Review of Review of 21 Books on the Financial Crisis

Posted on by David Wright

I had a 7 hour drive today back to the city so I was ready for the podcast firehose. I read about this paper this morning and experimented with some text-to-speech software and managed to listen to the whole paper in the car. Fun!

Anyway, I was hoping for more of an upshot than this:

There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Did CEOs take too much risk, or were they acting as they were incentivized to act? Was there too much leverage in the system? Did regulators do their jobs or was forbearance a significant factor? Was the Fed’s low interest-rate policy responsible for the housing bubble, or did other factors cause housing prices to skyrocket? Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks?

Apparently we still don’t know what the problem was, though leverage, regulatory capture/incompetence and ‘global imbalances’ show up a lot. Screaming for some mention is my favorite explanation, which is a Cowen-Sumner synthesis: we weren’t as rich as we thought we were and that realization was more painful than it should have been because the fed screwed up and continues to screw up. The rest is a bunch of banks that should have gone bust.

Lo goes on to finish the paper with a discussion of how economics is basically an irretrievably inexact science (ie we may never Know The Answer) and then, oddly, goes on to do a bit of primary journalistic research, suggesting some rule change by the SEC didn’t actually open the gate for increased leverage in 2004, contrary to many claims.

The real take-away for me is that the best academic and journalist books, respectively, on the crisis are “This Time It’s Different” and “Too Big to Fail“. I’ve read the second and will some day read the first, I think.

I’ve had just about enough financial crisis porn for a little while, though.

Lessons in Pitching

Posted on by David Wright

How Fab.com got its backing:

From a fundraising standpoint, providing access to the RJ data basically said to the VC’s, “here we are, here’s the data, we’ve got nothing to hide, take a look and decide for yourself if you want to pursue investing in Fab.” Effectively, we turned the pitching on its head. Since the RJ data updates several times per day directly from our database, it was many times more powerful than providing powerpoints and excel spreadsheets. This was the real stuff, auto-updating! And, since RJ enables all the data to be downloaded into excel, the analysts at the VC firms were able to do all of their own analysis on the front end of the investment process.

Now I’ll break away from this to describe what I do for a living: I raise capital for insurance companies.

Insurance companies typically aren’t financially strong enough to absorb the risks associated with the policies they write. Every year, then, they renew reinsurance arrangements with third party companies that give them a boost. This process has all kinds of effects:

  • In a fantastically capital-intensive business, scaling up becomes relatively trivial, if you can demonstrate that you’ll make money doing it.
  • The plain fact that reinsurers ‘give the pen’ to companies that can bind them to financial obligations without itemized signoff means the scrutiny during the renewal process is often intense. This acts as a powerful mechanism for dispensing best practices throughout the industry
  • Bringing several capital backers up to speed on what you’re doing consumes valuable management time. Every year.

This last point is where brokers come in: we’re middlemen that facilitate this process by being a negotiation agent, knowing the market and performing some common data-crunching and cleaning tasks.

Each of these tasks are things that could be done without us. We’re middlemen, after all, as derided a professional class as there has ever been. But in every deal we minimize a big risk of failure.

Negotiation is tough and can break down easily and data cleaning is a pain; most importantly, though, even a small market like mine changes ALL the time and by acting as a clearinghouse for relationships, we facilitate a more competitive reinsurance market (ie maximize terms for our clients in a macro-sense, as well as by being individually awesome).

So let’s go back to Fab.com. They sent out the data and had a quick negotiation in which, they claim, price wasn’t much discussed. Wow, wouldn’t you want to be Andreessen Horowitz in this case? Name your price!

Maybe Fab.com have such a powerful business model that they only need to show some trend numbers and have a quick chat and wrap up 50 million bucks. But as much as it warms an engineer’s cockles to hear a story where a great data system wins the day, all of my instincts tell me that these guys got screwed.

If a deal goes down with so little pain somebody left money on the table.
——
Update:

I just read this by Mark Suster which gives me a clue for why there might be a bigger pie at stake than I thought:

And anybody who follows this blog knows that I believe television disruption has already begun and it is more likely to resemble Internet content than streaming long-form content to our living rooms.

As I talked about this model with several friends in Silicon Valley I always heard the same refrain, “we don’t invest in content business – they are ‘hits driven’.”

I had to laugh a bit at at the irony of this. For one, the consumer-driven startup world has become immensely hits driven. You need star power of entrepreneurs surrounded by star power angels & VCs who in turn get tons of press from adoring journalists who are insiders amongst this crowd of tech cognoscenti.

Publicity! Big-time VCs are tech celebrities, of course, and affiliation with them can legitimize you in some important circles like with early adopters, journalists and investment bankers who will one day give you your big money exit.

Still, I need to swap my “let’s build a business!” hat for my cynic hat to have this make sense.

Then again, maybe legit publicity is actually so value-creating that it’s worth 10-30% of the upside.

Everything You Need to Know About Fiscal Policy

Posted on by David Wright

1. Its benefits are probably ambiguous. For every paper that says it’s good, there are some that say it is not.

2. The most powerful argument against fiscal policy has nothing to do with whether it works or not, actually. And Krugman knows it:

there is now overwhelming evidence that fiscal policy does in fact work when it’s not offset by monetary policy

Scott Sumner would say that Japan is all the evidence you need to know that the monetary authority will work to neutralize fiscal stimulus no matter what happens. It’s because ALL stimulus also raises inflation.

If people are freaked out by inflation via central bank monetary policy, they’re freaked out even more when it comes via big government. And the central bank is not interested in freaking anyone out.

Review of David Merkel’s Analysis of ROE During the GFC

Posted on by David Wright

Link here.

Abstract:

From 2005-2010, the change in public company returns on book equity [ROE] was wrenching during the financial crisis. The results were uneven by sectors, and even by geography, for stocks traded in US equity markets. This paper looks at the differences, and attempts to explain why there was so much variation by sector and geography. After that, the paper attempts to explain the correlation between changes in ROE and stock returns, by year, sector, and geography.

In a world in which I didn’t have only 20 minutes to read, analyze and write about this paper, I’d like to think through his model choices. I would feel much more comfortable on this point if he accepted the Russ Roberts Science challenge and have a section discussing the process by which he arrived at the process by which he arrived at his conclusions.

Aaaanyway, the paper is interesting in that it identifies some interesting countries (Mexico? Israel?) that had companies that did very well during the crisis. Another interesting thing is that he decomposes the performance of individual US States but immediately discounts the conclusion by saying that the location of these corporates are due to historical accident:

To some degree, historical accidents help explain why some states have high contributions to returns on equity, and others low contributions. Washington State has Microsoft, Amazon, and Costco, all of which started out there. Michigan has General Motors, Ford, and Chrysler; the automobile industry has long been a big part of the state economy.

The contribution to ROE of Arkansas can be entirely attributed to Wal-Mart. Washington, DC can largely be attributed to Danaher, though Fannie Mae pulled the contribution to ROE down considerably as it failed in 2008.

The results of Kansas are dominated by Sprint Nextel, which has been a weak competitor in wireless telephony, though YRC Worldwide also had some impact on the low contribution to ROE as it was too acquisitive heading into a major recession. Virginia has many strong companies, but Freddie Mac pulled the contribution to ROE down with it failure in 2008.

Companies don’t move often, so attributing the differing contributions to ROE to state policies is unlikely. In the extreme cases listed above, all of the companies listed had been headquartered in their respective states for a long time, and most had been started there

I’d have two comments:

1. What’s the point of decomposing them, then?

2. Can’t you just attribute ALL variance of corporates to ‘historical accident’? Can there be no policy implications?

On point #2, I’d defend Merkel by saying that policy implications need a big enough sample that you can reasonably hold other factors constant. You’d need a dataset of every industry in every state over every conceivable macro-economic environment, then control for those other factors. Same applies for analyzing different countries.

But, you might say, every industry isn’t in every state! Yep, that’s why this kind of analysis is probably better classified as ‘interesting’ than ‘science’.

He probably should have left the geographical component out if he (rightly) concluded that there aren’t any policy implications. Or at least chose a different basis than political geography: how about companies on coasts vs inland? High vs low altitudes? Near vs far geographically from ‘bad’ industries (like financial services)?

Anyway, none of the criticism is a knock on Merkel who is a first class analyst with a first class blog.

The Leap of Faith

Posted on by David Wright

Economics has this problem with a few of its most powerful ideas: they just SEEM wrong. The toughest of these is the idea of comparative advantage. But another is the idea that destroying jobs is good.

Here’s Alex Tabarrok about how India has too many jobs:

What India needs is fewer jobs; fewer jobs in retail, fewer jobs in apparel and, most of all, fewer jobs in farming. India cannot become even a middle income country if most of its workers, for example, are farmers. To improve its standard of living, India must use fewer people to produce more agricultural output.

The politics of growth are difficult because those who lose from change are always present and are often more numerous and perhaps even more deserving than the present winners, the capitalists, the business people, the international mega corps; but today’s losses and gains are fleeting, the permanent winners are the workers and consumers of the future who will know only the benefits of productivity.

There’s another group of people whose losses strongly influence public policy. Always remember Mancur Olsen’s idea: diffuse gains are at a substantial disadvantage when they come at the cost of creating a focused, specific group of losers. The losers will always be more motivated, vocal and effective because they have so much to lose.

Democratic systems are terrible at creating losers.

Expertise vs Scale

Posted on by David Wright

A little background:

I’ve dabbled a bit in web development and making your page doing look the same in different browsers is a pain. Most browsers, luckily, tend to ‘behave’ in similar ways when given instructions and even the differences eventually get ironed out in later versions.

But until they do, you’ve got to detect which browser your user has and call one of a few parallel (ie duplicated through hours of extra effort) implementations of your web page depending on the answer.

When you have not just a few different browsers, but also many many old versions of browsers out there, making a web page that substantially all web citizens can see and use is a time-consuming challenge.

Anyway, the worst offender in this respect is Internet Explorer 6. It’s notorious for interpreting instructions in a radically different way from other browsers and also for being incredibly long-lived.

So this announcement from Microsoft, that they’re auto-updating their browsers, is welcome. But what’s interested me is that this probably won’t solve the problem. To HN:

The article points out that MS will still provide blocking tools for companies. Corporations are the major source of IE6 browsers and I’m not sure this will have any impact on them. The best we can hope for is that high consumer adoption rates will force many more sites to drop IE6 support which might spur companies to finally test and upgrade.

One of the things that really blew my mind this year was a large ($40MM) software development project I became familiar with (a worldwide internal system for a multinational corporation) that concluded — in 2011 — and required MSIE 6. MSIE 6! Doesn’t even run on MSIE 7, much less any modern browser.
While I personally think that’s insane — if you are that specific (not to mention antiquated) with your browser requirements, why don’t you just code a native app? — I’ve also never developed software with a team larger than five, and certainly don’t know the nitty-gritty details about spreading the work over a dozen countries and hundreds of developers, the vast majority being low-cost Chinese and Indian coders. So I’m not judging (or at least I’m trying not to).
But my point is that Big Corporate just wants their freaky “web-based” apps to run predictably for the projected 6-year deployment timeframe and does not give one flying fuck about whether their staff can access the new hip and way-superior version of . Unless said had real business value to large enterprise, but then, if it did… it would probably support MSIE6.

I am persuaded by some of the recent arguments (John Siracusa’s maybe?) that both the innovation and the money in general-purpose computing industry have moved over to the consumer side of the equation, and that this change has put MS in a worse position than they’ve traditionally been in.

Very very interesting thread. The idea is appealing: that corporate customers who have built their own internal web-apps and aren’t interested in updating something that works just so their employees can use fancy new websites.

I don’t think that last point is on, though. I’ve tried to find the original material he’s mentioning but failed. I think that it is the case that consumer software are leaping ahead of corporate software, but I think it’s because of scale. Corporations build small-scale, customized solutions. These are going to always move slowly. It takes just as much effort to build something for 100m users (in the general Internets) as it does for 10,000 (in your little company).

The Culture of Hard Markets

Posted on by David Wright

In insurance, a hard market is when carriers can exert extraordinary pricing power. I spend an embarrassing amount of time discussing whether the market is hard or soft or hardening or softening and when the hardening or softening will change, etc.

It’s tiresome and really distracting, in my opinion. The business model that relies on timing the market is necessarily volatile and limited in scope, which are things that public equity markets (ie permanent capital bases) don’t like. They like consistency and reliability. A hard market strategy is anything but.

Anyway, I’ll stop my rant there and focus a bit on what hard markets do to the CULTURE of a business.

You see, if you can properly identify a hard market, you have properly identified a free lunch. In such a case, making lots of money is easy: you just have to show up with a minimum of skill. Put your kids in the chair, says my boss, and in a hard market you still get rich.

What would happen if a hard market was the norm? What would happen to an institution if the degree of difficulty for profit suddenly dropped? [edit: what I’m really asking is what happens when a hard market lasts a long time and then suddenly reverses. Like a bubble, you never know you’re in a hard market until you leave one]

Well, luckily we have a case study.

I’d say that this is what happened in the investment industry in the Great Moderation period, up until the wrenching (ongoing) financial crisis we’re living through right now.

We recently reviewed our pension scheme and we were astonished at the terrible menu of choices presented to us. In a book of 500 different mutual funds, there were very few index funds and even these only got as cheap as 0.72% of assets per year.

Expensive, but we’re a small company so our costs will be higher. Fine.

But how about the rest of the funds, with expense ratios of 1-3% per year? Maybe the managers can justify this when they’re beating the index funds reliably, but we know that’s simply not possible for the VAST MAJORITY of funds to do, right?  And run-of-the-mill mutual fund managers?

Puh-leeze. They’re 30th percentile at best.

Eventually, when the market turns, they get found out. As Tyler Cowen says, we aren’t as wealthy as we thought we were. Well, banks weren’t as smart as they thought they were. And that’s WITH bailouts protecting them from the realization of exactly how stupid their high leverage business models were.

When the music stops and you look back, here’s what I’d bet you realize was happening when you suffered the illusion of a prolonged hard market:

  • Lesser talent being paid like it’s higher talent
  • Aspects of Scott Adams’ confusopoly, where the money is so plentiful everybody starts taking little cuts from all over and it becomes really hard to compare options.
  • The market rewarding ex-ante status, power and wealth (ie status, status and status) as opposed to real value-creating activity.
  • Astonishingly stupid pseudo-science to explain what is going on

So if I may caricature: the median firm/employee becomes richer per point of IQ*, higher status (child of or former celebrity/ politician/professional athlete), employed in obfuscation rather than productive activity and unable to distinguish between luck and skill.

*I don’t like using IQ here because I tend to think its predictive power as an exogenous factor in success is vastly overstated. But it works as a placeholder for ‘units of ability’.

The Suckers At The Table

Posted on by David Wright

Credit rating agencies are always a popular topic when things are blowing up. Why didn’t they foresee this!? What are they good for?! Back in MY DAY, ‘AAA’ meant something!

In my mind, CRAs are little more than public declarations of opinion on assets. In that sense, they have a shared ancestry with sell-side analysts, more formal circulars like the Gartman letter and, yes, even run of the mill journalists.

But apes, chimps and folks like you and me all diverged and so did rating agencies. The interesting question is why and how, right?

I’ve found one good report and one bad report on their history. The key moment when the rating agencies came to be in the sense that Warren Buffett knows them (with an impenetrable competitive advantage) came in the 70s with the advent of the NRSRO.

But the real turning point came in the 30s. You see, in the 30s there was this Great Depression. And everyone figured that this should be the last such instance of massive bank failure, so the government did a whole bunch of stuff, even stuff FDR thought was stupid like, wait for it… deposit insurance:

It would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee. For a number of reasons of sound government finance, such plan would be quite dangerous.

Anyway, I say that for fun, but the backlash was coming.

The banks didn’t like the new capital rules and they eventually managed to wiggle themselves a bit of room. This came in the form of capital rules that looked more favorably on ‘safe’ assets (sound familiar?).

But who, pray tell, would deem the assets safe? Well, how about these folks that publish the public circulars rating bonds?

Bang.

Everyone liked the idea. Everyone, that is, except the (if I may take some political liberties) power-mad and incompetent SEC.

(from the Mercatus report above- that’s a right-wing organization by the way)

However, the SEC worried that references to “recognized rating manuals” were too vague and that a “bogus” rating firm might arise that would promise “AAA” ratings to those companies that would suitably reward it and “DDD” ratings to those that would not. If a broker-dealer claimed that those ratings were “recognized,” the SEC might have difficulties challenging this assertion.

To solve this problem, the SEC designated Moody’s, S&P, and Fitch as “Nationally Recognized Statistical Rating Organizations” (NRSROs). In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers’ capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.

So rating agencies are the creation of regulators and a result of the technocratic inclination to ever-finer engineering of rules and procedures and control. They are collections of 3rd quartile talent (guess who’s in the bottom quartile?) in an industry protected by the government.

Actually, most people that are in the bond business are protected by the government. Hell, anyone who depends on a massive slug of short-term financing to make money gets a free ride these days.

Rating agencies just don’t make as much hay.

Tiiiime to Pivot!

Posted on by David Wright

The ‘pivot’ is when a company with lots of human capital and a strong enough culture figures out if it’s done anything interesting yet. Mozilla needs to pivot. Here are some quotes:

From Marco:

Most Firefox users don’t know how the company pays its bills. The majority of its income — about $100 million annually — is from Google, who pays Mozilla for using Google by default in the stock homepage and built-in search box.

And this:

When the original three-year partnership deal was signed in 2008, Chrome was still on the drawing boards. Today, it is Google’s most prominent software product, and it is rapidly replacing Firefox as the alternative browser on every platform.

Uh oh. Would you subsidize your most important competitor?

I wouldn’t, which suggests that Mozilla needs to find some mojo pronto. I fled to Chrome for speed reasons 8 months ago and don’t expect to return.