Falkenblog

Lots of people bemoan the fact that we had the worst financial crisis since the Great Depression, and also that fools and skallywags brought this upon us. So it's fun to read this from the Commercial and Financial Cronicle in 1874, right after the Panic of 1873 when default rates jumped to 14%:

“It was a fearful storm while it lasted, and although every one of course can say now that he knew it was coming, yet the real truth is, its breaking was terribly sudden and unexpected. . . . There are few people who allow themselves to remember long the lessons experience would teach them. If this were not so, there would be many less failures in the world. . . . almost all felt they were carrying too much debt; they would henceforth be out of it. There are now, however, very evident signs that these resolutions have been mostly forgotten. Overtrading, as it is called, is an evil that has ever existed, and pretty much the same epitaph can be written above each business prostration—here lies the result of an attempt to do too much with too little capital. Must history necessarily repeat itself?”

Quoted in Giesecke et al, 2010.

Loyd Blankfein was grilled by the Senate yesterday, and he highlighted one of the oldest tricks in the alpha deception handbook. Don't admit to being a merely a middleman, because that's too transparent. That's a skill to be sure, but something many people can do, and most don't make $10MM a year doing it. Instead, say, you are 'transferring risk', 'taking risk', 'selling risk'. If you buy and sell investments, this is technically true.

But it's hugely misleading. Senator Claire McCaskill better characterized Goldman as a bookie whose main job is setting a line so they aren't taking a position on the outcome, their customers are, just in offsetting ways. Making markets is first and foremost about pricing (setting the line), secondarily about hedging, and finally about how the residual risk agregates up. If you price correctly, the other two are de minimus.

But as I explain in my Finding Alpha book, one reason why 'risk' remains prominent in academic finance though it has never been identified precisely is that it has the ability to rationalize a lot of useful deception. Risk is presumably the most important thing in finance, its essence. But what is 'risk'? That depends: it could be beta, a regression coefficient with the aggregate market; it could be volatility, or the correlation with the wealth-to-income ratio. Bill Sharpe, one of the founders of the Capital Asset Pricing Model, now prefers a 12 factor model of risk that totally obviates his Nobel Prize winning insight, though no one seems to note the inconsistency.

Risk is that which, in combination with an expected return, defines how much of some asset one wants to buy. Now, because an expected return is a straightforward concept, alpha deceptors don't like to go there. Instead, they talk about the risk that could rationalize any desire for any expected return. And since 'risk' has both an insanely rigorous definition (covariance with the Stochastic Discount Factor!), and also has a subjective, intuitive definition, it allows one to say nonsense and get away with it.

It's sort of like post-modern gibberish where one can talk about 'Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity', and get smart people to think you, too, are smart, because it uses profound but amorphous words in a plausible sequence.

So, when alpha deceptors hide behind the 'we are risk managers' defense, remember, a real risk manager has a prosaic job, doing things that one can understand: verifying income on loan applications, measuring CAPM betas, calculating VaRs even. They are straightforward, and you can argue about key assumptions. The whole 'risk manager' spiel is because if you are getting paid $1MM+ a year, you know that there's probably someone just as smart as you making half that who wants your job, so better make it sound like you are doing financial string theory. As 'risk' is essential, important, and undefinable, Blankfein and Sparks could talk about 'selling risk' and keep senators at bay.

A financial market middleman's job is difficult, and they have an essential and salutary function for society, but all the 'selling risk' stuff was obfuscatory: they sold Paulson short CDO exposure because he was bearish, so saying they were 'selling risk' was simply a way to avoid talking about it.

Goldman didn't do a good job defending themselves. You have to be a 'bright young thing' to get a job there, but I think their brand name and massive connections, make them appear much smarter than they really are. They could have mentioned that for most things they make markets in, it would be impossible to keep a consistent position (eg, long housing), because you have hedges, people bet not just on the direction but the volatility, you might believe a certain subset of a broad sector is bad, or you might change your mind every week. Also, in a large institution, you probably have certain groups with opposite views, and let the magic of their pnl determine who is right: they are net zero on the 'beta' bet, but one might demonstrate 'alpha', so your organization wins. Further, every asset, even 'shitty' ones, is attractive at the right price. A regulation on position direction is antithetical to the essence of being a market maker, who occasionally ends up with inventory long or short, which then needs to be exited.

Blankfein is a crony capitalist, begging for more 'regulation' because he knows that a 1300 page bill basically only helps those with connections and extant massive legal infrastructure, and hurts potential competitors who merely have good ideas. I'd miss them as much as I'd miss Drexel, a giant which died with much schadenfreude.

In today's senate hearing, there was a question how a portfolio of BBB rated securities can generate a AAA rated security. Ex-Goldman exec Dan Sparks basically said it was due to diversification. This is an incomplete answer. Diversification alone is insufficient. You also need to add an equity tranche, a first-loss position that is breached only in specified probabilities. This is modeled based on historical loss rates for the rated collateral, and the minimum amount of equity needed to imply the Senior securities have expected loss rates consistent with AAA ratings (expected loss is the expected default rate times the loss in event of default). This is modeled using Monte Carlo methods because these structures have waterfalls where reserves build-up and are paid down, so they don't assume 'gaussian' distributions.

So, turning B rated bonds into AAA rated bonds, involves both diversification and equity. You can't turn $100 worth of BBB bonds into $100 worth of AAA bonds. You turn it into $95 worth of AAA bonds (or something, depending on the time horizon).

And this was all farked because the ratings on the collateral were wrong, but that's a separate issue.

Yesterday I mocked Fab Tourre as a probable sales hack. I don't know him, but consider that he was selling a mortgage CDO derivative while the collateral that underlay it was collapsing in value (the ABX-HE 2007-1 BBB index had already started imploding, and was trading well below par). If Goldman did lose $83 MM on this deal as they say (because Goldman ended up long some of this issue), this means Fab did not tell Goldman this deal was doomed. He either mislead his own company, or was clueless as to what mortgage collateral credit analysis entails. I'm guessing the latter.

It should go without saying that while the average member of a group may be uninspiring, his group may have an essential function in society. Your average anything is a hack, mindlessly repeating tasks that get them through their daily toil. That's true for scientists, policemen, businessmen, lawyers--everyone. As Sturgeon's law states: 90% of everything is crap. Sales hacks have the distinguishing characteristics of knowing a few key tricks about persuasion, and a superficial knowledge about their product that is most useful to those who are totally ignorant. Their pitch benefits from a certain degree of ignorance.

Yet I should stress that salesmen are essential for a growing economy. Amar Bhide highlights the importance of entrepreneurial consumption, those consumers who buy things because they are 'neat', like iPods, iPads, or Photoshop. A small minority figure out a way to make these create really useful services, and these ideas create newer innovations. The consumers are the tinkerers whose trials-and-errors generates useful insights that can't be found via pure theory. An economy where consumers merely read their product manuals and followed the directions of the creators, would not discover as many valuable things. Salesmen encourage this entrepreneurial consumerism.

The benefits of salesmen are primarily that they are incented to educate the totally ignorant about the benefits of their product. If you are totally unaware of, say, databases, you might not know that using MS Access dominates using Excel at some point. Without someone getting paid, the chances you get this education are purely a function of serendipity. However, if you know a lot about databases, you might find the salesman annoying, because he neglects to inform you of alternatives to his database, such as MySQL, that are even better. Thus, the ignorance of salesmen is relative, and their primary beneficiary, the noob, is common enough, and is made better off moving his 5 MB excel sheets into Access. Given the pedestrian nature of your average consumer, nudging him to enjoy something slightly better is much more common, and important, than top-end refinements.

My prior post noting their ignorance was elitist, as most expert users find salesmen redundant, but we aren't their primary audience, and their benefit to the economy comes from the way they have sufficient knowledge and incentives to make a lot of consumers, especially those noobs, a little bit better. The point about Fab Tourre is that if we are going to learn something about the Credit Crisis of 2008, his level of knowledge is probably not useful to that end, in the same way that a MS Access salesman is not the best person for explaining the cutting edge trends in database development.

Fab Tourre is the Goldman saleman singled out by the SEC. It's important to remember a salesman's job is to get people to buy things they wouldn't otherwise buy. If a product sells itself it doesn't need salesmen. Salesmen get paid to get people to buy things they otherwise didn't want, and probably don't need or can't afford. If this is a crime, it's being committed right now by millions.

Further, salesmen tend to have a very superficial understanding of what they are selling. Very few salesmen can answer technical questions about their inventory. A really knowledgeable salesmen isn't a good salesmen, because anyone who knows a lot about their product and the competition knows that their product, at best, is not that much better than alternatives. Most things have cheaper substitutes that are just as good, that's what savvy people know--that's the essence of being savvy. Most salesmen are perforce selling inferior products, but to sell a product you can't know that otherwise you are not as convincing when giving the pitch as to why their product is a must buy. Cognitive dissonance is much easier to tolerate when you are too ignorant to sense it.

Persuasion is best done by people smart enough to know a few key selling tricks. For example, Kevin Hogan is a communications expert, and he highlights how words like 'imagine', 'now', 'because', and of course 'please' and 'thank you', are great words when making a sale. He also notes that while first names are great, use them sparingly or it sounds manipulative. So, start a discussion by saying the person's name, and end with their name ( 'OK John, ...make point... thanks, John, talk to you soon'), but don't use their name in the middle! All good stuff, and you can see that to master these tactics you need some skills, though knowing a lot about the product is not one of them.

Aristotle said that a judge should not be young, he should have learned to know evil, not from his own soul, but from long observation of the nature of evil in others. Similarly, bond investors and salemen should have experienced the crises that are the true tests of bond safety. As a 28 year old (circa 2007), Fab never experienced a true credit cycle, and bonds only demonstrate their value during those infrequent crises that occur every 5 to 10 years. Tourre started at Goldman in 2001, missing the tech bubble, and never had any experience with the Commercial Real Estate bubble of 1990, the oil-patch bubble in the 1980's, the interest rate crisis of 1994, etc. Buying a bond from someone who has only read about theses things is a problem because financial market history seems a lot more predictable than it is in real time.

So, when Fab speaks to congress this week, remember, he's a salesman. He probably didn't fully understand the CDOs he was selling, and was exaggerating its safety. That's not a crime, that's the definition of a salesman.

The key fact in this question appears to be whether Tourre or Goldman told asset manager ACA that Paulson & Co. was an equity investor, a material misrepresentation. Goldman flatly denies this, the SEC says they did. I think the real lawsuit should be against ACA for gross negligence, though I'm not sure what's left of ACA could make any restitution.

In today's WSJ, Niall Ferguson and Ted Forstmann make a very good point about new financial regulation:

The case for limiting leverage and regulating derivatives is overwhelming, but that doesn't require a new 1,300-page law.

This is a good example of how, theoretically, government can make things better, but in practice, they don't. Of course, a theory that applied the same selfish motives and asymmetric information to government agents would not predict government will probably make things better merely because they could (eg, public choice theory). But, most economists opining on policy just figure, 'I can make it better, ergo, the government should be given power to make it better'. Useful idiot-savants are they.

Here's the price of 10 year Greek bonds, starting on December 22 2009 when Moody's downgraded it to A2. Today, that last datapoint, they downgraded it to A3. In between, the price of their bonds went from about 100, to 84. I suppose somewhere around 50 it will be downgraded again!

Sometimes you wonder if almost everyone in finance simply tells people merely what happened last year.

My book, Finding Alpha, highlights that conventional, and really any intuitive measure of risk, is at best unrelated to return. At worst, it is negatively related to returns.

Baker, Bradley, and Wurgler have a new, simple, paper on low risk equity portfolios.

This was pointed to me by Pim van Vliet, a quantitative researcher at Robeco. He has a nice presentation on Robeco's low risk portfolios here, and an SSRN paper on low-risk equity portfolios here.

It seems everyone has an opinion on the Goldman case, as though there's some really big principle here. Lawsuits have very little to do with principle, as these are merely pretexts to get lucre. Think of ambulance chasing attorneys jumping on Toyota based on dubious claims that accelerators were 'stuck': supposedly they just want a safe public. Yeah sure.

In my lawsuit with Telluride Asset Management, they asserted I violated a confidentiality agreement. They claimed that any usage by me of certain base ingredients for portfolio selection was a violation, because it was necassarily informed by their sage stewardship at Telluride. Yet, I had used these criteria before Telluride as a portfolio manager, and they weren't exactly secret ingredients: profits, momentum, volatility, mean-variance optimization. After the judge noted I did not invent these while at Telluride, she then asked the simple question: "what's your end game? What do you want?" I would have loved an end game. Telluride's lawyers merely said 'to protect our property!' Later, a new judge came in, and asked the same question, and again an unassailable answer: 'to enforce a confidentiality agreement!' Well, the judge couldn't say he was against that, these are bedrock principles!

The key key issue was 'what is your property?' or 'what is your view of the scope of the confidentiality agreement?' It's hard to clear yourself when you've been accused of something to be defined later. Principles are great things in courts, or rhetoric in general, because its so easy to find one that supports whatever you want to do, and so impossible to argue against.

Anyway, if the principle here is that a large complex financial institution should not service issuers that seem certain to default, California should just declare bankruptcy today. Currently , one-third of their revenue is in deficit, an unsustainable cash-burn rate. Legislators are puppets of basically three unions, that make money based on laws passed by those same legislators: the SEIU (janitors, hospital workers), the Teacher's union, and the public safety workers (cops, firemen). California already has high taxes and people are out-migrating for the first time in a century, so they face the downward portion of the Laffer Curve (ie, higher tax rates → lower revenue). It seems pretty clear they need to cut costs, but why wouldn't the unions push for bankruptcy as opposed to benefit cuts? The city of Vallejo recently went bankrupt, and it's still to be determined whether the pensions and union contract have priority in their bankruptcy the way they did for General Motors and Chrysler. Bondholders should not anticipate priority.

I bet all of the major investment banks are facilitating debt issuance by the State of California and its various agencies, counties, and municipalities. I bet also there is a small but spirited set of shorts, trying to make money off of the inevitable bankruptcy. With hindsight it will be obvious, and everyone currently buying California-related debt will develop amnesia and claim they never liked California debt, and were hoodwinked by greedy bankers.

At that point, should all the investment banks be liable? If so, is every bank facilitating California debt issuance committing fraud right now?

One interesting thing in the Goldman suit is how manager ACA was totally oblivious to Paulson's intentions. Paulson & Co. were well-known shorts in this space at the time of their deal (first quarter 2007). For ACA to think Paulson was a long investor in this stuff, even if Goldman ever said this (remains in dispute) implies these people were insanely clueless about their industry. What proportion of executives are mindlessly going through the motions, getting paid to show up, and presenting themselves to family and friends as financial gurus in the arcane field of structured finance? There may not be a law against being clueless, but these are the true frauds in the Goldman/SEC lawsuit.

They suggested they looked at 'credit fundamentals', and then using their 30 professional dedicated to the CDO asset management business utilized 'proprietary models to stress and confirm the adequacy of cash flows'. This appears to have been looking at collateral credit ratings, and applying historical default rates.

Anyone working for this bunch of boobs should have a huge black mark. In any large failure executives all blame someone else and usually end up unscathed, but this deal highlights they were not doing what they advertized, assessing the collateral's credit quality. If they did, they would have noted that a high profile short gave them a bunch of credits that had an adverse sample of low FICO, adjustable rate mortgages. They clearly didn't do the most basic analysis of the portfolio they were managing, nothing.

ACA was a big player, and their business strategy was purportedly to 'assume, manage and trade credit risk'. Their action on this deal highlights their credit risk assessment appears to have merely been checking the agency ratings. That's understandable if you are a retail investor, not an institutional investor managing a $1B transaction. ACA probably was rubber stamping its portfolio collateral since inception, a strategy that worked until it didn't. These are the guys who should be inducted into the 'Empty Suit Hall of Fame':

Alan Roseman, CEO
Edward Gilpin, EVP and CFO
James Rothman, Senior MD and Head of Structured Credit
Peter Hill, EVP and Head of Public Finance
Joseph Pimbley, EVP and Head of Institutional Risk Management
Laura Schwartz, Senior MD and Head of CDO Asset Management
Hao Wu, Managing Director
Dennis Kraft, Managing Director
Kieth Gorman, Director
Ava Regal, Director
Shelby Carvalho, Director

I was talking to a risk manager recently, and he excitedly mentioned they just hired a PhD in physics from CountryWide to model RMBS--sort of like saying we just got the Madoff's operational risk manager. When investors lose money individual managers are pretty effective at avoiding blame, consequences are mainly apportioned to firms via their assets under management and share price, and then indirectly to individuals. I'm sure not everyone at ACA is a clueless hack, but the key players were, and its good to remember that more bad things happen because of ignorant bureaucrats like the people at ACA, as opposed to schemers like Fab Tourre and Goldman. After all, the world is full of sharks wanting to take your money, so a money manager susceptible to these pitches is a time bomb waiting to go off; if it wasn't Fab & Goldman, it would have been someone else.

To persuade.

Larry Summers has two Nobel laureates as uncles (Samuelson and Arrow). He was an economics prodigy, getting tenure at Harvard before he was 30. He is about as smart and educated as one can be.

And so now, the Wall Street Journal outlines his sell-out to the Obama machine. Summer's specialty, if anything, was labor economics (here's Summers' take). He did a couple papers, noting the well-documented fact that increasing unemployment insurance increases unemployment spells--if you pay for something, you get more of it. It makes obvious sense, it wasn't a surprising result, and no one disputes it.

So, how does Summers explain why now he thinks an increase in unemployment insurance will decrease unemployment? Well, a partial derivative is not necessarily the same sign as the total derivative. In theory, they could be different. In practice, they rarely are, and extraordinary claims require extra-ordinary evidence. But the benefit of a PhD in economics is you can rationalize this stretch much more efficiently than others. Anyway, Summers now argues that unemployment benefit increases will reduce unemployment through the fact that now, we are not at full employment, so the fiscal multiplier is especially strong. I have never lived during a period when we were at full employment, which Summers defines as ' where nearly every person who wants a job is able to obtain one'. I guess their earlier work was in some fantasy world of full employment, and in real life all that research is irrelevant, which I'm sure was not mentioned in those articles. Summers's casuistry highlights that ultimately, scientists are not far different than mercenary lawyers, articulate advocates arguing for a greater good.

Summers already demonstrated his lack of integrity in the gender-science hullabaloo, where he at listed among several explanations for the lack of female scientists that women could be less scientifically oriented in some natural way (motivation, analytics). He then cowardly backtracked, and got his deserved punishment, showing himself no friend of either PC leftists or those who think the hypothesis is legitimate.

It's good to know more, but don't think that the primary reason people become scientists is to find truths, but rather, to fortify their egalitarian or libertarian prejudices. Not all, but most.

Today, the SEC filed a complaint alleging that Goldman Sachs, and employee Fabrice Tourre, defrauded investors by failing to disclose that the party that picked the securities underlying a CDO was doing so to short it (Paulson & Co.). Their stock is down some 20%. In general, investment banks were caught up in the housing delusion with everyone else, which is why they too suffered so much in the meltdown. This transaction, however, is quite different.

As laid out in the SECs brief, Goldman and Tourre knew that Paulson was trying to create a CDO Paulson could then short. In effect, Goldman was the clearing house, taking merely a fee, while Paulson and the CDO buyers would have a future's type payoff. So, Goldman didn't really care what happened, they just wanted a deal done, to get fees. What makes this so special is that this deal was constructed when the first cracks were showing in the market, as the ABX Subprime CDO index started to falter in November 2006, and fell precipitously in February 2007. Internal emails indicate they were well aware the market was going down, and this was one of the last deals (the deal was presented to the relevant parties in January, and closed on April 26, 2007). On March 7, 2007, there was a BusinessWeek article on how Paulson & Co was making a fortune off shorting subprime CDOs, which were then showing massive signs of danger.


Goldman and Tourre got another company with a solid reputation, ACA, to be the official sponsor, because they knew no one would buy a CDO assembled by a short--too much opportunity to cherry pick the bad bonds. You don't need to do as much due diligence when you think the other parties involved have a consistent interest in your portfolio, so a sponsor with long-only interest is rather essential for such complex deals. Goldman told ACA that the collateral was picked by Paulson which would then hold the equity stake in the transaction. In fact Goldman knew Paulson had no such plans and wanted a vehicle to short, and as mentioned, there were articles discussing Paulson's shorting of subprime CDOs, so ACA was incredibly deaf. Nonetheless ACA was mislead (ACA soon basically failed, so they got their just reward).

In securities markets, people often buy from those who think the price will fall. Yet in this case the seller's intention was material because when there is incomplete information, knowing the intentions of the parties involved makes a huge difference. I know from my litigation experience, that appropriate tactics are vastly different when dealing with parties who have good faith, versus parties with bad faith. Intentions, motivations, go a long way in explaining things, but the problem with blaming intentions is they are usually impossible to determine objectively, and so best ignored. In this case, the portfolio was constructed by a short seller so the intentions are pretty clear. Whether there's a law against this, I'm not sure, but it's pretty bad business.

While I think Tourre and Goldman deserve a smacking for this, it should be recognized that this kind of deal is not representative, and that most CDOs were created by people who sincerely, if stupidly, thought they were good deals. Note that Paulson is one of the few hedge funds that really cleaned up in this mess, most hedge funds missed it with everyone else. If shorts were primary drivers of CDO demand, this would suggest a giant conspiracy, so it's the proportion, not the principle, which leads me to think that understanding the 2008 credit crisis via these kind of deals is misleading.

Note: Goldman fires back, disputing the main point of evidence for the SEC, that Goldman told Abacus manager ACA that Paulson was the equity owner. I think that is the most important fact in the case, and is either true or false. Goldman does note that since they lost $90MM on the deal, and ACA lost almost $1B, they actually did think it was a good deal, which makes sense. Even if they are not guilty, they were really short sighted, and Fab Tourre is either an idiot or a scumbag, and Goldman is stupid or scumy for hiring guys like that.

ProPublica has a big story on Magnetar, a company that actively shorted mortgage backed securities prior to the collapse, often encouraging the formation of securities they would then short. As this is a major theme in Michael Lewis's The Big Short, and was breathlessly mention by James Kwak, let me explain why this is not interesting. People as a group generally disagree on everything. There will always be someone saying a price is too high, or too low. Over time, as the price moves one way or the other, those correctly calling the price move were either right, or lucky. In any case, the existence of this prescient group does not imply either 1) that it was obvious the prior price was too low/high, or 2) there was a conspiracy.

This is classic hindsight analysis, and James Kwak and Simon Johnson, Michael Lewis, and Propublica may think it was all so obvious, but as prolific authors it would help their cause a lot if they made unambiguous statements prior to the crash that we were in a bubble. Any idiot can say a historical event was obvious (indeed, I find the best history showing how while some event was inevitable, it was not obvious at the time). Further, even if some people were correct they had to have been correct for the right reasons. If, like Nouriel Roubini, you were a permabear predicting a cataclysm for the same reasons as always, the fact of the credit crisis doesn't mean you called it. Or take my Nassim Taleb, who's shtick is that disaster's are always unexpected (don't get me started), but when he points to his correct Fannie Mae call, he notes an earlier criticism of the interest-rate Value-at-Risk methodology, an irrelevancy to their ultimate problems. Peter Schiff, in contrast, singled out the housing insanity, and so he's a better candidate, but even so, it doesn't mean it was obvious, because the voice of those like Schiff was outweighed by those thinking everything was just fine.

It's important to remember that with so many people in the world, just calling a historical event is not sufficient because there are always people predicting massive failure or success to any policy. The key is whether they right for the right reasons, as in Schiff's case, or right for the wrong reasons, as in Roubini or Taleb's cases.

The problem was that given the historical national housing price index, nominal housing price declines over the prior 70 years were rather minor, and suggested little risk. This is why in 2003 Joe Stiglitz wrote Fannie Mae was overcapitalized and was of no concern. The fact that this assumption supported efforts at increasing home ownership, and helping minorities, was a plus in the way that any assumption that supports what we want to do is taken less skeptically than otherwise, that's human nature. There's no conspiracy there, and while there were some general errors of repetition, it was also in many ways singular crisis (the repo bank run accelerator, the historic decline in housing prices).

For about 50 years, the definitive understanding of the depression was John Kenneth Galbraith's The Great Crash. He outlined the delusion of investors, but also highlighted the nefarious insider trading and financial skullduggery by those puppetmasters, the Captains of Industry. Charles E. Mitchell of National City, Andrew Mellon at the Treasury, in the 1930's were in highly public tax evasion trials, and were popular scapegoats, as if the recession was caused by greedy people with top hats.

Alas, this highlights that 'for every problem there is a solution which is simple, clean and wrong.' The 1929 stock market crash did not cause the Great Depression--ten years of weak performance--and while there was much financial skulduggery, no more than usual, and Mellon and Mitchell were hardly symbolic of some essential prime mover in the whole mess. Like most bad theories, this one died a slow, unpublicized death. Economists might seriously reference Galbraith to explain the death of animal spirits prior to the Great Depression in prior generations, but after 1987 the nexus between the stock market and the economy was shown to be not so clean, and the whole narrative became suspect, a classic 'just so' story.

So the current journalists that are now highlighting that various people actually shorted frothy sectors prior to the collapse, is really just another spin on the 'speculators caused the crisis' theory of the Great Depression. Greed, like lust, is pretty much in steady state. Anecdotes of greed do not lend any more evidence that the national greed-o-meter was especially high in 2006, because with 300 million Americans I could read 100 anecdotes a day and not add up to anything significant.

I heard ProPublica's story in a very well produced NPR radio story this weekend. A lot of work went into it, with dramatic narrative, and the kind of suggestion that, like The Matrix, you would at the end find some truth so large and shocking you would leave forever changed. Unfortunately, the fact that there were shorts during a market decline, and all that is associated with such shorts (eg, they wanted to make a lot of money, they encouraged people to buy from them, they got rich), is simply not news.

In the Weekly Standard, Andrew Ferguson notes the paradox of behavioral economics, that proving people are often irrational then begs the question as to why we think some subset of intellectuals or regulators are more rational:

Thaler, in a recent interview, said, “If there’s a regulatory philosophy in behavioral economics, it’s that we should recognize that people in the economy are human and that there are people out there trying to take advantage of them.” In this sense, behavioral economics is just conventional 1960s liberalism—and conventional 1960s economics, too—that assumes the free market itself is a kind of unending con game, with the smart guys exploiting the saps. As an advocate for the market’s hapless victims, the government has the responsibility to undo the con, a task that will require only the smartest administrators operating according to only the latest scientific research and making the most exquisite moral judgments.

You can see how useful the notion of irrational man is to a would-be regulator. It is less helpful to the rest of us, because it runs counter to every intuition a person has about himself. Nobody sees himself always as a boob, constantly misunderstanding his place in the world and the effect he has upon it. Surely the behavioral economists don’t see themselves that way. Only rational people can police the irrationality of others according to the principles of an advanced scientific discipline. If the behavioralists were boobs too, their entire edifice would collapse from its own contradictions. Somebody’s got to be smart enough to see how silly the rest of us are.

I would add for every quirky predictable irrationality for the masses--like the 401(k) default choice or bad toilet aim for men --there are offsetting irrational public policy fads such as Y2K, affordable housing goals, busing, the Iraq war, windfarms, ethanol, and global warming. As Reagan said, "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"

Washington Mutual, which at one time was the sixth-largest depository institution in the U.S., became the biggest bank failure in U.S. history when it was seized in September 2008 and sold to J.P. Morgan Chase & Co. Our legislators are now trying to figure out what happened, but still mystified: 'Details Scarce on WaMu Failure' reads today's WSJ headline. In another WSJ piece, Senator Carl Levin notes:

WaMu had poor policies, poor controls, inadequate oversight of its loans, it turned out toxic mortgages that sunk the bank, devastated homeowners and polluted the financial system like a poison

But back when the seeds of the recession were being sown WaMu was 'best practices'. The CRA gave activists veto power over bank mergers, so in 2003, when they took over Dime Bank, they bragged about pledging $375 billion towards funding low income borrowers at a time when their total assets were only $250B. They won the 2003 CRA Community Impact Award for such profligacy. The only way to shove that much crap thru is to lower underwriting standards. Thus, WaMu accepted a picture of a mariachi singer in his mariachi outfit as the sole documentation of his purported $100k income.

James Lockhart, an executive at the Fannie Mae regulator notes in his written testimony that Fannie and Freddie were very concernded with meeting 'affordable housing goals' (newspeak for giving loans to people who can't afford them), and made sure they met them. Further, they were actively appeasing Countrywide, who was a major customer of Fannie and Freddie.

It is important to remember that government legislators and regulators were encouraging reckless subprime lending the whole way down. Maybe they didn't cause the crisis, or they were not even one of the larger of several causes, but they were not arguing for stricter underwriting standards during the height of subprime lunacy. Even today, the only place you can get a home loan with only 3.5% down payment is from the government's FHA program.

So, when Armando Falcon, former chief regulator of Fannie and Freddie, who was on Capitol Hill Monday, suggests his problem was a lack of resources, remember, they had over 300 people looking at only two institutions, and were not saying anything about the novel, lower underwriting standards (eg, income verification, credit history, down payments, etc.). If they had 3000 people, they would not have done anything about the weakest link in Fannie's subprime initiatives.

Yet, the head of the Fannie and Freddie regulator continues to insist that "affordable housing goals" had absolutely nothing to do with their failure, because "The firms would not engage in any activity, goal fulfilling or otherwise, unless there was a profit to be made. Fannie and Freddie invested in subprime and Alt A mortgages in order to increase profits and regain market share." Further, "OFHEO made it very clear to both enterprises that safety and soundness was always a higher priority than the affordable housing goals." Yet there is no evidence they ever mentioned underwriting standards prior to 2007 as a concern. He seems to be saying that because these activities made money prior to 2007, and everyone was doing it, it was not risky. That's like saying you are against hangovers, but saw no evidence of such effects while you were on your seventh beer--you were just keeping up--so your strategy was unrelated to the ensuing hangover.

Risk taking, I argue, is uncompensated on average. There is no simple form of risk taking such that, if you can tie yourself to some intellectual mast and bear this psychic pain you should expect a higher return. There is a mistaken syllogism at the bottom of portfolio theory, as just because you have to take risk to get rich, or if you take risk you might get rich, this does not mean if you take risk you will become richer on average.

In some aspect, this is obvious. A lot of people would be willing to put their funds in some blind risky trust at a young age, if they could then know with statistical certainty this would maximize their wealth at retirement. If this were so investing would be a lot simpler. Also, think about other distasteful activities, such as cleaning septic tanks. Indeed, Keynes compared risk taking to working in 'smelly' occupations, noting such activity would require a premium. Yet septic tank work does not pay really well, and the Untouchables in India have long had a monopoly on cleaning sewers manually without much compensation.

So, if there is no extra return, why take risk? Roy Baumeister makes an interesting argument. He notes that historically 80% of females have reproduced, while only 40% of males passed on their genes. The rest of the males have been genetic dead ends. Historically a female could play it safe because there were always men willing to impregnate them, whereas a male who remained meek was elbowed out of sexual trysts. Males have to beat out other men to get access to females. Thus, men built ships and traveled to far-off lands because those were the guys who had more children, whereas a bunch of women could bear children just as easily staying put. Everyone's male ancestors have been disproportionately bold risk takers; not taking risk, over generations, is certain doom. We take risk, therefore, because not taking risk is genetic suicide, at least for the gender that generally takes such risks.

Currently selection is not so pressing, perhaps even opposite to our past, but our instincts are not shaped by the welfare state. Men are driven to take risks, improvising, which is why we see so much greater jazz improvisation by men, or risk taking in any area. Baumeister states it isn't the ability, so much as the drive to excel that leads them to create technological and cultural achievements.

Risk taking is the best way to find your comparative advantage, your alpha, because something you do well is something that requires more than just doing what anyone else can do, by definition. You need to take a risk not merely to inform yourself of some specialized competence, but to signal to others you would be a good person to assume greater responsibility in that area. Organizations are always looking for the best people for parochial tasks, and those who have demonstrated competence via successful risk-taking are prime candidates.

Risk takers dominate our lives via their disproportionate effect on our genes, and their influence on our technology and culture. They did not become successful, however, merely by taking some abstract 'risk' that is the same for everyone, and then enjoy the higher rewards that come with it. They instead took the right risks, those consistent with their unique strengths, and reaped rewards consistent with mastery of something important. Like a golfer with a long drive, you should risk a shot at the green as opposed to laying up, but only because you can hit the ball farther than most.

Modern finance is profoundly misleading when it suggests that reward is merely a function of our ability to withstand some abstruse risk (ie, the covariance with the as-yet-unidentified stochastic discount factor), and chance. Skill, effort, and learning play no part in this sterile world. In contrast, people should see risk taking as a process of self-discovery, of becoming the best you can be, and that playing it safe is, for males at least, a path of oblivion. The payoffs to risk-taking are partially chance, but if you want to take risks intelligently you will gravitate towards risks consistent with your skills, and get better and better at them. If some risk demands nothing of you, merely jumping at it is surely foolhardy because risks do not generate higher-than-average-returns as a general rule, and suggests whoever is selling this opportunity is a modern snake-oil salesman.

Today's mea culpa by finance executives includes the overpaid puppets in the Fannie/Freddie disaster ($127B and counting). In 2005 the chief regulator of Fannie and Freddie was addressing an accounting mini-scandal related to bonuses. They were basically moving earnings around to hit triggers, so their executives could receive their multi-million dollar bonuses. As Fannie and Freddie are filled with political hacks (Jamie Gorelick, Bill Syron, Franklin Raines), these are the prime sinecures of top Administration bureaucrats, and Congress appreciates the incentive this provides their minions. Ex-congressman are known to get lucrative consulting contracts with them. And all of this is subsidized by the U.S. taxpayer.

The government support provided to Fannie and Freddie is supposed to be used to expand home ownership for lower income Americans, as if that could be done at a profit by our wise bureaucrats. What do they think, bankers hate minorities more than they like making money? I'm sure there might exist such bankers, though I must say I never have met one, and am confident they are about as representative of bankers as the KKK is of America (I'm sure many on the far-Left would say--exactly! One and the same!).

Anyway, here is the chief regulator discussing the risks in Fannie, at just about the time seeds were being sown (2005) via reckless lending to people who could only afford the mortgages if their collateral increased in value:

Mr. FALCON: I think the guaranteed side of their business where they purchase qualifying affordable housing goal type mortgages, that does continue, and it is proceeding at a healthy pace. Despite the problems the company has with their accounting issues and internal control problems, that side of the business remains sound. So I can give you some comfort there, that while we are having to take some supervisory actions with the company to make sure that they continue to be as aggressive in fulfilling their mission as possible, when we get these other issues addressed properly over time, it will not deter them from continuing their guarantee side of their business.
...
I have always looked at our responsibility at OFHEO as part housing mission. A company that is experiencing severe financial difficulties is going to constrain the amount of work it can do in fulfilling its mission, and so the greater extent to which we can make sure that the company does not get into any kind of trouble
...
makes sure that there is no interruption in their ability to continue to fulfill the mission and innovate. With a fully authorized, well-resourced regulator, I think here would be a good safeguard to make sure that there are not unnecessary interruptions in the company’s business as a result of safety and soundness problems.

If you read this document, you will find nothing related to Alt-A mortgages, underwriting standards, the bread-and-butter basics of credit. No one cared. As Falcon states, everything's sound.

Worse, he clearly shows his hand by highlighting his objective is subservient to his 'mission', that clearing 'unnecessary interruptions' in that mission was essential. What is the mission? Making home ownership 'more affordable'. The intermediate goal being to "purchase qualifying affordable housing goal type mortgages". What is the goal? Increase home ownership, specifically in historically underserved communities. How can that be done? Lower underwriting standards.

The faulty premise in this plan is that historically underserved minorities did not have comparable home ownership rates for arbitrary--ie, racist--reasons, so this effort had a positive expected profit. It was an error in a factual assumption, made because many believe institutional racism is very real and important. This falsehood has real consequences.

These are the regulators. They should have been focused on the viability of these GSEs as going concerns, but instead, all they really cared about was fighting fires of the past so they could get back to fulfilling its eleemosynary pretext for creating a crony-capitalist monopoly to pay off obedient bureaucrats who help them maintain their power. The circle was complete. If only the private sector consisted solely of government-sanctioned monopolies, it seems, life would be great. Unfortunately, the essence of a monopoly is to keep people out, so not everyone can get a well-paid sinecure (eg, see Greece).

Today the old Fannie chief uses the 'everyone was doing it' excuse, a perennial because we all can empathize:

Executives decided that new, riskier loans were "not a fad, but a growing and permanent change" that the companies couldn't ignore, Mr. Mudd said in his testimony. Faced with the prospect of becoming irrelevant as private lenders fueled by Wall Street took over a larger share of the market, the company opted to strike a "middle course" by trying to offer less risky versions of loans.

Gee, benchmarking to guage risk, I should write a book! Risk, as I have argued, is a deviation of what 'everyone else' is doing. So, by not going with the flow, they felt they weren't taking more risk. Of course, the private label mortgage guarantors justified their increased subprime exposure by pointing to Freddie and Fannie's greater subprime portfolio, and on the primrose path we went to Armageddon. This is the mechanism for endogenous bubbles, where large players increase their exposure into previously risky areas, but don't notice it because each player thinks they are actually reducing their risk by playing catch-up in some new paradigm.

Tyler Cowen notes a new paper by Roland Fryer and Freaky Steve Levitt on the Muslim gender gap in math. This is interesting, but it isn't economics.

It reminded me of this Freakonomics take by the Onion that made me chuckle:

.. "Usually we can count on a stable average of 5 feet 8 inches, but last month's quarter-inch drop in height among Mexican dead-lift competitors in the middle-heavyweight division could spell disaster for GE's aviation and software subsidiaries," freakonomist James Duncan said. "But, like anything else, a shrewd investor must always ask himself one thing: How many hot dogs did I eat last year?"

A neat observation on creativity by Andrea Kuszewski:

First, teachers were asked if they valued creativity and enjoyed working with creative students, and they overwhelmingly answered "yes".
...
Interestingly, there was a significant negative correlation between the degree of creativity of the student and his favorable rating by the teachers. This means that the most creative students were the least favorite of the teachers, across the entire sample surveyed. Additionally, the students that were rated as favorites of the teachers possessed traits that would seem counter-productive to creative behavior, such as conformity and unquestioning acceptance of authority. On the other hand, these are behaviors that fit well in a classroom setting. Even back in 1975, Feldhusen and Treffinger reported that 96% of teachers felt that creativity should be promoted in the classroom. However, when asked which students they actually liked to teach, they chose the students that were more compliant.

Teachers say they want creativity, but that is not the behavior that is rewarded. In this study (as well as in many others), they found that there is a discrepancy between what teachers, and schools in general, say they value and desire, and what behaviors they actually reward and encourage. Teachers don't want the student who is always raising their hand and questioning the assignment; they want the student who unquestioningly follows the outline given to them and turns the assignment in on time.

Professors love creative students, as demonstrated by those who extend their work in predictable yet difficult dimensions. The 'creativity' is evidenced merely by embracing their own paradigm shifting work. A truly creative person, like a true risk taker, is seen as a crank in real-time, and indeed on average they are. But sometimes the cranks are right, at which time they are then seen as geniuses.

Like risk-taking, what these creativity lovers mean is, they like positive surprises. Risk-taking of a regular sort that leads to failure is considered just dumb, or worse, full of hubris. Creativity is great if it generates an obviously valuable thing, otherwise, it's annoying, and just inappropriate.

I once read an article that accompanied an exposition on the Capital Asset Pricing Model, and its implication that expected return was positively related to risk (via the 'beta', now an anachronism). They asked a bunch of well-known portfolio managers about their greatest risks, and each one was an unqualified success. This gives one the feeling that risk is related to return, because in these biased samples they are. Kids, and adults, should know that risk-taking usually fails, and so the only key is to know when to stop and when to keep trying, learning along the way.

The book This Time is Different" is a very important book, as it documents the facts about various financial crises, and enumerates many classes of crises. Facts are very important, and the fact to opinion ratio in this past crisis reach lameness a long time ago. Unfortunately, it is a very incomplete book because it does not attempt to find the default rate of countries. As if I said that there were 7 homicides in city X last year. A good question would be, 'how many people live in town X?', because we really want to know the rate, not the number.

The plural of anecdote may not be data, but looking at the events like financial crises, it's really all we have, so the book is useful. For example they note that many times, a great optimism precedes a default, as when Argentina was a star in 1998, but then defaulted in 2001. Eyeballing their data, I would say the default rate on sovereign debt is about 3% annually, about that on BB- debt, but that's a guess.

There are a lot of footnotes, which is helpful to whoever writes the more definitive survey. They quizzically note that while credit card issuers want to do the performance of their consumers, countries make it very difficult to ascertain their own default rate. That is because countries tend to have a lot of market power. It seems probable that most countries are much riskier than they claim.

The US states did not default in consequence of the Panic of 1819, and many foreign investors then thought they were risk free, yet in the recession of 1839-43, many states did default. And so it goes. California and New York have never defaulted, but I don't think their track record is a sufficient statistic of their default risk. Looking at the broad scope of history is needed to see this.

The authors suggests that 'countries may need to borrow to fight recessions or engage in highly productive infrastructure projects' (p. 55). I'm rather skeptical. The fact that countries get shut off seems to me a good thing. I don't see that countries with large capital deficits are strengthened, but in fact, it is symptomatic of weakness. The best thing a drug addict needs is less support. It makes me think that on average, international capital flows might merely allocate money to waste.

One prominent datapoint is that on average, real government debt rises by 86% three years following a banking crisis (p. 142, p. 170, p. 224, p. 231, p. 238). This is repeated so often, it should be on the cover. It highlights that banking crises generate real effects, because that's a lot of debt.

A highlight of how lame economics is as a science, is reflected in chapter 13, which tries to explain the most recent financial crisis. It fails miserably. Figure 13.4 shows the behavior of the US in 2008 compared to the most comparable crises. It's a rather weak comparison, and it's the best he can muster, meaning, it isn't very comparable to the past. Rogoff has done a lot of sophisticated analysis, but at the end of the day, he presents simple averages that show a very weak pattern, highlighting that you can't get blood out of stone. It would be nice if there were so much data we could just apply these off-the-shelf algorithms and see important results, but we can't. That is, macro-economic data are too few and non-stationary, to be amenable to the powerful logical techniques economists spend most of their time building.

Lots of people think that government mandates create new jobs, net net. It's a key different assumption between those who think government should do more, vs. those who think they should do less. See the short video on Bastiat(2 minutes). Some great quotes by Keynesians:

"..the terror attack .. like the original day of infamy, which brought an end to the Great Depression -- could even do some economic good."
~Paul Krugman, NYT, 9/14/2001

"...economically the net result of the terrorists's actions is likely to be beneficial to the United States.'
Tim Noah, Slate, 9/12/2001

"Despite the devastation, experts said today that in some ways the earthquake [in Kobe Japan] could give a boost to an economy struggling to recover from a long recession."
Nicholas Kristof, NYT, 1/18/95