Wednesday, December 31, 2008

How information gets into price

In most finance classes we talk about how information gets into the price of securities. Here is a great example. Apple (which SIMM owns) has traded down on rumors that Steve Jobs is sick.

Traders have been looking for information to prove or disprove these rumors. how far will they go? How about asking frozen yogurt clerks?

Steve Jobs In Great Health -- Frozen Yogurt Clerk (AAPL):
"Can't someone -- anyone -- verify that he's still walking around, doing his normal activities?

The answer: Yes, and he's fine, according to a frozen yogurt store clerk."
So suppose this clerk sees Jobs and then buys on this "news". It is by this trade that private information (Jobs had frozen yogurt) is incorporated into stock price.

Monday, December 29, 2008

Financial crisis of '08 among the worst ever

An interesting look at the current economic crisis from a historic perspective.

Financial crisis of '08 among the worst ever From SignonSan Diego:
"Scott Reynolds Nelson, a history professor at Virginia's College of William and Mary, suggests that 2008 may be much more like 1873 than 1929.

In 1873, the crisis started in Europe, where cheap mortgage terms spurred a residential real estate bubble. When the bubble popped, bankers in London tightened their credit terms, triggering a financial crisis in the United States, where banks already were overextended with speculative loans to railroads and railroad-related real estate.

“The echoes of the past in the current problems with residential mortgages trouble me,” Nelson wrote in the Chronicle of Higher Education. “As in 1873, a complex financial pyramid (in the past decade) rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans....”

The result in 1873 was an international depression that sparked double-digit unemployment rates, corporate bankruptcies and widespread labor unrest. The United States did not fully recover until the mid-1890s, by which time it endured another credit crisis, known as the Panic of 1893.

The response to the current crisis bears resemblance to past solutions."
Interesting. Here is Nelson's piece from the Chronicle. I won't go into all of it, but here is the conclusion:
"In the end, the Panic of 1873 demonstrated that the center of gravity for the world's credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess."

Friday, December 26, 2008

An Amazing Document On Madoff Said To Have Been Sent To SEC In 2005

What? There are enough sources on this one to report it. When I first saw it I assumed just an internet urban legend, but it seems legit enough (and yet still unbelievable as well) that I at least want to ention it so we can use it in class discussions. Wow!

An Amazing Document On Madoff Said To Have Been Sent To SEC In 2005 :: Business News :: Here Is The City News :: The Latest Business & Financial Markets News And Views:
"Here's a copy of a submission said to have been made in 2005 to US market regulator the Securities and Exchange Commission by money manager and investment investigator Harry Markopolos.
and later:
"As a result of this case, several careers on Wall Street and in Europe will be ruined. Therefore, I have not signed nor put my name on this report. I request that my name not be released to anyone other than the Branch Chief and Team Leader in the New York Region who are assigned to the case, without my express written permission. The fewer people who know who wrote this report the better. I am worried about the personal safety of myself and my family. Under no circumstances is this report or its contents to be shared with any other regulatory body without my express permission. This report has been written solely for the SEC's internal use.

As far as I know, none of the hedge fund, fund of funds (FOF's) mentioned in my report are engaged in a conspiracy to commit fraud. I believe they are naive men and women with a notable lack of derivatives expertise and possessing little or no quantitative finance ability.

There are 2 possible scenarios that involve fraud by Madoff Securities:

1. Scenario # 1 (Unlikely): I am submitting this case under Section 21A(e) of the 1934 Act in the event that the broker-dealer and ECN depicted is actually providing the stated returns to investors but is earning those returns by front-running customer order flow. Front-running qualifies as insider-trading since it relies upon material, non-public information that is acted upon for the benefit of one party to the detriment of another party....

2. Scenario # 2 (Highly likely) Madoff Securities is the world's largest Ponzi Scheme. In this case there is no SEC reward payment due the whistle-blower so basically I'm turning this case in because it's the right thing to do.""

It should be noted that even scenario #1 is illegal. Front running got many dealers in trouble over the years. It essentially is placing trades in advance of a large trade that you know is coming.

Lest we fall trap of going with a single made up story (hey it is the internet after-all), here are some more cites.

From Time.
"The WSJ describes them as "ranging from in-depth mathematical calculations that purported to show the Madoff investment strategy couldn't work, to little more than rumor or innuendo." That makes Markopolos sound like a little bit of a crank, but reading through his actual allegations doesn't leave that impression at all. Obviously hindsight plays a role here, but I can't imagine anyone reading them in 2005 and not concluding that there was something deeply suspect going on. Markopolos goes to great lengths to demonstrate that the investment returns claimed by Madoff were impossible to replicate by any known strategy. But to me that wasn't the biggest of his 29 red flags. The biggest red flag was Why on earth would a prominent brokerage firm chief run a giant, mostly secret money management business on the side and not charge any fees for his services if he wasn't up to something dodgy?"

"Markopolos waged a remarkable battle to uncover fraud at Madoff's operation, sounding the alarm back in 1999 and continuing with his warnings all through this decade. The government never acted, Madoff continued his ways, and people lost billions.

Markopolos reached his conclusion with the help of mathematicians like Dan diBartolomeo, whose analysis of the Madoff's methods in 1999 helped fuel Markopolos' suspicions.

"People should have seen the writing on the wall," diBartolomeo said.


Traders Say Madoff's Strategy Was Unworkable -

Traders Say Madoff's Strategy Was Unworkable -
"The other red flag easily available to investors was the shallow volume in the options Mr. Madoff claimed to use as a hedge.

About $3.25 billion of stock could have been protected by the total S&P 100 options outstanding at the end of November, according to the Chicago Board Options Exchange. Mr. Madoff was thought to have had as much as $50 billion under management.

A review of open interest in S&P 100 contracts showed that nobody owns more than 6,000 contracts at any single strike price, according to FactSet.

In a more liquid hedging market like that of S&P 500 options, there are often more than 100,000 contracts outstanding at a given strike price."

Tuesday, December 23, 2008

And the news gets worse

Now there appears to be a suicide tied to the Madoff case... Worldwide:
"Thierry Magon de La Villehuchet, who ran a fund that invested with Bernard Madoff, was found dead at his Madison Avenue office today, a New York City police officer at the scene said. The death appeared to be a suicide, he said."

Bernie Madoff: Ponzi For The Long Run

Clusterstock continues to do an amazingly good job at reporting on the Madoff ponzi scheme.

What is most puzzling is how one person could create and maintain such a intricate scheme. Just for instance, wouldn't the auditors (a small firm) have seen what was going on? How about those that invested with him?

Or even those people supposedly placing trades etc. It leads many to the conclusion that he either had help, or is a genius, or both.

So a few looks at Clusterstock's coverage

Bernie Madoff: Ponzi For The Long Run:
"Sixteen years ago the Securities and Exchange Commission cracked down on what was then one of largest ever sales of unregistered securities. Investors handed $440 million to two Florida accountants who promised unbelievable annual returns of 13.5% to 20%....How did the two investors deliver the promised returns? They had help from a powerful New York figure. You see, at the center of the scam was a mysterious money manager who authorities declined to name because they never charged him with wrong-doing....That man was Bernie were represented by Ira Lee Sorkin. The same lawyer, a former prosecutor turned defense attorney, is now representing Madoff."

Clearly in any big blow up, some will be eating crow. In this case there are many, but possibly the largest portions may be saved for Fairfield Greenwich Group.

From Clusterstock: Fairfield Greenwich:We Anlyze Every Client Trade Every Day
"Opinions about how Fairfield Greenwich Group came to incinerate $7 billion of client cash at the hands of Bernie Madoff vary from "incompetent" to "criminally negligent" to "co-conspirators." Regardless of where the truth lies, one thing is certain: FGG was very proud of its due diligence and risk management processes....They will show that, day after day, the professionals at FGG were fooled by an amazingly intricate fraud in which Madoff figured out, retroactively, at the close of business each day, bogus trades that added up to the reported return and stayed within FGG's vaunted risk parameters--and then emailed this spreadsheet to FGG so they could feed it into their system."
Sure they did. But if you have doubts, you are not alone. A staggering 74% of investors agree. Again from Clusterstock:
"..a CNN/Opinion Research poll, 74% of those surveyed said they think Madoff's behavior is common among financial advisors and institutions."
Can that number possibly be right? Seventy four percent? And if so what does it say given Wisdom of Crowds etc. I would like to see that survey and a definition of "common".

This one will continue to play out.

Friday, December 19, 2008

Tale of the first $350 billion - Dec. 19, 2008

Have you wondered where the first $350 billion went? Here is how CNN reports it:

Tale of the first $350 billion - Dec. 19, 2008:

  1. ..checks totaling $168 billion in varying amounts to 116 banks;
  2. ...committed another $82 billion to capitalize more banks;
  3. ... bought $40 billion in preferred shares of American International Group (AIG, Fortune 500) so the troubled insurer could pay off an earlier loan from the Federal Reserve;
  4. ... committed $20 billion to back any losses that the Federal Reserve Bank of New York might incur in a new program to lend money to owners of securities backed by credit card debt, student loans, auto loans and small business loans;
  5. ... committed to invest $20 billion in Citigroup on top of $25 billion the bank had already received;
  6. ...committed $5 billion as a loan loss backstop to Citigroup;
  7. ... agreed to loan $13.4 billion to GM and Chrysler to get them through the next few months."

Chinese Banks' Great Leap Backward -

In the department of what else can we worry about? The WSJ suggests that Chinese banks are being pressured to take some major chances.

Chinese Banks' Great Leap Backward -
"...risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.

Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years....

Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget."
It would be make for a great discussion in a Money and Banking class.

My Favorite Christmas movie; yes with Finance content

Sure it is a great movie even without the finance content, but when you throw in some subprime lending, a liquidity crisis, a run on a bank, and even some regulatory issues, and you have both a great movie and a financial learning opportunity.

Yes, it is A Wonderful Life! Surprisingly, the whole thing is online.

History repeats itself

What a GREAT article. It is by Carole Loomis in Fortune, but comes to us via

Featured Post Today's Post » Hedge fund industry enters time-warp in January 1970, pops out virtually unchanged in 2008:

A few look-ins:
"...the similarities between the hedge fund world of 1970 and that of 2008 and truly amazing - almost eerie in fact. Even the 39 year old Warren Buffett makes a cameo in this piece. As Motson pointed out to us, “…if you re-scale the numbers it could have been printed yesterday.”
and later:
"“…there is some disagreement these days as to the definition of a hedge fund…it would appear that they key feature of a hedge fund is neither the hedge nor the leverage, but instead the method by which the general partners are compensated.”

and still later:

"“Investing with the Stars”

Think Britney Spears and Sylvester Stallone were the first celebrities to invest in hedge funds? Think again. FORTUNE also reported that Jimmy Stewart, Rod Steiger, and Jack Palance were all co-investors in one California-based fund."

Great great piece. Very interesting and it reminds us the importance of history.

Thursday, December 18, 2008

Is compensation to blame?

History will look for answers to what caused the problems, but somewhere in that mix, compensation has to be a part of the problem. From increasing an already risky environment, to rewarding lending to questionable borrowers, to creating incentives to increase information asymmetries, compensation practices have to be examined.

From the NY Times:
The Reckoning - On Wall Street, Bonuses, Not Profits, Were Real - Series -
"Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.
and later:
"“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School.... “The whole organization was responding to distorted incentives.”Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well."
In other words, when you pay a year at a time and payoffs are not for many years down the road, it seems to be a problem that is exasperated by, while simultaneously exasperating, information asymmetries. Then when you add to this mix the idea that the bonus (or stock option plans) increase in value with risk, you have a recipe that is conducive to excessive risk taking.

For those interested, this is similar in spirit to some of the ideas put forth in John and John's 1993 Journal of Finance article.

People (especially those who want a bonus) will no doubt continue to argue that compensation did not play a role, but I can not even come up with that argument.

'A university bailout? from

'Shovel-Ready' on Campus -
"With the Big Three seeking a bailout from Washington,...executives of 36 public universities, state university systems and higher-education associations, urging Congress and President-elect Obama to rescue them.

Mr. Obama has already promised to expand federal subsidies to higher education by increasing Pell grants and making student-loan terms more permissive. The university chiefs seek an additional 'federal infusion of capital' -- as much as $45 billion -- to build new facilities, especially 'green' ones."

Dilbert on Finance-seriously.

The Motley Fool reports the following: 9 Things You Should Do Instead of Buying Stocks: "
Most know Scott Adams only as the creator of Dilbert. But ....Adams' passion for personal finance is matched only by his utter disdain for [individual] stocks. That's right, this keen observer of business and management trends believes that most people, himself included, cannot beat the market buying individual stocks -- especially when the companies behind those stocks are run by drunken chimpanzees.

Adams has nine steps that he says, when performed in order, can help you to generate -- and protect -- your wealth.....:
  1. Make a will.
  2. Pay off your credit cards.
  3. Get term life insurance if you have a family to support.
  4. Fund your 401(k) to the maximum.
  5. Fund your IRA to the maximum.
  6. Buy a house if you want to live in a house and can afford it.
  7. Put six months' worth of expenses in a money market account.
  8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker, and never touch it until retirement.
  9. If any of this confuses you, or if you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner."
Good advice.

In a full disclosure type of thing, Dilbert is often the last thing I read before falling to sleep or the first thing I wake up to in the morning, so I might be come on Dilbert and finance has to be a hit!

Wednesday, December 17, 2008

Eliot Spitzer Lost Money With Madoff

Class jokes rarely are funny to those not in the class, but since some former students may still br reading the bog I will include the following from Clusterstock.

Eliot Spitzer Lost Money With Madoff:
"Add the name Eliot Spitzer to the list of prominent people allegedly ripped off by Wall Street trader Bernard L. Madoff. Yesterday at Slate's holiday party Spitzer, who is writing a column for the online publication, confirmed that his family's firm had investments with a Madoff subsidiary."
You see, the joke in one MBA class last spring was to try and tie everything to Eliot Spitzer. Sort of like 6 degrees of Kevin Bacon but all at least somewhat finance related.

Pyramid Schemes Are as American as Apple Pie -

The Madoff fraud has many looking back at past Ponzi Schemes. The best history that I have seen is frm the WSJ (and John Gordon Steele). It is on US Grant and the pyramid scheme that used his name back in the 1880's.

Pyramid Schemes Are as American as Apple Pie -
"Ponzi schemes, where early investors are paid dividends out of the money put in by later investors, usually last only a few months. Charles Ponzi's eponymous scheme in 1919 started with just 16 investors and $870. Six months later, there were 20,000 investors who had put in $10,000,000. Ten million was a whole lot of money in 1919 and when it attracted attention, Ponzi soon found himself with a five-year jail term and the dubious honor of adding his name to the English language for a type of fraud he hadn't even invented.

Most Ponzi schemes are penny-ante affairs, such as chain letters, that bilk their victims out of a few dollars each. Even Charles Ponzi's investors put in an average of only $500 each. But Wall Street's most famous Ponzi scheme was, like the present one, no small affair. And its principal victim was a man few associate with Wall Street at all -- Ulysses S. Grant."

Tuesday, December 16, 2008

Done correcting and break update

Just a fast update on some non finance things:

  1. Grades are in. I wasn't sure if I would get them in by the deadline (and technically missed it but by less than an hour) but it is a relief to have them turned in. It was a very good group this semester. Smaller classes than normal, but the quality was excellent.
  2. Have several papers calling my name over break. To my co-authors, sorry. But you pretty much know that working with me things will take a while longer than expected.
  3. Before the papers however will be BonaResponds. We are going to help out in Bridge City Texas for 12 days (January 5-17th--and yes it is open to you! Come with us if only for a few days, actually if only for a few hours!). We will be helping rebuild after Hurricane Ike did its damage. It is really hard to believe how little coverage the area has been getting due to the election and the financial situation, but these people really need help. We'd love to have you help for as long as you can. And I guarantee you will help if you come! There is something for everyone to do. Contact me at or see for more info.
  4. Locally BonaResponds has several projects going and in fact today in an attempt to recover from correcting, I am going to go spend the day drywalling on a house we are making in Friendship NY. (Yes that is the name of the town!) So any posts will be later today.
To the students and faculty, have a great break! And keep checking the blog. Just because class is over, does not mean learning it :).

Sunday, December 14, 2008

Bernie Madoff's Victims: The List

Clusterstock is reporting that not only the Wilpons but also the Mets' minority owner Saul Katz lost money at the hands of Madoff. (also many any others. See the list:

Bernie Madoff's Victims: The List from Clusterstock

Mets owners are among those hurt by Madoff

Ok, now it is too much. Before the Madoff fraud was bad before but then it was just the economy and people's life savings (including many charities), now it is also the NY Mets! Yikes.

From The NY Times:
"Bob DuPuy, the president and chief operating officer of Major League Baseball, said Saturday that he and Commissioner Bud Selig had spoken with Wilpon on Friday. DuPuy said that all three believed that the fraud case would have no effect on the Mets’ operation.

But interviews Saturday with several people with knowledge of Wilpon’s business dealings revealed concern about significant problems that Wilpon and the Mets could encounter because of the reported fraud."

Friday, December 12, 2008

Madoff arrested, charged; may be facing $50 bln in losses: FBI - MarketWatch

When it rains it pours! As if investors didn't have enough to worry about, you can now add whether their fiduciaries are not only investing poorly, but whether they are ripping them off completely!

Madoff arrested, charged; may be facing $50 bln in losses: FBI - MarketWatch:
"Bernard Madoff, former Nasdaq Stock Market chairman and founder of Bernard L. Madoff Investment Securities LLC, was arrested and charged with securities fraud Thursday in what federal prosecutors called a Ponzi scheme that could involve losses of more than $50 billion."

It is still way too early to know how big this is (and early market reactions have been sort of a yawn), but as with most things dealing with Hedge Funds, it could be very explosive. This is espcially true since it hits them when already weakened by the market downturn (to say the least) and credit crunch. "

At SeekingAlpha, Michael Panzer quotes Real Money's Dough Kass:
"...alleged massive fraud at a well known investment firm could be "the biggest story of the year." In his view,

'It is bigger than Enron, bigger than Boesky and bigger than Tyco.
It attacks at the core of investor confidence -- because, if true, and this could happen ... investors might think that almost anything imaginable could happen to the money they have entrusted to their fudiciaries."

Stay tuned, we assuredly have not heard the end of this.

(And a note to my students, sign up now to do the case study in the spring! I have no doubt it will be a big one! Will be offered on a first come first serve basis)

So much for transparency

Shh. Don't tell them the bad news.

I guess we should have expected it. Government agencies are not known for being the most open of groups, but you'd think that in the case of making loans the Fed of all people would be a bit forthcoming. But to date that is not the case, which is a bit disturbing.

From Exclusive: Fed Refuses to Disclose Recipients of $2 Trillion in Lending "
"The Federal Reserve refused a request by Bloomberg News to disclose the recipients of more than $2 trillion of emergency loans from U.S. taxpayers and the assets the central bank is accepting as collateral."
In a way, this smells of the Japanese response during their bear market collapse when banks were urged to keep bad debts on the books. But not telling bad news is rarely an optimal solution.

More from the article:

"“If they told us what they held, we would know the potential losses that the government may take and that’s what they don’t want us to know,” said Carlos Mendez, who oversees about $14 billion at New York-based ICP Capital LLC....The Fed stepped into a rescue role that was the original purpose of the Treasury’s $700 billion Troubled Asset Relief Program. The central bank loans don’t have the oversight safeguards that Congress imposed upon the TARP....Total Fed lending exceeded $2 trillion for the first time Nov. 6. It rose by 138 percent, or $1.23 trillion, in the 12 weeks since Sept. 14, when central bank governors relaxed collateral standards to accept securities that weren’t rated AAA. "

What really is troubling is this quote, which seemingly is saying, "we have more bad news, but if we tell you, you might panic."

"In its response to Bloomberg’s request, the Fed said the U.S. is facing “an unprecedented crisis” when the “loss in confidence in and between financial institutions can occur with lightning speed and devastating effects.”"

While the incentive to not disclose is understandable, it is also probably wrong: by not saying who is in trouble, investors will fear the worse for all institutions.

Thursday, December 11, 2008

Stock Picker Bill Miller's Defeat -

We know so much less than we think we know. Just because someone has done well in the past, it does not mean that trend will continue.

It is fascinating that the big collapses (he financial debacles that are studied years later as well as the crushing military defeats) often happen after a long period of wins. Why? Because the decision makers fall in love with their ability (over confidence) and believe that just because it worked in the past, it will work again.

The following WSJ article talks about Bill Miller. Since many of you may not know him, let me give you a quote from the Legg Mason on its legendary fund manger:
"He was ranked among the top 30 most influential people in investing when he was named a member of the "Power 30" by SmartMoney. He was also named by Money magazine as "The Greatest Money Manager of the 1990's" and named Morningstar's 1998 "Domestic Equity Manager of the Year." In 1999, he was selected as the "Fund Manager of the Decade" by Also in 1999, Barron's named him to its All-Century Investment Team and BusinessWeek called him one of the "Heroes of Value Investing."
But that was before. Before this crash. Before things changed.

Without further adieu I give you the Wall Street Journal on (former?) stock market guru Bill Miller.

Stock Picker Bill Miller's Defeat -
"Fueled by winning bets on stocks other investors feared, Mr. Miller's Legg Mason Value Trust outperformed the broad market every year from 1991 to 2005. It's a streak no other fund manager has come close to matching.

Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying....

A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc.......These losses have wiped away Value Trust's years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar."
I feel like an ambulance chaser right now. Have to report it so others learn from mistakes and are not (as) Fooled by Randomness, but I still feel sorry for him.

U.S. Says It Will Bail Out Christmas -

U.S. Says It Will Bail Out Christmas -
"Government officials are said to be concerned at the risk that the collapse of Santa Claus could pose to the nation's intricately related system of holiday happiness. Though a failure by Santa Claus poses the largest systemic risk, the government is also prepared to step in to bail out Christmas trees, caroling parties and mistletoe producers.....Inside Treasury, some officials privately worry that such a precedent could result in the nationalization of Santa Claus, leading to similar calls for help next year from the Easter Bunny and even Valentine's Day. Treasury Secretary Henry Paulson personally concluded, however, that "Santa Claus is too big to fail.""
Read the whole thing here.

Hilarious....I had not seen this! Thanks JZ

The Predictive Power of Implied Volatility: Evidence from the Over-the-Counter Stock Index Options Market in Hong Kong and Japan by Wayne Yu, Evans Lui

In preparing for this weekend's derivatives lecture, I found this new paper by Yu and Lui that is consistent with the previous view that Implied Volatility is a better forecaster than either historical (naive) forecasts or GARCH forecasts.

One look at their paper from SSRN-The Predictive Power of Implied Volatility: Evidence from the Over-the-Counter Stock Index Options Market in Hong Kong and Japan by Wayne Yu, Evans Lui:

"Our findings suggest that implied volatility is superior to historical volatility or a GARCH-type volatility forecast in predicting future volatility in both the OTC and exchange markets. Our results also hold when we use the overlapping sampling procedure. We also compare the predictive power of implied volatility in the OTC market to that in the exchange market and we find that both markets are of similar efficiency.

"Using a proprietary database on the index options trading, we examine the predictive power of the implied volatility of both OTC and exchange-traded index options in Hong Kong and Japan. For the OTC market, our analysis reveals that the implied volatility of index options is informative of future realized volatility, that it outperforms the historical volatility and the GARCH(1,1) volatility forecast, and that it subsumes both of the historically-based volatility measures. Those findings are the same when we use the overlapping daily data. Our findings therefore support a popular theoretical proposition that implied volatility should be efficient since it is determined by market participants who are more informed and/or trained for predicting future volatility. After all, implied volatility is a forward-looking forecast, unlike any of the historically-based volatility including the more sophisticated GARCH forecast. Consistent with prior studies such as Christensen & Prabhala (1998) and Hansen (2001), in spite of its outperformance over the historically-based volatility measures, implied volatility is not an unbiased estimator for future volatility."

Now since this is looking at Hong Kong and Japanese markets, it might be useful to look back at some of the previous work on US option markets. For instance, consider this dated examination from Jonathan Godbey and myself.

Forecasting Power of Implied Volatility:Evidence from Individual Equities

"We find that [Implied Volatility (IV), Historical Volatility (HV) and GARCH based forecasts (GAR)] all provide useful information in forecasting realized volatility. However, the information content of the variables is not the same. Both alone and in more inclusive models, IV has more predictive ability than HV or GAR. Moreover, when all variables are examined simultaneously,
only IV is significant for all quintiles. These findings are consistent with the hypothesized view that IV has higher information content than HV or GAR. Equally interestingly, we show that while implied volatility is a significant predictor of realized volatility, its predictive ability increases with option market volume. This last finding may have important implications for options that trade infrequently.

Our work is unique in that we look at implied volatility from calls and puts separately while previous research relied solely on calls or an index of both. Because individual equity options are American options, the implied volatility based on puts and calls may be different. By keeping the data separate, we are able to show that the implied volatility estimate from each type of option has the similar amount of information and this information content is positively related to
the liquidity of the options"

Wednesday, December 10, 2008

When renting a ship to anchor it offshore makes sense (and cents!)

Contango and Backwardation are two terms that confuse many students. But with today's oil markets giving us an historic (and memorable!) example of contango, I trust many more will remember it going forward.

First the fast definitions: (want a better definition? see
Contango: when futures price is higher than spot price
Backwardation: when spot price is higher than futures price

Now the story. Oil prices have fallen sharply. In the short term there is more oil than we need. Of course producers will likely adjust (and the economy recover) so most future market participants beleive that oil prices will go up in the future. So why not buy now and hold on to it? Well one problem is that it is not a trivial thing to store oil for long periods of time. Contango Pays Most in Decade as Shell Stores Crude:
"...traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain."
Now of course there are costs involved (cost of capital and storage costs)
"After taking into account storage and financing costs investors would earn about 11 percent, according to Andy Lipow, president of Houston consultant Lipow Oil Associates LLC."
But where do you store so much oil? With storage facilities in Cushing Oklahoma and elsewhere filling up, companies are renting tankers to anchor off shore holding the oil.

Again from Bloomberg:
"Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery. The ship is one of as many as 16 booked for potential storage instead of transporting crude, said Johnny Plumbe, chief executive officer of London shipbroker ACM Shipping Group..."
Want to learn more about the contango and backwardation? Check out this teaching video from Bionic Turtle.

Tuesday, December 09, 2008

Say what? Yep a negative T-bill rate

From Treasury Bills Trade at Negative Rates as Haven Demand Surges :
"Treasuries rose, pushing rates on the three-month bill negative for the first time, as investors gravitate toward the safety of U.S. government debt amid the worst financial crisis since the Great Depression.

The Treasury sold $27 billion of three-month bills yesterday at a discount rate of 0.005 percent, the lowest since it starting auctioning the securities in 1929. The U.S. also sold $30 billion of four-week bills today at zero percent for the first time since it began selling the debt in 2001."
Which means:
"If you invested $1 million in three-month bills at today’s negative discount rate of 0.01 percent, for a price of 100.002556, at maturity you would receive the par value for a loss of $25.56."
Why? Probably in part window dressing so that they appeared to own safe securities at year end and in part because people are so scared they are going to lose money in other securities. Which really says something about risk aversion levels now.

Thanks Tom for the link!

Holding CEOs Accountable -

Jonathan Macey has a great piece in the WSJ on the problems with many boards.

Holding CEOs Accountable -
"As board tenure lengthens, it becomes increasingly less likely that boards will remain independent of the managers they are charged with monitoring. The capture problem is exacerbated by the incentives of managers to develop close personal ties with directors."
Sounds a lot like behavioral finance! Not willing to admit mistakes etc. One more look:
"Once an opinion, such as the opinion that a CEO is doing a good job, becomes ingrained in the minds of a board of directors, the possibility of altering those beliefs decreases substantially. All too often, it is only when an outsider takes an objective look does anybody realize the obvious: That the directors of a company are generally the last people to recognize management failure"
It is refreshing that Macey, like in his book "Corporate Governance: Promises Kept, Promises Broken", comes out for a market (and not a regulation) solution.
"We need to encourage market solutions -- not bureaucratic ones -- as the best strategy for addressing the corporate governance failures we face today. Hedge funds and activist investors like Carl Icahn are the solution, not the problem."

Customers as shareholders or shareholders as shareholders

Learning new things should cause us to rethink our positions. The reevaluation is much preferred over stubbornly clinging to what once seemed to be a good idea. That said there must be a happy median between just shifting in the wind and obstinacy.

With that in mind, it is time for a fast finance lesson.

Within the nexus of contracts that make a firm there are many ways we can link the various stakeholders. One such linkage is that a firm could link its customers and owners. This was mutualization once somewhat common in insurance, savings and loans, and other co-op type businesses (food co-ops etc).

Over the years this linkage has grown much less common and many former mutual firms have demutualized. The reasons for this evolution were as varied as the firms themselves. Some wanted access to more capital, others wanted the so-called market discipline that is supposed to come through better shareholder monitoring, and still others no doubt did it at the urging of investment bankers who saw a big pay day from the firms' IPO.

FinanceProfessors also frequently urged this efficiency gain. For instance in my classes I talked regularly of papers (in particular Cliff Smith's 1977 piece) about how through evolution it seemed that shareholders as an independent group seemed to be more efficient and had beaten shareholder-customer based firms. Take for example what I wrote in July of 2000 FinanceProfessor newsletter (a precursor to the blog)
"In times of change, it is often useful to be a public company. The market imposes discipline and guidance. This is what Cliff Smith predicted in his paper on the demutualization of insurance firms (1977). This demutualization has not been allowed in Japan. However, it looks like it soon will be allowed and already life insurance firms are lining up to take advantage of the deregulation. Daido Life is set to be the first. Currently the life insurance firms are mutuals which means they are owned by their customers."
And again in April of 2005 when I quoted Ohio State's Ingrid Werner on the pending IPO/demutualization of the NYSE as a
"NYSE's move illustrates the advantages of demutualization to increase transparency, raise capital for technological improvements and increase the speed the process for future changes"
This view that stock firms were more efficient than mutual firms was given further support in 2004 when Mayers and Smith looked at the empirical evidence:
"We examine 98 property-casualty insurance companies that convert to stock charter from a mutual or reciprocal form of organization....our evidence suggests there can be important costs associated with the operation of a mutual or reciprocal insurance company. These costs can include the opportunity costs associated with foregone investments arising because of higher incremental capital costs inherent in the mutual or reciprocal forms of ownership. There also is a cost disadvantage if a mutual or reciprocal is operating in activities more appropriate for the stock ownership form. These costs can in particular circumstances offset the advantage mutual ownership affords in controlling incentives to transfer wealth from policyholders to equityholders."
That was my classroom spiel. Combining shareholder and customer roles might have some advantages in marketing (think loyal customer base) but overall the stock corporation wins out as incentives are better and managers can be replaced (hostile takeover in extreme case) if they do not do their job.

So it was with great anticipation (and some trepidation) that I read the following from Forbes:

Mutual Respect -
"The sharpshooters at publicly owned insurers used to scoff at their stodgy competitors, the mutual insurers. Not anymore....

Without the shareholders' lash to whip them into shape and stock with which to buy rivals, policyholder-owned insurers were sure to get crushed by publicly traded rivals. So went the argument, and so began a flight from mutual ownership that included such stalwarts as Equitable, Prudential and Metropolitan."
But that has not worked out quite so well. Again from the article:
"...publicly traded insurers are scrambling for cash by cutting dividends and issuing new shares (diluting existing investors), begging regulators for a relaxation of capital requirements and lobbying Washington for a cut of the $700 billion Wall Street bailout.

Their mutually owned rivals haven't asked for a dime. Their statutory surpluses (the regulatory counterpart to book value) have held steady or even increased. Some are announcing plans to pay out near-record dividends to policyholders."

Acknowledging that there are some accounting differences which MIGHT be slowing the mutuals from admitting any failures, the article goes on to suggest that the root cause was that shareholders demanded too high of returns and that the only way to achieve these results was through increased risk taking.

"Life insurance analyst Arthur Fliegelman....puts the blame for their missteps squarely on the need to satisfy Wall Street and its lust for quarterly profit gains. Public companies felt they had to report a return on equity of at least 15%. "You just can't do that in a mature business without taking too much risk,""

"David Schiff, an industry gadfly and publisher of Schiff's Insurance Observer, has been warning since the late 1990s that earnings-per-share pressures would drive insurers to do dumb things. He was right. Since going public Prudential has spent $11 billion buying back shares at an average cost of $63, Schiff estimates. Those shares are now worth $19. Hartford spent $2 billion the past two years buying back stock. That's as much as the entire company is now worth"

(Quick time out. Are Peter and David brothers?)

Which gets us to what am I going to teach now?

I still maintain that decoupling the roles of shareholder and customer is generally the way to go. It does increase access to capital and allows firms to judge (albeit imperfectly) how well they are doing. There is also increased transparency and less entrenchment of management.

But that said, if the economy is growing at 3% per year, firms can not grow at 15% per year indefinitely without excessive leverage. Consequentially it is imperative that firms set realistic expectations for the future even when they don't have an incentive to do so. (Which I confess is a big problem!)

And finally there will likely always be a segment of the market that remains a mutual firm. That is fine. There need not be a single way. For some firms it may be optimal for a mutual structure but for the vast majority having shareholders as shareholders and customers as customers seems more efficient.

Monday, December 08, 2008

Warren Buffett: then and now

Clusterstock may have outdone themselves with their great look at Warren Buffett's previous articles. One in 1974, one in 1979, one in 1999, and then a recent opinion-editorial in the NY Times.

Buffett Calls The Market Again...And He's Never Been Wrong:
"...who is Buffett, anyway? How do we know he isn't one of these jokers who is never in doubt and usually wrong?"
While all of the articles are fascinating (historical and relevant at the same time), I will only give you one peek:

From October 16, 2008's NY Times
"THE financial world is a mess, both in the United States and abroad. Its problems,
moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."
If you can spare a few minutes, read the whole thing. I have had that window open for three days trying to read it and have to say it was definitely worth the wait! Great stuff!

Sunday, December 07, 2008

Looking back at Pearl Harbor

In a week that we spent quite a bit of class time talking about impact of "non linear" events (Black Swans etc) and almost 67 years to the day, I wanted to take a look at some Pearl Harbor sites and then got thinking maybe showing what happened to the US stock market would be interesting. So:

Disasters and Their Impact On the Stock Market:
"...for Pearl Harbor, on the first day after the attack the market dropped 2.93%. On the second day, it dropped another 2.84%. And on the third day it dropped an additional .27%"
Over the time of the war as it because apparent the Allies would win, the US stock market climbed dramatically. See this chart.

Saturday, December 06, 2008

Money Factory--Great for a Money and Banking class

If you are in a Money and Banking class, you will definitely want to watch this one!

Hulu - National Geographic Channel: Money Factory:
"Money: everyone wants it, dreams of it and schemes for it. Find out how U.S. currency is made, faked and protected, and meet the mastermind behind one of the biggest counterfeit.."

Friday, December 05, 2008

The Sky is falling!!! but maybe not all the way

With apologies to chicken little, it is bad out there: over half a million jobs lost in one month and almost 2 million so far this year, stock markets down, people fearing for their jobs, and the governments bail outs seemingly being every day events.

Not surprising this bad news is forcing investors to become more risk averse and many to become more pessimistic. Indeed, with all this bad news economists are suddenly making Thomas Malthus (the person largely responsible for Economics being called the Dismal Science) seem the norm.

A few of the more dire forecasts:

MarketWatch reports that
"...former Goldman Chairman John Whitehead? He "sees" a tragic ending: This Reagan Deputy Secretary of State and former New York Fed chairman "sees" America burning through trillions, over many years: "Nothing but large increases in the deficit ... worse than the Depression." See previous Paul B. Farrell. He worries that "tomorrow is the day Moody's and S&P will announce a downgrade of U.S. government bonds." Politicians and public are delusional, promising huge new programs plus tax cutting: "This is a road to disaster.' .... he says: "I don't see a solution.

(FTR the article presents several near Doomsday scenarios)

Faced with these possibilities, the government is doing what it can to prevent a repeat of the Great Depression of the 1930s.

Clusterstock quoting the Spectator:

"The Americans allowed a depression to develop in the 1930s because they were afraid of the consequences of losing the principles of sound money. In an effort to avoid a re-run of the 1930s, the Western world is imposing the opposite, equally unbalanced and intemperate solution. We might thereby avoid a depression — but the bad stuff which follows currency compromise will crash down upon us with great vigour. This is the one and only one, and probably last, shock that the credit crunch has yet to impose on a still unsuspecting world.

....The world has survived and thrived under a paper regime. But the greybeards were right, too. Within 15 years, the currencies of Russia, Germany and Austria were worthless. France’s had dropped in the eight years up to 1926 by 86 per cent, Portugal’s was down by 93 per cent and by 1930 only six had held steady against the ‘gold exchange’ dollar of 1918. The rules were understood by all. If you were going to have an inconvertible currency, you had to behave impeccably: deficits were dangerous and there must be no growth in the money supply."

Will it work? We don't know. But they are trying. Will it lead to inflation? Maybe. Probably. Is inflation better than the alternative of a long long recession/depression? Again, the best I can give you is a "probably".

How long will recession last? No idea.
How bad will it get? No idea.

So instead of just guessing, let's turn to noted NYU Economist, and famous Bear, Dr. Roubini. "Dr. Doom" does think equities will fall by another 20-30% and further drop in equities but that the recession will only last another year.

Dr. Doom Foresees Much More Pain So Why Is Roubini's 401(k) All in Stocks: Tech Ticker, Yahoo! Finance:
Roubini predicts that macroeconomic news and earnings will be much worse than expected in the coming months, as the dollar weakens even further. 'The surprise is how bad the the economy [will get].'""
But adds
" I'm not in the Armageddon camp," forecasting a severe recession through 2009, but not a repeat of the Great Depression.

Thursday, December 04, 2008

Treasury Weighs Plan To Cut U.S. Mortgage Rates : NPR

Treasury Weighs Plan To Cut U.S. Mortgage Rates : NPR:
"The Treasury Department is considering a plan to dramatically lower mortgage rates for homebuyers to as low as 4.5 percent — more than a full point below currently offered rates, sources say."
It seems that this would be done by the government buying up mortgages much like the Fed recently said they were going to do. One problem, as the piece suggests, is that if this idea is allowed to hang around without action it may have the reverse effect since buyers may wait for the lower rates much like deflation.
"Why should I buy a house today with a 5.5 percent mortgage rate if I can wait a month or two and buy it with a 4.5 percent mortgage rate?" says David Kotok, chief investment officer at the money management firm Cumberland Advisors.

So, he says, the government really can't take much longer to announce what's its planning to do."

CNN adds a very troubling aspect:
"Lobbyists are pushing the Treasury Department to consider a plan to purchase mortgage-backed securities in the hopes of driving mortgage rates to as low as 4.5%, an industry source said."
It is almost certain that the lobbyists and other industry groups are made up of people and as such they are looking out for what is the best for them, not necessarily the country. (And I can not stress enough I do not know enough about this to be in favor or against it. My prior is still less government intervention is better, but do not know the details so will be quiet). And weren't really low rates (almost artificially low) cited as one of the causes of the orginal real estate bubble. How will it be different this time is a big question that needs to be answered.

ML analyst suggests oil could go to below $25 a barrel! Worldwide:
"Crude oil may dip below $25 a barrel next year if the recession that’s slashing fuel demand around the world spreads to China, Merrill Lynch & Co. said.....Global oil demand has slumped as the U.S., Europe and Japan face simultaneous recessions for the first time since World War II. The number of Americans collecting jobless benefits rose to 4 million in the week to Nov. 22, a 26-year high, the Labor Department reported today. European Central Bank President Jean- Claude Trichet said the euro region’s economy will shrink in 2009."

It seems only yesterday (actually was end of spring semester) that experts were calling for $200 oil, which might suggest how much weight we should given so called-experts and their forecasts.

Freeport-McMoRan Gets Out The Ax -

Great class example.

Freeport-McMoRan Gets Out The Ax - "
The Phoenix-based mining company said Tuesday it was suspending its dividend, scaling back production and slashing its 2009 capital expenditures plans...Shares of Freeport tumbled 17.3%, or $3.77, to close Wednesday's trading session at $18.05"

A few comments:
1. Dividend cuts convey additional information about the future (signaling)
2. Capital Expenditures cuts are also generally seen as bad news and a bad sign for future.
3. That commodity prices had fallen was not news, so it does not explain why price of stock fell.

The first two points are included in the tables from Smith and Masulis that we use in class regularly.

BTW As an aside, the SBU Student Managed Investment Fund currently does own Freeport-McMoran. Oops!

Wednesday, December 03, 2008

For first time in 50 years, stocks yielding more than bonds - MarketWatch

For first time in 50 years, stocks yielding more than bonds - MarketWatch:
"As of Tuesday's close, for example, the S&P's dividend yield was 3.3%, while the 10-year T-Note was yielding 2.7% -- a spread of 0.6 percentage points in favor of stocks. To put this in historical context, the spread since 1958 has averaged 3.7 percentage points in favor of bonds."
Before 1958 what now seems an inversion was the norm. The MarketWatch article quotes Peter Bernstein on when dividend yields first became lower than t-bond yields:
"This ... was unprecedented. The two yields had come close in the past but had always backed away at the critical moment. In 1958, they reversed their historical positions and have never looked back."
Why? It is difficult to say but risk aversion is the likely culprit. The time prior to 1958 was close enough to the Great Depression that many investors still feared stocks and needed to be persuaded to buy ("can I get you to buy the riskier asset?") stocks. Again from the same article (citing Cliff Asness' work) that looks at the longer term relationship of T-Bond yields and dividend yields (from 1871 to present time)
"...the key element of this bet is investors' expectations....The memory of the Great Depression lingered for years after it ended...which is one reason why stocks' dividend yields remained so high.

In contrast, the Baby Boom generation (at least possibly until now) had no traumatic memory similar to their parents' memory of the Great Depression. That in turn helps to explain why stocks' dividend yield slipped in the 1960s and beyond, relative to bonds' yields.

The bottom line? If enough investors become sufficiently traumatized by what's going on right now, and as a result more or less permanently expect stocks' volatility to remain a lot higher than bonds' volatility, then stocks' dividend yield is likely to remain above bond yields.
Thanks Jon S for the link!

The Bailout So Far -

As Big Three auto manufacturers asks for $34 Billion (up $9 billion in a week) from the government, the government's TARP program comes under attack from the GAO for its loose controls, and AIG plans on asking for a still better deal, the WSJ gives us a look at the Bailout so far.

Important background for those who do not know who Doug Flutie is or do not remember the play for which he is most famous watch this video.

Holman W. Jenkins Jr.: The Bailout So Far -
"We have gone from arm's length, free market, just-in-time availability" of funding to a system where big credit-reliant businesses now have only one place to turn, government.

With pundits threatening the economy with deflation and another Great Depression, none have really been able to argue effectively against this expansion of government responsibility and interventionist zeal....

Maybe Washington will succeed in forestalling a deep and prolonged recession. Maybe all the money ($8 trillion by one count) being printed to acquire or insure mortgages, student loans, credit card receivables, commercial paper and banking shares will be seamlessly withdrawn once those assets are sold back to willing parties in the private sector when the panic has passed. Maybe taxpayers will even make a profit on the deal.

As Doug Flutie can testify, sometimes a 65-yard pass into the end zone lands in the hands of your own receiver....

The U.S. was not Japan when we started but may be Japan when we're done. Remember, the Japanese had a much more closed financial system when entering their post-bubble "lost decade" of the 1990s. We have venture capital, private equity, hedge funds, and an entrepreneurial tradition....

All that may come to an end as cheap government credit drives financial entrepreneurs to the sidelines. We may be able to roll over the resulting mounting federal debt at cheap rates for a while if international markets are willing (there is still confidence in government at least). But unless Gerard Phelan catches the ball in the end zone and GDP bounces back strongly, the bailout's end result may be towering tax rates, drastic spending cuts or serious inflation -- or all three."

How Stocks Have Returned 10% Per Year

After Henry Blodget from Clusterstock was on NPR saying that stocks were back to "fair value" (i.e. their long run average), he had a listener email him about how the 10% annual return in stocks is found. His answer is below:

How Stocks Have Returned 10% Per Year:
"...the 10% number includes dividends, which is the way people normally look at stock market returns. On a pure price basis, returns have been far lower.

In fact, here's an approximate breakdown of the 10% average return for the last 80 years:

4 points: Dividends
2 points: Real EPS growth
3 points: Inflation (reflected in EPS growth)
1 point: Multiple expansion

Now that stocks have finally dropped back to fair value again, I thinkt the long-term return from here is likely to be in the average range again. The multiple expansion might not continue, and dividends are currently about 3%, not 4%, so it could be lower. But the dividend payout ratio could rise again, and it may be that structural changes (more cash-efficient services companies vs. low-return-on-capital industrial companies) will lead to continued PE expansion"

Tuesday, December 02, 2008

Videos explaining aspects of the current financial situation

Wow. The Unknownprofessor over at Financial Rounds really found some great lessons done in video format. AMAZINGLY good and am embarrassed to say I had not seen them before today.

My personal favorite uses an Arctic Expedition to show what has happened and what credit default swaps are.

The second video is on CDOs. GREAT!

Thanks to Financial Rounds!

And finally one that I just found when watching the other two:

Potentially the biggest (most serious) situation since the American Revolution?

Granted this was a month ago, but bigger than the US Civil War? Bigger than the Depression? WW II? Wow. That was one of the warnings from Nissan Taleb on the PBS news Hour in late October about the current financial situation.

Thanks to Mark for pointing this one out to me.

Universities as sellers Exclusive:
"A push by the richest U.S. universities to unload their stakes in private-equity funds is flooding the market, driving down prices for the world’s best- known buyout firms.

Investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion, may increase so-called secondary sales of private-equity funds to more than $100 billion during the next year, overwhelming available pools of capital. Interests in funds managed by KKR & Co., Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent, according to people familiar with the sales."

in the same article about UVA.

"The University of Virginia in Charlottesville said in a statement posted on its Web site that it may sell some of the $1.6 billion it has invested in buyout funds, noting that proceeds “may be far below face value.”"

Dealbook - Putting a Value on a C.E.O. -

The NY Times has an interesting look at CEO pay and how having the government playing a role may lead to different outcomes. Using Citi as an example, the article asks how pay can be structured to bother create proper incentives and reward managers.

Dealbook - Putting a Value on a C.E.O. -
"...many people argue that Wall Street’s approach to compensation helped get us in this mess to begin with. Bankers were rewarded for taking risks that they clearly failed to manage. So something has to change.

The trick, of course, is to dole out enough rewards to keep executives working, and working hard, but not to dole out too much....firms need to find ways to keep and attract talented people who can make smart decisions, without lavishing pay on them or rewarding them for shoddy performance."

Which is easier said than done.

Remember there are two big questions with respect to pay that often get blurred. The level of pay (how much) and the form of pay(how do we pay them). And as we change one, the other must be accounted for as well.

What would I liek to see? Many CEOs (and others) get zero this year. If you get large rewards for good times, you must be penalized in bad times. Indeed, in some of these instances, you would really like to see the managers pay the firms back for what they made in the past as their systems led to the current problems.

Fed and tresury officials on why they did what they did

I am a "glass is half full" person who on top of that thinks that we will probably find more water before even that is gone. But I do get a tad concerned when smart people who have informational advanatges get worried. We had two examples of this today.

FromTreasury Secretary Henry Paulson as quoted at Worldwide:
"Treasury Secretary Henry Paulson said his actions bailing out some U.S. companies to help strengthen capital markets, while “objectionable,” were necessary to prevent a deeper collapse of the global economy.

“Some of the things that I’ve been part of have been very, very objectionable decisions, but they haven’t been difficult decisions” because the alternative would be “much worse,” Paulson said, responding to questions after a speech in Washington. “I’ve looked at some of the things I’ve done as being essential to preserve the free market system.”"

And from Ben Bernanke the Fed chairman in a speech in Texas:
"..this extraordinary period of financial turbulence is now well into its second year. Triggered by the contraction of the U.S. housing market that began in 2006 and the associated rise in delinquencies on subprime mortgages, the crisis has become global and is now affecting a wide range of financial institutions, asset classes, and markets. Constraints on credit availability and slumping asset values have in turn helped to generate a substantial slowing in economic activity.

The Federal Reserve's strategy for dealing with the financial crisis and its economic consequences has had three components. [1]First, to offset to the extent possible the effects of the crisis on credit conditions and the broader economy, the Federal Open Market Committee (FOMC) has aggressively eased monetary policy. ...The Committee's rapid monetary easing was not without risks. Some observers expressed concern at the time that these policies would stoke inflation, and, indeed, inflation reached high levels earlier this year....[but] As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation appears set to decline significantly over the next year toward levels consistent with price stability.

[2]... the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets.

To ensure that adequate liquidity is available, consistent with the central bank's traditional role as the liquidity provider of last resort, the Federal Reserve has taken a number of extraordinary steps. For instance, to provide banks and other depositories easier access to liquidity...Judging the effectiveness of the Federal Reserve's liquidity programs is difficult. Obviously, they have not yet returned private credit markets to normal functioning. But I am confident that market functioning would have been more seriously impaired in the absence of our actions.

and finally:

"...the third component of our policy response has been to use all our available tools to promote financial stability, which is essential for healthy economic growth. At times, this has required working to preserve the stability of systemically critical financial institutions, so as to avoid further costly disruptions to both the financial system and the broader economy during this extraordinary period. In particular, the Federal Reserve collaborated with the Treasury to facilitate the acquisition of the investment bank Bear Stearns by JPMorgan Chase and to stabilize the large insurer, American International Group (AIG). We worked with the Treasury and the Federal Deposit Insurance Corporation (FDIC) to put together a package of guarantees, liquidity access, and capital for Citigroup. Other efforts include our support of the actions by the Federal Housing Finance Agency and the Treasury to place the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac into conservatorship and our work with the FDIC and other bank regulators to assist in the resolution of troubled depositories, such as Wachovia. In each case, we judged that the failure of the institution in question would have posed substantial risks to the financial system and thus to the economy."

As CNN points out, these programs do come with big downsides:
"...there is a downside to all of the Fed's programs. Fed lending has ballooned. Bernanke said that the central bank's balance sheet will need to be brought back to a sustainable level in the future. The government does not want financial institutions to become reliant on the Fed for liquidity, and an enormous balance sheet could result in high inflation down the road.

"That is an issue for the future," Bernanke said. "For now, the goal of policy must be to support financial markets and the economy.""

Monday, December 01, 2008

It's official: U.S. in a recession since December 2007 - Dec. 1, 2008

It's official: U.S. in a recession since December 2007 - Dec. 1, 2008:
"The NBER is a private group of leading economists charged with dating the start and end of economic downturns. It typically takes a long time after the start of a recession to declare its start because of the need to look at final readings of various economic measures.

'The committee views the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment,' said the group's statement. 'This series reached a peak in December 2007 and has declined every month since then.'

Employers have trimmed payrolls by 1.2 million jobs in the first 10 months of this year."
Interesting. Earlier than I would have guessed.

Wednesday, November 26, 2008

Best Explanation in One Sentence - Mises Economics Blog

Whether you agree or not, this line is so awesome I have to include it...

Best Explanation in One Sentence - Mises Economics Blog:
"'If the money is used to prop up failing companies, that's particularly bad since it is an attempt to override market realities, an attempt that is about as successful as trying to repeal gravity by throwing things up in the air.'"
And it does serve as a good reminder throwing good money after bad is not an answer. Changes to prevent the same problems from happening again must be made or else the bailouts will create more problems (notably inflation, dwelling deficits, and a worsened morale hazard problem).

How Scientists Helped Cause Our Financial Crisis

Garbage in, Garbage out. Models are not reality. Models only help explain reality and therefore help our understanding of a reality that is generally too complex to fully grasp.

These ideas are taught in every stats, econometrics, and finance class worth its weight. On every test students use (indeed sometimes overuse) "data limitations", "it uses historical data", and "surprises (or black swans) can occur that would make our model incorrect" as problems with such and such model. And yet somehow, quantitative geniuses (or at least the traders and managers who relied on the models) seeming forgot (uh, looked the other way?) and ignored the problems.

So how did so many smart people seemingly forget? In part they were paid to forget (bonuses, promotions for big successes with little accounting for risks taken--for more of this see Taleb's "Fooled by Randomness".

Scientific America and ClusterStock look at this issue in How Scientists Helped Cause Our Financial Crisis
"In retrospect, the financial planning by our most sophisticated financial institution looks incredibly stupid. Merrill Lynch never included in its plans the risk that its counterparties could demand more collateral. Citigroup proceeded to dive headlong into the mortgage market on the assumption that a national housing decline was impossible. Everyone, it seems, failed to guard against the risk that they might be forced to sell assets to raise capital during a downturn. So it's worth asking: how did so many rich guys get so dumb?"
Scientific America quoted in the same piece:
"The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame....The government bailout has already left the U.S. Treasury and Federal Reserve with extraordinary powers. The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers....risk management models should serve only as aids not substitutes for the critical human factor. Like an airplane, financial models can never be allowed to fly solo."
Remember, models are representations of reality. Economic models, no matter how super, are no more reality than are super models are representations of the average Joe (or Jill or Jim or Jerry or Jane).

Schiff continues to believe that the worst is yet ahead.

Peter Schiff 'Opportunity of a Lifetime' in Gold Intl. Assets Not U.S. Stocks: Tech Ticker, Yahoo! Finance:
"Schiff believes have another 5 to 10 years of bear market action ahead as America struggles to come out from under a mountain of debt."
Clusterstock on the same:
"As discussed in the accompanying video, Schiff believes the recent dollar rally and commodity price weakness will prove temporary. Most troubling, he says the "economic crisis is only just beginning.""

Tuesday, November 25, 2008

A Reporter at Large: Anatomy of a Meltdown: Reporting & Essays: The New Yorker

A Reporter at Large: Anatomy of a Meltdown: Reporting & Essays: The New Yorker:
"For more than a year after he was appointed by President George W. Bush to chair the Fed, in February, 2006, he faithfully upheld the policies of his immediate predecessor, the charismatic free-market conservative Alan Greenspan, and he adhered to the central bank’s formal mandates: controlling inflation and maintaining employment. But since the market for subprime mortgages collapsed, in the summer of 2007, the growing financial crisis has forced Bernanke to intervene on Wall Street in ways never before contemplated by the Fed....These moves hardly amount to a Marxist revolution, but, in the eyes of many economists, including supporters and opponents of the measures, they represent a watershed in American economic and political history."

Thanks to MoneyScience for the link! VERY good stuff!

Baltimore Firm Delays IPO to Wait Out Risk -

Having just done IPOs in class, this was of special interest.

Baltimore Firm Delays IPO to Wait Out Risk -
"When Grand Canyon Education of Phoenix went public Thursday, it was the first U.S. company to have an initial stock offering since Aug. 8. On that day, Rackspace Hosting of San Antonio broke the longest IPO dry spell since 1975....Since August, at least 29 companies have canceled or postponed their offerings on U.S. markets, according to Reuters."

Jay Ritter has a fascinating look at IPOs by each month from 1960 to 2005. It is a spreadsheet and not labeled but the columns are month, year, average first day return for the month's IPO, and number of IPOs that month. From that data:





































Grand Average