Default Rates Lower than Expected

At the beginning of this year Moody's was taking a lot of heat for missing many financial company blow-ups, as well as the whole Mortgage-backed securities area where the grade AAA was clearly misapplied. So they forecast a scenario where speculative grade (BB and B) bond defaults to be higher than any time in history, including the Great Depression! Clearly, they would not be 'too optimistic' twice in a row. 7 months in to this year, default are high, but around where they were in the 1990 and 2001 recessions, not near the 15% default rate anticipated. Default rates (annualized) were at around 10.7% in July, vs. 14.9% expected.



This is why the speculative grade market has rebounded so smartly this year. After a horrendous 2008, 2009 has been a strong year in spite of climbing default because prices anticipated the Moody's doomsday scenario. Total return to the High Yield Index (Merrill's Master II) is 40.0% through 8/28, well above last year's -26% debacle. Spreads between Treasuries and B rated bonds averaged an astronomical 13.1% at the beginning of this year, implying the market anticipated a doomsday scenario much worse than Moody's forecast at that time, or the Great Depression.

It seems likely tat the risk premium actually manifested itself, too. That would be strange because usually there is no risk premium in High Yield bonds, as for many years the spread is about the same as the expected amortized loss rate, about 300 basis points. The High Yield index has done about as well as the Investment grade index since 1987, with significantly higher covariance with the business cycle, volatility, etc.

Spreads are currently about 5.8% for B rated bonds, which is well above historical norms, but way down from earlier this year. The worst-case scenario was baked in in January, default rates have not been as bad as they were expected, and things are now getting back to 'normal' stressed times.

Great Post on our Servant Overlords

I often hear the argument that people like Edward Kennedy (who died Wednesday, brother of John F Kennedy), born to wealth and privilege, are to be praised for working for the poor, becoming 'public servants' (see Blogging Heads below). My ideal servant would not spend all his time trying to boss me around, statistically speaking.

Don Boudreaux over at Cafe Hayek nails it:

While Kennedy didn’t choose a life of ease, he did something much worse: he chose a life of power. That choice satisfied an appetite that is far grosser, baser, and more anti-social than are any of the more private appetites that many rich people often choose to satisfy.

A true altruist gives his money or time to others, via friendship or charity. They don't write laws that force me to serve their ends.

Goldman Quant Case Continues

The Goldman quant case that brought High Frequency Trading into the blogosphere keeps getting interesting. The ex-Goldman quant sure sounds guilty. Why hire a programmer who came to Goldman without financial experience, and worked there only a couple years, for $1.1MM? Whence did he get this alpha? He had several megabytes of code relating to a trading program explicitly referenced in his confidentiality agreement, and was going to implement a high frequency trading algorithm.

I did realize that Citadel used the Goldman criminal case as an opportunity to enforce a litigation noncompete on the firm the ex-Goldman worker was planning on working for, filing a motion days after the initial Goldman arrest, probably based in part on information revealed in that case.

But what I found most interesting is that the phrases used in the complaintseem cut and pasted from my 18 month Kafkaesque nightmare.

From the NYT Aug 23 story on the Goldman case:

As part of the suit, Citadel detailed the extraordinary steps it takes to protect its software.

From my ex-employer's argument for a temporary restraining order:

Telluride...uses multiple layers of security

From the Citadel case:

While Teza is not yet conducting any trading, Citadel claimed the former employees had violated a noncompete agreement with Citadel and might even be trying to steal Citadel’s code, causing “irreparable harm.”

From my ex-employer's Temporary Restraining Order brief against me:

Telluride will suffer irreparable harm unless the Court enjoins Falkenstein from disclosing and using the confidential and trade secret information that Telluride entrustsed to Falkenstein...

From the Goldman case:

the proprietary code lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year.

From my Dec 07 hearing:

The Court: How much is at stake in this litigation, in terms of assessing the potential cost?

Telluride Lawyer: Unknown at this point. It could be tremendous. As you know, hedge funds deal in multimillions, hundreds of millions of dollars

Legal briefs are stored in hard-to-access form that makes searching by case, let alone key words, extremely difficult. Thus it is not obvious how repetitive their arguments are, except when you actually read them. A good argument one year by the other side, often makes it into your side the next year if you are on a different case, because in law it's all about whatever works (aka 'justice'). Thus, a lawyer can cut and paste arguments from other cases, and his clients don't know he's getting paid $500/hour to have his secretary retype a similar case and then do a 'replace' on the party's names. 'Irreparable harm'. 'Millions of dollars'. 'Extraordinary steps to secure trade secrets'. Judges must feel like they are stuck in Groundhog Day, seeing the same cases, only with different people.

If you worked for a large firm and you have any files on any computer in your possession that has files, even deleted files, on your hard drive, it could cause irreparable harm.

How much money, exactly? Well, financial firms generally have millions of dollars in assets, transactions, or both, so you can say millions.

And the precautions taken prove that the allegation is precisely the kind of thing the company, and our system of laws, is concerned about.

As the intellectual property in question is undefined at this stage of litigation, the accuser has broad rights for a fishing expedition that could take years, because very few states require a complaint define such property at the outset. It could be anything. The firm could be trading based on the Bible Code, and so merely having the number "27182" in a txt file from your employment could, and I stress could, relate to the Equidistant Letter Sequence number one must move forward from in Genesis to predict future events. That's for experts and juries to decide, not judges at the initiation of litigation. In the meantime, the defendant is unhirable, because he cannot prove he is not using the strategy in dispute, which is undefined. It is costly for both parties, but that's the point of litigation in many cases. Cases rarely go to trial because it can take years, and expenses balloon along the way, making the endgame (ladies and gentlemen of the jury) almost irrelevant.

The nasty thing about intellectual property cases is that one can use it to start discovery on a broad scope of information, and then generate a post hoc definition of what is covered. The key is that overbreadth in technical matters is not obvious. For example, one can say, "he took the secret of mean-variance optimization", and by the time the court figures out such a claim is absurdly overbroad, a more tenable claim can be made, such as 'a specific application of mean-variance opitimization that will be defined after discovery'. To the defendant, both claims place all his activities as potentially poisoned, so the effect on the defendant's ability to work is unabated. But to the court, the latter works as long as he has some deleted files on his home computer related to his work, and 'related' can be rather boring stuff that the court does not recognize as well-known, such as a spreadsheet with S&P returns and Excel formulae.

The key is that for anyone who does not throw away all their old computers and meticulously make sure all his files are unrelated to his old employer, judges can not tell if it's The DaVinci Code or a boring statistical evaluation of public data. Claims are allowed to change or replaced entirely so the accuser is not stuck with original, deficient claims that might surely stop the process.

Basically, the law allows companies broad leeway to inflict a lot of damage via intellectual property litigation. But why would firms do this if they don't have a real concern? Signaling (eg, precedent setting) is a rational reason, paranoia an irrational one. They then take the case out of a cost-benefit calculus to the one being accused, making them a means to an end unrelated to anything they have done or could do; you can't simply appeal to their 'self-interest' because sometimes that primarily involves crushing you like a bug. If this happens to you and you are innocent you're pretty much screwed, so the best defense is to check out the legal history of who you might work for, read briefs, and look for a pattern.

Hanson on Creativity

Robin Hanson wrote an excellent article on creativity for Forbes back in 2006, in response to Richard Florida's best-selling The Rise of the Creative Class. The book argues for a diversitopia, where "Diverse, inclusive communities that welcome unconventional people-gays, immigrants, artists, and free-thinking 'bohemians'-are ideal for nurturing the creativity and innovation that characterize the knowledge economy". Did he mention gays? It seems that "Gays predict not only the concentration of high-tech industry, but also its growth" Fabulous!

His advice is exactly what bureaucratic wonks like to hear, things like "The quality and range of schools is certainly critical for parents of school-age children." Amen. Basically, he argues we should create neighborhoods of loft apartments, good schools (how?), and a tolerance for diversity—catnip for bohemians—and growth will occur. It plays to the naive view of artsy creativity that sells itself. No wonder he reportedly gets $35k per lecture.

Robin throws some well-needed cold water on this line of thinking:

To succeed in academia, my graduate students and I had to learn to be less creative than we were initially inclined to be. Critics complain that schools squelch creativity, but most people are inclined to be more creative on the job than would be truly productive. So schooling is mostly about selecting the smarter and more diligent, and learning to show up day after day to somewhat boring jobs with ambiguous instructions.
...
What society needs is not more creativity or suggestions for change but better ways to encourage people to focus on important issues, identify the most promising ideas, and tell the right people about them. But our deification of creativity gets in the way.
...
In truth, we don't need more suggestion boxes or more street mimes to fill people with a spirit of creativity. We instead need to better manage the flood of ideas we already have and to reward managers for actually executing them.

But, what can a public sector middle manager do with that? Ignore.

Madoff Losing Status

As the New York Times only prints news fit to print, I feel obligated to keep inquiring financial minds informed on all dimensions of the financial crisis.

It's been documented that subordinates laugh more at their bosses jokes than vice versa. Such is the nature of interaction in a hierarchical society with a strong pretense for egalitarianism. Rich people have more friends, bigger birthday parties, etc. But once you lose everything, you suddenly aren't as funny, as friendworthy, as desirable.

Bernie Madoff's ex-mistress, clearly not above seeking financial gains where others don't, wrote a quickie book Madoff's Other Secret, in which she informs us about Bernie's various inadequacies, including one I never really thought about (from Bloomberg):

Bernie had a very small penis. Not only was it on the short side, it was small in circumference. That he was now pointing it out to me was telling. It clearly caused him great angst. I wanted to be careful how I responded. Men and their penises have a strange and unique relationship...[However] I liked this man and didn’t want to emasculate him. His tiny penis hadn’t prevented me from climaxing...On the bright side, oral sex would be a breeze.

In his position this isn't very damaging to his status. I can't think it helps her socially, but I imagine without that passage, there would absolutely nothing noteworthy in there.

Gorton Expands His Haircut Run Theory

Gary Gorton wrote an interesting piece (Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007) documenting that haircuts on a variety of Repo collateral went up severely in the financial crisis, and may be the essence of how this crisis accelerated. He has two papers that expand this idea, and the data underlying it. I think he makes an excellent point, and like how he clarifies his position, even at the risk of repeating himself.

In Securitized Banking and the Run on Repo, Gorton and colleague Andrew Metrick (great economist name) go over the basic idea of how repo haircuts relate to a bank run. He notes the crisis starts in July 2007, just when several AAA ABX-HE (subprime housing) tranches started trading below par.

At that point people realized these assets were not merely a normal bump in default rates, because anytime a large AAA CDO trades below par, you basically have a catastrophe alert. Given that even today commenters do not agree on what was wrong, the failure of informationally insensitive assets caused every informationally insensitive asset to trade as if a junk bond. That is, the problem could have been merely poor underwriting, but it could have been due to something else: Fed policy (Taylor), excessive confidence in models (Taleb), CDO assumptions (Felix Salmon), everything (Roubini), hubris (Tett), h government (Woods), and bubbles (Shiller).

Now, these explanation affect much more than subprime housing, and given the prominence of these hypotheses they are concerns reflected in the general investing public. I sense that many investors changed from taking any AAA rated securities as a given, to going over all the things that could go wrong, which using the minimax principle generates really low prices.

So, with the AAA for subprime went bad, all AAA ABS was suspect, haircuts rose, and through the mechanism described by Gorton, a reduction in the monetary base similar to if customers withdrew deposits. A modern bank run via repo haircuts rising.

If the idea of repo haircuts is not clear to you, no worries. Gorton and Metrick have a short paper, Haircuts, explaining that for all you haircut noobs.

Is Marketing Expense Wasteful?

In the health care debate, many have noted the high level of administration expense, as there's the idea that without marketing expense, public healthcare will be cheaper.

Marketing has always seemed wasteful to those who are optimistic about government solutions, and indeed a big theme of John Kenneth Galbraith's oeuvre was that businesses waste money advertising. It seem that many think advertizements merely reallocate our expenditures in a zero-sum game of moving from Coke to Pepsi, Bud to Coors, without any real effects.

In 1972 Lee Benham presented what I think is one of the greatest empirical economic articles of all time (The Effect of Advertising on the Price of Eyeglasses). Optometrists give eye exams, and provide prescription glasses. Some states regulated optometry such that they could not advertise, others did not. The result? Those states with advertising had lower prices. This table basically says it all.



It seems that without advertising, firms don't compete as much, leading to higher prices.

Giving Money to Poor People

In theory, the $175MM given to New Yorkers ($200 per child) will alleviate malnutrition, perhaps pay for shoes, school supplies, a crock pot. In practice, videogames:

Wegmans and Tops report that ATMs in their stores ran out of cash on Tuesday, the day the money was deposited to food stamp accounts. The county reports that employees at the Wal-Mart store on Hudson Avenue called the Department of Human Services to say they thought welfare fraud was going on because there was a run on high-end electronics.

Regulation: Redistribution or Efficiency?

Simon Johnson argues that the Fed is inept at protecting the consumer, and the new Consumer Financial Protection Agency is better suited. He articulates a Bank v. Consumer battle reminiscent of a certainly Hegelian dialectician (profits means less for the consumer). The CFPA is the proposed agency headed by Elizabeth Warren, who reminds me what it means to be overducated. Anyway, this new agency has as one of its goals to 'promote access to credit in line with community investment objectives.' As this puts this under the Treasury, as opposed to the Fed, it will be more compliant with political preferences, which is good if you think democracy is the essense of good government.

I think this will make it a pandering system that redistributes wealth via the pretext of fairness, creating barriers of entry to various business lines that end up subsidizing business practices that payoff various special interests. That is, regulatory capture works by making the redistribution conspicuous and welcomed by industry, who accept this for being able to keep outcompetitors via 'suitability' requirements such as whether agents are sufficiently licensed, or firms have sufficient oversight to provide check cashing services.

In a democracy there is a strong desire for redistribution. This comes merely from the masses voting to take money from the rich, who are relatively few, and appropriating this to the more numerous masses (who wouldn't vote for Bill Gates giving them each a $100 check? He could afford it, and still be a billionaire!). One can argue that inegalitarian distributions are bad for several reasons: because inequality causes civil unrest; it causes a glut of savings; the market is crooked anyway, or a Rawlsian argument that market value is the result of arbitrary power and preferences that have nothing to do with one's 'true worth'. I think it's more honest to say people are envious, and as inequality generates a pyramid with a relative few at the top, this is not resilient to coalitions of those more numerous on the bottom. Pathetic, but such is the crooked timber of humanity.

Thus regulators invariably seek two goals that are often at direct opposition. The desire to increase efficiency via ensuring people follow the rules (basically, adding criminal punishment to that of the market for lying, cheating and stealing). Then there is the desire to reduce poverty, or equalize outcomes between various ethnic and racial groups.

Interestingly, economists have long noted that redistribution is best done in simple lump-sum payments. Say you want Hmong to do 'better'. Well, instead of having vague guidelines larded in various activities (education, police force hiring, mortgage lending), it is better to given every Hmong a check for $X each year, and let the market deal with education, police force hiring, and mortgage lending. It creates less deadweight loss via all those subtle, tendentious biases.

Grutter v. Bollinger case found it illegal to give blacks extra points in their standardized scores for law school, but did allow schools to apply affirmative action via less obvious measures. Michael Kinsley noted that this simply makes preferential treatment less efficient and less honest:

The court actually seems to be in denial on this point. Although it forbids explicit racial quotas or mathematical formulas to achieve racial balance, it is happy enough to measure the success of its preferred fuzzier approaches in statistical terms. If a selection system is going to be judged by its success in approximating the results of a mathematical formula, how is it any different from using that formula explicitly? ... And if [discrimination] can be measured and judged using statistics, why is it wrong to achieve the statistical goal through statistical means?

That's a deadweight loss argument, that disingenuous redistribution is worse than explicit redistribution.

The problem is that laying bare the redistribution by race violates title 7 of the Civil Rights Act, and seems unfair to many, mainly to those at the lower tail of the presumed hegemonic group.

In the recent New England firefighters case, Supreme Court justice Antonin Scalia noted that eventually the congress needs to address the patent inconsistency within Title VII of the 1964 Civil Rights Act, which prohibits discrimination by covered employers on the basis of race, color, religion, sex or national origin. In Griggs v. Duke Power (1973) the Court found that under Title VII, if employment tests disparately impact ethnic minority groups, businesses must demonstrate that such tests are "reasonably related" to the job for which the test is required. This latter point is very difficult to prove in practice, which is why federal civil service exams got rid of standardized tests in 1981. So Title 7 contains a requirement that firms do not discriminate ex ante or ex post, in treatment or in effect. Notes Scalia:

the Court will have to confront the question: Whether, or to what extent, are the disparate-impact provisions of Title VII of the Civil Rights Act of 1964 consistent with the Constitution’s guarantee of equal protection?

You can't have equal treatment and equal outcomes, because lending inherently involves discriminating based on ability and willingness to pay, which is not distributed according to our preferences as to how the world should be. Finance is highly regulated, and many regulations are targeted towards treating people 'fairly', which mainly means redistributing outcomes towards politically powerful but economically marginal groups. As many advocates target 'the poor' directly, this leads to really bizarre stances, such as HUD advocating reworking a 125% Loan-to-Value mortgage while the OCC monitors leverage ratios of small business loans; simultaneously telling banks to increase their capital and also to loan more, etc. You can't advocate banks serve poor groups as well as the rich without messing up everything. It's like trying to fatten up the slower fish at the bottom of the tank—the big fast guys are going to burst before these poor souls get fatter.

I doubt this inconsistency will be resolved any time soon, but it's the congenital clusterpuck of financial regulation. In a democracy, policy makers exhibit the precise amount of hypocrisy demanded of them—no one campaigns with equal emphasis on increasing (or decreasing) spending & taxes. This comes at a cost, and listening to all these great new initiatives to help poor people via preventing foreclosures, or not raising their interest rates, creates a myriad of responses that in the end just make the system less efficient, which means it has less wealth. In an economy with mass immigration from the third-world, means less income for the unskilled.

At least these problems are made in good-faith.

Lesson of Wachovia

Wachovia was considered the gold standard of risk management for years. I remember in private discussions with regulators and consultants, one would always defer to the wisdom of Wachovia, because they were considered a 'best practices' bank in risk management.

But then Wachovia agreed to purchase Golden West Financial for $25.5 billion in 2006, before any mortgage problems had surfaced. That year Golden West Financial was named the "Most Admired Company" in the mortgage services business by Fortune magazine, and had over $125 billion in assets, compared to Wachovia's $540 billion. It is important to remember that in real time, companies that blow up are considered excellent before they cause real damage. If they weren't, they wouldn't cause any damage. Enron, Madoff, Countrywide--these were all considered excellent firms at their height, with only a handful of critics (certainly not the regulators).

Wachovia began to experience heavy losses in its Golden West portfolios over the next two years. In the second quarter of 2008, Wachovia reported a much larger than anticipated $8.9 billion loss. Wachovia's stock price plunged 27 percent during trading on September 26 2008 due to the seizure of Washington Mutual the previous night. On the same day, institutional depositors withdrew money from their accounts in order to drop their balances below the $100,000 insured by the FDIC—an event known in banking circles as a "silent run." On October 3, 2008 Wells Fargo announced it had agreed to acquire Wachovia for $15.1 billion in stock.

This is a reminder of how institutions can have really great 'risk management', but major corporate actions can make this all irrelevant. Similarly, companies with lousy 'risk management' can avoid catastrophes by avoiding these disasters. This makes it difficult to assess risk, because you have two, independent risks: the level of rigor and discipline in standard operations, and the chance they buy something really stupid. It highlights that mortgage CDO risk is really not 'more difficult' than most risks facing your average equity holder.

The Value of The Efficient Market Theory

I was an official economist for a while, back at KeyCorp, and would sometimes have to give little presentations on the standard macro variables. I remember once in early 1995 having a little 5 minute presentation to the board of a large hardware supply company (a small 'Home Depot' type chain). About 20 suits in a room, and they were all very interested in where interest rates were going. At that time, rates had rise a lot, the yield curve was steep, and they were very concerned. Now, given they had a lot of fixed rate long term debt, they could lose a lot of money if rates fell (rates fall, bond prices rise, and they were short bonds). If rates fell, their liabilities would go the other way. As rates were moving a lot, they were very concerned.

I told them in general, when the yield curve is really flat, rates tend to fall. They did, but that's not the point. Indeed, I should have told them I have no clue, but I knew they wanted a 'view', and I was trying to be helpful (we were a 'full service' bank). They debated back and forth for 20 minutes, and though I left, I had the sense they kept discussing it. I never found out what they actually did. The point is a large amount of management time was spent discussing something where they had no alpha, no comparative advantage, no value as management. They all assumed markets were 'wrong', so the question to them was clearly which way. If instead they thought bond prices incorporated all available information, they would have chosen a neutral position, say by having floating rate debt (it was feasible to swap into this).

A lot of resources are wasted by people who think it is imprudent to act as if markets are rational. They then basically take random gambles that on average lose money via fees paid on various transactions. Most importantly, they lose their focus on where they conceivably have alpha.

Reminder that 'Data Mining' is a Pejorative

Funny post about datamining by Jason Zwieg:

The stock market generates such vast quantities of information that, if you plow through enough of it for long enough, you can always find some relationship that appears to generate spectacular returns -- by coincidence alone. This sham is known as "data mining."

...

Mr. Leinweber got so frustrated by "irresponsible" data mining that he decided to satirize it. After casting about to find a statistic so absurd that no sensible person could possibly believe it could forecast U.S. stock prices, Mr. Leinweber settled on annual butter production in Bangladesh. Over an 13-year period, he found, this statistic "explained" 75% of the variation in the annual returns of the Standard & Poor's 500-stock index.

By tossing in U.S. cheese production and the total population of sheep in both Bangladesh and the U.S., Mr. Leinweber was able to "predict" past U.S. stock returns with 99% accuracy.

Blog Battle Recap

My blog war with Justin Fox over at CBS Money Watch ended today. I'm still alive and not in a prison camp, so I guess I won! Actually, like most debates, I'm sure we merely comforted those who agreed with us (has a debate ever changed anyone's mind?). Here's my Cliff's Notes version of the debate:

Post 1 (Fox) . Fox comes in with modest critique that no one really disagrees with:

Lulled into the belief that financial markets knew best, the reasoning goes, investors and regulators failed to do anything to rein in an out-of-control housing market bubble-and now we’re all still suffering from the consequences.
I wouldn’t go quite that far.

Post 2 (me). Well, that leaves a lot of room, including many reasonable and unreasonable inferences. I try to hit at his insinuation that the housing crisis was caused by the market

In light of this governmental housing exuberance, I doubt that a more powerful government would have mitigated the boom — rather, it would have made this crisis worse. Indeed, it was only the collapse of the subprime market at the beginning of 2007 as reflected by the ABX-HE subprime housing index that alerted people to the severity of this problem, and shut off financing by mid-2007, six months later. Market prices, not legislators, instigated the end of the insanity. How quickly are failed governmental initiatives usually stopped, once identified?

Post 3 (Fox). He argues that some regulations probably help.

There’s a lot of appeal to the argument that reducing leverage should be the main priority, because a financial system built on debt is inevitably more fragile than one that is not. There are also lots of ways to get around and game leverage restrictions, though. In any case, just saying that markets are better decision makers than governments and leaving it at that isn’t very helpful.

Post 4 (me). I argue we don't need regulation, and most regulation is about stiffling competition, not helping consumers.

In the bad old days prior to much financial regulation, or even a central bank, we had crises every twenty years: in 1819, 1838, 1857, 1873, 1893, and 1907. After a couple of years, though, things always got better...Much regulation is really about preventing competition, under the guise of protecting a consumer from some wily salesman, so it becomes a sanctuary for scalawags. Because of regulation, Wal-Mart can’t offer most simple banking services

Post 5 (Fox). Markets need a little help.

the Basel II capital standards are an unholy mix of (a) the conviction that financial regulation is needed and (b) the belief that said regulation should rely on market prices and on risk formulas devised by finance professors and their ilk... We will have financial regulations. So they ought to take explicitly into account the reality that financial markets tend to overshoot.

Post 6 (me). We have a lot of data. In practice, regulation makes things worse most of the time.

Consider the economy as an ecosystem growing in an equilibrium designed by no single agent. If you try to make it ‘better’, given the political realities of how rules and taxes are created, 99 percent of the time you create a counter effect that makes it worse, as a good idea is conflated with some targeted redistribution.

One point I didn't address was Fox's criticism of Basel II, which is quite interesting. He notes Basel is inconsistent, trying to be regulatory, and rely on market prices. But if you are trying to come up with capital adequacy, I don't see how you can do this without using all sorts of market data, because capital adequacy is a market issue. That is, regulators are concerned about market failure. Further, if you are estimating something like volatility, or value, and you ignore market prices, surely your estimates are arbitrary in a much less battle-tested way. In sum, if regulation is compromised to the extent it relies on market data, God help us all.

UFC 101 Awesome

I love Mixed Martial Arts. It takes skill from jiu-jitsu, wrestling, and boxing, a combination that makes the strategy space very large. But then the current best are truly awesome athletes that generate great shows. Saturday night's UFC 101 was up there.

At 155 pounds, BJ Penn dominated challenger Kenny Florian, and finally in the fourth round took him down. He then skillfully manuevered to Florian's back, setting up for a rear naked choke. Now, if a fighter gets a forearm under your chin from your back (he is hugging your body with his legs, facing your back), and locks this hand with his other arm, usually this ends the fight because you don't have the leverage to remove the choke, have nothing to strike, and simply must tap out or pass out. Florian is good at jiu-jitsu, so skillfully avoided the choke for a while. But then Penn started kicking him with his heel in Florian's gut, and when Florian finally reacted by naturally moving his hands to block these painful kicks, Penn slipped in the choke, and the fight was over in seconds. Beautiful.

In the other premier bout, Anderson Silva moved up to 205 from 185, and fought Forest Griffin. Silva was like a guy plugged into the Matrix, moving at three times the speed of Griffin. In one beautiful sequence of moves Silva first avoided a right then swerved to avoid a left, came over the left and floored Griffin with an overhand right. This was all done moving his upper body, like watching Sugar Ray Leonard in his prime. Finally, Griffin comes in with a lunging right, and Silva backs up. Griffin follows forward with a left, Silva leans back to avoid the punch, but throws a pinpoint right that lands right on the chin. Griffin goes down, fight over. What is so awesome is how punches from hands with light gloves, when it hits the jaw it turns the neck, and the body's reaction is to simply turn off, the knees buckle, and the person is unconscious for a second at least. He threw the punch moving backward, so it was not particularly hard, but it was so precise it was devastating. Rumor has it Griffin's jaw was dislocated.

All good fun.

Krugman Reviews Book He Didn't Read

I read the cover of Justin Fox's Myth of the Rational Market, and wrote a blog post defending the 'efficient markets hypothesis'. Justin Fox noted that I didn't read his book, because if I did he would have noted Fox's rather balanced treatment. True enough. So I read his book, and actually liked it a great deal. I debated Fox in a very collegial Blog War. He presents both sides in his book, and basically gives one a lot of color on the milieu and personalities involved in the debate. But basically, he says this guy (eg, Fama) thinks markets should be called efficient, and this other guy (eg, Dick Thaler) thinks markets should be called 'inefficient'. But Fox does not draw any such conclusion himself, or give one data to suggest one side is generally right. People disagree, pointing to various evidence as definitive, evidence the other side thinks is more anecdotal or irrelevant. Ships passing in the night, as in most big debates.

So it was fun, knowing so much about 'efficient markets', how extremely hard it is to generate alpha, and reading Fox's book carefully (I read it again for my blog war), to read Paul Krugman's review of Fox's book in the New York Times. In it, Krugman demonstrates he has strong opinions disproportionate to any evidence, and displays the measured analysis of an anonymous blog commenter.

In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process.

This is pure ad hominem, that EHM believers are simply believe in 'efficient markets' because they can brow-beat businesses into paying them a lot of money consulting. It is not an argument, and Krugman is no one to talk. He received $50k as a consultant for Enron before this fraudulent entity blew up, probably for classic perfunctory work that big name consultants do. I used to work at Moody's, and know he got paid a good chunk for a day's work, giving a cliche-ridden seminar on economics and meeting executives, around 2000. Who knows how many companies paid Krugman for such services. Why do you think so many make big bucks giving speeches to big companies? It's stupid, easy work, flattering powerful people in that disengenous way the muck-raking intellegentsia does. I'm not saying I wouldn't take $50k to tell Google how incredibly smart they all are (as evidenced by hiring me to tell them so). I'm just saying I wouldn't say the essense of those who disagree with me is they are craven, monied interests with ties to big business, as if that really sheds any light on anything but myself.

The quintessential collaboration between big money and academic superstars was the hedge fund Long-Term Capital Management, whose partners included Scholes and Robert Merton, with whom Scholes shared another finance Nobel. L.T.C.M. eventually imploded, nearly taking the world economy down with it. But efficient-markets theory retained its hold on financial thought.

If he actually knew something about hedge funds in general, or LTCM in particular, he would know that Merton and Scholes where marketing props. The strategies LTCM employed were neither derived by, or managed by Scholes and Merton. The LTCM strategy had nothing to do with a tweak to the Black-Scholes option formula.

Lawrence Summers, now a senior official in the Obama administration, began a paper on financial markets thus: “THERE ARE IDIOTS. Look around.” And a whole counter culture emerged in the form of “behavioral finance,” which argued that investors are irrational in predictable ways.

And here is the essense of Krugman. THERE ARE IDIOTS. All caps, to emphasize the screaming. He thinks those who disagree with him are lying bastards (such as those who take money from companies consulting), or those who just don't have his IQ. Idiots and/or liars. There's no other reason to disagree with him on policy.

There are two ways to think about markets. In one, the market is an idiot, like people who aren't smart enough to have PhDs in economics from MIT. Prices are thus invariably too low or too high. Pray tell, can you tell me a specific market price today that is too high or too low? No? Ok, lecture me again on AOL circa 1999, housing in 2006, or RCA in 1929. Boring! It is much smarter to approach markets as if markets are rational. As there are literally thousands of prices in thousands of markets, some are too low or too high, but it is not obvious which because most are priced 'just right' given the information available. If you think it is easy, as implied by an irrational market, you don't check your assumptions enough. Several, perhaps hundreds, prices are wrong, but it takes a lot of smart analysis to figure out which.

Now, this would all be typical Krugman overreach, except that he is reviewing Fox's book, Myth of the Rational Market, which as Fox noted responding to my negative comments, if you actually read you will find is a very balanced portrait of efficient markets. Good point. 'Don't judge a book by its cover', is actually a good cliche. You don't learn in there that markets are 'irrational', or that those creating that theory were biased, lazy, bought, or otherwise infringed. But clearly Krugman just takes the title and says here's another brick in my case why we need more government.

Justin Fox’s “Myth of the Rational Market” brilliantly tells the story of how that edifice [efficient markets] was built — and why so few were willing to acknowledge that it was a house built on sand.

I doubt Krugman read past page 2, because nowhere does Fox state that the EMH is a house of sand, metaphorically or otherwise. The theory has esteemed detractors, but that's about it. Indeed, it seems ultimately a semantics debate (ie, 'efficient' implies 'perfect' to some).

I also doubt Fox will have a problem with Krugman's review because a NY Times review from a famous intellectual is always welcomed, even if totally off base. I would like to think that if a famous person reviewed Finding Alpha, and praised it to high heaven for something I did not say or intend, I would note I appreciate the love, but must correct my reviewer (alas, I'm untested).

If I could fault Fox's book it would be twofold. First, it is a highly limited book, adding narrative, but no constructive argument to either side in the debate. Such a book has its place on the bookshelf, but it is not part of the intellectual debate, more like learning about Hitler's childhood, which is interesting but really doesn't explain the concentration camps or Operation Barbarossa. Secondly, Fox's book title and its jacket, leads to this kind of interpretation, and when interviewed he encourages this interpretation from overzealous interviewers. This is intellectually dishonest, because it merely plays into the inconsistent opinion that markets are stupid by those same professionals that said absolutely nothing about weakening mortgage standards prior to 2007 (to take one example). For Mark Haynes, bloviator general on CNBC, to spout markets are inefficient takes a lot of chutzpah, because he sure had the motive, means, and opportunity, to set the market straight in the past two bubbles, but merely cheered them on, then after the collapse says 'It was so obvious!' It's pathetic.

Krugman thinks that a major intellectual debate is as simple as one side having bad intelligence or bad faith. This is a stupid way to view such disagreements, one Krugman makes repeatedly in his prominent screeds. As Oscar Wilde states 'Education is an admirable thing, but is well to remember from time to time that nothing that is worth knowing can be taught.' I understand the paradox of not being able to teach creativity, but one would think educated people could learn temperament and humility are part of wisdom,. Unfortunately, esteemed intellectuals lack these virtues in spades, making them disproportionately moronic.

Debating EMH

I've got crappy internet access here, so my headlines are all in Thai or something. Anyway, see me debating the way overmatched Justin Fox (author of Myth of the Rational Market), who posted first here. Yeah, that's some good ole smack talk! Actually, Justin is not super anti-EMH or rational market, as say Simon Johnson, Paul Krugman, your average editor at a major newspaper, or Slate columnist. He just thinks more regulation can obviously make it better.

• Justin's first post anti-EMH
• My response
• Justin's second post
• My second response

Bias in Finance

Over at OvercomingBias, Robin Hanson blogs about my SSRN Paper:

My asking around a bit confirms Eric; finance folks’ reaction is that everyone is sure there is a positive risk premium even though they admit the data isn’t very clear and everyone also knows relative wealth preferences exist and if strong enough could eliminate the risk premium. My quick search didn’t find anyone else taking Eric’s strong position, and he says he can’t find anything either.

My best guess is that Eric is basically right. In fact, I’d guess lower returns for the highest risk investments come from enough investors being risk-loving in relative wealth; they are willing to lose out on average for a chance to gain the very most. However, even if Eric is eventually proven very clearly right, I’m not optimistic that he will get much credit or gain from it.

Read the whole thing.

Vacation

I'm on vacation! No posts 'till next Monday.