Friday, January 15, 2010

How Asset Bubbles and Rational Casino Investing relate to Financial Reform

One of the things I find interesting is that so many theoretical
economists and media talking heads think that an asset bubble is a
sign of highly irrational and greedy financial professionals. However,
many of these folks have never managed money or dealt with clients,
which means they are largely missing some important pieces of

Many, possibly most, professionals who look at securities in a bubble
understand that a bubble is one explanation for the price rise; maybe
they'll underestimate it, maybe they'll even dismiss it, but they
understand it. A great many participants will understand perfectly
that a bubble is happening.

However, there's an agency problem. One senior official in a financial
firm once told me (referring to one particular asset bubble), "we all
knew it was happening, but if you get out too early, you underperform
as it approaches its heights. We participate because our clients won't
tolerate underperformance for any period of time. If we didn't
participate, we'd be fired."

I never wish to use personal anecdote as a source of evidence, but I
happen to have been actively investing and doing research for another
large financial firm, partly on energy, during the energy bubble. I
claim no skill, just luck, in getting out unscathed. I took a risk I
shouldn't have - a lesson I've taken to heart as I look at the Chinese
asset bubble and the effects on securities around the globe. But my
choice to take a risk is not a choice for others.

While there certainly were legitimate questions about how high oil and
other energy prices could go based on growth trajectories in emerging
markets, a substantial fraction of us knew that oil was in a bubble
and would have to come back down. I remember considering both sides
and realizing that the marginal cost of producing a barrel of oil from
the most expensive conventional fields was about $90 or $95 a barrel,
and that while capacity was constrained in the short run, there was
potential for expansion at that level of marginal cost. Meanwhile, I
owned a number of energy stocks, including a very sizable position in
a company that built refineries (and whose earnings was thus
intricately tied to the price of oil, as long as credit was

When I bought in, oil was in the high $70s. When oil cleared 90, I
started wondering if it was a bubble, and when it hit 110, I became
convinced and was worried about when it would pop. I could have
certainly sold out right then, but the aim when selling a stock is
(obviously) to sell at the best price possible - you don't get extra
credit for recognizing and selling early (in fact, you lose if you
don't have a strong alternative security to own lined up, which I
didn't at the time). I started gauging sentiment (something I've
always hated doing), and didn't get spooked til oil hit 135. Oil
eventually got to 147 before collapsing, and the credit bubble popped,
and the rest is history.

Despite what everyone likes to say about all sorts of money management
incentives, the ultimate incentives of a money manager are to a)
manage as much money as possible and b) have the money you manage go
up as much as possible. Both of these are only achieved via
outperformance. They face the same incentives I did - maximize
outperformance while minimizing risks - except if they fail at either,
they lose their jobs. I became aware of the possibility of an oil
bubble when oil was in the high 80s/low 90s, became convinced of one
when oil was at 110/115, but because I wasn't convinced that everyone
ELSE was convinced of one, I stayed in. It's not a game I like to
play, and as I've learned more about alternate types of securities, I
avoid those situations more and more (I've removed all exposure from
China, for example). However, participating in the energy bubble
wasn't blind, it wasn't schizophrenic, it was calculated and in my
extremely lucky case, paid off. I'm not unique in this regard - some
people really did think oil was headed straight to 200, 300 and even
500**, but a lot of people played the casino game despite
understanding what was happening.

Which brings me to the point. Just as this credit crisis was
originally caused by consumers being so shortsighted that they bought
houses they could not afford (mortgage lenders like Countrywide were
certainly complicit in this), asset bubbles in general can partly spur
from a shortsightedness (or perhaps a lack of financial education) on
the part of people who are choosing financial advisers. Every
manager, no matter how good, underperforms periodically - Warren
Buffett, the best investor ever, has underperformed in 7 of his last
22 years (that's almost 1/3 of the time!) and has some years where he
is CRUSHED - in 2009 he underperformed by over 20%, and in 1999 he
underperformed by 40%. Warren Buffett is lucky and smart in that he
has set himself up in a position where he cannot be fired based on one
bad year, so he uses his tremendous intelligence and foresight to
compile an impressive record despite blips.

Most of the rest of finance isn't so well-positioned. When one bad
year by a manager leads to a mass exodus of capital, a firm has almost
no choice but to fire that manager in order to preserve the fund.
Managers who prioritize not getting fired then make sure they never
underperform too drastically in one year, which means that most of
them have to participate in bubbles.

Just as a public that understood how to live within its means could
not have caused a credit crisis with mortgages or anything else, a
more longsighted, patient public, who doesn't abandon a manager at the
first sign of underperformance, would be the single biggest factor in
preventing asset bubbles - more than anything you could do with
financial reform.

How do we achieve that? Fortunately, we don't need a patient public to
make the public act patient.

One possibility would be the introduction of back-end loads to mutual
and hedge funds in exchange for a reduction in annual fees, thus
strongly rewarding longer term investors. Less effective but
functionally similar would be a (voluntary or involuntary) "lockup"
period with withdrawal penalty in exchange for lower fees (this stops
working after the lockup period is done, however, while an end load
works forever). Another would be be better investor education, if
that's possible (we can't even teach reading consistently, though, so
that's going to be tough).

Far less effective would be the idiotically populist transactions tax
that Obama has proposed, because it cannot get large enough to stifle
that sort of activity without crippling our capital markets. Somewhat
effective would be a turnover tax, which I have outlined in a prior
post, found here:
A turnover tax wouldn't prevent fundamental investors from
participating in bubbles, but it would prevent high-frequency traders
from speeding up the ascent and descent of equity and standardized
credit bubbles, which they do by a factor of 2 or 3 in both directions
(best estimate, based on volume of HFT transactions). Speed
exacerbates bubbles significantly because participants don't have time
to react before becoming insolvent, and the Fed doesn't have time to
react with appropriate monetary policy. Removing high frequency
traders could reduce the impact of bubbles, even if it couldn't easily
eliminate them.

There are measures an agency can take, but they're more limited than
the government realizes, and are better at dealing with credit crises
than asset bubbles (related but different). Standardizing the products
that can be standardized and placing them on exchanges is a great idea
because it limits the web of counterparty risk that characterized this
recession, reducing the need for bailouts. Coming up with ways to
quickly, fairly, efficiently and consistently break apart illiquid
financial institutions to satisfy creditors would reduce the panic and
liquidity effects from a failure like Lehman's. Working with financial
institutions to implement the end load/lower fee plan or a turnover
tax would be helpful. Insulating the Fed from political pressure would
be useful, and investor education on accounting, economics and
financial markets will always be helpful. Creating mandatory processes
for evaluating the creditworthiness of consumers would be a
possibility- you don't want to limit who can be lent to, but you do
want to force lenders to go through a reasonable series of steps to
ensure that they are lending to people or firms who are representing
their assets and income truthfully, so that lenders can't advertise
"immediate credit" as a sales pitch and make mistakes when they do it.

The other issues - regulating bank bonuses, instituting bank taxes,
etc - will be highly counterproductive (I've listed a great deal of
why here:
and are mostly likely to result in costs to shareholders and customers
than they are to mitigate risky behavior. Trust me - no regulator can
keep up with the sophisticated products and processes that are in
finance. Regulators don't draw enough talented people, they're
perpetually understaffed and they face political pressure. It's better
to regulate and align the incentives of clients with a safe system
than the incentives of banks with a safe system because clients change
less and they're more fundamentally at the root of the problem
(financial firms wouldn't do it if their clients didn't require it).

**(I posted that report on the wall of my office because it was so
funny - oil was at 140, I'd just sold out after watching oil almost
triple already, and people were projecting $500 oil?)

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