Thanks, Guys

A war is like a bar fight in that 100% of them involve at least one real jerk and most are avoidable, yet sometimes you need to fight. I know that your average 19 year old doesn't really choose who he fights for, and so its not like American 19 year olds were more enlightened than the Germans or Soviets of WW2, but their actions are sometimes necessary, and always take courage and sacrifice. Hopefully this century will have fewer wars than last, but it all has to be put into context as there is a lot of suffering and death caused not by organized conflict, so unfortunately pacifism is not always the answer. So, here's a salute to the poor guys who gave up their life for others, such as the 50 million South Koreans who live a relatively nice life relative to the alternative.

Envy over Greed: The Movie

In the Canadian Report on Business Magazine, Tim Taylor has a nice article on my work. It's tied in with cool pictures of Gordon Gekko, who is moving over to my point of view:

When I was away, it seems that greed got greedier, with a little bit of envy mixed in

~Gordon Grekko in Wall Street II

Unintentionally Harmful Econometrics

Labor economists joshua Angrist and Jorn-Steffen Pischke have a neat little book on econometrics: Mostly Harmless Econometrics. Alas, the link to anything written by Douglas Adams is a bit strained, but I appreciate their light-hearted approach. Basically, they outline the fundamental problem that vexes econometric research: the omitted variables bias.

Say you want to estimate how schooling affects earnings. People who go to school longer have higher earnings. But they also have greater discipline, come from better socio-economic backgrounds, and have higher IQ, all of which might be the true cause. If you don't include these in the regression, you attribute too much benefit to schooling via these omitted variables (that are often difficult--or in the case of IQ, taboo--to measure). So the book goes over all sorts of ways to tease out the true relationship. Foremost in this approach is the Freakonomics method of natural experiments. This is when some arbitrary event creates different samples where the variable of interest (schooling) is different, but the other factors (IQ, wealth, discipline) are the same.

Basically, you compare a group affected by some arbitrary process that stopped group B from getting more schooling that is otherwise indistinguishable from group A that got more schooling. The signature example in the book is the Angrist and Krueger (1991) paper, which takes advantage of the fact that many states required kids to go to school until the age of 16, and they had to start school in September at age 6. Because school years end in June, this means kids born just before school starts would be 16 just before another year started, while those born just after would be only 15, and have to at least start another year. This causes kids to get different amounts of education merely because their birth date,, which is independent of IQ, discipline, and socio-economic status. A 'natural experiment'.

The precise methods of finding 'identifying restrictions' is not so important. It's the mainstay of rigorous research, but ultimately, if your result shows up only via coefficient t-stats in 2-stage least squares, but not a graph, it isn't there. The earnings are what they are, what's the difference for the kids who went to school an extra year? Here, we see the problem with econometrics. The authors are very excited by the saw-tooth pattern that shows a significant birthday bump around December 31 for the Angrist and Krueger study, highlighting that staying in school an extra year provided a statistically significant bump in earnings.

But the effect is small, about 3% effect on wages via the extra year for those kids born too late to skip their last grade. Sure, with enough observations it is significant, but not enough to change the world. It became an inspiration for a generation of Harvard economists like Levitt because the approach seemed to solve a problem using both cleverness, and high-brow econometric techniques. Yet, it does not follow that staying in school an extra year at 16 implies going to college would also help. Very few effects are linear. I could take golf lessons and lower my score by 10 strokes in a few lessons; it would not, over a year, put me on the PGA tour. The authors seem oblivious to this point.

One could say, he has a long section on nonlinearity, and indeed he does. But the inordinate amount of attention he pays to his little 3% wage increase belies this knowledge. The net-net inference is clearly that the 3% wage increase has policy implications, otherwise he, and the labor economics community, would not cite it so much. In the end, he doesn't think nonlinearities are relevant to his

One could imagine them testifying before Congress that their research proves we should spend more money on college, but that presumes a lot of things. It assumes a linear extrapolation of their 16-year old findings. It assumes spending more money on college aid actually increases schooling, as opposed to what is charged by schools. It assumes people will study subjects that are actually skill related, as opposed to becoming film-studies majors who don't learn anything useful.

Where all this excitement with econometric technique, and natural experiments, over common sense leads is best examplified by this paper on the the impact of file-sharing on record sales by Oberholzer-Gee and Strumpf, published as the lead article in the Feb 2007 Journal of Political Economics (Levitt's journal) to great fanfare. Their measured relationship between the instrument (German students on vacation) and the variable that it is instrumenting for, American downloading, is seen to have a large effect, presumably because Germans download and share a lot music, and spend a lot of time sharing files when on vacation.

Anyway, Most of Oberholzer-Gee and Strumpf's work emphasizes econometrics, not the stuff Stan Liebowitz brings up, such as the proportion of school kids who actually download music as a percent of music downloads in Germany and their percent of US music sales. Vacation time correlates with traditional US seasonal patterns, as music sales spike before Christmas when German Junge are in school for reason unrelated to file sharing (stockings need CDs). Basically, the empirical issue is one of institutional detail, know about seasonality of music sales, school schedules, time of music downloads, and very little to do with identifying restrictions that are emphasized in their academic piece.

In a sense, econometrics as a science allows shoddy empirical work to hide behind pretentious techniques that try to avoid these issues. Vector auto-regressions, or natural experiments, do not obviate the need for common sense, and understanding of the subject to which the tool is being applied. The manifest failure to predict stock returns, business cycles, interest rates that became so apparent in the 1980s caused econometricians to search for small subjects where natural experiments exist, and then draw some grand extrapolation. People think about the question less than the method, and then assume that because the results are so clean, it will be profound. I think many econometricians wish that it were so, so they could focus on what they really like, math, while still saying something interesting about important issues like schooling.

If the only way to tease out, say, the risk premium, is to use a method-of-moments estimation with 3 identifying restrictions based on some fundamental utility function, but the bottom line is you can't say whether Coke is a riskier stock than GM, you don't have a result. It's academic.

Risk-Return Bait and Switch

One of my big ideas is that risk, however measured, is not positively related to (rational) expected returns. It goes up a bit as you go from Treasuries, or overnight loans, to the slightly less safe BBB bonds, or 3 year maturities. But that's it, that's all you get for merely taking the psychic pain of risk. Just as septic tank cleaners do not make more than average, or teachers of unruly students do not make more than average, merely investing in something highly volatile does not generate automatic compensation. Getting rich has never been merely an ability to withstand some obvious discomfort.

This is a big idea because the risk premium pervades modern economics like the luminiferous aether pervaded 19th century physics. It's everywhere and explains everything (eg, why did markets fluctuate yesterday? The risk premium was moving!); it is also impossible to measure. One thing it certainly is not, however, is mere volatility. High beta stocks, and high volatility stocks, have lower than average returns. All financial researchers know if risk is priced, it is a covariance with a factor that proxies our 'marginal utility of wealth', often thought to be something like the S&P500 index. It is not 'total volatility', 'total non-diversifiable volatility', or a covariance with anything, well, intuitive--we've tried everything intuitive. The theory does not work in horse racing, lotteries, junk bonds, private-equity, temporal volatility, options, within equities, options on equities, the yield curve > 3 years, among other investments.

While no one has identified this elusive factor, it's an academic snipe hunt that has been going on for 50 years, and yet academics still believe it exists the same way any true believer knows the truth regardless of evidence. The triumph of theory over data is a powerful thing.

Yet I noticed that over at Journal of Finance editor Campbell Harvey's website, he has the standard two-dimensional plots with risk on the x-axis, return on the y-axis, such as the one below.


Now, Campbell Harvey is a clever guy (editor of the Journal of Finance), and does a lot of solid research. Yet to conflate risk with 'standard deviation' in this presentation highlights how the mind confabulates.

The psychologist Jonathan Haidt has this great study on presenting disgusting scenarios to students, like a story about a brother and sister who decide to have sex (with full protection), and who then decide it was a fun special moment. He then asks people, 'was that wrong?' Modern students generally say they don't have a problem with people doing things that don't hurt others, and in this hypothetical, no one was hurt. Yet most everyone finds it objectionable. So when pressed as to why they don't like it, they first offer reasons like 'they will have defective children', even though the risk of pregnancy was assumed zero, or 'it's illegal', when that point is moot because this takes place in France, where it is legal.

Although we like to think of ourselves having beliefs based on painstaking rational deliberation consistent with our enlightened liberal views, Haidt sees the process as just the reverse. We judge and then we reason. Reason is the press secretary of the emotions, the ex post facto spin doctor of beliefs we've arrived at through a largely intuitive process. Basically, our brains don't like it, and we first reach for the obvious reasons (eg, having Prince Edward-like spawn), and when these are shown deficient, move on to others. We don't like saying, 'because I believe it to be so!' when defending our beliefs.

Harvey knows that standard deviation is not even a proxy for risk, yet when presented with a simple graph that superficially works, he uses it as proof. He cherry picks asset classes where this works, and ignores the ones where it does not. For an experienced finance academic this risk-return nexus is burned into his neurons like our aversion to the smell of toe jam, they know it's true, regardless of what the data say. It's an answer that works for his naive MBA students, and so his rationalizing homunculus got the better of him.

Cam Harvey responds in comments:

... Do I believe in a positive relation between expected risk and expected return? Yes. Is is difficult to measure risk? Definitely. It is even difficult to measure expected returns.

Finally, let me comment on your idea that "risk, however measured, is not positively related to returns." Finance theory says nothing about this. Our theory relates risk to "expected returns" not ex-post returns. To be clear, "risk" should also be expected. I emphasize this in my class. I accept your critique of my graph which should have been labeled "Average Historical Returns" vs. "Standard Deviation of Returns."

Individuals vs. Groups.

To generalize is to be an idiot. To particularize alone is a distinction of merit.
~William Blake

Over at the Yale lecture series, there's a bunch of neat Intro to Psych lectures by Paul Bloom. In one of them, titled Why are People Different?, he notes that people have various attributes that help explain what they do: intelligence, openness, conscientiousness, extraversion, agreeableness, and neuroticism. These attributes are partially genetic, and they are interesting because they 1) are rather stable over an individual's life and 2) predict important real-world behavior.

Bloom highlights these are important because they explain why individuals are different. He then notes that when applied to groups, they are not important. His explanation here is rather unconvincing. He note Lewontin's famous anecdote of a crop of wheat, where seeds have a genetic potential that is very important, but a field of wheat can have different characteristics because one field is fertilized differently. True enough. But Bloom then says, because this is true, one can't say anything about groups of individuals. This simply isn't true, as the same reasoning can be applied to individuals, even more so. Further, one can do studies that abstract from important omitted variables, by in effect controlling for things like fertilizer, just as one does when estimating the effect of a characteristic for an individual.

Think of a stock. It has characteristics like its industry group, beta, and P/E ratio. These characteristics are important because they have different implications for risk and, sometimes, expected returns. When analyzing a large portfolio, this way of slicing things is informative. However, when looking at a specific stock to buy, the more you analyze the particulars of a stock like GOOG, these broad characteristics become merely one datum among many, almost irrelevant. Basically, factor analysis explains a lot only when applied to groups, not single stocks, for which the error is sufficiently large as to not make it a very meaningful bit of information compared to a narrative of GOOG's business strategy and stock performance against its peers. In contrast, most econometric financial research involves grouping stocks into deciles, sorted by a variable of interest.

I find it interesting that top psychologists only want to apply human characteristics to its most irrelevant application, the individual. That is, the the characteristics he discusses seem to have greater relevance to groups than individuals, but they don't want to look at that based on a very weak objection, that members don't all behave like their group. As if a tendency has to be 100% or 0% to be interesting. A young woman who avoids a dark alley where a bunch of young men are standing around is making a generalization that may be unfair, but prudent. Individuals often behave counter to their type--being more agreeable, or intelligent, in different applications on different days--but people understand that does not invalidate any label like 'intelligence'. I'm not saying one should only look at groups, just that it's an interesting application, no one is doing research here, and it's important. There is a lot of discussion of group differences in socio-economic variables, and the achievement gap seems to be the top focus of any American urban school system. Race, gender, and ethnicity are somehow both very important when discussing social justice, but also totally unimportant--if not meaningless--biologically.

There is a logical error in supposing that all groups are fundamentally the same on every metric of human behavior. Many things are heritable, important, and vary systematically between groups. Individual differences don't automatically wash away at the group level, otherwise there would never be evolution outside of rare bottleneck events (the whole 'Preservation of Favoured Races' subtitles in Origin of Species). It's really a rather weak assertion--that individual characteristics are at least as important at the group level--yet one of the taboos of our time.

Spin

The current headline in the NYTimes: In Victory for Obama, Court Bars Detainees’ Challenges.

A federal appeals court ruled Friday that three men who had been detained by the United States military for years without trial in Afghanistan had no recourse to American courts. The decision was a broad victory for the Obama administration in its efforts to hold terrorism suspects overseas for indefinite periods without judicial oversight.

I somehow think that the take-away would be different if a Republican were President.

An Example of Opposite Views

In anticipation of Susstein's Brave New World of idea diversity, Gawker has a neat post on scientists working to figure out why the universe exists (and you thought beating the market was hard).

Why are there things, instead of nothing? It may hinge on a kind of particle called a "b-meson," which constantly moves back and forth between its matter state and its antimatter state—but which moves more easily from antimatter to matter than the other way around.
...
People who are stoned are working on a competing theory of existence, based on that awesome scene in Blade Runner where the guy is on the roof? You know? Man.

Cass Susstein For Mandating Voluntary Blogger Action

Cass Susstein wrote Nudge, a book about 'libertarian paternalism'. This sounds like an oxymoron, but he would always try to highlight its character with the example of changing the default choice for 401k investments so that people save more.

Yesterday, however, he highlighted his strong paternalistic side, discussing his new idea that all websites provide 'the other side' of arguments:

If we could get voluntary arrangements in that direction, it would be great and if we can’t get voluntary arrangements maybe Congress should hold hearings about mandates.”

Alas, most bloggers aren't super political, and when you move beyond Left and Right, the other side isn't obvious. I mean, I disagree with 'market irrationality' man Robert Shiller on a lot of issues, but also 'market rationality' proponents like John Cochrane or Eugene Fama. I'm a strong critic of Financial Theory, but find most other critics of this theory to be 'more wrong', and probably have less in common with your average finance critic than with the ruling elite of modern financial theory.

I think Susstein is showing the absurd slippery slope of his libertarian paternalism, and he's doing the sliding. I disagree with everyone on something, agree with no one on everything, and often share similar conclusions with people for very different reasons, so the weighting of my disagreement would be vital in figuring out my opposite link. Who weights the issues of agreement/disagreement? If this incredibly naive, unworkable idea was sufficiently vetted to merit mention with NPR, I would love to know what his other ideas are.

On the other hand ... I guess the Al Gore would then have to admit the Climate Debate is not over! Indeed, a lot of issues Susstein finds have no legitimate other side would now be on the table! I'm thinking everything from racial profiling to all the Politically Correct taboos, such as the assertion the Holocaust never happened, HIV does not cause AIDS, etc. He would be 'hoist with his own petard', as the Bard would say.

Actually, if The Man starts giving me orders, I think it would be quite fun because I imagine the poor chaps in the "Office of Website 'Opposite Link' Definitions" would be in way over their heads, and that would mean fewer regulators actually doing real harm implementing regulations they could enforce.

Barry Nalebuff's Banana

Felix Salmon's post that I recently mentioned, contained in it a reference to Yale economist Barry Nalebuff, who is now trying to by some sort of life coach. If you see this lecture Barry talks about a lot of stuff, but his signature insight is his banana. You see, most people, including me, grew up peeling a banana from the stem down. However, the stem makes a better handle, and the other end is actually easier to peel, so peeling the banana from the other end is strategically dominant. Indeed, this is what banana-experts (monkeys) do. The implication is that some traditions we take for granted are suboptimal.

I remember in grad school reading some really difficult articles Nalebuff wrote on game theory. He was recognized as a true 'genius' by economists. There were stories of his brilliance. One anecdote had him visiting a campus as an undergrad, and he walked onto some debate forum. He entered the debate without preparation and won! A grad student was in a job interview with Yale professors, and Nalebuff supposedly told him one of his results was wrong even though Nalebuff hadn't read the paper, he was just thinking about the applicant's exposition (this annoyed the job applicant who thought he was not wrong, and I don't know if Nalebuff was indeed correct, but the chutzpah is what's important).

Hhowever, his great insight even in the early 1990's was his banana anecdote. Twenty years later, it remains his marquee idea. That would be a little humbling. All that genius, all that mathematical wizardry, and it comes down to watching a monkey peel a banana, and instructing us to do likewise.

Good ideas are hard to find, and great ones even more difficult. I would say humans are very good at finding good ideas, and smart people come up with a lot more than dumb people. Yet, great ideas are like great melodies, rare, with many one-hit wonders, often derived by people with many flaws. For example, if you read Kary Mullis's autobiography (he discovered PCR, a central technique in biochemistry and molecular biology), you'll see he has a rather adolescent sense of humor and strong views on lots of things that are bizarre, but usually intriguing. I'm sure a 21-year old Barry Nalebuff was considered a genius by most of his professors, destined for greatness, because Nalebuff was better at the techniques those professors thought were most important. Mullis was probably seen as a smart but much less impressive kid.

At the end of the day most really great economic ideas aren't derived through the formalism of abstruse mathematics, but rather, finding an important parochial problem and solving it, and then fortuitously finding out it has general relevance. Math is merely a way to compliment the exposition of an economic idea, not to prove it: if an idea is only compelling within the context of a complex mathematical proof, it is probably not robust to slight changes in assumptions. There is a strange emphasis in economics on rigor in economics, leading to lots of silly articles that aren't important, as Nalebuff's career demonstrates (I can't think of an important non-banana insight from his academic papers). When you look at the curriculum vitaes of economists you'll find their best good ideas, if they have any, are pretty independent of some trick using a fixed-point theorem (a la John Nash). And hopefully, a monkey hasn't figured it out first.

Felix Salmon Highlights Financial Inconsistency

Felix Salmon was on the HuffPost on May 10, telling people to sell, and generated 2904 comments and counting. This was just after the big system debacle, where volatility spiked and markets swooned. With hindsight, this was a bad idea, but that's not important.

In this blog post, Felix explains his logic. The basic idea comes straight out of our standard utility model of risk and return. The idea is basically that if you have a utility function that is standard^*, your desire for stocks should obey the equation:

% wealth in stock = Expected Return / (volatility^2 × RiskCoefficient)

So, we have three variables determining one's equity allocation. The risk coefficient constant is usually considered to be between 1 and 3, lets say 2 (as Salmon assumes). A higher risk coefficient means you are more risk averse, and note that if you increase it, your percent allocation of wealth to stocks goes to zero. The numerator is the expected return premium one gets for investing in the stock market. Most people assume this is 5% annually (I think it's practically zero). Finally, we have the variance of returns, or volatility squared. As 'the market' is diversified (unlike a single stock), the market's variance should be linearly related to priced risk. Luckily, we have a good proxy for that, the VIX index, which is a forward looking estimate of future volatility based on option values. This is really what changed, and drove Felix's recommendation.

On May 6 implied volatility on options went from 25% to 40%, implying to Salmon one should drastically reduces their market exposure. Plugging in the numbers, we see this allocation goes from 40% to 15.63%, a massive re-allocation. That is, theoretically, one should sell over half your equities according to the ineluctable logic of economics!

One way to note it's wrong, is that prices and quantities exist in an equilibrium. In the short run, quantities don't change, so if preferences or expectations change, then prices must adjust, not quantities. If this theory explains what everyone is doing (on average), it must affect prices and not the allocation to equities, because not everyone can sell over half their equities overnight: someone would have to buy them! So in equilibrium, the only way this allocation percentage applied to stocks stayed constant, if 1) risk aversion decreased, or 2) their expected return increased.

As volatility² went up by 2.56 in my example (from 0.25² to 0.40²), is it reasonable to think people became, suddenly, 2.56 times less risk averse? One can't observe 'risk aversion' directly, but this is highly implausible, because intuitively during a panic, people become more risk averse. That leaves the expected return. Presumably, the risk premium, the return you get for the displeasure of bearing undiversifiable risk, had to have risen 2.56 times. But this turns out to be an empirical matter: do expected returns rise when volatility rises? Is it plausible that during this cataclysm, people were simultaneously increasing their prospective anticipation of future returns?

I think anyone with common sense realizes these are bat-shiat crazy interpretations of what the representative investor was thinking.

The data on actual returns and market volatility is, if anything, negatively correlated. That is, think of volatile years, and you'll think of the worst years: 1990, 2008, 2001, 2002. But the standard response to such empirical rejections is to note that actual returns aren't the same as expected returns, they vary by some statistical noise, and so perhaps we just don't have enough data. Logically possible, though after over 50 years mining all the data ever recorded for the elusive 'risk factor' that explains asset return variability, I'm thinking it's improbable.

Steve Sharpe and Gene Amromin actually got around this objection by looking at survey data, and found that in questionnaires investors tended to have higher return expectations when they forecast volatility as being relatively low, and lower return expectations when they forecast higher volatility. Exactly the opposite of what they should be thinking. This isn't a missing a constant in the second decimal, rather, screwing up the sign.

As this is consistent with the theme of my book Finding Alpha, I thought this paper was awesome, and asked Steve Sharpe why it wasn't in a journal. He noted that referees just kept sending it back for various reasons. This is unsurprising, because all the referees presume there must be some sort of mistake, that this can't be true; it's counter to all their theoretical training. It reminds me of my attempt to get this paper published, which was rejected at several publications for being wrong, obvious, and irrelevant, which merely highlighted to me they didn't like it. I don't think it's a conspiracy, just another example that theory can make you see facts as noisy exceptions or highly important and causes you to respond accordingly. People see what they believe, not vice versa, so Sharpe's fact has to be wrong according to these referees.

Sharpe's result really puts the standard model in a box. Unlike the CAPM betas, for which we can say we 'just don't know the true market portfolio', this result takes fewer assumptions, so its empirical failure is all the more fatal to the core financial theory. People should be increasing their expected returns in volatile markets, and on average that should manifest itself in actual returns. We don't see that in actual returns, or in surveys of expected returns.

A powerfully bad theory is like a lie--it has many inconsistencies because it isn't true (a worse bad theory is wrong and consistent with the data, but merely because it doesn't predict anything). One of the many bad implications of having the delusion that risk begets a higher expected return is that people invest in the stock market thinking they then deserve a higher return, a strategy that worked pretty well in the US in the 20th century, as long as you implemented a low-cost strategy that minimized trading and taxes. In reality, you either have to hope for lady luck, or actually do a lot of work finding your investing alpha looking for subtle patterns, or like Warren Buffet actually manage the companies you own to perform better than average. The idea that a passive approach to equities implies higher-than-average returns puts you at the mercy of brokers who may be selling diamonds in the rough, but usually are selling hope (it's a Black Swan, trust me, I'm smart!).

If you don't expect a return merely for shelling out your dough, you see investing in a risky asset class as merely a necessary condition for higher-than-average returns, not a sufficient condition. This insight would encourage a great deal more prudence where it is needed.


* a standard utility function is of the form U(x)=x^(1-a)/(1-a), where x is your wealth or consumption, and 'a' is your coefficient of relative risk aversion. It has the desirable condition that your relative pain to a 40% loss is the same whether you are rich or poor (desirable because otherwise risk aversion should have gone down a lot over the past 100 years as we have gotten wealthier).

Nouriel Roubini's Missing Speech

In Michiko Kakutani's NYT book review of Nouriel Roubini's Crisis Economics, and in the book's foreward, a September 7, 2006 IMF speech is highlighted as containing specific warnings about US housing, and how this would lead to a financial contagion. This would seem to be highly prophetic. So I went to his website looking for this speech. It linked to something from 2009. To get to this point I had to register at his site, and they sent me a an email message, asking what I wanted to know (they seem to sell different levels of access at the Roubini Global Economics--a sort of CNBC with only negative spin). I asked to see the 2006 speech mentioned in the NYT book review, and they pointed me towards a different speech in 2006 that was rather vague. So I asked again for the rather prominent September 7 2006 speech, and they did not answer.

I bet the speech mentions not merely the housing problems, but a bunch of things that could go wrong that did not, which would suggest indiscriminate crisis prediction that is not so impressive. I noted that in his book, he highlights that he predicted exactly two Investment Banks would fail, and as Bear Stearn and Lehman failed, this was spot on. Such specificity is not a sign of accuracy, but tendentious hindsight. To predict '2', and then to count '2', in the maelstrom that occurred, is silly. Why not count Merrill Lynch, as such a failure? It's like trying to say Nostradamus predicted 9/11, or Robert Prector predicted last Thursday's intraday low of 1,065.79, because being that specific shows you can read anything into predictions if you look hard enough.

Nouriel Roubini is a permabear, having continually predicted crises from a variety of influences all the time. He's sensitive to this criticism, and so states he is not a permabear, in that if we make the right investments we can avoid crisis, as if his allowing the possibility of a non-collapse proves he sees both sides. Yet as we never do make the right investments that hypothetical is not very relevant. Further, all his bearish statements are hedged with 'may' in a way that they are nonfalsifiable (eg, there may be a calamity this year--alway true!).

I read his book Crisis Economics, and there's a lot of good stuff in there, but also a lot of strained assertions. For example, he notes that the invigorated SEC in the 1930's was responsible for the next three decades of financial stability in the US. Was that the true cause? Wasn't there a lot going on as well? How could one be confident the SEC was the primary driver here, reading the SEC's 1934 investment act (a lot of signing papers, kinda like our voluminous mortgage paperwork that proved irrelevant)?

It's an insanely naive post hoc ergo propter hoc type of proof, one that he would never find compelling for any of his adversaries. His recitation of the run-up to the housing crisis is, at this point, not interesting (everyone--government, investors, homeowners, banks--levered too much into housing, I'm bored reading about that fact).

Anyway, if anyone has a link to his singular speech, the internet could use it.

Crony Banking Investment

Chicago's ShoreBank has received dozens of accolades from politicians, nonprofits, and academia for their work lending to 'underserved' urban and rural communities. Above is a picture of one of the founders, Milton Davis--along with some community organizers--having a street named after him.

One of their executives testified to Congress in support of the 1977 Community Reinvestment Act. Shorebank worked with Clinton in Arkansas, and in 1992 Clinton called Shorebank 'the most important bank in America'. They gave money to Obama's presidential campaign, and he mentioned them as an example of good lending on his trip to Kenya when he was a Senator. The Illinois Finance Authority chairman and the current ShoreBank CEO are childhood friends (btw, did you know bank regulators included state 'Finance Authorities' that presumably help the commonweal?).

Now that we discovered you can actually 'overserve' borrowers--which isn't good either--and many banks have suffered, including Shorebank, which now needs about $125MM to avoid an FDIC takeover. Who ya gonna call? The WSJ reports that none other than über-weasel Lloyd Blankfein is stepping in to save this necessary institution!

Yesterday, Cliff Asness and Aaron Brown wrote about the new financial regulation bill in congress, and how what was so unsettling was not anything in the bill, just that there was a lot of power being granted without much guidance, a legislative dream. Finance has always been heavily regulated, and so bank executives have always been heavily populated with lending naifs who merely knew how to do PR. In our brave new world where government can take away your license to do business at a whim, you need to pay into the favor bank on regular occasions.

Nassim the Dream Top Tics It

There was a big story in the WSJ about one of Nassim Taleb-affiliated fund Universa Investments LP (he's merely an advisor, but he takes credit when it does well and it's run based on his long-Black Swan theory). Supposedly, they made a big trade around 2 pm EST on Thursday, just before the market tanked. As the electronic exchanges were spotty a large order like this didn't help, and wasn't very savvy on a pure tactical level (ie, don't make big trades when systems are down).

Anyway, lets look at the tape. Here's an S&P 115 June Put option from Thursday. Around 2 PM EST, it was price about $4.30. It went to about $8 (one bizarre print at $14), and is now about $2.50. Whatever he bought is probably down 50%.

I would bet that his Universa Fund will go exactly like his Empirica fund: up big in year 1, then slightly negative for the next five, when it is 5 times as large. Net net, it loses dollars, and like Emprical will have a Sharpe below the Hedge Fund Mendoza line of 0.5.

All the while, however, he makes huge fees, because 1% on $4B is a lot of money, and his wealth will serve as proof that he's an investing genius. More importantly, he then selectively presents to a credulous press he makes billions off his market savvy.

Gee, someone should write a book about blow-hard traders who misrepresent their track records and take excessive risk with other-people's money, all due to cognitive biases they are too shallow to notice in themselves. Oh yeah, Taleb has done that! I guess his insider status gives him better insight.

Greek Calculus

The Greek bailout is rather depressing, but I'm empathetic. As Reinhardt and Rogoff show, a financial crisis increases real government debt an average of 86% of GDP (this is noted five separate times in their book 'This Time It's Different' on the history of financial crises, so it's the #1 fact of financial crises). Think of this as the cost of letting a crisis happen. On the other hand, there is the cost of continuing to overspend, which also adds to the debt, and further signals to others that they too need not discipline their budgets. The hope is that the bailed-out party will amend its ways and not need a further bailout down the road--clearly, this isn't usually the case.

So, it's a trade-off, and it's benefits would depend a lot on intrinsically subjective probabilities. Reasonable people can disagree.

The Real Corporate Bond Return Puzzle

High Yield bonds highlight the most fundamental problem in finance: that risk is not positively related to expected returns, and this fact is not empirically obvious. This strikes at the heart of finance, because 'risk' is a rationalization for many things, but after 50 years, remains like dark matter, a convenient assumption for an empirical 'anomaly'. For example, in Steve Cecchetti's finance textbook, he highlights the extra return to lower rated bonds (aka 'High Yield' or 'Junk') as evidence of the risk-return nexus. In theory, if you take higher risk you get a higher return, so its understandable he would be cavalier about an assertion that seems obvious.


Yet a stated yield just means this is what is promised in the no-default case, and so not the same as an expected return. Many bonds actually default, the more so the higher the stated yield. In fact, the correlation is such that if you look at actual returns, the risk premium disappears. This is complicated by the fact that indices, such as the Merrill Lynch High Yield Master, show a nice 7.43% annualized return from December 2006 to April 2010 about 200 basis points higher than the BBB index. Yet actual high yield funds, and I used 25 different ones, generated a considerably lower 5.14% annual return over that same period. Not only is there a management fee (say 0.4%), but funds encounter costs transacting in their inventory, in terms of commissions, crossing the bid-ask spread, and price impact. The transaction costs here are multiples of that in equities, because there's less liquidity in this market. This adds up to a couple percent per year.

On average, B rated bonds have about a 320 basis point spread to Treasuries, but with a 6% average annual default rate, and a 50% recovery rate, that's about zero net forward return premium. Add in the extra expenses from these illiquid securities, and you would do better owning a savings account, because the high yield bond risk is much higher however you measure it (eg, beta, stdeviation of returns).

The conventional corporate bond puzzle is that spreads are too high. The most conspicuous bond index captures U.S. Baa and Aaa bond yields going back to 1919, which generates enough data to make it the corporate spread measure, especially when looking at correlations with business cycles. Yet Baa bonds are still investment grade, and have only a 4.7 percent 10-year cumulative default rate after their initial rating. As the recovery rate on defaulted bonds is around 50 percent, this annualizes to a mere 0.23 percent annualized loss rate. Since the spread between Baa and Aaa bonds has averaged around 1.2 percent since 1919, this generates an approximate 0.97 percent annualized excess return compared to the riskless Aaa yield, creating the puzzle that spreads are too high for the risk incurred.

Yet this corporate risk premium puzzle pertains to one portion of the risk spectrum the difference between a 0.03 percent and a 0.3 percent annualized default rate, a distinction without a difference to most people. When one goes from a 0.3 percent to a 15 percent default rate, as one does when you go from BBB- to C-rated bonds, there is no return premium at all. The annualized return premium between the Merrill Lynch High Yield Index and that of their BBB-AA index is only 89 basis points annually since 1987, which is eaten up by fees, explicit and implicit. Junk bond investors take extra risk for no extra return.

It may be that individual investors expect high returns when investing in high risk assets, only that this is a mass delusion, the triumph of hope over experience. If so, that isn't the 'expected return' one talks about in academic finance, that is, a statistically rational expected return. It is important to think of a return premium as due to two things: randomness and alpha. Randomness or luck we all understand. Alpha, however, is a little trickier. It isn't something you can buy, because due to competition, no one sells it for less than cost, meaning, the insiders who structure and sell any alpha idea will take out all the extra return, leaving nothing at best, a mean-mode trade* at worst. To get alpha, you don't buy something passively, you have to actively negotiate, time, or structure an investment, and while people can help you, no one will singularly present you with an extra-normal return. Further, most alpha attempts are like karaoke ballads, well intentioned but ultimately awful, meaning, after fees most alpha is negative (how else do so many alpha-less brokers afford their nice cars!?).

It is difficult to see how the little risk is priced, the big one not, if risk is to have any consistent meaning. If the corporate spread is a function of risk at one end, why is it not at the other, more intuitive end? This is but another reason I think there is no general risk premium, as explained in my series of Camtasia videos on my book here.

* mean-mode trade: mode is positive, mean is not, as in selling underpriced out-of-the-money options.

Freakonomics p.175

Economists might not be able to forecast business cycles, but we're always getting better at the making the obvious—and slightly risqué—seem like science, as this latest research demonstrates:

Michael Lynn, a Cornell University professor of marketing and tourism, surveyed 374 waitresses and asked them to assess their physical characteristics, including their breast size, and evaluate whether they perceived themselves as attractive.

Those with bigger breasts, slender waists and blond hair reported receiving the best tips. High-quality service, Lynn's analysis concluded, had less than a 2 percent effect on tip.
...
Lynn also suggested that restaurant managers might be wise to keep his research in mind during the hiring process, because servers who make better tips are more likely to stay at a given job.

"Ugly people are not a protected class, legally," he said. "It is not in fact illegal to hire only attractive waitresses."

Fannie Mae's MyCommunity Mortgage

Fannie Mae's MyCommunity Mortgage^TM was at the forefront of the credit crisis, and had many sub-programs, all targeted at low income communities and borrowers. These programs highlighted the mission that made these GSEs essential: they were doing what the private sector would not, serve the historically underserved.

Unfortunately, lending to people without the ability or willingness to payback homeloans is not sustainable, something that seems obvious now, but try telling that the Boston Fed or the American Economic Review in the 1990s. The key is that MyCommunity Mortgage got bundled into Fannie's ubiquitous DeskTop Underwriter, a mortgage origination program that made these abominations standard. Once they set this up (around 2000, with new twists every year), one can see how these bad ideas spread all over the industry. The method to process the innovative loans needed no extra work, and as to the 'risk': the regulators could not simultaneously view these loans as risky while another government branch created them, in the same way they can't push affirmative action and sue firms for having de facto quotas.

If you read the archived websites you see that real estate agents knew exactly what these MyCommunity spawn implied. Says one broker:

they are a breeze to close! 6% seller concessions and a minium buyer contribution of $500??? I love it

On this mortgage website, they go over note things like how to get a loan without a job or even 'with the worst credit history'.

One interesting aspect of this program is how disingenuous it is. They are 4 exceptions to having sufficient 'traditional credit history', with several pages of nuance often referring to another document entirely. They don't say NINJA loans, but that's what they mean. Such criteria are not meant to be read and understood, they just mean, if you wave this in front of someone (eg, regulator) no one will question you because you are probably correct (and we all know what the program wants--more poor people with houses). The practical credit criteria was merely a signature with an affirmation ('yeah, sure I'll pay you back'), as long as the borrower is sufficiently poor with sufficiently bad credit. It wasn't adverse selection--taking on disproportionate bad credits inadvertently--it was active targeting the bad credits.

NINJA loans became a standard in large part because the leading player in mortgage underwriting embedded them in their ubiquitious, market dominating, mortgage origination software (Desktop Underwriter). Fannie wants another $10.6B, let's note if anyone actually mentions they change they ways when writing this check.

Don't Panic

Greece is in a bad situation. They don't have enough revenue to pay their expenses, and the effected interest groups does not understand that the only alternative to merely promising to cut expenditures (to get IMF loans), is actualliy cutting expenditures. Bad news, but Greece's GDP is only 3% of the US, so it's not that important.

But then around 2:45 EST the market started a free fall. Electronic exchanges like Arca became frozen, unable to send orders, and without the electronic market makers the prices basically had no support. Some big stocks like Procter & Gamble and Citigroup had bid-ask spreads effectively at 10%. It wasn't clear if the Mayan doomsday had been accelerated, Israel was in a war, who knew? Later it was mentioned this was caused by some poor guy at Citi who sold $16 Billion worth of S&P futures, not the $16 Million he was supposed to trade (his performance review this year should be leaked to the internet as comedy gold) Some exchanges are going to cancel some silly trades, but they had to have moved more than 60%, meaning a lot slightly less ridiculous trades are going through.

Just another reminder: if the market is going bananas, stand back. Retail traders get screwed in these environments, but only the impatient ones. Don't think you will get out first, the institutions are way ahead of you.

Regulating Derivatives is Futile

A funny story of unintentional hypocrisy in the WSJ:

"I don't trade on margin"--Rep. Spencer Bachus (R., Ala.) who made roughly four dozen trades in shares of ProShares UltraShort QQQ and its options

"Representing Las Vegas, let me assure you, no casino on the planet behaves as irresponsibly and recklessly as Wall Street does"--Rep. Shelley Berkley (D., Nev.), had 57 trades in 2008 in levered, short, ETFs.

"[We must] rein in excessive risk and leverage in the pursuit of short-term profits."'--New York Democratic Sen. Kirsten Gillibrand, whose husband made more than 250 transactions in options in his E*Trade account in 2008.

As Lewis Carrol noted in his wonderful books, the meaning of words can be ambiguous, leading to all sorts of confusion and chicanery. The word 'derivative', for example, applies most to synthetic CDOs, but also to options, which theoretically applies to equity, which is an option on a firm where the strike price is the face value of the debt. If that makes no sense to you, then you should not be too excited about financial regulation, because as soon as you regulate certain securities, its spirit will migrate to something else you never anticipated

This happens all the time. In the late 1980's, it was 'HLTs' or Highly-Levered-Transactions, that were hot during the junk bond boom. In the internet bubble it was 'equity-based financing'--the equity of the firm was the collateral. In the latest, it was 'innovative underwritiing standards'. It's all leverage in a different product area.

So now, while congress is debating new restrictions on what investors can do, they should note that all sorts of securities are set up to go up N times as much as some reference index or security, where N could be negative. For example, ProShares offers equities targeted towards going short in factors of 1, 2 even 3 times the index.

In a growing economy, you can't prevent speculation while allowing innovation; the wheat and the chaff are intrinsically linked, separated primarily by hindsight, as when Michael Lewis notes the obviously prescient home mortgage short-sellers in his #1 Book The Big Short. If you pass a law against X, there will be a natural inclination to re-label such action via different vehicles that obtain the same results.

It is well known that excessive leverage is a distinguishing characteristic of financial crises; it is less well known that this is not an aggregate property, but rather, concentrated in different sectors and products each time, which is why economists can not predict business cycles. So note that whatever is specified in this new financial reform bill, will just be relabeled and continue, benefiting securities lawyers and other middle men like Goldman Sachs who are good at this game.

Ultimately, the only thing dampening excess is the rational foresight of investors, who generally get what they ask for good and hard. To the extent a certain activity recently caused a great deal of grief, you can be pretty sure that it will be safe for the next generation. That is, the great stability after the Great Depression was not from New Deal legislation, but its affect on the conservatism of investors in response to that crisis. All this financial regulation in the pipeline are classic hindsight fixes that just add fixed costs, as irrational and hubristic as any levered CDO.