One week hiatus

I will be taking a certification exam on Saturday. Thus, I will not post this week. I should be back to semi-regular posting after June 5th.

 

 

It's not austerity if it's not austere...

http://www.cnn.com/2010/BUSINESS/05/26/italy.austerity.measures/index.html?hpt=Sbin

 

 

Italy wants to cut its deficit to 3% of GDP.

 

However, a deficit is only sustainable if the rate at which the overall debt grows is smaller than the rate at which GDP grows.

 

Italy's Debt:GDP ratio is a bit over 100% (106% at the end of 2008 - http://www.forbes.com/feeds/afx/2009/03/31/afx6235203.html). If we say it's 110% now, a 3% of GDP deficit means that the country has to grow at about 2.73% (3% * 100%/110%) annually for its "austerity measures" to actually be sustainable.

 

Worse, because Italy is on the Euro, it can't just choose to inflate at will. Euro-sanctioned inflation has historically been very low. Additionally, even if Germany does consent to some inflation to help out Greece and Portugal, a lot of Italy's obligations are real obligations because they'll scale upwards with inflation anyway. The only major exception is interest cost.

 

If you believe that Italy would have to grow at 2.5% in real terms to make a 3% GDP deficit sustainable at today's credit rating and interest rates, you can't be optimistic about this "austerity plan". Italy's GDP growth has been well below 2% even before the recent recession, and many believe that Italy will struggle to hit 1% growth.

 

This is actually very generous, because it assumes Italy can survive indefinitely with the debt/GDP ratio at its current level. Italy's is very high right now, even relative to the rest of the overlevered developed world. If you look at some of the recent work that's been done on debt (Rinehart comes to mind), it finds that these debt levels aren't sustainable. The number they find is that above 90% debt/gdp, it's harder to sustain any degree of growth (reflected in Italy's poor growth estimates).

 

In other words, if Italy actually wants to be a factor in the world moving forward, it needs to run surpluses. It's not austerity if it's not austere...

Math I don't understand

I applaud the EPA and NHTSA for increasing CAFE fuel economy standards (http://money.cnn.com/2010/04/01/autos/cafe_standards_final/index.htm). This may be surprising, given how much I prefer free markets, generally, but fuel economy is absolutely an externality-laden characteristic of a car, and under any carbon-reduction legislation, it'd have to go up a lot anyway. I'm not sure the life of the car in years (for the discount rate) and assumed mileage used in the calculation of $900 additional cost and $3000 savings, but it is entirely possible that this has been inefficient anyway.

 

 

My question is this: how is it possible to have both a combined MPG target and separate individual MPG targets on cars and trucks without mandating the maximum percentage of vehicles on the road that can be trucks? That seems silly... wouldn't it be better to place MPG standards on overall cars as a whole, and let allocations and MPG of each group fall where they may? You may even end up improving over your target this way as companies that sell more trucks than cars are forced to innovate cheaper ways of cutting emissions and fuel usage, and other companies copy them.

 

I also think it's silly that we don't have a gas tax as part of this - we'd be much better off instituting a gas tax and allocating that revenue to cutting the corporate tax, if it's large enough to make a dent.

 

I am also a little annoyed that these standards didn't extend to heavy vehicles, which are like 20% of emissions despite being a miniscule percentage of vehicles on the road, but that could be coming.

Discrimination Lawsuits

This reminded me of the New Haven case... Alex actually put up a question from similar tests given by the New York, so I recommend looking at the Marginal Revolution site.

 

 

 

http://www.marginalrevolution.com/marginalrevolution/2010/05/rand-pauls-remarks-about-the-1964-civil-rights-act-brought-forth-lots-of-talk-about-libertarians-and-lunch-counters-but-almos.html

 

The case, Lewis v. Chicago, involved alleged discrimination against African American applicants for the Chicago Fire Department who took a test in 1995. The department set a passing score of 64 on the exam. Applicants who scored at least 64 but below 89 were informed that they passed the test, but would probably not be hired given the number of candidates who scored 89 or above. [26,000 applied and there were only a few hundred jobs, AT]  Applicants scoring 89 and above were classified as "well qualified".

The majority of "well-qualified" applicants were white. Only 11 percent were black... 

The trial court sided with the black applicants, and ordered the city to hire 132 randomly selected African American applicants who scored above 64. The court also ordered the city to divide backpay owed among the rest of the black applicants.

White, Asian and Hispanic applicants who also scored above 64 but below the 89 standard were not offered employment or backpay.

Perhaps you are wondering about the tests?  You would be hard pressed to find any obvious racial bias.  I haven't found the Chicago test online but you can find similar tests from New York (also the subject of lawsuits) here.

 

 

also, from the comments:

"In Sweden there are physical requirements for becoming a firefighter. These tests are fairly tough and selective, as the physical requirements on firefighters sometimes help save lives.

Needless to say, the requirements are lower for women, as it would be "discriminatory" otherwise. Sometimes you just have to wonder about the mental health of people deciding these things..."

 

Financial Reform Provisions: what concerns me, what I like, what I wish they'd add, and a general takeaway

http://blogs.wsj.com/dispatch/2010/05/20/major-provisions-in-senate-financial-overhaul-bill/

4 things that concern me:

"Most controversially, the bill would adopt language written by Sen. Blanche Lincoln (D., Ark.), that would compel any large commercial banks that have access to the Federal Reserve's discount window to spin off their derivatives trading business. The Fed, FDIC, Treasury as well as the banking industry have argued against this measure."

This is EXTREMELY stupid, and would actually increase the risk of the financial industry. There are two major reasons:

1) The minor point is that the more sources of revenue a bank has, the less likely it is to fail if one of them goes sour.

2) More importantly, a major reason for commercial banks to have derivatives trading desks is so that they can hedge their own risk away through fixed-for-floating interest rate swaps and credit default swaps. Not letting them hedge may make their risk easier to measure, but it also makes it higher. As Buffett says, it's better to be approximately right than to be precisely wrong. This measure will increase the risk banks face, not decrease it, and just because we're able to see collapses coming doesn't make it easier to unwind those exposures. EDIT: I may have misread this. As long as commercial banks are still allowed to OWN rate swaps and CDS, then not writing them is more ok. You still have the "diversified revenue streams are good" factor, but this is FAR less negative and I could even see it defended as a positive.

EDIT 2: According to this, my initial concerns are very legitimate: http://money.cnn.com/2010/05/21/news/economy/Wall_street_reform_senate_bill/index.htm?hpt=T2

"Calls for a one-time government audit of the all of the Fed's emergency lending programs from Dec. 2007 onward, including facilities used to help deal with the collapse of Bear Stearns & Co. and the program to stabilize asset-backed securities markets. The Government Accountability Office would also review the Fed's corporate governance, including whether there are conflicts of interest inherent in the current design of the Federal Reserve System."

The GAO has more conflicts of interest than the Fed does. One of the reasons the Fed has been so effective for the last 60 years is that it is independent, and is NOT accountable to Congress - if it feels raising interest rates are appropriate, then it raises them. If this move gets the Fed constantly looking over its shoulder when it moves to make sure it's not going to get in trouble with Congress, that will severly undermine its efficacy. It's hard to know if this problem will be exacerbated by the myriad of new powers granted to the Fed.

"Under an amendment adopted unanimously with little fan fare, the bill would force banks with more than $250 billion in assets to meet higher risk- and size-based capital standards. Treasury and Fed oppose the measure, authored by Sen. Susan Collins (R., Maine), warning it could make it harder for U.S. officials to negotiate global capital standards with foreign regulators."

Too Big to Fail is not the issue, and I'm interested to see if this would distort the incentives of banks hovering right around $250 billion in assets - would customers be treated worse? I don't know why Treasury and Fed say it'll be harder to negotiate global capital standards, but it is plausible, and if I had to take either Treasury and Fed's word for it or Congress's, I'll go with Treasury and Fed every single time.

"Would create a new Consumer Financial Protection Bureau within the Federal Reserve, with rulemaking and some enforcement power over banks and non-banks that offer consumer financial products or services such as credit cards, mortgages and other loans. "

The issue here is not what it is in the bill, but what it will evolve into. These bureaucracies never stay stable and never become efficient, and I worry that it will end up intervening in places it doesn't understand and make things worse, not better, either by stunting growth or permitting (or even forcing) risk.

4 things that I (think I) like:

"Would give shareholders of public corporations a non-binding vote on executive pay, and would give the SEC the authority to grant shareholders proxy access to nominate directors."

About time. I just wish they'd kill off proxy voting entirely.

"Would require the vast majority of all derivatives trading be executed on a public exchange as opposed to between banks and their customers as many contracts are currently."

Everyone likes to think that this is a panacea. It's not, but it's not a bad step.

"Sets up a liquidation procedure run by the FDIC."

Some stability in liquidation rules would be very, very helpful, so that we can look and understand exactly what will happen. This, of course, assumes the liquidation procedure is intelligent, but we don't know how it's going to work yet. I'll give the FDIC the benefit of the doubt.

"Would require firms that securitize mortgages and other loans to hold a portion of the risk on their own balance sheets."

This was the fundamental flaw in the Basel II capital accords that facilitated a lot of these problems in the first place - banks did that already, then everyone decided they needed more regulation and banks all of a sudden couldn't really do that as easily anymore, and everything turned downhill. The best part of this is that it also applies to the mortgage brokers, who are different to the banks and far more seedy (they're the 'predatory lenders' ripped apart in the news).

Things that I wish they'd put in:  (more here: http://tfideas.blogspot.com/2010/04/what-i-want-to-see-out-of-financial.html)

-"Living Wills" and each bank funding their own bailouts (which is the same as tighter capital requirements except psychologically different in the management of the firm)

-Contingent-convertible debt

-More limitations on high-frequency trading

-More on flash trading and dark pools (flash trading is blatantly unethical, and dark pools are only super important because of flash trading)

-An accelerating bailout tax - so that people understand exactly how they'll suffer if they'll bailed out.

-Reform/relaxation of Mark-To-Market rules

-Fewer subsidized mortgages

General Takeaway:

This still seems to me like the impressive observation of one of the New York Times columnists a few weeks ago - "This bill seems to feel that since the establishment (banks, regulators and government) couldn't predict the last bubble, more power should be vested in them to predict the next one." Fundamentally, I don't know that we've reduced risk by that much. I see a number of unintended side effects, a few good things, and generally just a very blah bill. It's not downright economically destructive the way the healthcare bill is (though I am concerned about the Fed audit and not allowing commercial banks to hedge rates and defaults)... it just seems uninspiring. 

Douthat on the ObamaCare Cost Update

http://douthat.blogs.nytimes.com/2010/05/12/the-costs-of-obamacare/

 

Douthat's post is very good.

 

Some quotes:

"First, the C.B.O. has released a new estimate of how much additional discretionary spending — on implementation costs, further subsidies for new and existing programs, etc. — health care reform is likely to generate over the first 10 years. The total comes to $115 billion above and beyond the official price tag, a sum that would almost wipe out the bill's projected deficit savings in the first decade."

 

"Nor is the news that Reihan Salam took note of last week, which bears on one of the potential fiscal time bombs embedded in reform — namely, the possibility that far more companies will offload their employees into the new government-run exchanges than the C.B.O.'s official estimate predicts. There's a penalty for dropping coverage, but for many employers the move would end up saving them (and their workers) a lot of money, the penalty notwithstanding. And if enough decide to take advantage, the government could find itself spending billions more in subsidies than the C.B.O.'s projections anticipate, driving health care reform deep into the red.

Now a Fortune piece offers evidence that a number of large employers are considering doing exactly that. "

"Of course that traditional employer-based architecture is a mess anyway, so there's a sense in which the more people who shift on to the exchanges the better. The problem is figuring out how to pay for it. In an ideal world, Washington would respond to a bigger-than-anticipated shift by slashing the subsidies and deregulating the exchanges, until you ended up with a system where the federal government was effectively paying for universal catastrophic coverage, rather than trying to subsidize comprehensive insurance. (The end result would be something that looked a bit like Wyden-Bennett, and a bit like Judd Gregg's  stillborn compromise.)

But in a less-than-ideal world, the Fortune piece notes, the fiscal picture will get very ugly very quickly:

What does it mean for health care reform if the employer-sponsored regime collapses? By Fortune's reckoning, each person who's dropped would cost the government an average of around $2,100 after deducting the extra taxes collected on their additional pay. So if 50% of people covered by company plans get dumped, federal health care costs will rise by $160 billion a year in 2016, in addition to the $93 billion in subsidies already forecast by the CBO.

"

Europe, China and the US

Pettis had a brilliant article on how the weakness in southern Europe feeds back onto China and the US. In short, Europe used to be close to trade neutral, with the northern countries having large surpluses and the southern countries having large deficits. If the southern countries can't have trade deficits anymore because they have no capital inflows (their budget deficits make their bonds too risky), then somewhere else in the world needs to increase their trade deficit or decrease their trade surplus - that's an immutable accounting identity.

 

The Euro has been weakening significantly, meaning that it's unlikely to be offset entirely by reduced northern European trade surpluses. China and Japan have been reducing their interest rates to keep their exporters strong - in effect, refusing to shoulder any of the currency adjustment. They're trying to force that adjustment onto the US, who does not actively intervene in its trade balance. Forcing us into even higher trade deficits in a period where we, too, have unemployment problems, budget problems, etc, is going to create a lot of tension and inevitably result in tariffs.

 

If China and Japan aren't going to allow their exporters to suffer (and structurally, they'll have a lot of trouble doing that), the only way for China to avoid very harmful US tariffs and the US to avoid a nasty trade deficit situation would be for China to buy lots of Euros, and thus force the northern European countries to balance more.

 

http://mpettis.com/2010/05/don%e2%80%99t-misread-the-trade-implications-of-the-euro-crisis-for-china/

 

My follow up to that is that China has been burned holding sovereign bonds from Europe because the European countries are almost all fiscally irresponsible, and there aren't enough non-governmental assets to buy with those Euros. So a number of those Euros will have to go towards consumption. Increased Chinese consumptino, either from Europe or the US, has to be the end result here, but it could take a while.

 

My bet's still on the US tariffs (I'd prefer an 'import certificate' system that doesn't single out goods and countries/currencies to tariff, but anyway)

Lessons from Seth Klarman

This is from Seth Klarman's Annual Letter. I recommend it not only to investors but also to anyone interested in government policy.

 

 

 

 

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the "depression mentality" of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank's management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
18. When a government official says a problem has been "contained," pay no attention.
19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.
2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
3. There is no amount of bad news that the markets cannot see past.
4. If you've just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
5. Excess capacity in people, machines, or property will be quickly absorbed.
6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
9. The government can indefinitely control both short-term and long-term interest rates.
10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

Why has Buffett been selling JNJ?

I have a number of theories, related to the healthcare bill, valuation and the recent dust-up over conditions at the Children's Over-the-Counter factory... but does anyone else have other thoughts?

Troubling Supreme Court Decision on Detainment

http://www.cnn.com/2010/CRIME/05/17/scotus.sex.offenders/index.html?hpt=T1

 

I can't believe I agree with Scalia and Thomas over the rest of the court in a civil liberties case, but the idea that a sex offender can be held beyond his or her prison sentence is concerning. I understand the need to monitor people, but these are US citizens who do have the right not to be tried twice for the same crime, which this amounts to. Monitoring should be mandatory, and perhaps some of them should be transferred to psychiatric institutions, but jail is not appropriate. Indefinite detainment of enemy combatants is concerning also, but at least the enemy combatants held at Guantanamo are demonstrably engaged in something approximating military activity, which is different to "common" crime.

High Frequency Trading

"These are short-term bets. Very short. The founder of Tradebot, in Kansas City, Mo., told students in 2008 that his firm typically held stocks for 11 seconds. Tradebot, one of the biggest high-frequency traders around, had not had a losing day in four years, he said. "

 

http://www.nytimes.com/2010/05/17/business/17trade.html?hp

 

This should not be happening. Arguments about liquidity are bunk (as I've explained many times on this blog) and this pattern of trading raises the cost of capital. Arbitraging my inability to own a supercomputer is abusive.

On Diversification

http://www.dilbert.com/2008-12-13/

 

Pretty sure I've posted this before, but I actually have a thought about it this time. This is pretty basic to the Buffett-o-philes but there are still a lot of economists and others who see diversification as a good risk reducer.

 

This gets at my problem with diversification as a risk reduction mechanism. Some academic financial economists decided years ago that volatility = risk
and people have been building on that for years. Certainly, there's risk that can be diversified away, but I'd bet that if you can find 15 securities that are not identical in most respects, adding a 16th doesn't cut as much risk as it saps return.

 

I've never seen it framed this way, but the volatility/risk fallacy seems to me to be a correlation/causation issue. Just because going from 1 to 2 securities is less risky and less volatile doesn't mean that it's less risky because its less volatile. If the security's price fluctuates significantly, you still hold the same intrinsic security, and if nothing has changed about the underlying security, that increase in volatility is not a good measure of risk. Instead, going from 1 to 2 securities is less risky because there are fewer events that can wipe out your investment.

 

In other words, if you're willing to step back from the "price fundamentally represents everything publicly known about a security" (semi-strong form efficient markets hypothesis), for which there is almost no empirical support (it's a tendency which can often be true but is not always true), then going from 1 to 2 securities cuts risk because a single major fundamental change to the world reduces the intrinsic value of your portfolio by less if not all of your securities are levered to the original state of the world.

 

This helps explain why markets can be efficient but are not necessarily efficient. If prices successfully respond to 95% of actual fundamental changes, and also to 80% of things which seem like fundamental changes but are not, plus some noise factor, then you have a situation where if the big news around stocks are actual fundamental issues, the markets are reasonably efficient because they're pretty good at reacting to real issues. This is most likely when there is a strong diversity of opinions, though this isn't a true necessity. If the market is reacting because a large number of people think something is a fundamental change, but it isn't, then markets don't necessarily have to be efficient. This also holds if people are no longer trading on the fundamental changes but on other factors (for example, levered firms liquidating positions they like to cover margin calls, as occurred for the end of 2008). This is how you see bubbles and busts, and why it was so easy to make a fortune if you could look at the market with a degree of time frame patience  in March 2009. Regressions that seem to signal efficient markets would be improved by thinking about this mechanism.

 

Even people who advocate for less diversification rarely understand this or acknowledge why they're doing so, and actually DO expose themselves to more risk in the process by saying "diversification isn't a good strategy" and thus loading up in securities exposed to the same fundamental sources of risk. Diversification is not about securities, but about sources of risk that aren't always reflected in prices (with the converse holding true, that changes in price often do not reflect actual sources of risk).

 

 

Interchange Fees

I'm studying nonstop for the CFA, so my posing will be sporadic, but I wanted to make a note on the Durbin amendment to financial reform to restrict interchange fees on debit cards.

 

I'm concerned about giving the Fed power to limit debit interchange fees. Not because the issue didn't require regulator intervention - in my opinion, the three biggest anti-trust issues that aren't being addressed right now are the Apple store, wireless companies (AT&T, Verizon, etc) and Mastercard/Visa - but because I think this shouldn't be a power given to the Fed, it should be a FTC action. It fits every definition of antitrust-  it's a collusive oligopoly, and the problems aren't the business model but with the prices they charge and the way they pressure their "customers" - in this case, merchants - to not work with "competitors" - in this case, cash. This is CLASSIC anti-trust. The FTC is well equipped for that. The Fed is already overstretched as it is, and it has a different set of desired outcomes than the FTC. The Fed is looking for financial and economic stability, and the FTC is looking for functional markets. In this case, financial stability is not the issue, it's a functional markets issue.

 

 

 

 

A Volatile Wall Street

Rose asks, "Could you possibly do a blogpost on how to prevent or
adjust for something like Thursday's Wall Street panic attack?"

So I suppose my response to that would be that we shouldn't adjust
anything- people who are really affected (day traders, people who use
margin) know the risks. The necessary adjustments on Wall Street (and
there are many) regard fairness foremost (I'll address this in a
second) and risk-taking (less obvious), neither of which are reflected
in a one day panic.

That said, defusing volatility without harming the regular functions
of markets or raising the cost of capital is (obviously) a good thing.
Thus, like financial reform, procedures for halting, slowing or
defusing intraday crises would be valuable. I was wondering if they'd
close the exchange for a bit but A) it didnt hit the built in
circuitbreaker for the whole market, though some stocks did, and B)
that wouldn't necessarily have stopped the plunge on other networks
like ECNs. In fact, stopping primary trading could have even worsened
things bc of less buying liquidity but continued selling panic.

Thus, a number of big improvements come to mind. Firstly, make the
circuit breaker time dependent, as well as magnitude dependent.
Clearly, a 10% drop in ten minutes is more serious than a 10% drop in
a day. Circuit breakers that factored in speed of drop would be good.
Secondly, coordinate the networks such that when the primary exchange
closes down, the secondary ones do, too. Incidentally, this should
also apply to market opens and closes - currently, the NYSE opens 30
seconds later than a lot of the secondary NASDAQ or ECN networks, so
anyone who submits trades before the open can get cheated out of a
portion of the spread. The secondary networks should not be permitted
to trade when the primary listing exchange is closed. This has both
fairness and anti-panic benefits. There are also decent reasons to
implement the circuit breaker on an upward basis, as well.

Additionally, improving liquidity makes it harder to have a panic.
High-frequency trading can exacerbate panics and drives liquidity from
the market by functionally stealing a piece of every spread (for more
information, see my prior comments at number 7 here:
http://tfideas.blogspot.com/2010/04/what-i-want-to-see-out-of-financial.html).

Flash trading (basically, where some people see trades a fraction of a
second before others) is blatantly unethical and drives liquidity from
the market because large block sellers or buyers don't want to be
jumped by hundredths of a penny by people who see their trades before
the market does. Dark pools make liquidity invisible and getting rid
of them would make the market deeper and less prone to panics (though
it's difficult to eliminate dark pools without getting rid of flash
trading first). To the Obama administration's credit, it has been
working to illegalize flash trading, and is looking at dark pools.

Some more ideas I've heard or had to combat UHFT and flash trading
(they're related but not the same) are to tax cancelled transactions
(instead of a turnover tax), or re-widening spreads away from pennies
to nickels (the market functioned perfectly fine in eighths until
1999). Even more radically, partially ECN-ing the market, where
matching and execution are not continuous but instead execution
happens at certain predetermined points (perhaps every 5 minutes, or
something like that) and only matching can happen in the interim,
would help to reduce a lot of the egregious HFT and flash trading
practices.

Finally, relaxing mark-to-market rules somewhat can, in some
instances, reduce liquidity crunches and, depending on the assets,
margin calls for some more sophisticated securities.

A shocking note on Apple

This is more of a "fun fact" than a policy suggestion... but did you realize that Apple's market cap is $235 billion?

 

That's more than Newmont Mining, Du Pont, Kellogg, Dreamworks, H&R Block, New York Times, Molson Coors, Estee Lauder, Tiffany & Co, Hershey, Harley-Davidson, Expedia, Abercrombie and Fitch, American Eagle, Burger King, CBS, Chipotle, Whole Foods, Starbucks, Netflix, JetBlue, NStar and Dr. Pepper-Snapple Corp.... combined.

 

I understand that on an enterprise value basis, it's not equivalent (I can't do the math right now, but someone wrote that all those companies together have $30 billion + of debt, while Apple has no debt and could probably pay a $20 billion dollar dividend and be fine... but you can adjust for that. Subtracting DuPont only gets you pretty close if the $30 billion is accurate)

 

 

Given Apple's abuse of Adobe's flash, and shenanigans with AT&T... why aren't they a bigger antitrust target?