Does Your Forecast Consider The Punchbowl?

Here is David Merkel:

Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record. But won’t revenue growth begin again? That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because ban lending will be perking up. At that point, it is anyone’s guess as to what will happen.

In other words, never forget that the central bank moves last.

Let’s say you have a forecast for what the economy/stock market will do in the medium term. Your forecast almost certainly assumes current fed policy stays in place, which, depending who you ask is somewhere between mildly accommodative and crazy-time loose. Bernanke is on my TV right now warning against prematurely tightening, so your assumption is probably good, right?

David, of course, is smarter than that; he knows that fed accommodation is a function of the consensus of a relatively small group of very fallible humans. Right now, for example, the market thinks fed accommodation is really important and that the fed is doing a good job of laying out the punchbowl. Rewind a few years and the market had a similar hope but the opposite evaluation.

Now David happens to not like the current monetary policy stance but his view (like that of anyone that thinks about this for a while) is rather complex. My view is that I believe some version of EMH and believe that aggregate stock market value is something of a proxy for the general economy (stock market goes up, economy is good). This means the market represents the most intelligent possible evaluation of monetary policy and it’s thumbs up right now.

But how might policy change when the recovery picks up? This is THE critical macro question and any analysis that ignores it should be thrown in the trash.

Failure Is a Precious Thing

Ahem. Failure is actually an awful, painful and humiliating thing but its retelling sticks so much more firmly in our minds. Hearing how smart, motivated, honest people fail is valuable: put yourself in their place, empathize with their horrible decisions; the likelihood is that you’d do the same in their place. Learn from it.

Here is a little piece on why Vinetrade (a wine distribution startup) failed.

The business strategy is a perfectly reasonable push to apply modern inventory and sales systems to a very old-school business:

We wanted to revolutionise the fine wine industry, a market with many layers of middle men, and one that has traditionally eschewed technology, failing to patch it’s many inefficiencies.(sic)

The core problems of this business idea are very common. None are truly toxic, sometimes they work. This time they didn’t.

1. Starting with the solution.

If you haven’t worked in a business and acquired what is known in startup lingo as “domain expertise”, you are unlikely to really understand what works and what does not in that business. I don’t know whether the founders of Vinetrade had any domain expertise, but judging by the tone of the post I am guessing not.

Now, in one school of startup thought, this is a feature, not a bug. A fresh perspective facilitates DISRUPTION, the holy grail of startup achievement. In this case, as is usual, it did not. That speaks to how tough pulling off disruption is more than anything. Industries are organized the way they are for a reason.

2. Assuming that middlemen are a sign of waste and inefficiency.

As a society we have an aversion to middlemen. See this podcast with Russ Roberts, from which I learned of an amazing article: “The Economic Organisation of a P.O.W. Camp” by R.A. Radford. Story goes like this:

There once was a P.O.W. camp where the prisoners got Red Cross packets full of various things: food, cigarettes and so on. Everybody has the same stuff but people have different tastes. Some people don’t smoke, some don’t eat beef, etc.

Enter the Itinerant Padre, who goes around and makes voluntary exchanges with people: carrots for molases, cigarettes for candy. At the end of the day he has two full packets plus a little more to himself. He wasn’t dishonest, he didn’t empty one of the tins. Could have extorted, but didn’t. Yet everyone was better off.

A middleman is someone who creates markets, a function we instinctively disdain. Middlemen happen to be really important in the wine industry, I think because it has many suppliers and many buyers. When a network is really complex you need a lot of humans to keep all of the relationships straight. Consolidation of middlemen can only follow and never lead consolidation of principals. 

Well, at least as long as #3 holds, which is:

3. Hoping we have the technology to replace human interaction.

We haven’t hit the singularity yet and there is no substitute for human interaction. Principals (buyers and/or sellers) resent anything other than the personal touch.  Eventually, firms will be able to spawn human minds inside machines, meaning a central technological force can manage relationships in an infinitely complex network.

But until the human mind is itself commoditized, there is no substitute for an attentive salesman.

Insurers (finally) Starting to Ape Buffett

David Merkel reviews Buffett’s 10k:

Buffett does very well, but I know of no other insurer that invests so much in equities funded by insurance liabilities.  There is a real risk that if the markets fall hard, a la 1929-32, 1973-4, 2007-8. that BRK would be hard-pressed, particularly if there were some significant disaster like Katrina or Sandy, or set of disasters like 2004 or 2011.

He’s right that this philosophy adds risk to the business model. But riding equities isn’t as lonely a strategy for Buffett as it once was.

Consider Greenlight Re, an offshore reinsurance company linked to a hedge fund. Their strategy departed from the typical offshore startup model: write long tail, low-volatility, high-float insurance business and pump the cash into the hedge fund.

Taking big investment risks isn’t new for insurers. It’s just that doing it on purpose is unorthodox. Many insurers quietly took on more asset risk in the mid-00s and got crushed in 08. So did Greenlight for that matter. The difference is that Greenlight, fully expecting such a scenario, kept a hand steady at the till and rode the market back up.

Others tucked their tail between their legs and liquidated, in many cases locking in the losses.

If everyone (regulator, rating agency, management, investors) is on board with the risk, aggressive asset investment coupled with stable, high-float liabilities can work. Put another way, linking a hedge fund to an insurance company means the insurer can get by at lower combined ratios and grow.

But don’t take my word for it, look to the market and see the latest wave of offshore startups copying Greenlight/BRK: Third Point Re, SAC Re. And we see this convergence coming from the other side as AWAC, an established (re)insurer, bought into a hedge fund.

The key is to think of these insurers as more akin to banks: low-risk liabilities, high-risk assets. One can be skeptical of whether they are doing a good job of balancing these risks but in principle there is no reason to assume they will fail.

Moral Hazard is Corporate Kryptonite

In *Thinking Fast and Slow*, Kahneman relates a story told to him by Richard Thaler. It goes like this:

Once there was a gathering of executives from a large company. Each were asked about taking risky projects with a positive risk-adjusted expected value. The middle managers, who would be taking those risks, took a pass: put my job on the line? No thanks.

The CEO, on the other hand, wanted them to go for it. Kahneman’s explanation, which I like, is that the CEO benefits from diversification while the middle managers do not. A losing bet could cost them their job, but if they all make the bet, the CEO will take credit for the (very likely) subsequent growth.

There are some assumptions built into this assessment, though. Here is another story, from Arnold Kling:

Although I took no formal survey, I got the impression that most of them [middle managers] would agree with the following statements:

  • Corporations should give middle managers more freedom to take risk.
  • Corporations should be more willing to make mistakes and accept failure.
  • Corporations should offer more rewards and incentives for innovation.

…Suppose we re-phrase [these points] in terms of economic risk and reward. We might express them as:

  • Corporations should enable middle managers to make larger bets with corporate resources than is the case currently.
  • The downside risk of these bets should be borne more by the corporation and less by the middle manager than is the case currently.
  • More of the upside of these bets should accrue to middle managers than is the case currently.

…Middle managers understandably do not want the same degree of personal downside risk as entrepreneurs. However, in the absence of personal downside risk, the middle manager’s incentives would be skewed toward taking unjustifiable risks. Bureaucratic controls and limits on upside incentives may be an appropriate adaptation for correcting this potential bias.

As happens all the time when evaluating risks, we think statistical when we should be thinking behavioral. The risk changes depending on who is facing it and with what incentives (ie how hard they will work).

The point, I suppose, is that risk, which is rather an abstract sort of thing, in most businesses it is really a measure of the degree to which someone will be up to the task and can be controlled by highly skilled and motivated players. Real motivation, though, only comes when your ass is on the line. This is unacceptable for most people. Excellence, this line of thought goes, is driven by incentives (risk), and so is rare.

Bureaucracy is the blunt instrument that protects an organization from its most potent threat: risk without accountability. Moral hazard.

The result, as Arnold says here, is mediocrity. The base case for all organizations.

An Important New Model For Stock Pricing

We’re geeking out today.

Assets are priced differently and we don’t know why. Treasuries have different return characteristics than stocks, for example, and these characteristics change over time, even if the risks do not. Economists have a fancy term for this (of course): the stochastic discount factor. But what is it? CAPM says it is β, the correlation to overall market return. There’s a theory out there that the key is the “covariance between the asset’s return and aggregate consumption”*, which is one that I hadn’t heard of before.

This article points us to this paper that offers a new explanation: the liquidity needs of broker dealers, the firms that actually conduct trades.

These firms need to hold capital because their core activity, market making, is risky. But they also lever up that capital, naturally, and sometimes by a lot. There’s a cycle to how much leverage they hold, in some years leverage is high and in others it’s low (see the first link above for a graph). This somewhat coincides with the business cycle, but not as much as you might think.

Assets that only make money in high leverage cycles are worth less to broker dealers than assets less sensitive to leverage availability. When a leverage crunch comes along, survival depends on being able to liquidate at book value. So, for example, dealers have more demand for treasuries than B grade debt or equities, for example.

This demand from broker dealers means that assets that they want are going to have a lower return: dealer demand dominates the market. Assets they don’t want need a higher return to compensate for the lower demand. The relative return of these assets are going to vary with the leverage cycle. When leverage is abundant their prices soar. When leverage is scarce, they collapse.

It’s a pretty simple explanation and quite a good one, I think. What interesting about it is that it isn’t clear to me that there is any identifiable process that drives the leverage cycle, so forward information about sudden contractions and expansions of leverage can’t be easily priced into these assets. In other words, if we can’t predict when the leverage cycle reverses this insight won’t get priced in.

So if you could predict when the leverage cycle is going to switch, you could make a LOT of money.

*I might be missing something, but from a data standpoint, this idea strikes me as… inadequate. Under the expenditure approach of GDP calculation aggregate consumption is calculated by household survey and extrapolated to the economy as a whole. It’s hardly what I’d call hard data. And that’s for countries that have reliable household surveys.

Incompetent S&P’s Day of Reckoning?

Felix Salmon has an excellent piece on how S&P royally effed over some municipalities in Australia and now might actually have to pay for its incompetence.

Put it all together, and you get a very shocking view of S&P. Here’s the list:

  • S&P used the wrong model input for starting spread.
  • S&P used the wrong model input for volatilty.
  • S&P used the wrong model input for average spread.
  • S&P completely ignored ratings migration.

If S&P had just got any one of these things right, the CPDO would never have gotten that triple-A rating. If it had got them all right, the CPDO would almost certainly not even have been investment grade, let alone triple-A.
S&P was not doing its job, and as a result a bunch of Australian municipalities lost a great deal of money. Jagot has found S&P liable, as she should. Good for her.

I’ve written about rating agencies before: they run a government-granted oligopoly grading financial instruments.

The big news here is that the disclaimer that rating agencies use, “don’t blame us if it goes wrong!” has actually been thrown out.  Is this the beginning of the end?

The thicket of industry regulations (and practices) that depend on these ratings is deep. If change is to happen, it would start in some jurisdiction that’s willing to roll the dice. Australia’s regulator, APRA, is a fairly progressive institution so perhaps we’ll see a competing model emerge.

Technology Giveth And Taketh Away

Independent Insurance agents are again on the rise. See below for a quote.

The story goes that technology forced consolidations in the 90s. Brokers needed scale and capital for SYSTEMS and batteries of tech priests to keep server rooms humming.

Today Automation is shaving all that infrastructure down to a rump. For many, an iPad takes care of 95% of what they need to do at work. The rest are either analysts, for whom a golden age of data has dawned, or middle-skilled system jockeys. The latter always glancing over their shoulders at aforementioned, all-consuming Automation.

Schumpeter, the job eating furnace: “Chomp, Chomp, Chomp, Chomp, Chomp, Chomp”

Key findings of the study, which is is sponsored by Future One, a collaboration of the Independent Insurance Agents & Brokers of America (the Big “I”) and independent agency companies, include:

  • The number of independent agencies has grown. After declining from 44,000 in 1996 to 37,500 in 2006, the number of independent agencies has grown to 38,500 in the past two years.
  • Business conditions for independent agencies improved between the 2010 and 2012 studies. In 2012, 60 percent reported increased revenue, compared to 42 percent in the 2010 study.
  •  Systems and data security are now the most important technology challenges facing agencies.
  • Agencies are beginning to use the Internet more to obtain new customers. About 25 percent use Facebook to keep in touch with prospects, and 20 percent use LinkedIn.

Hat tip

Money Be Tight (for econ-geeks)

Romney has (had?) a chance against Obama and the chart below tells you why. No seriously, it does, and I’ll (try to) explain it.

This podcast explains the chart pretty well. Look at the blue line. That is a measure of the change in money (M3) in the economy. Notice that it falls spectacularly starting in 08. That’s  a contraction in the money supply, which causes recessions, basically. Some argue about the importance of M3, but I’m now becoming convinced it matters. How did that happen? And whose fault is it?

Well, it’s the banks doing it. It’s the banks, banks, banks. They hold 85% of the money in the economy (the rest is government money) and so they dictate monetary policy. QE?Drop in the ocean.

So… why? Why are banks working against us (and themselves)?

First policy error: the Basel 3 regulations forced banks to hold more capital, which they don’t have. More capital, you’ll note, is normally a good thing.

Sure, in the long run, but how is a bank in 2009 supposed to operate (lend money, not run tight money) if they need to hold twice as much capital per loan as before? And after a big massive mistake (housing bubble/crisis) that has left them with less (negative?) capital than before? Really don’t want to go to equity markets because they’re paying sub-book and you’re worried about signalling weakness.

How about operations? Can the banks earn their way back out of zombiehood without taking risk?

With the fed’s interest on reserves program they can. Banks take checking deposits (free money, protected by FDIC) and park it at the fed and earn .25% per year on it. Buy longer Treasuries and you juice that more without a penny of allocated capital. Bang, let’s lend to the government then.

This isn’t strictly Obama’s fault but he could have nominating fed board members (to empty seats) and given Bernanke some loose money allies.

In the last two administrations there have been two failed “dream teams” of economic policymakers. First was Bernanke at the Fed and Hank Paulson at Treasury. They managed to not notice that money was incredibly tight and bail out their buddies at the big banks. That latter point still steams me up.

Next came the economic dream team of Obama. These folks also missed the tight money signs went all-in for fiscal stimulus.

We are left with crappy employment, slow growth and, incredibly, a continuing tight money policy.

It’s slowly getting better but it isn’t easy to tell when banks are going to be feeling bullish enough to actually operate again.We could well have years of stagnation ahead of us, folks. YEARS.

My Sandy Timeline

Mid-April: I move to Hoboken, NJ with my 6-month pregnant wife and Bree and Max, my two 10-pound dogs.

Some time in May: a relatively minor storm floods our parking garage and the nearby street. WTF? Lesson: Hoboken is really bad for flooding and we live in one of the worst parts.

End of July: I sign up for an actuarial exam for the end of October AND my son is born.

October 20: “A strong ridge of high pressure parked itself over Greenland beginning on October 20, creating a “blocking ridge” that prevented the normal west-to-east flow of winds over Eastern North America. Think of the blocking ridge like a big truck parked over Greenland. Storms approaching from the west or from the south were blocked from heading to the northeast.”

Some additional background from the same link:

We expect hurricanes to move from east to west in the tropics, where the prevailing trade winds blow that direction. But the prevailing wind direction reverses at mid-latitudes, flowing predominately west-to-east, due to the spin of the Earth. Hurricanes that penetrate to about Florida’s latitude usually get caught up in these westerly winds, and are whisked northeastwards, out to sea.

Bottom line: normal no longer applies.

October 22th: Tropical Depression 18 forms.

October 24th: Now Hurricane Sandy, the storm hits Cuba hard. The possibility of a US landfall dawns on the NHC for the first time.

October 27th (Saturday): I get a mass email from my building manager saying that the area flooded even during the over-hyped Irene last year and big floods trigger the fire alarm. I reply: as in the building-wide fire alarm? Yep, he fires back, and we can’t turn it off and it’s LOUD.

Well that sews this one up, but where do we go? Here’s our criteria:

  1. Town that has a hotel that wasn’t full
  2. Oh, yeah, and isn’t on a river
  3. That hotel needs to take dogs
  4. Is near a place where I can take my exam (still studying through all this!).

I pull up the intertubes and hit the phones. The answer? Three-hour away Albany.

October 28th (Sunday): no point studying, got to pack up an infant and dogs and supplies and whatnot and hit the road. That takes most of a day. The hotel is great and guest cancellations are rolling in. Papa John’s pizza and a practice exam for me.

October 29th (Monday): Holy Cow this is for real. Glued to CNN. Albany? A brisk wind is the worst we saw. Incredible luck.

October 30th (Tuesday): Hoboken is underwater. Everything is underwater. Uh, oh, when are we going to be able to get back?

October 31st (Wednesday): I write my exam in the morning. I’m the only one sitting it since the CAS let affected folks put it off. Not for me, let’s do this. That’s four hours.

Back at the hotel it’s becoming clear, as I scarf down yet more takeout, that we’re not going home. Looks like it’s back to Canada to my in-laws’. But first someone’s got to go back to Hoboken to get our travel documents. Saddle up!

Driving down the roads I see that about one in ten gas stations in Northern New Jersey is open and each has a gigantic queue of cars at it.

You know what that means: rationing by time instead of price. Far more importantly, however, it means that overall supply is lower. Here’s Yglesias who has been covering this very well:

Chris Christie, also put out a weekend press release warning that “price gouging during a state of emergency is illegal” and that complaints would be investigated by the attorney general. Specifically, Garden State merchants are barred from raising prices more than 10 percent over their normal level during emergency conditions (New York’s anti-gouging law sets a less precise definition, barring “unconscionably extreme” increases).

The bipartisan indignation is heartening, but there’s one problem. These laws are hideously misguided. Stopping price hikes during disasters may sound like a way to help people, but all it does is exacerbate shortages and complicate preparedness

And more:

But when it comes to things like gasoline and bottled water, neither the short-term nor the long-term supplies are genuinely fixed. Transportation routes into the area have been severely disrupted and many gas stations’ supplies are hard to access due to power outages, but it’s not impossible to transport this fuel from where it is into people’s cars and generators. It’s just much more annoying and difficult than usual. But the possibility of windfall profits is exactly the lure we need to get people to start making extraordinary efforts to get more fuel to the people who need it. There are things people will do to sell gasoline for $10 a gallon that they won’t do to sell gasoline for $3.40 a gallon (note that in Norway this is what gas costs all the time) and that’s what we need.

Power lines were down everywhere and electrical crews were working away. Roads were closed, though, and it took forever to get back to Hoboken. Eventually I had to park about a mile away and, now under the cover of darkness, run into town with my rubber boots, flashlight and backpack.

Very post-apocalyptic.

The phone networks were overloaded so there were definitely people around. You could see refugees sitting in cars charging their devices before going back up to, I dunno, play angry birds by candlelight, I suppose. The gold standard of disaster certifications is of course an on-location broadcast by Anderson Cooper, which happened while I was there! I didn’t see AC360 himself, though.

Anyway, got my stuff and booted it back to the car. Back to Albany by 11pm. Phew. what a day.

November 1st: quick check of the newswires. Still flooded. Ok, back in the car for 8 hours to Canada!

Post Scripts:

The insurance loss is getting picked at 10-20bn, which should put this after Katrina and Andrew as the third most costly hurricane in US history. That’s probably about right. There’s also a debate about whether hurricane deductibles (higher than normal storm deductibles) are going to apply to this “Post-Tropical Cyclone”. See here for example.

There is also a debate about the role of FEMA in these kinds of disasters. Here is an interesting point (via MR):

We’ve nationalized so many of the events over the last few decades that the federal government is involved in virtually every disaster that happens. And that’s not the way it’s supposed to be. It stresses FEMA unnecessarily. And it allows states to shift costs from themselves to other states, while defunding their own emergency management because Uncle Sam is going to pay. That’s not good for anyone.

When FEMA’s operational tempo is 100-plus disasters a year, it’s always having to do stuff. There’s not enough time to truly prepare for a catastrophic event. Time is a finite quantity. And when you’re spending time and money on 100-plus declarations, or over 200 last year, that taxes the system. It takes away time you could be spending getting ready for the big stuff.

…I think another issue is some people see the failed response to Hurricane Andrew as the reason George H.W. Bush lost Florida to Clinton. So now, you have presidents who are very concerned about the potential impact, from an election standpoint, of disasters. That created an incentive to nationalize things.

Finally, here’s a statistical wrap-up (great image at the link):

Death toll: 160 (88 in the U.S., 54 in Haiti, 11 in Cuba)

Damage estimates: $10 – $55 billion

Power outages: 8.5 million U.S. customers, 2nd most for a natural disaster behind the 1993 blizzard (10 million)

Maximum U.S. sustained winds: 69 mph at Westerly, RI

Peak U.S. wind gusts: 90 mph at Islip, NY and Tompkinsville, NJ

Maximum U.S. storm surge: 9.45′, Bergen Point, NJ 9:24 pm EDT October 29, 2012

Maximum U.S. Storm Tide: 14.60′, Bergen Point, NJ, 9:24 pm EDT October 29, 2012

Maximum wave height: 33.1′ at the buoy east of Cape Hatteras, NC (2nd highest: 32.5′ at the Entrance to New York Harbor)

Maximum U.S. rainfall: 12.55″, Easton, MD

Maximum snowfall: 36″, Richwood, WV

Minimum pressure: 945.5 mb, Atlantic City, NJ at 7:24 pm EST, October 29, 2012. This is the lowest pressure measured in the U.S., at any location north of Cape Hatteras, NC (previous record: 946 mb in the 1938 hurricane on Long Island, NY)

Destructive potential of storm surge: 5.8 on a scale of 0 to 6, highest of any hurricane observed since 1969. Previous record: 5.6 on a scale of 0 to 6, set during Hurricane Isabel of 2003.

Diameter of tropical storm-force winds at landfall: 945 miles

Diameter of ocean with 12′ seas at landfall: 1500 miles

This Year’s Economics Nobel

Explained by MR:

In honor of the Nobel prizes to Al Roth and Lloyd Shapley, here is a primer on matching theory. Matching is a fundamental property of many markets and social institutions. Jobs are matched to workers, husbands to wives, doctors to hospitals, kidneys to patients.

The field of matching may be said to start with the Gale-Shapley deferred choice algorithm. Here is how it works, applied to men and women and marriage (n.b. the algorithm can also work for gay marriage but it’s a little easier to explain and implement with men and women). Each man proposes to his first ranked choice. Each woman rejects any unacceptable proposals but defers accepting her highest-ranked remaining suitor. Each rejected man proposes to his second ranked choice. Each woman now rejects again any unacceptable proposals, which may include previous suitors who have now become unacceptable. The process repeats until no further proposals are made; each woman then accepts her most preferred suitor and the matches are made.

and more

And here is a good quote:

Roth has applied heavy-duty theory to the very practical problems of matching doctors to residency programs, children to schools, economists to departments and kidneys to patients in a way that is stable, incentive-compatible, and maximizes the gains from exchange.  In my view, Roth is the most influential economist working today. Influential among other economists?  Yes.  But what I really mean is influential in the world.