How Thinking Costs You

Michael S Rosenwald gives an overview of behavioural bias as he looks at how Thinking Costs You:

"Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors"

Collective price discrimination

The FT looks at the possible competition case against banks charging for loan protection.

One banker said: “Personal loan rates have been uneconomic for a while. Rates are likely to go up if PPI is sold separately.”

Bankers expect the commission to argue in its provisional investigation findings – due to be published early next month – that PPI is uncompetitive because customers typically buy it only from the bank where they took out the loan.

Despite industry lobbying, the commission will stick close to its provisional conclusion this year that banks selling the insurance are earning as much as £1.5bn a year above a reasonable rate of return by selling to buyers who are in effect a captive market.

The market for PPI – which covers loan-holders if they become ill or lose their jobs – is worth about £5.5bn a year. The Office of Fair Trading said last year that banks were loading cheap loans with expensive insurance policies.

One competition lawyer who acts for a bank said the commission had concluded that banks were in effect “getting people through the door, quoting them a very low price [for a loan] then selling them something else”.

Looks like a case of price discrimination. Those that will stand up to the hard-sale ("what if you lose your job?" etc) will get the cheap loan, others pay up.

American Idol

Freakonomics: look at the ways that voting on American Idol can be predicted. There is a lot here about information and the way that it can be used in trading.

"But there are many other ways to predict who would win. TiVo has experimented with using data from 20,000 random anonymous subscribers to find out when viewers fast-forward or re-watch particular contestants. Neat idea, but so far they have had a much lower success rate than DialIdol.Instead of looking at phone and television behavior, you can also try to make predictions from Internet behavior. Apple might look at iTunes downloads of the contestant songs. Or you could use Google Trends to see which contestant name has been searched more often. David Cook rules by this method as well:"

Scarcity of safe assets

Richard Kline looks at the way that the scarcity of safe assets (with US budget surplus and demand for Treasuries from China) contributed to the increased securitisation of debt.

Thus an unheard of budget surplus together with major new Treasury buyers indicated that the asset basis for large-volume transactions in the US was going to contract sharply, putting pressure on top tier banks and bank-like entities to find the next best alternative, and fast. These were . . . securitized GSE instruments. Which as slightly less favorable assets carried slightly more charming rates. It was this experience which in many ways set the feet of large US financials on the slippery slope of asset backed security speculation. Thus an event structurally possible within the US financial system, but of very low probability (hadn't happened since your grandfather was younger than your children are now, and wasn't intended to happen at all), refocused major capital flows at the top of the system. With disastrous near term results as we now see. That the budget surplus appears to have been largely generated by capital gains thrown off by the dot.com equities bubble, and so not sustainable not to say illusory, is secondary since the effect of the surplus on the system as a whole was real at the time.

This is one aspect of financial crisis that has not been much remarked upon. If there is scarcity, the price will rise and the financial system will seek to provide an alternative or substitute.

China in Africa

Edward Miguel looks at developments in Africa. One part is the increased presence of Chinese firms. He says.

"Why have Chinese individuals and firms dived in when European and U.S. investors have largely shied away? In discussions with Chinese investors, it seems the key motive is simple: profit. Africa provides bountiful profit opportunities across multiple economic sectors for Chinese firms flush with cash from their boundless growth at home. Chinese investors also have a major advantage over their Western counterparts in that they know how to make money in a developing–country business environment where the rule of law is optional, corruption and bribery are the norm, and infrastructure is patchy. Their experiences at home give them a big leg up on the competition."

Creative destruction

Michael Perelman looks at Schumpeter and Stolper.

I did find that one of these economists, David A. Wells, a name well known at Harvard, did clearly anticipate the theory of creative destruction (see Perelman 1995, p. 192). For Wells, the measure of success of an invention is the extent to which it can destroy capital values. He offered as an example “[t]he notable destruction or great impairment in the value of ships consequent upon the opening of the [Suez] Canal” (Wells 1889, p. 30). Wells asserted that each generation of ships becomes obsolete in a decade. From here, he concluded, “nothing marks more clearly the rate of material progress than the rapidity with which that which is old and has been considered wealth is destroyed by the results of new inventions and discoveries” (Ibid., p. 31).

Peak Whale

The Oil Drum looks at the price response to the over-Whaling of 19th Century.

Emotion and trading

Via Yves Smith some new research on investments and emotions, suggesting that people get too close to their investments.

Visiting Professor David Tuckett, UCL Psychoanalysis Unit, says: “Feelings and unconscious ‘phantasies’ are important; it is not simply a question of being rational when trading. The market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

It appears that bubbles are caused by people acting like they do when they are first in love. They concentate on the good things and completely ignore the bad things. When the bubble bursts, there is the opposite taking place

Reputation

The British Bankers' Association struggles with the recent hit to their reputation. As Arthur Anderson, LIFFE, Enron and Bear Stearns found, vital support can swiftly disappear. The FT reports.

Leverage

Some indication of the scale and effect of leverage comes from this Report in the FT highlighting the problems at a bond trading hedge fund EMF.

In the US Treasuries market banks are usually willing to lend money to investors with zero “haircut”, meaning they will lend the full purchase price, because of the safety of the US government and typically tiny daily price moves. But last month banks began to demand borrowers put up a margin, albeit a small one, in an indication of their desperation to reduce lending, the same problem that took down Bear.

The scale of borrowing on Treasuries is eye-popping: EMF, for example, started the year with leverage of 37 times its then assets of $294m, almost $11bn, not unusual for a Treasuries book. By the end of March it had reduced this to 25 times assets, according to a letter to investors.

The de-leverage selling of assets continues to unsettle markets.

Regulation of finance

Avinash Persaud looks at some ways to improve the regulation of finance.

The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.