Before I start this evening, to all my fellow bloggers out there, if you were invited to the gathering at the US Treasury and did not come, I have a request and a question:
Tell me why you decided not to come, if you would.
If present trends continue, I can tell you that bloggers are not pushovers for the US Treasury, but neither are they deaf or heartless.? Since my last post, here are the responses to the gathering:
As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.? As for me, I live near DC, and I am an economic libertarian, but I have many friends at many levels inside our bloated government.
They have to do their jobs.? If there is a conspiracy, it is well-hidden.? There are simpler ways to understand the mess that comes out of national politics.? We get the result that is least offensive to the most, and pleasing to few.
We had a good discussion, but I am not the one to put myself forward.? I made some comments, but did not get to ask my questions.? My personality was not the dominant one.
What I propose to do in this series of articles is go through the main arguments of the US Treasury from the handouts that they gave us (sorry, I can’t scan them and put them out for view), and try to give a fair rendering of what they have done.? My audience is dual: I am addressing those who read me in the blogosphere, and those at the Treasury.
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Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery.? Their goal is to put in place? regulations that will prevent future disasters once the current disaster is past.
David: Well, yeah, that’s what to do if you can.? The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago.? Much of that is not in the domain of the Treasury, but the Fed.
The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.
David: we over-encouraged single family housing as a goal for Americans.? When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage.? Residential real estate prices overshot by a lot.? We should be surprised that there are problems now?
I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest.? Get people financing with equity, not debt, even if it means the economy is sluggish for a few years.? It will bring a longer-lasting self-sustaining recovery.? Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.
To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.”? They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.
Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced.? We saw it coming, but could not predict exactly when the system would face crisis.? Bears are often right, but with significant delays.
The government is not the majority player in the system, but is the biggest player.? At critical points their willingness to offer support helped lead to a market rebound.
Now in the actions of the government, there is some “making virtue out of necessity.”? In supporting Fannie & Freddie in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing.? As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.
As for the bank stress-testing, one can look at it two ways: 1) the way I looked at it at the time — short on details, many generalities, not trusting the results.? (Remember, I have done many such analyses myself for insurers.) or, 2) something that gave confidence to the markets when they were in an oversold state.? Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.
I’m tired, and that’s enough for the evening.? I’ll pick this up tomorrow.
“Just give me the number, willya?”? Ugh.? I’ve had the question asked many times in my life working in or alongside financial reporting in a company.? They need a number for the budget, even though that number will certainly be wrong, leading to numerous explanations for why we are mistracking the budget.
The truth is though there will be one result for the question you ask prospectively, hypothetical answers will often systematically mis-estimate the result when average inputs are fed into models.
As I have experienced in the insurance industry many times, good companies accept feedback from claim experience? into new product pricing, and consider the potential downside risks.? Bad companies rely on industry tables (averages), and assume that downside deviations are just random.
Would we manage companies better if we shared data on how uncertain our estimates are?? Certainly, but the whole company would have to be geared toward understanding how to deal with risk and uncertainty.
Often there is option-like behavior in companies, where if sales are low, expenses will be cut back to a baseline level, but if they are high, expenses will run.? Average expense numbers rarely express the likely result.
Most people/companies assume that things will be stable.? If we look at projections of investment results, stability is the norm.? But our world is unstable.? There are booms and busts; there are wars.? Plans lose their validity when the real world appears.
“The Flaw of Averages” is a popular book on statistics.? It points out many ways in which statistics are abused.? This book will make you a skeptical and reasoned consumer of statistics.
Quibble:? My main difficultly with the book, is that much as the author tries to simplify the concept of complex simulations, is that in the ninth part of the book, he seems to overly encourage use of his own software.
Aside from that, the average reader will learn many ways that statistics such as averages can deceive.? As Benjamin Disraeli, once said, “There are three kinds of lies: lies, damned lies, and statistics.”? This book will help you avoid the last sort of lie.? I recommend this book.
Full disclosure: All purchases from Amazon entering through my site give me a small commission.? Your price at Amazon does not change as a result of the commission.
1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉
This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)
2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.
3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.
4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?
5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.
6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.
7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.
8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.
9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.
10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?
11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.
13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.
14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.
15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.
16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.
17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.
19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.
Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.
Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:
“What’s my illiquid structured finance bond worth?”
Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.
“How will this equity portfolio behave versus the market?”
Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.
“This investment will eventually come back, right?”
No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.
“What’s the interest rate sensitivity of this illiquid structured finance bond?”
Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.
“What’s the right spread to Treasuries for this illiquid bond?”
Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.
What’s the right yield tradeoff between bonds of different credit quality classes?
Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.
“Just Gimme the Answer, Will Ya?!? I need an Answer!”
Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.
Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.
You mean there are no answers?
No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.
I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”
I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.
Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.
So what should I do?
Keep a reserve fund of safe assets.
Be skeptical of short, intermediate, and long-term results, but for different reasons.
Resist trends during normal times, but during times of extreme movement, let it run.
Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.
There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.
Two pieces worth reading today from Eleanor Laise at the Wall Street Journal, which go along with what I have been writing in my Unstable Value Funds series:
I just want to make the short, simple point that an investor can only get two of the following three items (at best):
Principal Protection
Liquidity
Above-Market Returns
Perhaps I am a bit of a pessimist, but as a wide number of products came into existence attempting to offer all three back in the 90s, I would ask questions like, “But what happens if you have losses on assets and redemption requests at book at the same time?”? An answer would come back on the order of, “You worry too much.? We’re making money.”
True, as parties are willing to take more and more risk, you can get all three for a time.? But over a full market cycle, it can’t be done.? And, by a full market cycle, I mean a period of time long enough to include a major debt deflation, like the 30s and now.
So, be aware of withdrawal provisions on your investments, both the formal ones listed in the prospectus or its equivalent, and the informal ones where ability to withdraw is suspended as a matter of fairness to all clients, and/or protecting a business at a financial firm (though risking lawsuits in the process).
Also, try to understand what underlies the shares in any pooled investment vehicle that you own.? If the underlying does not have a liquid secondary market, the shares of the pool won’t be liquid under all conditions.? If the value of the assets vary considerably over time, stability of principal won’t be possible under all conditions.
So, be aware.? Though there are laws and courts, you are your own first and best defender when it comes to any investments.
I’m behind on my book reviews.? You should see two more in the near term.
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I try to resist doom-and-gloom literature.? Some of it finds its way to my door anyway.? When Giants Fall covers many of the issues that I have covered at my blog with an even more dour slant.? It contemplates the demise of American hegemony in the world.
Though I’m not crazy about the US Dollar, and the US in this economic environment, I’m not sure what can replace the US and its flexbile economy, which allows the rest of the world to shed its excesses here in exchange for buying our debts.? Yes, it is not sustainable.? But something not being sustainable does not tell us when it will end.? Nations like China following non-economic goals typically have to go through an experience where they eat so much of something bad for them and then they throw up.
Um, that’s not scientific-sounding, but I think it is a fair way to describe how a large unstable equilibrium gets destroyed.? The non-economic provider of liquidity (China) to the parasite in question (the US) must choke.
Who Would Benefit from this Book
Hmm… back to the book.? If you get easily dismayed, this is not the book for you.? Michael Panzner paints an “end of the era” picture for America, with the nation as a whole less well off.
For those that are willing to look at the pessimistic side of what is possible, When Giants Fall is a reasonable account of what could happen.? Warning: the book is long on description, and short on solutions, both personal and national.
PS ? Not many book reviewers read the books that they review.? They read the summary that the PR flacks send, and rely heavily on that.? I throw away those summaries, and read the books.? That takes time, but I like reading books, and when I wrote for RealMoney, I often missed reading books.? Now I read them more, and you can benefit from that, because I don?t always endorse the books that I review.
I don?t have a tip jar, but if you buy anything through Amazon, after entering through a link on my site, I get a small commission, and your costs don?t go up.? I like taking? the fees out of Amazon, and not out of my readers.
I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.
Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.
Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.
Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.
The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.
We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.
This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):
This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?
All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.
Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.
That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”
I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.
Bloomberg wrote a piece over the puzzlement that many in the Chicago School of Economics feel at the present time with all of the distress in the markets.? After all, don’t markets self-correct?? Sadly, no, not all the time, or, at least not with high speed during credit crunches.? (All of the econometric studies I have done note a weak tendency to mean reversion in financial markets, even excluding periods where there are credit difficulties.)
For markets to self-correct, it requires that economic agents have enough access to capital in order to make the investments necessary to arbitrage the differences between the markets that are in disarray.? It should be no surprise that during a time where credit is hard to come by, that there are potentially profitable arbitrages that are going begging.
Barry did a post today off of the Bloomberg piece, suggesting the death of the Chicago School.? I think that prediction is too early.
I am not a Chicago School economist.? I don’t like the neoclassical synthesis.? It posits human rationality in ways that make us robots, both individually and collectively.? I have been a critic of their methods through both behavioral economics and nonlinear dynamics, a la the Santa Fe Institute.? We need a new paradigm to replace the neoclassical synthesis.? It does not adequately describe how mankind behaves (and we have known that for 25 years — the models don’t predict well, either in micro or macro).
But the answer is not Keynesian policy, in my opinion.? Just because markets are unstable, that doesn’t mean that government action can stabilize them over the long run.? In the short-run, while credit is still easily available, yes, government action can work, whether through the Fed, subsidies, or tax incentives.? But Keynesian remedies don’t work when the government can’t easily tax or borrow in order to provide the stimulus.? We will face borrowing problems soon enough.
The answers are not to be found by asking the Chicago School or the Keynesians.? We need an economic theory that accepts the necessity of moderate booms and busts, where the government does little to try to correct the imbalances.? Moderate imbalances are normal, and if we try to eliminate the moderate busts, we get a series of small busts, followed by one humongous one.? We experienced easy money in the 20s, and in the 1990-2000s.? Easy money cured the moderate busts, but at a price.
A quick excursus: I agree that tight regulation of financial institutions is necessary if there is fiat money.? Controlling the money supply means controlling credit.? I don’t like fiat money, and would rather have a gold standard, but if we must have fiat money, then make life tough for the banks.? Restrict what they can invest in.? Regulate lending practices.
The present distress stems from both a lack of regulation and too much regulation.
Lack of regulation:
Lack of enforcement on bad lending
Leverage limits on commercial and investment banks were too loose.
Modest limits on the banks dealings with the non-regulated financials.
Regulatory arbitrage allowed depositary financial to choose weak regulators.
Failure to disallow investment in areas the regulators did not fully understand.
Too much regulation:
Lack of limits on Fed stimulus action (our “independent” central bank was/is compromised)
Tax deductions for residential real estate, including the home sale capital gains exclusion.
Limiting the number of rating agencies.
My view is that we eventually have to give our currency some backing and get the government out of the money business.? Until we get there the ride will be bumpy.? We need to transist back to an economy where credit is not easy, but not non-existent, and where total leverage declines.? Saving has to become a virtue again, which our present monetary policies will not encourage.
It is too early to declare the demise of the Chicago School, much as it should disappear.? But now we will get the test of the Keynesian School and I predict failure there; they will not solve our crisis.? The crisis will end when enough bad debts have been liquidated, and the financial system can begin lending normally again.? Call it unrealistic; call it the Austrian School if you like (I have not read and von Mises or Hayek), but it is what restores the financial sector, which cannot live with too much leverage once assets are deflating.
PS — The Bible says that the borrower is servant to the lender.? True enough, but if the lender is himself a borrower, like most of our banks, the proverb does not hold.? The only lenders that are truly soverign are those that control their own destinies, because they have no debt.
One of the great conceits in investments is trying to earn above average returns with low variability of returns.? Yet, when you consider the Madoff scandal, it is what can attract a lot of money from credulous investors.
One of the glories of a capitalistic economy is that markets are unstable, they adjust to point out what is no longer needed.? Often the adustments occur violently, because businessmen/consumers chase trends, which can lead to bubbles and bubblettes, until the cash flows of the assets cannot bear the interest flows on the debts that have been created to buy the assets.? Attempts to tame this, such as Alan Greenspan’s aggressive provisions of liquidity just build up more debt for an economywide bubble, followed by a depression.? We got the Great Moderation because of trust in the Greenspan Put.? The Fed would only take away the punchbowl for modest amounts of time, so speculation on debt instruments, real estate, financial institutions, etc., could go on to a much greater degree.? Boom phases would be long; bust phases short and low-impact.
There have been problems with lax regulation of bank underwriting, and investment bank leverage, but the key flaw was mismanagement of the money/credit supply.? Had the Fed held credit tighter during the ’90s and 2000s, we would not be here now.? The Fed could have kept the fed funds rate high, rewarding savings, perhaps leading to a lower cuurent account deficit as well.? Debt growth would have slowed, and securitization, which hates having an inverted or flat yield curve, would have slowed as well.? GDP growth would have been slower, but we would not be facing the crisis we have now.
Or consider housing, and how it became overbuilt because of lax loan underwriting, accommodative monetary policy, and a follow-the-leader mania.? Here’s an old CC post from the era:
1) For those with stable businesses that throw off a lot of earnings and cash flow, and want to dodge the tax man, here’s a possible way to do it, courtesy of the Wall Street Journal: start a defined benefit plan. Disadvantages: complex, relatively illiquid and expensive. Advantages: you can sock away a lot, and defer taxes until you begin taking your benefit, possibly (maybe likely) at lower tax rates.
(This message brought to you courtesy of one actuary who won’t benefit from the message itself… but hey, it helps the profession.)
2) Sea changes in the markets rarely take place in a single day or week. Tops, and changes in leadership tend to take place over months, and feel uncertain. Though Jim is pretty certain that it is time to shift out of energy, I am willing to hang on, and get my opportunities to average down if they come at all. My rebalance points are roughly 20% below current prices anyway, so I’d need a real pullback in order to add.
Though there may be temporary inventory gluts, the basic supply/demand story hasn’t changed, and energy stocks still discount oil prices in the 40s, not the 60s.
3) Contrary to what Jim Cramer wrote in his housing piece today, you can lose it all in housing. Granted, it would be unusual to see homeowners in multiple areas in the country lose their shirts all at the same time; that hasn’t happened since the Great Depression, and we all know that the Great Depression can’t recur, right?
Thing is, local hot real estate markets often revert; if the reversion is bad enough, it leads to foreclosures. Think of Houston in the mid-80s, and Southern California in the early 90s. For that matter, think of CBD real estate in the early 90s… not only did that threaten real estate owners, it did in a number of formerly venerable banks and insurance companies.
Real estate is not a one way street, any more than stocks are. We have never financed as much real estate with as little equity as today before. We have not used financing instruments that are as back-end loaded before. Finally, this speculation is being done on a basis where renting is far cheaper than owning, leaving little support for property prices if the incomes of leveraged homeowners can’t be maintained in a recession. (Oh, that’s right. No more recessions; the Fed has cured that.)
Look, I’m not pointing at any immediate demise of housing in the hot markets. I still think that any trouble is a 2006-7 issue. But this is not a stable situation; if you have a large mortgage relative to your income, make sure your employment situation is really stable. If you can make the payment, prices on the secondary market don’t matter. If you can’t… those prices matter a lot.
One more note: an average investor can sell all of his stocks in the next 20 minutes, with little effect on the market. This is true even in a bad market. In a bad real estate market, you can’t sell; buyers are gunshy — it is akin to what I went through as a corporate bond manager in 2002. There are months where there is no liquidity for some bonds at any reasonable price. So it is for houses in some neighborhoods when half a dozen “for sale” signs go up. No one can sell except at fire sale prices.
None
Well, that’s the macroeconomic problem with stability.? When it gets relied on, after a self-reinforcing boom, it goes away.? Trust in stability is dangerous in other contexts, though.? From another CC post:
Oil and Economic Strength (and a Rant on the Sharpe Ratio)
8/31/2005 3:13 PM EDT
I haven’t really talked about the issue of whether high oil prices portend economic strength or weakness for a good reason. No one knows. There are too many moving parts, and separating out the different effects is impossible; opinions here come down to more of one’s personality (optimist/pessimist) or investment positions (stocks/bonds/energy).
Even if someone did tests using Granger-causality, I’d still be suspicious of the result, whichever way it would point, because of the high probability of finding spurious correlations.
And, speaking of spurious correlations, since Charles Norton brought up the Sharpe ratio, I may as well say that it is a bankrupt concept as commonly used by investment consultants. First, variability is not risk. Losing money over your own personal time horizon is risk (which implies that risk varies for each investor). Second, there is not one type of risk, but many risks. Systematic risk may be measurable in hindsight, but never prospectively.
Third, any measure going off historical values is useless for forecasting purposes, because the values aren’t stable over time. When managers get measured in order for clients to make decisions, they are using the figures for forecasting purposes. It is no surprise that they don’t get good results from the exercise.
Why do figures like a Sharpe ratio gets used, then? Because consultants like simple answers that they can give to their clients, even if the answers yield no insight into the future. (It makes the math really simple, and allows a large number of strategies to be rapidly compared. It eliminates real work and thought.) Investment is a far more messy process than a few simple ratios can illustrate, and those that use these ratios get the results that they deserve.
Finally, an aside. Why am I so annoyed by this? Because of money lost by friends and clients who have been led along this path by investment consultants. There is a real cost to bad ideas.
Time Series Regression and Correlation (for wonks only)
7/12/2007 3:11 PM EDT
We’ve had a few discussions here recently involving correlation, so I thought I might post something on the topic. First, it is easy to abuse statistics of all sorts. Few on Wall Street really understand the limitations of the techniques; I have seen them abused many times, often to the tune of large losses.
When comparing multiple time series of any sort, the results can vary considerably if you run the calculation daily, weekly, monthly, quarterly, annually, etc. As you use fewer and fewer observations, the parameters calculated will change. The best estimate will be the one using all available observations, that is, assuming that the underlying processes that generated the time series will be the same in the future as in the past.
It gets worse when comparing the changes in time series. Here moving from daily to weekly to monthly (etc.) can make severe differences in the calculations, because two data series can be almost uncorrelated in the short-run, and very correlated in the long run. My “solution” is that you size your time interval to the time interval over which you make decisions. If daily, then daily, annually, then annually. Again, subject to the limitation that that the underlying processes that generated the changes in time series will be the same in the future as in the past.
But often, the results aren’t stable, because there is no real relationship between the time series being compared. High noise, low signal is a constant problem. Humility in financial statistics is required.
As an example, calculations of beta coefficients often vary significantly when the periodicity of the data changes. People think of beta as a constant, but I sure don’t.
For those who want more on this, there are my two articles, “Avoid the Dangers of Data-Mining,” Part 1 and Part 2.
Enough of this. Back to the roaring markets! Haven’t hit the trading collars yet!
Position: none, but intellectually short Modern Portfolio Theory [MPT]
My point is this: investors look for stable relationships that they can rely on.? Those relationships are precious few.? Sharpe ratios aren’t stable; correlation coefficients aren’t stable; return patterns aren’t stable.? They shouldn’t be stable.? They rely on a noisy economy? which is prone to booms and busts, and industries that are prone to booms and busts.? Seeking stable returns is a fool’s errand.? Warren Buffett has said something to the effect of, “I’d rather have a lumpy 15% return, than a smooth 12% return.”? Though we might mark down those percentages today, the idea is correct, so long as the investor’s time horizon is long enough to average out the lumpiness.
So, if we are going to be capitalists, let’s embrace the idea that conditions will be volatile, more volatile on a regular basis, but given the lower debt levels across the economy because of regular shakeouts, no depressions.? But this would imply:
Higher savings rates.
Greater scrutiny of balance sheets.
Aversion to debt, both personally, and in companies for investment.
Less overall financial complexity, and a smaller financial sector.
Lower P/Es at banks.
Even lower P/Es in non-regulated financials.? It’s a violent world.
Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.? Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.? Here’s the last paragaph:
On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”
When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.? All good credit models contain something for boom and bust.? Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.? That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.
But to my puzzled professor, there are fundamental reasons why.
Overlevered systems are inherently unstable.? Small changes in creditworthiness can have big impacts.
Rating agencies undersized subordination levels in order to win business.
Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
When financials ain’t healthy, ain’t no one healthy.
Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.? As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.
Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.? I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.? Beware the salesman that offers high yields with safety; there is usually one of four things involved:
Financial leverage
Options sold short
Low credit quality of the underlying debt instruments
Foreign currency risks
These deals fall far short of the “prudent man rule” in my opinion.? Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.? For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.? At least, though, a board member should read the “risks and disclosures” section of the prospectus.? There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.
The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.
We will probably see many more stories like this over the next year.? Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.? It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.? But now they have to live with the bad results; heads will roll.
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