Baseline Scenario

Apparantly a guest column today, but good.

The Baseline Scenario
One Last Thought on FDIC and Political Will
The Best of Behavioral Finance Anomalies
The Limits of Arbitrage
One Last Thought on FDIC and Political Will
Posted: 21 Aug 2009 10:23 AM PDT
So this is Mike Konczal signing off for the week – I’d like to thank James and Simon for giving me the opportunity to guest-blog here. And I’d like to thank all the readers and commenters for sparking discussions and refining my thoughts about many of the issues here.
You can follow my blogging at the rortybomb blog, and I’m also on twitter.
I want to close on one last note about where we, as a country, need to go from here. As a longtime fan of The Baseline Scenario, I read that there’s a project here to show the way in which capture by the financial industry has taken place in this country; through regulatory capture, through social networks and connections, etc.
There’s another element to it as well, and that’s what we as a country expect our government to be able to do about it. I want to point out this netroots nation video of Chris Hayes, an editor at The Nation, talking about The New Deal versus today (5m20s start):
Think about FDIC, how would we design FDIC today?…What we would do is, we wouldn’t set up an independent government agency which works very well, has worked smoothly, has prevented bank runs, since the bad old days of bank runs…we wouldn’t do that today. The banks would be like ‘what? you are just going to step into this market?’ What we’d do today if we were designing FDIC is we’d choose a bunch of the banks and we’d subsidize them insuring other banks…
The Home Ownership Loan Corporation…we have a lot of foreclosures, a lot of people underwater on mortgages. What are we doing? We are subsidizing the lenders with public dollars and telling them ‘if we give you guys some money, will you go help those people?’ And surprise, surprise, they have not really gotten their asses to do it. Now the Home Ownership Loan Corporation was faced with the same exact problem…and it went out and bought the mortgages and directly re-negotiated the terms of the mortgages, and it was very, very successful.
This is a massive conceptual problem.
I find this fascinating because I completely agree that, if we were to encounter bank runs for the first time today, this is how we’d try to set up FDIC. FDIC is an example of a government program that works, and the banks-insuring-one-another-with-public-money is exactly the kind of operation we’d expect to fail. I also find it fascinating because I believe part of what happened in this crisis is that we started a banking system in the capital markets, a ’shadow bank system’ if you will, that collapsed in a new 21st century style bank run, and going forward we need to find a way to regulate it properly to make sure it doesn’t happen again (here’s interview I did with Perry Mehrling about it).
It’s one thing to identify the problem – finding the will to conceptualize the problems, and begin to fix them, is the other half of the solving the problem. And that is what this country needs more of, less hoping that the problems will fix themselves if we shove enough public money to private parties, and more of working to find the solutions ourselves.
Thanks for the great week all!

The Best of Behavioral Finance Anomalies
Posted: 21 Aug 2009 09:37 AM PDT
And before I go, my two favorite Behavioral Finance anomalies. Learn them, because next time someone tells you that the market is perfectly efficient all the time, bring these up.Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market, Allen Poteshman, 2001.
This paper investigates the response of option market investors to the information contained in daily changes in the instantaneous variance of the underlying asset. Evidence is provided that these investors exhibit (1) short-horizon underreaction to daily information, (2) long-horizon overreaction to extended periods of mostly similar daily information, and (3) increasing misreaction (along a scale that ascends from underreaction to overreaction) to daily information as a function of the quantity of previous similar information. The increasing misreaction can reconcile the short-horizon underreaction with the long-horizon overreaction and is also consistent with well-established cognitive biases.
The behavioral cues related to overreaction and underreaction that we know show up in the stock market also show up in the options market. Why is this important? Because as opposed to the stock market, option traders are looking at one variable, the volatility, and trying to estimate it. Instead of a mix of P/E ratios and the whole mess of problems with equity valuation, options have one free variable, the volatility, and options traders have the same behavioral cues when they estimate it.
Also the market is dominated by professional investors. This isn’t the “I heard on the television to buy” crowd. These are people who know the market, and know that there are behavioral cues. Also the market is highly liquid, which removes one of those problems in trying to figure out if behavioral ticks in equities markets are the result of market imperfections.
So isolated down, to a professional, highly-paid investor in a highly liquid market looking at one single variable – volatility – we still see behavioral over/under-reaction. Score that for the behavioral crew.
Demographics and Industry Returns, Stefano DellaVigna and Joshua M. Pollet
How do investors respond to predictable shifts in profitability? We consider how demographic shifts affect profits and returns across industries. Cohort size fluctuations produce forecastable demand changes for age-sensitive sectors, such as toys, bicycles, beer, life insurance, and nursing homes. These demand changes are predictable once a specific cohort is born. We use lagged consumption and demographic data to forecast future consumption demand growth induced by changes in age structure. We find that demand forecasts predict profitability by industry. Moreover, forecast demand changes five to ten years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics predicts a 5 to 10 percentage point increase in annual abnormal industry stock returns. However, forecasted demand changes over shorter horizons do not predict stock returns. A trading strategy exploiting demographic information earns an annualized risk-adjusted return of approximately 6 percent. We present a model of inattention to information about the distant future that is consistent with the findings. We also discuss alternative explanations, including omitted risk-based factors.
So what’s going on here? If you ask financial analysts, they may tell you that they are trying to get it right 3 to 5 years out. If you ask a EMH guy, they’d say that’s impossible, markets have to be correct for all time, since they reflect all available information. So if there was going to be a predictable demand for a good 10 years out, the market should have already priced that.
How do we test that? In this paper, DellaVigna and Pollet took on the Herculean statistical task of looking at demographic groups as they age, using birth rates and life expectancy rates, and comparing that with predicted demand for goods/services across years, and see when the market realizes that these groups are going to start consuming toys for their children, nursing homes for the elderly, etc. They found that the market gets this right, but only about 3 to 5 years out. Past that point, the market ignores it.
Why? People and institutions have time and attention constraints. Perhaps people also don’t want to get rewarded for something that won’t happen for 10 years, when they may be at another job (or already denied the promotion that occurs every 3 years).
The problem is that things that may not happen for another 6 years are off the radar – there’s more immediate important and profitable stuff to deal with in the here and now. 6 years is a terribly long time in the finance world to sit and wait to weed out inefficiencies (there are limits to arbitrage!), though if they involve huge risks, say a nation-wide housing bubble, it isn’t clear that the market will be able to think through the effect of their actions 10 years down the line.
So check them out – both fantastic papers. What are you favorites?

The Limits of Arbitrage
Posted: 21 Aug 2009 08:56 AM PDT
Wow, it’s already Friday. I’ll feel that I’ve short-changed you if we don’t do some Finance Theory before I go.
Did you see this roundtable about the state of macroeconomics in The Economist’s Free Exchange? Fascinating stuff; in particular it became a bit of an odd defense of the Efficient Markets Hypthosis (EMH). A representative comment was made by William Easterly, in defense of EMH:
The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.
This is not true, and I want us to walk through why it isn’t. In March of 1997, Andrei Shleifer and Robert Vishny published a paper titled The Limits of Arbitrage (pdf) in the Journal of Finance. I think it’s the most important finance paper of the past 15 years, something everyone even remotely connected to financial markets should become familiar with. It builds on and summarizes a decade long research project, research they conducted with people such as Joseph Lakonishok and Brad Delong. In it they say that arbitrageurs, the very smart and talented traders at hedge funds who will take prices that are out of line and bring them back into line, making a good fee and making prices reflect all available information, the very building block necessary for EMH to work, can’t do their job if they are time or credit constrained. Specifically, if they are highly leveraged, and prices move against their position before they return to their fundamental value – if the market stays irrational longer than they can remain solvent – they’ll collapse before they can do their job.And sure enough, a year later in 1998, Long Term Capital Management, very smart highly leveraged arbitrageurs, found themselves in a situation where prices moved away from them, and they had no capital with which to keep themselves afloat, just like Limits Of Arbitrage predicted. (This is the standard narrative in finance research seminars; it also appears this way, correctly, in Justin Fox’s The Myth of the Rational Market, a very excellent book that gets these details correct.)
There’s an argument that says “If the market is inefficient, why aren’t you rich?” This gives us the framework to understand why markets could deviate from true value but there isn’t a way to capitalize on bringing them back to true value – sometimes there is risk inherent in arbitrage, and sometimes there are situations where it is difficult to get on the other side of a trade. And specifically, it’s risk that isn’t compensated.
Here’s an example of how this works. Let’s say something is trading at $5. You are positive it is going to reach $10. Positive. It must. No chance it won’t at some point in the future. So you buy it, telling your boss/manager/investors you are going to make $10-$5 = $5 for free. But the price goes to $2.50. What happens? You should buy a lot more. Now you are going to make $7.50! However your boss/manager/investor thinks you are insane and have lost them all kinds of money, as they now have half of what they gave you, and wants to pull your trading funds – if you sell then, you lose money, and put downward pressure on the price. Also, depending on how you were leveraged, you may also be bankrupt. That’s how this works.
This gives us a guideline for figuring out how markets can get out of alignment with value – if it is difficult to attract arbitrageurs, who are necessary to keep prices in alignment, we should expect the market to have prices that are more prone to manipulation and bubbles. What attracts arbitrageurs? The bond market – it is easy to calculate the value of a bond, and easy to realize the value quickly. Foreign exchange markets – it’s relatively easy for arbitrageurs to go after central banks attempts to maintain nonmarket exchange rates.
What doesn’t attract arbitrageurs as easily? The stock market. The absolute and relative value of a stock is harder to estimate, and it may take a long period of time to realize your gain. (If you are comfortable with the terms, expected alpha doesn’t increase in proportion to volatility if volatility includes fundamental risk – read the paper, it’s excellent!) And though it isn’t covered in the paper, housing.
There’s no real way to go short housing. You can go short the bank issuing mortgages, but if the bank has two internal businesses – jumbo subprime loans and boring small business loans – might it not be sensible for them to turn down the business loan division in response to the market shorting? You need to be able to exert price pressure directly onto the market itself – the more intermediaries, the more likely it is your signal is converted into noise. There’s talk about how in the future we’ll all trade derivatives contracts on each other’s neighborhoods; depending on how that’s implemented, it would be something to say “I want to go short Detroit and Peoria in my portfolio.” Is there moral hazard to drive down those prices then? And life would be more interesting if the investment firm of “My Ex-Girlfriends LLC” could take out a derivative insurance contract that pays out to them if my house burns down over the next year. Thankfully that market is still some time away, if it ever gets here, so we can iron out the difficulties.
There’s a lot more research to be done here, but contrary to popular belief we do have an intellectual framework to know how markets can get out of whack, one that takes the EMH are brings it to a reality where we face actual constraints over scarce resources such as time and capital.