Thursday, September 16, 2010

What I Don't Get About the Opposition to Elizabeth Warren

Okay, so Obama just appointed Elizabeth Warren to set up the new Consumer Financial Protection Bureau, which makes her the interim head of the agency, or something ... it's all still kind of confusing. She really deserves to be named to the job outright. What's the hold up? King Richard III had a lame leg and didn't do this much foot-dragging.

Ah, she may not be confirmable by the Senate, says Chris Dodd, head of the Senate Banking Committee. Why not? This too is a bit hazy; Senators can be maddeningly elusive when they don't want to discuss something. But the case against Warren seems to boil down to:

1. Lack of experience/qualifications.

This line of argument quickly falls apart though. She hasn't been knitting doilies in Dubuque and teaching night classes in creative writing for the last decade. She is (1) a bankruptcy law professor at Harvard who has "written several books over the years focusing on how debt, predatory lending and bankruptcy affect average middle-class Americans" (Bloomberg News) (2) the head of the TARP oversight committee, who in that position became intimately familiar with the mechanics of the massive bailout of the financial sector and the shenanigans that led to the financial crisis (3) (and here's the kicker) the person who argued in a 2007 article for the creation of an agency just like the Consumer Financial Protection Bureau.

2. Lack of objectiveness/not friendly enough to banks

This seems to be the real line of argument. Just listen to Senator Shelby of Alabama, from the Bloomberg story quoted above:
Shelby said he “would like to see a more objective person in that job. Elizabeth Warren, obviously, is not an objective person when it comes to the consumer issues.”
So Warren is perceived as too aggressive an advocate for consumers. She's not "bank-friendly" enough. (The banking sector has vigorously lobbied against her.)

Now think hard about this second point. Because it's the main reason the Senate would shoot down her candidacy, it's the point the Republicans are preparing to rally around, it's what has Dodd quaking with fear apparently ... and it's COMPLETE BULLSHIT. I'll show you why:

Say we're going to create a Dog Protection Bureau. Because, it so happens, there's a class of people who aren't always nice to dogs. These are rich, powerful people. They can afford to hire high-priced lobbyists to represent their interests in Congress (unlike the dogs). Sometimes, they abuse dogs in some reprehensible fashion and get away with it.

Now I'm not saying all these people are always horribly bad to dogs. Some of them may just steal a few milk bones here and there, or maybe they're making dog toys out of substances that aren't carcinogenic exactly, but that still cause mouth sores and runny eyes and nuisance stuff.

So we need to appoint someone to head the Dog Protection Bureau. We find a person who's an excellent, unquestioned advocate for dogs, float her candidacy, and the U.S. Senate says, "Eh, I don't think she's confirmable. She's not objective enough. She's too pro-dog."

To which a sane, logical person might respond: So what the hell are you creating the Dog Protection Bureau for? To be an impartial judicial arbiter on all matters dog, trying to see both viewpoints: the need to protect dogs and the need to abuse them/kick them around a little, for whatever reason? And if so, why are you calling it the Dog Protection Bureau? Why not call it the Dog Issues Administrative Court or something?

But if you are trying to protect dogs, you should welcome a strong advocate for dogs.

And if you are trying to protect consumers, you should welcome a strong advocate for consumers.

What am I missing here? Senate Republicans and Democrats, can you fill me in?

Saturday, September 11, 2010

Is Diversification Really a Free Lunch?

Scooting around the Net today, I found myself checking out what Greg Mankiw has been up to (besides relentlessly plugging the half dozen textbooks he's written). I drop by his blog from time to time, even though he doesn't allow comments on his posts, which I find a bit strange. Dropping by feels like the equivalent of paying a visit to someone but only being allowed to peer in the house windows: You can watch what they're doing, and eavesdrop to your heart's content, but no talking please.

So I came across this New York Times column by the good Harvard professor, brimming with advice for the college bound. I nodded enthusiastically at his scold that high schools spend too much time on Euclidean geometry and trigonometry (when was the last time someone stopped you in the street and asked if you knew the cosine of the angle of the shadow being thrown by the lamp post on the corner?) and not enough on probability and statistics.

Amen, brother!

In fact, I found myself pretty much onboard with the whole piece -- until I reached this paragraph and started scratching my noggin a little:
The evidence of financial naïveté shows up every time some company goes belly up. Whether it is Enron or Lehman Brothers, many company employees are often caught with a large fraction of their wealth in a single stock. They fail to heed the most basic lesson of finance — that diversification provides a free lunch. It reduces risk without lowering expected return.
Okay, let's think about this. Note that, first of all, the good professor has provided a lopsided universe of examples. Yes, Enron and Lehman Brothers flamed out, spectacularly, and punched a saucer-plate sized hole through plenty of their employees' 401(k)'s. Very true. But how many Microsoft and Google millionaires have we also heard about, ordinary secretaries or maybe even guys who changed the water in the fish tank on weekends and scrubbed the toilets, who got a glory ride to early retirement on their company stock? Had they properly diversified, they might have made only enough to buy a used Vespa.

So am I anti-diversification? A heretic in the investing community? Diversification, after all, is one of the ten commandments of smart investing.

Nope. Not at all. I believe in a diversified portfolio (I personally own a mix of U.S. stocks, bonds, emerging market equities, Japanese shares -- ugh, cash-like instruments and cash itself).

The problem is, I think Mankiw's only half-right in his last two sentences.

I agree with: Diversification reduces risk without lowering (or increasing -- he neglects the corollary on the upside) expected return.

Simplification: You work at an S&P 500 company. Let's say the average yearly gain on the S&P is 8 percent. You invest in only your company's stock. For any given year, it may rise 8 percent -- or it may surge 22 percent, or conversely, fall 15 percent. Lesson: an individual stock can be quite volatile. But say you buy shares in 30 S&P companies instead. Some may go up, negating the declines of others, and at the end of the day, you'll probably have a smoother ride -- less volatility.

I strongly disagree with: Diversification provides a free lunch.

What you just witnessed in the example above isn't a free lunch. It's a smoother ride (to mix metaphors). To wit: there's a greater chance, in any year, your company's stock will soar 40 percent or plunge 40 percent than a basket of 30 stocks will do the same. By diversifying, you tamp down volatility. But for the basket, while the losses may be bounded at say 25 percent, the gains won't be as high either (let's say 25 percent to keep it simple).

So by diversifying, you lose your chance to become a Google millionaire, but you also won't have to eat cat food and sleep under the freeway overpass during your golden years.

Ah, but if only "diversification provides a free lunch" were only wrong ... no, it's worse than that. It's very dangerous, as the financial crisis attests to.

Consider that a collateralized debt obligation, or CDO, is the poster child of diversification. It's stuffed with mortgages from all across the country, and once you get into the strange beast known as the CDO squared, it's more bewilderingly complex (and more diversified). Investors obviously thought that, through diversification, they were getting a free lunch by buying up CDO tranches.

Why do I say that? Somehow they came to accept that a CDO could be worth more than the sum of its parts. They must have by definition, because the assembler of the CDO must be paid to put together and market the thing (and extract a profit). So if the mortgages contained within it collectively yield say 6.4 percent on average, the CDO genie will do his magic and transform them into tranches that collectively pay 6.1 percent on average (or whatever the typical spread is for these products).

So where did the 0.3 percent go, which was being paid for assuming a certain amount of extra risk? That's your diversification "free lunch" (arrived at by manipulating correlation numbers foolishly, as it turned out, through the Gaussian copula). Actually it gets even better: investors thought they were getting free dessert too! Because, remember, through the copula wizardy, the slices of the CDO earned high ratings while paying more than similar-rated debt! (A free eclair with that sandwich, sir?)

The "free lunch" was later revealed to be a "fraud lunch" when CDO prices cratered and the ratings turned out to be ridiculously inflated. However, here's what the illusion of the free lunch did: it spawned a long line of hungry investors, who couldn't get enough of these amazing CDOs, which created further demand for dicey mortgages, which got sausaged into more CDOs, until finally the whole sham famously exploded.

So beware of savants, even Harvard professors, touting "free lunches" in the investment world.

Wednesday, September 1, 2010

Dick Fuld: Crazy Like a Fox?

Dick Fuld appeared before the Financial Crisis Inquiry Commission today and, some would say, showed himself as completely untethered from reality. The former Lehman Brothers CEO wasn't about to mince words; at the outset of his prepared remarks he asserted:
Lehman’s demise was caused by uncontrollable market forces and the incorrect perception and accompanying rumors that Lehman did not have sufficient capital to support its investments.
"Say WHAT?" was more or less the reaction over at naked capitalism. For how could any man be in such denial?

For my part, I think Fuld may be playing a role on a stage. Consider that a large Wall Street investment bank doesn't just go gently into the night. Lehman wiped out a lot of wealth on its way down. And note that phrase that keeps recurring in Anton Valukas' very, very thorough report on Lehman's demise: "colorable" claims. In other words, plenty of hungry lawyers may have sufficient grounds to sue Fuld's butt ten ways to Tuesday.

Also lots of prosecutors would love to put him behind bars for a long while. Let's not forget that Sarbanes-Oxley requires that a CEO sign off on financial statements as true and accurate, and in doing so, takes responsibility for their content.

Now, if you're Fuld, and you're sweating and conniving a way out of this mess, you know you can't really plead insanity. As bizarre as some in the current crop of U.S. CEOs are, they hardly qualify as insane. Yet there is another option that looks a bit like insanity, a sort of blind and resentful denial of any responsibility. Don't even try to be reasonable.

So if we could rig Fuld up to a lie detector, it would be interesting to find out if he really believes what he's saying right now -- if his public face concords with his private thoughts.

In other words, is Dick Fuld crazy? Or just crazy like a fox?