Good Reading -- August 2015
Charlie Munger: The Complete Investor -- This new book just arrived last week. It is not a biography but it is loaded with great Charlie Munger soundbites. I thought the layout of the book was a little tough to follow, and the heavy focus on Ben Graham and the "Graham value investing system" is somewhat odd. But anything about or involving Charlie Munger is worth a read and that's certainly the case here.
"Shaky Ground: The Strange Saga of the U.S. Mortgage Giants" -- Bethany McLean's new book on Fannie and Freddie, which will was scheduled to be released in September but may be shipping now. (I haven't read it yet.) See below for a recent op-ed on the topic.
A Short Course in Superforecasting -- Phil Tetlock discussing his work on forecasting and the Good Judgment Project, with none other than Danny Kahneman, among others, offering insights and experiences.
"The Really Big One" -- I'm no geologist, but I've always been curious as to why people focus on the San Andreas fault instead of the Cascadia subduction zone in the Northwest. To quote the article, "An earthquake will destroy a sizable portion of the coastal Northwest. The question is when. The next full-margin rupture of the Cascadia subduction zone will spell the worst natural disaster in the history of the continent...Our operating assumption is that everything west of Interstate 5 will be toast."
Longform podcast with Carol Loomis -- An hourlong conversation that I'd highly recommend.
"Charles Brandes and the Orthodoxy of Value Investing" -- A long profile in Institutional Investor that is worth reading, even if it's not always flattering and not always well written.
"Why the new SEC pay rule is the wrong way to fix CEO pay" -- This excellent column argues that inequality should be dealt with in the tax code, or otherwise by Congress, and is outside the realm of the SEC's role. I agree, and I'd add that Munger pointed out the ironic and unintended consequences of pay disclosure: envy.
Should Investors Bet on the Jockey or the Horse? -- This is an academic of how firms "evolve from early business plan to IPO to public company for 50 VC-financed companies." There are plenty of doubts to be raised, but it's worth a read. "The results suggest that, at the margin, investors in start-ups should place more weight on the business ('the horse') than on the management team ('the jockey')." [Thanks to Zhao for passing this along!]
Fannie and Freddie are Back, Bigger and Badder Than Ever -- Bethany McLean's op-ed in advance of her new book on the GSEs (due out this fall).
Kahneman: "What would I eliminate if I had a magic wand? Overconfidence." -- An interview with the great psychologist.
Fannie and Freddie are Back, Bigger and Badder Than Ever
By BETHANY McLEAN
JULY 20, 2015
AFTER the financial crisis of 2008, there was one thing that almost everyone agreed on. The government-sponsored mortgage giants, Fannie Mae and Freddie Mac, had to go. While shareholders and executives reaped the profits from Fannie and Freddie in good times, taxpayers were stuck with the bill in a crisis. President Obama described their dysfunctional business model as “Heads we win, tails you lose.” But here we are, seven years after the crisis, and nothing has changed.
Fannie Mae and Freddie Mac were meant to make it easier for Americans to buy their own homes. By buying up mortgages issued by other lenders, they enabled the lenders to make more loans. Fannie and Freddie could then package the payments that Americans made on their home mortgages into securities to sell to investors, from big bond funds to foreign central banks. In this way, a saver in China financed the purchase of a home in Kansas.
In many ways, the system worked beautifully. But Fannie and Freddie accrued tremendous power and wealth because of the primacy of housing at the center of the American dream, combined with the perception that these loans had the full backing of the United States government. They abused that perception. Executives paid themselves lavish salaries, and the companies, particularly Fannie, relentlessly lobbied Congress to keep their advantages and dodge regulations.
In the 2008 crisis, when it looked as if Fannie and Freddie might go bankrupt, Henry M. Paulson Jr., then the Treasury secretary, argued that their fall would cause economic catastrophe. Foreign investors, stuck with their securities, would panic, and the mortgage market would shut down. So Fannie and Freddie were put into something called conservatorship, and are now government controlled, supported by a line of credit from the Treasury.
Conservatorship was supposed to be temporary — a “time out,” according to Mr. Paulson. We were going to stabilize the companies’ finances, reduce their importance to the mortgage market, and figure out a better system. But nothing happened. In fact, the situation has gotten even more precarious. In the years since the crisis, private lenders, for the most part, have been willing to make mortgages if they can immediately sell them to government agencies, mainly Fannie and Freddie. In other words, without Fannie and Freddie, there wouldn’t be much of a mortgage market.
To make things worse, the government decided to “sweep” almost all the duo’s profits into its own coffers, to be used as a slush fund for general government expenses. As Treasury Secretary Jacob J. Lew said in congressional testimony this spring, “As a practical matter it’s what has helped us reduce our overall deficit.” If there is another downturn in the real estate market and Fannie and Freddie suffer losses on their some $5 trillion in outstanding securities, taxpayers will again have to foot the bill. Jim Parrott, a senior adviser with the National Economic Council in the Obama administration and now a fellow at the Urban Institute, wrote that the current system was “the worst of all worlds: It attracts too little private capital, provides too little mortgage credit, and still poses too much risk to the taxpayer.”
There has been one serious attempt to get rid of Fannie and Freddie, a bipartisan bill sponsored by Senators Bob Corker (Republican of Tennessee) and Mark Warner (Democrat of Virginia) that did not make it out of the Senate.
But is it really practical to kill Fannie and Freddie? We as a society want much of what they provide, which is relatively consistent access, through good times and bad, for a wide section of society, to a 30-year fixed-rate mortgage. Critics argued that the Corker-Warner plan would essentially turn the mortgage market over to the big banks, and lead to fewer loans at higher rates.
At a time of economic uncertainty, when income inequality is a major issue, it is also not a great thing for social cohesion to require those at the lower end of the income scale to start paying far higher rates for their mortgages than those at the upper end, which most analysts agree would be the case if purely private capital financed the mortgage market.
If we can’t do any better, isn’t it time to fix what we have and ease Fannie and Freddie out of conservatorship? The first step is to stop sending all their dividends to the Treasury. That would allow them to start rebuilding capital, eventually to a level substantially higher than what they were allowed to operate with before the crisis. Then, let’s devise a tighter regulatory structure, one that limits the businesses in which Fannie and Freddie can operate, limits the incentives of their management teams to take risk, and limits their ability to lobby. We could cap the returns to shareholders, as utilities do.
Franklin D. Raines, Fannie’s former chief executive, suggests structuring them like mutual insurance companies, which are owned by their policyholders, who would in this case be homeowners, rather than shareholders. A guarantee fund, modeled after the Federal Deposit Insurance Corporation, could support the companies in times of stress as the F.D.I.C. does banks. It would not be perfect. But if the alternative is doing nothing, it’s a whole lot better than that.
Bethany McLean is the co-author of “The Smartest Guys in the Room” and author of the forthcoming book “Shaky Ground: The Strange Saga of the U.S. Mortgage Giants.”
Daniel Kahneman: ‘What would I eliminate if I had a magic wand? Overconfidence’
The psychologist and bestselling author of Thinking, Fast and Slow reveals his new research and talks about prejudice, fleeing the Nazis, and how to hold an effective meeting
‘Organisations are essentially factories for making decision’ … Daniel Kahneman.
David Shariatmadari Saturday 18 July 201504.00 EDT
Daniel Kahneman is the very definition of unassuming: a small, softly spoken man in his 80s, his face and manners mild, his demeanour that of a cautious observer rather than someone who calls the shots. We meet in a quiet spot off the lobby of a London hotel. Even then I have trouble catching every word; his accent hovers between French and Israeli and his delivery is quiet, imbued with a slightly strained patience, helpful but cautious.
And yet this is a man whose experimental findings have shifted our understanding of thought on its axis – someone described by Steven Pinker as “the world’s most influential living psychologist”. With his long-time collaborator Amos Tversky, who died in 1996, he delineated the biases that warp our judgment, from figuring out if we can trust a prospective babysitter to buying and selling shares. In 2002 he was awarded the Nobel prize in economics, a testament to the boundary-busting nature of his research.
His 2011 book, Thinking, Fast and Slow, a primer on a career’s worth of psychological inquiry, won the US National Academy of Sciences book award, and the enthusiastic approval of his peers. It tells the story of “two systems” of thought, one automatic and intuitive, the realm of systematic biases, the other conscious and deliberative. It is a challenging work, clearly written but stuffed even so with difficult problems and counter-intuitive explanations. Despite that, it has sold millions of copies around the world. Nassim Nicholas Taleb, professor of risk engineering and author of The Black Swan, places it “in the same league asThe Wealth of Nations by Adam Smith and The Interpretation of Dreams by Sigmund Freud”.
What’s fascinating is that Kahneman’s work explicitly swims against the current of human thought. Not even he believes that the various flaws that bedevil decision-making can be successfully corrected. The most damaging of these is overconfidence: the kind of optimism that leads governments to believe that wars are quickly winnable and capital projects will come in on budget despite statistics predicting exactly the opposite. It is the bias he says he would most like to eliminate if he had a magic wand. But it “is built so deeply into the structure of the mind that you couldn’t change it without changing many other things”.
The same applies to our habit of predicting stereotypical outcomes at the expense of what’s known about the world. When told of a student, Tom, who has a preference for neat and tidy systems and a penchant for sci-fi, most of us guess that he’s studying computer sciences and not a humanities subject. This is despite the fact that the group studying the latter is far larger. “Think of it this way. A form of stereotyping is involved in understanding the world. So I have a stereotype of a table, I have a stereotype of chairs. Now when you start having stereotypes of social groups, it’s the human mind at work. It’s not a different mind. It’s what you need to get around in the world.” You can slow down and become aware of this, Kahneman believes, but the underlying mechanism isn’t going to change.
That tendency to stereotype social groups has affected Kahneman’s own life, in dramatic fashion. Born in Tel Aviv, to Lithuanian Jewish parents, he spent his early years in France. They lived there comfortably until the German invasion. His father, who worked for a company owned by L’Oreal, was arrested during an antisemitic roundup and taken to the internment camp at Drancy. “I remember visiting,” Kahneman tells me. “I was seven. You couldn’t get in of course, but there were lots of people at the windows – men and lots of women and children. And there was a French policeman and I still have that image of him telling us that they’re hungry in there, they’re eating vegetable peelings.” Thankfully, his father was so popular with his employers that after six weeks they arranged for him to return home, the occasion for another vivid memory. “My mother knew that her husband would be released and she and I – we were living in Neuilly, just outside the main part of Paris – went out shopping. We came back, and my father was there, wearing his best suit. He weighed 45 kilos. He was just skin and bones, but he hadn’t eaten: he was waiting for us. There was considerable dignity in that.”
As the occupation wore on the family was nevertheless forced to flee to Juan-les-Pins on the Côte d’Azur. But after the allies landed in north Africa the Germans took over the south, initiating a “very dark period”. Kahneman began to pray for his life. “I knew that God was extremely busy, so I wasn’t going to demand too much. But I was asking for one day at a time. That’s what it felt like. It felt like being hunted. We had the mentality of rabbits.” Moving from one village to another, making their way to the centre of France, they ended up living in a converted chicken coop. It was there that Kahneman’s father, who was diabetic, suffered a stroke and died, just six weeks before D-day. Another image sticks in his mind. “It was very, very cold in winter, and I remember my mother in full mourning with a veil and with an axe in her hand, breaking wood.” Still, he denies that the experience was traumatic. “It’s nothing compared with other Jewish stories. I was never really hungry, I never saw real violence. There was a lot of resilience.”
Soon afterwards, his life changed completely. France was liberated, and then, in 1946, the family moved to Palestine. Kahneman had been an intellectual child and he thrived in his new home, ending up some years later with a bachelor’s degree in psychology, conducting personality tests for prospective army officers.
As an Israeli, there at the very birth of the nation, Kahneman has had a front-row seat in one of the most vivid theatres of human misunderstanding. His work has much to say about prejudice, the inability to fully recognise alternative points of view and our strong aversion to losses, which considerably outweighs the satisfaction we get from gains. Can he explain why, in this area, it’s been so hard to achieve a meeting of minds?
“I’m far on the left of the spectrum in Israeli politics and always have been,” he says. “I hated the notion of occupation since the very beginning. My first memories from after the 67 war are travelling with my children in the occupied territories. There were awnings over groceries stores with Hebrew lettering advertising Osem noodles. I couldn’t bear it. I thought that was dreadful because I remembered German lettering in France. I have very strong feelings about Israel as an occupier.”
Despite this, Kahneman has found it impossible to envisage a settlement that will satisfy both sides. “I don’t believe in the power of rational argument in this context,” he says, with an air of resignation. He mentions one occasion when he was visited at his university by a Palestinian academic after 67. They were getting on famously. But then “we tried to negotiate peace, and we failed, essentially on the right of return, which although obviously a legitimate demand among the Palestinians, means the destruction of Israel. So people who don’t want Israel destroyed cannot accept the right of return, even though they might understand that it has legitimacy behind it.”
In general, Kahneman is downbeat about the capacity of his brand of psychology to effect change in the world. I imagine he would simply argue he’s a realist about human nature. And, indeed, studies showing that “skilled” analysts are hopeless at predicting the price of shares have yet to translate into mass sackings or even reduced bonuses on Wall Street or in the City. The same goes for evidence that the influence of a high-quality CEO on the performance of a company is barely greater than chance.
But there are more modest ways his insights can help us avoid making mistakes. He advises, for example, that meetings start with participants writing down their ideas about the issue at hand before anyone speaks. That way, the halo effect – whereby the concerns raised first and most assertively dominate the discussion – can be mitigated, and a range of views considered. Then there is the concept of adversarial collaboration, an attempt to do away with pointless academic feuding. Though he doesn’t like to think in terms of leaving a legacy, it’s one thing he says he hopes to be remembered for. In the early 2000s Kahneman sought out a leading opponent of his view that so-called expert judgments were frequently flawed. Gary Klein’s research focused on the ability of professionals such as firefighters to make intuitive but highly skilled judgments in difficult circumstances. “We spent five or six years trying to figure out the boundary, where he’s right, where I am right. And that was a very satisfying experience. We wrote a paper entitled ‘A Failure to Disagree’”.
Kahneman’s finely tuned ability to detect the biases in the thinking of others hasn’t, of course, released him from the cage of his own nature. He is a pessimist, “a worrier”, “not a jolly person”. But, despite this, he says, “I’m quite capable of great enjoyment, and I’ve had a great life.” His friendships – notably with Tversky, his academic soulmate, and behavioural economist Richard Thaler, have been long and fruitful. He has been married since 1978 to the perceptual psychologist Anne Treisman, and has two children. When I ask about them, he explains, matter of factly, that his son is schizophrenic. “He would have been a very brilliant economist.” His daughter is now “successful in hi-tech”.
Despite his sadness over his son, and all the other inevitable trials of life, it’s possible to regard Kahneman as a living, breathing counterargument to his theory of pervasive overconfidence. Who, after all, would have looked at the Jewish boy in the chicken coop in occupied France and predicted his survival, let alone his many accomplishments? Or the transition from respected academic to intellectual superstar? Yet popular recognition, which has come late in his career, was never his primary aim. “I had limited ambitions, I didn’t aspire to great success. I was very hardworking, but I didn’t expect to be a famous psychologist.”
The next problem on his list is “noise”, or random variability: the fact that different people in the same situation make very different judgments. Random error is a very different phenomenon from the systematic biases he’s been studying for several decades. It’s the kind of error you can’t reliably predict. Noise, he says, applies to people approving loans, to underwriters, to radiologists. One worker might be more optimistic than another, say, and it becomes difficult to ensure uniformity. “Mood is noxious. Noise is costly to organisations, which are essentially factories for making decisions. If another underwriter had seen that case he would put a different premium on it …” It’s even worse, presumably, in the case of a radiologist examining a scan for signs of cancer. Kahneman is interested in looking at how to increase the consistency of operations – not the same, he explains, as controlling biases. It sounds like a new and fascinating chapter. And when he decides to write it, one thing is now certain – he can count on millions of readers.