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.