Category Archives: markets

Would you buy this book?

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The title is Predicting the Markets: A Professional Autobiography. It has many favorable reviews on Amazon, but they seem to pre-date the official release of the book, which makes one suspicious. Maybe you will download the Kindle sample and leave your comments here.

1. I was aware of Yardeni back in my days at the Fed, when he was a leading Wall Street forecasting guru. In fact, I was surprised to find out he is still active–I would have assumed he had aged out of the profession or died, given how well established he was by 1980, when I started at the Fed. But he had only graduated with his Yale Ph.D four years prior to that.

2. Many of the names and events that he recalls from the 1960s, 1970s, and 1980s are familiar to me. I vividly remember that he coined the term “bond market vigilantes.” It served to emphasize that the financial markets do not necessarily strictly respond to the short-term interest rate that the Fed can control. When bond market investors were really inflation-phobic, they kept long-term rates higher than the Fed wanted. More recently, between 2003 and 2006, the bond market did the opposite–keeping long-term rates low even when the Fed was tightening. This is what made the Bernank mutter about a “global savings glut.”

3. I preach, “stare at the world, not at your models,” and Yardeni adopted that in practice as soon as he left Yale. He says that around 1988 he converted from being a macroeconomist to a microeconomist. He writes, “I have become increasingly convinced that most of the more interesting and relevant influences on the outlook for the global economy have occurred at the microeconomic level.”

4. In a chapter (still part of the Kindle sample) on economic history, he credits the decision taken in June of 1938 to suspend mark-to-market accounting for banks as helping to end the Roosevelt recession that hit in 1937. My first exposure to the accounting issue was in the 1980s, when book-value accounting allowed many under-water savings and loan associations to remain in business, and that was not a good thing–it made the inevitable bailout more expensive. The problem is that not marking assets to market makes the institution less transparent to regulators. So I was long in favor of market-value accounting.

But I have since come to hold a different view of financial intermediation, in which full transparency could be a bug, not a feature. The function of banks and other financial intermediaries is to hold risky, long-term assets while issuing low-risk, short-term liabilities. This permits households and nonfinancial firms to do the opposite. This is somewhat magical, as long as it is not carried to excess. Market-value accounting takes away some of the magic, and it has the property of turning liquidity crises into solvency crises. I still think that when government is backing deposits (and going beyond that with its de facto commitment to prop up big banks) the regulators need market-value accounting. In 2008, instead of advocating getting rid of market-value accounting, the approach that I advocating for keeping banks from all dumping assets at the same time would have been to temporarily relax capital requirements.

5. I have doubts that I would enjoy the whole book. Yardeni’s life represents a “road not taken” by me, and nothing I’ve read so far gives me regrets. I regard my own experiences as more interesting than his. Tyler Cowen says he would like to see more memoirs. I wonder if he could get through this one.

Off-topic: fantasy inefficiency

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A commenter asks,

Have you thought about efficient markets and fantasy baseball?

I.e., if you knew the market prices (via aggregating other auctions from this year) for a standard Yahoo! league, can you think of a better strategy than trying to maximize the difference between those values and what you pay

I do not think that the market is efficient. For one thing, On Yahoo, prices seem anchored much too closely to the pre-draft values posted by Yahoo. I jokingly refer to it as the YSRP–Yahoo Suggested Retail Price.

But here is a major inefficiency. Suppose I told you that there is a pitcher who last year won 13 games, struck out 203 batters, had an ERA under 2.5 and a WHIP under 0.9 In a 12-team mixed league, in what round would you be willing to take that pitcher?

It sounds like a starter you would take early in the 2nd round. But it actually is the combined statistics of Chad Green and Chris Devenski, who in 12-team mixed league are drafted in garbage time if they are drafted at all. So we can not spend resources on a top starter and pick those two guys instead.

You cannot use that trick with hitters, because they don’t take days off the way pitchers do. If you have two first basemen who each hit 20 homers, you can only play one of them at a time (assuming all your other positions are filled), so it does not give you 40 home runs. Although dang if owners on Yahoo don’t act like they can play their bench hitters. Some owners draft a bench that consists entirely of hitters, which I think has to be wrong. If I have 5 players on the bench, then I want at most 3 hitters. The strategy I am favoring here calls for 3 pitchers and 2 hitters on the bench.

With four of the top middle relievers, the top of our pitching staff is taken care of. Fill out the rest with 2 top-tier relievers and 5 late-round starters. That means in the Yahoo format that 10 out of your first 12 picks can be hitters. (In an auction format, it means spending over $200 of a $260 budget on hitting).

Another way that the Yahoo Rotisserie format favors this approach is that there is no innings minimum but there is an innings maximum of 1400. If we find another closer early in the season and everything else is going ok, we might blow off wins and strikeouts to lock up the other pitching categories.

With this approach, I think we can come out of the draft close to the top in all five hitting categories plus the pitching ratio categories. We are near the bottom in wins, but not hopeless. We are decently positioned in saves, but that is a category that really gets shuffled once the season gets going. We’d better hope that the closers we chose are not among those who lose their jobs during the season, and it would be nice if we pick up one of the relievers who gets promoted to closer and does the job.

We will have a good ratio of strikeouts to innings, but we will be short of innings (late-round starters usually give you only 160 innings or so). If we can add a 6th starter without messing up our ratios, then we can be competitive in strikeouts.

In an efficient market, we should have a one out of three chance of finishing in the top 4. But with this strategy, I think our chances are closer to two out of three.

This year, I tried this strategy in a Yahoo money league. Money leagues are the only ones you can rely on to be reasonable. In other leagues, owners will bail out before the draft is even over, and then you are stuck playing the whole season with only a handful of serious owners.

Anyway, I executed the strategy, spending mostly on hitters. Fortunately, others in my league were not into this strategy. If anything, starting pitchers went above YSRP more than hitters did.

By May, when a hitter comes off the disabled list, nine of my ten hitters will be projected to hit at least 25 home runs (and my tenth is projected to hit just under that), with eight of the ten projected to have batting averages over .280. My team is not projected to be near the top in stolen bases, but that is not a big worry.

I only bought two middle relievers, but I will raise that to four right away, because I also took two players that I knew were on the disabled list, and I will immediately bring in middle relievers for them. When the two players return from the disabled list in late April, the plan is to keep the middle relievers and to drop my least-useful bench hitter and starting pitcher as of that time.

On paper, by May I will have a 1st-place team. But meanwhile, there is the actual baseball season, and nothing happens like it’s supposed to on paper.

Bitcoin and the prospects for a dollar collapse

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For Medium, I take a skeptical view of the value of Bitcoin as a hedge against hyperinflation.

For citizens looking for hard assets, gold is not the only option. Other commodities, such as copper or wheat, are traded in futures markets. By taking long positions in those commodities, you can profit from inflation. There are mutual funds that invest in commodity indexes, just as there are stock mutual funds that invest in stock indexes.

Credit scoring and securitization

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Amar Bhide writes,

more than just soft information is lost when lenders rely on generic credit scores. Practical obstacles — and in some cases political considerations — exclude from the scores factors, such as income and education, that self-evidently affect creditworthiness. Moreover, score-based lenders, like Friedrich Hayek’s central planners, rely on “statistical information” that ignores “crucial circumstances of time and place.” From their far-away perch, they cannot recognize substance abusers, nor can they distinguish workers in plants scheduled to close from judges with lifetime tenure.

He argues that we need more traditional banking, involving credit judgment and originate-to-hold, and less securitization using credit scores. My thoughts.

1. Although in theory underwriting judgment could lead to wise decisions to over-ride credit scores, in practice I do not think this happens. Human underwriters are not geniuses. And they do not necessarily know when the information they have is really news to the scoring system. Maybe the scoring system does not explicitly know that someone is a substance abuser, but it may nonetheless observe behavior that reflects that substance abuse. I believe that judgmental over-rides tend to lead decisions that are worse, not better.

2. As Bhide points out, some of the shift toward originate-to-distribute was influenced by capital regulations.

3. In mortgages, the private securitization market remains pretty dormant. That is, without a guarantee from Freddie and Fannie, investors are reluctant to buy mortgage securities just based on loan-to-value ratios and credit scores.

4. I think that for bank regulation, stress testing is the least bad way to promote safety and soundness. Stress tests for mortgage portfolios should include scenarios of falling house prices. Stress tests for consumer portfolios should include rising unemployment.

My essay on financial bubbles

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For Medium, I wrote on financial bubbles, with plenty of Bitcoin trolling thrown in.

it is mathematically impossible for all of the bullish investors to get out with a profit. If a stock goes from $10 a share to $100 a share and back down to $5 a share, then on average the shares bought on the way up have to be sold for less than their purchase price on the way down. If you buy into a bubble, then the chances are you will lose.

Karl Denninger on Bitcoin

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He writes,

All existing cryptocurrencies are designed around a math problem that gets exponentially harder to solve as time goes on. However, the number of “coins” you achieve for solving it is fixed irrespective of where on the curve you solve it. This is a Ponzi scheme by definition since the first people obtain a given reward for little effort yet later people must expend exponentially greater effort for the same reward, and the laws of mathematics say that eventually the reward cannot be had for any rational (or even possible) expenditure.

…Ponzi scheme. They are thus all illegal — every one of them — under said laws, and are designed to funnel money from later adopters to earlier adopters.

Sounds as though he agrees with my chain-letter analogy. But to be honest, I do not follow the substance of what he is saying.

He is one of 21 alleged experts interviewed on that page, and most of them are reluctant even to call “bubble,” much less “scam.”

Pointer from Miles Kimball.

Merry Christmas.

How I think about Bitcoin

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Tyler Cowen writes,

With crypto-assets, I am carrying wealth more generally into the future. The person who most wants that payoff structure for the wealth carry will end up owning the crypto-asset.

Read the whole thing, with which I do not agree one bit. Tyler knows more than I do about the topic, but for what it’s worth, here is my view.

I think of Bitcoin as functioning like a chain letter, of the sort where you say “Send ten dollars to the person at the top of this list scratch that person off the list, put yourself on the bottom of the list, and then send this letter to six of your friends.” If the chain letter keeps going until you are at the top of the list, you might get thousands of dollars.

A chain letter is a redistribution scheme that creates a few big winners and a lot of little losers. I see Bitcoin playing out the same way. As long as the Bitcoin chain letter keeps reaching new people, its value will rise. Once Bitcoin runs out of new suckers, er, investors, it will crash. Then we will find out who were the winners and losers. The few who sell before the crash will have made fortunes at the expense of those who paid up for it and held on for too long.

If you participate in a chain letter, the odds are very low that you will make it to the top of the list. Similarly, with Bitcoin, the odds are very low that you will sell your Bitcoin before it goes down in value. The majority of Bitcoin investors will buy high and sell low.

Cantercap Charlie on finance and the 2008 crisis

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He wrote,

if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash. In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy. Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks.

This is another way of saying what I like to say, which is that the public wants to issue risky, long-term liabilities and to hold riskless, short-term assets, and financial intermediaries accommodate this by doing the opposite. This implies that for financial firms, a liquidity crisis blends into a solvency crisis. Banks must shrink their activity if there is sudden pressure on them to make their balance sheets more liquid.

In a more recent post, he writes,

what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation. Mainly, the Basel I and Basel II Capital Standards.

He is referring to the Financial Crisis of 2008. Actually, I don’t believe that Basel II was all that important, because it still was mostly unimplemented by the time of the crisis. I would focus on Basel I and also on the Recourse Rule of 2001, which we might think of as Basel I(a).

More interestingly, he goes on to say,

the great untold secret of the crisis was the strength of the US commercial banking industry.

As crazy as this sounds, it may be spot on. Yes, Citigroup was in trouble, as he acknowledges. But most other commercial banks were not in bad shape. Some U.S. investment banks (aka “shadow banks”) were shakier, but the real problems were in Europe. He writes,

European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.

I would add that many of the beneficiaries of the “AIG bailout” were European banks.

There is a lot of potential for revisionist history here.

The Cowen-Cochrane dispute on banking

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You can start with Tyler, and work backwards.

I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.

As spelled out in Specialization and Trade, my simple account of financial intermediation is this.

1. We start with a risky investment, fruit trees, and it is costly to observe how the fruit trees are doing and how much skill and dedication the entrepreneur is contributing.

2. It helps to finance these fruit trees in part with debt. This is not because debt is easier to trade than equity, but because it is a less expensive way to align incentives.

3. It helps to have a bank buy the debt and issue short-term, risk-free liabilities. This is because people do want to hold and exchange short-term, risk-free liabilities. An intermediary that backs the fruit-tree debt with a combination of bank equity and demand deposits makes people better off.

So I am afraid that I am with Tyler on this one.

From capitalism to financialism

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Fredrik Erixon and Björn Weigel write,

In 2013, natural persons owned only 40 percent of all issued public stock, down from 84 percent in the 1960s. And if we take all issued equity, the trend has been even more pronounced. In the 1950s only 6.1 percent of all issued equity was owned by institutions but, in 2009, institutions held more than 50 percent of all equity.

…the shift from capitalist ownership to institutional ownership has undermined the ethos of capitalism and has created a new class of companies without entrepreneurial and controlling owners. Contrary to some expectations, that has not created new space for free-wheeling and entrepreneurial managers to act on their own judgment instead of following the instructions of owners. Rather, managers are subject to a growing number of rules and guidelines designed for and by risk-averse owners with little knowledge about their investees.

I am not convinced that the current system is as dire as the authors make it out to be. Fifty years ago, it was difficult to keep a large firm from throwing capital at investments with poor returns. Today, reallocating away from firms with poor opportunities is easier.