1) lose weight
2) teach my kids to be more courageous, polite, and better at math
3) wag more, bark less
Friday, December 31, 2010
Thursday, December 30, 2010
End of Year Tax Strategy
Above are the returns (based at 100) for a portfolio long the top 50 winners, short the bottom 50 losers. US stocks, market cap over $500MM as of Monday.
I remember reading about this end of year strategy a while back: go long year-to-day winners, short year-to-day losers, in December. As winners have tax gains, and losers tax losses, there is good theoretical reason why such portfolios should have different returns in December on a partial equilibrium basis. Why take a taxable gain in December, when you can postpone it until the next year? Why not take the taxable loss now? If all the winners have hesitant sellers, the losers willing sellers, winners should outperform losers in December. They did for decades.
With theory and data, I put on this trade in 2003, and got destroyed. In my personal backtests at that time, where I also did market cap and other (clever) filters, it had an extremely good history, losing only a couple of times over the prior 30 years. Of course, I had an out-of-sample adverse experience.
This highlights that even if you can articulate a strategy that make sense, over time it will disappear regardless. This is why having an 'equilibrium' result for some tendency is important for a strategy everyone knows about, because if it's not, it's probably an epiphenomenon, like noting that internet companies are good shorts (true if you have 2001 prominent in your sample).
Index additions/deletions, low price stocks, all these have been arbitraged out of the market after they were discovered. It's best to simply not play a game that brokers send to traders in white papers if it is based on being clever, because brokers are not clever, but rather conventional wisdom.
Tuesday, December 28, 2010
Smile
People who smile more, are happier in the long run. This study looked at baseball cards from the early 1950s and coded whether players were smiling or not. Players who did not smile at all on average lived for 72 years. Those who smiled a bit on average lived for 75 years. And those with big smiles on average lived for 80 years.
These researchers also analyzed 114 pictures from the 1958 and 1960 yearbooks of a women's college in the Bay Area. All but three of the young women were smiling, but the smiles varied. The researchers chose these particular pictures for analysis because the women in them were participants in a long-term study of important life events. Specifically, the researchers knew - decades after the yearbook photos - whether the women were married and if they were satisfied with their marriage. As it turns out, the degree of their smiles years earlier predicted both of these outcomes.
These researchers also analyzed 114 pictures from the 1958 and 1960 yearbooks of a women's college in the Bay Area. All but three of the young women were smiling, but the smiles varied. The researchers chose these particular pictures for analysis because the women in them were participants in a long-term study of important life events. Specifically, the researchers knew - decades after the yearbook photos - whether the women were married and if they were satisfied with their marriage. As it turns out, the degree of their smiles years earlier predicted both of these outcomes.
The Advisor Weblog
The Advisor Weblog |
| Posted: 28 Dec 2010 03:26 PM PST Sorry for the lack of post people, I have been pretty busy getting ready for what I do expect to be a great year for all of us! If anything, Tuesday has been yet another proof of lack of strength in both major European currencies, Euro and Pound. Despite market is lately showing no interest in selling euro bellow the 1.3100 mark against greenback, with the cross hanging above the 1.3080 price zone, 50% retracement of the 1.1870/1.4280 rally.
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Facts More Important than Theory
Most people think facts are easy and theory is difficult. It is often the other way around. As Charles Darwin wrote:
So I got a lot of pleasure reading the insane amount of commentary on Steven Landsburg's puzzle about the percentage of boys in a population where they stop on the first boy (answer: with 1 family 30.685...%, approaching 50% as the number of families goes to infinity). The disagreement between many very smart people gets into semantics (is it really 50%, or just beneath it?), but in any case, if you put out a logic puzzle and make a mistake, it won't last long if its important. Not many people redo empirical analysis, however, because it's not something you can just figure out in your head: you have to gather data, understand it, clean it, etc., and then apply statistics.
False facts are highly injurious to the progress of science, for they often long endure; but false views, if supported by some evidence, do little harm, as every one takes a salutary pleasure in proving their falseness.
So I got a lot of pleasure reading the insane amount of commentary on Steven Landsburg's puzzle about the percentage of boys in a population where they stop on the first boy (answer: with 1 family 30.685...%, approaching 50% as the number of families goes to infinity). The disagreement between many very smart people gets into semantics (is it really 50%, or just beneath it?), but in any case, if you put out a logic puzzle and make a mistake, it won't last long if its important. Not many people redo empirical analysis, however, because it's not something you can just figure out in your head: you have to gather data, understand it, clean it, etc., and then apply statistics.
Monday, December 27, 2010
Remember the Rational Model
Say there's a two-sided matching game, where you trade a good with another; not trading generates no utility, so you want to get the highest possible value. All goods, including yours, are of uncertain value, and you have a noisy, unbiased estimate of all the values, as do others. Some have less noise around their estimations than others, though you do not know who. So, when someone shows up, and really really wants to trade their good for yours good, are you excited? No. They probably they have value well beneath yours. What is most interesting is if the person is marginally interested in trading with you, because that means they might be right in the sweet spot: not so low you could do obviously better, but high enough to be practically optimal given search costs.
This is exactly what they find in dating markets, surprising no one. People are attracted more to those who are kind of interested, as opposed to really interested. This is consistent with the simple, rational bayesian model that is perfunctory for economists. It is almost more common than not that a popular book on economics caricatures this model as insanely unrealistic. We should remember that this model actually explains a lot, and when it fails often points out we are missing something in people's information sets, as opposed to something in their neurology. When a company announces positive news, the stock generally rises, when Treasuries fall, its usually because people are forecasting lower inflation or lower future real rates. These are uninteresting 'dog bites man' stories because they are so common and make sense using the standard rational model.
This is exactly what they find in dating markets, surprising no one. People are attracted more to those who are kind of interested, as opposed to really interested. This is consistent with the simple, rational bayesian model that is perfunctory for economists. It is almost more common than not that a popular book on economics caricatures this model as insanely unrealistic. We should remember that this model actually explains a lot, and when it fails often points out we are missing something in people's information sets, as opposed to something in their neurology. When a company announces positive news, the stock generally rises, when Treasuries fall, its usually because people are forecasting lower inflation or lower future real rates. These are uninteresting 'dog bites man' stories because they are so common and make sense using the standard rational model.
Saturday, December 25, 2010
Friday, December 24, 2010
Some Myths are Better than Others
Norad tracks Santa. With about 2 billion Christians, say 1B independent households, and given Santa has a day to deliver gifts, that's only 86 microseconds per house. Given he tends to leave half eaten carrots (from the reindeer) and cookies, I imagine this speed would actually incinerate most homes. Nevertheless, I love Christmas--the songs, decorations, stories, meals, gift-giving--and my kids do too.
John Cochrane wrote, the CAPM “proved stunningly successful in a quarter century of empirical work,” meaning it seemed to explain the data pretty well, until we found out this was merely due to beta picking up the size effect, which itself was mainly measurement errors.
This longing for a prior sense of ignorance, when a popular theory appeared to be working, is a rather bizarre stance for an economist. It’s like saying how fun Christmas was when we believed in Santa Claus. True, but that’s harmless fun, not science. The CAPM was never a benign conspiracy of professors to create joy in MBAs, but a serious hypothesis about the way the world works. In a similar vein, Paul Samuelson stated about Karl Marx in his 1995 edition of Economics, after the fall of the Berlin Wall reduced the allocation of his text on Marxism to a footnote: “Marx was wrong about many things—notably the superiority of socialism as an economic system—but that does not diminish his stature as an important economist.”
Ah, the “being wrong” part—never mind!—Marx was popular and inspirational. Clearly, economists see theories in context larger than falsifiable predictions. Any idea that generates a large literature, supposedly, is good. The thought that an idea was edifying, even if wrong, is comforting to academics who often investigate unproven ideas. I disagree. There are an infinite number of bad ideas, so eliminating many of them puts hardly a dent in the shelf from which they are drawn. This is especially true when an error merely postpones an inevitable education with reality, like saying drinking and driving was a great idea until I hit a school bus. The fact that economists as preeminent as Cochrane and Samuelson adopt the same stance toward what constitutes a successful theory (ephemeral popularity among scientists), highlights the strange power of any idea that spawns a large literature.
Wednesday, December 22, 2010
The Advisor Weblog
The Advisor Weblog |
| Posted: 22 Dec 2010 04:43 AM PST Here is the EUR/USD technical perspective: http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2010/12/22/
 |
| Posted: 22 Dec 2010 04:37 AM PST Hi all and welcome back to this blog! Not much activity ahead of Christmas, the holidays’ are among us, and markets are getting thinner day after day. Stocks are slightly higher, barely unchanged, while Euro and Pound managed to correct some of the ground lost yesterday, still limited to the upside: key levels to watch there are 1.3180 in Euro and 1.5560 in Pound. No much upside there unless clearly above those levels. I was seing that around 1.3080 yesterday’s low, we have the 50% reacement in EUR/USD of the 1.1870/1.4280 rally. Quite a support, so if the pair manages to close the day, or better the week below it, should signal midterm falls in the cross, adding to the fact that historically, EUR/USD tends to fall in January is giving us an advance of what we could expect for the cross. Anyway, will post EUR/USD chart right after this post. Here is the link for today's calendar: http://www.fxstreet.com/fundamental/economic-calendar/ Have a great day!
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When People Agree for Different Reasons
Among people who might agree with me on various issues, it is usually for very different reasons. Consider the many reasons people are for abortion or tax cuts. People often focus upon those who agree on their goals, and dismiss the reasons why as uninteresting details. This has pragmatic merit (Keynes's dictum that 'everything is always decided for reasons other than the real merits of the case'), but it highlight the tenuous foundation of our beliefs.
Harvard Law professor Noah Feldman just wrote a book--Scorpions--about the Supreme court justices from when President Franklin Roosevelt was battling to get his radical initiatives implemented in the 1930's. The Supreme court presumably constrains the executive and legislative branches based on whether their conduct or laws are 'valid'. Very smart people study law to decide whether things are 'legal', and then try to convince judges various actions or laws are valid.
He notes all the justices were very smart and driven, and most importantly key supporters of the New Deal. While they disagreed on almost everything (ergo 'scorpions in a bottle'), they arrived at similar conclusions through quite varied philosophies. William Douglas was results-oriented, Robert Jackson relied on constitutional principles, etc. In other words, they all agreed on the answer, just not why it was correct.
The 'why' matters for a host of reasons: it can point to other applications, and suggest the degree of arbitrariness in the decision. For example, if one person doesn't want to rob me because he fears punishment, another because he thinks it is morally wrong, I'm going to try to stay away from the guy whose only fear is the police.
Feldman praises the justices for their role in helping the high court deliver the landmark desegregation decision, Brown v. Board of Education. He contends that their willingness to “break [philosophical] rules of their own,’’ was good because they learn the art of politics from FDR. Not only did they all have different legal principles, they would break these when convenient, highlighting the profound goodness of these men. Well, what if they justified a law you didn't like that way? There seems to be a total absence of principle among these legal titans.
Jonathan Haidt highlights brain research that shows people make decisions first, often unconsciously, then confabulate answers, and they've done this with people whose brain's corpus collosum has been severed and showing things to one eye, ask them to point with the other hand, etc. He likens the conscious confabulator and the unconscious decider of our selves to an elephant and its rider. The rider represents the 'controlled' processes of the mind, the planning and reasoning that takes place one step at a time in conscious awareness, while the elephant represents the hundreds of automatic operations we carry out every second outside of conscious awareness. Over time, the rider can influence the elephant, but never always, and only so much.
This highlights that all people develop beliefs via a process of 'anything goes'. Reality has its constraints, mainly because it is easier to argue for things that are true than untrue--but it's not impossible to argue for things that are false, or even really hard. As Paul Feyerabend argues in his great book Against Method, there is no singular method to science any more than there is single method how a child comes to understand the world: from tradition, direct experience, command, advice, instinct, reading, etc. Surely children learn much more quickly than adults, most of it true, and do so in a very unstructured way. They are on the whole quite ignorant, but importantly, our betters at 'learning'.
When people say their ideas are based on reality, science, rigorous proof, or statistics, they just mean they think their ideas have convincing articulations to some people they respect. They are naive if they think that any mildly complex idea is unambiguously true according to some unimpeachable proof. There are just too many assumptions and implications in any assertion for one to say A is apodictically better than B. Sure, you can come up with simple examples of ideas where the alternatives are silly, but consider most issues people disagree upon--specific tax rates, welfare policies, environmental regulations, criminal statutes--and you will find smart, educated persons on both sides of the debate.
Remember that the economic profession became pretty convinced in the empirical validity of the CAPM (recounted here), over the period 1965 to 1985. Fama and MacBeth, and other seminal papers documented the Sharpe/Linter/Mossin model of how covariance with 'the market' determined expected, and thus average, returns. Miller and Scholes (1972) did empirical work on the CAPM where they controlled for changing interest rates, volatility, measurement error, residual volatility, and skewness, what appeared to be 'everything'; they did just forgot to control for size, which Fama and French (1992) showed got rid of any beta correlation with returns. You simply can't control for everything, so it seemed pretty convincing at the time. This merely highlights what counts as 'proven' is always ignoring some inconsistency, even when the theory is true (as one wag said, no theory is consistent with all the facts, because all the facts aren't true!).
The progressive faith circa 1900 that all we needed was education to create a better world seems like one of those naive beliefs in socialism. The same truths would become obvious to everyone. The problem is, you can't teach common sense, and even those who have it have idiot-savant status, such as when the brilliant surgeon is a conspiracy theorist, or a great labor economist who is a poor macroeconomist. I know I have both good and bad ideas, but alas don't know which are which so I'm stuck with both. You could say, just don't believe in anything much, but that would leave me catatonic, unable to decide the most trivial thing because of the infinite reasons for and against anything.
Oscar Wilde said 'the man who sees both sides of a question is a man who sees absolutely nothing at all', meaning, you have to take a risk, assume something is true in spite of its unprovability, and act--at least tentatively--otherwise you really are in a state of precognition, as when a naive researcher looks at a bunch of data without focus, seeing nothing. To focus is to theorize, to form model of what is important and how things are measured and interact, and our education gives us many tools to do this. But as in geometry where sometimes you assume parallel lines meet, sometimes not, so too with all assumptions and criteria, and the justification is always somewhat arbitrary.
I'm not some sort of Derridean postmodernist, I just know that at the end of the day, people will probably agree or disagree with you for reasons other than what you articulate. I just try to remember that having good prejudices is as important as the having good empirical evidence--eg, the prejudice that risk and return are not related in asset markets--and so work on those as well as remembering how best to calculate corporate default probabilities. Think of your prejudices as your ultimate strategy that dictates your tactics.
It's good to have good reasons they help find these true ideas more efficiently; there just isn't one rational method, or even meta-method.
A good method for justifying your beliefs--say applying GMM to a utility function, economists love that!, or flow charts if you are a sociologist--will bring along interlopers who may not have an interest in your specific outcome, but rather, like your application of some methodology, and become a kindred spirit that way, helping your cause and career.
Free competition among people's services, goods, and beliefs is all that tends to make most centuries a little better than the prior one, and forces us to generate better services, goods, and ideas. Truth, like low prices, is not the result of an individual, but rather the byproduct of our collective interaction.
Harvard Law professor Noah Feldman just wrote a book--Scorpions--about the Supreme court justices from when President Franklin Roosevelt was battling to get his radical initiatives implemented in the 1930's. The Supreme court presumably constrains the executive and legislative branches based on whether their conduct or laws are 'valid'. Very smart people study law to decide whether things are 'legal', and then try to convince judges various actions or laws are valid.
He notes all the justices were very smart and driven, and most importantly key supporters of the New Deal. While they disagreed on almost everything (ergo 'scorpions in a bottle'), they arrived at similar conclusions through quite varied philosophies. William Douglas was results-oriented, Robert Jackson relied on constitutional principles, etc. In other words, they all agreed on the answer, just not why it was correct.
The 'why' matters for a host of reasons: it can point to other applications, and suggest the degree of arbitrariness in the decision. For example, if one person doesn't want to rob me because he fears punishment, another because he thinks it is morally wrong, I'm going to try to stay away from the guy whose only fear is the police.
Feldman praises the justices for their role in helping the high court deliver the landmark desegregation decision, Brown v. Board of Education. He contends that their willingness to “break [philosophical] rules of their own,’’ was good because they learn the art of politics from FDR. Not only did they all have different legal principles, they would break these when convenient, highlighting the profound goodness of these men. Well, what if they justified a law you didn't like that way? There seems to be a total absence of principle among these legal titans.
Jonathan Haidt highlights brain research that shows people make decisions first, often unconsciously, then confabulate answers, and they've done this with people whose brain's corpus collosum has been severed and showing things to one eye, ask them to point with the other hand, etc. He likens the conscious confabulator and the unconscious decider of our selves to an elephant and its rider. The rider represents the 'controlled' processes of the mind, the planning and reasoning that takes place one step at a time in conscious awareness, while the elephant represents the hundreds of automatic operations we carry out every second outside of conscious awareness. Over time, the rider can influence the elephant, but never always, and only so much.
This highlights that all people develop beliefs via a process of 'anything goes'. Reality has its constraints, mainly because it is easier to argue for things that are true than untrue--but it's not impossible to argue for things that are false, or even really hard. As Paul Feyerabend argues in his great book Against Method, there is no singular method to science any more than there is single method how a child comes to understand the world: from tradition, direct experience, command, advice, instinct, reading, etc. Surely children learn much more quickly than adults, most of it true, and do so in a very unstructured way. They are on the whole quite ignorant, but importantly, our betters at 'learning'.
When people say their ideas are based on reality, science, rigorous proof, or statistics, they just mean they think their ideas have convincing articulations to some people they respect. They are naive if they think that any mildly complex idea is unambiguously true according to some unimpeachable proof. There are just too many assumptions and implications in any assertion for one to say A is apodictically better than B. Sure, you can come up with simple examples of ideas where the alternatives are silly, but consider most issues people disagree upon--specific tax rates, welfare policies, environmental regulations, criminal statutes--and you will find smart, educated persons on both sides of the debate.
Remember that the economic profession became pretty convinced in the empirical validity of the CAPM (recounted here), over the period 1965 to 1985. Fama and MacBeth, and other seminal papers documented the Sharpe/Linter/Mossin model of how covariance with 'the market' determined expected, and thus average, returns. Miller and Scholes (1972) did empirical work on the CAPM where they controlled for changing interest rates, volatility, measurement error, residual volatility, and skewness, what appeared to be 'everything'; they did just forgot to control for size, which Fama and French (1992) showed got rid of any beta correlation with returns. You simply can't control for everything, so it seemed pretty convincing at the time. This merely highlights what counts as 'proven' is always ignoring some inconsistency, even when the theory is true (as one wag said, no theory is consistent with all the facts, because all the facts aren't true!).
The progressive faith circa 1900 that all we needed was education to create a better world seems like one of those naive beliefs in socialism. The same truths would become obvious to everyone. The problem is, you can't teach common sense, and even those who have it have idiot-savant status, such as when the brilliant surgeon is a conspiracy theorist, or a great labor economist who is a poor macroeconomist. I know I have both good and bad ideas, but alas don't know which are which so I'm stuck with both. You could say, just don't believe in anything much, but that would leave me catatonic, unable to decide the most trivial thing because of the infinite reasons for and against anything.
Oscar Wilde said 'the man who sees both sides of a question is a man who sees absolutely nothing at all', meaning, you have to take a risk, assume something is true in spite of its unprovability, and act--at least tentatively--otherwise you really are in a state of precognition, as when a naive researcher looks at a bunch of data without focus, seeing nothing. To focus is to theorize, to form model of what is important and how things are measured and interact, and our education gives us many tools to do this. But as in geometry where sometimes you assume parallel lines meet, sometimes not, so too with all assumptions and criteria, and the justification is always somewhat arbitrary.
I'm not some sort of Derridean postmodernist, I just know that at the end of the day, people will probably agree or disagree with you for reasons other than what you articulate. I just try to remember that having good prejudices is as important as the having good empirical evidence--eg, the prejudice that risk and return are not related in asset markets--and so work on those as well as remembering how best to calculate corporate default probabilities. Think of your prejudices as your ultimate strategy that dictates your tactics.
It's good to have good reasons they help find these true ideas more efficiently; there just isn't one rational method, or even meta-method.
A good method for justifying your beliefs--say applying GMM to a utility function, economists love that!, or flow charts if you are a sociologist--will bring along interlopers who may not have an interest in your specific outcome, but rather, like your application of some methodology, and become a kindred spirit that way, helping your cause and career. Free competition among people's services, goods, and beliefs is all that tends to make most centuries a little better than the prior one, and forces us to generate better services, goods, and ideas. Truth, like low prices, is not the result of an individual, but rather the byproduct of our collective interaction.
Tuesday, December 21, 2010
The Advisor Weblog
The Advisor Weblog |
| Best pair to trade now: GBP/USD Posted: 21 Dec 2010 04:05 AM PST Here is my first choice for today: http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2010/12/21/02/
 |
| Posted: 21 Dec 2010 04:04 AM PST Hi everybody and welcome back! Thin market conditions are not enough to halt Euro and Pound weakness, that remain pressured since past week; fundamental data is also weighting on both currencies, with sovereign debt woes in Europe increasing as well as UK public borrowing tht hit a record high in November, as spending rose at the fastest pace since February, fueling fears that the public finances are far from under control. Still and despite short term bearish momentum, there were news late yesterday that the BOE will start raising interest rates within six months to curb inflation, according to a report from the Confederation of British Industry, targeting 2.75% before reviewing the pace of hikes. A bit of a long term view for GBP.
Here is the link for today's calendar: http://www.fxstreet.com/fundamental/economic-calendar/ Have a great day!
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Bank Leverage Limits
I've seen several posts riffing on Tyler Cowen's American Interest article stating banks tend to go 'short volatility'. I'm not too interested in it because I think it's a misleading way to put the problem.
Banking crises are correlated with business cycles, and business cycles are correlated with volatility. Thus, one could say they have too often gone 'short volatility'. But that is rather incidental, not an explicit strategy. The real question is why their portfolios tend to experience highly correlated declines that threaten their solvency every 15 years or so (just within the US: 1819, 1837, 1857, 1873, 1893, 1907, 1901,1929, 1966, 1970, 1975, 1981, 1990, 2008). My theory, based on Batesian mimicry, is here.
As to how to ameliorate if not eliminate these crises, Cowen supports Kevin Drum's argument:
I do like the way his solution actually makes sense, in that you know what he is saying. You can listen to some people talk for an hour and realize they are merely for more and better regulation, without any specifics. But, the reason why prominent people are vague is because then you aren't wrong, like Drum and Cowen are in this instance. The problem with this great idea is that if you make leverage the key point, regulators will focus on that, and so banks will just invest in riskier assets.
Crises are often compared to drinking binges, where excessive exuberance is followed by hangovers. Following that analogy, if you try to say, 'we don't want people drinking to excess, so we will stop everyone at 6 drinks', well then, they will switch from beer to wine, whiskey, or grain alcohol.
But the drinking problem is potentially soluble because you can measure alcohol, and say allow people one 12 ounce beer, one 5 ounce glass of wine, etc. Basically, the key unit is 'ethanol, which has measurable properties. In contrast, we don't know what 'risk' is. Beta? Volatility? Skew? Get back to me on that. You can't regulate what you can't define.
What about leverage as a proxy for this unmeasurable risk? As Proshares is showing with the Ultra (2x leverage), UltraPro (3x leverage), and short products, a security can have double or triple leverage behind it, have positive or negative exposure, and still be called a 'stock'. Similarly, a bank with 10:1 ratio but plenty of ninja loans had a lot more risk than a bank with 20:1 leverage but all their mortgages had 20% down (the bad old days per Alicia Munnell). Facility risk (eg, loan-to-value) is part of the problem, so too is obligor risk (eg, credit and bureau scores), and so the multiheaded beast grows, with risk hiding from any one metric that can be applied across any large financial institution. This, alas, brings forth many demographics, all who want unsecured lending, which has a populist appeal.
The key is that drinkers engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids--who generally are below the 21 year old drinking age--tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leveraged a lot, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.
I used to be head of 'economic risk capital allocations' for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron's $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don't end via argument, but rather conspicuous failure.
So, define risk--not its correlates like leverage, but actual risk--first. Make sure it isn't backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That's really hard, you might say, and we have to do something now. Doing something is not better, unless you think pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.
Banking crises are correlated with business cycles, and business cycles are correlated with volatility. Thus, one could say they have too often gone 'short volatility'. But that is rather incidental, not an explicit strategy. The real question is why their portfolios tend to experience highly correlated declines that threaten their solvency every 15 years or so (just within the US: 1819, 1837, 1857, 1873, 1893, 1907, 1901,1929, 1966, 1970, 1975, 1981, 1990, 2008). My theory, based on Batesian mimicry, is here.
As to how to ameliorate if not eliminate these crises, Cowen supports Kevin Drum's argument:
The way to do it is with very simple, very blunt leverage restrictions that apply to all financial actors over a certain size: banks, insurance companies, hedge funds, private equity, you name it. If you have assets over, say, $10 billion, then the rules kick in. Strict leverage limits (say, 10:1 or maybe 15:1) based on conservative notions of both assets and capital would be a pretty effective bulwark against excessive risk taking but wouldn't seriously interfere with the basic asset allocation function of the financial industry.
I do like the way his solution actually makes sense, in that you know what he is saying. You can listen to some people talk for an hour and realize they are merely for more and better regulation, without any specifics. But, the reason why prominent people are vague is because then you aren't wrong, like Drum and Cowen are in this instance. The problem with this great idea is that if you make leverage the key point, regulators will focus on that, and so banks will just invest in riskier assets.
Crises are often compared to drinking binges, where excessive exuberance is followed by hangovers. Following that analogy, if you try to say, 'we don't want people drinking to excess, so we will stop everyone at 6 drinks', well then, they will switch from beer to wine, whiskey, or grain alcohol.
But the drinking problem is potentially soluble because you can measure alcohol, and say allow people one 12 ounce beer, one 5 ounce glass of wine, etc. Basically, the key unit is 'ethanol, which has measurable properties. In contrast, we don't know what 'risk' is. Beta? Volatility? Skew? Get back to me on that. You can't regulate what you can't define.
What about leverage as a proxy for this unmeasurable risk? As Proshares is showing with the Ultra (2x leverage), UltraPro (3x leverage), and short products, a security can have double or triple leverage behind it, have positive or negative exposure, and still be called a 'stock'. Similarly, a bank with 10:1 ratio but plenty of ninja loans had a lot more risk than a bank with 20:1 leverage but all their mortgages had 20% down (the bad old days per Alicia Munnell). Facility risk (eg, loan-to-value) is part of the problem, so too is obligor risk (eg, credit and bureau scores), and so the multiheaded beast grows, with risk hiding from any one metric that can be applied across any large financial institution. This, alas, brings forth many demographics, all who want unsecured lending, which has a populist appeal.
The key is that drinkers engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids--who generally are below the 21 year old drinking age--tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leveraged a lot, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.
I used to be head of 'economic risk capital allocations' for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron's $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don't end via argument, but rather conspicuous failure.
So, define risk--not its correlates like leverage, but actual risk--first. Make sure it isn't backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That's really hard, you might say, and we have to do something now. Doing something is not better, unless you think pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.
Monday, December 20, 2010
The Advisor Weblog
The Advisor Weblog |
| Posted: 20 Dec 2010 01:26 PM PST Dollar ended the day mixed against major rivals, as despite stocks rose strongly with S&P reaching fresh yearly highs, nor Euro nor Pound managed to post gains against greenback; the weakness of the two European majors remains intact, and falls had been limited mostly on dollar weakness, although the bearish pressure remains intact.USD/SGD quotes around 1.3160, slightly bearish according to the 4 hours chart, yet finding support in a flat 20 SMA barely below current price. Lack of liquidity keeps increasing, be aware some strange spikes could be trigger over the next sessions, yet below 1.3140, pair should turn more bearish short term talking, aiming to test 1.3100 psychological level first, ahead of 1.3060/80 support area. resistances now, come at 1.3170 1.3210 and 1.3245. USD/HDK has lost past week strong bullish momentum, and retreated from 7.7800 price zone, also with a slightly bearish tone according to 4 hours chart: price is below 20 SMA while momentum broke 100 level, yet losing previous bearish strength. Pair will find some support now around 7.7715, but if this last gives up, 7.7660 area is next in line. Below this last, 7.7620 come next. Resistances for the upcoming hours are located at 7.7765, and the 7.7790/7.7800 price zone.
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Russ Roberts Interviews Joe Nocera
Russ Roberts interviews Joe Nocera about his book "All the Devils are Here". I thought this book was OK, but it spent a lot of time discussing the background of major players, who all seemed to either grow up 'on the wrong side of the tracks' or went to Groton. Am I the only person who had middle class parents, average in most ways? Perhaps that's my exceptionalism--extreme conventionality!
One important take-away seem to be, send all the econ bloggers a free copy of your book, because I think it was uniformly rated well in praise surrounding extended quotes (see Tabarrok here, Kling here).I can tell you that there is little upside to slamming a book on your blog, but you might receive a nice note from the publisher, or some nice links from the popular author if you have nice things to say. Book reviews are like stock analyst recommendations pre Sarbanes-Oxley.
Here's a snippet Nocera and Russel's take-away of they big mover in the 2008 crisis:
In other words, 'models' were the main problem. We shouldn't believe so much in models. This is not insightful, because it leads to infinite regress. If you believe models are imprecise, and so add some uncertainty around them, this too is a model. Sure, you can keep compounding your uncertainty, but eventually this leads to avoid lending altogether, which is clearly suboptimal. But then Nocera mentions this pertaining to MBIA:
So, the problem was not essentially models, hubris, or securitization, but rather this singular assumption: that housing prices, nationally, would not fall significantly year-over-year. It is much more parsimonious explanation; it explains more with less.
One important take-away seem to be, send all the econ bloggers a free copy of your book, because I think it was uniformly rated well in praise surrounding extended quotes (see Tabarrok here, Kling here).I can tell you that there is little upside to slamming a book on your blog, but you might receive a nice note from the publisher, or some nice links from the popular author if you have nice things to say. Book reviews are like stock analyst recommendations pre Sarbanes-Oxley.
Here's a snippet Nocera and Russel's take-away of they big mover in the 2008 crisis:
My interpretation of that has to do with modeling. I think one of the things that happened over the course of the last 20 years is the core idea that you could model away risk. One of the things that was striking in [Greenspan's] apology was when he said: Several people have won Nobel Prizes for the work that has turned out to be flawed.
In other words, 'models' were the main problem. We shouldn't believe so much in models. This is not insightful, because it leads to infinite regress. If you believe models are imprecise, and so add some uncertainty around them, this too is a model. Sure, you can keep compounding your uncertainty, but eventually this leads to avoid lending altogether, which is clearly suboptimal. But then Nocera mentions this pertaining to MBIA:
One of the things we said to them, we asked them about, was their models. They said: Actually, our models were pretty accurate. If we plugged in a 20% decline in housing prices, they showed the world blowing up. But we just assumed that that could never possibly happen! Famous paper by the Orszag brothers and Joseph Stiglitz, who was a Nobel Laureate, showing how remote it is that Fannie or Freddie would ever go bankrupt. Absolutely true.
So, the problem was not essentially models, hubris, or securitization, but rather this singular assumption: that housing prices, nationally, would not fall significantly year-over-year. It is much more parsimonious explanation; it explains more with less.
Saturday, December 18, 2010
A Christmas Story
When I got out of grad school and was working for KeyCorp, the 8th largest bank in the US at that time, I found myself at a holiday employee party in Beachwood Ohio, ground zero for Jews in the Cleveland area. I'm a born Lutheran who likes Christmas and Easter, but am pretty indifferent to organized religion. As Eric Hoffer noted, 'the opposite of the religious fanatic is not the fanatical atheist but the gentle cynic who cares not whether there is a god or not.' Anyway our CEO Victor Riley was there to give the standard holiday pep talk. The theme was 'The Real Meaning of Christmas', which I figured meant something relating to transcendent ideas about love, charity, or family. Instead told the audience that the real meaning of Christmas was: The baby Jesus.
The mainly Jewish audience looked at each other. Sure, it made sense to a Catholic, but it's important to know your audience. I thought it was a hysterically obtuse attempt at profundity. Luckily, he didn't follow up with his thoughts on the real meaning of Easter.
The CEO left and we were drinking holiday spirits, everyone tried to forget his statements as if they were never said. Now, CEOs are generally people-persons, emotionally intelligent, people who can work a room. It reminded me that everyone's an idiot at something, even things in their bailiwick.
Friday, December 17, 2010
The Advisor Weblog
The Advisor Weblog |
| Posted: 17 Dec 2010 04:33 AM PST Hi everyone and welcome to my blog! Friday of a pretty wild week, where again lack of certain trend ruled; is enough to take a look at daily charts to see the flatness in market despite the intraday woes. We could expect this to get even worse during the upcoming week. However, some short term chances are always available: here is what I do expect for EUR/USD for today: http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2010/12/17/02/ We have no more fundamental data to take care about, so no calendar to follow today, but of course, we should keep an eye on gold and stocks. Have a great day!
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AEA Meeting Topics
Hundreds of papers are being presented, and more than a few are sure to be very interesting, so keep up to date as the papers get filled in (they post the papers online, so you don't actually have to go). Think of it like a flea market: mainly junk, but some real finds if you look around. Many have straightforward groupings like "Banks, Credit Constraints and International Business Cycles" and "Optimal Fiscal Policy", where there are usally 3 papers that address the issue. Then there's this grouping, the ubiquitous 'other' category:
Five Unrelated but Interesting Papers
Driving Under the (Cellular) Influence
Do Public Subsidies Sell Green Cars? Evidence from the U.S. Cash for Clunkers Program
A History of Violence: The "Culture of Honor" as a Determinant of Homicide in the U.S. South
The Lion's Share: An Experimental Analysis of Polygamy in Northern Nigeria
White Men Can't Jump, But Would You Bet on It?
Thursday, December 16, 2010
The Advisor Weblog
The Advisor Weblog |
| Best pair to trade now: GBP/USD Posted: 16 Dec 2010 03:11 AM PST Here is my first choice for today: http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2010/12/16/02/
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| Posted: 16 Dec 2010 01:22 AM PST Hi everyone and welcome back! Market is all about mood these days: while Asian stocks had been under pressure, supporting dollar gains, European opening, and news that China’s credit rating was raised to AA- from A+ by Standard & Poor’s, are wakening risk appetite, and sending dollar slightly down across the board. Still European macro data up to now has been quite negative, with PMI’s under expectations in France, and mixed in Germany and the euro zone. In Europe, a 2-day Eurozone summit has started, and of course, it will be focusing on the crisis mechanism, a possible capital hike for the ECB and fiscal surveillance; I don’t expect it to affect the market today, but it won’t be a bad idea to keep eyes open an see what ythey are on. Anyway! day is young and we have even more macro data ahead, starting ina few minutes in the UK, so here is the link for today's calendar: http://www.fxstreet.com/fundamental/economic-calendar/ Have a great day!
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