Saturday, November 28, 2009

The CRU Scandals: A Reflection on Academia

I am sure that you have been tracking the story of the hacked emails between top climatologists and the ensuing debate about whether those atop the discipline have stifled skeptics in the global warming debate. If you have not, here is a quick review:
I do not intend to wade into that debate but the entire controversy has held up a mirror to academic research in general and I don't think the reflected image is flattering.

Let us start with the ideal. Seekers of truth (Scientists, professors, Phd students... the academic research community) come up with interesting and provocative questions to answer, look at these questions objectively (and with no financial interests at stake) and with no preconceptions, develop theories and test them rigorously and then report these results without skewing them. Their research is reviewed by their peers, who bring the same objectivity and fairness to their assessments, and decide whether the research should be published.

As with most ideals, this one is utopian. Here is my more cynical view of how the process works.
1. Research what will be published, not what is interesting: When you first start climbing the academic ladder, the name of the game is to get published. Would you rather publish a ground breaking paper than an incremental one? Of course. But would you rather publish an incremental paper than have a ground breaking paper that does not get published? The answer again is affirmative. It is far easier to publish a paper than nibbles at the edges of big questions than one that asks and tries to answer big questions. If you pick up any academic journal and browse through the contents, you will see the evidence of this marginalization.

2, Bias in, bias out: Researchers are human and come in with biases and preconceptions, some of which are formed early in life, some during their academic experiences and some of which they acquire from their mentors and peers. Those biases then drive not only the topics that they choose to research but also how they set up the research agenda and in some cases how they look at the data.

3. Who you are matters: Where you went to school to get your doctorate, who your mentor is and what school you teach at right now all affect your chances of getting published. If you went to an elite school (and the elite can vary from discipline to discipline), worked with the right mentor (preferably a journal editor) and teach at another elite school, your chances of publication increase significantly.

4. Every discipline has an "establishment" view: There is an establishment view in every discipline. Papers that hew to this view have a much easier path to publication than papers that challenge the view. In finance, the establishment view for decades was that markets were efficient and that any evidence of inefficiency was more a problem with the models we had than with the underlying efficient market hypothesis. It has taken almost two decades for behavioral economists to breach this wall. Now, I sense that they are becoming part of the establishment and don't quite know what to do.

5. Peer review is wildly variable and sometimes biased: When you write a paper in a particular area, it will be sent out to other "experts" in the area for review. Some of them are scrupulously fair, read your paper in detail and provide you with extraordinary feedback that improves your paper. Others are defensive, especially if the paper challenges one of their pet theories, and find reasons to reject the paper. Still others are extremely casual about feedback and make suggestions that border on the absurd. While peer review, on average, improves papers, it does so at considerable cost.

6. Data abuse happens: As the volume of and access to data improves, it has become far easier to abuse the data by (a) selecting the slices of data that best fit your story (b) expanding sample sizes to the point that the sheer amount of data overwhelms the opposition and (c) reporting only a subset of the results that you get with the data.

I think peer review is useful and empirical testing is crucial. However, my advice to laymen looking at academic research is the following.
1. Don't assume that academics don't have an agenda and don't play politics. They do.
2. Don't let "research findings" sway you too much - for every conclusive result in one direction, there is almost always just as conclusive a result in the opposite one.
3. Just because something has been published does not make it the truth. Conversely, the failure to publish does not mean that a paper is unworthy.
4, Develop your own vision of the world before you start reading papers in an area. Take what you find to be interesting and provocative and abandon the fluff (and there is plenty in the typical published paper).
5. Learn statistics. It is amazing how much of what you see reported as the truth fails the "standard error" test.

One final note on the CRU email story. For the most part the faults of academic research create no significant damage because so much of the research is inconsequential. The scandal of the data manipulation and stonewalling of critics in this case is that it is so consequential, no matter what you think about global warming. If there is no global warming and the data has been manipulated to show that there is warming, the academics at the heart of this affair should be forced to answer to the coal miners, SUV assembly workers and others who lost their jobs because of warming-related environmental legislation. If there is global warming and the numbers were being cooked to make the case stronger, there is the real possibility that people will turn skeptical about warming about revert back to old habits. In either case, it behooves those involved in this mess to step down.

Friday, November 27, 2009

A tax on financial transactions: Good or Bad Idea?

In recent days, we have heard talk from Congress about imposing a tax on financial transactions. While there has been heated debate on the topic, there seems be more smoke than substance in most of the arguments. This morning, Paul Krugman, who seems to have made a speedy and seamless transition from economist to polemicist, has an article on why such a tax is a good idea:
As always, Krugman sees the villains here (the speculators, who else?), decides that this tax will not have much effect on the good guys (a group of long term investors, into which he puts himself and his readers) and sees potential benefits to markets from the action.

Very convenient, but not very balanced!!! I would like to provide a counter, by first examining the motives for a transactions tax and then considering the laws of unintended consequences.

As I see it, there are three motives for a transactions tax.
1. Revenue generation: As government budgets get squeezed and deficits mount, legislators are flailing around for ways to raise revenues in fragile economies. Given the sheer volume of trading volume in financial markets, even a small tax seems likely to raise huge revenues. (In a classic example of how governments compute potential revenues from taxes, the estimated tax receipts are computed by taking the existing dollar value of trades in a market and multiplying by the tax rate.... If only we lived in a static world...)

2. Punish bad behavior: As a bonus, the tax will fall most heavily on those who trade short term or in derivatives markets. If we assume, as Krugman has, that these trades are for the most part speculative, the tax punishes that "bad" behavior. (It is the same rationale that allows governments to raise taxes on tobacco and alcohol...)

3. Target the "right" entities: The perception on the part of many is that the biggest traders in derivatives markets are investment banks and hedge funds. The billions of dollars that these entities are reporting in profits, in conjunction with their absence of suitable remorse for their role in creating the banking crisis of last year, has made them easy targets. (I am quite surprised that legislators have not proposed a windfall profits tax on just the bad guys, at least as they see them... they would probably call it the Goldman tax!!)

So, what can go wrong?
1. Motives are internally inconsistent: There seems to me to be a direct contradiction between motives 1 and 2. Put another way, the only way in which this transactions cost will raise revenues is if the bad behavior in question (short term trading) continues in the future. I think legislators need to specify what their primary objective and not try to argue out of both sides of their mouths. (I know little or no chance of this happening, but no harm hoping..)

2. Speculation versus Investing: As I have argued before, I am very uncomfortable drawing the line between speculation and investing. While I might not see much benefit to short term trading, I can see how others might. To label myself as the investor and the others as speculators is self serving and wrong. Furthermore, the notion that derivatives trading is driven primarily by speculation is fantasy. I can see plenty of reasons why a long-term, value investor may use derivatives to protect and augment his returns.

3. Liquidity costs: Even if we accept the premise that short term investors create noise and pricing bubbles, long term investors benefit from the liquidity they bring to the system. In fact, the markets where long term investing is most difficult are markets where there no short term investors. (Consider the market for fine art or even real estate.... Transactions costs inflate for everyone and insiders end up dominating the market)

4. Market mobility: As trading moves of exchange floors into ether space, it is difficult to visualize how a transactions tax will work, unless it is globally coordinated. All you need is one rogue player for the system to start coming apart at the seams. Krugman argues that the clearing systems for many of these markets are centralized and that the tax can be therefore collected at these locations. While this may work in the short term, how long will it take for an offshore location (say the Cayman Islands) to set up a competitive system? (It will cost money but the potential benefits from the system will be huge.) Once that happens, any chance of regulating these markets, even in sensible ways, becomes remote.

All in all, I think this is a dumb idea that should be throttled early in the process. I am sure that you will hear variants of the concept, and they will all share a common feature. They will try to focus the tax on what they view as the markets or securities that they view as most speculative and argue that only the entities in these markets will be affected by the tax. I don't think so. Ultimately, we will all bear the cost.

Monday, November 23, 2009

Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?
The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?
If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?
The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.

Sunday, November 15, 2009

The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.

Tuesday, November 10, 2009

The Agency for Financial Stability? Good idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed
There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk
The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.

Thursday, November 5, 2009

Bad companies and good investments...

One of the big news items of the week is Berkshire Hathaway's acquisition of a Burlington Northern, a large US railroad.
Since Berkshire Hathaway is Warren Buffett's brainchild, this has provided a platform for many analysts to read the tea leaves. Here is some of the spin that I have seen and what I think about the spin.

A significant number of the analysts have argued that Buffett is making a bet on the US economy recovering by making this investment. I find this puzzling at two levels. First, if you were going to make a bet on the US economy, railroads seem like a pretty poor choice. Unlike housing and consumer durables, railroads have not seen their earnings increase dramatically in good economic times. Second, Buffett has always expressed his skepticism about market timing and macro investing strategy and this investment would be a significant departure.

Here is my take on the investment. Railroads in the United States are the quintessential mature business. It is extremely unlikely that you will see much real growth in this business; constructing a new railroad or even adding new rail lines would have prohibitive costs in the US, given real estate costs and litigation issues. Companies in this business have earned returns on invested capital that have lagged the cost of capital for decades. Put another way, very few railroads would make the list of most glamorous companies or be featured in Tom Peter's list of excellent companies.

So, why would Buffett invest in a bad business? I have said some unfavorable things about Warren Buffett on this blog before. At the risk of repeating myself, I think he has been hypocritical on corporate governance and he plays the "I am just a hick from Omaha" role to perfection. However, I think his status as a great investor can be boiled down to his capacity to separate "great companies" from "great investments" . Put another way, Buffett has always recognized that a great company can be a terrible investment, if you pay too much for it, or that a mediocre company can be a great investment, at the right price.

Here is the bottom line. I don't think that Buffett's investment in Burlington Northern is a bet on the US economy or an expectation of a surge in profitability for railroads. I think it reflects a more prosaic choice. Buffett thinks he is getting a good deal for the company at the current price, and he has history on his side. The best investments in the market are often among the companies that are viewed as the least glamorous and most boring: Burlington Northern clearly fits the bill.