Did we miss a trick?

Deus Ex Macchiato:

Larry Elliott has a thought provoking article in today’s Guardian. He quotes Roubini, who says

… that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”

But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.

Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.

Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.

What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen … until there is system failure.

This is an interesting thesis. I don’t wholly buy it, but the idea that precisely by doing enough to fix the immediate problem, but not enough to address its causes, we have left ourselves exposed to a Japanese style slow, shallow but long lasting recession is interesting. Certainly by missing the chance to nationalise the worst affected parties, such as RBS, we also lost the opportunity to restructure banking broadly. It might well turn out that that ideologically-motivated decision was a bad one. That won’t be clear for some years, and it may well be that the summer 2010 panic is minor. But if it isn’t, we will be criticising 2008’s crisis management for some time.

James Montier: “I want to break free”

James Montier, former Societe Generale analyst now forking for GMO, put out couple days ago a nice report about risk, benchmarking and asset allocation. Whole report is worth reading, but let me high,light two things:

Problems with Policy Portfolios

Problem 1:  Risk isn’t volatility. To begin, we should ask ourselves why we are concerned with volatility as a measure of risk. Modern portfolio theory is so entrenched in the innermost workings of the world of finance that risk is typically defined as standard deviation or variance. 

However, risk isn’t a number. It is a concept. Ben Graham argued that we should focus on the danger of permanent loss of capital as a sensible measure of risk: What is the chance that I will see my capital permanently impaired by this investment? This strikes me as a much more sensible viewpoint than the mathematically elegant but ultimately distracting practice of assuming that risk is equivalent to standard deviation. 

Volatility creates opportunity, not risk. As John Maynard Keynes long ago opined, “It is largely the  uctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”  

For instance, let’s look at equity volatility. Exhibit 3 shows a measure of the volatility of the S&P 500. Were equities more risky in late 2007 or early 2009? If you follow the edicts of standard nance, then 2007 was a much less risky year than 2009. Now, tell me again that risk and volatility are the same thing! 

Problem 3:  Benchmarking alters behavior. The third problem is that benchmarking tends to alter investment Managers’ behavior along three important dimensions. First, managers motivated to compete against an index may lose sight of whether an investment is attractive or even sound in an absolute sense. They focus upon relative, not absolute, valuation.

Second, as soon as you give a manager an index, the measure of “risk” changes to tracking error: how far away from the benchmark are we? Sadly, in a benchmark-tracking-error, career–risk-dominated world, Keynes’ edict that “It is better for reputation to fail conventionally than to succeed unconventionally” governs the day. For benchmarked investors, the risk-free asset is no longer cash, but the index that they are compared against. 

This is evidenced by the drive to be fully invested at all points in time. After all, if the goal is to beat the market without falling significantly behind, it makes sense to remain 100% invested. (Witness Exhibit 6, which shows the relentless decline in cash levels in U.S. equity mutual funds.) Remaining fully invested at all times means that the investor simply chooses the best available investment. Relative attractiveness becomes the only investment yardstick. 

Finally, benchmarked managers start to think about return in a relative sense as well. I’ve always hated the idea of sitting in front of a client having lost money, but claiming good performance because I’d just lost less than an index. That very concept sticks in my craw as an investor.

The bottom line is that, effectively, everything becomes relative (risk, return, and valuation) in a benchmarked world. 

JM-I Want to Break Free

Bailouts Didn't Save The World

The Daily Capitalist:

David Wessel, I have five words for you: post hoc, ergo propter hoc.

Mr. Wessel is the Wall Street Journal's chief economics commentator, and is often the face of the Journal on television. He wrote an article recently ('Bailouts Save Day, Win Scorn") that laments the fact that, despite the fact that the bailouts saved the world, Mr. and Mrs. America don't believe it. In fact, he points out that Americans' distrust of government and large corporations has grown as a result of the bailouts, something they see as unfair, and an example of cronyism between Wall Street and Washington.

He says in the article:

The world has had a terrifying brush with another Great Depression. Although the recent scare in Europe is a reminder that this isn't over yet, it looks like we've escaped that—in no small measure because of taxpayer-financed bailouts and fiscal stimulus, as maligned and imperfect as they were.

Mr. Wessel is a bright guy, a star of a pro-capitalism newspaper. Yet he makes serious economic and logic errors that are not based on theory or the record. He needs a lesson in economics and epistemology (the science of how we know what we know).

Post hoc, ergo propter hoc is a Latin phrase describing a logical fallacy. The fallacy is: because A occurred and then B occurred, then A caused B. In modern behavioral economics this also coincides with the principle of 'confirmation bias,' where you look for data that coincides with your desired conclusion.

There are two fallacies here.

The first fallacy is that bailouts saved the world. The second fallacy is that without the bailouts we would have had another Great Depression. As Mr. Wessel says:

It just doesn't seem fair. Because it isn't. The bailouts weren't designed to be fair. They were designed to prevent a financial virus from infecting the entire economy. And there was no quick way to keep credit flowing, so the economy kept functioning, without saving some big financial institutions and the folks who work in them.

With regard to the bailouts saving the world, I would ask him how he could prove that. I think I could easily argue that in fact the thing he feared would happen, a financial meltdown and credit freeze, did actually happen and the world didn't end. Except for the 10 largest banks which had access to the various Fed ATM machines, the economy is still suffering from the meltdown. Mr. Wessel confuses these large banks with the economy.

I could further argue that the bailouts have actually harmed the economy and have delayed recovery because some of these large financial institutions were bankrupt and should have been allowed to go under in an orderly manner. The pain would have been intense, but short. Now we are still in pain, the economy is on the verge of setback, and we have saddled future generations with the cost of paying for it.

There is no basis to say that fiscal or monetary stimulus has saved the economy. I challenge Mr. Wessel to prove this assertion as well.

Since the Fed had boasted that it could easily manage recessions by pumping money into the system, why hasn't that worked? Why are we still having a credit freeze? Why is money supply continuing to decline? Why is unemployment, especially U-6 unemployment, growing? Why are we experiencing deflation instead of inflation? Why does he assume that Keynesian fiscal stimulus has any lasting effect?

The second fallacy is that he believes we would have had another Great Depression without the bailout.

Again, what proof is the proof that that would have happened? I would say, as I have many times on The Daily Capitalist, that depressions are caused by government action. Mr. Wessel apparently believes that economies go into serious depression all on their own, which was not the case of the Great Depression. Had the government under Messrs. Hoover and Roosevelt not interfered with the corrective process of what was originally a garden variety recession, the economy would have recovered in 18 months, as did the much worse recession of 1920-1921 when the government did essentially nothing.

What really happened to us was the Great Panic of 2008. I'm not talking about the collapse of Lehman Brothers. I am talking about the panic of Hank Paulson and Ben Bernanke. They had no idea what was happening at the time and didn't know what to do. They too confused Wall Street with the economy. So they resorted to doing something, which was the bailout. History has shown that usually when the government does something in these circumstances, we all end up suffering.

Like the Great Depression, Mr. Wessel needs to understand the causes of this recession. It has more to do with the Fed and government housing policies than Wall Street. Wall Street made huge errors--mainly in assessing risk. But the cause can be found in the Halls of Power.

If the Journal wishes to be an advocate of capitalism, it needs to abandon its Keynesian myths. It seems the American people already understand this.

Presenting What Could Be The Oddest Capital Flow Observation In History

Zero Hedge: "

It is no secret that the last few weeks saw massive liquidations along all asset classes. The result was a huge outflow across almost all products: Loans, HY Bonds, Municipals, Commodities... all a typical reaction to broad based liquidations. However, note we said 'almost' - one class that actually posted a $6.2 billion inflow was equities. Yet not is all as it seems: peeking underneath the hood indicates that the bulk of this inflow, or $10.3 billion, had to do with inflow into ETFs... or rather, just one ETF - the SPY, accounting for $10.1 billion. Did someone prop up the entire equity market last week by massively pushing capital into the most liquid equity proxy available?

The plot thickens: as Bank of America points out: 'The number of SPY's shares outstanding rose by 5.3% on Thursday and Friday of last week (May 6-7th), at the time when S&P 500 was trading lower on both days." BofA asks: "The question then becomes if this large intake into SPY was a part of the rogue trade that took place on Thursday, May 6th, or was it part of bona-fide rush by investors to buy equities at their lows...This suggests to us that the inflow into SPY, and by extent the overall equity category, was at least partially attributable to that trade dislocation. Potentially, some form of market-making activity closing on divergences between shares, ETFs, and derivative instruments may have been responsible for positive net interest in SPY." That, or is this the biggest faux pas ever conducted by the "invisible hand" which openly flooded the market with $10 billion in the form of ultra liquid SPY, at a time when massive derisking was taking all single names lower. A much more relevant question according to Zero Hedge, is whether there is any sense trading single names anymore - all the action is now in the form of index equity proxies now that liquidity in single names is virtually non-existent: this means trading only SPY and ES. Was last week's freak occurrence a huge ETF rebalancing, an implosion in one or more market neutral funds, which were forced to cover billions in SPY shorts as single names were being sold off en masse, or was this merely a direct intervention into equities by the Federal Reserve? We are confident that the SEC will immediately rush to answer all these questions and will have a definitive conclusion within a week"

Three things worth remembering

Nice charts from Dresdner Kleinwort Wasserstein:

I personaly agree with all above. Charts are from 2004, but they are and will be actual for a long time. Analysts are bullish most of the time. Because in the long term... stock and also GDP is rising.


One more note from Dresdner:


Look at the chart below.  In a study by Torngren and Montgomery, two groups of participants, lay people and professionals, were asked to choose which stock was going to outperform each month.  The laypeople were undergrads in psychology and the professional investors were portfolio managers, analysts and brokers.

They would chose between two stocks (well known blue chip names).  They were all given the name, the industry and previous 12 months performance for each stock.

The students were 59% confident in their stock picking abilities on average and the professionals averaged 65% confidence.  Obviously the lay people outperformed the professionals by a large margin.

When the professionals were 100% sure they were correct, they were actually right less than 15% of the time!  Look below at how, as the "perfect calibration" line (confidence level) moves up, performance declined -- dramatically for the professionals.  Also notice how lay people never said they were 100% confident.

You might think these studies are flawed or that I'm cherry picking the studies, but I have tons of research on this with a number of other studies that show the same thing.  The point is you don't want to be overly confident when positioning yourself.

It's always important to know what the indicators that you're following actually mean, to get as good of a grip on market action as possible.  But no matter what, always remain humble and avoid the cycle described above, and avoid having an ego at all costs.

It's no wonder 85% - 90% of fund managers underperform the market.

And what is "The Market" anyway?  Not what most people think ...



Hat Tip Chris Rowe

The Dark Magic of Structured Finance

I read somewhere last week that you can make from $100 bn portfolio of BBB rated securities brand new portfolio of $90 bn triple A rated securities... Amazing stuff.

Too bad I cant find a link. Anyway, this story from Marginal Revolution is also very interesting.

Marginal Revolution:

In Too Big To Save Robert Pozen gives a clever example, based on an excellent paper by Coval, Jurek and Stafford, which explains both the lure of structured finance and why the model exploded so quickly.

Suppose we have 100 mortgages that pay $1 or $0. The probability of default is 0.05 (assume independence). We pool the mortgages and then prioritize them into tranches such that tranche 1 pays out $1 if no mortgage defaults and $0 otherwise, tranche 2 pays out $1 if 1 or fewer mortgages defaults, $0 otherwise. Tranche 10 then pays out $1 if 9 or fewer mortgages default and $0 otherwise. Tranche 10 has a probability of defaulting of 2.82 percent. A fortioritranches 11 and higher all have lower probabilities of defaulting. Thus, we have transformed 100 securities each with a default of 5% into 9 with probabilities of default greater than 5% and 91 with probabilities of default less than 5%.

Now let's try this trick again. Suppose we take 100 of these type-10 tranches and suppose we now pool and prioritize these into tranches creating 100 new securities. Now tranche 10 of what is in effect a CDO will have a probability of default of just 0.05 percent, i.e. p=.000543895 to be exact. We have now created some "super safe," securities which can be very profitable if there are a lot of investors demanding triple AAA.

To review we have assumed that the underlying mortgages each have a probability of default of p=.05 and by pooling and prioritizing we have created a tranche with a probability of default of just p=.0282 and a CDO with a probability of default of p=.0005. In this way, structured finance was able to create many triple AAA securities from a pool of securities none of which were triple AAA. This point is widely understood. Now here is a much less well understood consequence.

Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06. In terms of our original mortgages the true default rate is 20 percent higher than we thought--not good but not deadly either. However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase. Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!

The dark magic of structured finance conjured many low-risk securities out of many risky securities. Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined.

Here is an excel file, StructuredFinanceMath, with the calculations.

Addendum: Adding in correlation among mortgage defaults makes the math more difficult but doesn't change the bottom line that I wanted to illustrate which is that small changes in the underling default risk (or correlation) are highly amplified in the tranches and CDOs.

Complexity in Financial Systems

The Psy-Fi Blog:

What's Complexity?

We can probably all agree that modern day financial systems are complex, but what that actually means isn’t something that everyone agrees on. Typically, though, a system characterised by complexity isn’t something that anyone’s designed – it emerges, it adapts spontaneously and it produces stunningly unexpected outcomes when no one’s expecting them.

Which, let’s face it, sounds a lot like modern finance. The problem is that many economists are focusing on how they manage this system when, in reality, it’s impossible to do so. It’s like trying to contain swine flu using a butterfly net.

Complexity Is Not Engineering

When many people, including economists, discuss complex systems they often use analogies with complicated engineered systems like aircraft or nuclear power systems. Now these are definitely complicated, with many, many interacting parts, the failure of any of which may compromise their integrity. However, complicated human engineered systems are not truly complex. For the most part the designers of these systems go out of their way to make sure that they don’t exhibit the trademark unpredictability and non-linear outcomes of complexity.

Indeed, the very fact that these systems have a designer is a sure sign that they’re not truly complex. This was the problem that Charles Darwin solved – how do complex things like human beings come into existence if not through the guidance of a designer? The answer, of course, is that complexity can arise through interaction with the environment as long as there’s some means of adaptation. These are the trademarks of complex adaptive systems. Darwin was concerned with biological evolution, but the global financial system is of the same type.

Complex Means Adaptive

There are two noteworthy things about complex adaptive systems. The first is that they’re complex. The second is that they’re adaptive.

And while that may be a statement of the bloody obvious it’s one that seems to escape many financiers studying the subject. The ability of the system to adapt, often in completely unpredictable ways, means that you can’t model it and you can’t foresee the outcomes of any strategy of intervention. It’s all completely unknowable in advance.

Once you accept this it becomes suddenly apparent that a huge swathe of modern finance is complete rubbish. For example, in a complex system you expect to see “tipping points” or phase transitions when the system suddenly and unpredictably switches from one stable state to another. As Caballero and Krishnamurthy have documented this appears to be exactly what happens during the episodes of liquidity hoarding and flights to quality associated with financial crises. People suddenly switch from a belief that they’re in a state where risk is measurable based on probability to one characterised by fear in the face of absolute uncertainty, so called Knightian uncertainty.

So, in the depths of the panic of 2008 we saw investors selling Collateralised Debt Obligations at almost any price largely because they didn’t know how to analyse them. What it looks like is that they bought these sub-prime backed securities because they’d been given the highest rating possible by the credit rating agencies. When some of these went bad the investors – many of them supposedly high powered institutions – belatedly recognised that they hadn’t got a clue about what they’d bought and sold, virtually at any price. One day they had nice risk models giving default probabilities, the next day they had junk.

The Theory of Rational Ignorance

In fact the problem is slightly worse than this. Many of these institutions had rationally decided not to invest in understanding the products they were investing in because they figured out that it was too expensive to employ the people capable of analysing the issues, an example of The Theory of Rational Ignorance. As Steven L. Schwarcz has remarked in Regulating Complexity in Financial Markets:

“The complexities of modern investment securities can lead to a failure of investing standards and financial-market practices for several reasons: these complexities impair disclosure; they obscure the ability of market participants to see and judge consequences; and they make financial markets more susceptible to financial contagion and also more susceptible to fraud.”

Our problem is that most of the time we’re not prepared to invest as though everything’s about to go wrong. We’re habitually biased to look at the upside, not the downside so we build portfolios without hedges, because they’ll restrict our short-term profits and we’ll always take the view we can get out before it all goes wrong. This is where an understanding of the instability of the global financial system can help investors: it spends its life permanently tip-toeing across a shaky wire over a gorge populated with extremely hungry crocodiles.

And it's got vertigo.

The Next Cause Will Be Different

There’s quite a lot of work now going into figuring out how we prevent the next crisis, much of it looking at how the financial system is re-engineered to prevent these types of failures. It’s a pointless exercise, because as fast as one set of rules is created the system will mutate to find ways around it. In so doing it’ll create all manner of unexpected connections, invisible to the overseers. Who, for instance could have predicted that badly designed mortgage schemes in middle America could have led to the collapse of the Icelandic government? Hidden links and invisible chains of consequence are everywhere in global finance.

Because the global financial system isn’t engineered and doesn’t have a designer there’s no way of controlling it. Those industrious academics trying to figure out how to use engineering concepts used to manage risk on complicated systems like aircraft are wasting their time. The failure of the global financial system isn’t like a single airplane unexpectedly crashing, it’s more like every single aircraft crashing simultaneously. It’s not the problems we can see, like the design of the avionics computer, that are the issue, it’s the fact that air-traffic control systems are dependent on a small number of global positioning satellites each of which happen to use the same specialised microprocessor, which has an unknown bug which is triggered by a combination of a certain date and freak sunspot activity.

Or something else, equally unpredictable.

Punks

Taken together the complexity of the global financial system, and the way that it’s often linked by tight but unappreciated couplings such that a small perturbation in one area can lead to devastating consequences elsewhere, makes it fundamentally unstable. Worse, however, is that even if you can get a handle on the risks today by tomorrow they’ll have changed. In such circumstances believing any prediction is an act of faith, rather than an intelligent assumption.

Equally any set of economic theories or financial models or loudmouthed gurus that claim to be able to foresee the future are hopelessly lost in their own rhetoric. There is no designer, there is no plan, there is no predictability. There’s just stuff, which happens. The best we can do either is plan with a margin of safety or just get lucky.

So, do you feel lucky, punks?