Academic Finance – Page 10

The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models (II)

Posted on 13 December 200814 December 2008 by David Merkel

One of my commenters wrote in response to my piece Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models:

Kurt Osis Says:
December 13th, 20085:05 pm at EditDavid:

How can advocate people using these models which clearly don?t work? Estimating volatility is a suckers bet. Even if you could estimate the underlying ?actual? volatility with 100% accuracy there would be sample error in your realized volatility. And of course the volatility isn?t just changing, the fundamentals of the underlying are changing.

I once heard of a man named Mandelbrot who said volatility was infinite, in which case these sigmas and lemmas are a bit beside the point, no?

Kurt, I’ve met Mandelbrot, and have discussed these issues with him.? The two books that I recommended are also up on those issues.? Implied volatility estimates as applied to option pricing formulas are a fall-out.? No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.? That is the philosophy behind the books that I reviewed.

I’m on your page, Kurt.? Variance is infinite, and B-S blows up.? But within the options world, there has to be a way of calculating relative value, and these books aid us in that calculation.

If you think I am wrong here, go to your local library, and get these books via Interlibrary loan.? Read them, and you will see that we are all in agreement.

One Dozen Observations on the Current Market Stress

Posted on 2 December 2008 by David Merkel

1) What a mess.? I had been lightening up on equity exposure over the last week, but seemingly not enough.? The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months.? Well, at least I admit it when I lose; let’s see if I can’t do better in the future.

2) The rally in long Treasuries is the cousin to the fall in equities.

A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%.? That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run.? The long run is another matter.

3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries.? If I may, what isn’t the Fed going to buy?? Do they really want to flatten the yield curve when the long end is this low already?? Don’t they have enough to do with instruments that have credit risk?? They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.

4) One example of that is the junk bond market, where the average yield is now over 20%.? Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.

5)? So I’m not impressed with the FDIC insured bond offerings from a public policy standpoint.? They crowd out non-guaranteed bonds.? But I would be inclined to buy the bonds in place of allocations to Treasuries or Agencies.

6) TIPS, excluding the long end, are trading below par.

Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities.? The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation.? I don’t see that coming over the intermediate-term, but in the short-term we could see that.? Eventually the Fed will have to monetize many of the promises that it is making.

7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP.? That is a true horror.? I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now.? My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.

8 ) It is no surprise here that GM is scrambling, as are the other automakers.? Let them try to get debtors to compromise.?? They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy.? They have refused to accept some liabilities in the past.

9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved.? I guess it took Paulson longer to realize the immensity of setting up those auctions.? It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.

10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan.? (Note the dirty float free market-like movements. 😉 )

Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.

It would be a simple matter of fairness as well.? As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.

11) It’s my view that the economics profession comes out of this crisis with a black eye or two.? There is a lot of room for humility here.? Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.).? That is a strength of the Austrian school, though.

Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller.? The way that assets are financed does make a difference when there is financial stress, and even more in insolvency.? Also, the financing windows are not always open.? Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments are not valid except when the market has “fair weather.”

12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply.? Personally, I don’t think it will work.? It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive.? Three last semi-related articles that I found interesting:

T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them.? There are some dangers though:

a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.

It might be better for the US Government to lock in long funding rates while they are available.? Who thought the 10-year or 30-year could be so low?

Sell Stocks, Buy Corporate Bonds

Posted on 8 November 20089 November 2008 by David Merkel

I have lots of models, but I am only one person, so some of my models sit idle becuase I don’t have time to update them.? Well, today, as I was reading Barron’s, I ran across the “Current Yield” column, and read this:

THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That’s not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody’s and Standard & Poor’s designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That’s a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. “I haven’t seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002,” says Arnott.

Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.

You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there’s never been such a full-court response to the threat of debt deflation — the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve’s balance sheet in just over two months.

I know things are bad in the corporate bond market, but I didn’t think it was that bad.? This made me ask, “Hmm… what about my stocks versus bonds model?”? That article is one of my better ones; a lot of time and effort got poured into that.? So, I sat down and re-engineered the model, since, embarrassingly, the original model was lost.

The key question is whether the yield on BBB corporates is more than 3.9% higher than the earnings yield on the S&P 500.? The answer is yes, and that means we should sell stocks and buy corporate bonds.? But, here is the embarrassing thing for me.? The first recent signal to sell stocks and buy bonds came in mid-August, but since I didn’t track the model regularly, I missed that.? Since the original model worked off monthly data, even selling in early September would have preserved a lot of value.? It is not as if corporate bonds have done well since August, but they have done much better than the S&P 500.

Here’s a graph summarizing 2008 via my model:

When the green line goes over 3.9%, it is time to buy corporate bonds. That is not a frequent occurrence; this model gives of signals only a few times per decade. Check out my original piece for more details.

So, with that, I offer my conclusions:

It is still time to allocate money to corporate bonds versus equities.? Where I have flexibility with my own money, I am allocating money away from Equity and to BBB investment grade and high yield corporates.
Though there are a lot of reasons to worry, corporate yield spreads discount a lot of trouble.
The model indicates a fair value of the S&P 500 at around 700.? Uh, I’m not predicting that, but if we hang around at yield levels like this for long, yes, the equity market will adjust to the competition.? More likely is the equity market treads water while corporates rally.
A caveat I toss out is that all areas of the credit markets where the government is not meddling are disproportionately hurt, because investors are fleeing toward guaranteed areas.? Thus, corporates are hurting.
College endowments and other investors that hate to buy conventional assets should consider corporates now.? It is my bet that a portfolio of low investment grade and junk grade corporates will outperform a 60/40 portfolio of Stocks and T-Notes.
If you have the freedom to sell protection on a broad basket of corporates, this might be a good time to do it, when everyone else is scared to death.? Time to insure corporate credit, perhaps.
One more caveat before I am done.? The rule has only been tested on data since 1953.? It is not depression-proof.??? I hope to gather the data from that era and validate the formula, but that will be difficult.

So, be careful out there, and remember that corporate bonds typically do better than stocks in a prolonged bear market for credit.? Yield levels like the present typically bode well for corporate bonds versus stocks.

Blame Game

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

The Banking Industry Should Learn from the Insurance Industry

Posted on 2 September 2008 by David Merkel

I can’t comment on everything, at least above the degree of quality that I try to impose on myself.? (I know, the standards could be raised. 😉 )? But I did want to comment on a paper on banking capital regulations that came out of the Jackson Hole conference.? Odd Numbers and Naked Capitalism commented on it, and I thought both had good things to say.? I have my own twist to share, having been a risk manager inside two insurance companies.

The basic idea of the paper is that risk levels have to be reduced at banks, but banks want to stay highly levered so that they can earn high returns on equity, so asking them to reduce debt levels or internal leverage is not feasible.? Instead, why not have them buy insurance policies that pay out during banking crises?? Then they will have the capital when it is needed, and they can continue to lend in all environments.

(SIgh.)? I have oversimplified their arguments, but I have done it to help make some points, which are:

1) The cost of the insurance policy will get factored into the equity calculation for return on equity, at least at far as a prudent bank manager would view it.? The insurance policy is illiquid, and its cost should be reckoned as a part of the surplus it replaces, which may allow for a reduction in overall surplus levels carrying the business.? (Note to regulators: anytime you allow a financial entity a reduction in required surplus from a risk transfer agreement, you should analyze the alternative of using the premium(s) paid to add to surplus, and ask, which looks better.? Also, these are collateralized agreements, but in uncollateralized agreements, analyze the counterparties, and deny surplus credit frequently.)

2) Do the authors realize how expensive these agreements should be?? Consider:

The insurer is asked to post the collateral, which takes money out of its surplus.
The insurer is asked to be ready to lose an asset at a very bad point in the credit cycle.
The monies are invested in Treasury securities, so there is no possiblity for the insurer to make money from investing the premium more aggressively, but still safely.
Large banking crises happen about once every 20 years or so, with smaller ones more frequent.? With a long enough agreement, the loss of the Treasury collateral is almost certain, making the cost high.
If these were common, a sort of moral hazard would develop, similar to what has happened with the financial guarantors.? Banks would conduct business aggressively, realizing that they have the capital backstop.? Initial results would look good, until the crisis. Then, double surprise! The insurers figure out that they didn’t charge enough for the insurance, and the banks find out that their losses were larger, because of their aggressive behavior.? Wound banks be willing to pay premiums around 5-15% of the face amount insured, depending upon where the risk trigger kicks in?

3) Beyond that, there would probably be a scarcity of providers.? Few want to dedicate a large portion of their capital bases to the events that are entirely a process of human action.

Take a lesson from the reinsurance industry.? Ideally, you would want an agreement that took the risks directly off of your books, such that the capital would come when you specifically had losses above a threshold.? That’s been done in the insurance industry for reinsuring companies as a whole, and the reinsurers have usually come off the worse for it.? The insurers almost always know their risks better than the outsiders.? Reinsurers prefer to reinsure specific risks that they can underwrite, not companies as a whole.

But, lest I merely seem to be a critic, let me offer three suggestions for how to try to make this work.

1) Call Ajit Jain at Berkshire Hathaway.? They have the capital.? Give him a detailed proposal of what you want, and let him give you the quote that makes your jaw drop, or, watch him decline the business, unless you put your bank into a straitjacket of terms and limitations of coverage.

2) Try setting this up through an Industry Loss Warranty.? You would get paid capital during bad times if the industry has suffered losses past a threshold, and you have suffered losses in excess of a threshold as well.

3) Or, try setting this up as a catastrophe bond.? Borrow money through the bond at a high rate of interest.? Junk bond buyers will fund you.? During a crisis, if the banking industry losses exceed a threshold, the principal of the notes gets written down, and voila!? You have capital when you need it.? Note that the junk bond buyers should require more of a premium here, because bank losses tend to be correlated with other junk bond losses — no big benefit from diversification here.

I will leave aside the idea of setting up captive reinsurance sidecars, because those are just regulatory arbitrage.

My main point here is that I don’t think that this type of insurance will work.? Even for those willing to contemplate the structure, the true price will be too high for the banks to gain any benefit.? Perhaps this could be done on a limited basis for one more turn of the credit cycle, but I think for those that offer the insurance, the banks that buy it, and the regulators, they will be less than happy with the results.

In my opinion, we need to bring down leverage ratios for the banks, slowly but inexorably.? If that hurts their ROEs, well, I’m sorry.? If we are going to do a leveraged fiat money system, the leverage must be considerably lower than where we are now, and all synthetic exposures (derivatives) must be brought on balance sheet as if they were cash transactions.? It is that lack of transparency and increase in leverage that has made our financial system so much more risky, as this other paper from the Jackson Hole conference states.? I did not feel that the discussants really understood what they were talking about, because they could see the micro level risk reductions from derivatives, but miss the added leverage, lack of transparency, and concentration of risk in the hands of parties that were greedy for yield, and may not be able to make good on all agreements in a crisis.

Much complexity and leverage will need to be unwound before this credit crisis is over.? The era of high ROEs for banks should be over for some time, that is, until the regulators fall asleep again during the next boom phase.? Some things rarely change.

How I Evaluate Investment Managers

Posted on 27 June 2008 by David Merkel

This post will probably be too brief, but here goes.? The most important aspect of analysis is trying to gauge any sort of sustainable competitive advantage.? Qualitatively, do they really have something special going that other are unlikely to imitate?? Second, do they fit their paradigm?? If they are growth investors, do they use momentum?? If they are value investors, are they willing to be wrong for a while?

Third, how do they handle lesser questions like earnings quality?? Do they look at cash flow, free cash flow or earnings, and how do they justify their answers?? Do they have a decent decisionmaking process, given that managers that trade less tend to do better?

Finally, have they been successful?? Do they win, and do they win for the reasons that their methods would favor? Good track records that emerge for reasons other than managerial intentions are unlikely to be repeated.

Now what don’t I look at?? Sharpe ratios and other quantitative measures of risk.? The measures aren’t predictive of future performance, and the risk adjustment is too short term in nature.? These measures are backward looking, and not indicative of future performance.? Better to spend time sweating over how a manager chooses assets, limits risks, etc., than to focus on quantititive measures of risk that have no relation to long term performance.

I am NOT Your Public Relations Outlet

Posted on 27 June 2008 by David Merkel

Hi.? I’m back home, and happy, before a one-day turnaround where I leave again.? We were able to get the business of the church done one day ahead of schedule.? While at the meeting, I had no internet… there is something odd about my laptop that blocked them from connecting me, and, they messed up my laptop in trying to connect me, so that I can’t use my dedicated line.? Kinda sad.

One quick rant because when you get a boatload of e-mail at once, things get clearer.? I think someone has created a mailing list for economics/finance bloggers, because I have a number of semi-interesting press releases in my e-mail.? They would be interesting, but there are over a dozen of them, and none of them really fit my profile, aside from a professor asking me to review an academic finance article. (Me?! I’m on the hinterlands of the profession.)? I appreciate truly personal mail, but the faux personal mail, which is really PR, does not get me to move.

One other note: while I was away, since I did not have internet, during free time, I went through my files to cull through research that I downloaded to be read.? By the time I was done, I went through about 200 articles, and added 20 or so to my research files.? I could do a post on what I think is valuable in academic/professional finance research — I’m not sure how much my readers would value it.? That said, going through the research sharpened my views on what I think is valuable in academic research… so, at least I gained something from it.

I should be able to post more tomorrow, beyond that, I have no idea what kind of connectivity I might have.

If You Want to Do Well, Study Math, Science, or Business, and Work Hard

Posted on 13 June 200813 June 2008 by David Merkel

I read the coverage of this academic paper with some amusement. Something not mentioned by the reviewers is that the data set came from just one college. Should that then be applicable everywhere? I don’t know.

Also, the idea of correcting for brightness of students strikes me as misguided. Smart students know to apply themselves to majors that will pay off. Also, the concept that high-paying careers require more hours is also misguided. Most of the graduates in lower earning professions can’t work more hours, even if they want to; there is no demand for that.

The paper was written to deal with how one statistically deals with non-responses in surveying. That it deals with education is a happy accident. I would be careful generalizing from this paper. To me, it is another example of advanced research that is highly intelligent, but may lack common sense.

Don’t Do It!

Posted on 5 June 2008 by David Merkel

Fifteen years ago, when I was still pretty much a novice investor, I went to an AAII meeting to hear Jeremy Siegel speak about his new book, “Stocks for the Long Run.”? I brought my copy to have him sign it.? I hung around after the talk to? listen to some of the more informal things he might say, and in a dead moment, I asked him (something to the effect of),? “You suggest that young people should lever up to buy stock; do you really mean that?”? His answer was and unreserved “Yes.”

Dr. Siegel is brighter than me.? The guys who write the CXO Advisory Blog are brighter than me as well.? Felix Salmon is clever, and he puts up this supporting piece.

I am here to disagree.? Why?? It is all very well and good for academics to assume that returns occur randomly, but returns occur in streaks.? Think of all of the “lost decade” articles you have seen in the recent past.? Here’s my main reason for not levering up while young: It won’t work well about? one-third of the time, because young people will take humongous losses during a “lost decade,” and in the panic, they will sell at the wrong time.? My secondary reason, is that in really bad markets, such as 1929-32, 1973-4, and 2000-2002, you could be wiped out.

Don’t trust the results that rely on the veracity of Modern Portfolio Theory, when those ideas would have failed off of historical returns.? As I often say, “The markets always have a new way to make a fool out of you.”? This is another example.

One final note, perhaps more scholarly: the idea of levering up requires buying and holding, and that bad markets happen randomly, with no streaks.? Unfortunately, the equity market returns less than a buy-and-hold investor receives, because people buy and sell at the wrong times.? Buy-and-hold investors are daring people; they confront the natural tendencies toward greed and panic, and they do better than average in the long run.? One buying and holding on leverage would have to have a steel gut, which is not characteristic of younger investors.

So, don’t lever up.? I say this to investors young and old, experienced and inexperienced.? Getting an equity-like return is difficult enough in the long run.? Don’t make your life more difficult by levering up.

Blowing the Bubble Bigger

Posted on 24 May 2008 by David Merkel

Maybe there is something different about the way that neoclassical economists and historians approach things. I am a bit of a generalist, so I try to look at things from many angles. The two books that I cited in my recent book review on bubbles were written by historians, not economists. Let me cite my summary of Kindleberger’s paradigm:

Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies of those that borrowed to finance the assets
A lender of last resort appears to end the cycle

That’s not the way a neoclassical economist views the world. Either men are rational, or, their errors tend to cancel each other out in the short run. Certainly there are never destabilizing feedback loops. Errors on the part of one person don’t lead others to make the same errors.

It is said that neoclassical economics cannot explain the existence of marketing and financial markets, without relaxing their rationality assumptions significantly. As an economist trained in the neoclassical school, I think we forget that these are assumptions that are made in order to get the math to work, not the way things actually work in the world. People are influenced by other people, and they do stupid things as a result, even when there is money on the line. (Maybe, especially when there is money on the line, due to the effects of fear and greed.)

Anyway, when I wrote my last post, I figured that someone would take issue with the concept of bubbles. The commenter raises a few issues, some of which are answered in the article itself.

What’s the definition of a bubble? When does something become a bubble?
When did housing become a bubble? Who identified it?

Another commenter, more polite, poses these questions:

Don’t they effectively borrow to finance the oil futures market?
Was the internet a bubble?
Isn’t housing unique, in that the speculators can walk away so easily?

In an attempt to answer these questions, “What’s the definition of a bubble? When does something become a bubble? Was the internet a bubble?” consider this piece from RealMoney’s Columnist Conversation:

		David Merkel
		Bubbling Over
		1/21/05 4:38 PM ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems: 1) Lack of data on private transactions. 2) Lack of divisional data in corporations with multiple divisions. 3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc. 4) Lack of data on corporations as they get dissolved or merged into other operations. 5) Survivorship bias. 6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided? This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified. To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well. Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue. It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.

In the internet bubble, there wasn’t that much debt, aside from vendor financing. Some faced the obligations of paying taxes on employee stock options, without having the cash to do so. Others speculated on margin, favoring the long side, of course. The real bubble was the low cost of equity capital, which led to the creation of dubious businesses, and weird stock price movements at IPOs. Say what you want about the present era, the IPO market is relatively calm, and the few deals getting done seem to have some quality.

Regarding the oil futures markets, yes, many participants are levered, but the commodity funds which are huge typically are not. Most of the selling to them comes from the oil companies, which find it profitable to lock in prices at $60, $70, $80…. $130, you get it. In that sense, I don’t think the majority of the activity is coming from levered players that are active investors — the commodity funds are passive hoarders, and the oil companies have a commercial interest.

For another example, consider the silver bubble in the late 70s / early 80s. The Hunt brothers tried to corner the silver market. In the process, the price of silver touched $54/ounce. What stopped them?

COMEX limited their ability to hold silver futures.
The Fed tightened monetary policy.
Silver came from everywhere to meet demand. People sold the family silver, mines that were closed reopened, mines that were marginal began producing like the was no tomorrow.

That last point is why I think it is very hard to corner any commodity, and why bubbles don’t last. Supply overwhelms speculative demand. The speculative demand in this environment is coming from a bunch of nerds who advise pension funds. This isn’t hot money.

This brings me to the last point, regarding housing: “When did housing become a bubble? Who identified it? Isn’t housing unique, in that the speculators can walk away so easily?”

Housing became a bubble when lenders loosened underwriting standards and offered lending terms that were atrocious — what lender in his right mind would ignore equity, recourse, and amortization? Yet in a mania to earn current profits, many lenders did. The bubble started in 2003, and crested in 2005. I posted on this for four years 2003-2007. I posted at RealMoney as it was cresting, with my main article in May 2005, and several more through the remainder of the year.

There were many others who also pointed at the bubble, but as with all bubbles, the naysayers are at the fringe. It can’t be otherwise.

Regarding the ability of the housing speculators to walk away, I like Tanta’s line at Calculated Risk that there aren’t many true walk aways. Most people abandoning their former homes have tried to keep them, and have lost a lot in the process. Away from that, the lenders do screen delinquencies for likely ability to pay. If there are significant assets in a state that allows for recourse, you can bet the lawyers are active.

In closing, I think the concept of a bubble is meaningful. It is a series of two self-reinforcing cycles, one positive, and one negative. These cycles occur because market players chase past performance, suffering from greed as prices rise, and fear as they fall. Any lending to finance the speculation intensifies the size and the speed of the event.

PS — if it helps at all, my equity investing methods borrow from these ideas. I am always trying to analyze industry cycles, to make money and avoid losses. So far it has worked well.