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.

The price of petrol

Business Week looks at signs that petrol use may be responding to the increase in prices.
For 20 years now, county workers in Palm Beach County, Fla., have been counting cars with sensors at strategic points along its 4,000 miles of roads. Nearly every year traffic volume has climbed at least 2%. But in 2007 there was a slight decline in the number of vehicles on the roads. This year traffic is down 7.5% through March. "We're seeing a very significant change," says county engineer George Webb. "We're having a good time speculating why."

It's not just Palm Beach. Traffic levels are trending downward nationwide. Preliminary figures from the Federal Highway Administration show it falling 1.4% last year. Now, with nationwide gasoline prices having passed the inflation-adjusted record of $3.40 a gallon set back in 1981, the U.S. Energy Information Administration is predicting that gasoline consumption will actually fall 0.3% this year. That would be the first annual decline since 1991. Others believe the falloff in consumption is steeper than the government's numbers show. "Our canaries out there tell us they are seeing demand drop much more considerably than the fraction the EIA is talking about," says Tom Kloza, chief oil analyst at Oil Price Information Service, a Gaithersburg (Md.) market research firm.

Of course, it is unclear at this stage how much of this is a response to higher prices and how much is a response to weaker economic activity.

Negative equity

The FT looks at the risk of a rise in negative equity and concludes that because of the relatively modest offerings by banks and the lower proportion of first time borrowers, there will be less negative equity than there was in 1990.

This may come as a surprise, given the problems that banks have encountered following their profligacy at the height of the housing boom. But the reason is simple. Unlike in the late 1980s, they have sought to gain a competitive advantage by offering low mortgage rates, rather than by seeking to out-do each other by offering ever bigger mortgages as a proportion of a home's value.

Bank of England figures last published in 2005 show that in the late 1980s more than 40 per cent of all mortgages - for house purchase and remortgaging - had loan-to-value ratios of more than 90 per cent. In recent years that number has halved to about 20 per cent.

House purchases by first-time buyers, the group that tends to have by far the highest loan-to-value ratios, were also much lower. There were 750,000 in 2006 and 2007, compared with 1.04m in 1988 and 1989. Working out the strength of every mortgage in the UK is difficult.

There are no data on the exact number of mortgages outstanding, the initial price paid and the subsequent movement in house prices. But the FT estimates that 350,000, or 2.8 per cent, of people owning their own homes would succumb to negative equity if prices were to fall 10 per cent.

If prices fell 15 per cent, the FT's estimate is still that only 5 per cent of mortgagors - 2 per cent of all households - would be in negative equity.

Kate Barker, a member of the Bank's monetary policy committee, arrived at the same figure in a speech in February that was based on a Bank survey.

They are also in line with the figures published by some lenders in their annual accounts. HBOS, the country's largest mortgage lender, says only 4 per cent of its stock of loans has a loan-to-value ratio greater than 90 per cent, while Nationwide, another of the country's big four mortgage lenders, has only 1 per cent of its mortgage book in this category.

Gary Styles, strategy, risk and economics director of Hometrack, says that many scare stories about negative equity use figures that are "very inaccurate and far too high".

"Most of the largest lenders in the UK have very few customers with less than 10 per cent equity in their properties and several of the biggest players have only around 2 per cent of their existing mortgage customers with less than 10 per cent equity," he said.

De-leverage

The FT provides a good overview of the way that the de-leveraging in the banking system spreads out through the rest of the financial sector.

The most leveraged funds are now borrowing no more than five times their asset base, compared with 10 times their asset base just six months ago, according to fund of hedge fund managers. The move comes as banks withdraw from risk-taking to repair tattered balance sheets, and places strains on formally lucrative hedge fund relationships.

This will reduce returns (and risk).

Mergers and market power

Do mergers increase prices and allow the new combination to gain market power? A new study suggests that they do. Looking at some extreme cases where makers of substitute products got together, Orley Ashenfelter and Danniel Hosken report an increase of prices of between 3% and 7%. This does not look at long-term cost improvements that may be apparent or the effect of the development of new products. However, given the large-scale industries that are represented, it does suggest a substantial transfer from consumers to producers.

Buffett talks

Warren Buffett talks to students about EMH and regulation amongest othere topics.

The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. And (b) they can't pick stocks that are better than average. Stocks are a good thing to own over time. There's only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that's too much to expect. Of course, you shouldn't get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.

Exchanges and Silos

The FT looks at the LSE model which uses the market and external settlement. The contrast is the virticle silo that is favoured by Deutsche Bourse. Though the EU Commission appears to be in favour of competition, there are some signs that sentiment in the US is switching towards the integrated model. Those exchanges that are integrated, appear to enjoy higher valuations.

And around, and around....

Macro Man with an excellent look at the way financial crisis comes around again.

LTCM

The carry trade

Markus Brunnermeier, Stefan Nagel, Lasse Pedersen look at the carry trade.

Our findings...show theoretically that securities that speculators invest in have a positive average return and a negative skewness. The positive return is a premium for providing liquidity and the negative skewness arrises from an asymmetric response to fundamental shocks: shocks that lead to speculator losses are amplified when speculators hit funding constraints and unwind their positions, further depresing prices, increasing the funding problems, volatility, and margins, and so on. Conversely, shocks that lead to speculator gains are not amplified.