Archive for the ‘Investing’ Category

Uptick roolz

Tuesday, April 7th, 2009

Wonder why the market is up 25% in a single month, despite no improvement in fundamentals?  Consider this interesting coincidence.

The recent huge market rally began March 10, the same day Barney Frank announced the imminent, nearly certain elimination of the short uptick rule.  Berkshire Hathaway, a popular short in recent months, rose 19% that day.

Meanwhile, judging from what clients tell me, a lot of big funds lately are simply speculating on short-term momentum.

Connect these two dots:  massive short covering began March 10, anticipating the end of the uptick rule.  This caused a mini-rally.  Big momentum investors reacted to that, and to each other, creating self-sustaining momentum.

Result:  sustained rally on no fundamentals.

Not saying that’s definitely what happened, but it is a simple and plausible interpretation of events.  More plausible, in fact, than an abrupt improvement in the economy or financial system.

Credit card optimization and inflexibility

Friday, March 20th, 2009

I’ve mentioned before the general principle that optimization creates inflexibility — in business, investing, computer programming, law and much else.

The credit card industry’s current travails offer an example.  Many have written on this subject recently, many good, but usually with the leftist or moralist subtext that 30% interest rates are somehow inherently wrong, so card issuers are getting what they deserve.  I’ll leave the Biblical debates to other writer.  This post just talks about the relationship between steady-state profit maximization and brittleness in economic shocks.

Credit card issuers mainly make money from so-called “revolvers” — people who endlessly pay interest on high balances, too high to pay down, but never quite high enough to trigger  default.  The issuer’s business revolves around revolvers, endlessly optimizing to maximize cash extraction from that particular group.  (Conceptually similar to the way casinos make much of their money by catering to and optimizing for “whales,” a gaming industry term for high-stakes compulsive gamblers.)

The 2005 bankruptcy reform, in force since 1/1/06, was intended as yet another credit card industry optimization.  By making Chapter 13 harder to qualify for, debtors could not easily write off consumer even in bankruptcy.  Instead, they were placed in repayment programs by the bankruptcy court.  According to at least one reliable source, issuers responded to this by lending more freely, assuming they would always be able to collect, even in bankruptcy.

This and other optimizations were in a sense too successful:  the more effectively the issuer optimizes, the closer it pushes the “revolver” to his absolute theoretical fiscal limit, the more exposed both borrower and issuer become to an economic shock.

Say you are a lender.  Would you want most of your customers to be paying you 100% of their EBIT in interest payments?  A residential lender would answer no.  Corporate bond issuers would say “no way.”  Too dangerous, no margin of safety.  A one-dollar decrease in the borrower’s income would trigger default.  Yet card issuers were actively seeking that 100%.  They tried to control losses with higher rates and better collections, but mainly just crossed their fingers on general economic stability.  That turned out to be an ill-placed hope.

What if it’s all about transparency?

Saturday, February 21st, 2009

As we launch into the biggest Keynesian stimulus in history, it bears mentioning that its purported efficacy is based on a single historical example, whose success is still debated.

So, as long as we are making unproven assertions about what cures a great depression, here is an alternative. Judge for yourself.

High debt and unknowable exposure don’t mix. You can have one or the other, but not both. If you have low debt, you can tolerate uncertainty about exposure and risk. If you have high debt, you can still take risks, but critically, you need to know exactly where your exposure is, how big it is, or you quickly become insomniac and sensitive to loud noises.

Thus, if you have a debt-driven depression, the first order of business is to massively increase transparency, so that risk can be better quantified by anyone who wants to risk their capital.  Under this model, even bad news would unlock capital, if that news served to quantify exposure.

Repeat:  if you have high debt, unknowns may be OK, but unknowable unknowns are not.

What is a financial panic?  It is the fear of unquantifiable exposure.

“How bad is it right now?” ask investors, consumers and managers. If they can’t answer the question even approximately, then they must assume the worst. When you aggregate those assumptions together, you get a depression.

The obvious policy response is to massively increase the transparency of such exposure. That may bring bad news, but according to Adam Smith (remember him? policymakers sure don’t), individual agents are quite efficient at working around problems, if they know what they are.

This seems to be a forgotten lesson of the Great Depression. “The only thing we have to fear is fear itself.”  What fear? Unknowable unknowns. For example, how safe is your bank?  Are you really getting market price from your broker when you buy a stock? Everyone thought they knew the answers in 1928, but found they could not estimate them even approximately in 1931.

One of the primary policy responses then was to make risks more knowable. For example, consider banking regulation. If a depositor knows his bank must disclose its exposure in great detail to the federal government, his loss exposure is not zero, but it becomes somewhat predictable. Such transparency is much more useful than deposit insurance, because it guides good decisions for both banks and depositors, without moral hazard on either side.

Now investors, managers and consumers are faced again with a sudden tidal wave of unknowable uncertainty.  They thought they knew these basic things, and now realize they know nothing:

  • What is the true default risk of a Moody’s AAA rating?
  • What is the resale value of this or that mortgage-backed security?
  • What is the true financial position of my bank, insurance company or broker?

Throwing money around doesn’t address this problem. No matter what the Fed or Treasury does, the credibility of the credit rating agencies is still suspect. No one knows what certain unregulated securities are worth. Again, high debt is intolerable without transparency.  Until transparency is restored, everyone will still be racing to deleverage, and the ship will keep going down.

Here are some specific actions, which could be taken immediately, that would help restore transparency, permitting all those little rational agents to resume their business:

  1. Create a regulatory agency specifically overseeing credit rating agencies.  Enforce limitations on conflict of interest.  Force one more re-rating of all MBS.
  2. Create a federal mortgage-backed security information website.  Display the contact info of any entity owning more than 10% of a given issue.  Display the deal terms.  Display the actual individual properties held by each mortgage-backed security, scrubbed of personal info, but  still showing 9-digit zip code, square feet, and so on. This would permit anyone to value any MBS, and to contact major owners to make offers.
  3. Several months later (after there has been time to absorb the information), require at least one US exchange to offer a listed market in MBS, displaying bid/ask prices publicly.
  4. Several months later (again, for info absorption time), require all banks and all public companies to disclose their specific MBS holdings.  On the balance sheet, they may either mark to market or hold to maturity, but in any event, must disclose all individual holdings.

The above would drain the swamp in MBS and the rating agencies.  Yes, it would be ugly.  Banks would fail.  But, er, at risk of stating the obvious, if they are holding bad assets, they will fail anyway.

These are the sorts of changes that would bring a true solution.

The long-term stimulus: productivity

Sunday, January 18th, 2009

A key function of a head of state is to articulate national goals, reflecting what the populace already wants, but in a focused, actionable way.

Citizens follow that lead. Deng Xiaoping’s famous quote, “To get rich is glorious,” may be apocryphally attributed, but undoubtedly refocused China on capitalism, with results that speak for themselves.

Americans want to advance economically, but don’t know how.  The government is not helping. Unknown to nearly all Americans, there is a vanishingly simple formula:  maximize your net income per work hour.

What?  you may say.  It is not that simple.  What about controlling spending?  Education?  Savings and investment?  Retirement and vacations?  Yes, those matter, but all are contained within the above formula, if you define net income as any business does:  revenue minus expenses.

Controlling spending:  if you earn $100k this year and spend it all, your net income is zero.  To increase net income quickly, spend less.

Saving:  identical to controlling spending.  If you spend 20% less than you make, you have saved 20% of income.  

Investment:  identical to saving.  Bank accounts are an investment, but there are many other, better investments.  More importantly, investment income doesn’t consume your time:  conservative investments yield very high income per work hour.  Thus, spending less than you earn may not quickly increase your total gross income, but the increase per marginal work hour is incredibly high.

Education:  identical to investment.  It is a way of spending time or money to increase net income per work hour.

Retirement and vacations:  the fewer hours you work for a given income, the higher your income per work hour.  Thus, vacations and retirement go hand in hand with maximizing net income per work hour.  Again, all contained within the simple definition above.

In short, everything comes down to net income per work hour.  Economists would call this a measure of productivity.

The ultimate economically empowering statement from an American president would be “To increase productivity is glorious.”

Rationalizing the auto industry

Monday, December 15th, 2008

In the political debate over how and whether to save GM and Chrysler, microeconomics has been forgotten.

Autos pretend to be a brand-driven industry, but are more like a commodity industry. Under conditions of overcapacity, the highest-cost producers of a commodity shut down, while the lowest-cost continue to make money.  These shutdowns are most efficient if they happen at the plant level, not the firm level.

It’s not clear that union-busting — currently demanded by the Senate minority in return for a rescue — is economically necessary or politically constructive.  Current GM workers are actually paid less than Toyota workers in the US.  GM’s higher costs result not from current staff, but retirement obligations, mainly retiree healthcare.

GM is in an interesting position:  they are uncompetitive mainly due to retiree benefits.  In fact, it barely exaggerates to say that GM is going broke due to the US healthcare system.  The system is not cost effective, and has become less so over time, to the point that it is beginning to bring down even very large firms.  Fixing the cost effectiveness of US healthcare would dramatically improve US competitiveness, profitability, employment — and could by itself save GM.

But that takes time.  In the meantime, if GM is to be saved, logically it should be done as a workout or prepackaged bankruptcy, in which retirement liabilities are nationalized and the oldest, highest-cost plants are shut down.  GM is competitive enough that, with these two changes, they should survive.  Without these changes, they’ll just fail again.  

Reconciling the experts

Thursday, November 20th, 2008

Buffett is buying.  Soros is gloomy.  Who is right?  Probably both.

Schiller’s 125-year historical record suggests the broad index reverts to a long-term mean P/E ratio of about 16.5.  Today, it’s 32% below that, about 11.  So there is no question the market is cheap by historical measure.

But when will it turn?  There is the rub.

There is historical precedent to go much lower (in the 1970s, broad index P/E bottomed out at only 6 or 7 albeit while competing against much higher interest rates), so it would not be surprising to see a further market decline of as much as 40% — particularly if the Fed loses control of long-term interest rates.  

But for a very long holding period (15 years), mean reversion alone argues for buying now.  

Thus your strategy now depends upon your holding period.  This reconciles the conflicting public statements of famous investors.  Buffett holds forever, so he is buying.  Soros, Rogers et al play much shorter time frames, so they are staying out.  Both are rational, given their specialization.

The Game of Capital

Wednesday, November 5th, 2008

American capitalism has been so stable, for so long, that everyone has apparently forgotten what it is.  Capitalism is presumed by both liberals and conservatives to be an ideology of total deregulation.  That’s mistaken.

Capitalism is, and has always been, a game whose rules are designed and enforced by government to maximize the efficiency of capital allocation.  

“What?”  my laissez-faire readers argue.  ”Capitalism has inherent rules?”  No, they argue, capitalism is the totally free, utterly unfettered flow of capital.  The rules are what get in the way.

“What?”  my Bay Area friends argue.  ”Capitalism has inherent rules?”  No, they argue, capitalism is the unrestrained excess of the greedy.  The rules are what keep them at bay.

These positions both misunderstand the history and definition of capitalism.  Basic regulation — the rules that define incentives in the capital allocation game — are central.  Capitalism cannot function without them.  The objective is not to increase or decrease regulation, but rather to design a legal structure that maximizes the efficiency of capital allocation at minimum cost.

Consider:  capitalism depends upon private ownership.  But what does “ownership” mean?  Property is, at its core, a form of monopoly granted and enforced by government.  When you buy a house, what are you paying for?  Exclusive use.  Who protects that exclusivity?  What stops your neighbor from crashing on your couch whenever he wants?  Laws and police, paid for by tax.  Private ownership cannot exist without this government sanction and enforcement.  Thus regulation is inherent to capitalism.

This is a special case of the most general function of government:  to assign individual costs and benefits to externalities, in a way that makes most people better off.

The cost of such assignment can easily exceed the benefits, which is why so much of the regulation of the 1960s and 1970s was wasteful and counterproductive.  This set the stage for a conservative backlash that is only now running out of steam, as it hits the problems that exist at the other end of the regulatory scale.  As posted here years ago, Baja California demonstrates how poorly under-regulated capitalism works.

In the US, wasteful regulation and counterproductive deregulation are both driven mainly by politicians born before 1960, who, as posted here previously, grew up in conditions of essentially unlimited American power, stability and financial resources, and thus never developed the judgment necessary to make decisions under conditions of limited resources.  

With the passing of the torch to a new generation that grew up with declining living standards and American balkanization, we may reasonably hope for better cost/benefit analysis.

For Sale by Owner – Hummer

Friday, October 17th, 2008


General Motors continues to seek a buyer for Hummer. From the WSJ:

General Motors Corp. said Friday it has begun sending out a sale prospectus for the Hummer brand to potential buyers as it moves “as quickly as practical” in deciding the fate of the division.

Imagine the prospectus: “For Sale by Owner: loss-making American car brand. Primitive 1970’s-era body-on-frame design. Poor safety record. High vehicle price point and operating costs. Collapsing demand. Most buyers require credit, now unavailable. Brand image symbolizes failed and globally vilified American military gambit. No export potential. Huge idle plants with high fixed costs and unruly labor force. Acres of unsold inventory. Make offer.”

Sign me up.

Financial WMD made simple

Thursday, October 9th, 2008

This post was inspired by a recent NPR program.

Several years ago, Warren Buffett famously referred to financial derivatives as “financial weapons of mass destruction.” Unfortunately, he, and nearly everyone else, didn’t elaborate. For nearly everyone, “derivatives” remained just a word, vaguely associated with big money and big danger.

This post attempts to explain why one particular type of derivative, “credit default swaps,” caused the financial system to implode.

The layman’s confusion is caused in part by opaque naming. (”Credit default swap?” What the heck does that mean?) But it’s really pretty simple. “Credit default swaps” are bond insurance policies. The buyer of such a policy pays a premium to the insurer, for protection against the default of a bond. If the bond doesn’t default, the insurer just keeps the premium. If the bond does default, the insurer must pay the buyer the face value of the bond.

If it’s a bond insurance policy, why don’t they just call it “bond insurance” instead of CDS? There is a reason, and it stinks. More on that in a moment.

Among other uses, CDS were widely employed to improve the credit rating of mortgage-backed securities. For example, a dicey pile of Countrywide mortgages would be securitized, and might have a fairly risky default rating. To reduce risk, the end buyer might simultaneously buy both the securitized mortgages AND a credit default swap (again, bond insurance) to insure against the risk that the mortgage securities might fail to pay off as agreed.

The obvious problem here was that the mortgages were much dicier than expected, too many of them defaulted, and too many insurers (sellers of credit default swaps) were forced to pay insurance claims.

So far, this is a case of bad risk management, but not bad enough to take down the whole financial system. To see where the dynamite was hidden, let’s return to this mysterious reluctance to call these financial contracts “insurance,” even though that’s clearly what they are.

Insurance is a regulated industry. Insurers are required to maintain capital reserves (e.g. cash and investments), to ensure they can actually pay out claims on the policies they sell. This regulation stabilizes the financial system, but irritates the more aggressive financial types, who could enjoy vastly higher return on capital if they didn’t bother to maintain reserves to actually pay claims.

Their ultimate dream of avarice: an insurance company that has no capital to pay claims. Divide by zero: infinite return on capital. Just write policies, collect premiums, and if a claim rolls in, just declare bankruptcy and start over. Easy money.

In the 1990s, when the idea of securitization was expanding rapidly, prospective sellers of bond insurance, fueled by this utopian vision of infinite return on capital, decided not to call their product “insurance.” Instead, they called it a “credit default swap,” and argued it was not really insurance, but a “forward contract” between two private parties. This clever definition meant that, from a regulatory perspective, these products weren’t insurance, and weren’t listed securities, placing them outside the purview of all regulatory agencies.

This unregulated environment was made explicit in law with Web-Bubble-era legislation led by Phil Gramm (John McCain’s chief economic strategist until a few weeks ago).

Freed from the irritant of capital requirements, a credit default swap (CDS) free-for-all ensued. Increasingly, they were used not by bond holders, but by speculators. For example, you could buy a CDS contract to insure against the default of a bond you didn’t actually own.

To see how strange this speculation is, consider an analogy. Suppose you think your neighbor will default on his mortgage. Imagine if you could buy an insurance policy on your NEIGHBOR’S mortgage. If he defaults, you collect the entire value of his mortgage. Everyone on your street could do it, and would each collect the entire value of the mortgage if your neighbor defaults.

This is exactly what was going on in credit default swaps. Today, for every dollar of mortgage backed securities, there are believed to be about 12 dollars of CDS contracts. This is a form of leverage, in that, if a dollar of MBS defaults, then 12 dollars must be paid out by someone.

Now we start to see how the entire system could fail (but it gets worse — see below). The maximum exposure to MBS is not the total MBS market of $5 trillion, but 12 times that, the entire CDS market, or $60 trillion. This is more than 4 times the entire annual output of the United States.

How could the CDS market be so huge? One reason is that they could be structured, typically by hedge funds, into a seemingly riskless bet, known as “netting.” This trick takes advantage of the simple fact that insurance premiums are higher when a claim is more likely. (For example, it costs more to insure a 16-year-old driving a red Ferrari than to insure a 40-year-old bookkeeper driving a Honda Accord.) Hedge funds took advantage of this fact as follows.

Say you run a hedge fund. You buy a CDS on a bond when the risk of default seems low. The price of such a CDS is low, because the perceived default risk is low. Then, as the mortgage collapse unfolds, you also SELL a CDS on the same bond. In the latter transaction, you, the hedge fund, are acting as the insurer. (Why not? CDS are totally unregulated, so anyone can write a policy.)

Because the mortgage collapse is under way, the underlying bond seems more likely to default than it did before. So you can charge a much higher premium for the insurance you are selling than you paid earlier for the insurance you bought. Your profit is the premium received in the second transaction minus the premium paid in the first transaction.

Superficially, you are taking no risk, because if the bond actually defaults, you collect on the insurance policy you bought, and use that money to pay out on the insurance policy you sold. That nets out to zero (hence the term “netting”), but you still have your profit described in the previous paragraph.

What’s the problem here? Something called counterparty risk. In an actual default, you make your insurance claim and try to collect on the policy you bought (the first transaction above). What if they don’t pay you? For example, what if you bought that policy from Lehman Brothers, and they went broke before you could collect? Now the person to whom you SOLD insurance (the second transaction) comes to collect from you. You can’t pay, because Lehman stiffed you, so you are suddenly insolvent, aka broke.

So many people were netting, and the CDS speculation market had become so large over the years, that everyone was dependent upon the counterparty risk (ability to pay a claim) of everyone else. Everyone had booked profits on netting transactions, but in an actual MBS default, if any link in the chain failed to pay, everyone would go broke. Circle of interdependency. Cascading defaults.

The first link to fail was Lehman. The federal government appears not to have understood until very recently (just the past few weeks) that CDS were mainly used to speculate, not to insure one’s own bonds. As a result, the feds didn’t realize that letting Lehman fail would break the chain of interdependencies on CDS claims, causing everyone else to collapse.

So AIG went down. In addition to their regular insurance business, AIG was dabbling in CDS. Well, more than dabbling: they sold $400 billion of CDS, and in the wake of Lehman, enough of these went south to take down the company.

Belatedly, everyone understands that the CDS market should be regulated either as insurance, or as listed securities, or both.

In the meantime, we face the problem of a money supply collapse. For every dollar of MBS default, 12 dollars vanishes from the money supply. This is why the Fed is massively loosening monetary policy.

Optimization creates inflexibility

Friday, June 27th, 2008

Programmers know this, but I’m not talking about code.

In any field, it seems, optimization creates inflexibility. This is because optimization (maximization of performance) generally requires assumptions about the continuity of conditions.

In computer programming, you gain great speed benefits by writing graphics software in assembly language, rather than a compiled language such as C. But assembly is purpose-designed for a single microprocessor family. Change families, and all your work must be thrown away. So this optimization require one big assumption about future use of your software.

In investing, you can gain higher returns with leverage. But the greater the leverage, the more central your assumption of price stability or continuity, the greater your reliance on avoiding one really bad day, and its associated margin call.

In advertising, you can maximize conversion rates by having each CPC ad click through to a specific landing page designed for that ad. But the amount of work required to make a campaign-wide change increases by an order of magnitude.

Maximizing international trade optimizes economic output but greatly increases exposure to common-factor economic collapse, such as a discontinuity in the oil supply.

Thus optimization increases performance (narrowly measured), but also exposure to Black Swans.