Sarah Palin: Framing the Debate

As a defeated lefty, I have to admire the GOP for framing political debate to their advantage.

To that end, I think Sarah Palin is a pretty brilliant choice as VP for this reason: even if they lose the debate they win.

At best us lefties, who are totally distracted by Palin, prove that she is not qualified to be president. (Duh.) Is this really a victory? People voted for Bush Sr. despite Dan Quayle! I don't think a VP can be enough of a liability to warrant getting so off message.

Only one thing wins it for the democrats: "McCain is Bush Jr., and look at the mess we're in."

Bob Vila Does Not Have $700 Billion

It's been a while since I've put up a good financial rant, but today deserves one, because these are special times.  I have a superb deal for you:

• You give me $700 billion in cash.
• I will give you $700 billion in bad mortgage bonds, toxic derivative products, and whatever fertilizer I happen to have in my garage right now.

Foo - I'm too late.  Uncle Sam is already signing you up for that deal.

Asymmetric Risk

At the core of the entire financial disaster is asymmetric risk.  Any time you have a situation where the party who takes a loss is different from the party who takes the gain, the party that takes the gain is going to try their hardest to make the transaction happen.  This asymmetric situation is everywhere:

• A home buyer who is not required to make a down-payment (zero percent equity) gets the up-side of a rise in housing price, but transfers the down-side risk to the bank.
• A mortgage broker that makes a commission on a mortgage but doesn't hold the mortgage makes money on the deal but doesn't get penalized if the mortgage goes into default.
• A bank that has FDIC insurance, but does not have to back up its risky investments with capital holdings gets the up-side of the risky investments but gets bailed out for the down-side. (See below.)

Fundamentally what we have is a situation where risk has been transferred (often using derivatives) from the party making a profit to a party that has insurance (whether real or implied) from Uncle Sam.

Grass Fires

Derivatives are the vehicle that makes this possible.  Basically a derivative is a contract that obligates parties to perform a financial transaction (one that will usually be really bad for one party) but does not require the party at risk to hold any money in reserve.

In the good old days, your bank took deposits from working people, loaned money out in mortgages to home owners, and kept the interest rate difference as profit.  Now since working people always want their money bank but home owners sometimes default, the bank had to keep a little bit of deposit money aside (its reserves) just in case; the size of that reserve has to be proportional to the risk of the home owners failing to make their mortgage payments.

Derivatives have no such capital holding requirements.  To see how insane this is, let's look at a "credit default swap" (CDS) - one of the most ludicrous inventions ever.  A CDS is basically insurance on a bankruptcy.  Here's how it works:

• You have $100 in General Motors bonds and are a little bit worried that GM might go under.
• I have $100 in treasury bills.
• We enter the following contractual agreement: in the event that GM does go broke, I will swap my treasury bills for your (now quite worthless) GM bonds.
• You will pay me some money right now to take this idiotic deal.

So basically what we have is bond insurance - you pay me a small premium, and in the rare event of a default, I insure you.  Now here's the rub: I don't have to keep the treasury bills locked away!!!  Heck, I don't even have to keep a fraction of them locked away.  I can go spend them on beer and pray that GM doesn't go broke.

Of course, this has some unfortunate effects.  Perhaps your GM bonds had a low rating because GM is in deep doo-doo.  But if you buy some insurance from me, you can "enhance" the credit of the bonds...GM bonds + insurance are a lot nicer than GM bonds.  But what happens if I, the writer of the insurance, go broke?  Your GM bonds instantly turn back into a pumpkin, so to speak.  At that instant, any other deals that made sense only if GM bonds are good is now quite screwed up.

And this is the nature of counter-party risk.  If you enter into a derivative contract and you need that contract to be valid for your business, you take on the risk of the other side of the contract going broke.

The experts told us that derivatives would spread risk and make the system more robust.  They were half right - derivatives definitely spread risk.  Derivatives on risk is like on a grass fire.

Selling Uncle Sam

Now we can start to see why Uncle Sam is considering spending $700 billion dollars to buy a huge pile of toxic waste.  If you have counter-party risk, it becomes in your interest to keep the other party alive.  Uncle Sam's umbrella of protection has been wrenched out from over the small depositor and home owner and extended to wall street through the mechanism of derivatives.

John Hussman has a great explanation of how you can hook Uncle Sam into insuring things that the tax payers really should not be insuring:

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

The financial alchemy is in Citibank exposing itself to risk (and making money by doing so) without reserves.  Remember the good old days?  Well, in this transaction Citibank didn't put any money inside to cover the case where GM goes under.  (If GM goes under, Citibank is left writing mortgages at fixed rates while paying depositors a floating rate.  If interest rates go up, Citibank will lose money with every transaction.  But Citibank has no "nest egg" of cash stashed away to cover this case.)

Simply put, if you can get Uncle Sam to be counter-party to another entity, Uncle Sam has to protect the other entity.  And thus here we are, trying to bail out all of Wall Street.

Extending the Umbrella

Let's go back even further - how did we get here?  We have a policy in this country (the "American Dream") of subsidizing home ownership in the form of tax breaks and credit enhancement.  Basically Uncle Sam is willing to spend money to get you to buy a home by:

• Providing tax breaks for mortgage interest (which creates an incentive to borrow money, not save, and makes financing of houses effectively cheaper).
• Keeping interest rates low, which also makes financing cheaper.*
• Providing credit enhancement to borrowers (that is, guaranteeing mortgages).

To this last point, the Government does this both by writing guaranteed mortgages (FHA, etc.) and also by creating Fanny Mae and Freddie Mac - two companies that write mortgages.  Fanny and Freddie make mortgages cheaper by using their good credit rating to get cheap financing for home buyers.  Why would Fanny and Freddie have a good credit rating if their job is to make housing a little bit too easy to get?  Simple: we all assumed that the government would bail them out if things got ugly.  And of course, that is exactly what happened.  As a net transaction, Fanny and Freddie represent Uncle Sam backing up a huge number of home buyers on their mortgage.

So we have the government providing credit enhancement.  How can Wall Street profit off of this?  Simple: they need two things:

• They need a lot of people to buy homes and utilize that credit enhancement, so that it can then be transferred.
• Wall street then needs to find a way to transfer that credit enhancement from the individuals doing the borrowing to other parties, who will pay a fee for this.

Getting people to utilize the credit enhancement is pretty easy: offer them cheap financing. Offer them all the up-side of a market increase without the down-side by writing nothing-down mortgages.

You then write products that are tied to this sea of government-backed paper and you pull in Uncle Sam as a counter-party.  You sell this off with the wink-and-a-nod that the products are credit enhanced because you-know-who is a counter-party.  The huge chain of derivatives and "engineered" financial products spreads the risk all over the place, and thus spreads Uncle Sam's umbrella all over the place.

If Uncle Sam walks away and lets Wall Street go down, the chain of derivatives guarantees it hurts "main street", the little guy, for whom cheap housing was invented.  This is the true price of subsidized housing.

Only Pain Will Heal

Besides a huge credit mess, what we have is overproduction: too many houses and too many mortgage bonds.  The only way out is to stop making houses and mortgage bonds for a while. And this is where I have the greatest fear; falling prices for houses and mortgage bonds is the market's way of dealing with the extra product floating around.  

If the Government starts spending hundreds of billions of dollars to prop either, that is money spent on an inefficient and overproduced part of the economy, destroying real investment in future US growth.  But I fear that the debate in Washington is on who gets the bail-out, not whether there should be a bailout.

* I know, there is an immense amount of hand-waving in that statement and it isn't really supportable.  In fact, this whole rant scrambles cause and effect pretty thoroughly.  But I must point out that this is the nature of asymmetric risk; parties may not have known Uncle Sam would bail them out, but they didn't have to care, since they were in a position to make all the profit and take none of the pain.

Going For Broke

Lori got an awesome graph in her mail the other day - it was her Van Guard 401k statement from a former employer. This is a "2040" plan - that is, they mix the stocks and bonds for you according to theoretical models so that you can retire in the year 2040. As 2040 draws closer, they move from stocks to bonds so you get higher return on higher risk when young, but the bottom doesn't drop out of your retirement 3 days before you need it.

Due to the employment duration and market performance, the graph was a simple straight line going from "more" to "less". The caption had some marketing drivel about preparing for retirement...extrapolate the line out and Van Guard will have carefully lost all of her money by the time 2040 rolls around.

Now it could be a lot worse - the expense ratios on Van Guard's plan are really low, and we have to accept that stocks are risky and there will be periods like this when the market gets the hell beaten out of it.

But what caught my attention was the mix. For someone retiring in 32 years Van Guard recommends 90% stocks and only 10% bonds! Wow! (By comparion, the "old" models would have been 70% stocks.)

Hrm...how did we get here?

• Nerdy analysts look at historical stock-bond returns and recommend a 70-30 mix.
• Lots of people put 70% of their retirement into stocks via mutual funds.
• This increases demand for stocks, their value goes up and up and up.
• Stocks now have a higher historical return.
• Nerdy analysts recalculate. The mix should be 80-20 because stocks are even better than we thought.
• People put even more money into stocks!
• Stocks go up even more.
• Now stocks have an even higher historical return.
• Nerdy analysts recalculate...

I think I hear Adam Smith laughing at us...

Bob Vila Would Never Club a Robotic Baby Seal

...Because they're too cute apparently. I must admit that, having heard the story before viewing it on the web, I imagined the robotic baby seals to be cuter than they really are.

Now part of me thinks that when we are using a robotic pet to comfort the elderly, we have really, really lost our way.

But the truth is, I am a technological grumpy-old-man, and the war between the young and old regarding technological integration (that is, integration of technological into the domain we would have reserved for "life") is being lost every time a new baby is born.

Having had my formative years before the internet and instant messaging and ubiquitous wireless technology, the notion of asking someone out on a date (or ending a relationship) via text message or posting all of your personal information on a MySpace page strikes me as moderately ridiculous.

But to my own self I must be true: I am a fossil. Human beings, when presented with these technologies (among others) see nothing unusual - we integrate every technology we develop into our lives. I don't think my 2-year-old nephew sees any difference between the remote control and wooden blocks. They are all simply objects to be explored, touched, chewed on, and mastered until, like all tools and technologies, they are an extension of him, part of the fabric of human life.

My negative reaction initial to robotic seal pets* (besides being caused by a lack of coffee) comes from a line in the sand that is crossed when technology starts to affect us emotionally. But this is a ludicrous line in the sand; all technology affects us emotionally, even ones that are not supposed to. (Tell me there isn't enough hate caused by Microsoft Windows Vista to start a war!!) We connect emotionally to our cars and computer programs, perhaps because we connect emotionally to everything.

And robots don't have a monopoly on button-pushing. In "The Truth About Dogs" Stephen Budiansky argues that dogs are fundamentally parasites. A successful parasite attaches to its host using a property of the host so integral to its survival that the host cannot "close the door" on the parasite . In the case of dogs, by triggering all of the responses that make us care for children, they obtain food, shelter, medical care, toys, belly rubs, and in some cases trips to spas. If we didn't think dogs were cute, we'd probably toss our babies out on the street too.

As Lori and I sit around blathering about how cute it is that the dog is rolling around under the bed or that the cat approves of the new sofa (as shown by sleeping on it) we realize that we have animals in the house that have reduced our mental functioning, and in the process, mooched hundreds of pounds of pet food. If Martians came to do a documentary on human culture I am sure the narrator (who would sound just like Morgan Freeman) would say:

"This human pair has become infecting by a dog and a cat. The animals play on the humans nesting instincts, diverting their normal course of development. The humans do not yet have offspring, but instead foster the dog and cat."

In the end I think Daniel Ariely's view makes sense; we humans are hopelessly hard-wired for some irrational behavior. Whether it's another species that wants a free meal, or a robotic baby seal engineered by researchers, we are going to attach to things emotionally whether it makes any sense or not. We can't change who we are. All we can do is be aware of our human heritage and navigate the murky waters of technological change as best we can.

* If someone makes a robotic baby seal with laser beams mounted on its head, I will be the first to buy it!

This Is My Day

CC and Nala's relationship has come a long way in almost a year; originally we could not have them in the same room, and we had a gate or door separating them at all times. We've reached a point now where I don't have to separate them at all.

The turning point in their relationship was when Nala decided it was more fun to hit CC than run away from her. Nala's previous owners declawed her - if she had a little more firepower they would have found a balance of power much quicker (basically the dog doing whatever the cat wants). Instead this drama plays itself out probably about once a day.

Now I must admit, I did intentionally allow this to happen by asking the dog to come sniff the cat once I had the camera ready. It's a situation with a predictable course:

1. Dog decides she really, really, really needs to smell the cat - perhaps the cat smells different than yesterday? You never know!
2. Dog attempts to smell the cat, usually by jamming her nose as close to the cat's belly as she possibly can.
3. Cat decides she does not like the dog doing this and hits the dog, perhaps 8, 9, 10 times in a row.
4. While it didn't happen this time, the cat usually then immediately washes her paws because she has "dog cooties", which are totally gross.
5. Cat decides to leave and go somewhere else.
6. Dog whimpers because the cat doesn't love her.

Never a dull moment.

These days I have been catching both of them sleeping in the same room (once even in my office) fairly close together, e.g. dog on the floor, cat on the chair, or cat on the dog's bed, dog on the floor...but the cat is always on alert so I haven't been able to get a good picture yet.

Ah, CNBC

http://www.cnbc.com/id/15840232?video=753754816&play=1

I have a simple rule of thumb for resolving economic questions: whatever the loud guy shouting on CNBC says is wrong. Ergo, there is oil speculation.

This argument has been thrown out before: because the spot price is based on real oil, "paper speculators" (index funds that buy and sell futures to avoid actually ever having the oil) then the real price of oil (the spot price) can't be influenced by speculators.

To paraphrase the Simpsons, Rick Santelli makes a very loud point.

His argument is essentially that if there's a lot more people speculating on oil going up then down, then when those speculators defer receiving the oil, they'll pay a premium since no one wants the oil (supply and demand).

Of course, that is exactly what's happening: the market is in contango - that is to say, there is a cost to paying someone else to hold your oil for you (so you can lock in the speculative gains). The index speculators are paying month to month. (Of course, they are rolling from 2 months to 1 months, at least in the case of Barclays oil ETF.)

So how can the spot price be affected? Simple: oil producers are in a perfect position to make a killing off of the contango.

Imagine I drill for oil in my back yard and can produce a barrel of oil a month. I enter a futures contract (locking in a higher price due to contango) to deliver in two months and put the oil in my garage. At the end of the month I look at the market and see that I can make a profit by selling another two-month contract while buying a one-month contract.

That one-month I bought perfectly balances the one I sold (two months ago, so now it's a one-month) and the barrel of oil in my garage backs the new two-month. I make (for free and risk free) the roll yield the commodity indexes are losing.

Of course, I've shut my well down. Is this a big problem? It depends on what I'd rather have: oil in the ground or dollars (which I'm making anyway).

Of course I don't even need an oil well to play this game - I could just buy one barrel of oil, sell it forward, and start rolling the contract. Essentially contango pays people to store oil.

So when you invest in rolling oil futures, you really are hoarding oil - contango is the "rent" you pay someone else to do the dirty work of stashing your barrels somewhere. (But you most certainly have a real claim on a real resource - that's what a futures contract is. No one is going to do anything else with "your" oil until the contract is settled.)

So what about the spot price? If this is all about contango and negative roll yield, why are we paying $4+ at the pump? What ties the spot price to the futures price? (Santelli's argument is that since the speculators only play with futures, they can only move futures prices.)

The answer is arbitrage. In a situation where the prices of futures contracts have gone much higher than spot prices, oil producers can make a ton of money with zero risk. They sell less oil on the spot market and more using futures contracts. As long as the price difference is larger than the storage cost, the producers make a profit, and the spot price goes up (due to a lack of supply).

Yellow Books

I enjoy spotting the yellow "X for Dummies" books in Barnes & Nobles...the topics that the books hope to explain to dummies strike me as, well...ambitious. Still, "Currency Trading for Dummies" cracked me up.

By comparison, I thought "Hedge Funds For Dummies" was a fitting title - with the hedge fund manager taking 20% of the profits and 0% of the losses, how could a hedge fund be for anyone else? :-)

Wicked Good Eggs

I read The Omnivore's Dilemma and strongly recommend it. Even if you don't agree with Pollen's opinions on food culture (I do, but that's just my opinion, not something I would argue about) I believe the book is a good for its treatment of farm economics, something that city slickers like myself might not be aware of.

The factor that I think is now so relevant (with both high food and high oil prices) is the chain of subsidies and non-renewable inputs that goes into our food.

• It starts with oil, something we can't make more of, and something we don't really have (to the scale that we require) in the US. I'll blog about oil some other time, but for now let's just say that starting the chain with oil gets us off on the wrong foot.
• The oil is used to make fertilizers...basically you couldn't grow corn to the quantity we do without adding a lot of fertilizer, and that process requires energy, which in the US means fossil fuels. (I suppose that we could move some of our energy dependence to nuclear power - I am for this, and not just because I could then blog that the beginning link in a bag of Dorritos is Uranium!)
• The farmers grow a pretty huge amount of corn - the Government pays them to do so, allowing them to spend more on production costs than the corn is worth.
• That makes corn so cheap that we go feed it to cows who aren't even supposed to be eating corn (and get really sick from it).*
• This ends with a Quizznos add telling us that for $5 we should get more meat!
• Actually, it ends with us all getting really fat.

When I look back at the entire chain of events, it strikes me as completely absurd, and more importantly really inefficient! A lot of expenditure for something (in this case fast food) that isn't even that great. I'd like my taxes back, I can live without fast food, thank you.*

But it turns out that Polyface Farms, which is featured in Pollen's book, delivers to the DC metro area via buying clubs. So Lori and I signed up.

Now I do have to admit that while signing up makes my liberal conscience feel good, the amount of food we ordered is a drop in the bucket of our total callorie consumption - we're going to have to find sustainable sources for a wide range of other types of food.

But the point of this blog post is not that Polyface is sustainable, with almost no outside non-renewable inputs. It is that their eggs are magical.

Lori and I try to buy the freshest eggs we can, but Polyface eggs are in a different dimension. I found this out last night when making meringues and zabaglione; the meringues whipped in perhaps half the time normal eggs would and became so thick as to lower the RPM of the mixer. The initial beating of the yolks takes significantly more effort than with your regular store-bought yolks-break-by-looking-at-them variety.

Forget sustainability and the planet, I would like all my food to be farmed the Polyface way because the quality is unreal!

* There is now a fork in the road - we could go down a different path and use our cheap subsidized corn to make fuel...sort of like the fuel we used to make the fertilizer to grow the corn. I've read that the output-input energy ratio for Ethanol is 1.2 (that is, it's a slight win, prodcuing 20% more energy than it took to make) but 1.2 is still totally lame.

Bob Vila Would Not Invest in Fixed Income

Or would he? One of my friends told me he's only 10% in fixed-income in his retirement savings account; for the last two days I've been trying to write a blog post on why that's not a good idea for someone in their 30s, and each time have failed. The problem is I can tell you more about why any investment theory is built on shaky ground than I can about why any particular one is good.

I have some entertaining performance numbers from various investments over the last two years, but while they're good for a laugh, but not much else. If someone says "my investment strategy is to play the lottery" we'd call that person a moron. If the person then won would we go "no, you were smart all along"?

My gut feeling is that my generation doesn't adequately fear the stock market. Consider the following:

• Periods of relative success increase risk. When things are quiet, we humans with our short-term memory think we can gamble more, until something bad happens. This is essentially what happened with the housing crisis: complex engineered fixed income investments were quiet and steady so people built more and more risk into them for less reward; when they went awry, the result was carnage.

• Both bonds and stocks have return both on investment fundamentals (the coupon for a bond, dividend and earnings yields on a stock) and speculation (sell the investment on to someone who pays more). Since 1982 we've seen a huge increase in how much people are willing to pay for a stock with a given return. The results of this are two-fold: the investment yields on stocks keep going down, but along the way people make specualtive yield.
  
• This means that the potential for future returns keeps going down (since the investment component is getting smaller) and yet we think that stocks do well because their past growth has been high (due to speculative yield). We have to see this for what it is: a pyramid scheme. The speculative component of stoc k yield cannot grow indefinitely, and the investment yield is low due to high prices. I'm not saying stocks won't make money, I'm just saying that when people say "the stock market returns 10%" they're throwing out numbers that were true from 1980-2000 but probably won't be from 2010-2030.

So here is some data, mostly food for thought.

Sometimes the Rules Change

This chart shows the relationship between stock earnings yields, stoc dividend yields, and bond yields. Note what happens in 1955: until then, bond yields have always been lower than stock dividends. In 1955, this relationship changes and it never goes back.

My point here is that sometimes the rules of the game change forever. Benjamin Graham said that in the short term the market is a voting machine, in the long term a weighing machine. Basically he was saying that in the long term speculation will wash out and your long term return will be based on fundamentals.

But I'd say: sometimes in the long term the rules of the game change and you don't win what you thought would be yours. If you made investments under the assumption in 1955 that the weighing machine would vindicate you, you'd never make your money back.

This has applicability to two cases:

1. More strongly for "regression to the mean" or "value" investors - that is, investors who try to identify temporarily incorrect prices and invest to profit when they come back. This is often a good stragey, but it is not risk free - every now and then the rules change and you blow up.
2. More subtly, but also more importantly, this also applies to arguments that "X has never happened in the past". For example, you'll find a ton of posts in the last year suggesting an over-weight in equities for retirement investors. The logic is: they return more and over N years they've never lost money" where N is long enough that the stock market recovered. There are specific problems with this argument I'll blog about some other time, but it's worth noting that in 1955 stock dividends had never been lower than bond yields, until that wasn't true forever.

Sometimes the Rules Don't Change

This is a graph of the Nikkei 225, that is, Japan's major stock market index. My generation is too young to really understand Japan in the 1980s I fear. Note that not only has it not made back its peak pricing, it hasn't even come close.

Whenever there is a bubble, you'll hear "this time it's different" - think dot bombs that lose money on every transaction but make it up in volume with $100+ stock valuations. Sometimes the rules change, but a lot of the time they don't.

The Nikkei provides a number of warnings about stocks:

• If your underlying asset is subject to bubbles and heavy speculation, you might never get your money back. A diversified, balanced portfolio is a good defense to this.
• When you invest really does matter...if you hear "99% of the time strategy X returned great results" ask yourself: what happened in the 1%? Would you take a drug that will fix your headache 99% of the time and kill you 1% of the time?
• Stock markets don't "always go up". That's what they said about housing.

The Life of a Turkey

There is a wonderful graph in The Black Swan called "The life of a turkey" - it is a steadily increasing graph of the amount of food fed to a turkey on a given day, until right before Thanksgiving the graph abruptly plummets to zero.

The fundamental problem with a whole pile of the financial tools we rely on is that they look at past data to answer questions about the future. But, as the life of the turkey points out, before Thanksgiving there was no data in the Turkey's history that could predict what was going to happen.

Taking Stock

And this is where I recommend a certain amount of skepticism when approaching stocks. You will see articles like this one, but as you read, remember the life of the turkey! In no 30-day period in the turkey's life did our poor bird die once - and yet he was not immortal.

There is simply no guarantee that trends from past data will sustain themselves - the "30 year win" theory of stock investing does not make a stock investment safe. Stocks can and do lose money - we have to look at the underlying mechanism of the investment, not just what the numbers have done in the past.

Stocks do not become like T-Bills over 30 years just because their average peformance shows the same volatility over a long enough time frame!

To end with my favorite epistemologist, Donald Rumsfeld, there are known unknowns and unknown unknowns. Past stock performance might give us some insight into the known unknowns, but it does not tell us anything about the big unknown unknown: namely how and when have the rules of the game changed?*

Unfortunately we go to war with the investment analysis tools we've got, not the ones we want. I am not saying "put your money under the mattress", and I do believe that diversification is a damned good idea.

My point is this: when you look at "risk", consider whether scenarios exist where you would lose more money than you are comfortable with, not the average and typical outcomes. There is no guarantee that the average or typical will happen, or even that it really is likely. Today Modern Portfolio Theory has become gospel, but don't let the gospel keep you from thinking about the unthinkable.

* Of course, people now are saying the rules have changed because we will have "decoupling" of the US and Asian economies. This strikes me as even more ludicrous than past statements about dot.bomb valuations, but that's another blog post.

A Good Podcast on Housing

Well timed for the week that we've spotted our first short sale in the neighborhood, "This American Life" (which you should listen to all the time anyway because it's great) did a really wonderful comprehensive one-hour show on the housing crisis. It should be mandatory listening for, well, everyone. Not only did they cover all aspects of the crisis, but they did so in a way that was both accessible to non-nerds and yet not dumbed down to ignore important details.

Last post I ranted about the issue of over-exposure...that is, in our attempt to own our own houses, most Americans are totally over-exposed to housing price changes with no diversification within the sector (real-estate); the equivalent of borrowing a million dollars and then investing it entirely on a single internet stock. (After a bubble bursts, it's a lot easier to see how stupid an investment idea is; I think an important lesson we all have to learn from the housing crisis is that if we're going to directly connect real-estate to the global financial system, the chaotic, non-linear, unpredictable nature of the financial system is going to infect housing prices.*)

A trend that you'll spot over and over when you look at the current financial crisis and how we got here is intermediation - that is, the ability of Wall Street to take something, process it like a TV dinner, and then send it back out to someone else. The effect of this "financial engineering" (financial processing might be more correct) on our system is about as healthy as eating heavily processed food is on our gut.

But John Bogle puts financial processing in the right perspective: Wall Street's profits are the fees they take on transactions. To the extent that their profits have grown faster than GDP (that is, their growth cannot just be explained by taking the same cut from more general economic activity), we can see that Wall Street is taking a bigger slice of the pie than they used to. Finance-geeks will give you all sorts of lines about increasing efficiency of the market, but this is crap; if the financial-sector's profits grow faster than GDP, they're simply keeping more for themselves.

Financial processing is how they do it. When you listen to the slice-and-dice game that financed the housing bubble, with a mortgage getting passed on over and over, you have to remember that the parties involved didn't just do it because they wouldn't be bearing the real risk. They did it because they got paid every time they made a transaction. Wall Street had a few years of huge profits, and those profits were a slice coming out of everyone's mortgage payments. Someone did get rich off this whole mess.

Another Case of Food Processing

A caller on Marketplace Money wanted to know what to do about his auction-rate securities. If you don't follow this kind of thing, basically the investment banks convinced very reliable long-term municipal borrowers like the NJ turn-pike authority to set their bonds up in an auction-like scheme where the bonds were constantly resold each week. (Normally the bond would be 30-year fixed rate, someone would buy it, keep it for 30 years and everyone goes home. Life is boring for 30 years.)

The rationale for this scheme was: by re-auctioning the bonds, the turn-pike would constantly be getting "the latest" interest rates, which were at the time very low. (When interest rates are down at 1%, it's basically impossible to convince anyone to buy a 30-year bond at that rate.) The theory was that by making a municipal bond look variable-rate instead of fixed-rate, the borrower could get the lower current variable rate (1%).

Investors in this were told that this was just about the same as holding cash, but for slightly higher interest; since the auction is every week, you can always sell your bonds off in the next auction.

If you get higher interest, you're always taking a risk, so it's good to know what that risk is. It turns out the risk here is that the entire auction system would break down when the investment banks who ran the system ran out of money. The poor caller needed to sell his bonds ASAP (his short-term funds were in the bonds) but the auction system had ground to a halt so he couldn't find a buyer. In the long term he's not going to lose any money; the odds of the Turnpike-authority defaulting is very, very low. But he needs his money now!

(These are long-term bonds that are resold in the short term...so you can get your money now if there is an auction, or you wait 30 years if there isn't.)

Now you could say that this investor was chasing higher returns without knowing the risks, but I think we need to look at the roll of the brokers and investment banks. This poor guy got these bonds through a broker, who gave him some "good advice" - look at this clever way you can make more money. Look how clever we (the investment bank) is in creating this new trick to improve returns. Look how kind we are to let you in on this little secret. (Implicit message: returns are higher because not everyone knows about this. Truth: there are nerds on wall-street who control such large piles of money that if it's worth knowing about it, they know about it and buy it before you ever find out.)

There's a conflict of interest that was present in the dot-com bubble burst that's present here both in the housing crisis, and in all of the other instruments (like auction-rate bonds) that have started to break down as a result of the stress the housing crisis has induced. And that is the conflict of interest between profits for Wall Street itself and profits for the investors who are one set of Wall Street's clients (and the borrows who are the other)!

Auction-rate bonds turned into a deal that went ugly for both the investors and the borrowers. One might speculate that the only group for whom the deal was any good was the investment banks who ran it and got to collect transaction fees all over the place, without having to carry any of the risk themselves.

Good Advice

So if there is a common thread to this rant, it is: don't trust "advice" - see that any party that makes its money on transaction fees has an incentive that goes against your best interests. This would include:

• Real estate agents. (See Freakanomics regarding agent selling practices for their own houses vs. client's houses.)
  
• Mortgage Brokers. (See This American Life for poor recommendation on Mortgages.)
  
• Stock Brokers. (See the dot-com bubble.)
  
• Investment Advisers. (See the recent 401k kick-back scandle)
  

Of course if you believe any of what I've written, it does beg the question: why are you listening to some cranky blogger on the interweb?

* That's actually a bit disingenuous of me - real-estate has been subject to bubbles for hundreds of years; but connecting real-estate to hedge funds certainly doesn't make things better.

Housing: Why We're All Doomed

I don't think there's any even remotely good way out of the housing crisis - here's why:

For any market where the supply of housing can be increased, high prices are not sustainable. If a 3 bedroom house in Nevada is selling for half a million dollars, someone is going to go build another house in Nevada for less than half a million dollars, sell it, make a profit, and repeat until the price of housing comes down.

So for any market that isn't limited by available land, there's no sane way to prop up the price of housing. Anyone who took a mortgage based on bubble-level housing prices is simply screwed; when we (homeowners) buy a house, we are assuming market pricing risk ourselves. The only way out is to give up on equity (if there is any), stop payments, let the bank foreclose, and forget about your credit rating for the next decade. This transfers the market risk unceremoniously onto the investors who bought the mortgage.

(Requiring a real down-payment was the safety mechanism that kept these kinds of things from happening - of the people I know who bought a house, I don't think any of them actually put 20% down.)

Most of the "rescue" packages I've heard discussed on the media come down to some mix of either strong-arming lenders into accepting new financing terms or providing new financing. I have no qualms with strong-arming lenders even if it makes libertarians cringe. The libertarian in me says: buyer beware...investors should know that if their investment requires elected officials to stand by while citizens get the short end of the stick in an investment, someone is going to step in and do something populist. That's part of the risk of the investment. When you buy asset-backed whatevers, you should care about what the underlying asset is because that's the only thing protecting you. (Sure the house behind the mortgage has value, but having to foreclose to make good on the loan is an ugly solution.)

However I simply don't think adding additional financing is going to do a lot - we could hope to stem the wave of foreclosures but not the price change for anyone who bought a house at peak prices. If you're underwater, why would you want to accept fixed rate financing so you can protect your negative equity? I think it's a question of "how much is a credit rating" worth. Is a credit rating worth $50,000?

I'm not saying we shouldn't have additional loan help. In particular, I think that there needs to be disintermediation in the mortgage business (letting the people writing the mortages not own them has proven to be a bad idea). Securitization of mortgages has lowered their cost; if we are going to go back to traditional lending and we want to maintain credit costs similar to what we've had for the last twenty years, new investment has to come from somewhere.

Subsidizing housing prices seems like a non-option and unfeasible; not only would additional housing subsidies further increase the overall supply of housing (via new construction), but the scale of the problem is too large. Consider: by spending $150 billion we don't have, the government is putting a mere $600 in our pockets per person. How many home-owners are only underwater by $600 or only behind by $600? The rebate is a drop in the bucket, which is why it won't address housing problems at all. You can see how the market correction is beyond the scale of government intervention.

Stepping back, I come to a question more fundamental than "what went wrong" and "what should we do"...I want to know: should we even own our own homes at all?

When I plan my retirement savings each year, I try to diversify my investments - within stocks, I have an index fund to protect me from one company's downfall. Not all my money is in stocks, etc. etc. If I said "I'm going to put all of my life savings into Raytheon stock" you'd say I was an idiot.

But wait - look at my total set of investments. I have more money plugged into domestic property (in fact, into a single unit in a single neighborhood) than I have in all of my other investments combined!! That's not diversification at all? I am subject to an immense amount of market risk!

Home ownership is heavily subsidized in the US, and that's one of the reasons Lori and I bought - it's generally a better deal than renting. But this exposed us to huge market risk. I think one of the reasons that the housing crisis has hit so hard is that the nature of houses as a commodity has changed over the last thirty years. With the invention of securitization, REITs, etc. it's possible for speculative money to enter the real-estate market in a much bigger way and this means that the volatility of housing prices is going to resemble the rest of the instruments wall-street pedals. I think that, as a country, we didn't see our houses as dot-com stocks until it was too late.

(Here's my alternate approach: owner-occupied REIT coops. Basically the ownership rights (when you move, what you can do to the property) remain with the owner-occupier of the house. But the capital gains are owned collectively by all participants in the co-op.

(The owner-occupier would be forced to hold a larger stake in his or her own property, perhaps a minimum of 20%, so that the owner has a strong interest in maintaining property value.)

This would allow home owners to spread market risk across geographically diverse areas and/or different market profiles, or even sell off market risk to outside investors who want to buy it.

Bob Vila Probably Picks His Own 401k

Why can't we all? With tax time approaching and the recent news about 401k abuses, a simple remedy occurs to me.

The fundamental problem with 401ks is that they provide the only outlet for someone to save 25% of their income for retirement with tax deferral. So your choice is: use the company's 401k (no matter how expensive, how lame the investment choices, and how much the kickbacks) or lose that tax-deferred savings vehicle entirely. (A traditional IRA pales in comparison, with its $4000 limit, plus if you're married the maximum income ceiling is relatively low.)

This isn't a problem for me - as a self-employed contractor, I get a SEP-IRA. I get all the savings of a 401k (up to 25%) but I can put it anywhere I please, shopping the market place for an IRA that has investment choices I like and isn't gummed up with fees.

So my proposal is greedy - it solves our problems but doesn't help savers who aren't
paying attention. Simply put:

• The IRS should allow savers to treat all employment income as eligible for a SEP-IRA as long as the tax payer opts out of his or her company 401k.
• Matching benefits would be paid to the employee for direct deposit into the SEP-IRA.
  

The tax treatments and infrastructure already exist! Consumers could vote against their company with their feet.

A Financial Mini-Rant

It's been a while since I've posted a financial rant on this blog, but we seem to be cursed with "interesting times"....a few random thoughts on the economy:

• Compared to 2001 the upcoming financial pain has to be worse. If there's any industry I'd want to be at the focus of a bubble-collapse-recession it'd be the computer industry; we're an industry with high growth and usually low unemployment; we bounced back. I think this time around, with housing hit hard it's going to be worse for more people with fewer options.
• I think the hopes of "decoupling" (the idea that the rest of the global economy will march on, allowing the US to quickly turn around via exports to strong foreign economies) will prove to be a fantasy. Over and over when finance gets ugly, everything moves together. Perhaps it is because there are so many positive feedback cycles. Read the downfall of LTCM - the experts are always surprised by "perfect storms".
  
• The stimulus package strikes me as a poor idea. We're in a jam because we've collectively borrowed and spent a lot of money we didn't have - the heart of this financial mess is about insolvency. So borrowing another $150 billion seems like a supremely poor idea. It's like our solution to maxing out our credit cards and getting a pink slip is to go apply for another credit card and immediately max that one out too. I don't know how the US will get over its debt addiction, but buying an eight-ball isn't the right approach.
• The financial system is parallelized by fear of counter-party risk, but I don't buy that we got anything useful out of the heavily engineered products that got us here. You could make some kind of argument about greater financial efficiency, but it looks to me like Wall Street invented a series of instruments whose primary feature was to make Wall Street rich. If we can't understand how to value these things, are they really helping us manage capital more efficiently?
• The recent bond-insurance melt-down shows a conflict of purpose to me. On one hand, insurance involves taking money now for services to be rendered later, so there's a lot to be said for your insurance company not going broke. On the other hand, if we don't let financial companies fall flat on their face when they do really stupid things, we introduce a moral hazard. The way to mediate this would have been more regulation - not letting any insurance company play with fire. (And frankly if we didn't have municipal bond insurance, the world would continue to turn. If Louisiana doesn't need bond insurance, no one does.)

Okay that's enough of that for now. I have to go hide my money under the mattress.

Bob Vila Would Not Eat Low-Carb Ice Cream

There is no experience as heart-breaking as coming home from Europe to the US and then eating. I have made this fall from food grace five times now, and it's painful every time. The five steps are:

1. Denial. The food in the US can't really be that bad, can it?
2. Anger. Why the hell is our entire country's food supply such a disaster. Why are there hormones in the milk? Why is their E Coli in the meat? Why doesnt' a tomato have any flavor any more? Why is it legal to sell a baked good that can go unrefrigerated for four years?*
   
3. Bargaining. So you make a plan - I'll make my own bread, I'll go to whole-foods, I'll give up Doritos, anything!
   
4. Depression. What's the point of eating?
   
5. Acceptance. Let's go to Taco Bel..

If you haven't been to France or Italy, here's what I have experienced: food is of better quality all the way up and down the spectrum. From the sandwich you buy on the street to a restaurant meal, the ingredients are better, the preparation is better, the experience is just better.

Now if I may tangent slightly, Lori and I made a really really good pizza the other day. The dough was made from scratch (thanks to our bread-maker this is really easy), cooked on stone, with caramelized onions and fresh Mozzarella, it was just a really good pizza.

But if you buy into the latest "healthy eating" trends in the US, what we did was not healthy because it's high in carbohydrates.

So here's my rant: back in the 70s, fat was the evil food. Americans ate a ton of processed food. So the food companies did their best to remove as much fat as possible from processed food. We kept eating processed food (now jam packed with carbohydrates) and we continued to get fat.

Then the Atkins diet gets all trendy*, and the processed food companies try to remove all carbs from processed foods, we keep eating processed foods, and we keep getting fat.

Perhaps we should just stop eating processed foods?

* I had a science teacher in 7th grade who took a Twinky, injected it with water from a local pond (read: water with a heavy concentration of microorganisms) and then left it on top of the blackboard on a shelf. Several years later he took a job in another state. Before he left, he unwrapped the Twinky and cut it in half. There was absolutely no sign of organic growth.

** I know many people who have lost weight from the Atkins diet. But the trend I see is that it really really disrupts your regular eating habits. I can't help but wonder to what extent the Atkins diet causes weight loss by either (1) lowering total caloric intake or (2) eliminating "empty" foods like processed snacks.

Pod-cast induced rants...

As I listen to pod-casts...

• We have a strange idea of what it is to be rich...our houses got more expensive, as did oil and gold and fuel and food...didn't the dollar just fall? Measuring the cost of living via consumer electronics is silly! I can't eat my iPod (not that I haven't tried).
• Yelling at China about how they "rig" their currency strikes me as disingenuous. You only need to have one multi-course dinner for two with a lot of beer for $3 in Beijing to realize that no adjustment in currency is going to undo the huge cost of labor advantage that China has. The RMB could go up 50% and we wouldn't get our factories back.
• Countries don't "rig" their currencies with willpower (ask South America). China has earned the right to do whatever they want with their currency by having about a gajillion billion trillion dollars in reserve. Having them release that reserve would be a lot worse than the "low" price of their currency is now. China does what they do via market muscle - if they didn't have the muscle to back it up, they'd get taken apart by speculators.

The deteriorating domestic opinion of our relationship with China is what worries me most. I think there's only two ways forward: the Chinese population consuming more, fueling growth and balancing trade deficits (and destroying the environment, plus they are not trending toward increased consumption) or we could have a trade war that would remove the largest potential upside for our local economy (exports to other growing economies) while making everything more expensive at the same time. Plus, who would we borrow money from?

Devil Puppy!

This year for Halloween CC dressed up as "Devil Puppy".



Here you can see her trying very hard to be good and not eat her costume. (But it's so tasty!)



Nala says: I do not trust Devil Puppy at all.

Furniture and Curtains

We have furniture!

These are a few pieces from the bedroom set. The bedroom was prety spotless when it was delivered, but no more.

Lori's parents came to visit and helped us put in the other set of curtains that my mother made - here they are in the new dining room. The room is not really that red, but with the sun setting the photo is a bit over-exposed. We also have new dining room furniture.



The sideboard and it's contents, mostly weddign leftovers.



Nala also got some furniture for her sun room...she likes to sleep on the chairs!

Honey, I zapped the Sox...

So I was watching Wakefield pitch knuckle balls in a scoreless game when I hit the cable TV wire with a dog toy while playing fetch. Sparks flew and the circuit blew...turns out that the junction box near the cable TV wires is held in by what might generously be described as metal clips (tinfoil seems more accurate) and the impact of the Kong flying ring with the cable TV wires next door bent a clip into a screw terminal, shorting the whole circuit.

Half an hour later, after finding the problem, unwelding the clip from the screw terminal and bending it back into place, we turned everything back on to discover Cleveland up 7. Apparently the clip wasn't the only thing that suffered a melt-down. :-(

Houston, we have FIOS

No matter how grumpy I was with Verizon I was about the complete slurry they made out of my order, I just can't stay angry while connected to the Internet with 2 Mbs of upload. (Compare to less than 400 Kbs with Comcast.) For my work we use CVS, and CVS has the design flaw^H^H^H^H^H^H^H^H^H^H charming property of uploading everything and letting the server do the real work - it is thus really sluggish on asymmetric home connections, and is a lot more usable with FIOS.

We also have a new DVR, sort of. Comcast and Verizon use the same dual-tuner Motorola DVR (I think it's the 6412), but the software is different. A comparison of the two (this is with Verizon's newly revised software):

• The layout and navigation of the Verizon DVR is a lot simpler. It's still not Tivo, but it's a lot closer.
• The Comcast software was a bit of a mess to use - it had a way of changing channels on you surprisingly, or asking you if you wanted to change channels in ways where the right answer wasn't obvious. The Verizon DVR will be a lot less surprising.
• On the other hand, the Comcast DVR provided access to both tuners for TV browsing...it wasn't easy to do, but you could have "history" on two shows at once. (This wasn't real useful - the Comcast DVR's tendency to drop live TV for recordings without warning means you lost your history a lot.)
• While the Verizon DVR doesn't provide both tuners for live TV "browsing" (a feature that's confusing at both), it also seems to lose your recording history after just about any operation, which is a bit annoying.

Overall I think for anyone who's not a programming nerd, the Verizon DVR provides a better interface - it comes closer to the princple of "least astonishment."

This Blog Has Gone to the Dogs...

...which I think is indicative of how much time we spend on the dog and how little we have to work on the house these days.

We don't know what breeds CC is (she's clearly a mix of something and, um, something else), and I think I don't want to know. There are breed specific behaviors and I'd be tempted to attribute at least some of her actions to genetics if I knew.

Now that is theoretically fine, since some of her actions probably are genetic, but in practice dogs learn, and they learn in ways we might not expect. It's easy for us to say "Rover is doing X because he's a Y" but perhaps Rover learned to do X...perhaps we taught him without realizing it.

CC had a behavior that I finally figured out (which says more about how stupid I am about dogs than about her behavior): she would dig a little in the lawn, grab a big chunk of grass in her mouth, and run like hell.

I finally realized, it's not somethign she's predisposed to, it's something she learned. Normally digging would involve trying to bury something, or digging in its own right (a 'play' behavior, one part of a normal sequence of behaviors taken out of sequence). I don't know if she learned it from her previous home and we reinforced it, or she learned it from us, but our attempt to stop this behavior (by moving toward her to reclaim the hole, yelling at her, or chasing her to attempt to get control of her) all reward what she's done. She figured out that the best way to ask her human friends to play a nice game of chase was to dig, eat the lawn, or both.

We have figured out something that does stop the behavior almost immediately: Lori and I say nothing, don't react, and simply walk into the house, closing the door behind us. She immediately drops what she's doing and comes to the door.

The moral of the story (besides "CC is bad for the lawn") is that social recognition is enough of a positive reward to encourage behaviors, and being told "no" is probably more fun than being told nothing. (And being chased after is really, really fun!) As we've internalized this (I would not have thought before getting a dog that yelling "no" at it would be a reward) it's changed how we manage problem behaviors, and helped us get CC under control.

As a final thought: sometimes dogs become anxious in the dog park, sometimes with merit, sometimes just because. The humans (owners and otherwise) almost always react the same way: "you poor thing", comfort the smaller, more fearful dog. But what is that smaller dog really learning? In mathematical terms...

big dog + anxiety = affection

Hrm...accidental operant conditioning...that's probably not what we want to teach our dogs.