Good news on the corporate-bully front: Hertz, which was behaving abominably towards Audit Integrity, has utterly caved, dropping its libel suit on the grounds that it was “not worth pursuing now”. Or, one assumes, ever again. A small but important victory for freedom of speech in the financial markets.
Fama and French have a very long blog entry (over 5,000 words) about the latest version of their paper on mutual fund returns. As you might expect from research sponsored by an index-fund company, it shows that active mutual-fund managers fail to outperform the market. But at least it does so with pretty charts.
Here’s what happens when you compare actual before-fees returns from mutual-fund managers (the blue line) with what you’d expect if no managers had any skill at all, and the returns were simply distributed by chance (the red line).
On the left hand side of the chart, you see actual fund managers significantly underperforming what you’d expect by luck alone. On the right hand side, however, it seems that if you’re skilled at manager selection, there is a glimmer of hope that you might find a little bit of alpha. Not a lot, but something statistically significant.
Unfortunately, all that alpha — and then some — gets eaten away by fees. Here’s the chart for after-fees returns:
The red line, remember, is the distribution of returns you’d expect if all mutual-fund managers had an alpha of zero. The blue line is actual returns. Fama and French conclude:
For the vast majority of actively managed funds, true α is probably negative; that is, the fund managers do not have enough skill to produce risk adjusted expected returns that cover their costs.
Which comes as no surprise, but it’s still good to see some relatively solid empirics here. Anybody wanting to make an intellectually-credible case in favor of investing in actively-managed mutual funds is going to have to attack this paper head-on.
If a home is not an investment, what about a Treasury bond? In my comments, Dan responds forcefully to Urban Legend, who was trying to make the case that low interest rates do a lot of harm to those poor millionaires looking to live on their risk-free interest payments alone:
If you think it is reasonable to get a 5% return on top of inflation without taking risk, I have some oceanfront property in Nevada to sell you. That may have been possible in the past, but we are in a new world now.
Investing is not about loaning your funds out to a government, completely abdicating responsibility for finding meaningful uses for the capital and then expecting a substantial return above inflation. Our governments are nearly bankrupt.
If you lend to a nearly bankrupt and profligate entity, you deserve to lose a lot of money. You are like a bartender serving a drunk who is drinking himself to death. You are not innocent. You are part of the problem, and your investments are making the world worse. You don’t deserve a good return for that.
How to invest? If you really want risk fee, go for TIPs, but don’t expect much beyond inflation. Better yet, learn basics of business and investing and carefully loan out to local small businesses. Or be a landlord, watching your profit and dividends every month. Or invest in important and useful companies via the stockmarket. Or invest in making your house energy efficient. Or invest in your childrens’ and grandchildrens’ educations. Or donate it for research to invest in everyone’s future.
Whine about the Fed if you want. Your treasury buys make all these games possible.
I just made a significant investment in Apple, but I didn’t touch the stock: instead, my house now sports two brand-new computers, and already the returns on those computers are proving higher than I’d anticipated. (Although if you’re in NYC and are willing to trade knowledge of Mac OS X Server for good food and wine, I think I have a deal for you.)
There are lots of ways to invest well, and most of them don’t involve buying securities which rise in value. I often feel that stock-picker types are missing the point, rather — especially nowadays, when the future of the capital markets has never been cloudier.
If you really want to play a game where the person with the best-performing stock portfolio wins, then fine. But other kinds of investing, like for instance Dan’s idea of providing much-needed funds for a small local business, can be more rewarding in other ways. The world of securitization and capital markets turns out not to have been nearly as good at capital allocation as most of us thought it was. So maybe we should go back to making our own real-world investment decisions, rather than trusting in the markets to get it right.
Ryan Grim gets a great quote out of Treasury today, trying to explain why they’re pushing to allow banks to open branches in any state they like, despite the opposition of small banks, individual states, and Barney Frank:
“This eliminates a difference between thrifts and banks. While banks are subject to these limits, thrifts are not,” said Treasury spokeswoman Meg Reilly. “Although we are proposing to eliminate the thrift charter, this is an important step towards increased competition in banking and will reduce costs for consumers.”
One might think that eliminating the thrift charter would probably in and of itself do all that needs to be done in terms of eliminating the difference between thrifts and banks. But obviously not at Treasury. Instead, they seem to believe that allowing big banks in where they have previously been disallowed “will reduce costs for consumers”.
But big banks — and big thrifts — have been expanding across state lines for many years now. Is there any empirical evidence whatsoever that when that happens, costs for consumers go down? ‘Cos looking at the amount of money that banks are making in fee income, I’d doubt it.
It seems the housing speculators are back, and Daniel Indiviglio is joining their ranks, now that mortgage rates are back at record lows. “If you’re in the market for a home as a long-term investment, say at least 10-15 years, it’s pretty hard to make an argument against buying now,” he says.
It’s hard to know what to make of this. Some people are looking to buy a home — that’s understandable, given that everybody needs shelter. And some people are looking to invest money with a long-term time horizon. And some people even fall into both categories at once. But that’s no reason to desperately try to conflate the two, and to describe yourself as being “in the market for a home as a long-term investment”.
It bears repeating: homes aren’t investments, they’re places to live. If you can buy a nice house for less than you’d otherwise pay in rent, then go ahead and buy — no matter what the market looks like, or where mortgage rates are. On the other hand, if you’re looking for an “investment”, stick to securities. You can sell those much more easily when you need some money, and they won’t drive you into possible bankruptcy and homelessness if they go down rather than up.
In any event, low mortgage rates are if anything a reason not to buy: after all, the best way to make a lot of money in the housing market is generally to buy when rates are high and sell when rates are low. If rates rise from here that will keep a lid on prices, and if they fall then there’s no particular reason to buy now.
Some people have a strong emotional need to buy a house, and those people will always be able to find themselves some kind of good reason why they should Buy Now. But if you’re genuinely on the fence about whether to buy or not, then looking at mortgage rates isn’t going to be nearly as useful as looking at local rental rates, and their possible future course. Right now is one of those rare times when prevailing rents might actually fall rather than rise — in which case the rent vs buy calculator is likely to tip even further into “rent” territory. If it signals a “buy”, and you have the money to purchase a house, that’s great. Just make sure you’re happy with the house qua house, and you’re not kidding yourself that you’re making an “investment”.
Back in April, Willem Buiter called Citigroup “a conglomeration of worst-practice from across the financial spectrum”; he followed up in June with a blog post entitled “Too big to fail is too big“, in which he likened Citi’s former chairman and CEO, Win Bischoff, to Ayatollah Ali Khamenei. Which maybe explains why there’s no quote from Buiter himself in the press release announcing his arrival at Citigroup. Maybe they just thought it would be better to have him inside the tent pissing out.
Willem Buiter is joining Citigroup as its chief economist. It’s an important role — so important, in fact, that Buiter should be able to demand that he be allowed to continue to write his rather fabulous blog, either in its current location at the FT or else somewhere on citigroup.com. A widely-read and widely-respected blog is a useful tool for any economist to have, and Citi should be encouraging Buiter to keep his.
The first thing to jump out from the list is that just 5 of the 30 companies are American, and none of the six insurers: the likes of Mizuho, Intesa and Aviva are considered systemically important, while, say, Wells Fargo isn’t. (It’s not clear what the status of AIG is. Maybe it can’t be too big to fail if it’s already failed.)
The second thing of note is that there’s not much in the way of BRICs here, or even emerging-market institutions in general. Two of the four UK groups — Standard Chartered and HSBC — are about as close as it comes; there’s no Chinese bank on the list at all. Never mind all the chatter over Dubai: emerging markets are still very much the victims of financial meltdown, rather than the cause of it.
Finally, why is it only European insurers who make the cut? Two of them are Swiss; the others (Axa, Aegon, Allianz, and Aviva) are generally considered French, Dutch, German, and English respectively. What’s Berkshire Hathaway, chopped liver?
Only about one-fourth of homeowner defaults are strategic, with the other three-fourths triggered by job losses, divorce or other financial difficulties, which when combined with negative equity give homeowners no option but to let go of their homes. In other words, for the vast majority of homeowners, negative equity is a necessary but not a sufficient condition for default… Though more than 32% of U.S. homeowners were underwater on their mortgages by the end of the second quarter of 2009, the strategic default rate was roughly 3%.
Not all property owners behave like this, of course, and the best example right now of an underwater property owner walking away from his obligations is that of Sheikh Mohammed bin Rashid al-Maktoum. As Willem Buiter explains,
The shareholder (the al-Maktoum family aka the government of Dubai) will decide on ordinary commercial principles whether to provide additional financial support to these companies.
If the shareholder of Dubai World and of Nakheel believes that a further capital injection makes commercial sense, it will inject additional capital (assuming it can find the financial resources to do so). If, as I suspect is the case with Nakheel, the company is so deep under water that injecting additional shareholder capital would be throwing good money after bad, the company will not be financially supported by the shareholder. That’s how financial capitalism works.
Except, of course, that’s not how financial capitalism works in the US. Here’s White:
Luigi Guiso, Paola Sapienza, and Luigi Zingales found that 81% of homeowners believe that it is immoral to default on a mortgage, and that homeowners who hold this attitude are 77% less likely to declare their intention to default than those who do not. Indeed, once the equity shortfall exceeds 10% of a home’s value, the study found that “moral and social considerations” are the “most important variables predicting strategic default.” So strong are these variables, in fact, that only 17% of homeowners indicted that they would default if the equity shortfall reached 50%…
Moreover, foreclosure rates are considerably lower than would be suggested by the Guiso, Sapienza, and Zingales study, as the percentage of people who actually default is much lower than the percentage that indicated they would default in the survey, moral qualms or not.
White goes on to enumerate an astonishingly long list of institutions, up to and including the president himself, which are speaking with a single voice on this question, and saying that paying an underwater mortgage in full is the morally correct thing to do. Hank Paulson did it, despite the fact that he would have fired anyone at Goldman who behaved similarly; Neil Cavuto likened people who walk away from their mortgages to people who would have “quit” and handed over Europe to the Nazis.
Even Gail Cunningham, of the National Foundation for Credit Counseling, declared in an interview on NPR that “Walking away from one’s home should be the absolute last resort. However desperate a situation might become for a homeowner, that does not relieve us of our responsibilities.” If you’re thinking of walking away, you’ll almost certainly do so while overcoming enormous feelings of guilt. And where there’s guilt, there’s belief in dire consequences:
Most people simply do not believe they will escape punishment for their moral transgressions. Guilt and fear of punishment go together. Thus, the notion that one will suffer great consequences for walking away from one’s financial obligations not only seems possible, but feels quite right. It just can’t be that one can walk away from their mortgage with no significant consequence. As such, people rarely question apocalyptic descriptions of foreclosure’s consequences.
The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world’s largest-ever guilt trip on any borrower who might think about joining them in that world. It’s asymmetrical, it’s unfair, and it’s about time that homeowners started being informed that a ding to their credit score is not the end of the world; that no one would expect a capitalist company to behave in the way that individuals are being told to behave; and that their options are in fact broader than they might believe. White’s paper is the perfect place for them to start their reading.
Most people, if they’ve hired a legendary fund manager on a multi-million-dollar salary to look after investments and liquidity, would listen to the advice of that person. But most people aren’t Larry Summers:
It happened at least once a year, every year. In a roomful of a dozen Harvard University financial officials, Jack Meyer, the hugely successful head of Harvard’s endowment, and Lawrence Summers, then the school’s president, would face off in a heated debate. The topic: cash and how the university was managing – or mismanaging – its basic operating funds.
Through the first half of this decade, Meyer repeatedly warned Summers and other Harvard officials that the school was being too aggressive with billions of dollars in cash, according to people present for the discussions, investing almost all of it with the endowment’s risky mix of stocks, bonds, hedge funds, and private equity. Meyer’s successor, Mohamed El-Erian, would later sound the same warnings to Summers, and to Harvard financial staff and board members.
“Mohamed was having a heart attack,’’ said one former financial executive, who spoke on the condition of anonymity for fear of angering Harvard and Summers. He considered the cash investment a “doubling up’’ of the university’s investment risk.
But the warnings fell on deaf ears.
Summers, amazingly, wanted to invest 100% of the university’s cash in the endowment, and had to be talked down to investing a mere 80%. No wonder Meyer and El-Erian tried to talk him out of it: the Harvard endowment was never designed as a place to invest sums of cash which might be needed immediately. Instead, it’s designed to invest for the very long term, taking advantage of the higher returns on illiquid investments.
Summers was playing a high-risk carry-trade game with Harvard’s cash:
The aggressive investment of cash accounts is part of how the university has long run its “central bank,’’ an account that holds funds from its various schools and pays them a modest US Treasury rate of return. The “bank,’’ in turn, has invested the lion’s share of that money with the endowment, generating returns that are used to pay for shared needs, like graduate housing and financial aid.
No one had the stones to stand up to Summers when it came to this high-risk strategy of essentially borrowing at Treasury rates and investing the proceeds in an illiquid long-term endowment — certainly not James Rothenberg, Harvard’s part-time, unpaid, California-based treasurer.
After Summers left, sheer inertia took over, and nothing happened — maybe because El-Erian was soon on his way out as well. The result was that the university ended up losing 27% of its $6 billion in “cash”: a whopping $1.8 billion. There’s no indication, of course, of any kind of apology from Summers.
Update: Brad DeLong, in the comments, does some back-of-the-envelope math and reckons that Harvard came out ahead of the game, on net, even after accounting for that $1.8 billion loss. But that’s exactly the difference between a long-term endowment, on the one hand, and a “cash account”, on the other. If you have money in a cash account, you spend it. And money you’re spending should be liquid, not tied up in an endowment which can drop 27% in one year.