Archive for the ‘Finance’ Category
I wish that Inside-Job-Style critics of economics could have attended Ed Kane’s keynote address at the Western Economic Association conference last weekend. I’ve never seen a group of academics so ready to grab torches and pitchforks and march on Wall Street.
I don’t know if anyone recorded the session, but his powerpoints are available here:
I recommend Sebastian Mallaby’s book, More Money Than God, if you are at all curious about how hedge funds work. The writing style resembles Malcolm Gladwell or Michael Lewis in that a technical subject is made interesting and straightforward by anecdote-driven narrative. It made me want to join a hedge fund or at least start actively investing my own money. Mallaby also focuses on the two things every economist wonders about hedge funds- do they produce social value, and how can they make money if markets are efficient.
I had heard some of Paul Samuelson’s story before, but it is amazing that the first man to work out the math of efficient markets theory and a major proponent of index funds was also a major investor in one of the first hedge funds. Hedge funds have a way of making academics look like suckers. When the people at Samuelson’s fund found a non-random pattern in commodities markets, they used their knowledge to make huge amounts of money; twenty years later, an academic economist found the same pattern and published a paper about it, making no money and ending the pattern.
Sometimes the reason markets are not efficient and the reason hedge funds can provide social value are one and the same- illiquidity. Rather than making a premium by picking stocks (which is supposed to be impossible except by luck), they are paid a premium for providing liquidity to illiquid markets- for instance by buying a stock that is being sold en masse by an insurance company that needs to cash out to make payments. If you can identify sellers who sell for a reason other than a belief that an investment is getting less valuable, you will do well by buying from them.
Another way to make money off of inefficient markets is to identify nominal rigidities- like interest rates or currency values being fixed by governments. When a currency is pegged a government will buy and sell it at prices other than the efficient market price- this is almost the definition of a peg. But this mispricing is only valuable to traders if there is a chance that it will be corrected soon- that the peg will be abandoned. The book tells the stories of how Soros and the markets famously pushed Britain and Thailand to abandon their pegs.
Do such ‘speculative attacks’ provide social value? Sometimes they are pushing firms and governments to abandon sooner the unwise policies they would have to abandon later. However, the book also tells of many attacks on firms that were merely illiquid, not insolvent. Rather than watching fundamentals, many funds spend time watching each other and attacking the weak ones into deleveraging spirals. If a firm is leveraged 5 to 1, it can only afford to have a 20% loss, and the margin calls that come with borrowing plus investors who can pull their capital make this number even lower. This means that firms that lose a bit of money may need to sell quickly- and if they need to sell in illiquid markets or if other firms find out and bet against their positions, selling begets selling until a firm goes bust. When the market comes after your firm in particular, the correlation on all your positions can go to one. Such positive feedback loops are normally value-destroying.
One anecdote makes me worry about the accuracy of most empirical academic research. At a top hedge fund, “the data they looked at had been painstakingly swept for typing glitches and errors- it was cleaner than anything available to most finance professors. Time and time again, an eager academic would contact D.E. Shaw, claiming to have discovered a profitable anomaly in markets. Time and again, Shaw’s faculty would find that the anomaly consisted merely of misreported numbers.” If a hedge fund analyzes data and comes to an incorrect conclusion, it loses money. If a professor does the same, he probably loses nothing. It is very common for economists to critique how data is analyzed, and somewhat common to argue about which dataset to use, but it is extremely rare to check that data was properly cleaned and there were no coding errors in the analysis. For instance, right now I am working on cleaning a large dataset on gas prices, rearranging it and checking for errors, with the goal of publishing an academic paper. However, if I were going to bet money on the conclusions of the paper I would surely be more thorough.
Anyhow, read the book, for the economics and the stories. I have made it sound less interesting by focusing on the economic issues, but it is quite accessible.
Michael Lewis’ book The Big Short: Inside the Doomsday Machine has been a popular bestseller even as it received unanimously good reviews from economists- the harshest review I saw was Eric Falkenstein’s “entertaining but doesn’t get to the heart of the issues” take. So of course a part of me was secretly hoping the book’s arguments would be wrong or oversimplified, and I could explain why and feel superior to everyone else. But I am afraid it was simply an excellent book. It is very entertaining, gives a good explanaiton of the crisis (though not mutually exlusive of other potential explainations), and explains complicated financial ideas in a way that most people should be able to grasp.
One of the big themes of the book (though it is not explicitly stated this way) is that the Efficient Markets Hypothesis often fails to apply to U.S. financial markets. This is often because its assumptions are not met, particularly in bond markets where there are few buyers and sellers and little information is publicly available. But sometimes large, liquid markets seem to take a surprisingly long time to incorporate publicly available information. For instance, one small hedge fund claimed that they were the only people really examining the financial statements released by subprime mortgage companies in early 1997, and that it took the market months to look at the same data and realize the firms would soon be bankrupt; the fund’s accountant said “it made me feel good that there was such inefficiency to this market… if the market catches on to everything, I probably have the wrong job.”
Another small hedge fund, Scion Capital, made huge returns when their “decision-making apparatus consisted of one guy [Mike Burry] in a room… poring over publicly available information”. Lewis tells the entertaining and inspiring stories of how three small, wildly successful hedge funds got started. My favorite was Cornwall Capital, “two guys in a garage in Berkeley with $110,000 in a checking account”.
One small part of the book gave me an idea for a great economics paper (which has probably been written already). There is now a great debate about whether “bubbles” can be meaningfully defined, discovered in advance and deflated. Many argue that once you have a definition of a “bubble” that is meaningful and testable, you will not be able to find any. But in the book, Mike Burry puts forward the thesis that
“It is ludicrous to believe that asset bubbles can only be recognized in hindsight. There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid increase in the incidence and complexity of fraud… the FBI reports mortgage-related fraud is up fivefold since 2000.”
I would love to get fraud and financial data by sector and look for relationships. I am sure others have done this already, but if not it would be cool to test the theory, and if it holds up start making money on it. (of course, making money by killing the Efficient Markets Hypothesis only serves to make it stronger going forward… it is like Obi-Wan Kenobi.) Another potential way to make money described in the book is to buy options (which at least as of 2007 were usually priced by assuming a normal distribution of potential prices) on stocks which should have a bi-modal distribution of future prices; it made me wonder if this still works.
As far as an explanation of the financial crisis, the book has two main explanations. One is that the bond market is opaque and oligopolistic. “The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair. The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure… bond traders could exploit inside information without worrying that the would be caught… in the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.”
The second, and related explanation is that the bond-rating agencies were very bad at their jobs, and only some people realized that. The Wall Street banks making securities could exploit the flaws in the rating agencies models to get their product rated too highly. Meanwhile, some investors stupidly trust the rating agencies and buy bonds at high prices assuming their ratings to be correct. There were many flaws in the rating agency model, perhaps the most surprising to me is that “both Moody’s and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones”. Many people focus on the potential corruprtion at the rating agencies and Lewis does bring that up, but his main focus is on stupidity. “You know how when you walk into a post office you realize there is such a difference between a government employee and other people. The ratings agency people were all like government employees. They’re underpaid. The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for.”
In the epilogue Lewis turns to a third explanation for the crisis: a faulty incentive structure for employees in financial firms. “What are the odds people will make smart decisions about money if they don’t need to make smart decisions about money- if they can get rich making dumb decisions?”
Before this post gets any longer, I’ll just say: read the book, it tells some great stories. Also, check out Lewis’ article on the Greek debt crisis. He manages to interview a lot of important Greeks. The article is fascinating but somewhat depressing as it makes me wonder how Greece can possibly fix its government and social order; I can understand why Paul Romer proposes giving the EU a bigger role in governing Greece.
It’s real hard to know exactly when we hit rock bottom, but after enough free-fall its a pretty safe bet that the big splat is near. If you’re in to speculation, now seems like a great time to get into commodity and currency markets; say, buying some oil futures high and holding Icelandic kronas.
For some speculation safe enough to resemble investing more than gambling, the major stock indices are hard to beat. Every time the Dow has fallen this far this fast, it was way up within a year; the only exception is the Great Depression, and even then it was back within 5 years. I might even bet on this one with my own money. That, or buy most of Iceland.