This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
Let’s start with the more esoteric of the two books, The Complete Guide To Option Pricing Formulas.? Almost every option formula is included there, together with ways of estimating volatility, certain statistical techniques, aspects of compound interest math, etc.? The book is very comprehensive, and for those that need how to estimate the value of standard and non-standard options, it is a good book to keep on hand as a reference, together with the free CD-ROM containing an Excel add-in that allows you to use the formulas inside Excel.? I have used them for some of the insurance companies I have worked for; the software was easy and reliable.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
There are quirky aspects to this book, including cartoons and photos that are somewhat self-aggrandizing to the author, but make the point in a humorous way.? I liked both books, but only a modest fraction of my readers should have any interest here.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? My objective is to aid my readers, and not explicitly take money from them.
Ding!? Round one ends in the legal fight between Bloomberg, LP, and The Federal Reserve.? The Columbia Journalism Review provides a summary, as does Bloomberg itself.
Here’s a redacted version, showing the changes.? (Please note I scanned two bitmap documents, and did OCR on them, and ran a document compare — there may be some errors here, but I did the best that I could.)? The main expansion of the complaint is the inclusion of a request for documents related to the Bear Stearns rescue.? It also clarifies that it is looking for loan records.
Here’s the the Fed’s answer to the amended and expanded complaint.
The Fed’s basic response is that no documents exist for some of the requests, that it has turned over some documents, but is holding onto pages of 231 documents for which they claim to have an exemption under FOIA.? They claim exemptions 4 and 5, which are (from Wikipedia):
4) trade secrets and commercial or financial information obtained from a person and privileged or confidential;
5) inter-agency or intra-agency memoranda or letters which would not be available by law to a party other than an agency in litigation with the agency;
This is just my take, and I could be wrong, but it seems to me that the Fed refuses to disclose on the grounds that the documents are sensitive since they contain confidential financial information, or, they involve inter- or intra-agency communication, such as with the Treasury, or inside the Fed itself.? Point 5 seems to be a pretty broad exemption, but it remains to be proven whether the information is of such a nature that only an inter-agency suit could force divulging the data.
The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn?t lend against.
They are playing favorites with institutions, and don?t want that to be revealed.
The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
Certain banks would be embarrassed by revealing what they own.
It?s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).
As pointed out in the Bloomberg article above, there is a good possibility that they are trying to hide the amount that they have lost already.? Also, as I have pointed out in my last piece on this topic, the insurance industry discloses everything with their assets, and it does not harm them.? It would not hurt banks to do the same, and certainly if it is a matter of this one limited disclosure, the confidentiality of the banks would probably not be materially harmed.
So, I tried to replicate it, and got close — my data only begins in 1952, but the shape of the graph from there is similar, though the levels are a little lower.
/www/alephblog.com/wp-content/uploads/2008/12/
The debt figures came from the Federal Reserve’s Z.1 report, adding the Domestic nonfinancial sectors and Domestic financial sectors data from the D.3 table.? I think I would reproduce the first graph if I added in the foreign debt, but that is money borrowed by foreign institutions from US institutions.? But, that’s not what I am trying to analyze.? I don’t care about the debts of other countries (for this purpose), only that of the US.
This graph tells two stories:
1) Increasing financial intermediation over the last 56 years, with a small over-reported disintermediation in the mid-70s.? (For this purpose, money market funds are intermediaries.)
2) Relatively stable debt levels until the middle of the Reagan Administration, and then a rapid increase over the next 23 years.? The increase was faster for the second term of Reagan, and for Bush, Jr, and slower for Bush, Sr, and Clinton.? That said, the increase in financial intermediation accelerated during the terms of Bush, Sr, and Clinton.? Securitization was running ahead, and no one was questioning it.
Upshot
From 1984 through 2008, the financial system of the US experienced a quantum leap in terms of size and complexity, which was enabled by regulatory policy and monetary policy.? Monetary policy did not take away the punchbowl, and regulatory policy did not check to see if banks were lending prudently or not.? Both were corrosive in the long term to a fiat currency system in the US.? Both were promoted by politicians, because they accelerated “prosperity” in the US.? Pity that the prosperity was fake in aggregate.
My friend Caroline Baum argues that central banks should fight debt and asset bubbles.? I agree.? Perhaps if central banks should have a dual mandate, it should be to maintain? a certain inflation level (fairly calculated), and a certain debt/GDP ratio, say 150% at maximum.? Ignore labor unemployment, and let people maximize their efforts within a paradigm that would not be given to big booms and busts.
I think this would be a good system, but I am open to comments.
1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.
2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?
4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.
5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.
6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.
7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.
8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.
9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.
11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.
12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.
13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.
14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.
Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.
The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.
An End to Redemption-Related Selling by Hedge and Mutual Funds
Increased Lending
Tax Cuts
I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”
19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.
20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:
Endemic Political Corruption
Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.
21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.
I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.
23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.
24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).
After my piece yesterday where I ran a regression on Shiller’s data from 1871-1998, I got some comments pointing me to this piece at Clusterstock, citing the estimable Richard Bernstein.? I will confirm what was suggested: after 10-year negative total returns, the returns are always positive over the next ten years in the US context, 1871-1998.? The average is a ~7.5%/yr return.
But not so in Japan.? We can talk about lost decades here, but in Japan the stockmarket has gone nowhere for over 20 years.? Given some of the Japan-like remedies the US is pursuing, why should we expect returns that match the historical averages?? Japan went through a period where debt levels were a very high multiple of GDP, like the US is at today.
When conditions are abnormal due to very high debt levels, one must factor that in, and not give credibility to statistics realized during periods with low debt levels.
Remember, my model can be used in two ways: in the red zone, for short term momentum players.? (Look at all of those relatively stable predictable industries.)? Or, the green zone, for value/contrarian players.? (Look at all of those cyclicals and financials.)
Which do you think will do better?? Mean reversion or relative safety?? My portfolio is spread across both, so I don’t have a dog in that fight.? I do think that portfolios in this environment have to aim to be self-financing, avoiding the need for capital raises in an environment where capital is scarce.
Away from that, I am still not a believer in financials, aside from insurers, and I don’t see much good among housing or autos, regardless of who gets bailed out.
After I wrote the piece on momentum, I thought, “Wait a minute.? Momentum and valuation are stronger together than separate — run the calculations and write a new piece.
That’s what led to this article.? I added valuation metrics to the momentum regressions for one month and one year returns and found they were of little value.
Ouch. Not what I expected, so I tried momentum and valuation variables to predict ten-year returns. The results for the regression were significant.
Some definitions:
Last year: total return over the last year for the S&P 500
Last month: total return over the last month for the S&P 500
Last 10: total return over the last 10 years for the S&P 500
DP: dividend yield
EP: earnings yield
Int: 10-year Treasury yield
Inflation: trailing 12-month inflation from the CPI
EP10: earnings yield using trailing 10-year earnings.
Trying to forecast ten years into the future, technical variables diminish and fundamental variables show their stuff.? As I have stated before, both current period and long term earnings matter in estimating fair value.? Though I am using Shiller’s data set, it shows that 10-year average earnings are not enough.
That is a big enough finding on its own, but I have something more: using this formula, stocks are expected to earn 2.26%/yr over the next ten years.? After a pathetic decade, do we have another to come?? I(Ask Japan, they have gotten zero over more than 20 years…)
Why might that low return be true?
Bad momentum begets bad momentum.
Government bond yields are low offering little competition to stocks.
Earnings yields still are not high.
Valuations are better than when I wrote the piece, Kiss the Equity Premium Goodbye, but the same problem still exists to a lesser extent.? Where are the projects with high returns on assets that can easily be invested in?? At present, we are not seeing them in bulk.
That is what helps laed me to consider that corporate bonds and bank loans may still be better investments at this point in the cycle — less downside and perhaps a competitive upside.
I often fail, and am no good at identifying short candidates because I am not good at timing.? I can spot a bad balance sheet easily, but often companies with the worst balance sheets soar during the bull phase of the market.? What that suggests to me regarding shorting is:
During the bull phase identify bad balance sheets, but don’t short anything.? Make your list of future failures.
Watch for when junk yields rise over 500 bps, then start shorting the names you identified.? There is a risk that you can’t get a borrow, but then buy puts if you can’t get the borrow.
So, maybe I could do shorting.? I’ve gotten a lot of names right, but timing is problematic.? You don’t want to short names too soon, or you won’t be able to carry your position to its demise.? But one name you could not short (using stock) was Tribune after Sam Zell took it private.? I wrote twice about Tribune, and for two reasons:
As I have said elsewhere, it stinks that Sam Zell influenced Tribune employees to invest in a failing business.? It is usually a bad idea to invest in the company that you draw wages from, because it lacks diversification.? Beyond that, if the buyout by Zell had lasted five years, I could argue that the employees had gotten their money’s worth through wages.? As it is, after one year-plus, they got hosed.
It’s sad, and it may get sadder still, as other newspaper holding companies die.? Will the New York Times survive?? Maybe.? What I do know is that its economics are poor, and that they are borrowing against their last solid assets.? Does that sound like a recipe for success?
Just a quick note because I am tired, but Ken Heebner has turned bullish on financials.? I’m not there yet, because I think there is more pain to come in losses from benk lending in HELOCs, Credit Cards, Commericial Mortgages, etc.? I am slightly underweight at present with exposure to insurance only.
I admire Ken Heebner a great deal… I think he is early here, unless collateral prices stop declining.? Unlike Ken, I think the actions of our government will prove ineffectual.? Perhaps it would be better to buy the bank loans or senior debt of these firms.? Less downside, and reasonable upside.
Sometimes I wonder whether there are elements of the economic system that are hard to discern, that lead economic players down a path they want to go on in the short-run, but don’t want to go on in the long-run, but that short-run choices inevitably lead to a bad long-run result.? Another way to say it is that past mistakes were the result of logic that linear thinkers would consider rational even now.
This post derives from MIchael Pettis’ post regarding a post of Dani Rodrik.? Beijing wants to employ many people who are migrating from the farms to the cities, and so it wants to produce more goods that they can export.? To make those goods competitive, they don’t want the Yuan to appreciate.? And over the past week, it has depreciated.
If you want a Keynesian stimulus to work more powerfully, you don’t want its effect to leak out to other nations, and thus, a tendency toward protectionism.? Interventionism begets more interventionism.? Everyone protecting their own interests leads to a collapse of the division of labor, and greater poverty.
No fun, I say, and it will be interesting if the US and China can strike a better deal than protectionism.
This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
