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Posts Tagged ‘risk adjusted returns’

Risk Adjusted GDP growth and taxing the rich

May 13, 2011 6 comments

Matt Y tackles a tough problem. Many economists believe that lower taxes on the rich increase economic growth by a few tenths of a percent.  We do not have much solid empirical evidence for this, but they still believe it.  So of course, these people agitate for lower taxes on the rich – its a no brainer because it makes everyone better off.

But the most cursory investigation makes it obvious they care far more about low taxes than economic growth.

First, Nearly all the benefit from this .2% comes after the current generation is dead.  The extra benefit is barely visible after 40 years.

Economic Growth after 40 years

3.5%   296%

3.7%  328%

The overall economy is 30% better off after 40 years. Thats great, but not exactly earthshaking extra growth.

Next, This is the total economic growth. It doesn’t account for distributional effects.  If the entire economy is 328% better off, but the middle class is only 200% better off, the deal is much better for the middle class to go with taxing the rich.

Over the last 40 years, the middle class is closer to 0% better off than 200% better off. No wonder why the middle class wants to tax the rich more.  They don’t get any growth otherwise.

Then, This thinking doesn’t account for increased economic volatility that results from wealth concentration.  I pound the table about this – we need to think about risk adjusted returns when looking at economic growth.

Downside volatility is horrible for long term growth, because digging out of the hole takes a long time.  Some people are waking up to the idea, but we need more focus on the risk and not just the return when thinking about long term GDP growth.

From the Comments: Why So bearish on Housing, TC?

January 12, 2011 3 comments

TC is Bearish the Housing Market

In the comments on my Strategic Analysis Page, someone asked why I was so bearish on Housing.

I have a list of reasons:

1. Dr. Housing bubbles rental posts: Seems like much of California is still 100% overpriced compared to rentals.  Many parts of California still have significant drops coming.
2. Long term Housing prices from Robert Schiller shows that the depression shaved 50% off home prices. A similar bust today would take us down 20% more.
3. Foreclosed properties are trading at a 25% discount right now.
4. We have a huge shadow inventory of homes sitting out there, either not foreclosed or foreclosed and not on the market.
5. We’re looking at 9% unemployment for the next 3 years, even with a moderate recovery.  This is an extra 5% of people who wont even consider purchasing a house.
6. 22-25% of the housing market is  “underwater”, so I expect strategic defaults to increase starting Q3 2011. I’ve had 2 people ask me for advice about how to “give the house back to the bank” in the last 3 months, planning for next year. Mike Konzal is right to point out this hasn’t happened yet, and that you paid more money for the right to do this.  He is wrong to think that because it hasn’t happened, so it won’t happen.  This is a meme that is slowly finding its way into the popular consciousness.*

7. Standard market price overshooting during bad and good times
8. Securitization process broken, so home loans are more difficult to get today
9. Expectations that prices will be lower delays purchases.

All of this adds up to a 20% drop easily, with significant risk of further downside to a 30% drop. I do not have a formal data model to support this contention.  Housing prices seemed to jump after the War to a new level. Is this the correct level, or is the pre-war level more appropriate?

*About the Mike Konzal post, I found this section very interesting.  (P.S. That guy is on fire – he just keeps writing excellent posts.)

“You can see this in the testimony of David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at a House committee:  ”In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.”  So what you see is a lot of people, over half, who have stopped paying their first mortgage trying to make some sort of payment.   If people were economically informed, financially literate and strategic they’d not pay the second (especially if they can’t pay the first).   But they want to be paying something.”

Mike takes this as good news – that we have people paying their second when they should be paying their first, and are financially illiterate.  And it is in a way.

But I take this same information very differently.  These people who are paying their first and not the second are strategically defaulting.  They know that every ding on their credit makes a difference.  If I am not mistaken, the second mortgage is a recourse loan – and banks are likely to go after them for a judgement or check garnishment if they do not pay.  This can happen extremely rapidly.

These homeowners would have to go into bankruptcy to write it down the second.  However, if the house is repossessed, the second may get wiped out in the process.  It is worth speculating on this in todays market.

[Updated by adding Link.  I am still getting the hang of this!]

Tyler Cowen: Weak Opinions, Strongly Held, and blind in real-time

December 16, 2010 2 comments

I hate to write this about Tyler Cowen.  He seems like a nice guy, and he is certainly very smart.  But this article about inequality is a train wreck, and his real time record is nearly propagandistic.  Cowen is part of the problem, like Hoenig is part of the problem.  (Kudos to Matt to calling Hoening out – he has been wrong for 20 years)

He just wrote an article that has the blogging world aflutter, talking about the “inequality that matters”:  Wall Street captured the political process, and does not fail when it loses all of its money.  Wall Street rips off its customers.  Wall Street plays short volatility. Wall Street deliberately exposes itselt to systemic risk.  This is not news to anyone in 2010.

In real time, Cowen was MIA.  This would have been a prescient article to write in 2003 or 2004.  Or a strong article in 2005, 2006, 2007, or even 2008.   But in December 2010, please.  Don’t bother searching through his blog archives from those years.  You’ll find interesting articles about food, but not much real time information on the greatest wealth transfer in human history.

And the remedy?  “Throw up your hands, we are powerless against this system – we just have to pay the price, and let these rich financial institutions destroy our economy, over and over again.”  I will call this Bullshit now, and get to the reasons why later.

Please, please remember: Nearly everything that went wrong in the most recent crisis happened in financial products specifically created to avoid the laws passed after the first Great Depression.  The entire shadow banking system grew up to evade these laws – that is the reason it is called the shadow banking system.

But lest we get lost, let’s examine the two different ideas, one, that Cowen was MIA when it counted, and two, he is totally wrong about the remedy.

Cowen: The real time record sucks

Look closely at his Slate review of Taleb’s Black Swan.  Yes, The Black Swan is a flawed book – the author is full of himself, it dismisses all risk management as always useless, it claims that the Black Swan idea is nearly all Taleb’s.

But it is also a book that:

  • devotes a significant number of pages to discussing how the banking system fails over and over again and gets bailed out by the government;
  • shows how banking is designed to systemically fail;
  • talks extensively about how short volatility strategies blow up financial institutions and enrich bankers – and the clean up is paid for by governments and ultimately taxpayers.

In addition, The Black Swan makes a startling claim about banks – that banks are not net profitable over our entire history of banking, but rather survive only because of repeated government bailouts.

Cowen does not mention these issues in his review. Cowen does mention finance. Choice quote from the June 2007 Slate review:

“Oddly, Taleb’s argument is weakest in the area he knows best, namely finance. Only on Wall Street do people seem to give proper credence—not too much, not too little—to very unlikely events.”

Just fifteen months later, the U.S. is handing $200bn to AIG.  Treasury Secretary Hank Paulson issues a one page note asking for $1,000,000,000,000 to bailout Wall Street Banks, because they are all broke.  “Proper Credence”, indeed.

Wall Street  – and any bank  – has a massive incentive to underprice the risks it faces.  It can make more money when it does.  This is why we passed the Securities Act of 1933, Glass-Steagall, and the Securities Exchange Act of 1934 – to prevent banks from underpricing risk and misleading their customers about that underpriced risk.  Much of Minsky’s work is devoted to this idea: Banks face perverse incentives to pile on risk in good times, even if they know bad times – where they will not be able to suppor that risk – are just around the corner.

These ideas are well known, and were well known in June 2007.

On inequality, look through his blog archives.  See if you can figure out what his opinion is on inequality.  He doesn’t even think it really exists, but I could be wrong.

Short Volatility Strategies?  Not mentioned as far as I can remember.

How about banking bailouts as a long term fact of the world financial system?  Not mentioned on his blog, prior to 2009.

Overall – where was he in real time on what he seems to think are the most important issues facing us today.  Nowhere to be found.  In fact, he spent much of his time shilling for EMH, or maybe not – I cannot always figure out what side of an issue he is on.  He has weak opinions, strongly held – the very reason why Harry S. Truman asked for a one-handed economist.

Despair, for Cowen does not understand risk adjusted returns

Currently, we run our economic system as though the natural path is the optimum path.  But what does optimum mean?  Does it mean highest returns?

Any trader worth their salt knows about risk adjusted returns. What are the risk adjusted returns of our current approach to banking?  We do not seem to get much better returns, and the risks seem very, very high right now.

I think much of the despair of the article comes from this one line:

For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism.

He forgets that we had an excellent solution after the first great depression – make broad based rules that limit banks to specific functions.  In this specific area of human existence, follow “rule of law” based regulations: everything not specifically allowed by the rules is banned.

We use this method with other extremely dangerous substances, like plutonium. We have laws like “reckless driving”, which essentially ban everything not specifically allowed by the rules.

Why not with something that has proven itself to be dangerous over and over again – unregulated banking?  Remember the S&L crisis? That was “only” $200bn or so. Is it possible that some people looked to the S&L crisis as a trial run?

I find it odd that humans can: Put people on the moon; design, build, and program computers; improve traffic patterns; run profitable businesses; create and run the internet; raise ever more intelligent kids.  But for many economists, their most sacred principle is that even the smallest deviation from unfettered natural systems reduces economic performance.

The idea of maximizing economic performance instead of maximizing the risk adjusted returns of our economy is probably flawed.   Brad Delong points to an interesting chart that shows how much volatility we have taken out of our economy with active management.   But the long term growth rate has remained largely the same – we’ve just cut off the lower tail.

This is similar to the return curve that most Long Term Trend Followers have, and why they insist on using the Sortino Ratio, instead of the Sharpe Ratio. Downside return volatility is far more devastating than upside volatility, even though you need to monitor both.

It does not make coherent sense, on some basic level.  Either humans can figure stuff out to make it better, or they cannot.   There isn’t some vast, cosmic, “un-figure-out-able” off-limits sign on economic activity, just the ones we put their ourselves.  I am not claiming it is easy, only that the natural order isn’t likely to deliver what we want.

I find it even odder: We had a banking system that produced massive prosperity for most Americans, and then dismantled it.  We can change the risk of our banking system.

Hoeing And Cowen do not deserve any accolades

Matt wrote this incredible article about how Hoenig has been wrong for the last 20 years, and doesn’t deserve any praise at all.   Actually, it has been longer than that, but Matt is correct – Hoenig has been wrong for a vast majority of his career.

With Cowen, the problem is a bit more pernicious.  It isn’t that he has been wrong, but that you cannot tell.   What does Cowen strongly support?   I think he does not like government meddling – ok that might be one.  However, when I read his posts, I frequently cannot tell what his position might be on the topic.  He is the reason Harry S. asked for a one handed economist.

Even worse is that this guy missed the worst economic debacle of our lifetime in real time, and his solution  – well, he does not have a solution.   Where is his wisdom?  Where is his Strong Opinion, Weakly Held?  Is it “we are powerless against the banks?”

It seems like it comes down to support and enable the status quo.  He doesn’t see a way to change anything, because the markets have naturally evolved to put banks and financial companies at the top of the food chain.  By his philosophy, he does not want to meddle, so he cannot do anything about it.  Dude, it isn’t that we are powerless, it is that you tie your own hands behind your back.  We’ve changed the laws dramatically to favor capital and financial firms – just look at the tax code on how hedge fund managers are taxed.

I however, remain unfettered.


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