Opinion

Felix Salmon

Taleb and Feyerabend

Felix Salmon
Jul 21, 2009 02:17 UTC

Back in March, Scott Locklin’s second-ever blog entry was a takedown of my Wired article which ended with this:

I’ll be fine until someone sends me another piece of nonsense by Nassim Taleb, at which point, as my favorite wrestler, the Iron Sheik likes to say, “I will make him humble; old country way.”

Happily, that day has now come, and Locklin’s screed against Taleb makes for delicious reading. Among his vocabulary: clowns; impostures; mush headed absurdity; Berkeley tapwater; careen; chicken entrails and pixie dust; utile; dyspepsia; serfs; mountebanks; and “heretical alpha monkey of the quants”.

Substantively, Locklin makes a very astute comparison:

Taleb, on the other hand, is sort of the Paul Feyerabend of quantitative finance. Like Feyerabend, he is well read, a good writer and quite charming. Like Feyerabend, Taleb seems to earn his daily bread by showing up and being kind of witty. Finally, both Feyerabend and Taleb are very much Against Method. This means, effectively, they’re both intellectual nihilists. Feyerabend thought we couldn’t know anything for various reasons too silly to get into right now. Taleb thinks all of quantitative finance is nonsense and we should do away with quants.

I’m a fan of Feyerabend, which is maybe why I’m a fan of Taleb as well: both of them force us to carefully examine things we believe mainly because clever and successful experts tell us that they’re true. And I haven’t asked Taleb about this, but I suspect that he wouldn’t be very upset to be called “the Paul Feyerabend of quantitative finance”. Certainly the two share an interest in thinking big.

Locklin ends his blog entry by saying that a successful quant like Jim Simons is “making money more or less proving people like Taleb wrong”. To use Locklin’s own analogy, that’s like saying that a successful physics experiment more or less proves Feyerabend wrong. Which given that Feyerabend was a successful physicist before he became a philosopher, is a bit weird.

It’s perfectly possible to spend a lifetime in science without ever having to grapple with or worry about Feyerabend’s philosophy — just as it’s perfectly possible to spend a lifetime in finance without expending any time on Taleb’s arguments. Many of those scientists and financiers will be very successful. But for those of us who want to take a step back and re-examine the foundations of science, or finance, then grappling with Feyerabend and Taleb is I think a useful and illuminating thing to do.

Update: Taleb emails to say he considers himself closer to Hayek than to Feyerabend.

COMMENT

I wrote the following comment on Scott Locklin’s critique of your post on the Gaussian copula, and it’s currently awaiting moderation.
I found your blog post because Felix Salmon, who certainly lives up to his first name, cheerfully provided a link to it in his own blog post of July 21, 2009. Here, you said, “The problem is, houses cost too much because money was too cheap. That’s the financial crisis in one line. It’s not any more complicated than that….” Did I not already have other information and some critical acumen of my own, I might have read your hand-wavy explanation and gone away flattered that I’m among the enlightened.

Assuming that we know what it means for money to be too cheap, that we know when it is too cheap, and that on the given occasion it really was, we’re still faced with the circumstance that housing suffered a bubble this time, while tulip bulbs and companies trading in South America were more or less spared the insane run-up. We must also try to account for the circumstance that house prices didn’t rise at all uniformally across the United States, as one learns from even a little time spent examining the histories of the twenty cities in the Case-Shiller index. Moreover, in order to accept your opinion that “cheap money” was the cause of the housing bubble, we have to assume that hand-wavy quantitative financial analysts, complacent risk managers, authors of legal restrictions on land use, and supposedly powerful members of Congress such as Barney Frank and Chris Dodd are all actually non-causal. So I do think the matter is more complicated than that. Oddly, for one who is so sensitive to others’ simplifications, it appears you may even have made a habit of simplifying. Consider that in this same blog post, you gave us the formula for popular science-writing, then immediately allowed that Isaac Asimov had a much different way of going about it.

Monday links only think that they’re interesting

Felix Salmon
Jul 20, 2009 16:26 UTC

Gladwell on overconfidence: a reprise of his May speech.

  “Greg Mankiw is just about the least interesting economics blogger out there.”  

Pepper spray in ATMs — what could possibly go wrong?

The decline of Google, Barbie edition

“Two of my friends vehemently declared the rice not al dente enough, which caused me to become irate.”

The cost of parking in cities around the world. Interesting utter lack of correlation between daily and montly rates.

COMMENT

Mankiw is a political hack, but he is better on that account than Krugman. Care to skewer him?

Posted by Jake | Report as abusive

Financial innovation

Felix Salmon
Jul 20, 2009 15:51 UTC

In my blog entry this morning about Robert Shiller and his bonkers defense of subprime mortgages, I made an en passant reference to financial innovation being, net-net, a bad thing. I didn’t go into too much detail, because it wasn’t all that relevant to the point at hand, and because, as Sean Matthews pointed out, this question has been debated in the blogosphere in some depth in the recent past.

But Tyler Cowen picked up on the line, and wrote:

I can understand that particular financial innovations might be bad, but financial innovation overall? Surely this claim was false in years 1200, 1900, and also 1950. (Of course you’ll find very harmful financial explosions between those years and the current day but still on net you’ll take the progress.) If the U.S. economy resumes growing at an average rate of about two percent a year, eventually our economy will look very, very different than it does today. It’s hard for me to see running the economy of 2100 with the banking system of…what is the nostalgic year? 1992? 1957?

We’ll need more than better ATMs, which is not to say we need approve of every step along the way.

I think that the case for the positive effects of financial innovation is yes pretty strong if you roll back the clock to 1200 or 1900 or 1950. But over the past 25 years or so, the claim is much harder to make stick.

As for banking systems, Tyler I think concedes that there’s an important distinction which needs to be made here. On the one hand, there’s what you might generally lump into back-office functions — the distribution, clearing, and settlement of exchange. ATMs, charge cards, debit cards, PayPal, online banking, m-banking, etc all fall into this bucket, and advances here are often (although not always) a good thing.

Then there’s the more purely financial innovation. There are good things here too — fractional reserve banking, factoring, common-stock limited-liability companies, tradable fungible bonds, stock-market index funds, that sort of thing. But on this front I think the low-hanging fruit was plucked decades if not centuries ago, and that we’ve long since entered a world of diminishing returns when it comes to the positive developments. Meanwhile, the negative developments, from portfolio insurance to CDO-squareds, have been arriving at an ever-accelerating pace.

I agree with Justin Fox:

I’m with Tyler in that I’d rather have today’s financial system, however flawed it is, than the financial system of 1200. But at the same time, an estimated 97.3% of all financial innovations (I just made that up, but it seems about right) are just new ways to fleece customers or hide risk, and all major financial crises have been associated with some financial innovation or another.

The point is that we’re not in 1200, or 1900, or even 1950. And if you look at how fast the US economy managed to grow in the 50s and 60s without the benefit of Black-Scholes or the Gaussian copula function — or, for that matter, how fast the Chinese economy has grown of late with very strict fetters on financial activities — it looks very much as though most of the financial innovation in recent decades constitutes a history of increasingly-desperate attempts to eke out returns in the context of a naturally-slowing economy. And that history, I think, is doomed to failure.

So yes, in 2100 I’m sure that checks and credit cards — hell, maybe even cash, too — are going to be a thing of the past. But all that falls under the general rubric of “better ATMs”. Are we going to need more than that to run the 22nd-Century economy? I’m not convinced. And even if we do, there’s no reason why we can’t get there from here slowly, and with circumspection.

COMMENT

As noted earlier, modeling prepayment options on both fixed-rate or adjustable-rate mortgage loans is not a futile exercise. In fact, most in the mortgage finance field would contend the greater good provided by examining in-the-money refi behavior, for one example.

Or, we can just yearn for the days of a 15% fixed-rate home loan with 20% down. The good old days of 3-6-3…

Posted by Griff | Report as abusive

CIT kicks the ball down the road

Felix Salmon
Jul 20, 2009 10:03 UTC

What are the chances of this CIT deal actually preventing a bankruptcy filing, rather than just delaying it for a few months? At first glance, it would seem that the chances are good: why else would bondholders throw $3 billion of good money after the bad money they’ve already invested? But at second glance it’s not so simple: that $3 billion in new funding not only carries a double-digit interest rate, but is also secured by a whopping $10 billion in assets.

Consider the $1.1 billion of CIT debt which is coming due in August. Those bonds were changing hands last week at an extremely steep discount, which means that many of the current bondholders bought them at 50 or 30 or even 10 cents on the dollar. For those bondholders, this deal is a no-brainer. They’re advancing CIT enough money to pay off the August bonds in full, which means that they get to double their initial investment right there. They’re getting more than 10% interest on the money they’re lending. And they’re massively overcollateralized on that money, too, which means that their recovery given default is almost certain to be 100%. Add it all up, and you’re looking at a very high return for very little risk.

So where does that leave CIT? For one thing, it leaves the lender with no unpledged assets at all, which is not a position any financial institution likes to be in. But more to the point, the $3 billion is going to run out very quickly, some time in the first quarter.

Over the rest of this year, CIT is going to have to embark upon a series of debt-for-equity or debt-for-debt swaps, all designed to take out a huge chunk of those monster first-quarter maturities and allow the company time to start making money again. But it’s not clear why CIT’s bondholders would particularly want new equity or longer-maturity debt. And the one asset which Jeffrey Peek had to play with until this weekend — those $10 billion in unpledged assets — is now spoken for.

This deal makes sense for the lenders, then, and at worst delays the inevitable for CIT. But it’s still far from clear that the private sector is capable of putting together a lasting solution to the problem of a leveraged financial institution facing a massive liquidity crisis.

COMMENT

“For one thing, it leaves the lender with no unpledged assets at all, which is not a position any financial institution likes to be in.”

Is that really the way the deal is structured? I’ve heard differently. The Reuters article just says the new financing is backed by “unsecuritized” assets that probably exceeded $10bn. Unsecuritized assets are much different than unsecured assets, and saying that the financing is backed by unsecuritized assets isn’t very helpful, because CIT obviously can’t pledge assets they already securitized.

Posted by Mark | Report as abusive

Shiller tries to defend subprime mortgages

Felix Salmon
Jul 20, 2009 03:10 UTC

Robert Shiller thinks that creating a Consumer Financial Protection Agency “seems a good idea”, but is also a fan of financial innovation:

Our financial system has essentially exploded, with financial innovations like collateralized debt obligations, credit default swaps and subprime mortgages giving rise in the past few years to abuses that culminated in disasters in many sectors of the economy.

We need to invent our way out of these hazards…

The subprime mortgage is an example of a recent invention that offered benefits and risks… the higher rates compensated lenders for higher default rates. And the prepayment penalties made sure that people whose credit improved couldn’t just refinance somewhere else at a lower rate, thus leaving the lenders stuck with the rest, including those whose credit had worsened.

We need consumer products that people can use properly, and if this is what “plain vanilla” means, that’s a good thing. But we also need financial innovation.

This is the point at which I want to do my Jon-Stewart-rubbing-his-eyes act: Shiller really has just written a column defending “financial innovation” and using, as his sole example of a good financial innovation, the subprime mortgage.

Shiller seems to think that the best response to harmful financial innovations like CDOs is even more financial innovation, to reverse the damage initially caused. Wouldn’t it be better just to scale back the amount of financial innovation we had in the first place? Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years.

And Shiller’s defense of subprime mortgages is unbelievably weak. He never comes close to addressing the point that a huge proportion of subprime mortgages were sold to people who could have qualified for a prime mortgage; and his attempted defense of prepayment penalties is utterly bonkers. People prepaid subprime mortgages for three main reasons: (a) because their house had gone up in value and they wanted to do a cash-out refinance; (b) because they were selling their house; and (c) because interest rates had fallen since they took out their mortgage. The number of people who wanted to prepay a subprime mortgage because their credit had improved was negligible.

In fact, as Shiller knows but won’t admit, prepayment penalties were a profit center for subprime lenders — a way of squeezing money out of borrowers at the end of the relationship as well as at the beginning. If this is financial innovation, I want much less of it, thanks for asking. And while I agree that the CFPA “should be staffed by people who know finance and its intricacies”. I just don’t think they should start from the assumption that financial innovation is a good thing.

COMMENT

The foreclosure rate in the third quarter rose by almost 30 % as compared to that in the second quarter. Even though the government is trying to come up with feasible solution to the problems of distressed homeowners, with a good number of loans due to resent by mid of year 2008, the foreclosure rates are expected to remain high. Thus housing market is expected to remain slump throughout next year and even in early 2009.
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Best Mortgages

Posted by biju005 | Report as abusive

Right-to-rent gets more traction

Felix Salmon
Jul 20, 2009 02:39 UTC

Obama administration officials are now going on the record when it comes to what I’ve been calling the Baker-Samwick proposal but which Dean Baker has now much more pithily rechristened the right-to-rent plan:

A top Treasury Department official told a Senate panel yesterday that the government is considering a proposal to allow homeowners to stay in their home as renters after a foreclosure…

“It’s certainly an idea we’re thinking about,” Herbert M. Allison, assistant secretary for financial stability, told the Senate Banking Committee.

The idea was first floated by Dean Baker in August 2007; Andrew Samwick signed on, from the other end of the political spectrum, almost immediately. (Contra Joe Nocera, this idea was not “first broached” by Dan Alpert in October 2008; the Alpert plan is needlessly complicated, and involves giving away to homeowners a valuable option to repurchase their homes which is neither necessary nor desirable.)

It’s worth noting that the right-to-rent plan is very different from the existing Fannie Mae plan which allows homeowners to rent their homes on a month-to-month basis, if they give up their cash-for-keys option whereby they get paid for moving out. Renting month-to-month is not a happy state of affairs: your landlord can kick you out of your home at any time. It’s easy to see why most homeowners would prefer cash up front for moving now. Under right-to-rent, by contrast, the homeowner can stay in the home for at least five years, if not ten.

In an ideal world, banks which foreclosed on homeowners would then sell those homes to professional landlords, who would rent the houses out in perpetuity, either to the former homeowner or to renters who moved in after the homeowners moved out. That would raise the amount of rented housing in the US, and decrease the homeownership rate — and lower homeownership means lower unemployment. This plan isn’t just good for soon-to-be-foreclosed-upon homeowners, it’s good for employment, too!

COMMENT

American Homeowner Preservation(www.ahphelp.com) offers a program in which investors purchase homes on short sales from underwater homeowners and then provide the selling families affordable 5-year leases and favorable 5-year recorded options to repurchase. There is no cost to the homeowners or taxpayers, and most of the short sale savings are passed on to the familes – for instance, if they owe $100,000 on a home now worth $50,000, and AHP’s investor purchases for $40,000, then the family will have option to repurchase at $46,000 – 52,000. This provides incentive for families to stay, pay and repurchase; gives lenders prompt cash dispositions on troubled loans; and reduces blight caused by additional vacant bank-owned homes pockmarking neighborhoods.

American Homeowner Preservation is an active functional program which is helping homeowners now, and has already provided long term solutions to many at-risk families.

Posted by JorgeN | Report as abusive

How debt becomes equity, REIT edition

Felix Salmon
Jul 20, 2009 01:21 UTC

Phil Wahba and Ilaina Jonas report:

Several large investment firms are creating new lending companies that plan to go public to raise billions of dollars to take advantage of the distress in the commercial real estate market, and more are on the horizon.

The planned IPOs, which include units of firms like Apollo Management and Alliance Bernstein, could be just the beginning of what some bankers expect to be a boom in Real Estate Investment Trusts (REITs) going public over the next few years.

The U.S. commercial real estate market has been reeling ever since a prime source of financing, the commercial mortgage-backed securities (CMBS) market, virtually closed and banks shut off their lending spigots in the past year.

Essentially what’s happening here is that debt (in the form of CMBS) is being rolled over into equity (in the form of REITs). This is a good thing, and I hope we see much more of it.

This is a two-stage process, I think: first the REITs will buy up distressed CMBS at a discount, then they will wait for those CMBS to default, at which time the REITs will take possession of the collateral — the commercial real-estate securing the CMBS. In other words, the REITs — and the REIT investors — aren’t looking at yields, they are looking at property values.

It’s an open question, of course, how much leverage these new REITs will be able to use, and also whether the kind of institutional investors who used to invest in CMBS will ever have any interest investing in REITs instead. But I hope that the answers are “very little” and “yes” respectively. It’s a good idea for an investor to accept a bit of short-term equity market volatility if it means losing a lot of long-term tail risk.

COMMENT

Essentially what’s happening here is that debt (in the form of CMBS) is being rolled over into equity (in the form of REITs). This is a good thing, and I hope we see much more of it.

Posted by David hogard | Report as abusive

Abolish the FSA!

Felix Salmon
Jul 20, 2009 01:03 UTC

There should be as few financial regulators as possible, and they should be as powerful as possible. So this is a good idea, I think:

Conservative leader David Cameron will abolish the Financial Services Authority and give its powers to the Bank of England if his party wins the next general election.

The beefed up central bank would monitor the health of the financial system, setting capital requirements and leverage limits, and police individual lenders. A Financial Policy Committee would be established with the same stature as the bank’s existing interest rate-setting Monetary Policy Committee.

Having strong regulators is obviously not a sufficient condition for preventing financial crises, but it is a necessary condition. Everybody thought that the FSA was a strong “super-regulator”, of course. But further consolidation can’t hurt.

COMMENT

If you spread it out, you have more bits for offending parties to capture. While one super-regulator can be an improvement, many small regulators can be better in other cases (the various conflicts between state AGs and the never-to-be-cursed-enough OCC and OTS come to mind)

Posted by Jason | Report as abusive

Blogging magazine articles

Felix Salmon
Jul 20, 2009 00:25 UTC

Yvette Kantrow has a truly astonishing parenthetical in her peculiar piece on the CJR, Goldman Sachs, and Matt Taibbi:

Audit writer Ryan Chittum said his site’s silence had nothing to do with Goldman but everything to do with the fact that Rolling Stone was slow to put the entire Taibbi piece online. (It was a complaint lodged by many bloggers, who apparently did not want to shell out $5.95 at the newsstand. How sad for magazines.)

Chittum is more than capable of defending himself on the merits. But where on earth does Kantrow get the idea that financial bloggers should be perfectly happy to pay $5.95 to read Taibbi’s article on paper?

I get a lot of stuff sent to me, for free, which is normally behind some kind of subscription firewall: controlled-circulation magazines, research reports, paysite passwords, that sort of thing. I very rarely blog any of it, because I feel like an idiot blogging something which my readers can’t read. (For that reason, I try to link to WSJ articles via Google, to minimize the chances of my readers running into a firewall.)

So, yes, Chittum could have gone out and spent $6 on the paper version of Taibbi’s article. But then what would he have done? He’s a blogger, and you can’t link from your blog to a magazine sitting on your bedside table. What’s more, when you blog an article you generally want to quote from it, which is always much easier when you can copy-and-paste.

It’s entirely reasonable, then, for bloggers in general, and Chittum in particular, to wait until there was an easy and legitimate way for readers to read the article before blogging it. A blog without a hyperlink is a sad and sorry thing, and most decent bloggers will try pretty hard to avoid writing such a thing.

(Incidentally, both Kantrow and Chittum truncate their RSS feeds. Come on, people! Get with the program!)

COMMENT

Have you ever heard of a magazine called uncensored? It has really good articles in it, but I could only find a subscription for 4 a year and like 70 dollars

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