Good News for Banks, No Cram Down

The Senate defeated a law that would have allowed a cram-down provision for mortgage lenders. This increases the value of mortgages, and so helps banks, not merely directly via their mortgages, but indirectly as this would have hurt home prices. The specter of Cram-Down legislation surely has put a drag on mortgages, though it seems there are so many Federal plans outstanding, it is probably too much to get worked up about defeating one of them. Bad mortgage fixes these days are like dandelions in my yard.

For unsecured debt like credit cards, or accounts payable, if you declare bankruptcy you can then go to court, and depending on your income and assets, the judge writes down your debts by 50% or 100%, depending on what seems feasible. After that judgment, credit card and other bills are simply no longer recoverable at par, but only at the new, lower amount. A home loan is a secured loan, meaning, the house is collateral that secures the loan. When you buy a house with a mortgage, the bank really owns the house until the mortgage is paid. It owns it in the sense that if you stop paying, they take the house back, just as if you stopped paying your auto loan your car would be repossessed. Historically, in conjunction with a large downpayment and good credit checks, this led to very small mortgage lending loss rates. As those paying mortgages have non-recourse loans, meaning the bank can only repossess the house and not go after other assets, the borrower has the option to walk away. Adding cram down means they would also have the option of writing down the mortgage.

In banking, you price a loan with an expected loss build in there. This is basically the probability of a default times the loss in event of default: E(loss)=PD*LIED. Allowing borrowers to write down their homes through bankruptcy, no matter what your motivation, increases both the PD and the LIED. This would lead to higher lending rates. If you don't believe that, then you don't believe businesses try to make money, or that markets are competitive. Lender lobbyists basically drove this point home, that this legislation would just kill the current mortgage market at an especially sensitive time, and scared 12 Democrats to join the Republicans in opposing the Cram-Down.

Of course, Elizabeth Warren, who cares deeply about the little guy, lobbied for the cram down. If she had succeeded, no doubt she would have responded to the higher rates, lower mortgage lending, and cratering bank stock prices, via Fannie-backed lending to rectify the situation. Every patch needs a fix, which needs a patch, which is nice because then everyone has a government job to implement these fixes. Who is left to actually make money that pays government salaries, is not her problem.

The bill won handily in the House, but lost pretty strongly in the Senate. I'm sure it will come up again, but at least for now it is dead.

GDP And FOMC Roundup - Yen Hurt

Advance GDP and the FOMC Statement supplied much volatility for the forex market. Most currency pair eventually stayed in the same place. Only the Yen was significantly hurt.

Advance GDP was very bad: According to the early indicator, the American economy squeezed by 6.1% in the first quarter of 2009, much worse than early expectations of a 4.8% fall. This continues the tend of the last quarter of 2008, when Gross Domestic Product dropped by 6.3%.

The bad news didn’t move the market too much. The market was shaky, trading in a high volume, but eventually not moving too much. Traders were awaiting the FOMC Statement.

Towards the FOMC Statement, risk appetite took over and the dollar weakened. For instance, EUR/USD climbed above 1.33, a level not seen for about two weeks.

The FOMC Statement took the hot air out the balloon. Ben Bernanke’s guys didn’t declare any change in policy: buying bonds will continue, no new inflation fears exist,, the interest rate (Federal Funds Rate) will stay unchanged and no new action will be taken.

Yet the FOMC stated that they’re seeing a slight improvement, or stabilization in the economy. This new hope triggered a “normal” response: the dollar gained! The risk factor didn’t act.

Another risk related phenomenon was the break of the Dollar Yen Correlation: The Yen fell against the dollar, exactly like the Euro and Pound fell. USD/JPY broke upwards, and now trades at 97.64.

The break of this correlation is serious news. If this persists, it also takes out the hot air out of the roller coaster Yen crosses.

Moody's Predicts Tripling of Corp Default Rates

Moody's is getting beat up for not calling the recent crisis and rubber stamping ratings on the disastrous 'mortgage innovations'. I think this criticism is largely overplayed, in that everyone was drinking the Kool-Aid pre-crisis, so their errors are those manifested by academics, regulators, legislators, businessmen, and investors. They didn't set the absurd mortgage lending zeitgeist in motion, merely enabled it with many others. If the current crisis is like World War II, the Rating Agencies would not be Hitler, rather Siemens.

But Moody's feels the heat, so like any good forecaster who missed the turning point, they are sure to error on the other side going forward. As a risk manager, predicting doom and gloom has an obvious advantage, one reason they are so often ignored. People are much more foregiving of an overly pessimistic forecast than an overly optimistic one, so the costs of missing in one direction are clearly skewed towards encouraging the 'Roubini' scenarios. Consider all the lawsuits in the pipeline against the Ratings Agencies, and note the absence of lawsuits for whenever defaults were below average.

As per optimistic forecasts, there are few benefits to mere accuracy. When have you heard of a risk manager getting an extra bonus for predicting low probability events won't happen that subsequently don't? There's good reason for this, because coming up with improbabilities (Black Swans) that won't happen is like paying a computer programmer to find and fix bugs: the supply is infinite. So, risk manager warnings are like the 'check engine' light. When it's on, it usually means the 'check engine' light is broken.

The default rate for speculative grade loans was 4.1% in 2008, which is 71st out of the 89 years of data on this series. Well below the 2001, 1990, and 1970 peaks. The prediction (see top graph) for a 16% default rate in 2010 is for a record year in defaults, higher than any year, including the peak of 15.4% in 1933. If the End of Times comes, you can't blame the current Moody's personnel for not warning you.

The Moody's forecasting model is not a very good one. I worked closely with someone who built their earlier model back in 1999 and there were ridiculously few observations, because basically you then had two default peaks for post WW2 data: 1970 and 1990. The data is highly serially correlated, implying the number of observations vastly overstates the degrees of freedom in that sample. Thus, it had the challenges of all time series forecasting in that environment. As the Thumper noted in Bambi, "if you can't say something nice, don't say anything at all." Therefore.

But, that was ages ago. They made a new model in 2007 called the the Credit Transition Model. This model uses recent credit transitions, an unemployment rate forecast, and current high yield spreads. The recent credit transitions are clearly negative, and so projecting those forward is sure to generate an increase in default rates. The unemployment rate is going up, but how that correlates with defaults is non trivial (even though it defines the Geithner stess tests, this is still not much to hang a forecast upon). But are High Yield spreads correlated with future default rates? They called an increase that did not happen in 1998. In 1990 and 2000, they did not predict they future increases in defaults, they merely rose with the default rates. To the extent default rates are serially correlated, the high yield spreads did not add much information, as much as people like to highlight how forward looking they are. Clearly, a bond trading well below par is in trouble, and this is useful information for a specific company, but the hypothesis that aggregate high yield spreads predicts future default rates, in the context of historical default rates, is doubtful. Nonetheless, the new model shows an eerily accurate forecast over the past 15 years (from the Moody's Credit Transition Model 2007 document. It's hard to read, but note there are two lines joined like tapeworms in flagrante delicto, one a forecast, one the actual data):



Beware any time series forecast that caught trend changes in the past, because these are invariably fit to that data. Indeed, reading the Moody's Annual Default report from 1999 published in January 2000 before the market melted, we have this little prediction about the future default rates: a decline in the speculative grade default rate, to 'between 6.0% and 4.5%", but "trending downward over the year", with increasing recovery rates. They noted we were moving away from the 'Asian Crisis' of 1998, and so were like all risk managers, oblivious to the next crisis but astutely aware of the most recent one. What happened, of course, was that default rates doubled, peaking in 2001. But that was before the New Credit Transition Model, which as shown above, predicts with an R2 that would shame any back-fitting statistician. Given high credit spreads and the incentives they face, the backtesting and inner workings of that model are largely irrelevant.

So, like those AAA-rated circa 2005 Mortgaged Backed Securities, Moody's is giving the market exactly what it agrees with and wants right now. It is being pessimistic this time so this kind of appeasement is supposed to be better, but in reality it shows the same lack of intellectual courage. I don't blame them, the cost-benefit asymmetry at this point clearly suggests shareholder value is maximized by re-affirming the disaster scenario implicit in high yield spreads, but if i wanted to see what high yield spreads implied about future default rates I would look at high yield spreads, not Moody's.

Fundamentally, no one can predict aggregate time series turning points much better than simple auto-regressive moving average (ARMA) models, so it's pointless to try. Best to focus on what quants can do, pick relative winners and losers. I remember once meeting a new consumer credit risk executive back in the late 1990s, and she told me that instead of predicting relative default rates by obligors, it would be great to be able to avoid the next recession. True, but part of being a professional credit executive is knowing the difference between what you can predict and what you can't. Moody's should simply stop forecasting aggregate default rates. They don't add any value here and merely highlight that for anything many people already have an opinion on, Moody's is not a special lens, but rather a mirror.

Keynote Speaker

So, my flight at Midway is cancelled, and we schlep about an hour away to stay overnight. The next morning at 6 AM at O'Hare, the same tired set of frustrated travellers is in line to get on the next flight out. A woman in her fifties comes racing up to the front of the line, cutting in front of everyone else, with singular purpose. She notes to the woman at the desk for everyone to hear:

I have to get to Detroit right away. I'm the keynote speaker!

That she took her self so seriously and was so oblivious to our situation with all our important meetings, was comedy gold. It brought at first eye rolling from my fellow frustrated travellers, but then endless mirth for the next hour between my new buddies. The obtuseness of the statement was parody-perfect, and 'Detroit' was icing on the cake. Clearly, everyone had been to a seminar of some sort presided by such a smarmy woman, on "finding our cheese" or "enhancing gender equality" exercises where the men are separated from the women like we are back in 5th grade sex-ed class.

There's nothing funnier than real life. Note to self: never publicly say, "I can fix this, I'm an economist!"

Can't Teach Creativity

In a new book on education (Why Don't Students Like School?) by Daniel Willlingham, sounds like a lot of common sense. The reviewer notes:

Another question: "What is the secret to getting students to think like real scientists, mathematicians, and historians?" According to Mr. Willingham, this goal is too ambitious: Students are ready to understand knowledge but not create it. For most, that is enough. Attempting a great leap forward is likely to fail.

I've always noted that academic creativity exercises were cliches, where we students would sit around, learning new levels of disrespect for our educators. The corny lessons were almost patronizing--like those Successories posters--and our minds would wander appropriately.

Most people are not creative about abstract academic issues like math, science, or philosophy, and there is nothing wrong with that. Often they are still very funny, decent, valuable people. Academic creativity is a rarity among academics, for God's sake. But when a curriculum trains kids with the idea they have to train the next Albert Einstein, they waste time. As educators, they are too stupid to realize this, but Albert was hardly a product of some dopey excercise where one connects lines outside the box (thus giving the great insight to think outside the box).

My two boys, ages 9 and 7, go to Kumon, a chain that teaches English and Math. They mainly drill, overlearning basics, and then are introduced to the next level. They are first tested, and then start workbooks slightly below their level so they hit the ground running. It's a workbook, where my 7 year old will add the number 3 to a bunch of numbers for 10 pages (eg), but only 20 minutes or less a day. When they master a workbook, they move to the next level, but if not, they repeat that lesson. At $100 per month, they learn more math at Kumon than at their school, which costs 10 times as much and has them for a longer time. [Another key to Kumon is tracking, so each kid is at a level determined by his measured ability, which creates the wrong kind of diversity].

Teachers love to pooh-pooh drills and systems, because they discourage creativity, and seem to make them less important. It's just the serenity prayer in practice: affect what you can. What is most boring is listening to pointless lectures, lectures you know won't help you, and kids can sense when the teacher's 'big idea' lesson plan is merely nonsense. Teacher would love to teach the higher level skills that define genius because they want credit for the next genius, but the sad fact is that while good teachers are very helpful, it is almost always impossible to explain an Einstein, Feynman, or Crick by pointing to some deep insight from an 8th grade teacher. These are exceptional people, and teaching the basics is what they needed most.

Posner Reviews Akerlof and Shiller

From Posner's review of Shorting Reason:

As one reads this book, one has the sense that deep down Akerlof and Shiller believe that being rational is the same as being right. That is a mistake. It prevents them from entertaining the possibility that what has now plunged the world into depression is a cascade of mistakes by rational businessmen, government officials, academic economists, consumers, and homebuyers, operating in an unexpectedly fragile economic environment, and that what is retarding recovery is not the "unreasoning fear" of which Franklin Roosevelt famously spoke but the rational fears--the reasoning fear, to use Roosevelt's idiom--of businesspeople, consumers, and officials who confront economic uncertainties for which no one had prepared them.

You get very different view of a crisis if you think it was because of bad faith or greed versus an unintentioned, reasonable error. I was not following this in real time, but putting myself back into 2006 I can empathize with those convinced by the absence of historical losses in the face of easier credit terms. I would like to think I would have noted that the recent housing spike made things much different, but I can see how that view would be a minority one (remember, even Shiller did not suggest a nation-wide housing price collapse was probable).

Chavez gave Obama a book to read, the Marxist conspiracy history Open Veins of Latin America. It's a typical tract that paints Latin American's as victims by wealthy northerners, always selling their commodities 'too low'. As novelist Mario Vargas Llosa explains in the foreword for counter to 'Open Veins', The Guide to the Perfect Latin American Idiot:

"History" for the idiot "is a successful conspiracy of the evil ones against the good, in which they always win and we always lose.

Business and politics involves planning and building coalitions, so it is natural to think everything happens because of some kind of big plan. But broad trends are usually not the sum of their parts. They reflect an equilibrium of deeper preferences and productivity. Understanding the trends and breakpoints in an economy, is best done assuming people are neither idiots nor evil, merely imperfect. Bad faith and stupidity explain a lot of specific trades or litigation, but they don't generalize well because people tend to be mean or stupid in idiosyncratic ways.

Stress Test Constraint

From the New York Times:

Officials have said that at least a handful of the 19 banks undergoing the exam will need to raise sizable amounts of fresh capital, a move that will severely dilute existing shareholders. For the tests to be credible, regulators recognize that not all of the banks can pass the exam with flying colors.

So, this is not like a test with objective criteria. There will be 'several' losers. There has to be.

Hat tip to Matt Stichnoth

Treasury Methodology Begs Essential Questions

From today's Treasury methodology paper:

To guide estimation, the BHCs were provided with a range of indicative two‐year cumulative loss rates for each of the 12 loan categories for the baseline and more adverse scenarios. [Banks] were permitted to submit loss rates outside of the ranges, but were required to provide strong supporting evidence, especially if they fell below the range minimum. The indicative loss rate ranges were derived using a variety of methods for predicting loan losses, including analysis of historical loss experience at large BHCs and quantitative models relating the performance of individual loans and groups of loans to macroeconomic variables.

The 12 categories are as follows:

• Mortgages
• prime
• Alt-A
• Subprime
• Closed-end junior liens
• Home equity loans/lines
• Commercial Real Estate
• Construction
• Multifamily housing
• Non-farm, nonresidential
• Consumer
• CreditCards
• other (auto, RV, boats)
• Commercial and Industrial Loans
• Other

Note the fine distinctions on the past 2 banking crises: commercial (1990) and residential real estate (2007+). You can always count on regulators to protect us against the most recent credit events. Odds that the next banking crisis is centered in some subcategory of 'other': 98.76%.

The big question is, given unemployment rises by 3%, GDP falls by 4%, and housing falls another 20%, what are the effects on all these categories? The white paper does not say. What is the Treasury's base assumption for the average asset in these 12 categories? Who knows!

Ask yourself how much money your business would lose if GDP fell by 4%. Do you know with any certainty? Of course not, no one does. It will fall, but any exact number is spurious precision. Their estimates have large standard errors. They may be decent estimates, but this is the Federal Government operating in a very politicized environment so I'm not going to give them the benefit of the doubt. Their reluctance to say what these numbers are, on average, for the 12 lending areas, suggests they are not confident enough to defend them.

You might as well say, the number is Y=a*b*X, where a=3.141592654 and b=2.71828182. Gee, you have two fancy numbers in there to many digits, but as "X" is unknown, it really does not clarify anything.

Treasury tries to bury methodology

The methodology of the Treasury stress tests are going to be released today around 2 pm EST. This is when most companies announce embarrassing results, such as when their CFO leaves to 'be with their family' or something. Most people don't dig into new stuff after 2 pm on Friday.

Elizabeth Warren Grills Geithner

During a Congressional hearing yesterday Elizabeth Warren pointedly asked Treasury Secretary Tim Geithner about the plan for assisting homeowners who have substantially negative value in their homes. So, their mortgage is worth $400k, their house worth $300K, and supposedly the government has to help the 'homeowner'. At the very least, this suggests a $100K writedown so the owner has some option value. She also made a statement, that simultaneously called for banks reducing interest rates and increasing lending, which nicely highlights her naive view of business and economics.

She's an unqualified advocate for the little guy in the most direct way. So, anything that would cost such individuals more, or take away their power in a negotiation, is considered bad. Such thinking is antithetical to economics, because good economics looks at the unseen as well as the seen, indirect effects, which are often effects on future behavior via the incentives of the rules. Her arguments always have the flavor of intelligent but ignorant earnest students in High School sociology classes: businesses should be forced to lower prices and raise wages and benefits. I guess her template is India or Venezuela. She is a caricature of a simple minded do-gooder because the solution to every problem as merely having a large organization write a check or give stuff away. She takes the size of the economy, its production of goods and services, as a given.

She's on TV shows all the time because journalists and left-wingers agree with her conclusions, and she's from Harvard, so she can make an absurd statement and get away with it because we all know Harvard contains only the Best of the Best in thought. She contributed to John Edward's book, Ending Poverty in America published in early 2007, which argued for more home ownership in America via what came to be known as NINJA loans. The consequence of that objective, in her mind, is merely another random opportunity for the government to help the little guy.

TARP Anecdote

I was talking to someone at a bank and he said the form needed to receive TARP funds was 4 pages. The form needed to pay it back, 16.

He also said that all new initiatives were being blocked until the TARP funds are paid back. That is, TARP is considered so harmful, that it is the number one dis-investment priority. Meanwhile, the Treasury is wary of letting banks pay the money back. New lending, necessary for actual economic growth, is being constrained by TARP debt.

The law of unintended consequences at work.

Solow Reviews Posner

Robert Solow is one of my favorite economists even though he's a liberal and I'm not, and he helped focus a lot of attention on aggregate production functions, a monumental distraction (the Solow Growth Model). Reifying technology as a parameter with an exogenous growth process, and capital as a number K, is about as useful as telling me I should judge my daughter's welfare by her height and weight.

But he has loads of common sense, and as he does not have an opinion on everything like other Nobelists--or at least does not feel compelled to tell us his opinion on everything--his opinions have a lot more weight. Like myself, he finds most nonfiction not just imperfect, but plain wrong, consistent with Sturgeon's Law (that 90% of everything is crap). In contrast, Tyler Cowen's reviews seems to assume a 10% crap base rate, but he reads books much differently than I do.

Anyway, Posner's book A Failure of Capitalism goes over the latest financial crisis, and Solow rips it a new binding. But Solow makes some statements that were clearly too good to check:

In the past, 10-to-1 leverage would have been about par for a bank. More recently, during the housing bubble that preceded the current crisis, many large financial institutions, including now-defunct investment banks such as Bear Stearns and Lehman Brothers, reached for 30-to-1 leverage, sometimes even more.

This canard is not made more plausible by repition. Bear Stearns had 34-to-1 leverage in 1989, 35 in 1992, 37 in 1997, and 33 in 2007. Lehman has a similar story, with leverage well above 30 throughout the 1990s. It seems high because he is conflating investment banks with traditional banks, which generally have leverage ratios around 12-to-1, and those have not changed much over the past 15 years. So the increase in leverage is because of an apples to oranges comparison. This fact is simply not true, unless you define leverage using notional derivative amounts, but there one would have to offset derivatives, and a lack of transparency makes that very difficult. In general, the really high notional amounts are for market makers who sold offsetting derivatives, creating a very misleading amount of exposure. [tech fact: I'm using TotalAssets/BookEquity as leverage--other measures give similar results].

Later, Solow notes:

I have deliberately kept this story stylized, omitting the juicy details about complicated derivative securities that seem to bear only the most tenuous connection to the everyday economic realities of production, employment, consumption, and so on

Consider that the main assets in trouble are all based on mortgages, which are linked to home prices. If home prices did not fall, this crisis would not be happening. The link between the economy, and the derivatives based on it, could not be more direct. Many times people talk about Wall Street as if it competes with the working class for economic spoils, but when you look at periods good for workers, they were generally good for the stock market, and so too with bad periods (30's and 70's bad for both, 50's and 90's good for both).

At the end, Solow argues for greater regulation:

I find it hard to believe, and I suspect that Judge Posner shares my disbelief, that our overgrown, largely unregulated financial sector was actually fully engaged in improving the allocation of real economic resources.

The less regulated hedge fund sector was not at the epicenter of this crisis, and they lost only about 25% in value in 2008, as opposed to the 60% average for banks. The bad actors were all heavily regulated by our mishmash of Federal Reserve, Treasury, State, and Federal oversight (eg, you need to get a good Community Reinvestment Act rating if you want to merge): CountryWide, IndyMac, Wachovia, Washington Mutual, Lehman, Fannie Mae, Lehman, etc. These institutions were much more regulated than the industrial sector of the economy.

These regulators litigated against lenders who failed to meet targets for serving 'historically underserved markets' (aka, 'those that can't pay back debts'), and Presidents, Congressmen and these same bankers made many speeches together extolling the costless benefit of increased home ownership. If you had 10 times more regulators, I fail to see these extra government employees telling banks to quit making so many NINJA loans because these loans served the objective of increasing home ownership, especially to minority communities. Further, traditional lending criteria (like a hefty down payment, no teaser rates, income verification) were seen as redlining in another guise because as home prices in aggregate had only risen since WW2, credit losses for these mortgage innovation were absent empirically, supporting the allegation they were arbitrary lending criteria used to keep poor folks down. Regulators may not have been necessary nor sufficient for this bubble, but they were definitely encouraging it the whole way up.

When Government Does You a Favor

The best way to make someone like you is not to do them a favor, but ask for one. That is, ask a new acquaintance for some modest help with something. This makes them feel appreciated, useful, competent, and also, an equal at worst in the relationship. In contrast, accepting favors right off the bat presages a subservient relationship, one where you owe right from the start. Naturally, people prefer the former.

Another point to remember is that generally things that are free or have ridiculously low prices, have the greatest costs. TARP money was supposedly really cheap capital, but that's only if you ignore all the implicit conditions.

When the Treasury's Troubled Asset Relief Program (TARP) started, many banks were pressured to accept money because it would supposedly reassure the public, and if some demurred it might cause some banks to be afraid to take the money, which would then prevent the Treasury from saving the system. Basically, a coordination problem with signaling implied they all needed to take the money for it to work. There were also hints that if they did not take the money, some might infer they were 'too weak' to get it, sort of a vague disaster scenario that in October 08 was not crazy. So the banks accepted the money.

As it became clear that accepting money invited all sorts of oversight of compensation and other issues, the banks scrambled to pay it back. The Treasury now is sitting on these requests, basically, not allowing banks to return money.

This weekend, Obama stated he will make sure those banks who have taken money 'are held accountable'. Not coincidentally, the Obama administration plans to address credit card 'abuses', basically limiting the ability of banks to raise interest rates on credit cards (we know how problematic high lending rates have been in creating this crisis). The White House needs them to appear beholden to the government so their forthcoming slew of bank policy initiatives is easier to pass. On TV this weekend, Larry Summers makes the case:

We don’t want people to be paying back the government in ways that would put themselves right back in trouble, and leaving themselves with inadequate capital.

Of course, they have a 'big picture' pretext, and who's to say how much money is necessary for potential risk? One could rationalize any finite number. The bottom line is, they got their foot in the door and aren't about to pull it out. As Rahm Emanuel noted, 'never let a crisis go to waste'.

AIG Pleads Their Case

AIG's memo to legislators, humorously labeled 'strictly confidential', has made it to the internet (see here). It highlights the play book for anyone seeking federal money. The key is to note the huge cascading implications of letting them fail, with special emphasis on 'the middle class', cities, states, everyone. It's a great strategy, because then any legislator has to face the fact that if AIG's failure can conceivably be linked to any poor schlep losing their job, you can be sure his opponent will highlight that they were warned. You can't prove them wrong, and it seems imprudent to take chances, but basically any large organization could make this kind of argument, and you can't afford to buy into it.

I would just tell them that if it is this bad, their normal business is clearly a public hazard. Therefore, I would guarantee their obligations during a liquidation where all their businesses are sold to the highest bidders, with minimum bids at some measure of fair value as defined by consultants in the field.

Stupid Microsoft Issues

1) In the Vista Folders view the default attribute is by 'rating' and tag--you have to add 'modified date'. Modified date, and name, are my most obvious search terms. Who rates their files? This spreadsheet is a 2 out of 5!

2) Excel2007 takes about 15 seconds to pull up the 'add-ins' menu, as opposed to instantly in Excel2003. Why is this better?

3) Excel spends about 15 seconds telling me about an obvious circular reference caused by an errant keystroke, as if it is so proud of its logic. It did this in 2003 too, but you would think someone would tell them that they are not going to get the Fields Medal for telling me that a cell with sum(A1:A15) that includes A15 is circular with neat arrows. It was a mistake--just say #N/A and let me fix it!

4) The search in Vista is 100% more efficient than the old search in XP--if you know the when and where of the file you are searching for. The new 'expanded' search pane does not allow searches between two dates, or between two sizes, in the search pane. But, you have to 'index' all the areas you want searched, which is not obvious as I recently downloaded a file that went to C:\users\ericf\AppData\Local\bla bla, which was not indexed, so I could not find it even though I just downloaded it. If you do index your entire hard drive, your system is weighed down by indexing everything. Basically, the search is much more efficient if you know exactly what you want in the exact space you want. Indeed, you can click on a file in the folders view, and it gives you the option to index the file for searches. If I took the time to check on its properties, what are the odds I won't know where it is? This was designed by an idiot.

5) To get to 'Task Manager' you need to navigate an extra menu. To create a new Word or Excel document you need to navigate an extra menu. In Word, the option is blog post, in Excel, the option is their collection of stupid templates. More is not merely different in Vista/Office07, it is worse.

6) There's more functionality and more buttons for everything in Office 2007--but good luck finding it. If you are upgrading from 2003, spend an hour to create your own custom toolbar, because if you have been using Word or Excel since 1987 like me, their reorganization is like moving from English to Dutch--Dutch may be a more efficient language, but I really don't feel like learning it at this point. It may test well with newbie teenagers or grandmothers, but it sucks for an experienced 43 year old user. Best to avoid by bring your most favorite 40 tools onto the toolbar, then using Google for help in figuring out how to do what you can't find (Google Search is better for help that the application-specific built in help).

7) Graphics in Excel is now much more difficult. Try rotating a surface, the old one is a breeze, the new one much more complicated. Try re-ordering legend list. Try formating an axis label. It is 'rich', in the way that C++ is rich: it contains the solution to everything, you merely have to work it out from some obscure first principles.

If I did not have to upgrade from Office2003 or XP, I would not.

Stress Test Precision

It is important to have realistic objectives. Thus it was discomforting to know that in the words of White House Press Secretary Robert Gibbs

The stress tests were designed to ensure the administration “would have an exact diagnosis of what the problem was"

Exact? As there is considerable uncertainty as to the value of untraded bank assets, assessing their change in value given unemployment moving up to 13%, or housing assets fall 15%, is like asking what happens to Yankees if they lose their starting pitcher. Sure, they will be worse. How much worse? People will disagree. Indeed, the more knowledgeable the person, the greater the range in their disagreement. An ignorant person would probably just compare the wins of the pitcher to the average of the staff and take the difference. A more sophisticated Sabermetrics approach would look at the pitcher's recent performance, especially in spring season, how this compared to last year, as well as his best year.

Forecasting an exact diagnosis suggests the White House is clueless and expects to use this result as something that will seemingly clearly support whatever policy is in the pipeline (because the diagnosis is exact, the implication will be obvious). Their only problem is convincing people their stress tests are exact, which I think they will find impossible. Pointing to 'models' and sophisticated reasoning are not enough. Show us the assumptions, the simulations, the delineation of risk within the institution by obligor and facility, and there is no way you can not reject the hypothesis the number you generate is off by a factor of 3, which would generate a totally different policy recommendation.

Perfection is the enemy of the good, and by stating you expect a diagnosis to be perfect, you are ensuring failure. This is because if you believe bank assets and their sensitivities do not have large standard errors, you would do a different policy than if they do have large standard errors.

Consider crime. A realistic objective tries to minimize violence, and minimize the chance an innocent person will be convicted. An idealist will have try to eliminate both crime and wrongful convictions. The realistic approach will be more successful on type 1 and type 2 errors because it accepts its limitations.

I was watching Bloggingheads between two political scientist types, and they were talking about how 'complex' the problem is because you can't let ships carry small arms, you can't shoot all the pirates, the pirates are just trying to make money and generally don't hurt their victims (I snipped 1 minute of their whiny reasoning below). Fundamentally, there is no perfect solution, which in the end they noted was really irsksome. In their academic circles, this sounds like reasoned debate, but it is merely wimpy indecision in the face of a dilemma driven by an imperfect solution. It reminded me of the scene in Godfather Part 1 where the Don slaps a crying Johnny Fontaine and says 'you can act like a man!' Accept the solution will be imperfect, people will die, and some people will object.

Do Global Climate Models Contain Keynesian Macro Models?

In the 1970s there was a period when large scale, multi-equation macro models with hundreds of equations were used to forecast the economy. Those efforts were a dead end. Of course, the modelers themselves never admitted that, and those making macro models in the 1970s still make macro models today (see Macroeconomic Advisers LLC). Economics does not note approaches are failures, rather, it just stops doing them as the professors grow old and graduate students do not replace them.

Their demise was twofold. Chris Sims showed that a three instrument Vector Auto Regression (insanely simpler reduced form model) did just as well. His argument is applicable to any complicated model: when you have lots of interactions, every variable should be included in every equation, and so the model is underidentified because then there are more parameters than datapoints. Structural parameters with very different forecast implications are consistent with the same data, so you cannot forecast because you cannot identify the correct model. Secondly, no economic model, especially a large scale macro model, predicted that the socialist countries would severely underperform the capitalist countries, or that Africa would stagnate, or that the Asian tigers would flourish. Just about every major economic trend--computers, energy shortages, internet bubble, mortgage crisis--was seen only after they happened. Of course, they missed business cycles, and the secular decrease in inflation from 1980. If an economist were to tell me the average GDP for Paraguay in 2050, I imagine the more complex the model, the worse their forecast.

It is very easy to convince yourself that a complex model is correct, because you can always fine tune it to the data, and the pieces are never fully specified so outsiders can't judge how much it was fit to explain the data it is testing. For climate models it appears obvious there are more degrees of freedom in such a model than the two main datapoints driving them: the 0.75 degree Celsius increase in temperature and the 35% increase in atmospheric CO2 from 1900-2000. It is very suspicious that the models disagree a lot on specifics, like how much water vapor is expected over Antarctica, but generally agree on the temperature and CO2 implications. For a model with lots of interactions, one should see greater variability than what I have seen. I get the sense that to get funding one's work on a model has to be plausible, where 'plausibility' has already been decided.

Ronald Prin has a video on MIT's latest climate models, and he highlighted the economic aspects of the global climate model. Uh oh. He stated the climate models were as uncertain as the economic models. That's a high standard. Prinn admits to big uncertainties in climate models: clouds, which play a large role, are difficult to model. There are also uncertainties about emissions, and ocean-mixing, the churning of cooler and warmer waters, which can bring carbon buried on the ocean floor to the surface. He says there are 'hundreds' of these uncertainties. His solution is to look at the model under various changes in assumptions, generating hundreds of thousands of forecasts to estimate the probability of various amounts of climate change. As he states, “in the Monte Carlo sense, building up a set of forecasts on which we can put a measure of the odds of being correct or incorrect.”

But enumerating changes in assumptions and then looking at the effects is not an unbiased nor asymptotically consistent estimation process. Why should we believe the model is correct even if we knew the assumptions? You have, by Prin's estimate, 'hundreds' of uncertain parameters and processes, and forecasting over 100 years. Read Sokolove's outline, and you merely get graphics of 20 to 30 categories interacting in some massive feedback loop, and you have these for Land, Ocean, Urban area, and the Atmosphere, broken down by 20 regions, and then assumptions on technological changes (nuclear vs biofuel growth) as well as economic growth. Looking at Sokolov's description, it appears to be using a macro model within the super global climate model:

The current EPPA version specifically projects economic variables (GDP, energy use, sectoral output, consumption, etc.) ... Special provision is made for analysis of uncertainty in key human influences, such as the growth of population and economic activity, and the pace and direction of technical change.

Add to that the sociology-like graphs with big arrows pointing to A --> B --> A, enumerating sectoral employment growth in Modesto, and it looks a lot like those old, discredited large-scale macro models! Using a multi equation macro model in the Global Climate Model is like using a CDO squared formula to manage your portfolio.

I'm not saying there are much better models out there, just that these models are known to be useless for long term forecasting, and specifying every sector of the economy in such a manner seems like deliberate spurious precision given the known way such precision is treated by outsiders (eg, journalists) and the wealth of experience by insiders on how fruitless this approach is. These complex 'structural models' are like the early days of flight when people would strap on bird wings to fly because it emulated reality. Now we know that is a dead end, and use nothing like nature to fly. Specifying input-output relations by sector is a reasonable approach if it was not so thoroughly tried, tested, and found lousy.

Econometrician Arnold Zellner noted, after a lifetime of forecasting:

I do not know of a complicated model in any area of science that performs well in explanation and prediction and have challenged many audiences to give me examples. So far, I have not heard about a single one. ..it appears useful to start with a well understood, sophisticatedly simple model and check its performance empirically in explanation and prediction.

Instead of evaluating the models by how much they agree under various assumptions, I would want to see some step-forward, out-of-sample forecasting. That is, run the model through time T using data only from prior to T, and see how it does in period T+1. You do this through time and get a step foreward forecast. I haven't seen this. There are data on changes in CO2 and temperature using ice cores, but there is a causation problem: say the sun (or something exogenous) causes both warmth and CO2 rise. This will not allow you to estimate the effect of an exogenous CO2 rise on temperature unless you can identify an event with clear exogenous increases in CO2, as in a volcano. For example weight is correlated with height in humans: taller people tend to be heavier. But if you gain weight, that won't make you taller. The correlation we see over time in individuals, or cross sectionally, does not imply height is caused by changes in weight.

So many Global Warming proponents emphasize this is all about the facts and impugn the motives of global warming skeptics, yet the facts and theories underlying Global Warming scenarios are actually quite tenuous. There have been no important human-created trends or events that have been foreseen by a consensus of scientists. Adding that fact to the model implies we should ignore them.

Merton on the Crisis

Nobelist Robert Merton gave a talk on the crisis, and he had a few novel points.

First, everyone castigates the markets for creating really complex instruments like derivatives, such as credit default swaps and mortgage backed securities. But, compare these assets to the assets and liabilities within a company: goodwill, deferred tax expense, intangibles, patents. Who can value these from first principles? Further, the company has the ability to change its business mix at any time, creating new products. We happily trade equities of these companies, and these are residual claims on this pyramid of assets and liabilities. Thus, the complexity of a mortgage-backed security of any sort is actually quite modest in that context. The complexity is not the key problem, in his view.

Secondly, he notes that when people extend debt, they aren't used to a portfolio that is in this kind of distress. So, take a bond trader used to managing his risk via hedging with Treasuries. The interest rate risk is paramount, and exposure to the stock market infinitesimal. After this major credit event, the sensitivities of his portfolio with equities is greater than his sensitivity to interest rate risk. This change is new to him, and he is confused. Looking at this like a put option that goes from out of the money to in the money, highlights how this regime change can happen, how a sensitivity to equity and volatility change goes from zero to material.

He argues we don't need a new paradigm to explain this, even mentioning 'Black Swan' by name. I agree that the concept of Black Swans is unhelpful, but I think the existing paradigm needs something new to explain this, in terms of the transmission mechanism.

Mortgage Capital

Back in the late 1990's when I was allocating economic capital, residential mortgages had the lowest amount of risk assigned to any major loan category. Most asset classes had about 7-9% allocations, mortgages about 4%. But this made sense in 1999, because back then people had 20% down payments and verified income commensurate with their debt payments. One would have never guessed, back in 1999, that among all the things banks could invest in, mortgages would be the trouble area. The Commercial Real Estate debacle of 1990, or the oil patch lending problems in the 1980's, or lending to South America, was considered the biggest risk.

I'd like to think that I would have increased my capital allocation through the 2000's based on my estimates of the new lending standards, or the increase in housing prices, but that's not obvious. After all, in 2005 even Robert Shiller was not predicting a fall in housing, only noting that it could not continue its torrid upward pace and that some areas might have some agressive declines. The LOB heads (line of business heads) would be arguing the new lending standards were basically the same, in that poor people are even more likely to sell everything to meet their monthly payments. The data at that time would have backed them up through 2006. Further, we will be sued or will not meet our CRA lending targets if we don't apply them, so it would have been hard to say that risk went up 100% because of what our erstwhile regulators were encouraging us to do. Regulators don't encourage banks to invest more in risky areas, after all.

In 1999, internet lending was primarily called 'structured' finance, and derided as 'air ball' lending because you lent based on the equity of the firm--an 'air ball' to experienced lenders. The collateral would only be counted on when it was by definition worthless. Banks had minimal exposure to this bubble, because they saw it coming.

We should not kid ourselves with all this focus on recent disastrous mortgage practices of banks. Having recently lost a boatload on residential mortgages, I suspect this will not be our problem area going forward. What is the current equivalent of residential mortgages circa 1999, the largest low risk asset on bank books? The only asset that did not explode in terms of its spread was US Treasuries. Given our new spending regime, poor demographics for social security, my best guess is that the banking sector's currently most riskless product is a good bet for our next lending cancer.

What is the Alternative to Value at Risk?

VAR has taken a lot of heat lately, mainly by people who never use it. If you are managing a desk of diverse instruments, it remains the best way to amalgamate risk. Consider you run a trading operation, and your desk has, at the end of the day, the following positions:

$100 Euro (Long Euro)
$100 US 30 year Tbond
$100 SPX stock index

What, other than a Value at Risk, would you use to amalgamate this portfolio of risks in USD risk?

I would say, this basket has a 95% daily VAR of $7.04. This is because the daily standard deviations are {2.74%, 0.97%, 1.58%}, and the correlation matrix is


The basic idea is to take a 95% extremum move in dollars, or whatever you base currency is, and then run it through the correlation matrix. To assume the correlation matrix is filled with ones, that all correlations are perfect, is not 'conservative' because that could be easily gamed, encouraging eople to put on hedges that will not work as well asthe perfect correlation assumes. One should probably apply a bayesian assumption so that a sample correlation is modified by some common sense.

Value at risk is not useful for long maturity assets, (most of what is in a bank portfolio), but is very useful for a trading desk, anything with a liquid daily mark-to-market. It gives you a measure of a worst-case scenario that you should see several times a year. If you see it too much, or too little, you need to adjust your formula. The main advantage of this approach is allowing one to aggregregate different asset types into a common denominator: dollar pnl change. By using the 95% tail, you should capture some of the nonlinearities in your book. Of course, for a highly nonlinear trading desk, like a desk with a lot of credit risk, or optionality, there are other limits and measures that are essential.

Anyway, if someone has an alternative to Value at Risk for such a portfolio, I'd be interested in hearing what it is.

Religious Questions

We don't go to church, but I'm not stridently atheist. Indeed, I selfishly appreciate my two young son's belief in God right now because if I were to die, my sons thinking I am in heaven looking down on them would be very comforting. At least, it's comforting to me.

But this leads to problems, because I don't have a very coherent religious philosophy. For example, he asked why bunnies deliver eggs on Easter. The questions, and my answers, only got worse.

Son: why do we celebrate Easter?
Dad: it's the day Jesus rose from the dead
Son: Jesus is a zombie?

There are a lot of zombies in his cartoons and joke books, and they aren't really the kind of people you want your kids emulating (especially eating habits). Then there's the Lutheran church he sometimes goes to in the summer for daycare or camp. There is a strong German tone to the church, and I have a lot of German ancestors. So, of course,

Son: we worship a German God?
Dad: well, Lutheranism has a lot of German influence, blah bla bla...
Son: so, we worship Hitler?

If you had to pick one guy to not worship, I'm sure the Fuhrer would be in the top 3. I guess this highlights that there's no such thing as bad publicity (I do watch the History channel a lot, which has a quota for Hitler programming each day). I imagined him telling the principal we belong to one of the Protestant offshoots, you know, the Hitler/zombie worshiping faction.

MoonBat Crazy

I kind of wish this crisis happened in 1990 because then Ravi Batra would be head of the TARP oversight committee, and he's looking a lot better than those currently proposing radical transformations of our economy. I listened to MIT professor and pundit Simon Johnson on Bloggingheads outline his master plan to save the economy: nationalize the big banks if they can't recapitalize in 30 days after marking their assets to 'true' value. It's all laid out here. What is the true value of a bank's balance sheet? That's not trivial. Indeed, if we knew that there are lots of interesting solutions. But, he gives himself a good margin for error, estimating the plan will cost $1.5 Trillion. The other part of his plan is cultural, ridding us of the kulaks--oops, 'oligarchs'--by capping their pay, and replacing them with public servants. Nothing like a 2000 word article to instigate a $1.5 Trillion dollar project. I wonder what that RFP would look like.

Who do we replace our evil oligarchs with? Rahm Emmanuel (who made $19MM in 18 months as an investment banker)? Jamie Gorelick (made $40MM at Fannie, appropriate for a former Clinton Attorney General)? These were government officials and representative of the types of people who are useful to corporations. They are even more dangerous because their connections make them valuable precisely because all they do is navigate regulations and government oversight, granting their firms special status relative to those who compete on the merits. We need fewer of these people, more unsympathetic Wall Streeters who everyone knows is selfish and greedy. The last thing we need are bankers who do the 'public good', because saddling these institutions with this vague objective gives rise to all sorts of payoffs under the guise of helping the poor, as it merely makes sure the SEIU, African-Americans, women, the handicapped, and transgendered Native Americans--to mention only a few--are treated fairly. The do-gooders usually end up pocketing more for themselves than anyone; at least a businessman is honest about his selfishness (United Way and CRA blather excepted).

Seeing the jack-boot of corporate oligarchs as our root problem, and comparisons of American bankers to third-world government-sponsored businesses suggest he slipped in some bat guano that might have gone into his ear. As a former chief economist at the IMF, his resume is a gold-plated do not hire for anyone actually trying to solve problems. The IMF is not known as a successful turnaround specialist, though they do have experience spending trillions of dollars. They are filled with government do-gooders who, paradoxically, are painted as part of a capitalist conspiracy by leftists (funny because the only IMF and World Bankers I have known are staunch Democrats). Chief economists are generally people paid to do PR. They don't get their hands dirty actually banking, instead they talk a lot about 'important' things like the money multiplier, the Phillips curve, and how the latest durable goods report is really interesting. If you think executives or any powerful executive group listens to their Chief Economist for practical advice, you probably think the Easter Bunny at the mall has a tough weekend ahead of him.

For $1.5 Trillion less I have a better plan (for $1.5T, who doesn't?). Leave the market alone. If a bank goes bankrupt, let the bankruptcy courts handle it. At least, try my plan for all banks west of Philadelphia, and in five years we can do an evaluation.

Regulatory Capital Arbitrage

I was in charge economic capital allocations at KeyCorp. We allocated 'economic' or 'risk' capital within the bank. This exercise was used for reporting, pricing, compensation, and risk management. One issue that often arose was what to do when the economic risk capital allocation was different than the regulatory capital allocation. I wrote an article in Bank Accounting and Finance in 1997 on this issue. As there were relatively few buckets for regulatory capital--6% for most assets, 2% for OECD debt--the issue was always present. But 'arbitraging' regulatory capital was only recommended when the estimated risk capital was lower than the regulatory capital. That is, people don't increase leverage by securitizing unless they believe, and their debtors believe, they do not need the capital required by regulators. You arbitrage it when it is too high, not too low. Banks don't intentionally take on too much risk.

Felix Salmon notes one can reduce one's regulatory capital requirement by about 1% by securitizing. That's fine, but in general banks that could avail themselves of this strategy were not increasing leverage over the past 20 years. Most estimates of the required risk capital were much lower than regulatory capital, around 2-3%, because they were assumed to have their historical credit loss rates, which were de minimus. That was a mistake, to be sure, and people like Peter Schiff were spot on in seeing that, but it was the best estimate of academics, regulators, investors, and bankers.

Thus, the idea that we need to prevent regulatory arbitrage presumes this is because risk capital is greater than regulatory capital requirements in certain circumstances. With hindsight, there was too little capital allocated for mortgages originated between 2005 and 2007. Then again, with hindsight, they had a negative NPV, and should not have been issued by any rational profit maximizing firm. But that's hindsight. The market risk capital for those assets is probably much higher than any regulatory requirement right now. This is a problem that does not need fixing, because bankers do not take on too much risk on purpose. If the regulatory capital requirement is 2%, and your assessment is 6%, you allocate 6% unless you have excess capital from other investments. The idea that bankers knew the asset required a 10 to 1 leverage ratio, but chose 30 to 1 because regulations allowed it, is like assuming that people drink 12 shots of scotch in 30 minutes because it is legal to do so. The key reason is the willingness, not the legal ability. It is impractical to design a legal system that will capture the myriad nuances involved in allocating capital to literally thousands of different bank liabilities. Currently there are 3 different regulatory capital buckets (OECD government debt, A rated investments, and other). In a few years, this might change to 5.

The bottom line is this crisis was not caused by regulatory arbitrage, but rather, everyone assuming mortgages had much less risk than they did, or do. You should not give a mortgage to someone who can't pay for it on the presumption that collateral never declines in value. We now know mortgages are much riskier than we thought in 2006. Bankers do not lever investments more than they should merely because it is feasible under the regulatory requirements. Like the Space Shuttle disaster, fixing the specific cause of the last crash is easy (more resilient O-rings). Having a mechanism that better anticipates the next unknown failure is not so simple.

Emphasis not Helpful

Often you read an essay, and the words in italics, or in ALL CAPS, seems off. The emphasis is unhelpful at best, and makes the passage difficult to read. I was struck by Mark Rubinstein's mention of John Lintner CAPM paper from 1965 (in A History of the Theory of Investments). Lintner was one of 4 co-discoverers of the CAPM, the others being Bill Sharpe, Jan Mossin, and Jack Treynor.

Lintner's writing style, unfortunately, makes his results difficult to digest. He habitually uses very long setnences stating precisely all conditions and frequently italicizes words to help the reader pull out the most significant ideas. Despite this, it is often difficult to tell what is important and what isn't.

More Educated, Less Informed

In Just How Stupid Are We? Rick Shenkman notes that in the 1940, 60% of Americans had not finished 8th grade. Currently, most Americans have had some college education. Yet they score worse on simple civics tests, such as 'what is the difference between Republicans and Democrats?', or 'how many branches of government are in the US?'

In science, it is pretty bad too. Political scientist John Miller notes that american adults in general do not understand what molecules are (other than that they are really small). Fewer than a third can identify DNA as a key to heredity. One adult American in five thinks the Sun revolves around the Earth. In one very funny study, (A Private Universe) they asked students at Harvard's commencement why seasons occur. Most thought it was because the earth is closer to the sun in summer. Harvard grads.

Behavioral Finance in Practice

Barberis and Thaler have a survey chapter in the Handbook of Finance on Behavioral Finance. They note the following financial opportunities caused by behavioral quirks:

• pairs trading dual listed shares (Royal Dutch and Shell Transport)
  
• Index inclusion (buy stocks goinp into index, sell going out)
  
• Internet carve-outs (eg, when 3Com sold 5% of Palm)
  
• Agg. Div/Price generates 27% predictability over next 4 years
  
• 3 year mean-reversion (DeBondt and Thaler)
  
• 18 month Momentum (Jegadeesh and Titman)
  
• B/M and P/E predicting stocks (book and size)
  
• positive drift after earnings announcements
  
• positive (negative) drift after initiating (omitting) dividend
  
• Repurchase shares outpefrom, issue shares underperform
  
• Closed end funds trade at discount to NAV
  

I think only half of these are true today, and they may have only been true anecdotally in the past. For example, the 3Com-Palm spinoff was an arbitrage, and I personally know people who arbitraged it. But it does not happen often enough to be interesting. The predictability of the aggregate dividend price ratio uses a 4 year horizon, so how many 4 year horizons do we have in the US? About 20 (80 years divided by 4). That's hardly enough to draw strong conclusions. The index-add/delete strategy was over years ago. Is it really that strange to note that there are many ways to make money if you could go backtward in time?

Strangely, they list the momentum effect of Jegadeesh and Titman and also their 'overreaction' effect, even though these are contradictory. Further, no one has updated their 3 year mean reversion result. If you think contradictory empirical results are true, and no one publishes 3 year mean reversion follow-ups, chances are you did make a technical mistake (in their case, rebalancing daily returns for low-price stocks).

Value, size, momentum, and equity issuance can add value to a strategy, but I don't see how behavioral economics helps you exploit this. But my bottom line is that the rational market school tells you to be skeptical, to check things again and again. Behavioralism lends itself to seeing too many anomalies that are not, or no longer, there. The batting average of someone jumping into these strategies would be less than 50%. Many have a short time frame, so one taking advantage would have to be a full time short term trader to capture these, and you would have been let go long ago if these were pillars of your strategy.


The article highlights how Kahneman and Tversky's prospect theory has allowed people to formalize this approach. Above is a utility graph from Harry Markowitz back in a 1952 JPE article, who was commenting on Milton Friedman and Savage's analysis in this same vein. It has the essence of prospect theory: risk loving for losses, risk aversion for gains, for some arbitrary wealth point. The profession dropped this thread because it was too rich: allowing people to be risk averse or loving, ignoring or overweighting small probability events, is not a useful insight. I don't know how many times I hear intellectual dilettantes note how Khaneman's work is really exciting, which is odd given how old the double inflected utility function is. 50 years is a long time; it was not discovered when Kahneman won the Nobel prize in 2002.

Will Citi, Goldman et al Game Geithner's Plan?

Doubtful (see scare potential at FT, picked up by many others). The analogy to Enron is not applicable because there are more players to this game. Enron could game California's energy market because they were the clear dominant player, and too few people were looking at it. Further, Enron was gaming the system so that those implementing the plan were making the money. Player A was making money for player A, as opposed to having player A make money for player B. Collusions, like secrets, are very hard to keep as the number of players goes from 1 to 5. Ever try to keep a great secret with 5 of your best friends in school?

Consider the scenario where the asset management arm of Citibank buys assets of JPMorgan, in an implicit quid-pro quo with JPMorgan's asset management group buying assets from Citibank. The criticism implies the asset management group is overpaying for these assets. The benefit of this collusion occurs at the Corporate Level, not to asset management, which expects to lose money. Thus, there would have to be discussions between the CEOs and their Asset Management chiefs on the 'plan' with emphasis than this plan must be seen in the 'bigger picture'. Supposedly, the Asset Management players would be promised some kind of future cushy job instead of bonus payment. Further, this strategy would be risky because the banks with the targeted assets are not the majority of only players lined up to bid on these securities. If they are overbidding, Treasury officials should see a clear pattern (winning bid disproportionately from a bank-owned asset manager), and one would have to hope Treasury is too stupid to figure it out (probability between zero and 1).

So, for the asset management group at Citi (or Goldman, or wherever), your grand conspiracy is crowded, convoluted, illegal, and uncertain. Would you play such a game?

Technocrat=Good Government

Felix Salmon is blogging at Reuters now. He highlights lots of stuff I like, and a lot I don't like (mainly, too many posts). Felix Simon on 'good government':

a government of technocrats — which is what I think we now have — is nearly always to be preferred to a government of idealogues

In my experience 'technocrat' means a details oriented politician who does 'good' things, and is used more often by European journalists, probably because they tend to be even more supportive of government planners. 'Good' is whatever increases social welfare over the long run.

Technocrat means 'detail-oriented wonk I like' just as fascist means 'power grabbing politician I don't like'. One's preferences can be well reasoned and correct, but don't kid yourself that only those that agree with you are being objective. It is important to remember that while there is a lot of bad faith in argumentation, there is always a principled position behind either side of any policy debate. One side may be wrong, but it is not untenable.

Thus, not everyone who thinks giving free food to poor single mothers is a bad (or good) idea is an idealogue. Same act, different interpretation. Merit pay for teachers, nationalizing banks, investing in ethanol infrastructure, 'card check' for unions, all involve 'technical' issues, detail. But there is no way one can avoid coming out looking partisan at then end because unintentionally or not your solution will by simpatico with the Left or Right.

Scope of Financial Crisis

One interesting puzzle of this crisis is that while it started with mortgages, it affected every financial sector pretty similarly. Below are the total returns from April 30 2008 through March 31 2009, for a variety of financial institutions with market cap greater than $30MM as of April 2008 (about 800 firms).

Stock Returns By Sub Industry From 4/30/08 - 3/31/09


One would think that size or industry would highlight those with the most direct mortgage ownership. It suggests that while mortgages may have started the crisis, the real problem was the amplification process that decimated everything. To this day only mortgage backed debt has had abnormally large loss rates. Speculative grade defaults for 2008 were 4.1%, which makes it the 12th worst year in the last 30, hardly consistent with the market debacle of the past 12 months. Auto loans, credit cards, etc. have reported an increase in losses, but are holding up pretty well. Everyone expects them to get much worse, but that's a forecast.

A similar issue is the performance across countries, where the US is actually doing better than most countries. This is all quite puzzling, as it appears the amplification mechanism is much more important than the initial cause. I don't really understand that mechanism.

Economists are Here to Help (heh)

Mark Thoma and Scott Sumner were on Blogging Heads talking about the financial crisis. They seemed to agree that taxing 'excess reserves' of banks was a good idea, because you want to incent lending, and get money flowing to alleviate the liquidity crisis.

However, banks are hoarding cash because they feel they need a bigger cushion. Indeed, the 'stress tests' of Geithner are looking at banks and evaluating whether they have sufficient capital to withstand some hit to their portfolios. Lower levels of capital would make them fail this test, and then they would be taken over.

In 1937 the US implemented a tax on retained earnings, which seemed like a good idea to economically incompetent Roosevelt because he assumed he was just taxing 'money', and unused money at that. The idea was, we wanted to get this money 'working'. Plus, taxes on capital are progressive (good). See here for a 1937 rationale, and note it mentions Henry Ford by name.

The 1937 recession was one of America's worst. Unemployment rose from 5 million to almost 12 million in early 1938. Manufacturing output fell off by 40% from the 1937 peak.

Taxing 'excess bank reserves' is just like taxing retained earnings in this environment. Luckily, Bernanke is very conversant with this episode, and the need for firms to have 'excess' cash.

Difference Between Economics and Physics

In physics, there are constants defined to 10+ decimal places. Most economic debates are about the sign: is Coke riskier than GM stock? Does increasing the minimum wage increase aggregate worker total wage, or reduce it? Would increasing government spending increase or decrease GDP over the next 5 years?

Consider the following example, from Shane Frederick's
presentation on time discounting at MIT. This is the estimate of the spped of light over the past 150 years or so:

In contrast, below are a set of estimates of an important parameter in economics, the time discount parameter. If delta =1, you count the future equal to today, and are indifferent to receiving a massage in 1 year or tomorrow. If you have a delta=0, you totally ignore the future, and so glue sniffing is optimal, because though it kills your brain cells, it is a great rush over the next 5 minutes (or however long glue-sniffing highs last).


Note even at first, the estimates of the speed of light were reasonably close to the true value (or, the current value), off by about 0.07%, and converged to the current estimate about 50 years ago. In contrast, estimates for the discount factor seem to be a random draw from the uniform distribution between 0 and 1, though slightly more between 0.9 and 1.0.

So, the equations in advanced economics and physics look the same, but that's a pretty superficial similarity

Stiglitz is an Idiot

Ok, I read on Tyler Cowen's blog that using negative words like "idiot" and "moron" increases the number of commenters, and presumably readers. Clearly my favorite flâneur, Nassim Taleb, has climbed the best-seller ranks with this rhetorical style, so, I'll give it a try. I think Stiglitz is intelligent and educated. But he is also incredibly biased in a totally predictable, simple-minded way. This is not a partisan critique, just look at his activity: he gives speeches about once every two days. Guys like that don't have time to look at the detailed data, or derive a fresh view, but rather fit it to their internal templates. They are using their position to 'make a difference', which sounds nice, but it just means you are an amoral, confabulating advocate. Think lawyer.

In that way, he is not thinking when he writes, merely advocating the best case for his big picture idea that markets should be sublimated to government control whenever there is not perfect information (no uncertainty or asymmetric information, ie always). He edited volumes 1-3 of the collected works of Paul Samuelson, with a heavy emphasis on market failures. He loves pointing out scenarios where a market equilibrium is not a Pareto Optimum or vice versa (Pareto Optimum being the idea you can't make anyone better off without making someone worse off, a rather modest definition of optimality). Government failure is not interesting to those obsessed with market failure, a common blind spot in the Marxist tradition (very little in Das Capital outlines how communism actually works, it's mainly a criticism of free markets).

Anyway, in today's NYT he rails against Geithner's plan for several dubious reasons, but fundamentally because it is a subsidy to banks and investors. It isn't clear if his distinction between banks and investors is the difference between management and equity, or equity owners and bond owners. Whatever, his Big Idea is that there is always imperfect information, therefore markets are not optimal, therefore have the politburo control it. Here's the Nobel Prize winning argumentation in block quotes:

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets.

Where's the data? Bank leverage, as measured by common equity to total assets, did not materially change over the past 15 years for banks. Did you mean "Investment Banks"? That did change, but only for a handful (ie, Citi and Morgan Stanley). It's not true merely because you say it every other day when lecturing as Expert on Everything.

In the process, they used overly complex instruments like collateralized debt obligations.

Derivatives are the tail of the dog. If mortgage prices did not collapse, CDOs would not have collapsed. CDO's facilitated risk transfer, if anything, it prevented a worse crisis by moving the effect of the housing price collapse out of banks and into Hedge Funds and Government (ie Fannie and Freddie). This diversification is generally considered a good thing, but here it is insinuated that it was the fuel for the risk taking. Sorry, the impetus was at the other end, with $5 Trillion in Community Reinvestment Act pledges for investing in 'traditionally underserved communities'--ie, groups previously not lent to because they were bad credit risks. Mortgage innovations like low, and even no, money down, implies the greatest leverage was to the individuals, not the banks.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently.

Anytime a bubble collapses we can say this, but this criticism needs more flesh on it. It seems to imply that any payment scheme that is a function of revenue generated, that does not have an infinite clawback provision, encourages excessive risk taking. That's a nice bargaining position for a socialist like Stiglitz. That may seem like a partisan shot, but it's true: he's always for giving the state more control into economic activity, to the point that it always has veto power and generally sets the agenda and mission statement, compensation, etc. His ends dictate, with perfect predictability, his interpretation of events and his prescription for rectifying the situation.

Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

Partly to be sure. But for commercial banks this was pretty small. The biggest problem was on balance sheet. Look at the data. Look at a regional bank like KeyCorp. Their stock has fallen 75%, and they lost $1B last year. Most of this was an increase in the provision for loan losses on their books. They had $1.25B in credit default swaps at the end of 2008, and noted (page 60 of 10-K) "These swaps did not have a significant effect on Key’s operating results for 2008." Banks, as opposed to Investment Banks, are not primarily hurting because of derivatives. Their exposure would have only been worse without them.

The problems of AIG and Lehman were of taking too much risk in CDOs and credit default swaps, and to this day I have not seen specifics of their balance sheet. That is, until I see what the reference assets for the swaps, I can't assess their actual solvency, or potential for insolvency (and thus a logical run by short-term debt holders). But those problems are not the problems of our banks, 7000 little companies that try to intermediate between savers and investors. Most Commercial Banks are not Investment Banks, their balance sheets are not dominated by marketable securities.

Stiglitz notes the problem of offering banks basically 6:1 leverage, and a 50% match-funding, by looking at the following scenario. Assume there is an asset with a price of $150, that will pay off $200 or $0 next period. A $12 investment by private companies, a $12 match funding by the government, and a $126 senior debt by government. The return on the 'total value' of this transaction is either +33% or -100% [$200 or $0]. Well, with 6:1 leverage and match funding, that means a 208% return in the up state, or a -100% return in the down state. The expected return: 54% {(208-100)/2}. What a deal! Meanwhile, government gets an expected -40% return on 7 times the capital.

A key here seems to be what the prices and returns really are. If you suppose such a bad transaction, clearly, it is a greater subsidy to the private sector. But given the government is trying to fix things without nationalization, presumably a subsidy is a given. The issue is, are these deals this much of a give away? I doubt it. When was the last time a pool of mortgages was worth zero. Geithner's plan refers to pools of mortgages, not mortgage tranches. A tranche of a pool of mortgages can easily go to zero, especially the mezzanine tranches, but the pool itself? If this seems possible to you, you are, well, an idiot.

It seems like you are giving money away, to fat-cats. The problem is, these are mortgages, so they are not 'idiosyncratic risk assets'. You can not buy 100 of them, with a 54% return, and lock in that return. Instead, investing through time, and I doubt any investors are willing to put up large amounts (billions) in investments with a 50% chance of a negative 100% return. Further, the auction method of selling assets implies that even if this were a case of idiosyncratic risk (say, adverse selection made it 50% of these were worth $200, 50% $0), then somehow investors would be colluding to keep the return at these insanely high (54%) levels. Ah, the deals Captains of Industry make in the back rooms. The nice thing about greed is that it implies competition, and competition abhors easy profits the way nature abhors a vacuum.

Stiglitz notes how efficient government is in nationalizing banks. Who's to say how much value was saved, or destroyed, via government's take over of IndyMac (sold at a loss of $9B last January)? But this will only be worse if they take on lots of banks because then their portfolios will be politicized to the n-th degree, as then broader considerations will be in play. Consider that once they took over IndyMac they halted foreclosure on mortgages, leaving zombie properties where 'owners' had no equity in the properties, and bank's could not resell them. That merely added to their losses, and didn't help the little guy, it just delayed the inevitable resale of that property to someone who was a viable homeowner. Do that with 100 IndyMacs and you have really depressed the market, and a larger impact on poor communities that do not need more unowned properties. When the effective owner has no money in the house, it is not maintained, managed, or re-allocated. It just serves as a place for punks to cause trouble. Indeed, the 'owner' of the house in foreclosure limbo has zero incentive to do anything with the property, just wait and pray for hyperinflation (a potential plank II of the Treasury plan).

After the Great Depression, John Kenneth Galbraith wrote 'The Great Crash', and it was a best seller. The thesis was that greed and short-sighted risk taking, especially by corporate executives, caused the Stock market crash, which then caused the Depression. This was the standard perception for decades. Today, I doubt more than 10% of economists think that greed or short-sightedness was a singular, or useful explanation for the 1929 crash and subsequent collapse, or that the Great Depression was caused by the stock market crash.