...Archive for October 2006

How (not) to regulate investment funds

Today seems to be the day for waxing cynical about the prospect of hedge fund regulation. John Carney at DealBreaker writes:

It’s a pretty simple formula: regulate an industry and you instantly politicize it. Which is another way of saying that you monetize the industry for politicians…

All the other talk -— about “systemic risk” or pension funds or low-liquidity real estate millionaires -— is just the sound of a policy in search of a rationale. And that policy, of course, is the enrichment of politicians. That’s always the policy.

Of course loyal readers (hi mom!) will know that I think “systemic risk” is very real, and that it will hit us all like a rocket-propelled two-by-four, soon. But I quite agree with the cynicism about policy and politicians. So what is to be done?

Here’s a simple suggestion. Investment funds should not be permitted to be limited liability entities. As legal entities, they should be restricted to organization as ordinary partnerships.

This isn’t really regulation at all — It simply amounts to the state declining to confer the privilege of limited liability to certain kinds of organizations. Limited liability is rife with moral hazard problems, but most people (including emphatically myself) would argue that its advantages far outweigh its disadvantages for nonfinancial businesses.

But limited liability, like copyright, is a legal oddity conferred for a specific purpose: to encourage entrepreneurs to start and invest in risky but productive ventures. The businesses that investment funds put their money in should certainly be limited liability ventures. But the risks taken by the investment funds themselves are speculative financial risks. When a fund invests without leverage in a corporation, the fund’s own limited liability status is worthless. With or without limited liability, the fund can lose all of, but no more than, the value of its investment. But if a fund borrows from a bank to invest ten times its own money in that same corporation, the fund’s limited liability status is a big deal. It lets the funds investors reap investment gains from much more money than they own, while risking no more than the same meagre amount as in the unleveraged case.

There’s no reason the state should grant investment funds a special dispensation to encourage this kind of risk. Fund investors should be allowed to take speculative financial risks, sure. But fund investors should be responsible for all the money they lose if things go sour. They shouldn’t be able to let the bankruptcy of some shell corporation or LLP shield them from the consequences of speculative financial foolhardiness.

It’s one thing to socialize the risk faced by an entrepreneur starting a productive business. It’s quite another thing to socialize the risk of taking on leverage to achieve speculative financial gains. Limited liability is a privilege, not a right, and an oddity from a libertarian perspective. It should not be extended to leveraged investment funds.

Hedge funds should not be leveraged

My inner Roubini has been kicking the shit out of my inner Cramer for more than a year now. So it was with some surprise that I found myself nodding along and murmuring “Amen” to Cramer’s New York magazine piece on hedge funds, After Amaranth.

Cramer makes some pretty obvious, good points. Like, since hedge funds are supposed to be for highly risk-tolerant investors, pension funds oughtn’t be in the game.

(I know, I know. Asset allocation, low covariance, diversification benefits, yadda yadda yadda. With perfectly disciplined, reasonably informed investment managers, pension funds ought to be able to achieve more optimal portfolios with some exposure to this alternative investment class. But, star pension fund managers will always be more competitive than discipled, and hedge funds are too secretive for pension managers to adequately evaluate. Risk-taking by pension funds is particularly unethical since risk-intolerant pensioners are much more exposed to the downside than the upside of pension returns. See agency cost #4.)

Regarding pensions, Cramer offered the following suggestion:

The other way to regulate hedge funds is to say that you can’t borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money.

This got me thinking. Why should hedge fund be leveraged at all?

“What?!? Hedge funds are all about leveraged investment strategies!” I know, I know. But hear me out. Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn’t hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. And while investors may enjoy letting their bankers share much of the downside of their investments, there’s little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy. If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund). Also, investors could better tailor their hedge-fund investments to their own level of risk tolerance.

Finally, without leverage, hedge funds would have to compete based on the intelligence of their investments, rather than their ability cajole bankers into lending them too much money, too cheaply. In such a world, it might actually be true that these funds would fuction to squeeze inefficiencies out of markets, rather than highlight and take advantage of conflicts of interest between bank managers, depositors, and governments..

I’m not suggesting that hedge funds shouldn’t be able to borrow at all, as many hedge-fund strategies, like going short, require borrowing. And the implicit leverage inherent in many derivatives positions would represent a challenge to any regime that purported to regulate hedge fund leverage without otherwise limiting investment cleverness. Nevertheless, at least in theory, is there any good reason why limited liability investment funds for the rich and creditworthy should be permitted to take on high degree of leverage?

Update History:
  • 1-Nov-2006, 6:00 a.m. EET: Removed an unnecessary word. (“…pension managers to adequately evaluate them.”)

Agency Costs and Leveraged Investment Funds

With all the fuss about hedge funds and private equity these days, I think it’s worth cataloging in simple terms the multiple levels of “agency costs” associated with leveraged investment funds. [1]

  1. Agency costs imposed by fund managers on investors
  2. Agency costs imposed by fund investors on banks and other creditors
  3. Agency costs imposed by bank managers on bank shareholders, depositors and governments
  4. Agency costs imposed by investment managers on institutional investors
  5. Agency costs imposed by institutional investors on governments and the public at large

  1. Agency costs imposed by fund managers on investors

    As is widely discussed, many hedge-fund managers have a “two and twenty” fee structure, meaning they take as fees 2% of the funds they manage under any circumstances, and 20% of any profits achieved. Because fund managers see the upside of gains but not the downside of losses, a rational self-interested fund manager will take more risks than her investors would if they were managing their own money. Also, fund managers often compete on the basis of short-term apparent performance. A rational, self-interested fund manager may prefer a “get rich quick” strategy to a long career. Such a manager might take positions that trade high immediate returns for large future risks. Credit default swaps are an ideal vehicle for this sort of thing. A “get rich quick” fund manager might also aggressively value illiquid investments on the fund’s books, creating high phantom returns that cannot be realized when the positions are liquidated. Conversely, she might take-on “off balance sheet” liabilities, inflating the apparent value of the fund. Carefully written “derivatives” permit parties to assume contingent liabilities in ways that hide the leverage of the fund. [2]

  2. Agency costs imposed by fund investors on banks and other creditors

    Limited-liability creates a potential conflict of interest between investment funds and their creditors. If a fund is heavily leveraged, fund investors can reap large rewards by assuming risky positions with the understanding that if those positions go sour, a large fraction of the cost can be shifted (via actual or threatened bankruptcy) to the fund’s creditors. I’ve described this at length in a previous post.

  3. Agency costs imposed by bank managers on bank shareholders, depositors and governments

    Keynes famously wrote in 1931 that “a ‘sound’ banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” [3] There is no reason to believe that bankers are any less sound today then they were in the 1920s, or the 1980s. Banks earn money in a highly competitive environment by lending money, and bank managers are evaluated by the profitability of their operations in relation to those of peers. Leveraged investment funds have become a breathtakingly large clientele. They hold trillions of dollars of equity which they are in the habit of borrowing against aggressively. Since the mid-nineties, the scale of hedge and private equity fund investment has grown astronomically, and few banks have been burned by extending them credit. Suppose that after the late 1990s when the Long Term Capital Management famously blew up, a bank manager decided that future lending to investment funds would be done conservatively and only on the basis of extensive due diligence. How would her performance have compared to that of his peers who lent more freely? A rational, self-interested bank manager may well conclude that her best strategy with respect to the huge, lucrative investment fund market is to “see no evil” with respect to systemic risks. Rational managers would diversify their exposure among many funds, to reduce fund-specific risks, but would want to aggressively pursue business volume in the sector as a whole. This is a classic “tragedy of the commons”. By competing well for volume, bank managers exceed performance benchmarks and earn bonuses. But they also diminish the cost and increase the quantity of leverage available to investment funds, magnifying systemic risks. Should a “meltdown” occur, individual bank managers will point to their industry-standard, state-of-the-art risk management practices and demand safe harbor. A few managers with fraudulent books or eggregiously risky positions will be tarred and feathered. The rest will keep their bonuses, while bank shareholders, bank depositors, and eventually taxpayers eat their losses. [4]

  4. Agency costs imposed by investment managers on institutional investors

    Like any other sort of investment manager, the interests of those who manage funds for pensions, university endowments, and charitable foundations may diverge from the interests of their diverse clientele. In particular, rational, self-interested managers may determine that pursuing peer-competitive short-term gains is wiser than carefully managing the long-term risks of fund stakeholders. Managers of pension funds, for example, may “chase high returns” via risky, leveraged investment funds, hoping to maintain or achieve “fully funded” status so the plan sponsor can avoid transfers to, or pull cash out of, the fund. In this case, there are two levels of agency cost: the managers who try to please their employers at the expense of fund beneficiaries by implementing the strategy, and the plan sponsors themselves, who impose risks on beneficiaries to extract cash or avoid future payments.

  5. Agency costs imposed by institutional investors on governments and the public at large

    It is not only self-interested managers or pension-raiding corporations who impose agency costs on others. Institutional investors that increasingly invest in highly leveraged investment funds don’t do so only so fund managers can look good. Institutional investors impose agency costs on the general public, when institutions important to the public take risks whose benefit accrue to direct stakeholders but whose costs would be shared by the community at large. Suppose a university chooses to invest its endowment in highly leveraged investment funds in hopes of receiving outsized returns, which it will use to fund expanded programs, higher salaries, and other good things. The improved endowment returns benefit the university community much more than it does the general public. A catastrophic loss of endowment funds, however, imposes very large costs to the surrounding community, which may have to underwrite a bail-out of some form if important programs are threatened. A rational, self-interested university might choose an investment portfolio which provides high, steady returns in exchange for assuming a small but significant risk of catastrophic loss. In this way, the university community enjoys enhanced programs and salaries under the most probable scenarios, and forces public intervention on its behalf under less favorable scenarios. This sort of strategy can be rationally adopted by universities, important charities, pensions, any sort of institution willing to gamble that, within its own community, it is “too big to fail”.

[1] “Agency costs” is economist-speak for the damage done by conflicts of interest between decision-makers and those on behalf decisions are made. If the CEO of a firm acts to provoke an unsustainable spike in his company’s stock-price to enhance his annual bonus, the costs borne by stockholders (the inflated bonus, damage to the firm if the CEO’s actions fail to maximize is long term value) are agency costs. Other examples of agency costs are political corruption and doctors who over-recommend lucrative procedures to their patients.

[2] Again, credit default swaps are a good example. When it can be argued that a CDS is a simple “loan guarantee”, the writer of “credit insurance” may not be required to account for its position as a liability, creating the appearance that the “premiums” are pure profit. I have no idea how widespread this is in practice, but it is a very large loophole in theory.

[3] Keynes quote from “Consequences to the Banks of a Collapse in Money Values”, 1931. Hat tip to Calculated Risk, writing on Angry Bear.

[4] Note that bank managers can take profitable risks even when they appear to be shedding risk. When a bank purchases “credit insurance” in the CDS market, apparently the bank is reducing risk, and accepting a fixed cost to do so. But just as writers of credit insurance may seek to keep their positions off-balance-sheet, purchasers would want their positions on-balance-sheet, offseting the assumed of the insurance with an asset. Given a high willingness by investment funds to sell credit insurance, banks may be able to purchase this insurance at unduly cheap rates. When credit conditions change and banks revalue their assets, they can book a profit by upping the book value of their CDS positions from cost to fair-value. In a systemic crisis these positions may turn out to be worthless, as the highly leveraged funds that sold the insurance go bankrupt. (It’s oversimplifying, but not inaccurate, to suggest that the banking system is selling insurance to itself by offloading risk to leveraged investment funds. The banks expect to be made whole by the very same clients whose inability to pay off loans may trigger their need to be made whole. Individual banks are lending to and buying insurance from different parties. But banks as a whole are doing much of their risky lending to the investment fund sector, and buying much of their insurance from that sector.)

This is an elaboration of a comment I posted in response to an Economonitor post.

Update History:
  • 19-Oct-2006, 4:40 a.m. EET: Removed a repetitive phrase. (“…as a fund manager.”)
  • 20-Oct-2006, 8:17 p.m. EET: Minor grammar and typo fixes.

In what sense are markets “positive sum”?

Barry Ritholtz has a post about the zero-sum-ness of things. I think he’s right from the perspective of most traders, but forgets that capital and hedging markets are supposed to be positive sum for economies as a whole. I tried this comment on his site, but TypePad thinks I’m comment spam, and refuses to post. Good thing I have my own danged blog.

From a trader’s perspective, markets are a zero-sum game.

But equity and hedging markets, when they function properly, are positive sum games for an economy as a whole. That’s why “investing” is treated differently than “gambling” from a social welfare perspective, and legal even in Utah.

Here’s an example of poor zero-sum reasoning: “I bought 100 shares of WhizCo from Joe. The stock went up $10 per share therefore my gain is Joe’s loss.”

That’s true 99.9999% of the time (and the people who criticize Barry by implying opportunity costs don’t count are full of it). But the 0.0001% of the time when the seller is the firm or entrepreneur are what make capital markets positive sum.

An example: Here at WhizCo, owing to our unique mix of technology and assets, we have an opportunity to develop the ReallyCoolThing[TM]. But to do so, we require a lot if capital up front, and it’s a risky venture. So, we — the existing shareholders — sell part of our stake in WhizCo by issuing stock. With the money, we develop ReallyCoolThing, and it’s the best thing ever. It sells very, very well. WhizCo rakes in profits, and its stock skyrockets.

Clearly, the recent purchasers of WhizCo gained from our sale of stock. But did the sellers, the existing stockholders lose? NO, because they could not have realized the gain in stock price if they hadn’t sold. There is no legitimate opportunity cost inherent in the sale, because the stock price would not have gone up if WhizCo had not sold stock to finance its project!

Stock markets don’t exist for traders. They exist for firms to obtain financing for risky ventures at the lowest rational prices, so that wealth-creating ventures that might otherwise not have occurred do occur. Traders function is to price stock accurately. Traders play a zero sum game — Barry is right about that — that is esteemed more than betting horses only because it contributes to the positive sum game of discriminating between the worthy and the unworthy in the financing of risky ventures.

I would argue that stock markets have been doing a poor job of this recently for a variety of reasons, and that Barry may be right that there is so little reason behind price fluctuation now that it’s best considered a zero-sum game of guessing arbitrary moves in advance. But it was not always thus, and will not be thus for long. Financial markets that forget who they are financing and why have a way of undoing themselves.

Even futures markets, the prototypical “zero-sum game” where for every long there is a short, are not in fact zero sum. Futures markets exist for hedgers. The role of speculators is to price risk. An example:

WhizCo can take year-in-advance orders from European customers because they can hedge the currency risk. When an order is placed in Euros, WhizCo buys dollars for Euros via 1-year-ahead futures positions. Knowing exactly how many dollars they will receive in a year, WhizCo is able to price its goods without assuming currency risk. They would not be able to afford to enter the European market if doing so would require them to risk selling in Euros, but getting paid a fraction of their dollar costs because the Euro has plummeted by the time they make delivery.

WhizCo’s futures positions, in isolation, are zero sum games. Sometimes they gain on the futures, and someone else loses. Sometimes they lose, and someone else gains. But WhizCo does not buy futures in isolation. By hedging legitimate orders, it in fact neither gains or loses by entering into the futures trade, but exactly offsets the change in the value of its Euro revenues. WhizCo gains overall, because it would not have built a large, wealth producing business in Europe had it not been able to hedge.

Suppose, due to persistent dollar decline, WhizCo’s contracts turn out always to be losers. WhizCo still gains, because their European business is profitable, and they weren’t hoping for speculation gains. Speculators are happy, because they took money from WhizCo that WhizCo would never have earned if it hadn’t been able to hedge. This is a win-win scenario, positive sum.

By definition, market share, or any relative valuation, is zero sum. But stock markets and hedging markets are not about rankings. They are important institutions involved in positive sum wealth creation. The zero-sum games played by traders serve to increase the total absolute sum wealth of an economy relative to what would have been, had reasonably priced hedging and risk-tolerant financing not been available.

Note: This piece actually published 2006-10-11 09:21:19 EST, not on 10-10 as shown. I set back the date, because I want yesterday’s post to keep the top spot for a bit. Update: The date and ordering of posts is now correct. The previous post has had its time in the sun. (Date fixed 2006-10-15 6:28 p.m. EET)

Entrepreneurialism and the Opportunity Cost of Capital During an Asset Price Boom

If interest rates are low, that means capital is cheap, right? And if capital is cheap, that means more edgy, entrepreneurial projects get funded, right? In an era of low interest rates, shouldn’t we see a lot of experimentation in creating businesses with high long-term potential but uncertain short-term return? Chris Dillow asks these questions in a specific case (about which I know little and care less). But as a general proposition, I think the chain of reasoning above is less reliable than you might think. For an explanation, and a suggestive empirical result, read on.

Economics is founded on the notion of opportunity costs. But opportunity costs are frequently overlooked when discussing the “cost of capital”. Suppose real interest rates are at 0%, or even negative. Does that mean capital is “cheap” for an entrepreneur with a project expected to earn a positive real return? At first blush, one might shout “Yes!” After all, anyone with money in the bank would be better off investing in the project than earning interest that fails even to keep up with inflation.

But this reasoning is flawed, because earning quoted interest is not an investor’s only alternative to the proposed project. Suppose there exist many alternative investments that, for a similar level of risk, offer twice the real return of the proposed project. Then the real financing cost faced by entrepreneurs pushing the project is not a quoted interest rate, but the rate of return offered to investors by the alternatives. If the project cannot match those returns, it will not be financed.

In an idealized world, with no stickiness in prices or information, no non-market intervention in interest rates, and objective appraisals of project risk and return, the scenario described could not occur. The “quoted interest rate” for projects at the relevant risk level would quickly rise to approach the returns of the most profitable available investments, and interest rate benchmarks would accurately approximate the cost of capital.

But we don’t live in that idealized world. Interest rate metrics can and do vary in ways that don’t obviously track the expected returns of investable projects in the economy. The risk and expected return of projects cannot be accurately measured, and market participants must rely on a variety of strategies from hyperrational modeling to recent-past extrapolation to make investment decisions. I’d suggest that recent past extrapolation is a common approach.

Suppose an exogenous shock reduces benchmark interest rates beneath equilibrium levels. Financial assets should revalue very quickly in response to interest rate changes. But suppose that, because of stickiness, momentum or other effects, an asset price boom of some duration, rather than an instantaneous price change, results. How does this affect the cost of capital of a small entrepreneur with a speculative project?

Benchmark interest rates are low, so the headline cost of capital is cheap. But if investors, extrapolating from recent experience, expect high returns at low risk from asset appreciation, our entrepreneur has to compete with those expected returns. Her real “hurdle rate” is defined not by the headline interest rate, but by asset-boom inflated expectations.

For some entrepreneurs, this distinction between asset markets and available financing would be fictional, as it ought to be in theory. An entrepreneur within a large firm, for example, could take advantage of an asset market boom by persuading the firm to issue bonds, commercial paper, or shares to finance her project, achieving financing costs at or even beneath levels what headline interest rates would suggest.

But for many entrepreneurs, rasing capital by issuing securities in the broad market is not an option. Their projects must instead rely on bank financing or “angel investors”, who would require higher returns when broad market expectations are high. If I’m right, during asset price booms this category of entrepreneurs should face an unusually high spread between quoted benchmark interest rates and the rates of return demanded by banks or angels. This is a testable proposition.

Unfortunately, I’m unaware of good data on the average returns required of small entrepreneurs by banks and angel investors. But until the late 1980s, there was a published interest rate reflecting the borrowing cost of businesses that rely on bank financing, the US Prime Rate. Presumably, the cost of bank loans for small entrepreneurs included the (observable) prime rate plus some (unobservable) spread. Though not conclusive, it would be suggestive if the spread of the Prime Rate over a low credit-risk benchmark tends to increase when asset markets boom. Naively, one would expect credit speads and asset prices to be negatively related, as higher credit spreads mean higher financing costs, and usually a risky business environment. So a positive association between a high spread for bank-financed loans and asset prices would be both surprising, and consistent with the hypothesis that asset price booms increase financing costs for firms unable to sell securities into the boom.

Regressing the spread between the US Federal Funds Rate and the Prime Rate against monthly percentage changes in the Dow Jones Industrial Average shows a significant positive relationship, with a coefficient of 0.04 (p < 0.001). In other words, a 1% monthly gain in the DJIA was associated with a 4 basis point increase in the spread, consistent with the opportunity cost of capital hypothesis. 34 years of monthly data were regressed form September 1955 though August, 1989. R2 of the regression is small, at 0.04, as would be expected since DJIA returns are much more volatile than the Prime Rate/Fed Funds spread. (The data is truncated in 1989 because, starting in the early nineties, the Prime Rate was altered to a near fixed 3% spread above Federal Funds. It now has little relevance as a specific measure of the cost of bank loans to business. DJIA was chosen as a proxy for asset prices simply because it is the most famous measure, and therefore intuitively likely to influence capital market expectations. I’ve not tried a similar test against other potential asset market price or borrowing cost spread measures.)

This was a butt-simple, univariate regression on data taken from FRED and Yahoo, and is very preliminary. Correlation ain’t causation, and there could be a variety of other factors accounting for the observed relationship. It’d be nice to come up with a more complete model of the Prime/FF spread, and see whether it seems consistent with the high-opportunity-cost-of-capital in an asset boom hypothesis. But this very simple test provides at least a little evidence that asset booms increase the cost of capital to bank-dependent small entrepreneurs relative to what benchmark interest rates would suggest.

If you’ve read this far, thank you.

Update History:
  • 11-Oct-2006, 4:00 a.m. EET: Removed an unnecessary “indeed”.

Is the Prime Rate a Scam?

While researching something quite subtle (more on that tomorrow), I noticed something not at all subtle. Below is a graph showing the spread between the US Federal Funds Rate and the so-called “Prime Rate”. Do you notice a change in this series around 1991?

Source: St. Louis Fed (FRED)

When I was a kid, the “prime rate” was something they announced on the news like it was something important. They don’t do that any more, because the prime rate no longer is important. The prime rate is supposedly “the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers)”. But the most prominent businesses no longer benchmark their loans against the prime rate. They use LIBOR instead. Only consumer and small business loans are typically indexed against Prime. LIBOR became prominent, well, around the early nineties I think.

Floating rate loans, whether to companies are consumers, are usually quoted as a benchmark rate plus a spread. Check your credit card documents: Your monthly interest rates are probably something like “the Prime Rate plus 3%”.

Now look at the graph above. The average spread between the Federal Funds Rate and the Prime Rate from August 1955 through August 1989 was 1.33%. From 1991 onward, that spread has been nearly constant at 3%. In the earlier period, the Prime Rate spread was what one would expect it to be, a variable, market-determined quantity reflecting the availability of capital and perceptions of risk even among “creditworthy” borrowers. Now it is a fixed quantity, more than double its average prior to 1989. At around the same time, sophisticated borrowers switched to an entirely different benchmark, leaving consumers and small businesses to pay the higher spread.

Of course, a benchmark is only a benchmark, and the various short-term dollar interest rates correlate strongly. In theory, a competitive lending market should force down bottom line rates, regardless of which benchmark is chosen. Nothing prevents a loan from being quoted as “Prime minus 1.5%”. But in practice, this doesn’t happen. Sophisticated consumers who know what the Prime Rate is supposed to mean understand that they should expect to pay a bit more than banks’ “most creditworthy, prominent, and stable business customers”. But I’ll bet that 99% of educated borrowers have no idea that the Prime Rate includes a spread roughly double what those best business customers actually pay. The Prime Rate to Federal Funds spread is now fixed, in both senses of the word.

Update: A bit of web searching turns up this (by Michael Evans):

…the spread between the Federal funds (and Treasury bill) rate and the prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan’s gift to the banking sector to insure that major banks would not fail. You may recall at the time that rumors were rife — including some repeaed on the floor of the House — that Citibank was about to go under. By doubling the margin between the prime and the funds rate — and essentially increasing the profitability fourfold after taking into consideration the costs of processing loans — an inverted yield spread lost all its meaning. And it will never return.

Update (October, 2008): “Prime-minus” loans did eventually come to be advertised, for secured consumer credit. The first time I ever saw one was sometime in 2007 or 2008. Most consumer loans remain “prime plus”, though. The 3% fixed prime rate is a gift that keeps on giving.

the camel’s philosophy of the future

gillies, in the comments to a post of Brad Setser’s, writes a parable of the age:

the camel’s philosophy of the future.

the camel’s back will probably be broken.
– that is a fairly predictable future event.
the last straw will be responsible.
– that is for sure.
(it is a fundamental law of backs and camel loading.)
but which is the last straw
– that is not easily predictable.
and when it goes on the camel’s back
– that is not predictable at all.
therefore those who make their millions loading camels
– cannot easily be deterred from adding straw.

Reposted with gillies’ permission. gillies writes at http://darkbrownriver.blogspot.com/, where a wealth of material awaits.

Pigou, or Pig in a Poke?

Gabriel Mihalache objects to Greg Mankiw‘s frequent invocation of Pigou in support of energy taxes he’d like to see enacted. In a thoughtful and eloquent rant, he makes an important point about the impossibility of implementing an optimal tax “scientifically”:

[T]hey draw you in under the pretense of restoring efficiency—what’s fair is fair, right?—who would argue against efficiency? That’s like saying you don’t like puppies!

But once they get you with the externalities/Pigou/efficiency argument, surprise! They don’t provide you with a practical formula for Lindahl pricing, an econometric/empirical test—this does not exist (yet)—and instead each of the members of the Pigou Club starts pushing his own political agenda: some, like Becker or Greenspan, want to see reliance on foreign authoritarians regimes reduced, others, like Mike Moffatt, want to equal-out the marginal effect of taxes, etc. But guess what, all these otherwise noble political causes have nothing to do with Pigou’s work.

I must strongly object to purely political proposals dressed-up as positive welfare economics/science.

[italics are Gabriel’s]

Read the whole thing (as well as my, er, eh-hem, lengthy and erudite comments) here.

Clocks and Investing

I’ve often seen the taunt “even a broken clock is right twice a day” leveled at Fin/Econ pundits, especially those whose opinions don’t seem to track the stock market very well. I have a hierarchy of clocks. In my hierarchy, a broken clock is the second best kind of clock to be. And if you are an investor, I think you are better off trying to be a broken clock than any other kind. Here’s my rundown of clocks:

The Accurate Clock — Obviously, the best kind of clock is one that always tells the time correctly. In stock market metaphor, this refers to the pundit or trader who can accurately time the market, call actionable peaks and lows and be right far more often than she is wrong. An accurate clock can become wealthy at a rate proportional to its accuracy. A perfectly accurate clock could become a billionaire in a single busy day. But, there are no perfectly accurate clocks. It may be impossible to be even a moderately accurate clock.

The Broken Clock — The prototypical broken clock never moves. Its hands point steadfastly towards a single time of the day. Broken clocks have one great virtue: They get to be right twice a day. Always. Every day. They are the turtle to the accurate clock’s hare. Rather than chasing the time around all day, they wait for the time to come to them. Among investors, so-called “permabears” or “permabulls” are usually referred to as broken clocks. I don’t think it’s good to be a “perma” anything. The world changes. A good broken clock is an investor who makes smart decisions based on the best available analysis she has, and then waits to profit, even if circumstances change, even if she comes to doubt her original reasoning. Behavioral finance types refer to this approach with words like “status quo bias” or “endowment effects”, like these are bad things. That’s okay. Broken clocks probably make more money than behavioral finance types. Being a broken clock is a perfectly sensible strategy in a world where information is worse than imperfect and there will always be great reasons to bail and take losses on positions that will eventually be winners. Note that not all broken clocks are alike. The hands of many broken clocks move, just not at the right speed. Some broken clocks move more slowly than real time. These clocks will always get to be right sometime, but not necessarily twice a day. Then there are the clocks whose hands move fast, or even backwards. These clocks get to be right more often than twice a day! Broken clock investors don’t try to just be broken. They compete on the basis of how long they have to be wrong before they get to be right. But broken clocks know that they really have no idea what time it is, and that they’d better be prepared to wait. They avoid inherently time-limited securities like options, and are cautious with leverage, because they hate to be forced to quit while they are wrong.

The Not Broken, Not Accurate Clock — The very worst kind of investor is the clock that keeps perfect time, but it is just not set properly. This kind of clock is never, ever right. It’s surprisingly easy to be a not broken, not accurate clock. If a clock is not broken, odds are 11 out of 12 that it will never even get the hour right. Not broken, not accurate clocks are always chasing reality, constantly moving, and never winning. In stock market terms, not broken, not accurate clocks are persuaded that it’s reasonable to take losses when circumstance change (as they always do). They take positions for good and sufficient reasons and liquidate them for good and sufficient reasons. In the meantime, they usually fail to profit. Most people who try to be accurate clocks make it half there. They end up moving at precisely the rhythm of the market, but out of phase, buying high into optimism and selling low into despair. Capital markets love not broken, not accurate clocks in the same way you or I love might love pancakes.

It’s pretty clear that I’m a big fan of broken clocks. That’s self-serving, because I am one. That means I am usually wrong. I’m wrong right now, portfolio-wise. I’m knee deep in red. Whether that fact recommends my advice as authentic, or damns it as stupid, I’ll leave for you, dear reader, to decide.

Update History:
  • 08-Oct-2006, 4:16 p.m. EET: Cleaned up some minor wordiness. Fixed place where I said “broken clock” when I mean “Not Broken, Not Accurate Clock”.

Productivity, Wages, and Asset Inflation

Dean Baker has a very interesting piece trying to make sense of why, with headline productivity so high since the mid-nineties, wages have not kept pace. Dean Baker begins…

Most economists view productivity growth as being the key to rising living standards through time. The basic story of productivity in the post-war era is that growth was rapid in the years from 1947-1973, but then slowed sharply over the years from 1973-1995. Productivity growth then ticked up again in 1995 and has been relatively rapid since 1995.

1995, huh. That was quite a year according to this article by Aaron Krowne. Aaron argues that in 1995, an obscure loosening of US bank reserve requirments, and an abandonment by the Greenspan Fed of a “virtual gold standard”, gave rise to an era of unprecedented growth in broad money. In my own mind, 1995 corresponds to about the beginning of the “asset economy”, when wealth accumulation from capital gains rather than wage or business income became an unusually important driver of the US economy. Hmmm.

I have an monetarist intuition about wages during this period. Suppose that under certain circumstances fast money supply expansion results in asset inflation rather than goods inflation. Goods prices remain stable, the economy seems to grow at a moderate clip, but asset prices grow far faster than GDP. Sellers of productive capital (tractors, factory equipment, etc.) as well as workers then have to compete with the financial sector for investable funds. As expectations of asset appreciation increase, more investors choose to purchase stocks, homes, hedge funds, oil, or gold than to build factories, open businesses, and hire workers. Of course stocks have to be backed by firms, and homes have to be built, but on the margin, investment dollars are diverted from direct deployment as productive capital to purchasing paper assets via financial intermediaries. The net effect is a reduction of the “velocity of money” in the real investment sector, reducing input prices while at the same time diminishing future capacity. Input prices include wages.

In an environment where capital is drawn to appreciating financial assets, workers and vendors of productive capital have to make price concessions relative to productivity in order to attract funding. Rocketing asset prices should be expected to reduce the bargaining power of workers, and to exert downward pressure on their wages.

UPDATE: Shamed by Greg Mankiw and some awful grammar, I’ve performed major surgery on this post, prettying things up and dropping a long digression from the main point. (I’ll insert the original version into the comments for posterity). 2006-10-08 03:11 am EET

By the way, Dean Baker’s piece offers a very different, but quite interesting explanation for the divergence between wages and productivity. He adjusts productivity growth by subtracting out growth in depreciation costs (which cannot go towards wages) and taking into account the diversion between consumer inflation (by which real wage grwoth is reckoned) and the GDP deflator (by which real productivity is measured). Since consumer inflation has been higher than broad GDP inflation, even wage earners who do see their wages of growing in proportion with GDP would see their “real” wage lagging, because they disproportionately buy goods that have gotten more expensive. Read the whole thing.