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Good Reading -- February 2010

Happy Friday. Hope everyone is doing well.


  1. "Airline pilot protocols in finance" -- Another phenomenal article from Atul Gawande. I'm reading his new book, The Checklist Manifesto, and it is excellent. And no, I'm not getting kick-backs.

  2. "The Thinking that IQ Tests Miss" -- a great and very important article about the surprisingly low correlation between IQs and rationality. It also has ome interesting mental tests with fascinating implications. The article is fairly brief but the book on the topic from the same author, What Intelligence Tests Miss: The Psychology of Rational Thought, looks good too.

  3. "Reported Earnings vs. 'Owner Earnings'" by John Hussman -- This is not necessarily an outright market forecast from the author* or and it's definitely not one from me (since you already know I don't do that), but nonetheless some very worthwhile thoughts here: "Presently, stocks remain richly valued on the basis of normalized earnings, book values, dividends, revenues and other metrics. Investors now rely on the renewed attainment of bubble valuations in order to achieve acceptable returns. If you keep one thing in mind during the current earnings season, it should be that operating earnings significantly overestimate what Warren Buffett would refer to as "owner earnings" - the actual amounts that are paid out or retained for the benefit of shareholders. Again, stocks are nothing but a claim to the long-term stream of cash flows that will actually be delivered to investors over time. Everything else is hype, smoke and mirrors."

* I would take the "Market Climate" section with an especially large grain of salt

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  1. An interview with Richard Thaler regarding a range of interesting and timely topics.

  2. "The Mysterious Ways of Fannie and Freddie" -- the GSEs are responsible for the single biggest destruction of wealth in the history of the world, and they are clearly one of the biggest ongoing scandals in American history. (Before the housing bubble even started, remember the accounting fraud a few short years ago?) So I'm always shocked that they don't get more attention and scorn, but this ever shameless behavior from the GSEs' creator -- Congress -- isn't as surprising. More background here and below in #4.

  3. Robert Monks on (Lack of) Corporate Governance

  4. "Obama's $6.3 Trillion Scam is America's Shame" -- this isn't meant as a political rant, but it does continue to harp on the Greatest Destroyers of Wealth in the History of the World, otherwise known as Fannie Mae and Freddie Mac.

January 21, 2010

Interview with Richard Thaler

Posted by John Cassidy

This is the eighth in a series of interviews with Chicago School economists. Read “After the Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers only.)

Thaler, one of the founders of behavioral economics, was out of town when I visited Chicago. I subsequently caught up with him on the phone, and I began by asking him what remained of the efficient-markets hypothesis, which he has long questioned.

Thaler: Well, I always stress that there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that. My own view is that you can [beat the market] but it is difficult.

The question of whether asset prices get things right is where there is a lot of dispute. Gene [Fama] doesn’t like to talk about that much, but it’s crucial from a policy point of view. We had two enormous bubbles in the last decade, with massive consequences for the allocation of resources.

When I spoke to Fama, he said he didn’t know what a bubble is—he doesn’t even like the term.

I think we know what a bubble is. It’s not that we can predict bubbles—if we could we would be rich. But we can certainly have a bubble warning system. You can look at things like price-to-earnings ratios, and price-to-rent ratios. These were telling stories, and the story they seemed to be telling was true.

So what are the policy implications? What should the government do to prevent bubbles from inflating, in the housing market, for example?

Several things. I think Fannie Mae and Freddie Mac should raise lending requirements in certain areas that look frothy. God did not say that you should be able to borrow one hundred percent of the price of a house.

What was the ultimate cause of the financial crisis? Poor regulation? Greed? Bad market signals? Human frailty?

Leverage caused the crisis—and I would say that is a pretty uncontroversial statement. Human frailty comes into play at two levels. One, the people who were taking out the subprime mortgage loans—many of them didn’t understand what they were doing. Two, the C.E.O.s clearly didn’t understand what their traders were doing. I call that the “dumb principal” problem. Go down the list—A.I.G., Citigroup, Bear Stearns, Lehman Brothers. These companies were destroyed or devastated by a small part of the firm that was hurtling forward and was risking the entire firm. The people in charge were either greedy or stupid, or possibly both.

What about the rational-expectations hypothesis, another Chicago theory? What’s left of that one?

(Laughs) Is there anybody who really believes in Ricardian equivalence? That’s a preposterous idea. I wonder if you can find anyone, other than, possibly, [John] Cochrane and [Robert] Barro, who has made the calculation as to what impact government spending will have on their future taxes and bequests. People don’t act “as if” they were doing that either. They are ignoring it.

I spoke to Cochrane. He said the problem with behavioral economics is it is too flexible—you can use it to explain anything. He also pointed out that Robert Shiller has been calling for economics to incorporate psychological insights for thirty years, but little progress has been made.

[In answering this question, Thaler brought up the Internet stock bubble, during which shares in Palm, the handheld computing companies, were worth more than the entire market capitalization of Palm’s parent company, 3Com.]

[Cochrane] has a model explaining why, during the Internet bubble, the prices of Palm and 3Com were rational. Rational models are one hundred per cent flexible. If you allow time-varying discount rates, there is no discipline whatsoever. If you look at what happened to tech stocks and then to real estate, and you say maybe there wasn’t a bubble—where is the discipline in that?

I think it’s fair to say that behavioral economics hasn’t solved everything. That is true. But to say Shiller and I have been doing it for thirty years—there was just me and him. Now we have some young recruits. We are not outmanned a thousand to one. But there is work to do.

Do you think the financial crisis will come to be seen as a watershed for behavioral economics—a moment it became mainstream, or even dominant?

I think it is seen as a watershed, but we have had a lot of watersheds. October 1987 was a watershed. The Internet stock bubble was a watershed. Now we have had another one. What is the old line—that science progresses funeral by funeral? Nobody changes their mind.

What will happen is that the economists [in their thirties and forties] are pretty open to these ideas. They don’t think it is very controversial. That’s where economics will be in ten years. They will be running the subject. People like Posner and Becker and Fama and Lucas and I—we will be history.

But you don’t think the financial crisis and recession will cause an intellectual revolution in economics, as happened in the nineteen-thirties?

No. Nothing will happen fast. But the next generation of economists, it is safe to say, will be more open to alternative models of human behavior and less confident that markets work perfectly.

Do you think that Chicago economics of the old school has lost some of its swagger?

No, I don’t see any measurable loss of swagger. Posner goes against the grain. He’s probably the counterexample to the theory that nobody learns anything. Becker and Lucas and so on—that group probably thinks he has lost his mind.

That brings us to the Keynesian revival, and to the dispute about the Obama Administration’s stimulus package. What are your views on that?

The General Theory—anybody who goes back and reads that book can’t help but be impressed. It contains so many insights, including many that anticipated behavioral finance. As for the stimulus, I don’t know where we would be now if there hadn’t been a stimulus package.

Back to Chicago matters. You say you don’t see much less swagger, but I hear that there has been a lot of internal discussion, and debate, about what happened. Is that not true?

Yes. There has been a ton of discussion in the lunchroom. For six months, it was the only thing anybody could talk about. The thing I will say about my colleagues is that they were very engaged by what was going on. The good thing I will say about the Chicago School is that it was always about the world, not about the abstract. That continues. People like Kevin Murphy just want to understand how the world works.

The tradition of Chicago price theory is a good one, and it is a low-tech methodology that tries to apply simple economic theory to the world. [Steve] Levitt is a perfect illustration of that. In some ways, I, too, can fit into that definition of the Chicago School.

The Mysterious Ways Of Fannie And Freddie

by Johan Norberg

Johan Norberg is a senior fellow at the Cato Institute and author of the new book, Financial Fiasco: How America's Infatuation with Home Ownership and Easy Money Created the Economic Crisis.

This article appeared on on January 15, 2010.

The Financial Crisis Inquiry Commission has started its work with a highly publicized two-day hearing in Washington, D.C. The Commission is supposed to find out what caused the financial crisis, but it seems like they are trying to enact Hamlet without the Prince of Denmark. Among all the bankers and regulators on stage during the hearings, there was not a single representative of the government-sponsored mortgage giants, Fannie Mae and Freddie Mac, which were major causes of the housing bubble.

The reason for the omission is disturbingly obvious. When Congress created the Commission they wanted a crisis narrative of greedy bankers and passive regulators. In other words, they wanted to put the blame somewhere else. Fannie Mae and Freddie Mac are creatures of Congress and it was Congress that pushed them to undermine underwriting standards and increase lending to low-income households while stalling reform.

Fannie and Freddie regularly let members of Congress announce large housing developments for low-income earners in exchange for political and financial support; over the past decade the two GSEs spent almost $200 million on lobbying and contributions to both parties, but most of all to Democrats, the present majority. Politicians wanted scapegoats on stage--Fannie and Freddie representatives would have functioned as a mirror.

Fannie and Freddie had an implicit government guarantee that made it possible for them to borrow cheaper than other financial institutions, and with those thousands of billions of dollars they bought mortgages from primary lenders, so that these got their money back and could lend even more to other prospective homebuyers.

In 2004, almost at the peak of the bubble, the Bush administration increased the ambitious targets for GSE lending of the Clinton Administration. It said that within four years, 56% of Fannie's and Freddie's mortgages should go to low-income households and 28% of the mortgages to those with a "very-low income." In plain English this means households that could not afford that mortgage the moment the interest rate returned to a more realistic level. The only thing we ever heard from Congress were demands to increase lending even more aggressively.

Fannie Mae and Freddie Mac pioneered securitization of mortgages, whereby they re-packaged loans and sold them to investors. Increased political pressure to serve low-income households meant that they soon began to buy mortgage-backed securities on an enormous scale themselves. After 2004 the market could make almost any kind of loans, knowing that the government-sponsored enterprises would buy them. About 40% of the loans were junk. "We didn't really know what we were buying," admits a former director at Fannie Mae.

Investment bankers have been publicly scolded by the Commission for taking on so much risk, with leverage ratios around 30 to 1. Shouldn't they ask how Fannie Mae and Freddie Mac ended up with a leverage ratio closer to 60 to 1?

As a result of their losses, Fannie and Freddie blew up in September 2008 and were in effect nationalized. The Treasury Department implemented $200 billion caps on government aid to each company, which have just been removed. The worst consequence of removing caps is not potential cost of hundreds of billions to taxpayer, but the effect on the rest of the market. The GSEs showed Wall Street that subprime lending was encouraged by the government; they made it profitable for lenders to make bad loans to sell them; and they pushed up house prices by opening up the market for owning homes to people who had previously rented.

The Financial Crisis Inquiry Commission couldn't care less. Granted, government-sponsored enterprises are mentioned in the 21st of 22 areas of inquiry for the Commission, but even there it is an afterthought: "financial institutions" in general is the object of study in No 21. And, as previously mentioned, no representative from Fannie or Freddie was invited to the hearing.

Today, former executives at the two GSEs say that the firms made so many bad loans because Congress constantly leaned on them to buy more mortgages from low-income borrowers. It is no surprise that Congress does not want anyone to hear that message. But it makes a mockery of their pretention to examine all possible causes of the crisis in an even-handed and objective way.

A former GSE employee recently said, self-critically: "It didn't take a lot of sophistication to notice what was happening to the quality of the loans. Anybody could have seen it. But nobody on the outside was even questioning us about it."

Apparently the outside world still isn't.

Robert Monks on (Lack of) Corporate Governance

Corporate governance is a subject attracting much rhetoric and little change. With governance failures responsible in large part for corporate disasters, new and old, we find Robert Monks' commentary on the subject, and his efforts to change the status quo, a beacon of hope. Shareholder activist and corporate governance advisor Robert Monks recently gave a speech at Harvard Law School about the state of corporate governance. The entire speech was recorded (including the Q&A with students). Please click here to view the video.

We found the following passages from Mr. Monks' speech especially illuminating:

  • Three quarters of registered shareholders are fiduciary institutions.

  • We can no longer blindly accept the received wisdom as to the roles and responsibilities of owners, directors and CEOs. Categories simply do not perform as advertised.

  • It is naïve to think and act as if the current arrangement of power is not satisfactory to many who hold it. Our efforts will be a struggle for reallocation of that power.

  • The core problem has been the disappearance of any practical or legal respect for the fiduciary standards that ensure a beneficiary of the loyal competence of the person responsible for managing his property. We have tolerated conflicts of interest throughout the commercial system with the result of enriching service providers and impoverishing beneficiaries. Worse, this regulatory neglect has placed the conscientious fiduciary at a competitive disadvantage.

  • Is there genuine commitment to an ownership based governance system? [It must be said that no such commitment exists at present.] This commitment will need be made by government. If so:

  • There must be effective enforcement of existing law so as to require fiduciaries to take appropriate action to protect and enhance the value of portfolio securities, and

  • There must be arrangement for financing “activism” either as an appropriate corporate expense or as a designated portion of the investment management fees.

  • Peter Drucker has long raised the question as to whether the current standard of board functioning is so unsatisfactory as to require structural change. - “Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years it is futile to blame men. It is the institution that malfunctions.” In the years subsequent to Drucker’s characterization, the inability of any portion of the governance structure to deal effectively with holding top management to account - the “smoking gun” being executive compensation - compels the conclusion of continuing systemic board failure. If the shareholder cannot hold the CEO accountable for his compensation, he has no right to assume that he exercises effective accountability in any other area.

Obama’s $6.3 Trillion Scam Is America’s Shame

Commentary by Jonathan Weil

Feb. 4 (Bloomberg) -- Look through President Barack Obama’s proposed 2011 budget, and you’ll see a line calling for a $235 million increase in the Justice Department’s funding to fight financial fraud. Lucky for them, the people who wrote the budget can’t be prosecuted for cooking the government’s books.

Whether on Wall Street or in Washington, the biggest frauds often are the perfectly legal ones hidden in broad daylight. And in terms of dollars, it would be hard to top the accounting scam that Obama’s budget wonks are trying to pull off now.

The ploy here is simple. They are keeping Fannie Mae and Freddie Mac off the government’s balance sheet and out of the federal budget, along with their $1.6 trillion of corporate debt and $4.7 trillion of mortgage obligations.

Never mind that the White House budget director, Peter Orszag, in September 2008 said Fannie and Freddie should be included. That was when he was director of the Congressional Budget Office and the two government-backed mortgage financiers had just been seized by the Treasury Department.

The White House is already forecasting a $1.3 trillion budget deficit for 2011, which is about $3 of spending for every $2 of government receipts. By all outward appearances, it seems Obama and his budget wizards decided that including the liabilities at Fannie and Freddie would be too much reality for the world to handle. So they left the companies out, in a trick worthy of Enron’s playbook, except not quite so hidden.

New Beginning

While the president had nothing to do with the mortgage zombies’ collapse, this was supposed to be the administration that, in his words, would put an end to “the era of irresponsibility in Washington.” Instead, he has provided us a new beginning.

Fannie and Freddie aren’t merely wards of the state. Practically speaking, they are the entire U.S. housing market. Their liabilities are the government’s liabilities. As Orszag said at a Sept. 9, 2008, news conference, two days after Fannie and Freddie were seized: “The degree of control exercised by the federal government over these entities is so strong that the best treatment is to incorporate them into the federal budget.”

That control is stronger today. Congress and the Treasury have given the companies a blank check to blow through whatever taxpayer money is necessary to keep the U.S. housing market afloat. Anyone buying large quantities of U.S. government bonds knows these liabilities exist. So why pretend they don’t?

Making Fudge

Obama’s White House didn’t invent this kind of fudging. President George W. Bush, for example, kept most war costs out of the budget. Obama’s proposal shows about $289 billion of war costs for 2010 and 2011, plus a $50 billion placeholder estimate for each year after that. Those dollars are small compared with the numbers at Fannie and Freddie, though.

Without federal backing, the mortgage guarantees issued by Fannie and Freddie might not be worth much. In that case, the $973 billion of mortgage-backed securities held by the Federal Reserve would be worth substantially less, rendering its $52 billion capital cushion illusory. Of course, it’s ridiculous to think the government would let this happen.

Excluding Fannie and Freddie, the national debt held by the public is about $7.9 trillion. With them, it exceeds last year’s $13.2 trillion gross domestic product. Even the geniuses at Moody’s Investors Service are warning that the country’s AAA rating might not last. No country can owe more than its yearly productive output for long without giving up its accustomed lifestyle and influence.

Catching On

The nation’s debt has become so immense that it’s corroding the government’s fundamental relationship with its own people. Put yourself in the shoes of a young couple thinking of buying their first home. The government needs folks like them to buy into the market to keep demand for houses up.

Yet without all the trillions of dollars of subsidies the government has pumped into housing, home prices would get creamed even worse than they already have, spurring greater loan defaults and saddling the Treasury with ever-higher costs from the guarantees Fannie and Freddie sold. What’s sickening is that the government can’t afford the subsidies. Suddenly, that $8,000 tax credit for first-time homebuyers looks like a nasty teaser aimed at sucking America’s newlyweds into a giant Ponzi scheme.

Worst of all is the example the government is setting for its citizenry. There still have been no indictments of senior executives at any of the big financial institutions that cratered in 2008 while sporting pristine balance sheets. No wonder. The government lacks moral standing to prosecute crimes such as accounting fraud when its own books lack integrity.

And how does Orszag explain his about-face on including the government-sponsored enterprises in the federal budget? Here’s the response I got in an e-mail from Kenneth Baer, a spokesman for the White House Office of Management and Budget: “The relationship between the GSEs and the federal government is in flux. Until it is settled, it would be too disruptive to change how they are accounted for in the budget.”

That didn’t answer my question. (Are we supposed to believe the relationship wasn’t “in flux” in September 2008 after Fannie and Freddie got seized?) So I asked again. Baer replied: “Our statement is our statement.”

It speaks volumes, too, confirming what we otherwise could only surmise: They don’t have a good explanation.

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