How to Double Productivity

Macroeconomists focus on things like increasing education, tax breaks for trendy investments, even space aliens and hurricanes (more jobs!), but the best way to increase productivity is to deregulate. A lot of this overbearing regulation is from union-related work rules. In this Ed Prescott video he mentions this case study of how the Minnesota mining productivity soared after being exposed to new competition from international markets. Output fell about 50% from 1979-82. This study is from James Schmitz an the Minneapolis Fed:

In response to the crisis, these iron-ore industries dramatically changed how they produced iron-ore, in the process doubling their labor productivity and pushing foreign competition out of the Great Lakes.

...I begin my analysis of productivity in Section 3 by describing the work rules that prevailed before the crisis. These placed restrictions on the tasks individuals could perform at mines, particularly repair work. First, machine operators were not permitted to perform even the simplest repair work on their machines. Second, repair staff had restrictions on their work. In particular, there were a very large number of repair job classifications, close to thirty. A person with a given classification was permitted to complete repair jobs assigned to this classification but not others. In response to the crisis, work rules were changed to allow machine operators to conduct simple repairs and which reduced the number of repair job classes... a growth accounting exercise would show this growth (from changes in work rules) was “accounted” for by increases in total factor productivity, and in the capital-labor and materials-labor ratios.

Over the next five years, productivity doubled.

The increase in regulations is difficult to quantify, but consider that just last week the proposed TransCanada pipeline, known as Keystone XL, has had dozens of public meetings, hundreds of thousands of comments, and extensive consultations with the EPA, DOT, USDA, DOI, DOE as well as several other federal and state agencies. A recent abortion kerfuffle occurred when Virginia's Department of Health proposed regulations for abortion clinics that are consistent with the construction of new hospitals, and all the sudden liberals realized how insanely onerous these regulations are. The bottom line is that regulations are very costly, and they are growing, as Obama is pushing for more EPA regulations based on fanciful savings to health care costs.

Unfortunately, for Keynesians there's no interest in the effects of regulations on aggregate demand.

Painful Problems Aren't Anticipated

After under preparing for the big snowstorm in December 2010, Mayor Bloomberg over prepared for Hurricane Irene, which left New York City with pretty minor damage. This pattern is rather typical, because the cost/benefit ratio for over hyping a disaster clearly favors over-reacting after under reacting. Bad events are usually really damaging only when we totally do not see them coming.



Back in 1999, every risk management department had allocated considerable resources to the Y2K problem: that old software with two digit dates would implode at the end of the year. Many scaremongers conjured up plausible hypothetical, generalized, and scared the crap out of everyone. It turned out to be a non-event, and probably would not have been a problem even if there was no preparation.



In 2009, with financial crisis fresh in people's minds, everyone was worried about immanent commercial real estate crisis, which via the necessary refinancings, suggested several large defaults. The logic seemed impecable, but these haven't happened, as there are many ways to modify contracts to eliminate the dead-weight costs of a true crisis, and I predict this sector will work around these problems without any serious crisis.



In contrast, consider the housing crisis of 2008-9. I was at an NBER meeting in May of 2008, just before everything hit the fan, and remember a very well received talk by Markus Brunnermeier that the market had, at that time, overreacted. Virtually all the esteemed audience found the presentation convincing (including me!). The logic was as follows. Global stock markets had fallend by $8Trillion, though it appeared housing seemed to have only extinguished $500B in value. Brad DeLong, with hindsight, even makes a similar argument for a different narrative, but the logic is the same: no one understood the extent of the mortgage problem even after it was identified. The extent of the decline in underwriting, the legislative and regulatory reaction that lowered borrower's willingness to pay, was totally unappreciated. The base idea is that most experts didn't understand the crisis as it was happening, which is why things were as bad as they were. The things that hurt us are those things expert conventional wisdom does not see coming.



I would put default by the PIGS, a double-dip US recession, and muni defaults, in the category of something scary that many people are considering. A big jump in inflation or US interest rates, is something that I think most people would find rather surprising, and so would probably be much more damaging.

Beta Adored Before Data

There's a cover story from the September 1971 Institutional Investor entitled 'The Beta Revolution', which mentions 'portfolio managers and security analysts who mathematical backgrounds extend only slightly beyond long division are tossing betas around with the abandon of Ph.D.'s in statistical theory.'



They write the 'beta theory' started with Markowitz in 1952, and later papers by William Sharpe and Jack Treynor in 1963 and 65. By 1968, they note 253 articles and 89 books written about 'beta' (really, the Capital Asset Pricing Theory).



What's conspicuously absent is any mention of empirical corroboration. A simple scatter plot, with beta on the x-axis, returns on the y-axis, would have been nice. In fact, the first empirical support wasn't even until a couple years later, meaning, there was no data supporting the theory at this time, but the experts all believed the theory anyway. The subsequent supporting data was weak and contained a serious omitted variables bias, namely, that size explained any correlation between beta and average returns. All the hubbub was purely from theorists, without even any flawed empirical support. One can see why the initial flawed empirical research got through, because all the experts knew the right answer, and so didn't think to test the theory with appropriate skepticism.



Yet even then, the article notes that 'very low beta stocks, in fact, tend to have higher alphas and high beta stocks tend to have low alphas.' That is, the beta-return relationship, to the extent it did exist in unpublished studies, was pretty flat. A fund manager back in 1971 could have jumped on that small insight and blown away everyone over the next generation, but that little nugget was ignored.



The description of beta is distressingly vague, but the intuition they mention is based, in their words, on two 'widely accepted ideas.' First, that to obtain higher rewards, one must take higher risks. Secondly, that individual stock returns are correlated with the market as a whole. Interestingly, it is true that given standard utility functions (eg, u(x)=-exp(-ax), these do lead to beta-type risk premiums. Something's clearly wrong, and while most researchers seem to think it's schizophrenic risk-loving (within asset classes, not between them), I think it has to be we are more envious than greedy.

Benefits of Diversification

In 1971, the US dollar was removed from the gold standard for good. Since then, the price of gold has risen, though basically in spurts. The equity market has also been subject to major cycles. Looking at the raw price of gold and comparing this to the total US equity market return, you see both end up around the same place: 7.9% for Equities, 7.0% for gold, through 2010. But combined 50-50, and reweighting each year, one would generate an 8.4% return via the lower volatility (geometric average is greater due to its lower volatility).

The Endogeneity of Risk

I was at a risk manager conference and met someone involved in risk capital allocations at a large bank. Interestingly, she said that mortgages now had the same allocation as credit cards. When I was doing this in 1999, credit cards had the highest risk capital allocation within the bank, and mortgages were just above US Treasuries among 'safe' asset classes. Back then, historical loss rates were near zero, and 'underwriting innovations' were just a gleam in Bill Syron's eye.



So, in only 10 years a major asset class transmogrifies from safest to riskiest. The underwriting (credit risk minimums and money down payment), the loss-in-event-of-default assumption (new legal risks), the 'willingness to pay', and collateral price volatility, have all changed significantly. Perhaps this is all endogenous, that a 'safe' asset like mortgages must become risky because everyone--investors, mortgage issuers, home builders, legislators, non-profits--all see it as a vehicle to achieve various ends.

Cost of Organic Shingles

My neighborhood was built around 2001, and now all my neighbors have to replace our roofs. It seems the trendy roofing tile was this Certainteed Organic product, which combines waste paper with asphalt. Unfortunately the shingles seems to have a 10 year life because they are literally simultaneously disintegrating across hundreds of homes, necessitating massive replacement. Most people get about $500-$2000 from the class action suit, but new roofs cost between $8 and $25k depending, and so this is a costly mistake. Many are getting their insurance company to pay via 'hail damage' clauses, but most don't.



I have a feeling that when they were selling these organic shingles they were heralded as being green and progressive. The new fiberglass shingles should last 50 years or more, but unlike the old ones, you can't eat them.

PRMIA talk today

I'm giving a talk today at the Marquette Hotel in Minneapolis for the Professional Risk Management International Association meeting. It's about risk and return. RSVP with your name, title, company, phone number and email address at support@prmia.org or call 651-605-5370 to attend. Fun starts at 4 PM.

Risk Premium Worthless, Convoluted

One of the most obvious failings of modern finance is that the risk premium that is so central to its core appears fleetingly and parochially. Much of what distinguishes a PhD in finance or economics from a PhD in physics is that the former know a lot more about utility functions. Yet anyone working in finance sees this is hardly an intellectual asset that makes them more valuable, precisely because any risk premium derived via Stochastic Discount Functions and the like aren't very convincing to someone wanting to invest real money. The failure of this approach is best reflected by the absence of any value to finance/econ-specific quantitative rigor, which is mainly built around utility functions. I know a lot about these, and know they are a waste of time.



Another problem with this line of reasoning is that orthodox economists tend to find risk premiums in the most bizarre cases. Consider this explanation for why highly levered stocks have lower than average equity returns (George and Hwang, 2010):

Costs associated with financial distress are crucial to our explanation for two reasons. First, distress costs depress asset payoffs in low states. Since the occurrence of low states is at least partly systematic, distress costs heighten exposure to systematic risk. Second, firms with high distress costs optimally utilize less leverage than firms with low costs. Since firms with high costs choose low leverage, low leverage firms will have the greatest exposure to systematic risk relating to distress costs. The cross section of expected returns will therefore be negatively related to leverage.

So, as opposed to Miller-Modigliani, which implies that higher leverage is associated with higher risk, higher leverage implies lower risk because such firms are actually less risky, which is why they have higher leverage. Never mind that higher leverage is associated with higher default rates, or that higher leverage is associated with higher volatility. Higher returning assets must be riskier, and so assets that have high volatility, default risk, etc., are just risky in a very subtle way because they must!



One sees what one believes.

Gold vs. SP500

If you would have bought Gold (the white line) at any time since 1991, it would have been a better investment than the Standard and Poor's 500 index (orange line), with a lot less volatility.

Mark Cuban on Investing

Mark Cuban channels Keynes when he says diversification is for idiots. Keynes thought similarly:

As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. [...] One's knowledge and experience are denitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence. (letter to F. C. Scott, 15 August, 1934)

Keynes's pre-Markowitzian view is regularly dismissed, but Cuban makes an intriguing point about sitting in cash until you see an opportunity, as opposed to simply being fulling invested all the time. The longer it takes the market to reach prior peaks, the more markets may begin to think a P/E of 12, not 20, is the status quo. It would be a good thing if investors thought less about trying to make money in the abstract market, where they have little control or responsibility. Market timing is improbable, so the key is not to think staying in cash is waiting for some market bottom to jump in, rather to wait until something more unconventional like a chance to invest with some acquaintances in a franchise or something where alpha is more conceivable.



The idea of getting paid to take some 'abstract risk,' is becoming more quaint every year.

Obama Calling Krugman Names

Who called Krugman a 'political rookie,' a hysterical 'fanatic' and an 'idealogue'? Obama for America (OFA) New Mexico State Director Ray Sandoval. Given his position, it's improbable Obama doesn't agree with this sentiment, as it was written, not spoken extemporaneously. As Brad De Long recently called for the elimination of the Republican party (ruh-roh!), I think liberal economists are demonstrating they aren't handling their frustrations well, making even their allies hate them. All those inferior students growing up and making policy is driving them crazy.



I too think our politicians are inadequate, but I don't want them to listen to me, rather, I would like them to be less important. That would take people actually voting for people who aren't promising to increase government, however, and I sense I'm not in the majority on that, and may never be. It's not optimal, but it's not horrible.

A Perennial Risk Problem

Cash strapped Detroit recently announced it won't be responding to home alarms: 99% of them are false. A naive risk solution is to itemize everything that can go wrong, but in doing so it is as bad as not mentioning any risks: moderation in all things, in this case, the perennial balance between type 1 and type 2 errors. Hyperactive risk reports have the benefit of rarely being 'wrong', just not useful, because after a short while decision makers get used to ignoring these risks. I remember the first time I bought a house, and didn't know what to look for in the inspection. I hired someone to do this for me and for a couple hundred bucks I got a list of over 100 items that were not prioritized, which I found totally unhelpful, but I had to pay him (he obviously did work).



The 1986 Challenger Space Shuttle disaster was a great example. No fewer than 748 parts were designated 'Criticality 1', meaning they violated NASA's redundancy criterion: if they failed the shuttle would be lost. In the first 25 flights up through its last, 131 technical flows proved serious enough to warrant NASA's designation of 'launch constraint.' Of these, 66 were resolved after 1 flight, the rest, like the O-ring joint that ultimately failed, overridden repeatedly. If there are that many high level risks going off, that's what happens.



Real risk reports prioritize risks in a way proportional to their expected damage: probability times cost. Many times these probabilities are so small, they are rather qualitative, but such is risk. Nonetheless, Detroit reminds us that merely saying anything or everything can go wrong, while true, is quite useless and not profound. Enumerating a long list of disparate things that may happen, without any probabilities, may work for Nouriel Roubini, but he's a charlatan: here he is last week taking credit for his client switching to cash a couple months ago, he doesn't mention he has been suggesting investors go to cash since 1990, always for a slew of reasons (though Lawrence Summers is here giving props to Roub for calling the housing crisis). I have seen reports that endlessly enumerate risks many times in large corporations, and they are highly correlated with people who either are too afraid to make a mistake, or profoundly do not understand their job.

Krugman Takes Keynesianism into Twighlight Zone

It seems Krugman so believes in the Keynesian multiplier, that he really doesn't think it matter what the money is spent on:

"If we discovered that, you know, space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits took secondary place to that, this slump would be over in 18 months," he said. "And then if we discovered, oops, we made a mistake, there aren't any aliens, we'd be better--"

...

"There was a 'Twilight Zone' episode like this in which scientists fake an alien threat in order to achieve world peace,"

It turns out this was actually an Outer Limits episode, but no matter. If they really don't care what the money is spent on, why not just reduce taxes across the board? It would be far simpler and faster. I suspect because the real objective is redistribution, and lower tax rates across the board is regressive on a dollar basis even if proportionately the same. Too bad, but it highlights that old maxim I learned in my litigation--a dispute is never about what its most zealous disputant says it's about. In this case, the real wish of Keynesians is to redistribute wealth via the government, giving bureaucrats more power over the bourgeois. If it were otherwise it would be too easy to stimulate the economy in short order via their model of the economy.



Consider that the 2001 Bush tax cuts were a Keynesian idea to stimulate the economy. These are largely seen as a give-away to the rich, but here's the cuts:

• a new 10% bracket was created for single filers with taxable income up to $6,000, joint filers up to $12,000, and heads of households up to $10,000.
• the 15% bracket's lower threshold was indexed to the new 10% bracket
• the 28% bracket would be lowered to 25% by 2006.
• the 31% bracket would be lowered to 28% by 2006
• the 36% bracket would be lowered to 33% by 2006
• the 39.6% bracket would be lowered to 35% by 2006

Of course, the economy never reached full employment, which is always the case in real time, as full employment is something people apply to the past; the present is always below its potential, seemingly. This is why spending more is so problematic, because it is very improbable that such spending will be temporary as opposed to part of the new baseline, all to work on fighting aliens, or whatever they do in the Department of Education.

Risk-Loving or Stupidity?

There are lots of cases where insanely risky assets have low, even negative returns. Highly volatile stocks have insanely poor returns. This is part of a general pattern, such as when lottery tickets with the most extreme odds have the lowest returns. The longshot bias in horseracing noted by Griffith in 1949, and remains: 100/1 or greater loses 61%, the favorite loses only 5.5%, the average bet loses 23%.



Justin Wolfers and Erik Snowberg published an excellent paper (Explaining the Favorite–Long Shot Bias: Is It Risk-Love or Misperceptions?) that tests if the horseracing longshot bias is due to risk-loving or systematically overestimated probabilities. They do this by looking at horse racing returns to single horses, and for combinations such as the exacta where one chooses the first and second horses in a race. They note that if the risk-loving model is correct, one has the model



Pr(a)*U(O(a))=Pr(b)*U(O(b))



where O(a) is the odds (eg, 10-1) of horse a winning. In contrast, in the misconception (stupidity) model, the implied relation is



Pr(a)*(O(a)+1)=Pr(b)*(O(b)+1)=1



By manipulating the equations they calibrating these models to the data--returns and odds for individual horses and their combinations--they find that the misconception model works much better. Look at the graph below, and notice the misconceptions model generates a nice prediction-actual set of points (blue dots), while the risk-loving model is basically nonsensical. In horse racing, people don't love risk, they are simply overconfident.







With the advent of low volatility equity investing, the implication is that excluding the highly volatile stocks increases a portfolio's Sharpe ratio. It is important to understand if these crappy stocks--higher volatility, lower return--are due to a preference towards the wild ride, or perhaps just because people are overconfident when they buy these stocks. To the extent the poor returns to high volatility are from simple mistaken odds, it should disappear as investors become aware of this mistake. Yet there are other forces at work, including:

Signaling: an investor with alpha applies this were it is most valuable, so investing in the most risky stock highlights your high alpha.

Investor flow: mutual fund inflow are very convex, highlighting the importance of getting in the top decile. Fund managers rationally will choose risky portfolios to maximize their return conditional upon this.

Alpha discovery: The best way to assess if you have alpha, is to make a choice where the returns will be stark: big win or big loss. That way, you can assess your ability better than picking a stock that only modestly out or under-performs.

Story Telling: portfolio managers are fond of telling their clients why they own what they own. It is a lot easier to tell a story about a highly risky stock than a really safe stock, because safe stocks don't have that much going on, whereas the risky stocks have lots of conspicuous events that may or may not happen.

With these forces at work, it isn't clear that even after high volatility investing becomes well-known as having below-average returns, there still won't be an 'excess demand' for these stinkers.

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Intervention.... really? Posted: 10 Aug 2011 05:23 AM PDT I have stated several times that single intervention from a Central Bank is not enough to change a trend, and USD/JPY proved me right. We have just erased all gains set after past week intervention movement, with the pair now barely 20 pips above the all time low. And I'm expecting now further slides in the cross; check my short term report about it:   http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2011/08/10/ The SNB reported past week that it has lost 10.8 billion francs (near, $13.5 billion) in the first half of the year due mainly to the recent surge in the Swiss currency."The appreciation of the Swiss franc against all major investment currencies resulted in substantial valuation losses," said the central bank in a statement. About 9.9 billion francs was lost on its foreign currency positions, as the US dollar depreciated by 9.6 percent, the yen by 8.9 percent and the euro by 2.4 percent against the Swiss currency over the first six months of the year. Cutting rates was neither the solution, as the pair lost more than 400 pips ever since, with a fresh record low set yesterday at 0.7065. 2010 losses due intervention, had been estimated in 21 billion francs. Up to this point, and inverted Fibonacci points for a 0.6500 area as next bearish target. And latest FOMC outcome is surely not helping.   Selling on pullbacks, continues to be the best market option these days.

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EUR/USD remains subdue Posted: 08 Aug 2011 05:27 AM PDT Risk aversion eased, bond yield spreads tighten, yet Euro is unable to stand up: the common currency is at daily lows and aiming lower, still limited to the upside by the daily descendant trend line coming from the year high at 1.4940. The line is currently @ 1.4450 so it takes at least a daily close above it to see more gains in the cross. Despite we will be breaking a triangle to the upside, I won't be betting on too much gains in the cross these days. The common currency will likely remain weighted by the sovereign debt woes and the facilities the ECB has announced recently. Yet at least we may see the bearish pressure easing in the cross. The base, around 1.3840, seems too far away to be tested in the short term.       Anyway! here is the short term outlook for the cross for today:   http://www.fxstreet.com/technical/forex-strategy/the-best-pair-to-trade-now/2011/08/08/ This posting includes an audio/video/photo media file: Download Now

Risk dominates the weekly opening Posted: 07 Aug 2011 05:08 PM PDT Risk aversion dominates the scenes in Asian opening, with stocks futures strongly down across the board and gold, the ultimate safe haven, reaching another record high at $ 1691/oz by the time of writing. Over the weekend, Standard & Poor's rating agency has downgraded the US government debt to AA+, something with no precedents. The agency, stated that "the downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics".   Crossing the Atlantic, things are not looking good either: the ECB has decided to intervene markets to respond to the escalating debt crisis, while a joint statement today by German Chancellor Angela Merkel and French President Nicolas Sarkozy supports the action, and reiterating their commitment to fully implement the decisions taken by the heads of state and government of the euro area and the EU institutions on July 21st 2011. This Sunday the ECB said it will "actively implement" its bond-purchase program, signaling it is ready to start buying Italian and Spanish securities to counter the sovereign debt crisis. And if that is not enough, Japanese Finance Minister Yoshihiko Noda said a couple hours ago that he would make some comments after a telephone meeting between the finance leaders of the G7 major industrialized nations. As comment several times in webinars and reports, I do believe that only a coordinated intervention may halt Yen gains at this point. Anyway, tension is in the air! Debts are huge and keep growing, investors trust gold and nothing else, and dollar is set to extend its slide particularly against European rivals: while CHF remains the strongest currency on the board, GBP may follow, and both are expected to overcome the EUR. As said above, JPY may continue gaining ground to fresh record highs against dollar, unless a G7 coordinated intervention takes place. And while AUD and CAD are now losing ground on risk sentiment, the slide may not last particularly when comes to CAD. While the EUR/USD opened the week in a strong tone, beware of the 1.4260 support zone, as once below, the slide may extend towards 1.4170 on Monday. Tops in case of bullish runs, should be 1.4450, the daily descendant trend line coming from this year high. The GBP/USD is stronger right now, holding above 1.6400; bearish momentum may increase if the pair loses 1.6360 area, yet not much lower than 1.6250 for today, while breaks above 1.6480 should point for stronger gains. The USD/CHF, is unstoppable: bullish rallies should remain contained by 0.7670/0.7700 area, while fresh record lows below 0.7500 are at sight now. The USD/JPY will remain bearish as long as below 78.50 yet needs to lose again 78.10 to resume its long term bearish trend, and retest the 76.20/40 price zone. Intervention rise has price now below the 50% retracement at mentioned 78.50. Beware of major long term support in AUD/USD at 1.0200 area: if the slide continues, at least the first test of that level should trigger a strong bullish bounce. Pair needs to recover the far away 1.0550 price zone to erase current bearish tone.

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Treasuries a New Kind of Giffen Good

In introductory economics one usually learns about Giffen goods, where people paradoxically consume more of it as the price rises, violating the law of demand.



Your demand for an item is influenced by its relative value, and your over all wealth: substitution and income effects. This is formalized in the Slutsky equation (as with 'homoskedasticity' and 'fat tails', guaranteed to make the class snicker), but the bottom line is that the effects can go in different directions under very unusual circumstances. For normal goods, the income effect is positive, higher income leads to more demand, but for some inferior goods like Ramen noodles and American cars, the demand decreases with greater income. For a select few inferior goods the income effect is so large it overwhelms the substitution effect, making it a Giffen good. I suppose it's a similar model to how burning coal causes global cooling in standard models.



In practice economists have used Irish potatos circa 1850 as prototypical Giffen goods, but this example has pretty much been discounted as apocryphal. The best example now is wheat in China, and that's basically the only one.



But what about US Treasuries? Over the weekend, their value certainly declined, as the S&P downgrade may have been wrong, but it didn't decrease anyone's default probability. Yet after a full day of trading the 10 year US T-Bond fell 25 basis points (ie, the price rose)! On a relative basis, the decline in US interest rates was greater than for the Australia, Great Britain, Canada, Germany, Japan, or Switzerland. Meanwhile, the US equity market tanked, which suggests the Treasury markets were not rebounding from prior expectations of an even larger downgrade.



So, the value of the US Treasury falls, which lowers it relative price via the substitution effect relative to other assets. But everyone is now poorer, as with $60T or so in present valued unfunded promises, the AA+ downgrade is about a 0.1% increase in our discount rate, and that's about a $1T drop in our net worth. This income effect is so large, the relative value of Treasuries increases because now other financial assets actually decline by even more, so much so the absolute value of Treasuries increase after a fall in their 'quality'.



Today's Treasury move didn't work directly via the income effect, but indirectly via the income effect's effect on the substitution effect, so it's not a traditional Giffen good, rather, a 'Geithner good.'

What's the Difference between AAA and AA+?

We simply don't have enough AAA and AA rated data to be statistically confident in these distinctions ex ante, which is why AA+ and AAA rated securities differ very little in their yields, usually by only 10 basis points (0.1%) on average. Here's the data from Moody's, that excludes Munis and ABS:

Average Cumulative Issuer-Weighted Global Default Rates (%), 1920-2009

Rating	1yr	5yr	10yr
Aaa	0.00	0.16	0.85
Aa	0.07	0.72	2.22
A	0.09	1.26	3.30
Baa	0.29	3.14	7.21
Ba	1.36	9.90	19.22
B	4.03	22.42	36.37
Caa-C	14.28	41.18	52.80

Note that the +/- addition, as in grades you got in college, just adds further granularity (Moody's uses the less obvious 1,2 and 3 suffixes, 1 being +, 3 being -), but with the following exception: there is no AAA+ or AAA-! So AAA to AA+ is one 'notch'. The main thing to realize is the default rates are approximately log linear in ratings category, and I would say this is a general law. People perceive things in log space (decibels, Richter scales, brightness, acidity), and so an "AA" is 2-5x as risky as an AAA.



Data on ratings performance would be a great project for our many regulators because ratings agencies compile these default studies themselves and self-servingly exclude various data points (note the complete absence of AAA defaults even though several AAA mortgage-backed CDOs went down, because ABS aren't included in the general tables!). It's basically impossible to compile these without some regulatory authority, and it would be straightforward and very useful.



Yet it appears ratings are pretty good ordinal rankings over 5-10 years. The key is that moving from AAA to AA+ is in one sense small (0.03% in annual default rate), another a paradigm shift, from the state where risk is 'as low as conceivable' to not, and this will focus Treasury buyers on the real probability of a US default ($14T in debt, but if you include social security, medicare and medicaid, it is around $75T).

Dendreon Drop Overdue

I'm a long term bear, but there's no double-dip on the horizon, just endless slog. Thus, I'm buying here.

As per Dendreon (DNDN), the stock that lost 65% of it's value yesterday based on lower earnings guidance, I think it was well overdue. It had a $6B market cap based on no current earnings and one drug, Provenge, which was shown to increase the age of prostate cancer victims by 4.1 months. The price tag is a staggering $93k, which supposedly was going to be paid by US taxpayers, as by law Medicare does not take into account a drug's cost when considering if it will pay for it (which they said they would)!

I think we are broke enough to tell men if they don't have and want to spend the $93k, you're just going to die a little sooner from this cause, which is what non-Medicare patients will do. The FDA study shows people living 25 rather than 21 months, which I don't think is a good buy. I would bet most people would rather leave their family $93k more than live in agony another 4 months, but in our crazy health care market no one pays for anything out-of-pocket, so they feel insulted to actually have to make the decision. If we really just wanted to prioritize life enhancing dollars, we could increase it more than 4 months by simply giving everyone access to aerobics classes and a dietitian, which would cost much less.

The Advisor Weblog

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Life, choices and SCAMS Posted: 04 Aug 2011 07:54 AM PDT Life is a matter of choices. Whether the choices I had made in my life are considered wise or dumb by other persons, is something that hardly, HARDLY affects me. And giving explanations of what I do with my life is something that I'm not happy to do. However, I have been push to this extreme and for once I will do against my will. I'm nobody. I'm just a woman that choose forex trading as a profession and that's it. I also choose my family always above my profession. That's why I work from home, and with Fxstreet.com. I have been trading for myself, and working with this amazing team of human beings for already 3 years, and I don't regret one single second of this choice. I manage no personal extra business: I don't teach but trough Fxstreet.com and Fxstreet.es webinars in both languages, Spanish and English. I don't provide signals, but trough "the best pair to trade now" or "El mejor par para operar ahora" again in both languages, published 3 times a day in Fxstreet pages. I have chosen not to sell ANYTHING, to ANYONE 3 years ago, in regards of the forex market. True, I may be able to made heaps of money doing such things. But go figure! I'm not rich, and more, I DON'T CARE BEING SO. Money is an instrument, not the objective in life. However, where is money involved, there is fraud and scams. It has come to my knowledge that someone is using my name to sell signals. Have no clue where it comes from, unfortunately, and will be eternally thank if you can help me with that. Claiming to be me, and using a FAKE EMAIL, with some typos in my last name (the mail that provides the signals is val_badnarik@hotmail.com ), they are selling forex stuff. Well, my friends THAT'S A SCAM. I have two mail addresses: valbednarikATgmail.com and valeriaATfxstreet.com, and I can barely manage to keep them up to date. The rest is again A SCAM. I'm outraged since I found out this, that's why I'm making this public statement, that I would love for anyone to share EVERYWHERE. That's my choice. And as said above, I never regret them. Valeria Bednarik

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Poor Brad DeLong

Über Keynesian Bradley DeLong seems pretty unhappy in this Bloggingheads.tv diavlog, just as he does in his blog posts. In this clip he gratuitously slams liberaltarian Brink Lindsey for not being an economist and spouting economic opinions, as if he would apply this qualification to anyone who agrees with his assumptions (eg, Obama, Matt Yglesias, Ezra Klein), or that macroeconomists have demonstrated any reason for deference on these matters:



When I'm this grumpy I try to not to talk or write to people because I'm not effective at getting what I want. He's clearly in funk, perhaps because he wasn't invited to join the Obama administration in some major capacity, though with this performance he's just proving why that was a good move.

I'm generally pessimistic on the USA because our deficit is still unsustainable and regulations are only increasing, but I must say all this anger on the Left is making me feel better. Here's Kieth Olbermann telling his audience to get mad (clip starts at 8:41 so you get the key riff):



And then there was last weekend's 'Tea Partiers are terrorist' talking point, and Elizabeth Warren's angry exit. Anger is a sign of frustration, and signifies no greater wisdom or righteousness than when my 4 year old gets ticked off (no juice!). Perhaps the proponents of government growth feel they are losing because they really are? Perhaps they see that when legislators disappoint them the answer is not to get new ones, rather to reduce the size of government so these people don't have so much power?

I doubt it. I just think the second derivative on Federal spending has finally changed signs, and so in their minds the future will never seem as good as it did in 2008.

The Mortgage Crisis Continues

Federal and state prosecutors are in negotiations with Bank of America in pursuit of a settlement that would provide 'some kind of assistance' to those who are 'in distress, which can be defined by the number of days late a borrower is on his mortgage payments.' That's a clear incentive to stop paying your mortgage. It will be interesting what they do to Fannie and Freddie, who guarantee half the mortgage debt out there, and appear to be just as guilty of this 'crime' as anyone (just add it to our off-balance sheet debt, it doesn't really matter at this point).

Add to this the number of people telling mortgage payers that there's a good chance their mortgage could be legally invalid due to some arcane rule related to the "clear chain of title" that requires the note be endorsed over to the buyer of the mortgage at each sale, and public recording of the transfer (see here and here). So even if notes can be produced in foreclosure cases, the banks may not have the necessary assignments showing each sale and thus proof of the chain of title, and it's at least worth a court filing that allows the squatter to live their rent free another 6-12 months.

This is hurting housing, neighborhoods and the economy.

Epstein on the Flat Tax

Richard Epstein has an article arguing for a flat tax on two grounds. First, progressive taxes generate wasteful tax avoidance. If you've ever talked to someone in asset management for wealthy people you'll know that the most pressing issues have nothing to do with picking good pre-tax investments, because moving income across time or some artificial category has a much bigger after-tax return. Secondly, when taxes are shared pro-rata the discussion on the size of government is more rational because everyone internalizes the cost. Currently only half of working Americans pay income taxes and so don't have to consider the tax effects on their income.

These are good arguments, but I'd add the following. James Mirrlees won a Nobel prize for his work on optimal taxes (see his seminal 1971 paper, An Exploration in the Theory of Optimum Income Taxation). In these models the optimal tax rates depend on assumptions about the distribution of income earning ability, the rate at which the marginal utility of income declines, and how much the tax rate deters income producing.

It is easy to see the utilitarian argument for progressive taxation: rich people don't value $1 as much as the poor, so they should be taxed more on that final dollar, but there is a powerful countervailing force which is less obvious. Given income earning opportunities are lognormally distributed, the highest earners generate much more wealth than the middle income earners. Thus, under most parameterizations you find that lower tax rates on the high earners are better because these earners are wealth-producing machines. Higher tax rates on the most productive people affects these people first, which is the exact opposite of what you want, which is to affect them the least--as far as maximizing total wealth created.

I find this literature compelling because I'm a libertarian, which is really just a dynamic utilitarian: I like to count up happiness over time in a world where people choose their actions in anticipation of certain payoffs, unlike simple utilitarians that assume output is given. Further, we tend to take for granted the unintended benefits of wealth in terms of science, art, and general human camaraderie; Marx's 'idiocy of rural life' comes from never having time to think.

Unfortunately, I think the problem is worsened by the practical fact that people are more concerned with relative than absolute income; we are more envious than we are greedy. It is a hard thing for most people, especially intellectuals, to acknowledge benefits from their rich moral inferiors who never so intended it, people who seem to enjoy it without any sense of extra obligation. Such 'progressives' see progressive tax rates as a good thing no matter how much wealth is destroyed because preventing one dollar more going to the Koch brothers is worth $10 dollars less going to a bunch of working stiffs, especially because these stiffs would probably in some way be doing business with such a bastard.


This is why the Mirrlees model is now so quaint. No one really cares about quantifying the trade-off in wealth vs. equality, because for people who care about relative wealth, aggregate wealth doesn’t matter, and what drives their confabulations is bringing down those above them (see above). No one wants to look at trade-offs because admitting there is one highlights the fiscal multipler isn’t greater than one. Better to focus on aggregate GDP, which assumes government spending and investment are perfect substitutes, and argue about the multiplier in the context of insufficient aggregate demand, a fancy both defensible and sterile.

Envy, while natural, is a vice to rise above and not a virtue to celebrate under the pretext of equality and justice.