J. Bradford DeLong's Grasping Reality with All Eight Tentacles

Mesdames et Messieurs, Faites vos Jeux...

Whether relative-value arbitrage is, as I think Myron Scholes once said, "using computers to suck up nickles on a global scale" or "using borrowed money to put a chip on 35 of the 36 roulette numbers and hoping for no zero/36" and in the long run profiting from the shield of limited liabiity and your lenders' idiocy--that is a genuinely hard problem. Which it is depends extremely sensitively on the shape of the tails of the return distribution--and that information is, of course, hard to get because the tails of the distribution are, you know, the tails, and we don't see them very often.

John Meriwether's two attempts to test this as a strategy rather than as a small part of the portfolio of a much better capitalized firm that can be rescued by Warren Buffett and so wait out panics have not turned out so well. So he's going to do it again! Matthew Yglesias:

Matthew Yglesias: Another Spin at the Wheel: Good news for investors who like to lose all their money, “John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.” What’s that, you ask, didn’t his first fund lose all its money? Why, yes. And didn’t the second fund fold because it lost a ton of money? Yes, quite so. So how will this new one be different? It won’t! It’s

expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.

The way this works is that you identify arbitrage opportunities such that you make trades you’re overwhelmingly likely to make money on. But those opportunities only exist because the opportunities are very small. So to make them worth pursuing, you need to lever-up with huge amounts of debt. Which means that on the rare moments when the trades do go bad, everything falls apart: “The strategy typically has a high ‘blow-up’ risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.”

As a friend puts it, this strategy is “literally the equivalent of putting a chip on 35 of the 36 roulette numbers and hoping for no zero/36.” But you’re doing it with borrowed money. I’m not a huge believer in human rationality, so I totally understand how this scam worked once. That he was able to get a second fund off the ground is pretty amazing. If he finds investors for a third spin around the wheel I’m going to propose confiscating all the rich peoples’ money and giving it to capuchin monkeys.

Are Chicago Economics Nobel-Prize Winners von Neumann-Morgenstern Agents?

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

There is one really interesting juxtaposition from Lucas's part of the interview:

LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...

[...]

LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me.

KEENE: What will be the signal for Robert Lucas to go back into the markets...?

LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...

Let's parse this. First, Robert Lucas says that it is highly likely--certainly his median forecast--that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income, and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to normal--a normal multiple of a ten-year moving average of lagged earnings, for example. That means a year-2013 S&P of 2000 or so, compared to its current value of 1044 or its 2009 low of 667. Investing in the S&P 500 for a four-year horizon now is risky, certainly, but the expected return is high. And holding your money in cash is not all that safe either: most of the scenarios I can envision in which the S&P 500 is at a real value in 2013 corresponding to today's 667 are scenarios in which inflation has eaten away most of the value of cash.

So what is Robert Lucas doing holding his entire portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% while his expected four-year return on equities over Treasuries has gone from 2.5% or so to 20%? Has his personal tolerance for risk suddenly collapsed to such an extent because he has become a complete coward? Or does he no longer believe his forecast that the U.S. economy is highly likely to be back to normal in four years? Or is he simply not a von Neumann-Morgenstern agent, and moreover lacks any desire to behave as if he were one?

No von Neumann-Morgenstern agent faced with such returns would hold his entire TIAA-CREF portfolio in cash. Not a one.

Now let me back up a little to Lucas's attack on Robert Shiller and George Akerlof, and their book Animal Spirits:

LUCAS: I just don’t get it. I mean look at the Black_Scholes formula. People come up with a formula for pricing options, just out of purely mathematical reasoning, and then it turns out it fits certain data amazingly well. And it’s been incredibly useful to people. Now it’s not useful for everything, but for what it does it’s a huge advance in human knowledge. Now what’s the behavioral finance contribution? They reinforce the idea of skepticism. Well, skepticism, it’s easy to be a skeptic. What’s harder is to tell somebody how to do something they didn’t know how to do yesterday. That’s what Black and Scholes did...

Lucas seems to miss the entire big point. Black-Scholes tells you how to do things only if the trades of the non-von Neumann-Morgenstern agents in the economy--that's you, Bob--cancel each other out. If they don't cancel each other out--if there are, as you say, "millions of people like me," then a whole bunch of banks running off of Black-Scholes and similar models without taking account of your existence are going to create a hell of a lot of systemic risk, and then 10% unemployment.

DeLong: The Simplest Possible Behavioral Finance Bubble Model

There are, I think, two big questions in behavioral finance:

1. Under what circumstances will normal, human behavior by investors produce forces in financial markets that drive them to speculative excess?

2. Under what circumstances will arbitrageurs--smart, sophisticated investors who understand what is going on--fail to help the situation much?

A first whack at trying to answer (1):

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Download now or preview on posterous

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We Are Live at "The Week" with the Eclipse of the Chicago School

The Chicago School is eclipsed - THE WEEK:

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Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, “A Failure of Capitalism,” to try to rescue the Chicago School’s foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators. In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

Thus he writes: "At no stage need irrationality" on the part of markets or their participants "be posited to explain” the collapse of financial markets last year and the current deep recession.

Posner’s effort looks to me like an earlier effort to “save the appearances” in the face of discomfiting contradiction. The Jesuit astronomers of 17th-century Rome wanted above all to maintain the assumption that the sun revolved around the earth—for if it did not then the Bible’s declaration that Joshua called on God to make the sun stand still in the sky was a lie, and a Bible that lies even once cannot be the inerrant foundation of faith.

Thus the Jesuits created much more complicated models than the elegant heresy of Copernicus, in which the earth revolved around the sun. They succeeded in their attempt to save the appearances. Posner’s attempt does not: It is definitely a retrograde motion, for we see many things in the financial crisis and the recession that are not what we would see in an economy populated by smoothly rational utilitarian calculators.

• It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets.

• It was not rational for Citigroup CEO Charles Prince to keep dancing to the music, without thinking which seat Citi would claim when the round of musical chairs came abruptly to a halt.

• It was not rational for shareholders of newly incorporated investment banks to offer traders large annual bonuses for performance assessed by a year-to-year mark-to-market yardstick—rather than rewarding them with long-run restricted stock that would hold its value only if the traders' portfolio strategies proved durable.

• It was not rational for the shareholders and executives of General Motors and Chrysler to ignore the need for a Plan B in the event Americans fell out of love with SUVs.

The litany of financial lunacy is longer than even the Eastern Orthodox litany of the saints. Yet Posner’s insistence that the crisis cannot spring from compound irrationality drives him to a claim that the real cause is a failure of government—specifically a too-lax, too-nurturing, insufficiently strict Mommy State that raised the children all wrong.

"The mistakes were systemic,” he writes, “the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools." What we needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher. The Daddy State should have restricted financial innovation because a "depression is too remote an event to influence business behavior. The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy."

Posner's claim that the Princes of Wall Street were rationally ignoring small probabilities is simply not true. The venture capitalists of Silicon Valley in the 1990s raised money for their funds overwhelmingly through equity rather than debt tranches. They did so because they wanted themselves and their clients to retain some considerable fraction of their fortunes in an event that they regarded as small probability—but actually happened—that the overwhelming bulk of the value from the internet revolution flowed to customers rather than to businesses.

Jamie Dimon and his team at JPMorgan Chase tried to move their firm out of the subprime mortgage market and into position to profit from the correction by the end of 2006. So did Lloyd Blankfein and his team at Goldman Sachs. (They suffered anyway because neither imagined the possibility that a hedged long position in mortgages was not really hedged at all if the counterparty on the short leg was AIG.)

Yet while Posner insists on saving the appearance of individual rationality, he is willing to jettison the Chicago School's conclusion that markets are everywhere and always perfect. As Robert Solow observed: "If I had written that, it would not be news. From Richard Posner, it is." Abandoning the conclusion of market perfection opens the door to the idea that government needs to properly check, balance, and regulate markets in order to help them function as well as possible. But clinging to the assumption of individual rationality forces Posner’s view of what regulation is appropriate into a very awkward straightjacket.

If the dons of the Chicago School were locked in an ivory tower, it would not matter that Posner tries to save the appearances, and so attributes the crisis not to failure on the part of “capitalists” but rather of regulators. Posner, however, is one of America’s leading public intellectuals. His views spread. His influence is very wide. For example, Jonathan Rauch in The New York Times Book Review joins in and extends Posner’s error. For Rauch, “to see the crisis through populist spectacles, as President Obama does when he attributes it to 'irresponsibility,' is to misunderstand the whole problem by blaming capitalists." Rauch echoes and congratulates Posner, asserting that Posner’s “merciless scrutiny” leaves "not one populist cliché” remaining intact.

But Posner’s Chicago clichés not only remain intact but burst into full flower. Attributing responsibility to the errant Princes of Wall Street, and the directors and shareholders who were supposed to be overseeing them, would be "populism." And "populism" is bad. There should be no sanctions—not even a reduction in influence—for financiers. As for reregulation of the financial market, we should be satisfied with “pretty small beer,” because the failure was not a failure of individual capitalists but of capitalism itself.

As remedy, we should prohibit the Federal Reserve from seeking full employment through low interest rates. One actor whom Posner does clearly blame is Alan Greenspan, whose reduction of interest rates to 1 percent in 2002–2003 was, in Posner's eyes, a root of the evil. Full employment already loses out to price stability when the latter is threatened by inflation. In Posner's view, full employment must also give way if achieving it requires low interest rates.

Let us conduct a thought experiment. Suppose that Judge Posner had been willing to embrace Copernican theory. In that case, what would his policy recommendations have been? Start with the observation that financial markets have six useful purposes:

• to aggregate the money of people who ought to be savers into pools large enough to finance large-scale enterprises.

• to channel the money of people who ought to be savers to institutions and people who ought to be borrowers.

• to spread risks so that no one individual finds herself ruined by the failure of any one investment or the bankruptcy of any one company or the slow growth of any one region.

• to keep managements efficient by upsetting and replacing teams and organizations that have outlived their usefulness.

• to encourage savings by creating liquidity—the marvelous fact that one can own a piece of an extremely illiquid and durable piece of social capital (an oil refinery, say) and yet get your money out quickly and cheaply should you suddenly have an unexpected need for it.

• to take the money of rich people who like to gamble and, by providing some excitement for them as they watch their gains and losses, use it to buy capital equipment that raises the wages of the rest of us (at the price of paying a 20 percent cut to the Princes of Wall Street). This is a superior use for the rich—and for the rest of us—than, say, taking their wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as they promote these six useful purposes. Call them aggregation, accumulation, diversification, efficientization, liquiditization, and casinoization.

By these standards, the current compensation scheme on Wall Street—large annual bonuses based on annual marked-to-market results—is absurd. It helps achieve none of these six goals, and it greatly increases the chance of a crash by providing everyone with an incentive to help their friends by marking up value, marking down risk, and ignoring the impact of their actions on the long-term survival of the enterprise. Silicon Valley compensation schemes seem much better: no large payouts until assets have reached maturity and portfolio strategies have proved their value in all phases of the business cycle.

From this perspective, the rapid growth of derivative markets has also proved to be absurd. Derivatives were supposed to assist in risk spreading and diversification. Amateurs and outsiders could take on a position easily, and the professionals who sold it to them could then dynamically hedge it away, and so tap the risk-bearing capacity of the public to a greater degree. It did not work, and it made the books of Wall Street firms opaque even to the most sophisticated of executives. Kenneth Arrow would tell us that stocks, bonds, commodities, puts, and calls alone already carry us as close to a spanning set of securities as we are going to get. The potential diversification benefits of more complicated securities appear to be outweighed by the information they destroy.

The thirty-to-one effective leverage ratios achieved in the 2000s by major banks were absurd. When public money is involved—and when high-leverage portfolio strategies become common, public money is always involved—any system that relies on the intelligence of equity holders to restrain traders’ risks within bounds at a thirty-to-one leverage ratio is absurd. Every financial institution should be a bank holding company regulated by the Federal Reserve. And every bank holding company should keep a healthy proportion of its liabilities—10 percent? 20 p?—on deposit at the local Federal Reserve.

In the future, we need to change the culture of Wall Street by changing how top-earning financial professionals are paid, changing the assets they trade to make the markets less opaque, and changing the risks they run by taking capital requirements very seriously once again. If we accomplish all three, there’s a chance that the next Minsky Moment that comes along will be a minor disturbance rather than a globe-shaking catastrophe for 100 million people.

The key irrationality was a private-sector failure on the part of the shareholders and top managements of the banks to make sure that their traders had an appropriate stake in the long-run survival of the bank and not just in constructing a portfolio that would be marked-to-market at a high valuation on Dec. 31. And the government needs, for all our sakes, to compensate for this private-sector irrationality. That’s the conclusion that Posner’s book should have reached. But it never gets there: Because to get there, he would have had to begin his book by acknowledging that it matters that the earth revolves around the sun.

Project Syndicate: The Hidden Purposes of High Finance

BusinessWorld Online: Commentary -- By J. Bradford Delong: "The hidden purposes of high finance": BERKELEY — No one questions the usefulness of "low" finance.

The ability to use checks, banknotes, and credit cards rather than having to cart around chests of silver, scales, and reagents to assay purity, and needing armed guards to protect the silver (and more guards to watch the first set of guards) has obvious efficiencies.

So does the ability of households to borrow and lend in order not to be forced to match income and expenditure every day, week, month, or year.

But what use is "high" finance?

Economists’ conventional description depicts high finance as providing us with three types of utility. First, it allows for many savers to pool their wealth to finance large enterprises that can achieve the efficiencies of scale possible from capital-intensive modern industry.

Second, high finance provides an arena to curb the worst abuses by managers of large corporations. Managers’ fear that if the stock price drops too low they will be out on their ears provides a useful restraint.

Finally, high finance allows for portfolio diversification, so that individual investors can seek high expected returns without being forced to assume large, idiosyncratic risks of bankruptcy and poverty.

But these are the benefits of high finance as they apply to the ideal world of economists — that is, a world of rational utilitarian actors who are skilled calculators of expected utility under uncertainty, who are masters of dynamic programming. We do not live in such a world.

Economists have spent their lives attempting to evolve theories that would account for how salient features of reality might emerge if we did live in their ideal world, but since we don’t, their theoretical enterprise is of doubtful utility. It is like describing how one could bake a delicious wedding cake using only honey, bicarbonate of soda, and raw eggplant.

If we take the world as it really is, we see that high finance performs two further tasks that advance our collective welfare. It induces us to save, accumulate, and invest by promising us safe, liquid investments even in extraordinary times.

It is a fact that we are much happier saving and accumulating, and that we are much more likely to do so when we think that the resources we have saved and accumulated are at hand. It is also true that when we invest our wealth — in Pfizer’s intellectual property, factories in Shenzhen, or worldwide distribution networks — it is not, in fact, at hand. Our invested wealth can only be made to appear liquid, and only if there is no general shift in our collective desire for liquidity.

And it is also a fact that we are happier saving and accumulating if we receive positive and negative feedback on our decisions on a time scale that allows us to believe that we can do better next time by altering our strategy — hence marketwatch.com and CNN/Money.

Of course, investors who believe that their wealth is securely liquid, and that they are adding value for themselves by buying and selling are suffering from a delusion. Our financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...."

Moreover, for Keynes, "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...."

It is for these reasons that we have seemed frozen for the past generation or two whenever we have contemplated reforming our system of financial regulation. And it is why, even in the face of a severe financial crisis, we remain frozen today.

Refocusing the Discussion of the Mortgage Boom...

Edmund Andrews emails:

The [premise of my] book is that my mortgage was obviously insane, and my goal was to explore how and why it was possible in the first place. [The book] is not a "cautionary tale," or a morality play about Everyman. It's an attempt to show the deception/self-deception and corruption of people at each level in the food chain. The Magazine excerpt is only about my self-delusion as a borrower, but the book tells about all the other players up to and including Greenspan. Those are the best parts...

He asks that the subject of the discussion be the book as a whole rather than just the New York Times Magazine article. I agree: that Edmund Andrews acted somewhat like a moonstruck idiot is not especially interesting--save perhaps in the hands of F. Scott Fitzgerald. That American Home Mortgage and company were willing to finance his acting like an idiot and so drag themelves down as well is somewhat more interesting.

Busted: Life Inside the Great Mortgage Meltdown, by Edmund L. Andrews.

Ed Andrews, Patty Barreiro, and Serial Bankruptcy: Megan McArdle: Smart Young Blogger or All-Knowing Being?

Felix Salmon says: McMegan FTW!!!!

Megan McArdle reports from the Montgomery County Courthouse:

The Road to Bankruptcy: At the end of his book's harrowing account of mortgage mistakes and credit card crises,  Edmund Andrews writes:  "While our misadventure had certainly been more extreme than those of many other Americans, our situation was not all that unusual."  And indeed the book reads like the story of an American Everyman, easily sucked in to the alluring world of easy credit as he struggled to blend a new family.  The terrifying implication is that it could happen to you--to anyone who leads with their heart and not their head. But... the story has been tidied up a little. Patty Barreiro, Andrews' wife, has declared bankruptcy twice.  The second time was while they were married, a detail that didn't make it into either the book or the excerpt....

Andrews' desire to shield his wife is understandable--hell, laudable.  No decent person wants to parade their spouse's financial trouble in front of the world.  But this is material information that changes the tenor of his story. Serial bankruptcy... doesn't just happen to anyone, particularly anyone with a six figure salary. In September 1998, California bankruptcy court records indicate that Patty and her first husband declared bankruptcy... family income of $174,000 in 1996, $87,000 in 1997, and $126,000 in the first nine months of 1998... the couple owed about $30,000 on 8 credit cards, over $200,000 in back taxes, and almost $15,000 in private school tuition, as well as substantial car and mortgage payments. In 2007, nearly as soon as she was eligible, Patty Barreiro filed again in Montgomery Country. When called for comment yesterday, Andrews was unavailable.... The bankruptcy code requires filers to wait 8 years after a previous Chapter 7 discharge.  Barely four months after she became eligible, Patty Barreiro filed again.  And the filing shows some suggestion of strategic debt management. Ms. Barreiro filed separately from Andrews, and had to amend the filing to include Andrews' income after a complaint from a creditor.... She filed when her income was at rock bottom, consisting only of unemployment; the timing may have just excluded having to declare $5,000 in freelance editing income Andrews mentions in the book. And she shed what appear to be jointly incurred debts, such as a Comcast account....

Serial bankruptcies can, of course, happen to anyone with enough bad luck.  But they usually don't.  And when they do, they usually hit people with marginal incomes that leave no margin for error in the budget.  Most people, even in LA, are able to build a sustainable budget out of an income in the low six figures. Moreover, pesky bad luck isn't really the picture painted by either filing.  Rather, Ms. Barreiro seems to have spent most of the last two decades living right up to the edge of her income, and beyond, and then massively defaulting. If you structure your finances so that absolutely everything has to go right, it's hard to blame the mortgage company when you don't quite make it.

Andrews has been admirably open about many of the poor decisions and the wishful thinking that led him deep into debt.  Nonetheless, he has laid much of the blame onto irresponsible bankers and mortgage brokers. The missing bankruptcies substantially undermine this basic narrative arc of Andrews' story.  Particularly in his book, the bankers are the villains, America's current troubles are the inevitable denouement of their maniacal greed, and the Andrews household stands in for an American public led, by their own greed and longing and hopeful trust, into the money pit....

[I]t's still true that she and Andrews were able to dig themselves in a lot deeper because of fantastically easy credit from a variety of fantastically stupid bankers, most of whom now seem to have gone fantastically bankrupt. But while the willing lenders amplified the problem, given Ms. Barreiro's history, it seems unlikely they were at the root of it. It's hard to see them as victims either of those bankers, or a mass mania. Andrews married a woman with a lengthy history of debt and spending problems.  Serial bankrupts were getting into trouble long before there was a credit bubble, indeed long before there were credit cards or 30-year self-amortizing mortgages...

I disagree with Megan. If a road leads to the edge of a precipice and someone falls off, it is not terribly constructive to say: "Well! They were unsteady on their feet!" Instead, you build a guardrail. We are jumped-up East African Plains Apes whose key cognitive talents are figuring out which food is ripe, determining whether it is safe to leap to the next branch, keeping track of who is sleeping with whom so we don't proposition the wrong person and get beaten up, and guarding our children from violent death--we don't have the smarts to avoid serial bankruptcy. Which is why we should nudge ourselves into social systems in which serial bankruptcy is a very difficult thing to accomplish.

The financial companies of America bet that Patty Berreiro's financial judgment was so bad that they could extract enough in sky-high interest from her on her debts before she went bankrupt to make it a winning proposition to them although not to her. People whose business model rests on subtracting value from their customers need to be regulated out of existence.

And, of course, there are the shareholders who did not guard their own interests as well because they too were jumped-up East African Plains Apes. You can hear a certain glee in Ed Andrews' observation that two of his three mortgage lenders are now bankrupt.

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Laura Rowley:

Yahoo! Personal Finance: Calculators,Money Advice,Guides,& More: In a 'New York Times' story headlined “My Personal Credit Crisis”, economics reporter Edmund Andrews, 48, lays bare his finances and admits to a headlong dive into the subprime debacle. In the piece, excerpted from a forthcoming book, he describes buying a home he couldn’t afford with his second wife, Patty, falling ever deeper in debt, and cashing out his equity to finance a lifestyle that cost $3,000 a month more than they were earning. It ends with Andrews defaulting on the mortgage and, eight months later, still waiting for the bank to begin foreclosure proceedings.

Andrews’ story is riddled with classic personal-finance errors thought to be the province of the uneducated, underemployed, and ill-fated. Andrews was none of these; he earned $120,000 a year and didn’t suffer a disability or job loss. He explains his folly this way: "The money was there, and I was in love…I just thought I could beat the odds." But -- at least in hindsight -- the colossal improbability of beating the odds leaps off the written page. This is magical thinking at its finest, from a guy whose job is to write about the facts all day long. Multiplied by tens of millions of homeowners, it brought the U.S. economy to its knees.

Here are just a few lessons from his story:

1. Price your passions. Andrews divorced his first wife after 21 years of marriage and was responsible for $4,000 a month in alimony and child-support payments. This left him with $2,777 a month in take-home pay to support his new wife and her children.... [P]eople who stayed married accumulated 93 percent more wealth than single or divorced people.... In the book 'Spend ‘Til the End', authors Lawrence Kotlikoff and Scott Burns urge readers to “price their passions”...

2. Budget for the worst-case scenario. After the $2,500 mortgage payment, Andrews had $277 a month left for necessities, and hoped that Patty’s salary would make up the difference: “I was banking on Patty to earn enough money to keep us afloat.” Five months after moving into their home, Andrews was shocked to find just $196 left in his checking account. He writes, “How could I have glossed over the fact that we were spending about $3,000 more than we were earning, month after month?”...

3. Avoid the two-income trap. Counting on a second salary to make ends meet in the first place was an enormous gamble. Andrews writes, “Patty had spent much of the previous two decades as a stay-at-home mother in Los Angeles. Her last full-time job as an editor at a political research company was back in the early 1980s”...

4. Know what you can afford. A mortgage, property taxes, and insurance should total no more than 29 percent of gross income -- and those expenses, plus other long-term debts, should be no more than 36 percent of gross income...

5. Call your bank and ask them to cut you off in the event you attempt a debit or ATM transaction and the account has insufficient funds. As Andrews’ finances spiraled out of control, he repeatedly overshot his checking account. “Every time I overdrew my checking account by even a few dollars, the bank would tap my Mastercard for $100, helpfully deposit the cash in my account, and charge me $10 for the privilege,” Andrew writes. He recounts a $5 overdraft for school supplies. Assuming he deposited money two weeks later to repay the overdraft, his annual APR on the $10 overdraft “loan” would be 5,200 percent. (Here’s the calculator.)

6. Have a serious conversation about money with your intended before you tie the knot...

Neurological Evidence of Money Illusion

Bruce Bartlett sends us to:

Inflation 'felt' to be not so bad as a wage cut: Contact: Dr. Bernd Weber
bweber@lifeandbrain.com
49-228-688-5262
University of Bonn

Economists and brain researchers in Bonn have discovered a neuronal cause of the so-called 'money illusion'

What would you prefer: a three per cent wage rise at five per cent inflation? Or a two per cent wage-cut with stable prices? Many people, faced with this choice, would take the first option, although the true purchasing power of their income sinks in both cases by exactly the same amount, namely two per cent. Researchers at Bonn University and thhe California Institute of Technology have now discovered the cerebro-physiological cause underlying this so-called "money illusion". This effect is of great practical relevance in that it explains, for instance, why financial policy and inflation can have a beneficial effect on employment and economic growth.

Many people view a rise in their income as a good thing, even when the increase is completely negated again by inflation. This effect is called the "money illusion", and many economists are of the opinion that it should not exist. After all, the true purchasing power of the income remains exactly the same. So, for a rational market activist it should be of absolutely no concern under these conditions whether his nominal income sinks or rises. However, laboratory experiments and field studies have repeatedly confirmed that this effect does indeed exist.

Professor Dr. Armin Falk and Dr. Bernd Weber of Bonn University have now approached this topic of the money illusion from a completely different angle. Falk is an economist and Weber a brain researcher – an unusual alliance. Both have been trying to discover which neuronal processes underlie economic decisions. For this purpose, they arranged for their test subjects to "play" economic situations while, at the same time, they monitored their brain processes.

Experiments in the Brain Scanner

A total of 24 subjects participated in the study which has just been published. Whilst recumbent in a scanner, they were called upon to solve simple problems. Success brought a financial reward. At the same time, as the experiment evolved, the fluctuations in the blood oxygen saturation of diverse areas of their brains were monitored. This reading indicates the degree of activity in the relevant area of the brain. The prize-money was not subsequently paid out in cash, but the successful test subjects were allowed to choose goods from a catalogue – including CDs, sun cream or computer accessories.

"We had now confronted our test subjects with two different situations", Falk explains. "In the first, they could only earn a relatively small amount of money, but the items in the catalogue were also comparatively cheap. In the second scenario, the wage was 50 per cent higher, but now all the items were 50 per cent more expensive. Thus, in both scenarios the participants could afford exactly the same goods with the money they had earned – the true purchasing power had remained exactly the same." The test subjects were perfectly aware of this, too – not only did they know both catalogues, but they had been explicitly informed at the start that the true value of the money they earned would always remain the same.

Despite this, an astonishing manifestation emerged: "In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario", declares Bernd Weber, focusing on the main result. "In this case, it was the so-called ventro-medial prefrontal cortex - the area which produces the sense of quasi elation associated with pleasurable experiences". Hence, on the one hand, the study confirmed that this money illusion really exists, and on the other, it revealed the cerebro-physiological processes involved...

Animal Spirits: How Psychology Drives the Economy

Robert Shiller's talk the week before last at the New School. I am a discussant...

Monkeys Trade Assets I

Virginia Postrel writes:

Pop Psychology: For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens.... “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens....

The trading price should stick close to the expected value. At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best....

Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don’t, and vice versa for sellers. Financial assets, whether in the lab or the real world, are trickier to judge: Can I flip this security to a buyer who will pay more than I think it’s worth?... Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit.... Noussair... “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.

In fact, the people who make the most money in these experiments aren’t the ones who stick to fundamentals. They’re the speculators who buy a lot at the beginning and sell midway through, taking advantage of “momentum traders” who jump in when the market is going up, don’t sell until it’s going down, and wind up with the least money at the end. (“I have a lot of relatives and friends who are momentum traders,” comments Noussair.) Bubbles start to pop when the momentum traders run out of money and can no longer push prices up...

Do I Have to Become a Chartist?

The Dow-Jones Industrial Average has spent 25 of the past 40 years--62%--between 800 and 1250 or between 8000 and 12500. These ranges comprise roughly 25% of the (logarithmic) total range of the Dow as a function of time.

It really looks like there may something special about the nominal value of a 1 followed by a bunch of zeros.

This is disturbing to me as an economist.

Cleaning Up the Drafts File: Economist's View: Hard-Wired for Fairness

I was going to write about this too, but never did. From Mark Thoma:

Economist's View: Hard-Wired for Fairness: Fairness makes us happy:

Brain reacts to fairness as it does to money and chocolate, EurekAlert: The human brain responds to being treated fairly the same way it responds to winning money and eating chocolate, UCLA scientists report. Being treated fairly turns on the brain's reward circuitry. "We may be hard-wired to treat fairness as a reward," said study co-author Matthew D. Lieberman, UCLA associate professor of psychology.... "Receiving a fair offer activates the same brain circuitry as when we eat craved food, win money or see a beautiful face," said Golnaz Tabibnia, a postdoctoral scholar at ... UCLA and lead author of the study.... The activated brain regions include the ventral striatum and ventromedial prefrontal cortex. Humans share the ventral striatum with rats, mice and monkeys, Tabibnia said. "Fairness is activating the same part of the brain that responds to food in rats," she said. This is consistent with the notion that being treated fairly satisfies a basic need, she added.

In the study, subjects were asked whether they would accept or decline another person's offer to divide money in a particular way. If they declined, neither they nor the person making the offer would receive anything. Some of the offers were fair, such as receiving $5 out of $10 or $12, while others were unfair, such as receiving $5 out of $23. "In both cases, they were being offered the same amount of money, but in one case it's fair and in the other case it's not," Tabibnia said. Almost half the time, people agreed to accept offers of just 20 to 30 percent of the total money, but when they accepted these unfair offers, most of the brain's reward circuitry was not activated; those brain regions were activated only for the fair offers. Less than 2 percent accepted offers of 10 percent of the total money. The study group consisted of 12 UCLA students....

"The brain's reward regions were more active when people were given a $5 offer out of $10 than when they received a $5 offer out of $23," Lieberman said. "We call this finding the 'sunny side of fairness' because it shows the rewarding experience of being treated fairly." A region of the brain called the insula, associated with disgust, is more active when people are given insulting offers, Lieberman said. When people accepted the insulting offers, they tended to turn on a region of the prefrontal cortex that is associated with emotion regulation, while the insula was less active.

"We're showing what happens in the brain when people swallow their pride," Tabibnia said. "The region of the brain most associated with self-control gets activated and the disgust-related region shows less of a response."

"If we can regulate our sense of insult, we can say yes to the insulting offer and accept the cash," Lieberman said.

New Republic Death Spiral Watch

Why oh why can't we have a better press corps?

Outsourced to Dan Drezner:

Sweet Jesus, who let Alan Wolfe review economics books?: I’m not Alan Wolfe’s biggest fan.  His public intellectual forays into international relations have not displayed all that much erudition. That’s nothing, however, compared to Wolfe’s TNR review essay of behavioral economics.  Here’s the first paragraph, in which Wolfe wins the 2008 Straw Man award for Blinkered Punditry: 

When I first began hearing about what Bruno S. Frey, professor of economics at the University of Zurich, calls the “revolution” in his discipline, my reaction was one of delight. As far as I was concerned, it could not happen fast enough. Neoclassical economists had insisted upon the primacy of self- interest only in order to model human behavior, but the way rational choice theory developed (at the University of Chicago in particular) suggested that self-interest was not just a fact for these thinkers, but also an ideal: not just how people do act but also how they should act. Their relentless advocacy of market-based public policies was finally ideological–and, by my lights, ideologically wrong. Also the jargon grew impenetrable, and the mathematics ostentatious and obnoxious. When Chicago-style economists started to apply their methods to other social science disciplines, and then to virtually all the perplexities of human life, the charge of academic imperialism could be added. Friedrich August von Hayek and Milton Friedman had always seemed to me to be marginal and somewhat bizarre thinkers, especially when compared to such intellectual titans as John Maynard Keynes and Joseph Schumpeter. The rapid spread of their ideas throughout so much of academia did not bode well for the future.

Lord knows one could use a lot of adjectives to characterize von Hayek and Friedman, and not all of them would be complementary.  “Marginal” and “bizarre” are not ones that immediately come to mind. We can chalk this up to some public intellectuals’ fear of the social sciences (even if they are social scientists) and move on.  Then we get to this paragraph: 

What [Daniel] Kahneman and [Amos] Tversky began and [Richard] Thaler solidified is now frequently called behavioral economics. Its leading figures continue to sparkle. Steven D. Levitt, the co-author of Freakonomics, writes decent prose–or at least is willing to work with a journalist who does; and he, too, teaches at Chicago. The topics that behavioral economists address range far and wide, and often have little to do with the realm of getting and spending. They are interesting, intriguing, and sometimes too cute: raising children, deterring crime, gambling, choosing names. The public-policy implications associated with this way of thinking are anything but predictably right-wing, and in the person of Austan Goolsbee, another economist at Chicago who is also Barack Obama’s chief economic adviser, they now figure prominently in American politics. 

Now I’m no economist, but I have read Freakonomics, and I’m pretty sure Levitt is not a behavioralist.  The overarching theme of Levitt and Dubner’s book is “people respond to incentives.”  That’s pretty consistent with rational choice approaches. Don’t take my word fo it, however — take Steven Levitt’s: 

I am not a huge fan of what people call “behavioral economics,” which is a subfield of economics that expands the standard economic models to incorporate systematic biases in the way humans act. I’ve written about some of my concerns elsewhere, so I won’t reiterate them here. I don’t deny that the insights that emerge from behavioral economics can be important, it just seems that most often they are not — especially when subjected to the discipline of the market.

Whoever assigns and edits Alan Wolfe at The New Republic should really be taken out to the back of the woodshed today.

That would be Franklin Foer, Leon Wieseltier, and Marty Peretz.

When Hyperbolic Discounting Attacks!

Back in January, the question of whether to declare the last day of instruction here at U.C. Berkeley--May 12--part of reading period and cancel the class is a no-brainer. the students are good, enthusiastic, and well prepared. There are oceans of material to cover. The syllabus has just been hacked with a chainsaw--the half-week unit on contemporary Chinese monetary policy has just bitten the dust--and I don't wan;t to have to cut any more. And the question of whether to extend the semester and have another meeting on May 14 is also a no-brainer: it wouldn't be fair to grab normal course time for review, would it?

But today it is May 12, and this is the 44th time I have trudged into this particular course's classroom this semester. And my heart sinks at the thought that I have to do it again...

This is not to say that this has been a bad course: these are good kids, they were well-preoared, and they have learned a lot.They are still pestering me with questions about John Hicks's IS curve and John Taylor's monetary policy reaction function (which I have no covered at such length that I guessed they have to be on Friday's exam). But my marginal disutility of lecturing all of a sudden feels very high...

---

On a related issue, I have never been gladder that my real gradebook is in paper in my backpack then when I see this:

Nominal Wage Rigidity in England in the Long Run

Source: Jan de Vries 2/13/08 lecture, originally from Phelps-Brown and Sheila Hopkins (1956), "Seven Centuries of the Prices of Consumables, Compared with Builders' Wage- Rates," Economica 23:92 (November), pp. 296-314 http://links.jstor.org/sici?sici=0013-0427%28195611%292%3A23%3A92%3C296%3ASCOTPO%3E2.0.CO%3B2-C

• Extraordinarily impressive nominal wage rigidity across long spans of history.
  • Beware, however: the "ancillary" terms of the wage contract could and did vary at a much higher frequency ("we can still only pay you three pence a day, but we'll add a piece of sausage and a mug of beer at lunchtime"--that sort of thing).
• Neverthless, aside from 1932, 1921, and 1333, nominal wages simply do not fall. It doesn't happen.

Felix Salmon Is Unhappy About Those Who Write for GM

Felix Salmon condemns the low quality of the arguments of G.M.'s advocates:

Market Movers: GM's Weak Arguments Against Increased Fuel Economy - Portfolio.com: What wonders of disingenuousness the auto industry is capable of! Right now, the Big Three are worried about proposals to mandate that they increase the fuel economy of the vehicles they sell, and so they're wheeling out economists to say that the proposals don't make sense. But one would think they could do better than this.

The economists (Robert Crandall and Hal Singer)... my favorite part of the whole piece:

If there was fuel-saving technology out there that cost $1,000 but generated $2,500 in the discounted present value of fuel savings over the life of the vehicle, carmakers would surely voluntarily embrace that technology. The carmaker could split the net benefits (equal to the difference between the discounted fuel savings and the cost of the technology) with the car buyer such that both parties to the transaction would be better off.

No need for regulation there. With large numbers of vehicle producers and well-informed consumers, the market is so efficient, in fact, that it ensures that all such transactions will occur, generating the socially optimal level of fuel economy....

"Socially optimal" only if the price of gasoline is at its socially-optimal level--which it is not. And "socially optimal" only if people buy cars entirely because they are useful, and not at all as counters in a zero-sum East African Plains Ape status game.

Crandall and Singer really ought to know better.

Handout on Greenspanism and Its Critique

Greenspanism: For and Against: http://www.j-bradford-delong.net/2007_pdf/20070912_Greenspanism

Lunch Audio File

Objects in Your Calendar Are Closer than They Appear!

Did I really just commit myself to talk in 8 days at lunch about: "Monetary Policy, the Housing Bubble, and Its Unwinding"?

MuJeung.Yang - Macro/International Brown Bag Lunch

**Justin Fox World Exclusive** **Must Credit Justin Fox**

Justin Fox writes:

The David Laibson plan for ending mortgage teaser-rate insanity - The Curious Capitalist - Justin Fox - Economy - Markets - Business - TIME: My post Tuesday on the evils of teaser-rate mortgages engendered a lot of comment. This probably had less to do with the actual content of the post than with the fact that it was linked to on the CNNMoney home page, but whatever. It's a topic folks are interested in these days, for good reason.

Now Harvard economist David Laibson, whom I mentioned in the previous post as an expert on "hyperbolic discounting"--academicspeak for the human tendency to pay too little attention to costs and benefits in the distant (and sometimes not so distant) future--has come forward with a simple proposal to end teaser madness. Here it is, a Curious Capitalist World Exclusive:

To prevent lending institutions from offering misleading deals that trap borrowers, we should require that all future mortgage loans be prepayable with no penalty. This is an easy, simple rule. The rule will have the effect of leading banks to stop offering many of the teaser rates that serve as loss leaders (pay too little interest for the first 18 months but then pay extra on the back end). These loss leaders are often confusing and tempting for borrowers. Banks won't want to offer loss leaders if borrowers can get out of the loan without paying a penalty after the subsidized payment period -- the teaser period -- ends.

My proposal would not discourage banks from offering sensible adjustable rate mortgages (those without a loss leader component). Borrowers should be allowed to take out a mortgage pegged to short-term rates. That's not a loss leader and such mortgages will still be offered if prepayment is made penalty-free. My proposal will only hit the mortgages with early loss leaders built into the payment stream.

I like it. Simple and elegant.

Don't you have to eliminate "points" as well? A lot of points plus a concessional interest rate amount to a prepayment penalty...

Algorithmic Trading Strategies Are Short the Volatility of Volatility in the Short Run, but Long the Volatility of Volatility in the Long Run

I think this from the thoughtful and intelligent Emanuel Derman is wrong:

Emanuel Derman's Blog: Algorithmic Trading Strategies: It always seemed to me, and recent occurences seem to confirm it, that most algorithmic trading strategies are long volatility but short volatility of volatility...

It seems to me that this is probably wrong in a subtle fashion. When volatility declines, the value of the current positions held by a smart algorithmic trading strategy are likely to rise--it is going to report gangbusting profits in its current accounting period. But the decline in volatility means that it has little opportunity to exploit mispricings now and in the future. So when volatility declines funds pursuing smart algorithmic trading strategies are worth less of a premium going forward. So a fall in volatility should lead them to (a) report large profits, but (b) cut their fees because they can offer less value-added in the future, and (c) reduce their scope of operations.

By contrast, a rise in volatility sees funds pursuing smart algorithmic trading strategies get absolutely hammered. But they have great opportunities going forward.

Hence we right now have the interesting spectacle of people saying today: (a) we lost half our clients' money, but (b) our strategies are sound and (c) are opportunities going forward are unbelievable, so (d) you should invest and (e) we should raise our fees because we can offer more value added, and (f) we are expanding our operations.

The problem of course, is that when you have just lost half your clients' money it takes either an incredibly sophisticated or an incredibly unsophisticated investor to take that as a sign of your fundamental excellence. See, once again, Shleifer and Vishny. See also John Meriwether, trying to make these points to his investors in the LTCM context in 1998: http://delong.typepad.com/sdj/2005/06/an_historical_d.html.

Being a Chicken Is a Low-Risk Business

Chris Dillow speaks:

Stumbling and Mumbling: Chebyshev and chickens: Mr Viniar can't be that stupid. He knows financial returns are not normally distributed, but have fat tails; extreme events are more likely than a bell curve suggests. More likely, he's thinking of Chebyshev's inequality. It says that in any data sample, no more than 1/k2 of the values are more than k standard deviations away from the mean. On this view, a 25 standard deviation event is a one in 625 probability.

Does this make Mr Viniar look less stupid? No, however we cut it, [Goldman Sachs's] Mr Viniar is talking wibble. He just under-estimated risk.

There's one very stupid way of doing this. Imagine you're a chicken. Every day, the farmer feeds you. After a while, you figure: "My returns from the farmer are pretty stable, as I seem to get roughly the same amount of corn every day. Being a chicken  is a low-risk business." The following day, the farmer breaks your neck.

Any hedge fund who took default risk (say by holding CDOs) and boasted about its Sharpe ratio based on post-2003 returns would have done much the same as this; you can't measure default risk by looking at past returns. I had assumed that no-one was stupid enough to fall for this trick; one reason why I was underwhelmed by Taleb's The Black Swan - which laboured similar points - was that I thought he was just stating the bleedin' obvious. But perhaps I was wrong.

Not only were they massively exposed to subprime risk, but they didn't know that they were massively exposed to subprime risk, and they don't seem now to be able to coherently explain why they didn't know that they were massively exposed to suboprime risk.

Snatch the Pebble from My Hand, Grasshopper!

Tyler Cowen teaches Ezra Klein one of the arcana imperii:

Ezra Klein: Drinking Strategies: I'm not yet finished with my copy of Tyler Cowen's Discovering Your Inner Economist (it's very good, though!), so maybe this is included deeper into the book. But given that Cowen upholds that expensive drinks subsidizes food, particularly at fine restaurants where they make hefty margins off wine, etc, do we have any data on what the average mark-up is? If it's high, presumably the most cost-effective strategy be to forego drinking in fine establishments -- what you can't get at home is such fine cooking, and this way it's being subsidized for you. If it's relatively modest, there's certainly some added utility, even if it's partly imagined, to pairing a nice meal with good drink, so maybe it's worth it...

Alas, my highly favorable review of Discovering Your Inner Economist is still in the editorial process at the Chronicle of Higher Education.

But I will say that I did once try to convince Bob Hall at a restaurant in Palo Alto not to order wine: the fact that the wine would cost four times retail would, I said, depress me and lower my utility. Even though I wasn't paying for it, I would still feel as though I was being cheated, and as I drank the wine that would depress me more than the wine would please me.

He had two responses: (i) "You really are crazy." (ii) "Think, instead, that it's coming straight out of the Hoover Institution endowment, and order two bottles."

More than "A Commercial-Paper Hit"

Randall Smith and Henny Sender write:

A Commercial-Paper Hit Close to KKR - WSJ.com: The meltdown in mortgage markets hit Wall Street titan Kohlberg Kravis Roberts & Co. yesterday, as a KKR real-estate affiliate sought to delay repayment of $5 billion in short-term debt held by 15 money-market funds. The action at KKR Financial Holdings LLC is the biggest blowup to hit the market for commercial paper, a form of short-term debt used by companies to fund operations. Although it is designed as a haven for cash, some issuers of asset-backed commercial paper have been hit by declining values of collateral linked to subprime mortgages. The repayment delay and related losses of up to $290 million amount to a black eye for KKR founders Henry Kravis and George Roberts at a time when they are weighing a public offering and trying to complete several buyouts whose financing plans have been disrupted by the debt-market turmoil. KKR is also the latest big Wall Street name, after Bear Stearns Cos. and Goldman Sachs Group Inc., to face a situation in which an affiliate confronted losses and possible demands for debt payment or redemptions. Bear put up funds to repay creditors of a mortgage hedge fund, and Goldman pumped its own money into a money-losing hedge fund. But it wasn't clear whether KKR would consider such a step.

The news came as markets gyrated for a second day amid jitters over how far problems with the mortgage market might spread. An analyst downgrade of mortgage lender Countrywide Financial Corp. sent its shares lower and contributed to the hand-wringing over the credit markets. The Dow Jones Industrial Average fell below the 13000 mark for the first time in nearly four months, losing 167.45, or 1.3%, to 12861.47 after being up as much as 90 points during the day. KKR Financial has been hit by a pullback by banks and other lenders from investing in "jumbo" mortgages of more than $417,000, according to people familiar with the situation.... The KKR commercial-paper issuers, KKR Atlantic Funding Trust and KKR Pacific Funding Trust, asked to delay the repayment and extend the notes' maturity for up to six months, citing "the unprecedented disruption in the residential mortgage and global commercial-paper markets."

The two issuers raised money with $500 million in equity backing from KKR Financial and invested in mortgage securities based on a debt-to-equity ratio of about 20 to 1, said the people familiar with the situation. Such mortgages might fetch only 90% or less of their face value now, these people said.

KKR Financial sold some of the mortgages beginning in May, based on a decision to convert to a limited liability corporation from a real-estate investment trust, which offered favorable tax treatment but required that 75% of its assets be in real estate.... The repayment delay doesn't appear to pose an immediate threat to the money-market funds that hold the paper, said Peter Crane, a money-fund expert in Westborough, Mass. Mr. Crane said such funds must limit any single holding to 5% of assets... KKR Financial's strategy for KKR Atlantic and KKR Pacific was to issue triple-A commercial paper at low short-term rates and invest in triple-A mortgage securities, which paid slightly higher rates. However, the strategy depended on the ability to resell the mortgages on short notice, while demand has dried up unexpectedly...

This strikes me as more than a commercial paper hit: KKR must not want to borrow in the commercial paper market in the future, for it will be very hard for any bank executive to explain why they are holding it should something, anything go wrong in the future.

For KKR as an institution to want to shut itself off from this source of financing suggests that things are indeed dire in there.

Today Is a Great Day in Finance!

Today is a great day in finance! That is, it is a great intellectual day for those of us who are friends of and committed to the intellectual project of Shleifer and Vishny, for today one of their theories is made flesh, and stomps about Wall Street like Godzilla:

Andrei Shleifer and Robert W. Vishny (1997), "The Limits of Arbitrage," Journal of Finance, 52:1, pp. 35-55. Abstract: Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital, and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances, when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them...

Yes, today we have reached the limits to arbitrage: most of the people who spend their lives trying to buy low and sell high using other people's money and leverage have given up extending their positions (and so pushing prices back toward normal-time fundamentals), and are hunkered down simply hoping to survive the next month.

Whether this will have macroeconomic implications is unclear, but I would bet not. The Fed and the ECB are pegging the prices of liquid securities, and injecting as much in the way or safe, liquid, short-term assets into the system as needed to keep that so. They are also in the market in other ways. And the nightmare scenarios always involved a simultaneous collapse in the dollar and in consumer demand, and a Fed that couldn't decide whether to fight the inflation coming from rising import prices or the unemployment coming from collapsing consumer spending. Neither of those show any signs of happening.

Yet.

http://scholar.google.com/scholar?q=shleifer+vishny+limits+to+arbitrage&num=100&hl=en&c2coff=1&safe=off&client=safari&rls=en-us&pwst=1&um=1&oi=scholart

Greg Clark's New Book: "A Farewell to Alms"

Greg Clark's new book may be right, may be wrong, but it is brilliant--the pre-industrial chapters may well be the best short treatment of the topic ever.

Nicholas Wade reviews:

Review - A Farewell to Alms: For thousands of years, most people on earth lived in abject poverty, first as hunters and gatherers, then as peasants or laborers. But with the Industrial Revolution, some societies traded this ancient poverty for amazing affluence.... Gregory Clark, an economic historian at the University of California, Davis, believes that the Industrial Revolution ... occurred because of a change... people gradually developed the strange new behaviors required to make a modern economy work. The middle-class values of nonviolence, literacy, long working hours and a willingness to save.... Because they grew more common in the centuries before 1800, whether by cultural transmission or evolutionary adaptation, the English population at last became productive enough to escape from poverty, followed quickly by other countries with the same long agrarian past....

“This is a great book and deserves attention,” said Philip Hoffman, a historian at the California Institute of Technology. He described it as “delightfully provocative” and a “real challenge” to the prevailing school of thought that it is institutions that shape economic history. Samuel Bowles, an economist who studies cultural evolution at the Santa Fe Institute, said Dr. Clark’s work was “great historical sociology and, unlike the sociology of the past, is informed by modern economic theory.”...

[F]rom 1200 to 1800... the economy was locked in a Malthusian trap--each time new technology increased the efficiency of production a little, the population grew, the extra mouths ate up the surplus, and average income fell back to its former level. This income was pitifully low.... By 1790, the average person’s consumption in England was still just 2,322 calories a day, with the poor eating a mere 1,508.... “Primitive man ate well compared with one of the richest societies in the world in 1800,” Dr. Clark observes....

The Industrial Revolution... occurred when the efficiency of production at last accelerated, growing fast enough to outpace population growth and allow average incomes to rise....

[A]ncient wills... reveal[ed] a connection between wealth and the number of progeny.... Generation after generation, the rich had more surviving children than the poor.... “The modern population of the English is largely descended from the economic upper classes of the Middle Ages,” he concluded. As the progeny of the rich pervaded all levels of society, Dr. Clark considered, the behaviors that made for wealth could have spread with them. He has documented that several aspects of what might now be called middle-class values changed significantly from the days of hunter gatherer societies to 1800. Work hours increased, literacy and numeracy rose, and the level of interpersonal violence dropped.

Another significant change in behavior, Dr. Clark argues, was an increase in people’s preference for saving over instant consumption, which he sees reflected in the steady decline in interest rates from 1200 to 1800. “Thrift, prudence, negotiation and hard work were becoming values for communities that previously had been spendthrift, impulsive, violent and leisure loving,” Dr. Clark writes....

After the Industrial Revolution, the gap in living standards between the richest and the poorest countries started to accelerate, from a wealth disparity of about 4 to 1 in 1800 to more than 50 to 1 today. Just as there is no agreed explanation for the Industrial Revolution, economists cannot account well for the divergence between rich and poor nations or they would have better remedies to offer.... [T]he middle-class values needed for productivity could have been transmitted either culturally or genetically. But in some passages, he seems to lean toward evolution as the explanation. “Through the long agrarian passage leading up to the Industrial Revolution, man was becoming biologically more adapted to the modern economic world.”...

Dr. Clark’s view is that institutions and incentives have been much the same all along and explain very little....

“He deserves kudos for assembling all this data,” said Dr. Hoffman, the Caltech historian, “but I don’t agree with his underlying argument.” The decline in English interest rates, for example, could have been caused by the state’s providing better domestic security and enforcing property rights, Dr. Hoffman said, not by a change in people’s willingness to save, as Dr. Clark asserts.... Dr. Bowles, the Santa Fe economist, said he was “not averse to the idea” that genetic transmission of capitalist values is important, but that the evidence for it was not yet there.... He also took issue with Dr. Clark’s suggestion that the unwillingness to postpone consumption, called time preference by economists, had changed in people over the centuries. “If I were as poor as the people who take out payday loans, I might also have a high time preference,” he said....

“The actual data underlying this stuff is hard to dispute,” Dr. Clark said. “When people see the logic, they say ‘I don’t necessarily believe it, but it’s hard to dismiss.’”

IMHO, in all Malthusian economies downward mobility is the rule: that's what being rich buys you--enough food to feed your children. I am much more inclined to see virtuous circles--especially longer lifespan leading to a longer planning horizon and lower interest rates--and successful institutions driving changes in attitudes and the pace of technological improvement.

But the book is brilliant.

Fear of Finance II

I wound up being quite unhappy with my "fear of finance" piece, because it completely ducked one of the most important questions: why the extraordinarily outsized pay packets of the high financiers? Why doesn't competition--which sorta works elsewhere in the economy--cause us to see greatly reduced earnings? We understand, we think, why celebrities get paid so much--a combination of increasing returns in distribution, being the genuinely best in the world, and being well-known for your well-known-ness. But why financiers?

What is it that blocks effective entry and competition, exactly?

Fear of Finance

For Project Syndicate:

We are at that turn of the intellectual cycle where the world's great and good become fearful of finance: distrustful of the rich and high-paid people who live very well indeed and work behind computer screens in the cores of the world's major cities doing... well, doing something that doesn't look like work, or productive, or useful. Each turn the fears are similar: paper-shufflers are doing better than makers, speculators are doing better than managers, traders are doing better than entrepreneurs, rootless global cosmopolites are doing better than those with their toes and ancestors in the soil, arbitrageurs are doing better than accumulators, the clever are doing better than the solid, the (financial) market is more powerful than the (regulatory, bureaucratic) state. This, the current of opinion goes, is an inversion of the normal and the natural and the just. We must cast down, as Franklin Delano Roosevelt put it, the "money changers" from their "high seats in the temple of our civilization." We must "restore the ancient truths" that growing, making, managing, and inventing things should have higher status, more honor, and greater rewards than whatever it is that financiers do.

Truth to be told, there is a lot to fear in finance. The rewards to the successful are staggeringly outsized. The punishments to the unwary are brutal. The average investor in individual stocks achieves risk-adjusted returns of the overall global stock market return--call it 6% per year in inflation-adjusted terms--minus 3%. The average investor in a managed mutual fund receives the overall return minus 2%. The average investor in an index fund receives the overall return minus 0.5%. Since the average return must be average, the informed financiers pocket the vast gaps that the poor trading strategies of the uninformed and the rash open up between their returns and the average. And it is true that nothing visible is created.

Truth be told, the scale of modern global finance is staggering: more than $4T of mergers and acquisitions this year, with tradeable and (theoretically) liquid financial assets reaching perhaps $160T by the end of this year, all in a world where annual global GDP is perhaps $50T. Martin Wolf of the Financial Times quotes the McKinsey Global Institute as estimating that world financial assets, which today are more than three times world GDP, were only equal to world GDP in 1980 (and to only two-thirds of world GDP in the aftermath of World War II). And then there are the numbers that sound very large and are hard to interpret: $300T in value of "derivative" securities; $3T of wealth managed by 12,000 global "hedge funds"; $1.2T a year committed behind the screen of "private equity."

But things are created in our modern financial system: important things, and valuable things--both positive and negative.

Consider the $4T of mergers and acquisitions this year, as companies acquire and spinoff branches and divisions in the hopes of gaining synergies or market power or better management. Those owners who sell these assets will gain roughly $800B relative to what the pre-merger speculation value of their assets had been. The owners of the companies that buy--the shareholders of the acquirers--will lose roughly $300B in market value, as markets take the acquisition as a signal that managers are exuberant and uncontrolled empire-builders rather than flinty-eyed trustees maximizing payouts to shareholders. This $300B is a tax that shareholders of growing companies think is worth paying (or perhaps cannot find a way to avoid paying) for energy in their corporate executives.

There is left a net gain of roughly $500 billion in global market value. Where does this come from? We don't know. Some of it is a destructive transfer from consumers to shareholders as corporations gain more monopoly power, some of it is an improvement in efficiency coming from better management and more appropriate scales of operations, and some of it is an overpayment by those who become irrationally exuberant when companies get their names in the news that will be taken back over time as irrational exuberance dissipates. The proportions? We don't know.

Let us, however, guess that the proportions are 1/3, 1/3, 1/3. Then several conclusions follow:

The first is that, once we look outside transfers within the financial sector, the total global effects of this chunk of finance is a gain of perhaps $340B in increased real shareholder value from higher expected future profits counterbalanced by a loss of $170B in future real wages, for households will find themselves paying higher margins to companies with more market power.

Subtract one number from the other and get a net gain of $170B of added social value in 2007: it's 0.3% of world GDP, equal to the average product of 7M of the world's workers. In one sense we should as a globe be glad that we have our M&A technicians, well-paid as they are, hard at work: it is very important that businesses with lousy managements or that are operating at inefficient scale be under pressure from those who think they could do better, and can raise the money to attempt to do do so. We certainly cannot rely on shareholder democracy as our only system of corporate control.

The second conclusion is that the gross gains--fees, trading profits, and capital gains to the winners--of perhaps $800B from this year's M&A--are greatly in excess of the perhaps $170B of net gains. Governments have a very important educational, admonitory, and regulatory role to play in this business: people should know the risks and probabilities, for they may wind up among the $630B worth of losers. So far there is little sign that they do. Third, finance has long had--since before the days of J.P. Morgan it has had--an interest in stable monopolies and oligopolies with high profit margins, while the public has an interest in competitive markets with low margins. The more skeptical you are of the ability of government-run antitrust policy to offset the monopoly power-increasing effects of M&A, the more you should seek for other sources of countervailing power--which means progressive income taxation--to offset any upward leap in income inequality.

The eighteenth-century Physiocrats thought that only the farmer was productive--that the rest were somehow cheating the farmers out of their fair share. The twentieth-century Marxists thought that only the factor worker was productive--that the traders and the organizers were somehow cheating the factory workers out of their fair share. Let us educate and regulate our financial markets so that outsiders who invest are not sheared. But let us not make the mistake of fearing finance too much.

Tyler Cowen: Underappreciated Economist E. Glen Weyl

Tyler Cowen writes:

Marginal Revolution: Underappreciated economists: a continuing series: Today I will pick E. Glen Weyl, a mere Youngling, who is studying at Princeton University.  Here is his paper on neural networks, and the abstract:

I consider a potential neural basis of overconfidence, the well-documented tendency of individuals to overestimate the precision of their predictions. I present a simple, classic connectionist model for predicting a binary variable. I show that while the network initially makes weak predictions (in the middle of the probability range) regardless of input, after observing randomly generated data it learns to be overconfident in the sense that when presented with other, unrelated random data it makes strong predictions. The model matches behavioral data in that it shows overconfidence growing with experience and then, eventually, declining. The model shows how overconfidence, far from being a surprising fallacy, can be seen as a natural outgrowth of statistical over-fitting in the brain.

Glen probably won't be underappreciated for long.  Here is his seminal paper on two-sided markets (e.g., Match.com).  There is already talk he will be a leading economist of the next generation...

Regulating Hedge Funds

A piece from last January that I wanted to remember to file:

No Consensus On Regulating Hedge Funds: By Kara Scannell, Joellen Perry, and Alistair Macdonald: European officials are pushing for more disclosure of hedge-fund portfolios or a ratings system like that for corporate debt. German officials, using their chairmanship of the Group of Eight leading nations this year, are particularly aggressive. But U.S. and British officials are taking a more hands-off approach, advocating additional study and, at least in the U.S., focusing on making sure hedge funds take money only from the wealthy and sophisticated rather than on changing hedge-fund behavior to minimize risks to the global financial system....

There is a nagging worry among many regulators and central banks that hedge funds may pose a significant risk to the global financial system and could precipitate or exacerbate a monetary crisis. They have expressed a desire for a borderless solution.... Today, hedge funds are mainly regulated indirectly through the rules governing the banks and brokerage houses that they trade with and borrow from. In the United Kingdom, hedge-fund managers are required to register with the Financial Services Authority, making them subject to random inspections and examinations....

SEC Chairman Christopher Cox testified in July that "to the maximum extent possible, our actions should be nonintrusive." Timothy Geithner, president of the New York Federal Reserve, has said that it is important to monitor hedge funds but that it isn't desirable to regulate them for now. In Continental Europe, skepticism of hedge funds is greater....

In the U.S. lawmakers have turned their attention away from how funds invest toward who is investing in the funds as a way to protect vulnerable investors. Members of Congress have said they are concerned with pension investments in hedge funds, and the SEC last month proposed a rule that would limit the number of individual investors who qualify to invest in hedge funds by raising the minimum threshold of investment acumen they must meet.

There is the "guard against hedge fund-created systematic risk" point, which is a valid one. There is also the "protect vulnerable investors" point, which seems strangely misdirected: regulating hedge funds ranks perhaps 50th on the liast of steps one ought to take to protect vulnerable investors.

Books Do Furnish a Room

Tyler Cowen on books that require extra-sharp eyes:

Marginal Revolution: Which are the books with the smallest print?: Editions of Dostoyevsky and Tolstoy often have excessively small print.  Why?  The major works by those authors are long.  Larger print will make the volumes too long and thus too expensive.  Perhaps more importantly the volumes will appear too forbidding to the average buyer. But isn't miniscule type for Raskolnikov hard to read?  Ah... most of the people who buy the book don't read it.  If miniscule type gets them to stop reading sooner rather than later, you might even call it a Pareto improvement.

Self-help books almost always have reasonably large print or even ridiculously large print.  The author doesn't have much to say and the publisher wishes to pad the book so it looks real.  Furthermore most self-help books are read (at least in part), so to keep the reader happy the print should be large.

Can you think of other generalizations?

Which books are most likely to go into "Large Print" editions?

Brainless Business Reporting by Vikas Bajaj and Carole Gould

Eric Umansky is driven into shrillness by the brainless business reporting of Vikas Bajaj and Carole Gould. Don't read the New York Times. Buy the Financial Times instead: it doesn't do things like this.

Here is Eric Umansky:

Eric Umansky: Brainless Business Reporting: It is common knowledge most actively traded mutual funds are for suckers. Over the long term, the vast majority of actively traded funds underperform the overall stock market.  The key phrase is here is "long term." Plenty of funds have a good quarter here and there, but that doesn't tell you much about the fund in the end. Yes, I know. It's all very obvious.

It's just that might want to tell the New York Times business section, which today another one of its occasional (quarterly!) sections on Mutual Funds. What does it do with all its space an accumulated wisdom? Well it focuses on those funds that have done best over....the last quarter.  And delivers hyper-unintelligent copy like profiles of the genius money managers whose funds kicked butt during the quarter.  Why do they do it? My guess is that it's just something the NYT has long done and is now on auto-pilot. Plus, it makes for easy copy. And of course even easier handy, dandy brainless graphics...

Testosterone-Crazed Devil Apes Play the Ultimatum Game!

Marginal Revolution reports:

Marginal Revolution: Testosterone economics: Remember the ultimatum game?

In this game, one player divides a pot of money between himself and another.  The other then chooses whether to accept the offer.  If he rejects it, neither player benefits.  And despite the instincts of classical economics, a stingy offer (one that is less than about a quarter of the total) is, indeed, usually rejected...

Here is the latest result:

...the responders who rejected a low final offer had an average testosterone level more than 50% higher than the average of those who accepted.  Five of the seven men with the highest testosterone levels in the study rejected a $5 ultimate offer but only one of the 19 others made the same decision...

In other words, irrationality isn't just a deviation due to imperfection, we are programmed to be spiteful.  Here is information on how high testosterone levels are correlated with urges to compete and be dominant.  Here are some other correlations; should we make a few leaps and infer that women in "sheer" clothing are more likely to be spiteful?  Should you prefer to undertake joint projects with men of slight build and women in flat shoes?  Should you deliberately seek out non-hot mates, in the realization that long-run cooperativeness is of more value than short-run hotness?

Risks in the CDO Market

Felix Salmon:

Finance Blog - Market Movers by Felix Salmon: Unpacking the Risks in the CDO Market - Portfolio.com: I think it's worth teasing out exactly what the different risks in the CDO market are...[:]

First, there's the risk that holders of subprime mortgages will default on their loans. This is a known and relatively easy to quantify risk. Subprime mortgages issued in 2005 and 2006 already have high default rates, and those rates are likely to rise even higher when the mortgages reach their second birthday and higher adjustable rates start kicking in.... [T]he key risk in the market for any mortgage-backed security is not default risk but prepayment risk, and that a high mortgage default rate, in and of itself, is not necessarily particularly worrisome from the point of view of a CDO holder.

Second, there's the risk that CDO tranches, especially the riskier equity tranches and the ones with relatively low credit ratings, will start to default.... A key problem here is one of transparency: with many CDOs investing largely in other CDOs, it's very difficult often to get a handle on what the underlying cashflows are and how likely they are to be impaired.

Third, there's the discount which investors are currently demanding in order to buy illiquid securities with precious little transparency. There's talk in the market that triple-A rated CDO tranches – which, we can reasonably assume, are very unlikely to actually default – are getting bids at 270 basis points over Treasuries, or more. That huge spread is not a credit spread; rather, it's a good old-fashioned wide bid-offer spread on extremely illiquid securities. CDOs are similar in some ways to private equity, in that they tie up money for a long period of time and hope to provide excess returns over that time. They're not designed to be instruments which can be liquidated easily or quickly. If investors start being forced to liquidate their CDOs, then the price they receive might well be much lower than the actual credit risk on those CDOs might suggest.

Fourth, there's what used to be called rollover risk. If investors start liquidating their CDOs, that means there's going to be a pretty large supply of cheap CDOs on the secondary market. In turn that means that there's going to be much less demand for expensive CDOs on the primary market.... This is the credit crunch that many people are so worried about.... These four risks form a nice little circle.... But while all the risks are real, the linkages between them all are far from clear, and the different risks don't necessarily cascade onto and exacerbate each other in this way. They might – or they might not. If investors turn out to have reasonably strong stomachs, they might not want to liquidate at prices well below their entry points. And CDOs themselves, even the ones based on subprime mortgages, might not default nearly as much as homeowners. And without the passthrough mechanism of risks two and three, the vicious cycle loses a lot of its teeth.

So there is cause for concern, to be sure. But there isn't cause for panic.

CDOs: Mark-to-Model and Donner-Party Economics

Saskia Scholtes and Gillian Tett of FT on mark-to-model:

Saskia Scholtes and Gillian Tett of FT: As head of the financial stability unit at the Banque de France, Imène Rahmouni-Rousseau travelled to America this month to look at the current turmoil in the US subprime mortgage world. Although initially that had seemed an all-American saga, Ms Rahmouni suspected that French and other European investors also held assets linked to subprime securities. So on behalf of her central bank she wanted to assess the risks. What she discovered surprised her. There was little confidence about how to value the holdings. “Pricing data are difficult to obtain,” she says. It is a discovery being shared by numerous other policymakers and investors around the world as the fallout widens from a subprime lending boom, in which US banks provided vast amounts in home loans to financially stretched borrowers who put little money down and gave no proof of income. Among the casualties have been two hedge funds run by Bear Stearns, the Wall Street investment bank.

Until recently, when late payments and defaults on these mortgages spiked higher, the problem drew little attention. This was because, through the magic of so-called structured finance, risky assets such as subprime mortgages could be packaged into attractive investment products. These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years – thus providing the liquidity that was then channelled into mortgage loans.

But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe – not just in the mortgage sector but in the way many sorts of company fund themselves. This is because unlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading.

Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use – and thus what value is attached to their assets.

So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.

In the event, Bear Stearns’ creditors sold only a fraction of the assets put up for auction. Market participants suggest that this was in part because bids fell far below expectations, with traders increasingly reluctant to take on CDOs tainted with subprime exposure. But the crisis at Bear’s funds has left investors, brokers and regulators asking an uncomfortable question: can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses? “Investors are slightly more cautious, becoming more picky and asking more questions,” says Michael Ridley, co-head of high-grade debt capital markets at JPMorgan. “They want us to lift the lid off the box a bit more.”

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche.What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans and other debts into ever more complex structures. Last year alone, about $1,000bn (£500bn, €745bn) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds – making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor.

Since such instruments typically last three to five years – and the CDO boom is so recent – many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: “The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate.”

To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary – not least because dealer banks may hold positions in these instruments themselves.

“It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that,” says one banker who advises hedge funds. “Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture.”

Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market.

Christian Stracke, analyst at CreditSights, a research company, says: “With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess.“ Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave – as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the “unusually high probability” of events that “could have large effects on market values”.

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen’s Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used – which had been supplemented with brokers’ quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex. Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits – even when markets fall.

But Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. “The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market – I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the subprime world but the corporate world too.”

Adil Abdulali, a risk manager at Protégé Partners, a fund of funds, recently studied the performance of hedge funds and discovered clear statistical indications that they tend to stage-manage their earnings [known in the industry as “smoothing” them] when they trade illiquid instruments. “Conservatively, 30 per cent of funds trading illiquid securities smooth their returns,” says Mr Abdulali.

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough – and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. “We are getting a lot of calls from worried people,” says one third-party data provider.

However, history also shows that large-scale structural dislocations – such as a serious mispricing of assets – are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.

“If every CDO [manager] was forced to mark to market their subprime holdings, it would be – well, I can’t think of a strong enough word to describe what it would be,” confesses a US policymaker.

These assets do have finite lifetimes. Unless nominal asset values crash over the next five years, CMOs and CDOs held for the next five years until maturity will pay off at or close to their model value. Only those with faulty capital structures who are thus illiquid today are in trouble, and they aren't in big trouble unless the numbers of those willing, rich, liquid enough to take on the risk of holding more CDOs and CMOs and with the analytical capability to price them are small.

As long as underlying asset values don't collapse, this is a redistribution: those hedge and other funds leveraged and without liquidity lose big, and those hedge and other funds that are liquid gain big. The caravan moves on, and the returns of those who make it down the California side of Donner Pass look very impressive, with the flesh-stripped bones of the illiquid and their investors scattered near Donner Lake for future archeologists to examine.

Richard Thaler: Slippery Slope Arguments Should Be Avoided Unless There Is Proof that the Slope Is Greased

Via Pinky and the Brain: Richard Thaler:

Pinky and the Brain: Richard Thaler: Libertarian Paternalism: Let's recapitulate. People make mistakes, so sometimes they can be helped. It is possible to help without coercion. That is libertarian paternalism. The concept can be and is used in both the public and private sectors. For example, in London, pedestrians from abroad are reminded by signs on the pavement to "look right" because their instincts from back home are to expect traffic to approach from the left. No one is forced to look right, but fewer pedestrians are hit by trucks.

Another example comes from Sweden, which launched a partial privatization of their social security system in 2000. The plan was open to any fund, which meant that participants faced 456 options. There was also a very well-designed default fund -- using private managers selected by the government -- that offered global diversification at very low fees (16 basis points). By any standard, both ex ante and ex post, the participants who selected their own portfolio of funds did worse than those who took the default plan. The main mistake the government made in designing this plan was to discourage participants from choosing the default fund, perhaps thinking, as Mario does, that choosing for oneself is always the best approach.

Mario thinks we are naïve about government. We think he is naïve about firms. Does he think that the companies that offered stock options to student loan officers to induce them to feature their loans had the "actual preferences" of the students at heart? Maximizing profits does not always mean maximizing the welfare of the customers.

Finally Mario seems to have a phobia about slippery slopes. I guess he thinks that if governments start with signs that say "look right," the next thing you know we will have Prohibition coming back. By the same logic, we should worry that if libertarians succeed in eliminating rent control that we will be soon down the slippery slope toward anarchy. Slippery slope arguments should be avoided unless there is proof that the slope is greased. In our case, by insisting, as we do, on only libertarian paternalism, the slope runs into a brick wall before it even gets started. And besides, what is the alternative? Inept neglect?

Marginal Revolution: Hedge Funds

Tyler Cowen writes:

Marginal Revolution: Hedge funds: I've found at least one good piece on them, by Rene Stulz, in the Spring 2007 Journal of Economic Perspectives.  I learned or reaffirmed the following:

1. Hedge funds have existed since at least 1949.
2. Hedge funds exist because mutual funds do not deliver "complex investment strategies."  In part this is because mutual funds are regulated.
3. The largest mutual fund is about six times larger than the largest hedge fund.  Marketing constraints also encourage very large funds to adopt simpler and easier-to-explain strategies.
4. Investment advisors with fewer than 15 clients do not have to register with the SEC.
5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty).  That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance.  This is not obviously efficient, and of course hedge funds pay for performance.
6. Hedge funds don't have to disclose information to investors, other than by contractual agreement.
7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.
8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.
9. Available data on hedge fund returns are nearly worthless.

Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations.  Deregulating some aspects of mutual funds may be an alternative to regulation of hedge funds...

Ezra Klein Eats Barbecue on Memorial Day

First, however, he opines about the behavioral psychology of health care:

Ezra Klein: Preventive Care vs. Health Care?: Don't get me wrong, I'm fully for both preventive health measures and better public health policy. But I wouldn't get too excited over the insight that stripping lead paint from walls is a more efficient way to improve health outcomes than restructuring health care delivery.... Mark Kleiman, for instance, writes that "[a]ir quality improvement, noise reduction, better parenting... and changes in the social forces influencing diet and exercise all probably have greater bang for the buck." Than what? Probably not than encouraging the use of statins, or hypertensive drugs, or daily tablets of aspirin. There are a lot of highly effective medical interventions which are very, very cheap. But our system is very poor at incentivizing their use.

Meanwhile, the reason doctors are constantly prescribing statins along with admonitions to exercise and eat better is because using public policy to change diet and exercise habits is really, really, really hard, unless you're prepared to be very heavy-handed (i.e, outlawing trans fats in restaurants, setting portion limits, etc). Indeed, part of the problem with preventive health measures is that, rather often, they don't work very well. Like with traditional health care, some things really succeed (stripping lead out of gasoline, giving people antibiotics), and lots of things... don't. And that's to sidestep the weird reality that what drives health care politics is concern over money which, in fact, is quite rational: Folks don't want to go bankrupt, and smart politicians don't want the government to lose all space for spending on other priorities.

In any case, there is no tension between better preventive health measures and health reform -- a more integrated system would encourage preventive health, and every bill you know of that moves us towards universal health care actually has a massive amount of money, incentives, and policies going towards preventive care -- it's something everyone agrees on. But you're never going to get a focus on preventive care in the way you do on acute care: The politics of health care are about financial and medical peace of mind at the point of absolute need. They're not necessarily rational. If they were, we'd already be running laps and eating 5-11 servings of fruits and veggies, the benefits of which are fully available to us now, and which fully rational, forward-thinking beings would be going to great lengths to take advantage of. Sadly, anyone who's ever been offered decent barbecue knows how rational we are. Damn you, Capps...

Let me go run more laps--if my quadriceps will take it after this morning's climb out of the bowl of Lafayette Reservoir--and eat more vegetables...

Mathing Up "Why Bubbles Are Great for the Economy" (It Has Been Done Before Department)

Hoisted from Comments: Robert Waldmann asks, apropos of Daniel Gross's book Pop!: Why Bubbles Are Great for the Economy:

Grasping Reality with Both Hands: Brad DeLong's Semi-Daily Journal: A Review of Daniel Gross's Book "Pop": Yes, but do you know an academic economist who has formalized this argument [that bubbles are good for the economy by] writing a [formal] model in which irrationality is necessary for growth? It would not be hard. And have you asked yourself "If not me, who? If not now, when?" Posted by: Robert Waldmann | May 13, 2007 at 11:55 PM.

It was done two decades ago, Robert: a model in which the introduction of investors subject to irrational exuberance and panic can either raise or lower the economy's productive capital stock and hence enhance or diminish the economic welfare of others in the economy. The model doesn't have all the channels that Gross discusses, but it has some of them--and enough to make the point.

Unfortunately, the authors were chasing the case in which bubbles and panics were socially harmful--not the case when bubbles are beneficial to the rest of society. But that case is there in the model, if the parameter ρ^∗ is big enough and the shock variance ratio (σ_η²)/(σ_ε²) is small enough.

Here's an excerpt from the core of the argument:

Size and Incidence: There are two reasons why the capital stock [in the absence of bubbles and panics] is different.... If... misperceptions... are on average bullish [i.e., prone to bubbles, investors]... on average demand [more stock].... [I]f noise traders are on average bearish [i.e., prone to panics], the equilibrium capital stock is lower.... [I]nvestors’ demands [also] depend on the risk borne.... The θ²σ_η² term in the denominator of [equation] (15) captures the reduction in the [economy's] capital stock that arises from aversion to noise trader-generated price risk.... The second term dominates, and the capital stock is lower in the presence of noise traders, if:

(17) ρ^∗/(δ -r) < (θ/((1+r)²))((σ_η²)/(σ_ε²))

For ρ^∗≤0 [i.e., a market at least as prone to panics as bubbles], it is always the case that the presence of noise traders reduces the capital stock.

Even if ρ^∗ is positive, only if both the noise trader wealth share θ is small and if noise traders’ opinions are not volatile relative to dividend risk (that is, ((σ_η²)/(σ_ε²)) relatively small) is the ratio of productive capital to wealth increased because of noise traders.

A lower capital stock implies a lower average level of consumption. Since capital gains and losses on stockholdings simply redistribute wealth from one generation to another, the average level of consumption of a generation is simply:

(18) (1+r)W + K^∗(δ-r)

which is an increasing function of the capital stock.

The reference?

J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1989), "The Size and Incidence of Losses from Noise Trading," Journal of Finance 44: 3 (July), pp. 681-696 http://www.j-bradford-delong.net/pdf_files/Noise_Traders_Incidence.pdf.

---

Note: Robert's comment--that the source of utility gains to the sophisticated in DSSW (1990) is different from the source in Gross (2007)--is completely correct. Gross argues that volatility of opinions is good. DSSW argue implicitly that irrational exuberance can be good when such exuberance is not very volatile.

A Review of Daniel Gross's Book "Pop"

By Gillian Tett:

FT.com / Arts & weekend / Books - A heresy wise investors might embrace: Almost nothing makes financial journalists salivate as much as the world “bubble”. After all, in recent years it has been considered self evident that bubbles are a bad thing for society, particularly when they burst.... But could it be that the cassandras have it all wrong and that bubbles are actually a blessing, not a curse? This is the heretical idea advanced in a provocative book, Pop! Why Bubbles are Great for the Economy, which sketches out a history of the bubbles that have swept through America over the past 150 years. The author, Daniel Gross, is a columnist who has written for a range of publications, including most recently Slate, the internet magazine which itself emerged from the 1990s dotcom bubble. It is a pedigree which gives Gross a good perspective on the follies of the 1990s.

However, he advances his thesis by also exploring episodes which may be less familiar to modern investors, such as the telegraph investment bubble of the 1840s and 1850s and the railway frenzy of the 1880s and 1890s. He also covers the housing bubble that is bursting right now in the US – and a sector he considers the next candidate for investment excess, the alternative energy world.... Gross believes that America is prone to investment bubbles partly because its government tends to have a laisser faire attitude to innovation, preferring to let private investors fund new technologies, rather than the state. Thus “in every generation, people arise to proclaim that a new technology or set of economic assumptions and financial tools promises untold riches,” Gross writes....

[T]he interesting thing, Gross argues, is what happens after the bubble bursts.. a second round of entrepreneurs usually arrives who can create something valuable out of this excess infrastructure.... Today’s ruined infrastructure, in other words, can be the building blocks of tomorrow’s innovation. This infrastructure should not be viewed purely in physical terms. What is perhaps most beneficial about a bubble, Gross argues, is that mass mania changes the way society views the world: mad fashions or wild enthusiasms can be creative. Just look at how society has become internet-savvy in less than a decade. Or how quickly the world is now converting to the alternative energy cause as investors jump on to this bandwagon. While this investment trend will probably also end in tears, it could also produce a cleaner world – even after the “green” bubble bursts.

All this is scant comfort for anybody who lost money on internet stocks – let alone those facing foreclosure on a subprime mortgage. Gross does have the grace to acknowledge how callous his argument sounds, given that burst bubbles can unleash great suffering...

Hal Varian Says: Buy and Hold

He writes:

Sometimes the Stock Does Better Than the Investor That Buys the Stock - New York Times: There’s an old adage on Wall Street: “Buy on the rumor, sell on the news.” Unfortunately, small investors do not seem to follow this rule. Terrance Odean, a finance professor at the University of California, Berkeley, has found that small individual investors tend to buy stocks when they are mentioned in the media: they buy on the news. The professional and institutional investors are happy to sell to retail investors in such periods.

A recent article in The Financial Analysts Journal by Thomas Arnold, John H. Earl Jr. and David S. North, all finance professors at the University of Richmond, called “Are Cover Stories Effective Contrarian Indicators?” offers an intriguing finding. The professors look at how a company’s stock responds to a cover story in BusinessWeek, Fortune and Forbes. They find that positive stories follow periods of positive performance and negative stories follow periods of negative performance, which admittedly is not too surprising. More interesting, they also find that the appearance of a cover story tends to signal the end of the abnormal performance.

Hence, individuals who trade on such “news” are not likely to do well.

This is not to say that articles in the financial press are not worth reading. Quite the contrary. They often provide insightful reporting and in-depth analysis. But by the time the articles have been researched, written and published, they are no longer news — the market price of the stock already reflects the company’s future prospects.

Taken together, this research offers yet more support for the time-tested investment strategy of buy and hold. Anything that you think is news is old hat to the professionals. Trying to outguess the market is a sucker’s game.

An Attack on Jeremy Siegel...

Hussman is unhappy with Jeremy Siegel:

Hussman Funds - Weekly Market Comment: April 30, 2007 - Double Counting: In a little piece of hubris published in the Financial Times by Jeremy Siegel (who is increasingly becoming a modern-day Irving Fisher), investors were told:

Since the long-term real growth of per share earnings is also only about 2 per cent, pessimists project real returns of only 4 per cent in the stock market, well below the 6.5 to 7 per cent average real returns that the historical data have indicated.

Real returns can be estimated from the earnings yield, the reciprocal of the more popular price-earnings ratio. Since stock earnings are based on real assets, the earnings yield provides a good estimate of the real return on the stock market.

In the US , the long-term average p/e ratio has been 14.4 times, which corresponds to a 6.9 per cent earnings yield. This is extremely close to the historical average real return on equities. 2007 estimates for earnings on the S&P 500 Index range from $87 to $91 per share. With the index at 1,450, this leads to a current p/e ratio of between 15.5 and 16.5 times and a corresponding earnings yield – and hence real return – of 6.0 to 6.5 per cent on S&P 500 stocks. Even though current returns on stocks look good, future stock returns may even be higher....

[W]hy does Siegel say that the earnings yield is an estimate of the real return on stocks? Think of it this way. Reported earnings subtract out depreciation, which is another way of saying that earnings are reported as if the company reinvests only enough to replace depreciation and keep its stock of productive assets constant over time. If the company were not to invest anything for growth, it would theoretically be able to pay out all of its net earnings as dividends. If earnings on the fixed stock of capital could grow at the inflation rate by virtue of monetary factors alone, you would get zero real earnings growth. Then holding valuations constant over time, the earnings yield would be a measure of the real return on stocks. Fine if you believe the assumptions. Now let's look at the data.

The first problem is that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth. That's a tip-off that historically, competitive pressures have prevented earnings from simply growing at the rate of inflation without new investment. You had to invest new money to get your earnings growth up to the inflation rate. In general, once your return on invested capital falls to the point where you're willing to buy your own stock instead of making new investments, the simple earnings yield overstates probable long-term real returns (especially if the yield is based on record earnings). In fact, about 1% of the long-term real return on stocks has come from an increase in the overall level of valuation in recent decades. Absent that increase in valuations, the real return on stocks would actually have been at least 1% less than the average long-term earnings yield.

Next, the historical average p/e Siegel cites is based on trailing net earnings, not forward operating earnings. Also, current earnings figures reflect unusually wide profit margins. On the basis of trailing net earnings even modestly normalized for profit margins, the relevant p/e for the S&P 500 is currently above 20, and actually closer to 25. That puts the applicable, normalized earnings yield at about 4-5% here. Give that a 1% haircut as explained in the foregoing paragraph, and assuming that p/e valuations don't contract in the future, you could expect a long-term real return of 3-4% from stocks going forward. Add in inflation of 2-3% and the long-term nominal total return priced into stocks here (say, on a 20-30 year horizon) is probably somewhere between 5-7% annually.

Over a shorter horizon, say 5-7 years, the likely real and nominal returns on stocks will probably be lower. At GMO, Jeremy Grantham estimates (and my work largely agrees) that the real return on stocks over the coming 7 years should be about -2% annually (about zero in nominal terms). GMO calculates its estimates for a wide variety of asset classes, including bonds, foreign stocks, and so forth. Grantham noted last week that “We now show – drum roll – the first negative sloping return/risk line we have ever seen. The process of moving all asset prices to fair value over 7 years (which is how we do our 7-year forecasts) will have resulted in a world where investors are paying to take risk!”

If investors believe that stocks should be priced to deliver long-term returns of 5-7% annually, then yes, stocks might be fairly priced here.

Even optimistic assumptions and alternative models produce only modest changes to long-term expected returns. For example, optimists might take the current earnings yield of 5.5% (a trailing price/peak earnings multiple of over 18) as sustainable, assume that profit margins will never come down, assume all earnings can be paid out as dividends, and assume earnings will achieve nominal 2% growth anyway due to inflation alone. In that case, stocks would be priced to deliver a 7.5% long-term annual return. Alternatively, optimists can assume that earnings will continue to grow along the peak of their historical 6% peak-to-peak earnings channel (a point from which earnings have always been vulnerable to long periods of tepid growth), and that valuations and profit margins will remain permanently elevated. Adding in a further 1.8% dividend yield, they might even estimate stocks to be priced for a 7.8% annual return.

It's very difficult, however, for a reasonable analysis to project long-term returns on stocks much higher than about 7.8% over a 20-30 year horizon. Again, 5-7% is more likely in my estimation, with nominal total returns on stocks close to zero over the coming 5-7 years.

The criticisms appear to be three:

• Accounting earnings overstate true Haig-Simons earnings needed to maintain real profitability by about 1% of market value.
• We want not earnings but earnings adjusted for the business cycle, which would give another 1% of market value haircut to earnings.
• We want price-to-trailing-earnings, not price-to-current earnings, which would give an additional haircut of 0.1% of market value to earnings.

Add up these three criticisms, and you get an adjusted earnings yield of not 6.3% but 4.2% as the long-run real return to equities.

I tend to split the difference, sitting at 5.3%, and sharing Hussman's great anxiety about the medium-term. Of course, if the medium-term turns south one way it might turn south is with substantial inflation, so bonds are not an attractive hedge. Real estate is also not an attractive hedge. A combination of European and emerging market equities looks to be the best thing you are going to get.

Dan Gross Has a Book Coming Out

Those who invest in a bubble at its peak are great public benefactors. They give away all their money, and we get the organizations, the producers' durable equipment, the inventions and innovations, and the structures that their money paid for. On top of that the rest of us build the economic growth of the post-bubble generation.

But there are no testimonials or plaques to these great philanthropists--the investors in Insull's utility empire in 1929 or in Cisco in late 1999. They are unknown to the rest of us.

Daniel Gross (2007), Pop: Why Bubbles Are Great for the Economy (New York: Collins: 0061151548) http://www.amazon.com/exec/obidos/asin/0061151548/braddelong00

Hedge Funds: Two-and-Twenty

The list of top ten hedge-fund earners for 2006 includes three people who I guess to be turnaround specialists and "industrial statesmen"--management entrepreneurs building or fixing organizations a la Andy Carnegie or Johnny Rockefeller or Charlie Coster of a century ago--Icahn of Icahn, Lampert of Sears, and Tepper of Appaloosa. It includes three people who I guess to be primarily wholesale bankers--Griffin of Citadel, Jones of Tudor, and Kovner of Caxton--making money through financial intermediation: taking on relatively long-term or securitized risk and hoping to God their information about the true value of those risks is better than the market's and that they are properly diversified. It includes two people who I guess to be primarily speculators--one high-tech and quantitative, Simons, and one lower-tech and judgment-based, Soros. And it includes two people--Cohen of SAC and Barakett of Atticus--about whom I am basically clueless about what they are doing.

Their high fees may be best conceptualized as a gap between book and market value: if they were publicly-traded corporations, you would have to buy into the stock of their organizations at a premium to book value. The hedge fund form, however, allows you to buy in at book value--minus fees. And the premium between book and market is then captured not (as it is in a public corporation) by all the previous equity investors, but just by the first initial tier.

Why this particular hedge-fund form of organization has risen to the top of the barrel right now is an interesting question. But it is clear that at the top we have people and organizations either with real skills and real edges operating at the financial economy's pressure points and adding mammoth long-run organizational and intermediational value--or people taking on huge adverse tail risks in hard-to-assess ways who have so far been lucky. It's hard to tell the difference.

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

Suddenly, Hedge Fund Fees Seem High: Steve Rosenbush: The top-performing hedge funds and private equity firms have generated annual returns in excess of 50% during the last few years.... Now some institutional investors have started to complain, noting that the average hedge fund failed to keep pace with the market in 2006.... CalPERS Chief Investment Officer Russell Read said many hedge funds charge too much without delivering high enough returns or low enough risk. "We have no problem paying high-performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," Read told attendees at the Geneva conference.... A hedge fund typically charges investors a management fee of 1.5% to 2%, and takes 15% to 20% of profits the fund generates. An index fund's management fee, by contrast, is typically just hundredths of 1%. The prominent Vanguard 500 Index Fund (VFINX) has an expense ratio of just 0.18%, for example....

[I]n 2006... CalPERS... $4.3 billion in hedge fund investments generated a return of 13.4% for the year. That was slightly ahead of the average hedge fund return of 13%, but just below the 13.6% return the Standard & Poor's 500-stock index generated in 2006....

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

Investment banks such as Goldman Sachs (GS), Merrill Lynch (MER), and Morgan Stanley (MS) have introduced lower-priced investment vehicles that may compete for some hedge fund business. Goldman, for example, introduced a product in Europe last fall called the Absolute Return Tracker... "expected to display returns over time that resemble some of the patterns of hedge funds as a broad asset class."... [S]ome private equity shops are trimming fees as a response to the sheer size of many new funds. The Blackstone Group, which is in the process of issuing about $4 billion worth of stock in its management company to the public, charges a management fee closer to 1%, industry experts say...

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.

Simons, Griffin, Lampert, Soros, Cohen, Kovner

Two-and-twenty: two percent of assets under management, plus twenty percent of the (nominal) return on assets. That is said to be the typical fee charged to a hedge-fund investors. In an environment of 3% annual inflation and a 5% annual net real S&P index fund return, a hedge fund team has to deliver an average gross nominal return of 12% per year without taking on more systematic risk than the S&P in order to offer its investors a good deal. This is very hard to do.

Nevertheless, some people are doing it, and doing it repeatedly--or are doing it now, as long as they don't hit the tails of their portfolios' return distributions:

Top Hedge Fund Managers Earn Over $240 Million - New York Times: By JENNY ANDERSON and JULIE CRESWELL: James Simons, a 69-year-old publicity shy former math professor, uses complex computer-driven mathematical models to make bets on stocks, bonds and commodities, among other things. His earnings last year were $1.7 billion. As one of the leading hedge fund managers, Mr. Simons makes a sum that dwarfs that of the top chiefs on Wall Street. The highest paid on the Street, Lloyd C. Blankfein of Goldman Sachs, earned $54.3 million in salary, cash, restricted stock and stock options last year. (Unlike the total for Mr. Simons, Mr. Blankfein’s reported compensation does not include gains on investments.) And Mr. Simons, the founder of Renaissance Technologies, is not the only member of the billion-dollars-a-year club.

Two other hedge fund managers, Kenneth C. Griffin and Edward S. Lampert, each took home more than $1 billion last year, with George Soros missing the hurdle by a hair, give or take $50 million, according to an annual ranking of the top 25 hedge fund earners by Institutional Investor’s Alpha magazine, which comes out today. The rewards for managing hedge funds — lightly regulated private investment pools for institutions like endowments and wealthy individuals — have been lucrative for some time. Yet the survey also shows that for the hedge fund elite, the rich are getting much richer in a hurry. To make Alpha’s list, a manager needed to earn at least $240 million last year, nearly double the amount in 2005. That is up from a minimum of $30 million in 2001 and 2002. Combined, the top 25 hedge fund managers last year earned $14 billion — enough to pay New York City’s 80,000 public school teachers for nearly three years.

With the modern gilded age in full swing, hedge fund managers and their private equity counterparts are comfortably seated atop one of the most astounding piles of wealth in American history. Their ascendancy has been aided by an inflow of money from pension funds and other big investors, robust markets and fee-based compensation that can produce staggering amounts of individual wealth. Naturally, some look upon these masters of the new universe as this generation’s robber barons, using wealth to create wealth, often in secretive ways, and leaving little that is tangible in their wake. Others view them as new-economy financiers, evoking the likes of John D. Rockefeller or John Pierpont Morgan as they provide liquidity to the markets and broadly diversify risks in the banking and financial systems.

“You had railroads in the 19th century, which led to the opening up of the steel industry and huge fortunes being made,” said Stephen Brown, a professor at the Stern School of Business of New York University. “Now we’re seeing changes in financial technology leading to new fortunes being made and new dynasties created.” But as hedge funds and their private equity brethren begin to emerge more onto the public stage — playing increasingly bigger roles in art and cultural circles, tiptoeing into the Washington lobbying game, and even selling shares of their own firms to the public — all aspects of their activities, their own compensation in particular, are raising eyebrows.

“There is some question as to what the hell they are doing that is worth” that kind of money, said J. Bradford DeLong, an economist at the University of California, Berkeley. “The answer is damned mysterious.”...

While the debate rages, the new financiers are building up piles of money not seen since the heady days of the Internet boom. But unlike the wealth of many dot-com billionaires, who saw their fortunes collapse with the technology bubble, the gains of hedge funds are not simply returns on paper that fluctuate with the direction of the stock market. Instead the gains are huge cash payouts that most managers then reinvest in their funds, betting that they will continue to beat the markets. Still, the performance of these managers is as varied as their strategies, ranging from complex computer models to the more old-fashioned version of betting the farm on a few stocks. None of the managers contacted for this article returned calls or would comment....

Raymond T. Dalio, head of Bridgewater Associates, which has more than $30 billion in hedge fund assets, for example, took home $350 million last year even though his flagship Pure Alpha Strategy fund posted a net return of just 3.4 percent for the second consecutive year....

Mr. Simons, a former code breaker for the Defense Department, uses computer-driven models to detect pricing anomalies in stocks, commodities, futures and options. Even though he has some of the highest fees in the business — 5 percent of assets under management and 44 percent of profits — he trounces most of his competitors year after year. In 2006, the $6 billion Medallion fund posted gross returns of 84 percent; 44 percent after fees, explaining his $1.7 billion take. Some investors do not blink at paying those startling fees. “If you pay peanuts, you get monkeys,” said Jim Dunn, a managing director with Wilshire Associates, an investment advisory firm. “We don’t concern ourselves with fees. If you can provide Alpha, I’m less concerned about what you bring home.”...

[T]he hedge fund age illustrates that experience indeed pays. The average age of Alpha’s top 25 was 51, with only four thirty-somethings on the list. Among them is John Arnold, the 32-year-old from Centaurus Advisors who amassed net gains of 200 percent last year. Mr. Arnold hails from Enron’s energy desk, where he received a lifetime of trading and other experiences. His $3 billion fund, among the largest energy funds in the world, racked up huge gains by taking the other side of a natural gas bet that caused Amaranth to lose more than $6 billion in a week. But older, more familiar names dominate Alpha’s list. Boone Pickens, the 78-year-old oil tycoon, made $340 million on the back of strong returns at his energy funds and Carl C. Icahn, 71, the reborn activist investor, made $600 million...

Oh. Justin Fox Has a Book Coming Out...

Justin Fox wrote, long ago:

Is The Market Rational? No, say the experts. But neither are you--so don't go thinking you can outsmart it. - December 9, 2002: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name "efficient markets."

"In an efficient market," wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, "prices 'fully reflect' available information." That is, in an efficient market you can't beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama's teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

Over the next few pages we're going to take you on a journey through the academic battles that have brought us to this point.... The message that the behavioral finance guys have for investors is that yes, you can beat the market, but--for reasons that are essential to the whole behavioralist case--you almost certainly won't. As a result, they end up offering much of the same investment advice that the efficient markets folks do. Only this time we might actually listen....

[L]et us document the behavioralists' triumph. Half of this year's economics Nobel went to their patron saint, Princeton psychologist Daniel Kahneman (the other half went to Vernon Smith of George Mason, whose economic experiments have also shot holes in efficient-markets dogma). Then there's the John Bates Clark Medal, awarded by the American Economic Association every two years to the most important U.S. economist under 40: The 1999 and 2001 editions both went to behavioralists. On the pop-culture front, Yale efficient-markets skeptic Robert Shiller's 2000 bestseller Irrational Exuberance was the most talked-about book by an economist in years.

The most dramatic development of all, though, may be that the office directly below Fama's at Chicago's Graduate School of Business now belongs to behavioralist pioneer Richard Thaler, 57. A magazine profile last year characterized Thaler, to the undying amusement of his students, as "thick-set," but that's not quite fair. He is not the jock that his upstairs neighbor is--Fama beats him at tennis. But Thaler, who arrived in Chicago in 1995 after years in the relative academic wilderness of Cornell University, appears to have eclipsed Fama as the most influential faculty member at the business school that has had more influence on the study of finance than any other....

Thaler, who was working on a Ph.D. in economics at Rochester in the early 1970s. His dissertation was an attempt to put a value on human life.... Thaler decided to ask a few friends how much they'd be willing to pay to eliminate a one-in-1,000 chance of immediate death and how much they would have to be paid to willingly accept an extra one-in-1,000 chance of immediate death. What he found was that they wouldn't pay much for the extra margin of safety but demanded huge sums to accept added risk--which isn't, strictly speaking, rational. "I came to two conclusions about these answers," Thaler wrote years later. "(1) I had better get back to running regressions if I want to graduate, and (2) the disparity between buying and selling prices was very interesting."... to be a newly minted psychology Ph.D., who sent Thaler a copy of a 1974 article by Israeli psychology professors Amos Tversky and Daniel Kahneman... argued that in making decisions involving probability and risk, people rely on mental shortcuts that "are highly economical and usually effective but ... lead to systematic and predictable errors."

It was that last part that was so significant. That people make judgment errors wasn't news, but if those errors were "systematic and predictable," well, that was something an equation-wielding economist could get up and run with..... The efficient-markets guys, meanwhile, not only had come to occupy the academic mainstream but also had moved in on Wall Street. Not surprisingly, their initial relations with the Street had been hostile. What the professors were saying, after all, was that highly paid fund managers and analysts were not worth a dime. Some of the professors clearly reveled in that: In one famous mid-1960s exchange, a money manager asked MIT's Paul Cootner, "If you're so smart, why aren't you rich?" To which Cootner replied, "If you're so rich, why aren't you smart?"

The answer to that second question was that people on Wall Street didn't have to be smart to get rich, since they could make money off fees and brokerage commissions even when their market calls stank. But the devastating bear market of the 1970s caused some investors to question whether the people with whom they'd entrusted their money really were worth the expense. One logical result of such thinking was the index fund, which instead of trying to outsmart the market simply tried to imitate it while charging much lower fees than actively managed funds do. The first index fund for institutional investors was started in 1971 by Wells Fargo Investment Advisors (now Barclays Global Investors) in San Francisco. The first such fund for retail investors--the Vanguard Index Trust--was launched five years later....

[W]hile Sharpe believes in efficient markets, he has also spent much of his career helping investors make choices. That, it turns out, makes him a big fan of behavioral finance. "As a practical matter, I still think it's prudent to assume that the market is pretty close to efficient in terms of pricing and risk and return and all that," Sharpe says. "On the other hand, we've certainly learned from cognitive psychology that ordinary human beings need to have alternatives framed in ways that can help them make right decisions rather than wrong decisions."

Most of the wrong decisions investors make, behavioral research has shown, stem from overconfidence.... As a result, much of what the behavioralists have to offer in terms of advice has to do with protecting retail investors from themselves.... Daniel Kahneman, when asked by a CNBC anchorman the day after his Nobel was announced in October what investment tips he had for viewers, responded, "Buy and hold."...

[T]he real-world phenomenon that cemented the behavioralists' victory also illustrates why, when it comes to actual investing advice, they sound so much like Fama and Sharpe. That real-world phenomenon was the stock market bubble of the late 1990s. According to strict efficient-markets thinking, there must be a rational explanation for what happened. Fama describes those sky-high Internet stock valuations as a risky but not crazy bet that one or two of those money-losing Net companies would end up as big as Microsoft. But he's almost all alone on this one. "We have just lived through the biggest bubble of all time," says Malkiel, who now calls himself a "random walker with a crutch." Fama's favorite collaborator, Dartmouth's French, is on the verge of using the b-word as well when he stops himself. "I work very closely with Gene," he says. "He would be very upset if I used that word in print."...

The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile.... But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market's inefficiency to spend their careers trying to beat it....

[T]he argument of modern behavioralists includes a crucial observation that wasn't in Keynes--that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market. If they do, as was the case with a lot of value-oriented mutual funds in the late 1990s, they can soon find themselves without any customers' money to invest. That gets us to a world in which an investor with enough staying power and contrarian gumption can beat the market, but the vast majority of mutual funds and hedge funds don't. In other words, the behavioralists have reconciled the success of a Warren Buffett (which efficient-markets purists have absurdly termed dumb luck) with the overwhelmingly empirical evidence that most professional money managers fail to beat the market.

This is, we posit, a major intellectual accomplishment. What does it mean for you? That's easy: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible.

Justin Fox (forthcoming), The Myth of the Rational Investor: Wall Street's Impossible Quest for Predictable Markets (New York: Collins: 0060598999) http://www.amazon.com/exec/obidos/asin/0060598999/braddelong00

A Question I Have Never Asked Nick Barberis

In his 2000 Journal of Finance paper, "Investing for the Long Run when Returns Are Predictable" http://badger.som.yale.edu/faculty/ncb25/alloc_jnl.pdf, Nick Barberis wrote:

In the buy-and-hold case, we find that predictability in asset returns leads to strong horizon effects: an investor with a horizon of 10 years allocates significantly more to stocks than someone with a one-year horizon. The reason is that time-variation in expected returns such as that in equation (1) induces mean-reversion in returns, lowering the variance of cumulative returns over long hor izons. This makes stocks appear less risky to long-horizon investors and leads them to allocate more to equities than would investors with shor ter horizons.

We also find strong horizon effects when we solve the dynamic problem faced by an investor who rebalances optimally at regular intervals. However, the results here are of a different nature. Investors again hold substantially more in equities at longer horizons, but only when they are more risk-averse than log utility investors. The extra stock holdings of long-horizon investors are “hedging demands” in the sense of Merton (1973). Under the specification g iven in equation (1), the available investment opportunities change over time as the dividend yield changes: When the yield falls, expected returns fall. Merton shows that investors may want to hedge these changes in the opportunity set. In our data, we find that shocks to expected stock returns are negatively correlated with shocks to realized stock returns. Therefore, when investors choose to hedge, they do so by increasing their holdings of stocks...

I have never understood this distinction. When stock prices are mean reverting, a rebalancing investor will want to borrow and buy more after stock prices go down (expecting that they will then go up as they revert to the mean) and will want to sell and hold less stock after stock prices go up (expecting that they will then go down as they revert to the mean). The ultimate wealth of the rebalancing investor thus has a higher mean and a lower variance than the wealth of the buy-and-hold investor. The Merton hedge is not of an alternative nature to the mean-reversion-reduces-risk effect; it is an intensification of it.

Lamont and Stein: Stock Market Efficiency in Cross Section, Inefficiency in Time Series

Changes in cashflows and changes in "discount factors":

http://www.economics.harvard.edu/faculty/stein/papers/aer-p&p-micro-macro.pdf: Samuelson’s dictum has been made concrete in empirical work by John Campbell (1991) and Tuomo Vuolteenaho (2002). Campbell shows that innovations to aggregate stock returns are largely transitory: less than half of the variance in returns is due to changes in expected cashflows, leading to predictable reversals in future returns. If one adopts a behavioral perspective and thinks of return predictability as being indicative of investor sentiment, this is consistent with Samuelson’s idea that the aggregate market is quite inefficient, with a large fraction of its price variation being due to non-fundamental factors.

In contrast, Vuolteenaho shows that innovations to idiosyncratic firm-level returns are largely permanent: most of the variation in returns is driven by cashflow news, with a smaller component due to time-varying expected returns. This suggests that firm-level relative prices are reasonably efficient, with a smaller role for sentiment.

Harrison Hong and Jeremy Stein: Disagreement and the Stock Market

They make the case for "disagreement models" as the way forward for behavioral finance:

http://www.economics.harvard.edu/faculty/stein/papers/Disagreement-Dec-2006.pdf The enduring appeal of classical asset-pricing theory over the last several decades owes much to its success in forging a consensus around a foundational modeling platform. This platform consists of a core set of assumptions that have been widely-accepted by researchers working in the field as reasonable first-order descriptions of investor behavior, and that—-just as importantly—-lend themselves to elegant, powerful and tractable theorizing.

If behavioral finance is ever to approach the stature of classical asset pricing, it will have to move beyond being a large collection of empirical facts and competing one- off models, and ultimately reach a similar sort of consensus. While this goal seems well within sight in the part of the field that explores limits to arbitrage, it is much further away in the part that seeks to understand the origins of market mispricings. Many horses are still running in this latter race, and it is not at all clear whether a decisive winner will emerge in the foreseeable future.

Nevertheless, our view is that, taken collectively, the disagreement models described above represent the best horse on which to bet. Disagreement models uniquely hold the promise of being able to deliver a comprehensive joint account of stock prices and trading volume, which we consider to be one of the highest priorities for theoretical work in asset pricing. Moreover, the modeling ingredients are highly tractable, for two reasons. First, preferences are taken to be completely standard—-so the modeler can work with constant absolute risk aversion utility or whatever other functional form makes life easiest. Second, in disagreement models, investors’ beliefs are often a simple function of just their own priors and the signals that they each observe directly; this is in contrast to rational-expectations models, where each investor must also update based on inferences about others’ priors and signals. As a result, disagreement models can be usefully deployed in everything from simple illustrative examples (like the two-period model of momentum discussed earlier in this paper) to elegant continuous-time formulations (like Scheinkman and Xiong, 2003). We hope that future research with disagreement models continues to develop their potential.

The classical finance assumptions were never reasonable first-order descriptions of investor behavior; the most that was sever claimed was that they were reasonable first-order descriptions of those components of investor behavior that did not cancel themselves out.

And the fact that people in disagreement models aren't making inferences from price patterns strikes me as a defect, not a feature...

The U.S. Equity Return Premium: Past, Present, and Future

We have a new draft of J. Bradford DeLong and Konstantin Magin (forthcoming), "The U.S. Equity Return Premium: Past, Present, and Future," Journal of Economic Perspectives: http://delong.typepad.com/pdf/20070412_JEP_EP.pdf

It's good. It's not great yet. But we hope to make it great...

Note to Self: On Konstantin Magin's Social Security Privatization Project

Konstantin Magin strongly believes that the existence of the equity premium implies that large chunks of the Social Security system should be invested in equities in order that the poorer half of America's population can reap some of the extraordinary long run returns that follow equity ownership. (I agree.) He goes further than I do, however, and believes, for political economy reasons, that such investments should be made through the form of regulated, individual, private accounts.

The counterargument is that individual, private accounts are too risky to be a proper vehicle for the Social Security tranche of people's retirement savings. What if people misinvest--churn their accounts or fail to diversify or take on inappropriate systematic risks? Magin grants this point--such accounts would have to be regulated, and invested in a properly-diversified buy-and-hold portfolio. But there is a second bowstring to the counterargument: even if private accounts are invested in a diversified buy-and-hold portfolio, there is still the risk that the stock market will tank over the next generation--and that risk is inappropriate for the Social Security tranche of people's retirement portfolio.

Konstantin Magin's current project is to try to quantify this risk. How big a risk is a 35 year old running by placing the money he or she wishes to use to fund consumption at 75 in a unit beta diversified buy-and-hold stock market portfolio? The way that he quantitatively evaluates this risk is by running the obvious thought experiment: Suppose that the investor wants to insure him or herself against real declines in the value of the portfolio--wants to guarantee a real return of at least zero--by purchasing a put option on the portfolio that expires in 40 years with a strike price of the porfolio's current real value. What would be the value today of such a put option as a fraction of the value of today's initial portfolio investment?

The approach Konstantin Magin has taken has been to use Black-Scholes and the historical distribution of stock returns plus an assumed 1% or 2%$ per year riskless rate to value the cost of such a put: what would an insurance company that was going to then construct a dynamic hedge charge an investor who sought to insure his or her portfolio? There is, however, a second approach that he has started to explore: what would be the most that an investor with a specified coefficient of relative risk aversion would be willing to pay for such a put option?

The answer to Konstantin Magin's first question was that the cost of the put was small: about a nickel or a dime for each dollar invested. I think the answer to his second question is going to be much smaller for reasonable value of the coefficient of relative risk aversion--less than, say, five. I think this because the insurance company making the dynamic hedge is implicitly buying insurance from a market whose representative agent has a very high risk aversion--on the order of twenty or so. And so the willingness to pay for the put of an agent with a reasonable coefficient of relative risk aversion has to be a lot less than the cost someone would charge to write the put and then dynamically hedge it, which is what the value as calculated by Black-Scholes really is.

Here's a spreadsheet to do some preliminary finger exercises on this. The answers are--for historical returns and permanent components of variances--indeed smaller: mills rather than cents:

http://spreadsheets.google.com/pub?key=p_zylRhg4tozhBJyXhfclKw&output=xls
http://spreadsheets.google.com/ccc?key=p_zylRhg4tozhBJyXhfclKw&hl=en_US

This document at:

http://delong.typepad.com/sdj/2007/03/note_to_self_on.html