Darwin's Birthday and Evolution's Quagmire

It's Darwin's 200th birthday February 12, in the sesquicentenial of the publication of his Origin of Species: By Means of Natural Selection or the Preservation of Favoured Races in the Struggle for Life. I think his seminal theory, that of evolution as the mechanism for creation of all life from some unspecified simple beginning (virus?), is in a very strange way. Go to PZ Meyer's website, noted by Science magazine as the best science education site, and over half his posts are on why critics of evolution are not only wrong, but moronic. Similarly, there are many books arguing that evolution is true, even though only a trace of practicing professors are arguing the other side.

No one gets mad when you say 2+2=5, so methinks they doth protest too much. One does not see, say, physicists spending much (any?) of their time defending the second law of thermodynamics and slamming those who critique it. Thus, for a theory that almost all scientists believe is 100% true, many scientists spend a lot of time, and get very upset, defending this assertion. I would think a confident, productive scientist, would merely discuss applications of evolution.

However, these same appliers of Modern Evolutionary Theory (aka, Darwinists, which I use merely for clarity, and do not consider it pejorative) are hesitant to apply Darwinian logic to the entire human species (that whole 'preservation of favoured races' thing in the subtitle). Explanations about how our environment shaped differences in male/female brains, or how different environments may have shaped different regional group's brains, is about as taboo a topic as there is (see Arthur Jensen, Larry Summers). So, even though evolution affects our height, skin color, lactose tolerance, and other biological processes, supposedly it stopped at our brains, penis size, speed, and most things we esteem. Thus, Guns, Germs and Steel gets rave reviews and is a best seller, whereas 10,000 Year Explosion or A Farewell to Alms will never see much acclaim or popularity because we just can't tolerate the inegalitarian implications of human biodiversity.

My appreciation and criticism of evolutionary theory covers both ends of its unpopularity: applying it to explaining all life via the first prokaryote (no) and applying it to humans (yes). The more we learn about intracellular molecular biology, the more complex it becomes. Cellular machines have dozens of proteins, with logistic systems for building and supplying it, so that the functioning parts involve a complex system of necessary components. The response to this 'irreducable complexity' argument is that the prior forms of any complex working tissue or organelle could have been very different, and we can't know exactly what it function was, but they are theoretically possible, such as the assertion that lungs were probably first air bladders in marine animals. Different function, same proto-organ. But its one thing to say proteins A through F appear in other cells, quite another to explain how they transmogrified, step by step, to a totally new function. If they existed in a particular useful constellation, moving them to a totally new cellular function is like the Towers of Hanoi puzzle, where every plate must be moved following the logic that plates can only lie on top of larger plates. The constraint that all discs must be on a larger disc is like the contraint that every move must not decrease the organism's fitness, and turns a simple problem into one that becomes insanely complex as the number of plates increase. That is, evolution is blind, and each change in genes via reshuffling and mutation can't kill the host, which is a strong constraint because most mutations with effect are harmful. The number of moves needed to move the Towers of Hanoi is on the order of 2^k, where k is the number of discs. Assuming the survivability constraint is analogous, moving a complex cellular machine from say a set of 8 proteins that performs cellular secretion of toxins (Ken Miller's Type III secretory system), to a set of 20 proteins which act in concert with all sorts of supply chains (Behe's bacteria flagellum), takes an insanely large number of steps because each step needs to not kill the genetic vehicle. As proteins conservatively have about 100 amino acids each, this means 2000 amino acids. Each amino acid needs three different base codes, so that's 6000 DNA letters. If the mutations occurred only at this level of the DNA, it would involve on the order of 2^6000 moves to get from function A to function B, a number greater than 1E500. A modern evolutionary theorist would say, this number is big, but so is the number of organisms and things they could change into, and planets in the universe. True enough, but all these numbers are so large, I think its at least just as likely that evolution's probability of success is effectively zero, as opposed to one. As one can't really quantify these things (what is the state space of potential organelles that a Type III secretory system could be?), I think arguing too hard about one side being certainly true is difficult. I have never seen quantitative estimates by Darwinists, just hard waving about possible ways things could have arisen, as opposed to actual numbers and probabilities.

On the other hand, I often find evolutionary explanations very compelling and productive. Why are people who live towards the equator darker skinned that those at the pole (melanomas and vitamin D)? Why do some groups develop greater ability to digest milk (raising cattle for milk is more efficient than merely eating them)? It is absurd to think all these biological differences among humans are confined to unimportant things, and so we just have different culture to explain substantive differences between races. As if black Africans have a culture that appears to really value sprinting, and so it follows in the African diaspora. Kids everywhere race on their little legs all the time, the most obvious, cheapest, contest ever. Out of thousands of known mutations that cause disease in humans, only three are known to cause increased connections between neurons, and all three have surprisingly high frequencies among Ashkenazi Jews, even though those mutations have bad, even lethal effects in people with two copies. What are the odds this gene was not 'selected for', resulting in both highly lethal diseases and 112 average IQs for this group? Every Darwinian biologist agrees with the story that Africans have a greater propensity to get sickle cell anemia because of the evolutionary explanation: good if you have 1 copy, bad if you have 2. The only way such genes could flourish is because of the beneficial evolutionary effects of one copy of this gene. Yet, this same logic, applied to Ashkenazi Jews and their diseases and propensity towards higher than average IQ is supposedly a 'just-so story', because we know that some groups can't be genetically smarter than other people (on average).

Jerry Coyne is a professor of evolutionary genetics at the University of Chicago, and wrote Why Evolution is True. He spends 350 pages defending evolution. When it comes to humans, he allocates a couple pages to the concept of human races (they are real), lactose tolerance and sickel cell anemia, and notes that "My guess--and this is just informed speculation--is that human races are too young to have evolved important differences in intnellect and behavior. [p. 216]", and moves on. Wouldn't evolutionary theory be most interesting applied to current humans, as opposed to molluscs in the Tertiary period? Why is the origin of horseshoe crabs so much more interesting to these people, than the origin of the differences in behavior between expressive Italians and taciturn Amerindians?

I don't believe in God, and don't have an alternative explanation for how we got here from the Big Bang, but I look at the problem thusly: what is the chance that a nematode could, through mutation, selection, and reproduction, change into a horse? What is the total state space of mutations? What proportion of dead ends in the state space of changes that take us from a nematode to a human? Mutations can be point by point along the DNA, insertions, deletions, amplifications, or changes to the morphology of the the DNA (its folds affect its effects). The vast majority of these changes are deadly or irrelevant. The probability that such changes end in a dead end is very high. How high, exactly? Evolutionists agree, they just highlight that the number of organisms, the time, the number of planets in the universe, all outweigh this. I'm not so sure. We are dealing with numbers beyond our intuition, but just because one is really big, does not mean it offsets the one that is really small. One number might be 1E134 and the other 1E-163, both of which I have no intuition for, but the product is zero.

If the critics of evolution weren't so often biblical creationists, I think this criticism might be taken seriously. Yet even though it is important to understand the motivations and pretexts of your adversaries, it is not true that just because a view is sometimes, or even often, a pretext, that it has no credence. Further, my interest in biology and the history of life is actually increased thinking about the mystery, because it seems like a big unsolved mystery. For example, the DNA folds in a particular way so that certain regions of the DNA are physically close even though very far away in the sequence. How is this folding pattern regulated in the DNA? The idea that evolution is necessary as a motivation for scientific inquiry is simply absurd, because regardless of how life got here, it is interesting to know how it works.

I'm not religious, I just sense the probability that new phyla are create by incremental blind mutation, compounded with natural selection, to be so small it is implausibly the mechanism. I would like to see estimates of the state space of mutations that take a nematode to a lizard via molecular mutations. That is, within a factor of E20, how many mutations were needed to get from prokaryotes to dogs? How many times has this been tried? But like Global Warming advocates who insist the debate is over, for the Darwinists merely engaging this kind of question cedes too much credibility to their critics, so all they do is sneer, note homologies between species, discuss micro evolution (finch beaks, genetic drift in bacteria), and that this has been tried so many times in the universe it does not matter how improbable it is because Infinity times any positive probability generates a certainty. But surely some alien designer surely would have homologies in his toolkit and allow microevolution, and the size and existence of the universe is finite, so there are limits to how improbable something can be before we should expect it to happen (famously, the monkeys typing randomly would not generate Shakespeare's Hamlet given the 14B year age of the universe and a million monkeys--it is too improbable).

It has always been that people take the limits of their own field of vision for the limits of the world, but I figure that humans trying to completely explain their provenance given our brains is like a worm trying to understand where rain comes from. It's fun to think about, but I don't insist that our best theory must be true simply because its our best theory. Quantum physics highlights many bizarre facts (eg, the Einstein-Podolsky-Rosen paradox), and I'm perfectly content thinking I have no clue what is going on there and no one has a good explanation. I don't have answers, but I'm pretty sure that the current state of knowledge is just hand waving when trying to explain all life on earth. And I don't think it really matters much, that is, whether we were created via natural selection, panspermia, or are avatars in some giant computer game, I really don't think it matters. Evolution is real and important, I just don't think it has to answer everything to be so. After all, there are no theories in chemistry or physics or economics that explain everything. Saying a theory is incomplete is not a radical critique, just modest realism.

Meanwhile, human biodiversity has political implications that make it simply impossible to acknowledge in public arenas (eg, major academic journals, the New York Times, best sellers, at NBER conferences), and so evolution's most useful application is considered taboo by the very people who consider themselves morally superior to those who reject evolution on a priori grounds. Most people assume a slippery slope from acknowledging human differences, to subjugation, slavery and genocide (after all, Hitler believed in human biodiversity). Smart people like to point out they understand nuance, and here's a case where nuance is not being applied out of a belief in a 'greater good', or really, a 'greater evil'. The result is that evolution is a mess, as its main proponents apply it selectively and defensively, to the least interesting cases.

Keynesianism in Practice

Keynesian vs. Supply Siders can be a purely technical debate about substitution effects from issuing government debt, or multiplier estimates. But fundamentally, someone who want the government to spend more is a Keynesian.

The recenty Fiscal Stimulus bills is a pork-laden spending bill, designed to build and perpetuate a patronage system. Listen to Obama's response to such a criticism:

Speaking to a House Democratic retreat on Thursday night, Mr. Obama took on those critics. "So then you get the argument, well, this is not a stimulus bill, this is a spending bill. What do you think a stimulus is? (Laughter and applause.) That's the whole point. No, seriously. (Laughter.) That's the point. (Applause.)"

Well, that's the Democratic president, speaking in front of Democrats. I think it is not a caricature to say that for Democrats, all government spending is stimulus.

Edits on Book

I got back edits on my book, and some of the comments are pretty interesting. Clearly, my usage of "that" and "which" is almost as bad as guessing. Did you know that it is correct to say "435 BC", but then, "AD 800"? Or that there were two Rochefoucaulds? Further, somehow he/she was able to find my quotes of others, and though I thought I generally cut and pasted them directly from online texts, I made an unusual number of errors, perhaps as I re-wrote some parts from memory. Anyway, I'm spending a lot of time on it because I get only two weeks, and this is my last chance to make changes. I do find that having not had my manuscript for a while and looking at it anew, there are some plain errors, some really poor explanations.

It's funny because while I basically had the book done last spring and was very eager to get it out asap, the time since I got Wiley to publish it has really allowed me to make it much better, with often major substantive changes in my arguments. The process of a book, the time, the scope, the depth, make them a unique way to present an argument in a way that articles or blog posts simply can't match, because its a sustained, consistent argument. My hope is that the argument is consistent and concise as possible, because rarely do I read a 300 plus page book without thinking it could have been a 200 page book, where some chapters seem unnecessary.

Nudge in Practice

Cass Sunstein and Richard Thaler wrote Nudge, which argues a seemingly reasonable amount of paternalism can make the world a better place. The main example is changing default options, because most people choose the default option, and so if the default option is to invest 6% in the retirement account, in an index fund, that will probably be the modal choice. As saving for retirement, and index funds, are good iddeas, why not make that the default? Who could be against that?

Well, while that particular default option is not a problem, if you give large institutions power to nudge in various ways they have the power to do a lot of damage. Take housing. In John Campbell's 2006 American Finance Association Presidential Address, he examines household financial choices, and notes that many households do not refinance when rates go down, which is bad for them. Thus he makes the seemingly innocuous policy proposition:

In mortgage markets, the U.S. government plays a major role through GNMA and its sponsorship of FNMA and FHLMC. The ability of these agencies to issue low-cost debt has likely reduced the cost of the mortgages they hold. The agencies have traditionally favored nominal fixed- rate mortgages, and it is plausible that they could encourage the use of mortgages with inflation adjustment or automatic refinancing feature.
...
Finally, recent research in behavioral finance finds that default options–standard choices that households believe to be recommended by authoritative bodies–have a powerful effect on household behavior. The mortgage policies of GNMA, FNMA, and FHLMC may influence house-hold mortgage decisions through this channel as well as by driving down the cost of standard mortgage contracts.

In the context of his talk, he is clearly arguing a nudge policy by the influential, government-backed housing agencies. They are there, setting precedents for this market, so why not add the good ones Campbell sees are obvious?

Well, many other people thought of this first, and so GNMA and the rest were leading the charge in our subprime debacle using this same logic. Under the pretext of increasing home ownership--especially traditionally under served minorities--they got several large institutions, including but not limited to GNMA, FNMA and FHLMC, to nudge policy towards no income check, low or zero down payments. This was done in innumerable ways (the Fed and OCC approving mergers), as one would expect when billions of dollars are at issue. It's good policy, so why not? The historical default rates on residential mortgages was near zero for so long, mortgage risk was synonymous with 'prepayment risk' until 2006, as default rates were never large so off the radar scope.

If you give government-enmeshed institutions the power--indeed the obligation--to nudge people in view of some greater good (eg, more savings, owning a home), it will have a tendency to become co-opted by people using some principle as a pretext for less salutary objectives. I think the Nudge crowd needs to better appreciate that not everyone is as objective as an academic writing about a handful of good ideas that have been vetted for decades among his colleagues of diverse political affiliations (eg, the default choice on employee investment plans). There are lots of 'root causes' that can be addressed by a large institution, so the list of potential disastrous conflations of the public good with self-interested hucksters is impossible to enumerate.

If you give some institution great power to nudge, it has great power, and power is always corrupted.

High Risk, Low Return, Perfectly Consistent

Andrew Ang, Robert Hodrick et al wrote this piece on the Cross-Section of Volatility and Expected Returns. I'm about to get my edits back on my book, and so I'm rereading some of the works I reference. I had to spend a lot of money to be able to use or talk about the fact discussed (never mind it was in the public domain or my direct examination of this in my dissertation), so its a subject close to my heart. It's a pretty funny bit of post-modern finance.

They spend the first part of the paper presenting a formal conditional multifactor model. They then immediately note that "however, the true model in equation (1) is infeasible to examine because the true set of factors is unknown and the true conditional factor loadings are unobservable." Well, it was fun to go over anyway I guess.

Then they develop a factor mimicking portfolio by finding stocks that mimic the changes in the VIX index, and then sorting stocks by the prior correlations with the VIX changes and creating a portfolio of stocks correlated with future VIX changes. They then show, in true Fama-French fashion, that cross-tabbing portfolios formed on sensitivities to the changes in the VIX, are sensitive to the changes in the VIX! But the effect is small, as they estimate the price of volatility risk as -0.08% per month, factor loadings on the pre-sorted portfolios fall by a factor of 100, and adding or removing one August 1998 or October 1987 reverses the sign of the result. So, statistically significant, but not economically significant.

And totally unnecessary because it was motivated by the following, which basically insured the above '25-portfolio-Fama-French' test would work statistically. When they group stocks by low to high total volatility the stocks with the highest volatility had the lowest returns, so the 'price' of volatility is negative. They check robustness by presorting the stocks first by size (market cap), and the effect still shows, They do this for 8 or 9 other things. That's all we needed to know. The early part was less convincing, less intuitive, than the latter part. Good statistics is mainly about knowing what to control for, and these tests make it pretty clear that the obvious alternative hypotheses are not going to explain this. If you know X is correlated with returns in the presence of other variables, the Fama-French test is redundant, and suggests a spurious rigor that is not there.

Then, they get to the explanation, which is solid gold. Remember, higher volatility is correlated, cross sectionally, with lower returns empirically. What rational story might explain this?

our estimate of a negative price of risk of aggregate volatility is consistent with a [unspecified] multifactor model or Intertemproral CAPM. In these settings, aggregate volatility risk is priced with a negative sign because risk-averse agents reduce current consumption to increase precautionary savings in the presence of higher uncertainty about future market returns.

You see, in the Stone Ages we were taught higher risk implies higher return. Modern asset pricing just adds the nuance that higher volatility assets have lower returns, because of the offsetting demand for more savings (huh?). The specific model that generates that is an exercise for the reader, but I guess it could work, especially if we factor in the many worlds interpretation of reality, because I'm told there are universes where the Statue of Liberty waves at tourists when they sail by. But even there, the fanciful interpretation only works if you emphasize the factor loading stuff that was not economically significant, and not very compelling (note, it was not duplicated in their follow-up paper that documented this internationally). It's kind of like how Global Warming causes Global Cooling when you read the above rationalization. The bottom line is that stocks with higher volatility, that perform worst when times are really bad, have lower relative returns.

You can only get away with this kind of enlightened blather if you appear appear 100% serious and rigorous, even though the rigor only occluded the real result of this paper. If you just said, the standard model can't explain this, well, I know what happens to those papers.

Righteous Bonuses

Obama is rightly upset about the size of bonuses handed out when banks are getting a federal bailout, but not every bonus is undeserved, so it is not as easy as saying there should be zero bonuses until things are fixed. They key is how close they were to the decision making process. If someone in charge of a complex portfolio has his bonus cut back to zero, implying his future bonuses are also in peril, he has good reason to bolt and start at a new place. Worse, he has an incentive to screw up his portfolio by giving away securities to friends of his on the Street (brokers, other traders he deals with), building up a set of favors for his next position. Once there, the buddies he sold securities to at 72 when they were trading at 78 will remember him.

The reason we pay people a lot is because we think they are worth it. Many times they are not, but not always. A fund I know shut down one of its funds and people there basically gave away their positions before they left, making payments to the favor bank, for when they went to their new jobs. Why? They were told there would be no bonus, just exit your positions, and get your 1 month severance. A zero bonus is a horrible incentive structure for someone in charge of a portfolio, and it is not feasible to think your back office or audit group can monitor this. The portfolio managers know the best price, outsiders don't, that's why they get paid a lot. In the context of a moving market, and illiquid securities (such as mortgages), you don't really know how much money you are leaving on the table, but look at the incentives at the individual level, and expect people to act in their self interest.

Many times, bonuses are layered: the PM gets 10%, his boss gets 10% or the CEO gets another 10%. Infamous trader Joseph Jett made $9MM in his 1993 bonus (off fraudulent profits), and had to pay it back. His boss, Ed Cerullo, got $20MM in bonus that year in large part because of those same fraudulent profits. Cerullo was worse that Jett in that he not only had no idea what Jett was doing, but got paid more than Jett based on his activities, then was not held accountable (Cerullo paid a $50k fine and did not pay back any of his bonus)! This is why we mock 'management'. These higher ups can and should be squeezed.

Fundamentally, there is a continuum of rents earned from capital to labor. Those with special knowledge, or whose effort is difficult to monitor (even ex post), has alpha, because you can't necessarily replace him with a wage slave. Those with alpha negotiate with those with capital to share the proceeds of their venture, and they should be thought of as movie stars, those with talent, that get paid a bunch, but they aren't management, they aren't making strategic decisions. Management is sort of in the middle between capital and alpha, so there needs to be a judgment call as to how much these guys should make, but they generally aren't alpha producers. They tend to be overpaid, because they used to be on the front lines, and now manage those people, and using logic similar to a union (more senior people get paid more), think that anyone managing others should get paid more than them, via a cut of all their books. This is generally overdone, only because those setting their pay usually need the support of these managers, making it difficult to cut their pay. In these times, it would be a very good place to start docking all those Executive Vice President and Head of Global Market Derivatives, because there are lots of replacements on the street.

John Thain, doesn't need a bonus, nor any of his direct reports. But leave the lower level guys alone, regardless of their take. It may not be fair (isn't a schoolteacher worth more?), but they are in a position to do a lot of damage if you zero them out. These are the Atlases you don't want shrugging.

Prognosticators: Right but Wrong

Peter Schiff talked about the subprime crisis before it happened, so unlike others, he actually fingered the prime mover. But he also predicted that this would imply a weaker dollar and the US equity market would underperform. This latter implication seems totally reasonable, and highlights how tricky it is to predict the future, because even if you have a crystal ball and see one part of the economy doing something, the complexity of the economy makes it not obvious as to how best to play that hand. From the WSJ:

Peter Schiff predicted a collapse of the U.S. financial system. The bust-up he didn't foresee was the one that made mincemeat of investors who took his advice in 2008.

Mr. Schiff's Darien, Conn., broker-dealer firm, Euro Pacific Capital Inc., advised its clients to bet that the dollar would weaken significantly and that foreign stocks would outpace their U.S. peers. Instead, the dollar advanced against most currencies, magnifying the losses from foreign stocks Mr. Schiff steered his investors into.

Investors open accounts at Euro Pacific to take advantage of Mr. Schiff's investment advice, which generally involves shunning investments in dollars. Individual returns can vary. Some investors may like gold-mining stocks, while others prefer energy-focused stocks.

Most had one thing in common last year: heavy losses. A number of investors said their Euro Pacific portfolios lost 50% or more in 2008, worse than the 38% drop in the Standard & Poor's 500-stock index last year. People familiar with the firm say that hardly any securities recommended by Euro Pacific brokers gained ground in 2008.

Sports are Meaningless, So is Life

A letter to the editor in my local paper makes the most whiny observation on the Super Bowl I have read in a while:

Despite tough times, the football fans, being who they are, will see the game as almost a religious experience. But, when the stadium lights go out on Sunday night, will the country be a better place? Will its citizens be in a better place? No! Will the Super Bowl have benefitted anything or anyone other than the entities listed above? No! Jobless numbers will continue to rise; 45 million, including 18 million children, will still be without health insurance; schools will continue to hold bake sales to raise funds; much-needed human services will continue to be cut; veterans and the care they need will continue to be ignored; the causes and cures of deadly diseases will still remain a mystery, and government's indifference toward the average American will continue.

Well, that guy is a real buzz kill. As someone who does not believe in God, I think that all meaning is put into life by humans. That we enjoy sporting events, which are unimportant in themselves, is very important because all of life is about putting meaning and interest into intrinsically unimportant things. Existentialism sucks if you take it to mean 'I must find deep meaning and fix the problems of the world', rather than, 'life's pointless but interesting and fun'. Things that give me pleasure are all pointless in the context of a large, cold, world with injustice, death, and the eventual catastrophic ending (the sun will run out of fuel someday). If you think about poverty, the meaning of life, disease, and inequality, ALL THE TIME you won't be any happier, and won't improve upon those problems any faster.

As the great philosopher Frank Dreben said in Police Squad 2: "Maybe the problems of two people don't amount to a hill of beans. But this is our hill. And these are our beans!" Keep to your beans, and enjoy them.

Merit Pay and Teachers Unions

There is little accountability in teaching, as pay is based on seniority and degrees, because the unions do not want to give someone power to evaluate actual performance. In 2002, the Los Angeles Board of Education tried to remove 400 of the 35,000 teachers in a low performing district: in the end they were able to remove 3 (Policy Review, April 2004, page 26).

In Minnesota they introduced a program of 'merit pay' for teachers. As reported in the Star Tribune:

The program, called "Q Comp," is one of Gov. Tim Pawlenty's top initiatives to improve schools, and many educators say it is strengthening teacher evaluations and training. But others are questioning whether Q Comp has just become a cash handout.


Only 27 of the roughly 4,200 teachers eligible did not get a pay raise.

A merit criteria where 99.936% of people pass, is a strange definition of merit. In theory you can emulate the benefits of competition via trial and error and internal evaluation of costs and benefits at the margin. In practice, insiders simply protect their turf and nothing fundamental changes when they are evaluating their own productivity.

Thus, when United Auto Workers president Ron Gettlefinger argues that US autoworkers are more productive than non-union US counterparts:

According to the Harbour Report, the industry benchmark for productivity, union-represented workers are actually more efficient than their counterparts at non-union auto plants

If you exclude certain things, include others, I suppose he is right, but the bottom line is that work rules and benefits all add up to labor costs over 50% higher for UAW auto companies, and the net net is that US auto companies have not made any money making cars in 10 years, while the Japanese have. Productivity is the result of competition, not introspection by self-interested producers.

Landscapes Rule

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

Mortgages are Bank Assets!

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

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

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

BSDs Take Note

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

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

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

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

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

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

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

Selection Bias at Conferences

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

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

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

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

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

Backtesting Errors

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

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

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

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

What is the error?

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

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

Deephaven to Close

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

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

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

PermaBear Wisdom

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

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

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

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

Geron up 50% on Hope

The WSJ noted:

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

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

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

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

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

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

Fedor Awesome

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

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

Big Government's Big Effects

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

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

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

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

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

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

Keynes and Ellsberg's Paradox

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

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

GE May Lose AAA Rating

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

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

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

Bank Directors Often Empty Suits

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

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

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

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

Plausible Theories

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

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

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

The Case for Financial Stocks

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

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

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

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

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

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

They Didn't Use the Seat Cushions!

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

Experts are Curmudgeons

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

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

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

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

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

GM shorts pay 50% Annual Rate

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

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

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

Call-Put=PV(Forward-Strike)

As interest rates are near zero:

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

QED

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

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

Economists are Modelers

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

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

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

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

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

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

Rubin's Defense Suggests He was Overpaid

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

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

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

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

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

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

Austrian Business Cycle Theory

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

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

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

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

New Metaphor from Tough Minnesotans

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

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

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

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

Too Many Experts

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

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

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

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

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

Risk and Return Confabulations

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

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

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

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

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

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

Taking Things for Granted

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

~Alfred North Whitehead

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

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

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

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