While We're On the Subject...

"Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, along with 17 Democrats on the committee, demanded Tuesday that Northern Trust repay what it spent on entertainment during the [Northern Trust Open held in Los Angeles] which ended on Sunday."

"And Senator John Kerry of Massachusetts vowed to introduce legislation to end “the extravagant spending practices” of banks that received taxpayer dollars in the federal bailout."
Link to NYT story

Congressman Frank and Senator Kerry:

By my reckoning, the US federal deficit has soared from around $1 trillion when Congressman Frank first entered Congress in 1981 to $10 trillion today and we're on our way to $12 trillion according to the President's recent budget proposal.

Until the federal government pays back this money, there are a few expenditures I'd like to discuss with you.

In the meantime, I trust that you and your honorable colleagues in the House and Senate -- mindful of taxpayer concern over profligate spending -- are currently using the Metro for your daily commute. If not, you should know the Federal Center station is mere 6-minute walk to and from the Capitol. I know the fare-card system can be confusing at first, but my nephew's third-grade class has been studying the Metro and would be happy to organize a field trip to help you and your colleagues learn the ropes.



We look forward to your continuing vigilance on behalf of the tax-payers.

Dumb and Dumber

I don't know which is sillier.

1) The outrage professed by certain politicians that banks receiving government assistance engage in marketing activities, which might include entertaining clients and fulfilling obligations made months ago to sponsor a golf tournament, or

2) The ridiculous statements made by the PR departments of banks that "... the money for these activities comes from operating profits, not TARP funds."

One expects the grandstanding from politicians, but the bankers really ought to know better. What percent of the population do they think buys the notion that TARP funds are "balance sheet" cash distinct from cash used in operating activities? Please just stop it.

It suffices to say, as Northern Trust recently did, "We came to the conclusion that no public purpose would be served by canceling the Northern Trust Open and related events.” But then they blew it by trotting out the "No TARP funds were used..." defense.

Marketing your business, raising money for charitable purposes and supporting your local community are valid reasons for sponsoring a golf tournament and remain so today. Here's my suggestion. Take away the single malts in the courtesy tent: your customers will gladly drink blended scotch in these parlous times. Make your employees double up in hotel rooms; none of them will WANT to go without a compelling business reason for doing so. Keep it low key, and maybe get the local hospitality and restaurant businesses to highlight the dollars and jobs that are supported by a major golf event.

Then, shut up.

Taxpayers are not stupid. Eventually someone will observe that government assistance is not exactly a novel idea. Farmers receive agricultural subsidies, households receive tax credits, not-for-profits enjoy their tax-free status. If the receipt of a financial benefit from the federal government is sufficient reason for Barney Frank to weigh in on every recipient's every expenditure, then maybe he should personally do the grocery shopping for every family on food stamps.

Finally, I have to reprint comment 8. to the NYT article linked above. I can attribute it only to "Joe", but it bears quoting in its entirety.

"Money is fungible, idiots! Either give them money, or don’t and take them over. This false outrage is really getting tiresome. I say let them golf. But force them to tee off from the blue tees and make Barney Frank go along with them, in bright Madras shorts and cap, to provide oversight and prevent them from taking mulligans. That ought to freak them out a little bit. Then post their scores publicly. Bankers need all the humiliation they can get these days."

Golf PrimerHow to Make Birdies

"On the next hole, Woods hit his second shot to within four feet of the hole, using a 5-iron from 235 yards."

Quants vs. Suits - Who's to Blame for the Financial Meltdown?

Eric Falkenstein has posted an exceedingly well-written response to Felix Salmon's recent Wired article, "Recipe for Disaster: The Formula that Killed Wall Street" over on SeekingAlpha. Falkenstein nicely captures the interaction between the "quants" and senior management in financial institutions when he writes,

"The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it."

In my experience, the best quants are generally quite keen to identify and debate the risks and assumptions in their models, but too rarely encounter non-quant managers who show the patience to comprehend the implications. If you're rich, powerful and kind of smart, it's more comforting to say: "I don't pretend to understand all this greek, but I've hired the smartest guys to do the math" than to say "I've tried to understand it, and frankly it's over my head."

Felix Salmon's Wired article is indeed worth reading, although the headline is a tad melodramatic. In Salmon's view, the adoption of Gaussian copula techniques to model the risk characteristics of mortgage-backed securities mortally wounded Wall Street.

Over at the New York Times, Joe Nocera seems to think it was a Value-at-Risk spreadsheet that killed Wall Street in last month's "Risk Mismanagement" article.

Perhaps Wired magazine will sponsor a debate between Mr. Salmon and Mr. Nocera about whether it was a VaR model or a Gaussian copula model that buried Wall Street. Nassim Taleb might be willing to moderate.

To Mr. Salmon's credit, his article does discuss what is -- in my opinion -- the single biggest source of failure in these risk management models. Namely, the use of CDS price data as a proxy for otherwise hard-to-track correlations among many discrete and illiquid securities. It was the availability of a real-time price series that apparently made the Gaussian copula function "tractable", but the use of CDS price data appears to have led to models that vastly and tragically oversimplified the real world relationships they were meant to simulate. Moreover, as Salmon points out, the limited history of CDS prices meant that the historical data was largely drawn from a period of benign economic data. Finally, the CDS market ultimately became a speculator's market with the notional value of default insurance dwarfing the underling credits supposedly being insured, which undoubtedly raised the noise-to-signal ratio on CDS price movements and correlations.

Salmon's and Nocera's articles are the most prominent examples of a growing "The model made me do it" set of explanations for Wall Street's current predicament. Unfortunately, the journalistic imperative for a catchy headline and strongly themed story tends to gloss over the more complex human, institutional and managerial failings that are more appropriately to blame.

If you've read this far, and you're truly interested in the subject, I highly recommend reading UBS's confessional Shareholder Report on UBS Writedowns (pdf). This remarkable report from April 2008 describes the causes of UBS's losses related to US residential mortgages, which at that time were a mere $18.7 billion.

What you will find in this report is a board-approved "hurry up" strategy to rectify lagging league table performance in global fixed-income markets, which led to an aggressive market entry into the RMBS market as it was peaking. You will find that internal capital charges were not routinely adjusted for the true risks of proprietary positions, leading to "carry trades" and correspondingly high inventories of ultimately risky securities. You will find that "warehoused" securities held-for-sale were not hedged at all. You will find that dubious AAA-rated mortgage backed securities were hedged based on the five-year default histories of the small handful of remaining AAA-rated corporates during period of strong economic growth. And you will find that compensation policies rewarded traders for current year profits, even if the positions they held proved toxic down the road. What you don't find in this document is "Oops, the models broke" types of excuses.

For anyone interested in the subject, I also recommend Suna Reyent's article on SeekingAlpha as well.

The Equity Risk Premium Puzzle-Who are the Long-term Holders?

One of the unsolved mysteries of modern finance theory is the "Equity Risk Premium" puzzle. In a sentence, the puzzle is why equities have historically outperformed bonds (in real, dividend-adjusted terms) by such a large margin? For an elegant illustration of the concept, see Brad DeLong's 2006 blog post here.

Of course, stocks should deliver a larger return since they are riskier claims than bonds; and the variance of stock returns -- the measure of risk in modern finance theory -- is manifestly greater than the variance of bond returns. But the magnitude of stocks' outperformance is the puzzle, especially in light of the well-known fact that the variance of stock returns can be mitigated by long holding periods. (note 1)

This latter notion is most famously articulated in Jeremy Siegel's "Stocks for the Long Run" and more infamously in Glassman & Hassett's "Dow 36,000".

Barring a quick rebound in the US stock markets, the Equity Risk Premium puzzle is likely to be a hot topic in finance departments over the next few years. And if the US experiences another decade of meandering stock price performance to match the current Japanese experience, it may be decided that there's no puzzle at all. The major Japanese market indices are hovering at the same levels they first reached twenty years ago and are roughly 80% below their all-time highs. The current generation of Japanese investors are probably not scratching their heads over the inexplicably high historical returns of common stocks.

Recent news events may shed some light on the issue as well. Like many universities, Harvard has recently reported that it's endowment shrunk 22%, or $8 billion, in the last half of 2008 and that it may shrink by as much as 30% when illiquid assets such as private equity and venture capital positions are marked to market. Geraldine Fabrikant has covered this story for the New York Times here

"Harvard Endowment Loses 22%"

and here.

"Endowment Director is on Harvard Hot Seat"

What I find interesting in this news is the fact that "Harvard depends on its endowment for about 35 percent of its operating budget..." representing $1.4 billion of endowment income contributed to annual operating expenses according to this letter from Drew Gilpin Faust, the university's president.

"Letter to the Community - February 18, 2009"

Now, $1.4 billion per year equals 3.8% of Harvard's endowment of $36.9 billion as it stood on June 30, 2008. But $1.4 billion per year comes to 5.4% of the $25.8 billion that Harvard's endowment will shrink to if realized losses are in fact 30%. At current prices, I suppose it's possible to construct a diversified portfolio of this size that would generate a pre-tax return of 5.4% without touching the endowment principal; but it wouldn't be easy and, more importantly, the income stream likely would not grow as fast as the operating expenses it funds.

Hence, Harvard is selling off a number of its endowment positions in public and private equity and borrowing in the debt markets to provide short-term cash. On the operating front the university is tightening its belt, suspending some ambitious construction plans and instituting certain pay freezes. The university will undoubtedly be reaching out to the alumni base for increased giving as it celebrates its 373rd anniversary this year.

But if Harvard, whose endowment is managed with a multi-century time horizon, finds its liquidity affected by the current crash in financial asset prices, who exactly are the long-term holders who can ignore the current volatility in stock prices and sit tight for the long term? Insurance companies like, for example, AIG?

There may simply be an insufficient amount of investment capital with a multi-generational investment horizon that is indifferent to market volatility like we're experiencing today. This alone could explain a good bit of the Equity Premium Puzzle. Moreover, the NYT "Hot Seat" article on Jane Mendillo, Harvard's new endowment manager, suggests a related agency issue. Even if Harvard University can take a truly long-term view, ultimately the investment decisions are made by individuals (or committees) whose career horizons are quite a bit shorter than Harvard's. Even if one truly, truly believes that in the long-run stocks will deliver premium risk-adjusted returns, it's no fun to report a 30% decline on your watch.

So for all those young investment bankers who intend to wait out the current recession in business school for the next two years, start reading up on the Equity Risk Premium Puzzle and the Liquidity Preference Function. They should be hot topics for the next couple of years.

**********

Some more comments by RHH on this topic over at Seeking Alpha

Annals of Rank Hubris, Larry Summers Edition

Larry Summers's Billion Dollar Harvard Gamble



(note 1)
Much, though not all, of the data used to analyze the Equity Premium Puzzle comes from US stock returns from the mid-1920's, or in some cases stretching back to the Civil War. This is largely due to data availability and reliability. Some commentators on the Equity Risk Premium Puzzle have noted that returns for US equities over this period may be related to country-specific factors, specifically the evolution of the US from an agrarian, emerging economy into a political and economic super-power. As such, US returns may reflect a "success bias" making them unrepresentative of global equity returns over the same periods. For a good discussion of global equity returns, see "Global Evidence on the Equity Risk Premium" (pdf).

It should also be noted that even 160 years of stock price data represents only eight non-overlapping 20-year observation periods, a relatively small data sample. Likewise, the commonly used U.S. data back to 1925 represents less than five non-overlapping 20-year periods. This means that new, extreme data points can dramatically change our view on the odds of their occurring. This time last year, one could say that a 50% peak-to-trough decline in the S&P 500 had occurred only once in 88 years, and that was associated with the Great Depression. As of today, it's occurred twice.