Monday, June 24, 2013

If The Cook Leaves For Lunch


A cook who is paid for quantity not quality and does not have to eat his own cooking will probably not follow the recipe all that carefully.  A mortgage lender in the same position will have little concern for the quality of the loans being made.  This was the situation during the last years of the US housing bubble of 2001 through 2005.

Anyone who has seen Frank Capra's Christmas classic, It's a Wonderful Life, knows how a bank operates.  Back then, if a person wanted to buy a house, he or she would go to the lending institution and apply for a mortgage loan.  The banker would carefully check the applicant's credit rating, job history and stability, get an appraisal of the property and decide whether to make the loan.  The bank lent money and expected to be repaid since the lent money came from the collective deposits of the bank's customers.  The bank recycled one person's savings into another person's home loan and made money on the spread between the interest rate it paid on the savings account and the interest rate it charged for the loan.  The bank had to be conservative in its lending practices since it still had to meet the daily withdrawals of its customers regardless of the borrower's repayment of the home loan.

In 1938, late in the Depression, the government established the Federal National Mortgage Association (Fannie Mae) to stimulate the moribund economy and to support the national policy of encouraging home ownership by making it easier to get a home mortgage.  The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 to expand the government's efforts to provide funds for home loans. These agencies would purchase billions of dollars worth of mortgage loans from lenders across the country, repackage them into pools of securitized bonds which were then sold to debt investors.  The bond proceeds would then be used to buy yet more mortgage loans from the banks.  The theory was that the availability of this money would lower the cost of home loans.  

Wall Street copied the Fannie/Freddie models and got into the mortgage backed securities game during the housing bubble years in a big way.  Earlier, Congress had passed laws to make home loans affordable for many people whose credit was not strong enough to qualify them for a home loan.  These were referred to as subprime mortgage loans which provided very low "teaser" rates of interest for the first two years before the interest rate jumped to a market rate.  This increase would almost double the rate.  Mortgage lenders offered what were called "low doc" and "no doc" loans, i.e., loans made without credit checks or other traditional lending considerations and documents.  These loans were cynically called "liar loans" since the information on the credit applications was rarely, if ever, verified.  In an effort to keep them "honest," the mortgage brokers were required to keep a small percentage of their loans on their books. Despite this exposure, most brokers saw no reason to worry about repayment and creditworthiness.  

Repackaging subprime mortgages into bonds became a huge money machine for the investment banks.  In his book, The Big Short, Michael Lewis explains how billions of dollars in fees were earned by the mortgage companies and the investment banks by recycling money between American home buyers and bond investors worldwide.  The goal was booking loans, earning fees and converting the mortgage debt into bonds for sale around the world.  With those bonds went the risk of default.  Bond buyers were lulled by Triple A credit ratings for the bonds despite the subprime quality of the mortgages backing the bonds.  The poster child for this lending orgy, according to Lewis, was the California farm worker making $14,000 per year who received a home loan of over $700,000.  The underpinning of this debt debacle was the belief that home values would continue to rise, allowing otherwise unqualified borrowers to either refinance the debt or sell the property at a profit in less than the first two years.  When the teaser rates increased after the first two years, the loans became unaffordable.  Since the mortgage brokers and investment bankers had only a fractional interest in the loans and bonds or they had laid off the risk with credit default swaps, they did not believe they would suffer any loss.  What they failed to appreciate was the fact that a even a small fractional interest in hundreds of billions of dollars is still a large number.

The results of this played out when the housing bubble burst and an unexpectedly large percentage of the loans went into default.  The other part of this perfect storm was the rapid decline in home values.  Mortgage debt exceeded the value of the collateral with the obvious result - billions of dollars in losses for the holders of the mortgage backed bonds around the world.  As the music started to slow down in 2007, several very large publicly traded mortgage companies went out of business.

Two signs that the party was truly over were the failures of the venerable Wall Street firms, Bear Stearns and Lehman Brothers in 2008.  Lehman's September 15, 2008 bankruptcy filing, considered the largest in history, foretold the credit crisis to come.  The exposure of both Bear Stearns and Lehman to the subprime mortgage market played a significant role in their failures.

Comments are always welcome.

Monday, June 17, 2013

Markets and Birds of a Different Feather (2)


Dr. Taleb described his trading philosophy as one in which he limited his losses and left open the possibility of large gains if and when an unusual event should take place.  He complimented traders who bought options, which meant a loss was limited to the option fee paid, but which provided the trader with the opportunity to reap an out sized profit if something unexpected were to occur.  Taleb's investment strategy was to always look for a Black Swan even if he was not sure in what form it might appear.

He likened the unknown risks inherent in the strategies of many investors/traders to the dangers of inductive reasoning noted by the philosopher Bertrand Russell and symbolized by the life of a chicken.  Inductive reasoning begins with observations which lead to inferences, then to perceived patterns which lead, ultimately, to theories to address an issue or problem.  Dr. Taleb retells Russell's story from the perspective of a turkey:

Consider a turkey is fed every day.  Every feeding will firm-up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race "looking out for its best interests," as a politician would say.  On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey.  It will incur a revision of belief.

(Author's emphasis in bold)

I have heard two stories which illustrate the same point.

In the first anecdote, an individual returned from the west coast to his small Midwestern hometown after both his parents had passed away.  He had decided to live in his childhood home.  He deposited his savings in the local bank in which he had opened his first Christmas Club savings account as a child.  The very next day, the bank failed and was taken over by the Federal Deposit Insurance Corporation (FDIC).  This was his Black Swan.  The FDIC guaranties that, in the event of a bank failure, the depositors will be refunded their money (with some limitations).  Although he ultimately received his deposit back, he was heard to complain about the bank officer who had gladly taken his deposit less than twenty-four hours before the bank closed for good.

In the second one, a widow owned a small amount of stock in her local bank.  The shares had been purchased by her husband years before.  The local bank was purchased by a larger bank in the area, which in turn was purchased by a regional bank, which was itself purchased.  With stock splits, several subsequent bank mergers and a steadily rising price for her shares in the larger, publicly traded institutions along the way, she had accumulated a substantial number of shares worth a significant amount of money.  At one point, she sold enough stock to buy a new car.  The downside was that those holdings represented a fairly large percentage of her portfolio.  Aside from the car purchase, she refused to sell any more shares since the capital gains tax would have been substantial.  Things went well until the day the financial institution failed due to "accounting irregularities."  The market price of her shares dropped to less than a dollar per share within days of the public announcement that management had been "cooking the books."  Another Black Swan.

Although there are typically over a hundred bank failures throughout the US every year, there was no reason why the depositor should have anticipated the failure of a bank that had served his hometown for more than sixty years.  Given the years of increasing share price and the conflicting market proverbs to (i) let profits ride and (ii) diversify a stock portfolio, the widow saw no reason to sell shares and increase her taxes.  In the final analysis, she let the tax tail wag the investment dog.

Both stories, if true, are apocryphal examples of Black Swans.

Excerpt from The Black Swan The Impact of the Highly Improbable, Nassim Nicholas Taleb, copyright 2007, published by Random House, page 40.

Comments are always welcome.

Monday, June 10, 2013

Markets and Birds of a Different Feather (1)


Dr. Nassim Nicholas Taleb has been described as "part literary essayist, part empiricist and part no-nonsense mathematical trader."  He received his MBA from Wharton and his PhD from the University of Paris.  He was a successful derivatives trader on Wall Street, but his real talent is as a writer.  He is most famous for his books, Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets, published in 2004, and The Black Swan, The Impact of the Highly Improbable, published in 2007.  Both books, which take on conventional financial theory, are best sellers.

In his Prologue to Fooled By Randomness, Dr. Taleb, a self described Levantine (born in Lebanon), explains that his book is about luck, which is mistakenly perceived by those lucky souls as evidence of their personal skills, and about randomness  which is mistakenly seen as a surprising event which might have been, but was not, anticipated.  Something unusual (good or bad) happens in the market, shocking everyone, and market professionals immediately reach for explanations.  The response "We don't know why." is an unacceptable answer in the public media.  That would make for a fairly short television broadcast or newspaper story with a concomitant loss of advertising dollars.

Taleb criticizes economists, journalists, financial television analysts and others for refusing to acknowledge that the one-in-ten billion (or higher) possibility really can happen.  Their statistical analyses and Gaussian distribution (bell curve) charts do not take such extremely rare probabilities into account.  Although armed with reams of data based on computer analysis of vast numbers of probabilities, they do not know that they do not know.  Or, viewed more cynically, if they do know that they don't know, they won't admit it.

All swans were thought to be white until in 1697 the Dutch explorer, Willem de Vlamingh, discovered a black one in Australia.  One ugly bird destroyed a belief previously held by everyone in the ornithological world at that time.  Dr. Taleb uses the term Black Swan to identify an event with three characteristics.  First, the event is an outlier, which means that it is beyond the expectations of most, if not all, people.  It will not be revealed in a standard bell curve distribution. Second, it will have a significant effect or impact (think September 11, 2001 or the market crash of October, 1987).  Finally, it is an event in the wake of which people immediately demand an explanation.  The phrase "Sh_t Happens." is not an acceptable answer to "How could this happen?" for most on Wall Street.

One of the premises of the Black Swan is that events of this type actually happen with greater frequency than previously imagined.  It might be that, as a species, we humans need to perceive that we have order in and control over our lives.  Black Swans serve to remind us that we are not in total control, a terrifying thought for many.  The implications of this for the stock market are significant.  Taleb provides two rates of return in a single graph.  One line shows the return in the US stock market over the past fifty years.  The second one charts the return without the ten most volatile days (up or down) over that same fifty year period.  The reduction in return without those ten days is dramatic.  Individual investors should bear this in mind when formulating their investment strategies.

We will continue our look at Dr. Taleb's ideas in the next blog.

Comments are always welcome.

Monday, June 3, 2013

From Essays to Equations (2)


Another financial author known for writing ability, not equations, is Peter L. Bernstein.  He received his degree in economics from Harvard, but is known as a financial historian.  Several of his ten books became best sellers.  In 1992 he wrote Capital Ideas - The Improbable Origins of Modern Wall Street.  In this work, he chronicled the evolution of modern investment theories.  Starting with Louis Bachelier's 1900 Doctoral dissertation, The Theory of Speculation, Bernstein traces the evolution of Bachelier's dissertation with its formulas, which was "discovered" by later economists about sixty years after its publication, into the Modern Portfolio Theory (MPT).  Using MPT and its supporting mathematical equations, investment professionals try to assemble a portfolio of assets to either maximize return at a certain level of risk or minimize risk while achieving a desired rate of return.  It should come as no surprise that the use of equations in financial investing came at the same time as computers capable of executing those complex equations became the financial weapons of choice on Wall Street.

Bernstein summarized investment by equation as follows:

There is Louis Bachelier in 1900, holed up in the Sorbonne scratching out eternal verities about the behavior of speculative markets.....Fischer Black, Myron Scholes, and Robert Merton change the whole world of finance by staring at differential equations.  Through it all, the only sound we hear is the clanking of primitive computers...The clatter of the computer and the roar of the trading floor are the sounds of a great battle in which investors compete with one another to determine who can buy at the lowest and sell at the highest....If the final product of the efforts of the financial theorists was only an assemblage of abstractions, those abstractions are the essential insights into how people do act and how people should act as they engage in the competitive battle.*

One of a growing number of critics of formulaic financial theories is the Wall Street veteran and author, Nassim Nicholas Taleb.  In his 2004 best seller, Fooled By Randomness -- The Hidden Role of Chance in Life and in the Markets, Taleb takes economists to task for their reliance on equations as follows: 

What has gone wrong with the development of economics as a science?  Answer: there was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science.....Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes -- and they refused to accept the fact that no mathematics at all was probably better.**

Criticism of computerized, equation driven investing has grown after several highly publicized investment disasters.  It has spawned a new branch of economic study called Behavioral Finance.

*  Excerpts from Capital Ideas / The Improbable  Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc., page 305.  A new edition of the book was published in 2005 by John Wiley & Sons, Inc.

**  Excerpts from Fooled by Randomness, Nassim Nicholas Taleb, copyright 2004, published by Random House, page 177.

Comments are always welcome.