any full time risk managers, those actually making day to day risk management decisions, generating reports for senior management, who like the nihilistic focus on improbable events, who agree that Value-at-Risk should be abolished. Instead, the promoters of this extreme nihilism are lots of intellectuals and intellectual wanna-bes who understand risk management, the profession, from 10,000 feet up. I can see how, from the outside, his observations may appear a fresh, interesting view of finance, pregnant with implications for making improvements. Yet, criticisms of models for making 'wrong' assumptions is quite different than proposing a model with better assumptions.

I don't begrudge the popular people in my field who I think are very misguided. They are usually inspiring people to look further, always a good thing. Most aren't wrong, like Taleb (he suggests the most highly uncertain assets have the best returns--I argue that it's exactly the opposite), but rather merely boring. Suze Orman says sensible things, they just aren't very interesting to a professional.

I don't want to be like those movie reviewers saying that some movie stinks because it uses cliched imagery that most people find appealing. Not that I feel obligated to like what I perceive as tripe, but that I should appreciate the fact that others like it, because it's all new to them. Nothing wrong with that.

GM shorts pay 50% Annual Rate

Say you short General Motors (GM). You are selling it. You get the price in dollars in exchange for the stock you sold, currently about $4.00. Until you buy it back you get interest on that money, usually, Libor - 50 bps or something, currently about zero. But, GM is 'hard to borrow', meaning, everyone wants to short it. The current 'rebate' (argot for the interest on short sale proceeds) is negative 50% annualized! This is a stock worth $2.5B, that trades about $100MM worth a day. That means you don't earn money on your proceeds, you pay. The stock would have to fall 50% over the next year for you to break even if you shorted it.

Of course it's more complicated than that, but let me give a simple example of the opportunity. GM currently trades for $4.00. The June 2009 $4 strike put trades around $2.30, and the $4 strike call at $0.80. You can put on a June forward position in GM via options, by buying a call option, and selling the put.

Looking at Put-Call parity, we can generate the following implication. A synthetic forward position can be created by buying the call and selling the put:

Call-Put=PV(Forward-Strike)

As interest rates are near zero:

Call-Put=Forward - Strike
$0.80-$2.30=Forward - $4
Forward=$2.50

QED

Now, if you are a long term investor, why pay $4.00 for the current GM, when you can by the June forward for $2.50? If GM goes up to $5 in two years, one makes 100%, the other, 25%. The dominance of the forward doesn't get much more obvious than this.

Anyone long GM who is not capturing the huge negative rebate is leaving a lot of money on the table. They must be dancing over in Staten Island, as stock loan desks are living large because I imagine many if not most GM stockholders are not capturing this. If you like GM, buy a forward via options. If you dislike GM, know that a 50% decline is baked into the current stock price via the un-labeled stock rebate.

Economists are Modelers

I'm reading a lot of criticism of economists by the usual suspects and it reminds me of when people criticize politicians for 'arrogance' and 'not listening to the people'. Now, we tell children that politicians are 'leaders' who 'implement the will of the people', when in reality they are naive dupes who genuinely believe what the masses believe or cynical hypocrites who are willing to make any sacrifice of conviction and self-respect in order to hold their jobs. So, the criticism works, but only for someone who believes the kiddie version of the job description. Similarly, some people think economists are those who understand the economy, who study the economy, and indeed, many are. But for the best, the most prominent, this is their avocation.

Fundamentally, economists don't know much more than your average undergraduate economics major about economics or the market. Prominent economic theorists are 'modelers', they make little models, akin to Bohr's atom or Newton's inverse square law, that are meant to explain and predict (of course not nearly as successfully), using mathematics. Economists are perhaps better understood as 'those who model economic phenomena', as opposed to 'those who understand economic phenomena'.

Famous economists like Bob Lucas, Joe Stiglitz, or Greg Mankiw, got famous for creating models useful for teaching economics to grad students, and publishing by other economists. The model that made them famous, by the time they are famous, is usually forgotten. For example, Lucas' seminal model was a model that explains why unanticipated inflation causes business cycles. In the 1970's when he wrote it it seemed apt as inflation uncertainty and recessions were prominent, but it doesn't really work empirically, and it is mainly discussed now because it is a darn neat model, with an intuitive little functional form derived from intuitive--if implausible--assumptions: you push up this parameter (assumption), you get this nice implication. Mankiw's model tried to show how 'menu costs', the costs of changing pricing (eg, signage, menus), led to large business cycles. Again, plausible at first, now, not. Great economists are given a pass if their models fail empirically, because they are primarily judged as modelers, not describers of reality. A neat model has its own virtue.

One could go on and on. An economics or financial theorist, if prominent, is not really someone who really understands the economy, but rather, someone who takes some current stylized facts and creates a model that seems capable of explaining these facts. By the time they get tenure or their Nobel prize, everyone understands either the model merely begs the question (eg, what causes productivity growth in Solow's model? What causes increasing returns to scale in Krugman's model?), or it is empirically useless (input-output models, dynamic programming). The pedagogical value of a model can not be underestimated, because for a professor, if you can use a model to generate a lot of g-loaded logic puzzles that appear relevant to economics, it is surely much better than being forced to read a bunch of essays on how and why tax cuts work. Good models have unambiguous correct answers that are easy to grade and work through; real life doesn't.

Economists aren't wrong, they are idiot savants, and there's nothing wrong with that. It's depressing at one level, but we have enough people trying to explain and predict the big picture, taking into account the political-historical-sociocultural-global warming context. That is, the world is a vast, interconnected place with lots of important things going on, and reality has to take this into account. People who try to capture this big picture are called 'journalists', and while there are many good ones, this field does not seem to be advancing, any more than one could say legal theorists are using more discriminating logic than 100 years ago. So economists are not very successful, but neither are the alternative approaches.

Academics place an inordinately high premium on novelty and elegance, which often makes it irrelevant, as there is little correlation between originality and the usefulness of an idea. That they fail in describing reality, is about as shocking as discovering a Chicago politician was engaging in quid pro quos.

Rubin's Defense Suggests He was Overpaid

Bob Rubin appears to be a very thoughtful, reasonable guy. As a board member at Citi, I'm sure he's one of the better ones. But his defense of his role in this crisis seems to be that issues such as leverage, and investing billions subprime debt, was a detail outside the scope of his management:

"The board can't run the risk book of a company," he said. "The board as a whole is not going to have a granular knowledge" of operations.

Was investing in subprime in the bailiwick of Rubin, who was deferred to on these issues by the even less technical other board members?

I would say definitely. It appears that Citi, like the other investment banks, bought more and more residential mortgage backed CDOs during the housing bubble, about $54B worth of subprime-related securities on their balance sheet in September 2007, which is especially risky considering their core business has about $300B in residential loans.

Now, a $54B decision to purchase these securities is a conscious choice outside of a core business of the bank, which involves lending to home buyers via its branches. If this was outside of Rubin's scope, why did he pocket $115MM since 1999 from Citi, excluding stock options? Why does one have to pay such vast sums to figureheads who by their own admission don't affect the company's balance sheet? Can I apply for such a job? I'll promise to be supportive, yet look pensive, during board meetings, and I will follow the 10/20/30 rule in my PowerPoint presentations (10 slides, 20 minutes, 30 point font). Most importantly, you need only pay me less than half, $50MM, for for all my non-effectual services.

More realistically, I suppose management figured his value opening doors and influencing regulation was worth it.

Austrian Business Cycle Theory

When I was in charge of capital allocations at KeyCorp, I spoke with many of the business line managers, and was impressed by the fact that all of them had rather sterling track records, especially in the last recession. But I later figured this was all survivorship bias: the losers in the last recession lost their jobs. Thus, each thought they had some special alpha, special asset class, impervious to the mistakes of those who caused the big losses in the past. For a 45 year old who has never really screwed up it's hard not to think this is the case, as opposed to merely the blind selection process of capitalism. This error is the fundamental genesis of business cycles, in my opinion.

In grad school, while learning macro, I would spend nights reading Austrian Business cycle theory, including von Mises's Human Action (900+ pages!), and lots from Hayek (see picture, I don't think they are related but she's a lot prettier). I was intrigued by the idea that business cycles were caused by a misallocation of resources, as opposed to merely 'too much' investment. That is, say you have 10% of the country's resources in internet development, but discover the demand only wants 5%. All is fine as long as you don't care about profits, look at sales/price ratios, but then eventually people get tired of not making money, someone says 'the emperor has no clothes! There will never be profits', and everyone stops investing in these areas. The transition from the old to new regime is only possible via firm failures and involuntary unemployment, because people don't switch to new jobs until their old ones are gone, forcibly.

My only beef with the Austrians is that they emphasized the genesis of this missallocation via money creation, especially the fiat money creation of central banks and how this causes the interest rate to be 'too low', causing overinvestment in capital. This again gets into a straight aggregate overinvestment story, and that isn't very empirically robust. I think to the extent there is overinvestment, it isn't total investment nearly as much as in the wrong sectors. Today, that sector is housing, and finance. The key is finding some metrics one can apply to these subcategories to see that it is overinvested, and if there is some consistent tipping point in such a metric. The problem I see is that for commercial real estate in 1990, or residential real estate in 2008, there were real profits and cash flow immediately prior, based on people buying assets that were overvalued. In contrast, in the tech bubble, there were no profits immediately prior to the correction. So cash-flow in the sector would not work. You could say, use cashflow plus some metric of collateral overvaluation, but it is not obvious to construct a model of this, as even Shiller's 2006 revision of Irrational Exuberance had a rather wishy-washy forecast of housing prices (could go up, could go down) even though in hindsight it appears we were at the peak of an unsustainable housing bubble. I'm sure commercial real estate had a similar issue in 1990.

But, I think that idea, of a missallocation, is still the best explanation of recessions, and thus suggest a laissez-faire approach because until these guys lose their jobs, and firms fail, you won't get the appropriate (dare I say optimal) reallocation of resources. Looking at the current housing bubble, and all the strange incentives and errors by investors, legislators, regulators, etc., the missallocation's genesis is not unicausal, but one key is that it generally is in an industry that did well in the prior recession. Thus, just as commercial real estate CDO's had very low relative loss rates relative to other CDO's subsequent to 1990, I suspect that buying residential real estate CDO's now is probably one of the better investments around if you are in that space. Beware of the outperformers, as failure is endogenous to any business plan because success breeds overconfidence via the overattribution of their success to alpha versus random luck, though as always luck, skill, and effort are relevant.

New Metaphor from Tough Minnesotans

My kids are tough. Outside play is canceled at school only when the temperature is below zero (about -18C), and they don't whine about the weather nearly as much as I do. So I was reading about this woman in Duluth (western tip of Lake Superior), who fell in her yard and couldn't get up. She was found 4 hours later, with no heartbeat and a 70 degree (21 C) body temp. When she arrived at the emergency room, the doctor on call applied this, heretofore unknown northern aphorism:

But there's a saying in the emergency room, he said: "You're not dead until you're warm and dead."

There's some logic there, after all, many frogs simply freeze every winter, and thaw out in spring, avoiding the whole hibernation thing. So, after raising her temperature, they started her heart, and off she went to see her grandkids. "I'm a good old Norwegian" she noted.

I never thought about it like that, but there's something profound there. Maybe, instead of the cliche, 'he's down, but not out', one could say 'he's dead, but still cold', implying the same thing, but in a fresher way.

Too Many Experts

In theory, diversity is about accepting people different than you; in practice diversity means those who ignore diversity have more moral clout. Thus, my kid's schools do not have little birthday celebrations (eg, cupcakes) anymore because the new Somalis don't celebrate birthdays, and we wouldn't want to implicitly single them by having birthdays as was done for years. No one can mention this sucks in public, however, without being called in intolerant bigot, and as we all know, diversity is The Most Important Thing public schools teach. Or a bunch of Hasidim move to a small town in Iowa to run a kosher meat packing plant (and hire illegal immigrants at $5/hour), avoiding the locals in their social activities and in schools, referring to them as shiksas and goyim, and the locals, not the new asocial group, needed to learn to 'understand and respect each other's differences'. An institution that employs a bunch of autistic types is 'diverse', even though no individual who works there is accepting of diversity except management. Thus, diversity is about acceptance when you are passive or 'leading', but for those who are not considerate about existing mores or who are doing, it's a pretext for being insular.

Such are the paradoxes of modern life, the kind of thing that makes life difficult for machines trying to pass a Turing test, such as the fact that being 'hot', 'cool', or 'warm' are all compliments. Similarly, experts are supposed to tell one what to do, but in practice they merely help rationalize whatever one wants to do. Expert opinion usually spans the space of conceivable opinion. To wit, the WSJ has an article on the current economic mess, and interviewed several well-known economists. Here's their advice:

Barry Eichengreen: $300MM for banks, $800 fiscal stimulus.
Ken Rogoff: more inflation
Robert Hall: sales-tax holiday paid by the Federal government
Robert Shiller: subsidize financial advice (here here!)
Alan Blinder: Infrastructure spending stimulus
Anil Kashyap: shut down ‘bad’ banks
Jeremy Stein: audit banks
Adam Posen: shrink the banking sector
Douglas Diamond: convert bank long-term debt issued after the TARP to equity, make it easier to wipe out equity shareholders
Markus Brunnermeier: put in a new regulator framework for banks

So, give money to the banks, shrink them, extinguish debt or equity in banks, regulate them or audit them--perhaps all of the above! Also, give out tax rebates and spend more. In other words, whatever the Federal government can do, it should do, say the experts

The point is that expert opinion does not focus, but from a meta perspective, merely rationalizes. Thus, it means almost the opposite of what a single expert does. The paradox is like the way diversity, in practice, is license to insularity. A thing in practice is the opposite of what it is in theory.

Risk and Return Confabulations

Jonathan's Haidt's book, The Happiness Hypothesis, spends a lot of time on the idea that the conscious mind is like the rider on an elephant, and while he moves the elephant somewhat, the elephant has a will of its own that is more powerful. A solution to this problem for the elephant rider, is that when the elephant goes somewhere you don't want to go, you just convince yourself you wanted to go there all along. This is called confabulating a rational.

I note this because I read an excellent confabulation from the recent AFA meetings in San Fran, Uncertainty about Average Profitability and Diversification Discount (by Hund, Monk and Tice). Remember that risk generates a return premium: higher risk generates higher return. Of course, risk must be specified correctly, but whatever it is, it generates high returns. So, how to explain the fact that diversified firms, those with higher profitability, lower volatility of profitability, and lower idiosyncratic return volatility, have higher-than-average returns? How is this consistent with risk and return theory?

Well, I think their answer is as follows: diversified firms have a lot of incentive (aka agency) problems. There is a lot of cross subsidization, lots of allocation of common costs, lots of finger pointing. Thus, the return premium is from when these firms basically get taken over, and become focused again. Then they don't cross subsidize value-destroying projects.

They contrast this with the model of Pastor and Veronesi, which is an even sillier model. These guys assert that firms grow geometrically, and so given the logic of pure mathematics (E[firm value]=exp((mu+s^2/2-r)*t)), the more expected volatility, the greater the expected value, the higher the price, and lower return.

Now, these models are only tenable because they were presented with a straight face using the presentation protocols of the field. They suggest a massive amount of market inefficiency, but by noting this is 'rational learning' hope nobody notices that people are not anticipating what they are going to learn. At least behavioralists like Lakonishok and Thaler say 'people overextrapolate'; here, they are trying to sell an irrationality story in a convoluted way while maintaining the veneer of rationality.

Risk used to be standard deviation. Then Beta. Then APT factors. Then Stochastic Discount Factors. Now risk is just out of the picture, and we have people learning about the future stumbling in the dark--but you don't want to upset the financial theorist's applecart too much, so it is implicitly assured that risk models still work, of course. The spooky SDF will be revealed when the messiah arrives, I guess (of course, I think risk-return theory is wrong--there is no return for risk in general, however defined).

Taking Things for Granted

Many think we should cultivate the habit of thinking of what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them.

~Alfred North Whitehead

I think 2008's problem was mainly because after the rating agencies were exposed as making an error on their AAA and AA ratings, all investors viewed such securities skeptically. What was previously an asset class that did not require much thought, now need re-underwriting: evaluating the credit from the bottom up. This is very difficult, invariably there are many assumptions (especially for derivatives), and you find very quickly that there are lots of unknowns that are potentially dangerous. Usually, these assumptions are benign, but as the mortgage crisis proved, you can't rest on 'usually'.

Looking at the AAA and AA ratings, which had had annual default rates of 0.01% and 0.03%, it is a wonder this did not happen earlier. With such low default rates, inevitably, mimics would exploit this because those buying such securities are not doing their own due diligence. You just have to find the right buzz words, and as Franklin Raines noted in his testimony on Capital Hill, "These assets are so riskless, that their capital should be under two percent". Anything backed by mortgages had such low historic loss rates, that it seemed silly to worry about things like income verification or a down payment. With hindsight, this was a huge error, but an error made by prominent academics, regulators, investment bankers, legislators, and investors. Once someone figured out how to game this assumption it was doomed, but that did not happen right away.

As Whitehead notes we make advances by putting complex tasks into processes that are automated, or applying generalizations so that we do not need to know particulars. When we have to stop and think about everything, our productivity shrinks drastically. It's a good thing for investors, especially large investors, to re-underwrite anything they have a large stake it. Unfortunately, changing regimes involves a lot of tumult, which is what constipated the savings-investment nexus.

Bernie Madoff's scam will also leave a big mark. Previously, a hedge fund could get away with merely showing returns, and be vague about how they were making money. Now, they need not only that, but a story. Where is the alpha coming from? Anyone doing due diligence needs to do the simple things, like seeing if a 'conversion strike strategy' is remotely plausible in generating promised returns. I think this will greatly slow the rebound in hedge funds, because some hedge funds think that when things recover, money will again flow into hedge funds, but the game has changed. A hedge fund now needs to articulate a story that is both plausible, yet does not reveal too much, because you don't want to tell people exactly what you are doing. I suspect many more systematic funds will have real problems here, pounding the table that their firm head is 'well-known' and trusted, and in combination with returns, implies investors do not 'need to know' details about the alpha generating process. As an investor, given Madoff, such trust would be foolish.