Author: David Wright

Tad Montross recently tried to throw some cold water on the cat bond party:

“With interest rates being where they are, I don’t think it’s a surprise that a cat bond with a yield of 350 or 500 basis points over Libor looks attractive. People are drooling for those.”

“What happens after the $150 billion earthquake, when Nevada is basically coastline to the Pacific? This whole issue that it’s a non-correlated asset class, which makes it so attractive as people look at their risk-return profiles, is one that really needs to be thought through very, very carefully.”

More plus commentary here.

So here’s a chance to think a bit about all kinds of issues.

Number 1, and most importantly, Montross is biased. Incredibly biased. He competes against cat bonds. If his comments move their marginal prices up he can make more money.

So beware, Dan Kahneman teaches us that we systematically underestimate the effects of bias on others. I could (should?) end the post here because all of his comments should be interpreted as naked self-interest even if it’s not consciously intended.

Number 2, correlation is a brutally simple statistic that glosses over a lot of complexity in risk management. At the link, Steve Evans makes the point that many investors are too sophisticated to actually take the “non-correlation” line at face value with cat bonds. Or any other asset class for that matter.

But I’ll try to make a stronger stand. Low correlation is real and here to stay. Forget sophistication, if you have a portfolio of cat bonds diversified by region and peril, even if a 150bn EQ hits, ripping California from the mainland or whatever ridiculous sci-fi fantasy you want, your cat bond portfolio will vastly outperform every other asset class. It’s diversified, people. There’s US wind, there European perils, Japan, etc, etc. The general economy, on the other hand, would be toast.

Which takes me to point 3: the ONLY source of meaningful correlation to other assets is through the holding portfolio of treasuries or Money Market Funds. If these tank, cat bonds follow. This got found out in the financial crisis where some bonds got into real trouble because Lehman stuck the assets into garbage “AAA” mortgage CDOs. Luckily it was a small subset and we got a chance to learn the lesson (allow me to say that all collateralized deals we did pre-crisis used super-safe assets and didn’t blink in the crash).

Anyone can imagine a sufficiently unlikely scenario where all assets correlate (asteroid destroys earth and it’s correlation city: all assets go to 0). The key is that you need to tie it into your own risk management system. On a 1-in-100 portfolio basis tresauries are still liquid and as risk-free as possible and so cat bonds are non-correlating. End of story.

For his soccer tournament:

I also have a network of friends and buddies who are doormen around the city. They tell me who’s around. That’s how it falls into place.

Awesome.

I liked this article a lot, which is nominally about investors (Venture Capital) on a board of directors. But I think that it has a lot to offer to a similar idea I like: thinking about higher levels of management/ownership hierarchy as productive tools for building the business.

Here’s a great quote:

VCs crave the ability to help portfolio companies. We’re all secretly paranoid we’re not helping enough and want to know how to be more helpful. When a company gives you a discrete action to carry out – it’s gold dust – I promise you. If board members start joking amongst themselves (as we at DataSift do) that you “got another Rob assignment” you know you’re on the right track.

USE the VC who, normally, is the “boss”.

I work in a business with fairly flat organizations where, when the culture is healthy, everything is subordinated to the deal, even the ego of the CEO.

So to generalize a bit from the article, different members of the organization should drop in and out of the team as needed. We think hierarchically (you’re my boss, etc) and of course that’s necessary in many contexts. But the hierarchy of the team on an account need not always mirror that of the organization as a whole.

The key is for the ‘owners’ of the outcome of specific projects (account execs) to be able to identify problems and willing to search for the best available resource in the organization to solve it.

It takes leadership to break free of hierarchy when doing this and, echoing Dan Rockwell (see here but this is a constant theme for him), takes even more leadership to encourage a subordinate to do it.

Georgia Tech throws the first stone:

The Georgia Institute of Technology plans to offer a $7,000 online master’s degree to 10,000 new students over the next three years without hiring much more than a handful of new instructors.

Georgia Tech will work with AT&T and Udacity, the 15-month-old Silicon Valley-based company, to offer a new online master’s degree in computer science to students across the world at a sixth of the price of its current degree. The deal, announced Tuesday, is portrayed as a revolutionary attempt by a respected university, an education technology startup and a major corporate employer to drive down costs and expand higher education capacity.

Very exciting.

Udacity will receive 40 percent of the revenue from the new degree program, according to Georgia Tech, which will receive the rest. AT&T is subsidizing the effort financially to ensure that it will break even in its first year and is lending its name to the project

There will several kinds of students:

1. 6,000 students who meet the minimum standards will be admitted.
2. 2,000 students will take the courses but not be interested in the degree. Not clear whether these meet any standards.
3. 2,000 studnets who do not meet the minimum standards (GRE) who “do well in two core classes”. How do they take those core classes if they aren’t admitted? Well, they’re drawn from…
4. the unlimited number of students who can take the MOOC-version of the course with no instructor support and no real degree at the end.

Students will be assisted by instructors from Georgia Tech and Udacity employees who handle more run-of-the-mill questions:

Galil and Thrun both said that Udacity-paid staffers could answer most of the questions students in the courses come up with.

“In many cases, the questions are simple. In many cases these questions can be found in FAQs, even though students don’t find them in FAQs,” Galil said.

Thrun said there’s no reason to make a professor answer the same question 200 times for 200 students. He said his staff will free up Georgia Tech instructors to do more difficult work.

Oh, and everyone is getting paid. Welcome to the future!

…it seems that strong families tend to be good for people individually, but bad for the world as a whole. Family clans tend to bring personal benefits, but social harms, such as less sorting, specialization, agglomeration, innovation, trust, fairness, and rule of law.

That’s Robin Hanson.

In his post there are many quotes with interesting perspectives on this idea. I focused on this one:

Risk taking …in family firms … is positively associated with proactiveness and innovation. .. Even if family firms do take risks while engaged in entrepreneurial activities, they take risk to a lesser extent than nonfamily firms. … Risk taking in family firms is negatively related to performance. (more)

Interesting.

The essence of agency costs is that somebody else pays when something goes wrong. This encourages risky behavior.

Is risk really so great? Just hire some managers to bet the farm more often and everyone wins? What is “risk”, anyway? After a bit of digging I was able to find this definition of risk taking:

Thus, firms with an entrepreneurial orientation are often typified by risk-taking behavior, such as incurring heavy debt or making large resource commitments, in the interest of obtaining high returns by seizing opportunities in the marketplace…

Presently, however, there is a well accepted and widely used scale based on Miller’s (1983) approach to EO, which measures risk taking at the firm level by asking managers about the firm’s proclivity to engage in risky projects and managers’ preferences for bold versus cautious acts to achieve firm objectives.

Ok, so it’s survey data (ie watch out for bias!). Large, agent-run companies, remember, have their own risk-killing system which shrugs off survey results: bureaucracy. One can imagine a situation in which agents raise their status by boldly proclaiming a desire for risk with no hope of having to actually act.

These papers should say “professed desire for risk taking is associated with inferior results” for family-run companies. It’s my own view that real corporate strategy involves making lots and lots of small, decent bets.

Never swing for the fences. Never bet the firm. Big risks are unconscionably stupid business.

Here is a report by a UK equities research firm:

Changes are afoot inside the world‟s major central banks… After more than a decade of inflation targeting, monetary authorities are, it seems, increasingly minded to go for growth, as the problem is no longer rising prices, but unemployment.

The long-term consequences of this shift – which my colleague Jim Leaviss has termed “central bank regime change‟ – remain uncertain… With its incoming governor recognised as having one of the most informed understandings of the new regime, the Bank of England looks set to play an increasingly important role in the global monetary policy revolution. UK shares could stand to benefit.

I agree. When the central bankers get their act together, which they are doing, nominal incomes will rise, whipping up a tailwind for the recovery.

Now consider the price of of gold which, according to my view, should drop when the markets get comfortable with the bankers’ strategy. It has.

Humans are good at throwing things. In fact, we’re great at it; no other animal can throw stuff like we can.

Hm. How important is throwing? I wonder if Aliens, should they exist, throw? More here.

-=-=-

edit: the Randall Monroe post links us to this abstract (among others), which opens with this:

It has been proposed that the hominid lineage began when a group of chimpanzee-like apes began to throw rocks and swing clubs at adversaries, and that this behaviour yielded reproductive advantages for millions of years, driving natural selection for improved throwing and clubbing prowess.

But simple, beautiful mathematical explanations can make us greedy. While we wish for all explanations of the world around us to be elegant, science often involves “the slaying of a beautiful hypothesis by an ugly fact,”

…“there is growing empirical evidence that people use a common source for evaluations of both beauty and truth.” The source he refers to is processing fluency, the state of being able to easily parse and understand a situation. Essentially, the more easily we can get a handle on a situation (because it’s mathematically simple, we’ve seen it many times before, it’s symmetrical, etc.), the more likely it is to seem right.

That’s from this article by Sam Arbesman. I’ll bang my actuarial drum again here: we are trained to use a series of very elegant models of random processes which often involve some clever math but in reality the models only become convincing once you have enough historical data to… well, throw the model away.

There is nothing elegant about social/economic interaction. Go crude and go ugly.

Wolfers and Stevenson with a checklist for evaluating statistics. Here is the most important one, to me:

If the author can’t explain what they’re doing in terms you can understand, then you shouldn’t be convinced.

It’s the biggest problem I have with what I do for a living. I often don’t understand what I’m measuring, be it weather phenomena or auto accidents. They systems that produce Hurricanes and car crashes are too complex for anyone to understand.

Yet we fit statistical parameters to them and cross our fingers.