Worth reading

[parvus]

He Foresaw the End of an Era

For financial markets to allocate resources to their most productive uses on an ongoing basis, the price signals they send must be the right ones day after day after day. Is this a realistic goal? A typical investor following the Dow's gyrations on CNBC or Yahoo Finance might be tempted to say no, but then the typical investor doesn't have the benefit of an economics Ph.D. from the University of Chicago.

The benign view of markets owes much to three Chicago economists: Milton Friedman, Eugene Fama, and Robert Lucas. Although best known for his work on monetary theory and his enthusiastic espousal of capitalism, early in his career Friedman had played a key part in developing the "efficient markets hypothesis," which, together with its younger sibling the "rational expectation hypothesis"—see below—provided the intellectual underpinning for more than two decades of financial deregulation. Briefly put, the efficient markets hypothesis states that prices of stocks, bonds, and other speculative assets necessarily reflect everything that is known about economic fundamentals, such as inflation, exports, and corporate profitability. The proof proceeds by contradiction. Suppose stock prices have risen above levels justified by the fundamentals. Then clever speculators, such as Soros, will step in and sell them, thereby restoring prices to their proper levels. If stocks fall below their fundamental value, speculators will step in and buy them.

Friedman actually formulated the efficient markets hypothesis in an analysis of currencies. It was Fama, one of his students, who applied it to the stock market and pointed out an interesting corollary: if stock prices already reflect everything that is known and knowable, then investors can't hope to outperform the market using trading strategies based on publicly available information. Rather than wasting time and effort trying to pick individual stocks, they would be well advised to place their savings in a broadly diversified mutual fund that tracks the daily movement of the market. Largely thanks to Fama and his followers, so-called index funds today have a central part in many Americans' retirement planning.

Lucas, the third member of the Chicago triumvirate, was arguably more influential even than Friedman. In a series of ingenious papers published in the 1960s and 1970s, he and several colleagues extended the hyperrational methodology underpinning the efficient markets hypothesis to other parts of the economy, such as the job market, the output decisions of firms, and the formulation of economic policy. By the time they were done, Lucas et al. had invented a new way of doing macroeconomics, known as the rational expectations approach, which enshrined in higher mathematics the stabilizing properties of unfettered markets. You don't have to spend much time on Wall Street to recognize that expectations are what drive the markets. If investors anticipate good news, they buy; if they expect bad news, they sell.

Where, though, do these economic expectations come from? According to Lucas, they reflect a predefined, externally grounded, and commonly agreed upon reality. In his models, the economy's equations of motion are well defined and known to all—from Ph.D. economists at the University of Chicago to nurses and cab drivers. Utilizing this common knowledge, people form "rational expectations" of things like inflation and interest rates. They don't always get things right—a certain amount of randomness is allowed for—but they are precluded from making systematic errors. If in one period the economy gets out of sync, in the next period it jumps back to the "equilibrium" defined by the model.

Not content to create new models, Lucas also disparaged older theories that viewed financial capitalism more skeptically. Keynesianism wasn't merely wrong, he declared at one point: it was no longer intellectually respectable.

<snip>
Outside the idealized world of Lucas's theory, knowledge is imperfect, people stick to wrongheaded ideas, and there is no agreed version of how the economy works. In these circumstances, Soros rightly points out, economic expectations, even biased ones, can help to determine economic fundamentals.

[tidal]

Iirc, it is Samuelson who posits that markets are micro-efficient but macro-inefficient. I believe that Shiller referenced this in one of his books. Interesting in light of what is going on presently.

[Norbert Schlenker]

A letter sent to Gilleland by American Express, one of the nation’s largest credit-card issuers, includes these reasons why the spending limit on his Platinum Card was reduced:

* “Our credit experience with customers who have made purchases at establishments where you have recently used your card.”
* “Our analysis of the credit risk associated with customers who have residential loans from the creditor(s) indicated in your credit report.”

Credit-card experts and consumer advocates say that while such practices have been rumored for some time, this is the first time they’ve seen them cited as criteria for a credit limit reduction.

Amex rates credit risk by where you live and shop

[Bylo Selhi]

Advice for Today's Market? Diversify Wisely [N.B. Wisely, not necessarily widely. Small difference in wording. Large difference in implementation ]

Two pros say the fundamentals remain in times of market turmoil—and smart risk management can spare you financial pain in the long run...

[lilbit]

London Telegraph article about the situation with the Lehman CDS:

http://www.telegraph.co.uk/finance/comm ... rkets.html

[Norbert Schlenker]

In disclosing plans to buy a quarter-trillion dollars of bank stock in the name of the American taxpayer, Treasury Secretary Hank Paulson harped on confidence. "Today, there is a lack of confidence in our financial system, a lack of confidence that must be conquered," he said on Tuesday.

What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It's complacency that precedes bear markets.

If the confidence deficit seems so high, it's because the preceding confidence surplus was full to overflowing. People suspended critical judgment. They accepted at face value the pretensions of central bankers and the competence of investment bankers....

Destroying confidence, however, is what governments do best. And the confidence they can restore is usually the kind that got us where we are today. Inflation and moral hazard led directly to the immense overvaluation of equities and residential real estate -- and of the bloating of the leverage that sustained those prices. Yet, to cure what ails us, credit creation and the public guarantee of banking liabilities are the policies today most favored.

Perhaps the world has gone so far down the path of socialized finance that there's no turning back. However, the doughty remnant of capitalists should be under no illusion about the risks and opportunities they confront. They can't miss the risks. Mr. Paulson pledges that the government's bank investments will be passive and apolitical, but the record of the Depression-era Reconstruction Finance Corp. suggests that the federal government is a shareholder that can throw its weight around. Besides, would Mr. Paulson's apolitical intentions bind his successor?

For the false confidence that played so important a part in the creation of the late excesses, the government should decently bear its share of blame. It accepts none of it, however, at least none that Messrs. Paulson or Bernanke have admitted to. Not that a federal confession of sin would expunge the financial errors of the debt-financed upswing. But it would, at least, clear the intellectual air and help the country and its creditors find a way to do better next time. For a start, the Fed might foreswear the Greenspan-inspired conceit that it can put the economy back together again after a debt bomb explodes.....

http://online.wsj.com/article/SB122428355436946301.html

Very long article. Well worth digesting.

[parvus]

I liked this bit:

The would-be acquirers prided themselves on the thoroughness of their due diligence and on the conservatism of their financial forecasts. Each announced an acquisition price that, supposedly, gave full value to the selling shareholders while still affording the prospect of a not-so-distant payday for the leveraged acquirer. But, without willing lenders or a rising stock market, the buyers withdrew.

The share prices of the target companies thereupon pulled back. One had expected it. But the former takeover candidates' prices have plunged by 70% or more. Reddy Ice, the No. 1 manufacturer and distributor of packaged ice, is cheaper by 92% than it was on the day last summer when its falsely confident suitor, GSO Capital Partners, bid to take it private at 50 times earnings. Interestingly, no new buyer has appeared now that the shares are quoted at less than seven times earnings. Confidence in the judgment of our private equity titans is belatedly being marked to market.

Such is the way of markets -- and of the fallible investors who operate in them. High prices boost our confidence, low prices sap it. We seek out bargains in Wal-Mart, but run away from them on the New York Stock Exchange. The proliferation of investment bargains brings us no joy. Share-price volatility is testing all-time highs. The debt markets are inconsolable. The triple-A rated mortgage bonds that once yielded only a small increment over the basic wholesale money-market interest rate today fetch 12% and up. And those are the securities that, as Grant's Interest Rate Observer does the numbers, appear to be money-good -- barring another 20% or 25% decline in house prices. Yet if the risk of true apocalypse in real estate is great enough to warrant these towering mortgage yields, there can be no easy explanation of the relatively low yields still attached to the unsecured debentures of some big American retailers. Lowe's Cos., the giant home-improvement chain, would surely feel it if house prices dropped -- again -- through the floor. But an issue of unsecured Lowe's debentures, the 5s of October 2015, are quoted at a price to yield just 5.8%.

In investment markets, confidence and coherence tend to restore themselves. The hardy souls who lead the way back derive their confidence not from the Treasury Secretary but from the pages of "Security Analysis," by Benjamin Graham and David L. Dodd, the value investor's bible.

[parvus]

From a debate on The Economist:

Crises are caused by banks having too much leverage. They face an “inflexibility trap” and “negative convexity”. Generally, a shock occurs, a “fat-tailed event”, and as a result a bank suffers a loss on a product line such as subprime mortgages that, in turn, requires it to reduce the risk of its equity. To do so, it must issue additional equity or sell risky assets to pay back debt. With leverage, to reduce risk needs action. If the bank attempts to raise equity capital, however, it faces the “inflexibility trap”. By issuing equity, debt holders have more capital supporting their debt and are better off. Equity holders must be worse off. That is, on the announcement of the offering, the price of existing shares fall. This follows from option theory. When governments infuse capital into banks, the new capital benefits the debt holders. This is the true “moral hazard”.

The simple remedy, therefore, is to require banks to have less leverage or—its converse—to have additional equity capital. This garners flexibility. And flexibility is valuable. It is an option. We can measure its value and price it accordingly. If society is to provide the option, it should charge for it in advance, and then it becomes the supplier of contingent capital to the financial system. This creates the correct incentives. This is not regulation; this is economics.

“Negative convexity” arises as firms are required to invest to make money for their shareholders. When everyone else is driving over the speed limit, there is pressure to drive quickly as well; that is, more leverage to increase the return on equity capital. When a shock forces entities to reduce risk, they find it difficult to do so for many other entities are also attempting to liquidate positions at the same time. Not all the cars can slow down in time to prevent an accident. In financial markets liquidity prices increase dramatically, creating “fat tails”, and entities are unable to sell assets to reduce risks. With losses in one area, banks need to sell other more liquid assets. This, in turn, requires other banks to liquidate assets to reduce their risk. Liquidity prices increase and asset values fall across all markets as banks demand liquidity to reduce risk. This causes a deleveraging cascade in the financial markets affecting the capital of all banks.

Although I don’t have the data available, I predict that bank capital ratios have fallen dramatically over the last 20 years, with deregulation of the banking sector in the 1990s, coupled with the advent of the Bank for International Settlements’ implementation of Value at Risk, portfolio theory, that is in vogue to determine bank capital, and with changes in accounting rules.

Certainly, with additional equity capital, the return on equity capital of financial entities would fall, but the value of the enterprise would not be affected. Modigliani and Miller, over 50 years ago, wrote a classic paper in financial economics, demonstrating that the value of the firm is independent of its debt-to-equity ratio. For this and related work, each was awarded the Nobel prize in economics. Although the required rate of return on debt is less than that of equity, the required return on equity increases with additional debt to just offset debt’s lower cost. In its simplest form why would an investor pay more for a leveraged firm than an unleveraged firm if she could acquire the unleveraged firm at a lower price and create the same capital structure on personal account? Their simple and elegant model has withstood many academic attacks including issues such as the tax deductibility of debt or bankruptcy costs. Miller argued in his 1977 presidential address to the American Finance Association that these issues are second order, “akin to a horse and rabbit stew – one horse and one rabbit.” Although additional equity capital and less debt capital will not reduce the total value of the bank, it will reduce the expected return on equity. This is of no consequence, however, since with less debt the risk of the equity is correspondingly less. The return-to-risk tradeoff is unaffected. Investors will need to expect a lower return on equity capital. If individuals, hedge funds, etc, want to achieve a greater expected rate of return with commensurately more risk, they are able to achieve such by leveraging on their personal accounts. Remember, however, that leverage is a two-edged sword. Wonderful when things are going well; a cancer when things are going badly. Since there are few costs and many benefits to this approach, capital requirements and pricing flexibility are the correct way to regulate banks going forward. Since this is the correct economic response, it trumps regulating the financial system heavily going forward. There is no need to “throw sand into the gears” to slow down innovation and new products. Capital is the solution and it is a form of “light regulation”.

[Peculiar_Investor]

Has anyone read and is able to provide a recommendation on "Manias, Panic and Crashes" by Charles Kindleberger?

I'm currently reading "The Contrarian Investor's 13" by Benj Gallander and he makes mention of it and I was stuck by how it resonates with what is happening today. From Amazon.com

As Peter L. Bernstein summarizes nicely in his introduction, Professor Kindleberger's argument boils down to four principles:

(1) Irrational behavior does occur from time to time in financial markets.

(2) There is a general, repeatable pattern in how this irrational behavior plays out (a positive economic displacement is followed by euphoria that takes the form of overtrading, then distress following revulsion, discredit by lenders in the overtraded assets, and then panic leading possibly to a crash brought on by those who bought high).

(3) The economic system needs a lender of last resort to step in at the right time and in the right way to restore confidence and liquidity.

(4) Trying to solve these problems by being doctrinaire is "wrong . . . and dangerous."

Sound familiar?

Also interesting to note is a comment on the front cover, "Sometime in the next five years you may kick yourself for not reading and re-reading Kindelberger's Manias, Panics, and Crashes". This was published Sept 2005.

[NormR]

Has anyone read and is able to provide a recommendation on "Manias, Panic and Crashes" by Charles Kindleberger?

It's been a few years, but IIRC I found the book rather stuffy and academic.

Btw, the book was published in various editions. My copy says 1978, 1989, and 1996.

[Peculiar_Investor]

Has anyone read and is able to provide a recommendation on "Manias, Panic and Crashes" by Charles Kindleberger?

It's been a few years, but IIRC I found the book rather stuffy and academic.

Btw, the book was published in various editions. My copy says 1978, 1989, and 1996.

Thanks. At least one of the reviews on Amazon said similar things, but I have more faith in the opinions here.

[NormR]

Has anyone read and is able to provide a recommendation on "Manias, Panic and Crashes" by Charles Kindleberger?

It's been a few years, but IIRC I found the book rather stuffy and academic.

Btw, the book was published in various editions. My copy says 1978, 1989, and 1996.

Thanks. At least one of the reviews on Amazon said similar things, but I have more faith in the opinions here.

Keep in mind, I did read it years ago. However, I do very much like many other investment books that others would find stuffy and academic. So, ...

[milo]

His job at Bear gone, Mr Fox chose suicide

http://tinyurl.com/5do3wm

Despite years of hard work, he says, without adequate savings, Mr Fox "still felt he had nothing to show for it as he went into his 50s."

Sad story, but with 250k a year, how can one not have any savings?

[WynnQuon]

Has anyone read and is able to provide a recommendation on "Manias, Panic and Crashes" by Charles Kindleberger?

It's been a few years, but IIRC I found the book rather stuffy and academic.

Btw, the book was published in various editions. My copy says 1978, 1989, and 1996.

Thanks. At least one of the reviews on Amazon said similar things, but I have more faith in the opinions here.

Keep in mind, I did read it years ago. However, I do very much like many other investment books that others would find stuffy and academic. So, ...

I have to agree with Norm on this. It's good for some historical information on bubbles that are not well known and also for those who want to get into some economics. But it's not what I would call a top read either intellectually or literally.

My favorite book on bubbles and crashes is Galbraith's "Great Crash" which gives not only the history of that famous episode but also a number of insightful observations on how bubbles start, how they grow and what happens when they blow up. Finally, Galbraith writes like no other economist. He's witty and wise. Even if you have no interest in economics, this is still a rollicking read.

I'd recommend that every investor read it, but the fact that they don't means continual damage.

[parvus]

From Galbraith's Great Crash:

The Great Crash, 1929 was first published in 1955 and has been continuously in print ever since, a matter now of forty years and more. Authors (and publishers) being as they are, the tendency is to attribute this endurance to the excellence of the work. Evidently this book has some merit, but, for worse or perhaps better, there is another reason for its durability. Each time it has been about to pass from print in the bookstores, another speculative episode — another bubble or the ensuing misfortune — has stirred interest in the history of this, the great modern case of boom and collapse, which led on to an unforgiving depression.

One of the subsequent episodes occurred, in fact, as the book was coming from the printer. There was a small stock market boom in the spring of 1955; I was called to Washington to testify at a Senate hearing on the past experience. During my testimony that morning the stock market went suddenly south. I was blamed for the collapse, especially by those who were long in the market. A fair number of the latter wrote to threaten me with physical injury; a more devout citizenry told me they were praying for my ill health or early demise. A few days after my testimony I broke my leg while skiing in Vermont. The papers carried mention. Letters came in telling me of prayers that had been answered. I had at least done something for religion. In the mood of the times a senator from Indiana, Homer E. Capehart, said it was the work of a crypto-Communist.

[George$]

An article by George Soros from The New York Review of Books, December 4, 2008.
The Crisis & What to Do About It
a bit ...

This remarkable sequence of events can be understood only if we abandon the
prevailing theory of market behavior. As a way of explaining financial markets, I
propose an alternative paradigm that differs from the current one in two respects.
First, financial markets do not reflect prevailing conditions accurately; they
provide a picture that is always biased or distorted in one way or another.
Second, the distorted views held by market participants and expressed in market
prices can, under certain circumstances, affect the so-called fundamentals that
market prices are supposed to reflect. This two-way circular connection between
market prices and the underlying reality I call reflexivity.

[Norbert Schlenker]

The End

[WishingWealth]

At least, the 'writing' business is into a boomlet.
Wall Street Lays Another Egg
Niall Ferguson in Vanity Fair.

(...)
t remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style “great contraction” of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.

Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage—the lax central bankers, the reckless investment bankers, the hubristic quants—are now feeling the full force of this planet’s gravity.

But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions—not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.

On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives.

But back here on Planet Earth it suddenly seems like an extraordinary popular delusion.

WW

[Norbert Schlenker]

Henry Blodget's latest: What the Stock Market Will Be Worth If Earnings Go To Zero

BTW, that website is worth bookmarking. As well as Blodget, writers include John Carney and Joe Weisenthal (both late of DealBreaker).

[tidal]

The 10 Worst Predictions for 2008

“Peter writes: ‘Should I be worried about Bear Stearns in terms of liquidity and get my money out of there?’ No! No! No! Bear Stearns is fine! Do not take your money out. … Bear Stearns is not in trouble. I mean, if anything they’re more likely to be taken over. Don’t move your money from Bear! That’s just being silly! Don’t be silly!”
—Jim Cramer, responding to a viewer’s e-mail on CNBC’s Mad Money, March 11, 2008

[tidal]

CAN SCIENCE HELP SOLVE THE ECONOMIC CRISIS?
I have just glanced at this article over on Edge, but it looks intriguing. Maybe even worth a thread discussion?

[Norbert Schlenker]

First, we document that the losses incurred by individual investors are economically large. We estimate the total losses to individual investors to be $NT 935 billion ($US 32 billion) during our sample period or $NT 187 billion annually ($US 6.4 billion). (The average exchange rate that prevailed during our sample period was $NT 29.6 per $US 1 with a low of 24.5 and a high of 34.7 $NT/$US.) This is equivalent to a staggering 2.2% of Taiwan’s gross domestic product (GDP) or roughly 33, 85, and 170% of total private expenditures on transportation/communication, clothing/footwear, and fuel/power (respectively). Put differently, it is a 3.8 percentage point annual reduction in the return on the aggregate portfolio of individual investors. These losses can be broken down into four categories: trading losses (27%), commissions (32%), transaction taxes (34%), and market-timing losses (7%).

The trading and market-timing losses of individual investors represent gains for institutional investors. The institutional gains are eroded, but not eliminated by the commissions and transaction taxes that they pay. We estimate that aggregate portfolio of institutional investors enjoys annual abnormal returns of 1.5 percentage points after commissions and transaction taxes ...

Just How Much Do Individual Investors Lose By Trading?

[tidal]

[url=http://www.vanityfair.com/magazine/2009/01/stiglitz200901?printable=true&currentPage=all]Capitalist Fools
Behind the debate over remaking U.S. financial policy will be a debate over who’s to blame. It’s crucial to get the history right, writes a Nobel-laureate economist, identifying five key mistakes—under Reagan, Clinton, and Bush II—and one national delusion.
by Joseph E. Stiglitz[/url]

Was there any single decision which, had it been reversed, would have changed the course of history? Every decision—including decisions not to do something, as many of our bad economic decisions have been—is a consequence of prior decisions, an interlinked web stretching from the distant past into the future. You’ll hear some on the right point to certain actions by the government itself—such as the Community Reinvestment Act, which requires banks to make mortgage money available in low-income neighborhoods. (Defaults on C.R.A. lending were actually much lower than on other lending.) There has been much finger-pointing at Fannie Mae and Freddie Mac, the two huge mortgage lenders, which were originally government-owned. But in fact they came late to the subprime game, and their problem was similar to that of the private sector: their C.E.O.’s had the same perverse incentive to indulge in gambling.

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

[Shakespeare]

Not sure if this Harper's Feb 2008 article has been linked before:

[url=http://www.harpers.org/archive/2008/02/0081908]The next bubble:
Priming the markets for tomorrow's big crash[/url]

A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression....

Nowadays we barely pause between such bouts of insanity....

The bubble machine often starts with a new invention or discovery....

There are a number of plausible candidates for the next bubble, but only a few meet all the criteria....

There is one industry that fits the bill: alternative energy, the development of more energy-efficient products, along with viable alternatives to oil, including wind, solar, and geothermal power, along with the use of nuclear energy to produce sustainable oil substitutes, such as liquefied hydrogen from water.

[Gus]

Socialism with American characteristics

An interview with Gao Xiqing, the man who oversees $200 billion of China’s $2 trillion in dollar holdings.

About the financial crisis of 2008, which eliminated hundreds of billions of dollars’ worth of savings that the Chinese government had extracted from its people, through deliberately suppressed consumption levels:

We are not quite at the bottom yet. Because we don’t really know what’s going to happen next. Everyone is saying, “Oh, look, the dollar is getting stronger!” [As it was when we spoke.] I say, that’s really temporary. It’s simply because a lot of people need to cash in, they need U.S. dollars in order to pay back their creditors. But after a short while, the dollar may be going down again. I’d like to bet on that!

....

About stock market derivatives and their role as source of evil:

If you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people.

....

About the $700 billion U.S. financial-rescue plan enacted in October:

Finally, after months and months of struggling with your own ideology, with your own pride, your self-right-eousness … finally [the U.S. applied] one of the great gifts of Americans, which is that you’re pragmatic. Now our people are joking that we look at the U.S. and see “socialism with American characteristics.” [The Chinese term for its mainly capitalist market-opening of the last 30 years is “socialism with Chinese characteristics.”]

....

And how should Americans feel about the growing Chinese presence in their economy?

Americans are not sensitive in that regard. I mean, as a whole. The simple truth today is that your economy is built on the global economy. And it’s built on the support, the gratuitous support, of a lot of countries. So why don’t you come over and … I won’t say kowtow [with a laugh], but at least, be nice to the countries that lend you money.

Talk to the Chinese! Talk to the Middle Easterners! And pull your troops back! Take the troops back, demobilize many of the troops, so that you can save some money rather than spending $2 billion every day on them. And then tell your people that you need to save, and come out with a long-term, sustainable financial policy.