Opinion

Felix Salmon

Annals of dubious research, 401(k) loan-default edition

Felix Salmon
Aug 13, 2012 05:13 UTC

Bob Litan, formerly of the Kauffman Foundation and the Brookings Institution, has recently taken up a new job as director of research for Bloomberg Government, where he’s going to have to be transparent and impartial. But one of his last gigs before moving to Bloomberg — a paper on the subject of people borrowing money from their 401(k) accounts — was neither of those things.

To understand what’s going on here, first check out Jessica Toonkel’s article from Friday about Tod Ruble and his company, Custodia.

Tod Ruble is trying to sell retirement plan insurance that employers say they do not want and their employees may not need.

But the Dallas-based veteran commercial real estate investor is not letting that stop him. Since late 2010, he has started up a company, Custodia Financial, and spent more than $1 million pushing for legislation that would allow companies to automatically enroll employees who borrow from their 401(k) plans in insurance that could cost hundreds of dollars a year.

Once you’ve read that, go back and check out a spate of stories that hit a series of major news outlets in July. Alan Farnham of ABC News, for instance, ran a story under the headline “401(k) Loan Defaults Skyrocket”:

A new study estimates that such defaults might total $37 billion a year, a sharp increase from 2007, when defaults totaled only $665 million.

Similarly, check out Walter Hamilton, in the Chicago Tribune (and LA Times): the headline there is “Defaults on 401(k) loans reach $37 billion a year”. At Time, Dan Kadlec also ran with the $37 billion number, saying that “the default rate on these loans has skyrocketed since the recession”. Similar stories came from Blake Ellis at CNN Money (“Loan defaults drain $37 billion from 401(k)s each year”), Mitch Tuchman at MarketRiders (“401k Loan Default Time Bomb Is Ticking”), and many others.

The only hint of skepticism came from Barbara Whelehan at BankRate. She noted that the study cited Kevin Smart, CFO of Custodia Financial, as a source — and she also noted that “it would be a boon for the insurance industry to get the rules changed, and it is working behind the scenes to do just that. In April, Custodia Financial submitted a statement to the House & Ways Committee arguing for automatic enrollment into insurance coverage for 401(k) loans.”

Whelehan also smelled something fishy in the way the paper was paid for:

This paper by Navigant Economics, which made a big splash in the press, was financially supported by Americans for Retirement Protection. That organization has a website, ProtectMyRetirementBenefits.com, but no “about us” link. It does give you the opportunity to sign a petition demanding protection of retirement funds through insurance. Take a look at it, and see if you think the website was created by average Americans or by the insurance industry.

Whelehan was actually breaking news here: there’s no public linkage between Americans for Retirement Protection, the organization which paid for the paper, and the astroturf website. In fact, Americans for Retirement Protection seems to have no public existence at all, beyond a footnote in the paper, which was co-authored by Bob Litan and Hal Singer.

Enter Toonkel, writing her story about Custodia. In the course of her reporting, she discovered — and Custodia confirmed — that Americans for Retirement Protection, and ProtectMyRetirementBenefits.com, are basically alter egos of Custodia itself. Custodia would welcome other organizations joining in, but that’s unlikely to happen, because Custodia owns the patents on the big idea that the paper and the website are pushing — the idea that 401(k) loans should come bundled with opt-out insurance policies.

Once you’re armed with this information, it’s impossible not to look at the Litan-Singer paper in a very different way. Its abstract concludes: “We demonstrate that the social benefits of steering (but not compelling) plan participants towards insurance when they borrow are likely positive and economically significant.” And yet nowhere in the paper is there any indication that it was bought and paid for by the very company which has a patent on doing exactly that.

And what about that $37 billion number? Are defaults on 401(k) loans really as big a problem as the paper says that they are? After all, the smaller the problem, the less important it is to introduce an expensive fix for it.

The simple answer is no: 401(k) loan defaults are not $37 billion per year. But the fact is that nobody knows for sure exactly where they are, which makes it much easier to come up with exaggerated estimates. As the paper itself admits, “the sum total of 401(k) defaults ought to be an easily accessible statistic, but it is not”. And the $37 billion, far from being a good-faith estimate, in fact looks very much like an attempt to get the largest and scariest number possible.

So how did Litan and Singer arrive at their $37 billion figure? Let’s start with the only concrete numbers we have — the ones from the Department of Labor, whose most recent Private Pension Plan Bulletin gives a wealth of information about all private pension plans in the country. Every pension plan has to file something called a Form 5500, and the bulletin aggregates all the numbers from all the 5500s which are filed; the most recent bulletin gives data from 2009.

This bulletin has two datapoints which are germane to this discussion. First of all, there’s Table A3, on page 7 of the bulletin (page 11 of the PDF). That shows that loans from defined-contribution pension plans to their own participants totaled $51.7 billion in 2009. Secondly, there’s Table C9, the aggregated income statement for the year. If you look at page 32 of the bulletin (page 35 of the PDF), you’ll see a line item called “deemed distribution of participant loans”, which came to $670 million for the year. If you borrow money from your 401(k) and you don’t pay it back, then that money is deemed to have been distributed to you, and counts as a default. So we know that the official size of 401(k) defaults in 2009 was $670 million — a far cry from Litan and Singer’s $37 billion.

Now the $670 million figure does not account for all 401(k) defaults. Most importantly, in some situations, if you default on a 401(k) loan after having been fired from your job, then the money is counted as an “actual distribution” rather than as a “deemed distribution”.

The Litan-Singer paper goes into some detail about this. “According to a recent study by Smart (2012),” they write, “although Form 5500 reflects actual distributions, there is no way to determine the amount of actual defaults.” They then look in detail at Smart’s figures, footnoting him five consecutive times, and treating him as an undisputed authority on such matters. Their citation is merely “Kevin Smart, The Hidden Problem of Defined Contribution Loan Defaults, May 2012.”

Where might someone find this paper? Here, since you ask: it’s helpfully hosted at CustodiaFinancial.com. And on the front page of the paper, Kevin Smart is identified as the “Chief Financial Officer, Custodia Financial”.

There’s no indication whatsoever in the Litan-Singer paper that the “Smart” they cite so often is the CFO of Custodia Financial, the company which has the most to gain should their recommendation be accepted. And there’s certainly no indication that he’s essentially their employer: that Custodia paid them to write this paper. In fact, the name Custodia appears nowhere in the Litan-Singer paper at all.

It’s instructive to look at the Smart paper’s attempt to estimate the magnitude of the 401(k) default problem. I’ll simplify a little here, but to a first approximation, Smart assumes that 12% of people with 401(k) loans lose their jobs. He also assumes that if you lose your job when you have a 401(k) loan, there’s an 80% chance you’ll default on that loan. As a result, he comes up with a 9.6% default rate on 401(k) loans. He then multiplies that 9.6% default rate by total 401(k) loans of $51.7 billion, adds in some extra defaults due to death and disability, and comes up with a grand total of $6.2 billion in loan defaults per year, excluding the “deemed distributions” of $670 million. Call it $7 billion in total, of which $6 billion could be protected by insuring loans against unemployment, death, and disability.

Now remember that this is a paper written by the CFO of Custodia Financial — someone who clearly has a dog in this race. It’s in Smart’s interest to make the loan-default total look as big as possible, since the bigger the problem, the more likely it is that Congress will agree to implement Custodia’s preferred solution.

But when Litan and Singer looked at Smart’s paper, they weren’t happy going with his $6 billion figure. Indeed, as we’ve seen, their paper comes up with a number six times larger. So if even the CFO of Custodia only managed to estimate defaults at $6 billion, how on earth do Litan and Singer get to $37 billion?

It’s not easy. First, they double the total amount of 401(k) loans outstanding, from $52 billion to $104 billion. Then, they massively hike the default rate on those loans, from 9.6% to 17.9%. And finally, they add in another $12 billion or so to account for the taxes and penalties that borrowers have to pay when they default on their loans.

It’s possible to quibble with each of those changes — and I’ll do just that, in a minute. But it’s impossible to see Litan and Singer compounding all of them, in this manner, without coming to the conclusion that they were systematically trying to come up with the biggest and scariest number they could possibly find. It’s true that whenever they mention their $37 billion figure, it’s generally qualified with a “could be as high as” or similar. But they knew what they were doing, and they did it very well.

When the Chicago Tribune and the LA Times say in their headlines that 401(k) loan defaults have reached $37 billion a year, they’re printing exactly what Custodia and Litan and Singer wanted them to print. The Litan-Singer paper doesn’t exactly say that defaults have reached that figure. But if you put out a press release saying that “the leakage of funds in 401(k) plans due to involuntary loan defaults may be as high as $37 billion per year”, and you don’t explain anywhere in the press release that “leakage of funds” means something significantly different to — and significantly higher than — the total amount defaulted on, then it’s entirely predictable that journalists will misunderstand what you’re saying and apply the $37 billion number to total defaults, even though they shouldn’t.

But let’s backtrack a bit here. First of all, how on earth did Litan and Singer decide that the total amount of 401(k) loans outstanding was $104 billion, when the Department of Labor’s own statistics show the total to be just half that figure? Here’s how.

First, they decide that they need the total number of active participants in defined-contribution pension plans. They could get that number — 72 million — from the Labor Department bulletin: it’s right there in the very first table, A1. But the bulletin isn’t helpful to them, as we’ve seen, so instead they find the same number in a different document from the same source.

That’s as much Labor Department data as Litan and Singer want to use. Next, they go to the Investment Company Institute, which has its own survey, covering some 23 million of those 72 million 401(k) participants. According to that survey, in 2011, 18.5% of active participants had taken out a loan; Litan and Singer extrapolate that figure across the 401(k) universe as a whole.

Finally, Litan and Singer move on to Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income, a 2011 report from Aon Hewitt which is based on less than 2 million accounts, of the 72 million total. According to the Aon Hewitt report, which doesn’t go into any detail about methodology, when participants took out loans, “the average balance of the outstanding amount was $7,860″. Needless to say, that number was never designed to be multiplied by 72 million, as Litan and Singer do, to generate an estimate for the total number of loans outstanding.

If you want an indication of just how unreliable and unrepresentative the $7,860 number is, you just need to stay on the very same page of the Aon Hewitt report, which says that 27.6% of participants have a loan. If Litan and Singer think that the $7,860 figure is reliable, why not use the 27.6% number as well? If they did that, then the total number of 401(k) loans outstanding would be $7,860 per loan, times 72 million participants, times 27.6% of participants with a loan. Which comes to $156 billion.

But of course we know that there were just $51.7 billion of loans outstanding in 2009; evidently Litan and Singer reckoned that it just wouldn’t pass the smell test if they tried to get away with saying that number might have trebled in a single year. So they confined themselves to merely doubling the number, instead.

Litan and Singer give no reason to mistrust the official $51.7 billion number, except to say that it’s “outdated”. But if it’s outdated, it’s only outdated by one year: it’s based on 2009 data, while the much narrower surveys that Litan and Singer cite are generally based on 2010 data. At one point, they cite the ICI survey to declare that there is “an estimated $4.5 trillion in defined contribution plans”, despite the fact that the much more reliable Labor Department report shows that there was just $3.3 trillion in those plans as of 2009. This, I think, quite neatly puts the lie to the Litan-Singer implication that the problem with the Labor Department numbers is merely that they are out of date, and that when we get numbers for 2010 or 2011, they might well turn out to be in line with the Litan-Singer estimates. There’s simply no way that total DC assets rose from $3.3 trillion to $4.5 trillion in the space of a year or two.

In other words, whatever advantage the ICI and Aon Hewitt surveys have in terms of timeliness, they more than lose in terms of simply being based on a vastly smaller sample base. Litan and Singer adduce no reason whatsoever to believe that the ICI and Aon-Hewitt surveys are in any way representative or particularly accurate, despite the fact that the discrepancies between their figures and the Labor Department figures are prima facie evidence that they’re not representative or particularly accurate. If the ICI and Aon Hewitt surveys were all we had to go on, then I could understand Litan-Singer’s decision to use them. But given that the Labor Department already has the number they’re looking for, it just doesn’t make any sense that they would laboriously try to recreate it using less-reliable figures.

It’s true that the Labor Department’s figures do undercount in one respect: they cover only plans with 100 or more participants — and therefore cover “only” 61 million of the 72 million active participants in DC plans. If Litan and Singer had taken the Labor Department’s numbers and multiplied them by 72/61, or 1.18, that I could understand. But disappearing into a rabbit-warren of private-sector surveys of dubious accuracy, and emerging up with a number which is double the size of the official one? That’s hard to justify. So hard to justify, indeed, that Litan and Singer don’t even attempt to do so.

That, indeed, is the strongest indication that the Litan-Singer paper can’t really be taken seriously. For all their concave borrower utility functions and other such economic legerdemain, they simply assert, rather than argue, that they “believe” it is “more appropriate” to use private-sector surveys rather than hard public-sector data. Such decisions cannot be based on blind faith: there have to be reasons for them. And Litan-Singer never explain what those reasons might be.

Now the move from public-sector to private-sector data merely doubles the total size of the purported problem, while Litan-Singer are much more ambitious than that. So their next move is to bump up the default rate on loans substantially.

There’s no official data on default rates at all, so Litan and Singer, following Smart’s lead, decide to base their sums on a Wharton paper from 2010. Once again, they have to extrapolate from a very small sample: the Wharton researchers had at their disposal a dataset covering 1.5 million plan participants (just 2% of the total). Looking at what happened over a period of three years, from July 2005 to June 2008, the researchers found that the number of terminations, and the number of defaults, remained pretty steady:

defaults.tiff

These are the numbers that Smart used in his paper: roughly 12% of loan holders being terminated each year, and roughly 80% of those defaulting on their loans.

But these are not the numbers that Litan-Singer use. Instead, they notice that the overall default rate, as a percentage of overall loans outstanding, was roughly double the national unemployment rate at the time. And so since the unemployment rate doubled after June 2008, they conclude that the default rate on outstanding 401(k) loans probably doubled as well.

Do they have any evidence that the default rate on 401(k) loans might have doubled after 2008? No. Well, they have a tiny bit of evidence: they look at the small variations in default rates in each of the three years covered in the Wharton study, and see that those variations move roughly in line with the national unemployment rate. Never mind that the default rate fell, from 9.9% to 9.7%, between 2006 and 2008, even as the unemployment rate rose, from 4.8% to 5.0%. They’ve still somehow managed to convince themselves that it’s reasonable to assume that the default rate today is nowhere near the 9.6% seen in the Wharton survey, and in fact is probably closer to — get this — 17.9%.

This doesn’t pass the smell test. The primary determinant of the default rate, in the Wharton study, was the percentage of loan holders who wound up having their employment terminated, for whatever reason. And so what Litan-Singer should be looking at is the increase in the probability that any given employee will end up being terminated in any given year.

Remember that in any given month, or year, the number of people fired is roughly equally to the number of people hired. When the former is a bit larger than the latter for an extended period, then the unemployment rate tends to go up; when it’s smaller, the rate goes down. But the churning in the employment economy is a constant, even when the unemployment rate is very low.

When the unemployment rate rose after 2008, that was a function of the fact that the number of people being fired was a bit higher than normal, while the number of people being hired was a bit lower than normal. But looked at from a distance, neither of them changed that much. In terms of the Wharton study, what we saw happening to the unemployment rate is entirely consistent with the percentage of loan-holders being terminated, per year, staying pretty close to 12%. Of course it’s possible that number rose sharply, but it’s really not possible that number rose as sharply as the unemployment rate did. And so I find it literally incredible that Litan and Singer should decide to use the national unemployment rate as a proxy for the number of people whose employment is terminated each year.

Well, maybe not literally incredible — the fact is there’s one very good reason why they might do that. Which is that they were being paid by Custodia to use any means possible to exaggerate the number of annual 401(k) loan defaults.

Litan and Singer do actually provide a mini smell test of their own: they say that their hypothesized rise in 401(k) loan defaults is more or less in line with the rise in, say, student-loan defaults or in mortgage defaults over the same period. But those statistics aren’t comparable at all, because Litan and Singer are already assuming that the default rate on 401(k) loans, among people who lose their job, was a whopping 80% before the financial crisis. There’s a 100% upper bound here: you can’t have a default rate of more than 100%. Remember that the whole point of this paper is to provide the case that people taking out 401(k) loans should insure themselves against unemployment: any rise in the default rate from people who don’t lose their job (or die, or become disabled) is more or less irrelevant here. And when your starting point is a default rate of 80%, there really is a limit to how much that default rate can rise; it’s certainly going to be difficult to see it rise by more than 85%, even if you allow a simultaneous increase in the number of people being terminated.

All of this massive exaggeration has an impressive effect: if you take $104 billion in loans, and apply a 17.9% default rate, then that comes to a whopping $18.6 billion in 401(k) loan defaults every year. A big number — but still, evidently, not big enough for Litan and Singer. After all, their number is $37 billion: double what we’ve managed to come up with so far. We’ve already doubled the size of the loan base, and almost-doubled the size of the default rate, so how on earth are we going to manage to double the total again?

The answer is that LItan and Singer, at this point, stop measuring defaults altogether, and turn their attention to a much more vaguely-defined term called “leakage”. Once again, they decide to outsource all their methodology to Custodia’s CFO, Kevin Smart. The upshot is that if you borrowed $1,000 from your 401(k) and then defaulted on that loan, the amount of “leakage” from your 401(k) is deemed to be much greater than $1,000. Litan and Singer first add on the 10% early-withdrawal penalty that you get charged for taking money out of your plan before you retire. They also add on the income tax you have to pay on that $1,000, at a total rate of 30%. (They reckon you’ll pay 25% in federal taxes, and another 5% in state taxes.) So now your $1,000 default has become a $1,400 default.

How does that extra $400 count as leakage from the 401(k), rather than just something that gets added to your annual tax bill? Smart explains:

Most participants borrow from their retirement savings because they are illiquid and do not have access to other sources of credit. This clearly demonstrates that participants who default on a participant loan do not have the financial means to pay the taxes and penalty. Unfortunately, their only source of capital is their retirement savings plan so many take the remaining account balance as an additional early distribution to pay the taxes and penalty, further increasing the amount of taxes and penalties due. These taxes and penalties become an additional source of leakage from retirement assets.

Smart’s 16-page paper has no fewer than 24 footnotes, but he fails to provide any source at all for his assertion that “many” people raid their 401(k) plans in order to pay the taxes on the money they’ve already borrowed. In any event, Smart (as well as Litan and Singer, following his lead) makes the utterly unjustifiable assumption that not only many but all 401(k) defaulters end up withdrawing the totality of their penalties and extra taxes from their retirement plan. And then, just for good measure, because that withdrawal also comes with a penalty and taxes, they apply a “gross-up” to that.

By the time all’s said and done, the $1,000 that you lent yourself from your 401(k) plan, and failed to pay back in a timely manner, has become $1,520 in “leakage”. Add in some extra “leakage” for people who default due to death or disability (apparently even dead people raid their 401(k) plans to pay income tax on the money they withdrew), and somehow Litan and Singer contrive to come up with a total of $37 billion.

It’s an unjustifiable piling of the impossible onto the improbable, and the press just lapped it up — not least because it came with the imprimatur of Litan, a genuinely respected economist and researcher. Custodia hired him for precisely that reason: they knew that if his name was on the front page of a report, that would give it automatic credibility. But for exactly the same reason, Litan had a responsibility to be intellectually honest when writing this thing.

Instead, he never even questioned any of the assumptions made by Custodia’s CFO. For instance: if you’re terminated, and you default on your 401(k) loan, what are the chances that the money you received will end up being counted as an “actual distribution” rather than as a “deemed distribution”? Smart and Litan and Singer all implicitly assume that the answer is 100%, but they never spell out their reasoning; my gut feeling is that it’s not nearly as clear-cut as that, and that it all depends on things like when you lost your job, when you defaulted, and who your pension-plan administrator is.

Custodia’s business, and the Litan-Singer paper, are based on the idea that if people who borrowed money from their 401(k) plans had insurance against being terminated from their jobs, then that would have significant societal benefit. In order for the societal benefit to be large, the quantity of annual 401(k) loan defaults due to termination also has to be large. But right now, there’s not a huge amount of evidence that it actually is: in fact, we really have no idea how big it is.

I can say, however, that Custodia has already won this battle where it matters — in the press. “Protecting 401(k) savings from job loss makes a lot of sense,” said Time’s Kadlec in his post — and so long as Custodia can present lawmakers with lots of headlines touting the $37 billion number and supporting their plan, Litan and Singer will have done their job. The truth doesn’t matter: all that matters is the headlines, and the public perception of what the truth is.

Come to think, maybe this makes Litan the absolutely perfect person to run the research department at Bloomberg Government. On the theory that it takes a thief to catch a thief, Bloomberg has hired someone who clearly knows all the tricks when it comes to writing papers which come to a predetermined conclusion. And he also has a deep understanding of the real purpose of most of the white papers floating around DC: it’s not to get closer to the truth, but rather to stamp a superficially plausible institutional imprimatur onto a policy that some lobbyist or pressure group desperately wants enacted. I can only hope that in the wake of using his talents in order to serve Custodia Financial, Litan will now turn around and use them in order to serve rather greater masters. Like, for instance, truth, and transparency, and intellectual honesty.

COMMENT

Wow.

It must have taken a helluva long time to research all that. Either you are paid by the minute and receive bonuses per the written word or you are trying to serve greater masters.+

Litan clearly has contrived data to serve his own goals.

Posted by breezinthru | Report as abusive

Counterparties: Britain’s toughest board

Ben Walsh
Aug 10, 2012 22:26 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

Barclays has a new centurion: David Walker will take over from Marcus Agius as Barclays chairman on November 1. Walker is a former regulator who served in the UK Treasury and Bank of England. That background will give Walker’s credibility as he tries to overhaul the bank’s culture, operations and reputation in the wake of the Libor scandal.

As lead author of the eponymous 2009 report on corporate governance at UK banks, Walker has already committed to the standards he – and other board members – should act on:

The most critical need is for an environment in which effective challenge of the executive is expected and achieved in the boardroom before decisions are taken on major risk and strategic issues. For this to be achieved will require close attention to board composition to ensure the right mix of both financial industry capability and critical perspective from high-level experience in other major business. It will also require a materially increased time commitment from non-executive directors… In all of this, the role of the chairman is paramount, calling for both exceptional board leadership skills and ability to get confidently and competently to grips with major strategic issues. With so substantial an expectation and obligation, the chairman’s role will involve a priority of commitment that will leave little time for other business activity.

So far, Walker is following his own advice by committing to work a minimum of four days a week as chairman. Anything short of full-time may sound slight, but none of his peers have made their time commitment similarly transparent nor can credibly argue that theirs is greater. For that work, he’ll receive £750,000 ($1.17 million), of which £100,000 will be in Barclays stock.

Additional transparency may be coming to Barclays in other forms, as well: the Walker report called for disclosure of the number of employees earning more than £1 million in salary and bonus and a tally of those “earning between £1m and £2.5m; £2.5m and £5m; and over £5m”. Walker also called for the head of the board’s pay committee to automatically face re-election if their proposals are supported by less than 75% of shareholders.

Walker also thinks boards should hear directly from risk officers, and should have final say over their hiring and firing. He wants the chief risk officer to report to other executives, but the CRO also “should report to the board risk committee, with direct access to the chairman of the committee”.

These and Walker’s many other recommendations add up to a view of the relationship between the chairman and the CEO at financial institutions very different from what we’ve recently seen. UK board oversight is on the whole more rigorous than in the US, and the chairman and CEO roles are invariably separate. It’s hard to imagine Jamie Dimon working under Walker’s structure. In Walker’s view, chief executives cannot be allowed to become indispensable or inscrutable: “If the embedding of authority… makes the CEO become effectively unchallengeable (and possibly a control freak), the CEO will be a major source of risk and will probably need to be removed”. That should make for some interesting interviews as Walker takes up his first prominent task, finding a new CEO. – Ben Walsh

On to today’s links:

Politicking
Carl Levin is still not happy with Goldman Sachs – Politico
Will Erskine Bowles be our next Treasury Secretary? – Ezra Klein

Indicators
“Fresh data suggest key sectors of the economy might be gaining traction” or not – WaPo

The More You Know
Valuing the priceless: EPA would spend $9.1 million to save a life, while FDA feels $7.9 million is more appropriate – Care 2

You Are a Snowflake
The latest in coupons: perfectly legal personalized price discimination – NYT

Primary Sources
A very sensible set of proposed rules for mortgage servicers, including warnings to borrowers over rate hikes – CFPB

Alpha
Ex-Goldman programmer arrested again and charged by New York State for downloading “secret sauce” trading code – DealBook
Profit margins are “at unsustainable levels”, and corporate earnings might be too – The Big Picture

J’Regulate
Emile Zola, 1891: “the public is fooled and ruined by the brigands of Finance” – Liberty Street Economics

Legalese
Standard Chartered’s lawyers: from cost center to profit-seekers – FT

Oxpeckers
Writer critical of writers writing on writing – Salon
Time Magazine suspends Fareed Zakaria for a month over plagiarism – NYT

COMMENT

Keep trying, time and again, to figure this out – and only one (disagreeable) answer keeps coming up every time. We have three British banks caught ‘in flagrante delicto’ – Barclays’, StanChart and HSBC.

The first gets the most bad press, though in truth its offenses were plausibly far less damaging than either of the others. The second – SC – gets a pretty fair amount of bad ink, but it has guys like FS soft-selling its wrongdoing and attacking its prosecutor.

The last one – HSBC – is the most blatantly criminal (in a ‘street thug’ sort of way) and probably involves criminal liability for murder and other violent felonies – but scarcely a word is heard in condemnation.

What gives?

Posted by MrRFox | Report as abusive

Why Cash WinFall is a model for future lottery games

Felix Salmon
Aug 10, 2012 16:59 UTC

Last year, the Boston Globe’s Andrea Estes discovered that an obscure state lottery game called Cash WinFall could be — and was — gamed by sophisticated stats geeks. The secret was in the fact that the odds of winning the jackpot were so remote — just one in 9.6 million. As a result, it was almost certain that the jackpot would not be won in any given week.

Because the jackpot was basically never won, it couldn’t just keep on rising indefinitely. So Cash WinFall had a mechanism for distributing it: when the jackpot rose above $2 million, it would “roll down” into smaller prizes. For instance, if you got five out of six numbers correct in a normal week, you would win $4,000; in a roll-down week, you would win $40,000.

A bunch of what can only be called professional lottery players jumped on this quirk, and would buy up hundreds of thousands of dollars’ worth of tickets in roll-down weeks, when the swollen jackpot was certain to get distributed. By buying so many tickets, they pretty much guaranteed that they would buy enough winning tickets to turn a profit — in a typical roll-down week, they would win back 15% to 20% more than they gambled.

Weirdly, the big risk here was the 1.4% chance that the jackpot would be won — as happened, for instance, on July 10, 2008. That worked out very well for the winner, Wenxu Tong, the general partner of a company called Tong’s Fortunelot Limited Partnership, who took home nearly $2.5 million. But all the other consortiums trying to game the system that week all did very badly, losing hundreds of thousands of dollars.

There was a tinge of scandal to Estes’s reporting. “Cash WinFall isn’t being played as a game of chance,” she quoted Mohan Srivastava as saying. “Some smart people have figured out how to get rich while everyone else funds their winnings.’’ And a few days after her story appeared, the Boston Globe ran an editorial under the headline “Lottery game is fatally flawed; treasurer should shut it down”. The argument? In any lottery game, according to the paper, “the odds should be stacked equally against rich and poor”. And eventually, earlier this year, Cash WinFall was indeed phased out.

Now Gregory Sullivan, the state inspector general, has written a 25-page report on the Cash WinFall game, which is well worth reading; Estes, naturally, has written it up for the Globe, under the headline “Lottery officials knew about Cash WinFall’s flaws, IG says”. She never mentions, however, the report’s conclusion: those “flaws” ended up being very profitable for the state, and were a way for Massachusetts to get significant lottery revenues not only from the poor but also from the rich.

Over the course of seven years, professional gamblers spent about $40 million on Cash WinFall, and won about $48 million. As Sullivan says, “the Lottery benefited substantially from the large betting groups”. He explains:

The Lottery designed Cash WinFall to pay out 60 cents of every dollar wagered, leaving 40 cents for the Lottery to run its own operations and distribute to cities and towns in the form of local aid. Like all Lottery games, Cash WinFall was designed to make money and the more Cash WinFall tickets the Lottery sold, the more money the Lottery made.

As a result, those $40 million in extra tickets worked out to a good $16 million in excess revenues for the Lottery fund — money which went to good causes, and which wouldn’t have been available had Cash WinFall not been gamed.

The mathematics of the roll-down were a feature of the game: it was specifically designed so that in roll-down weeks total payouts would be $1.15, or sometimes more, for every dollar wagered. Cash WinFall was designed that way because the game it replaced, Mass Millions, went a whole year without paying out a jackpot, and eventually gamblers just gave up on it.

Although it was relatively easy to game Cash WinFall in theory, it was much harder to do so in practice. Most stores with lottery terminals gave short shrift to players seeking to tie them up for hours at a time, especially when they could be presenting thousands of “free bets” won in previous rounds. In humid weather, or when the terminals were running low on ink, the machines could be unreliable. And it was hard to come up with a way of identifying the handful of winning tickets among the hundreds of thousands of losing ones. What’s more, reports Sullivan,

Tax compliance was also a headache for high-volume bettors. Every time Random Strategies turned in a batch of winning tickets, the Lottery generated a W-2G for every member of the group. Even small investors in the MIT group – for example, someone who won $800 over the course of a year – would get dozens of W-2Gs every year and have to spend hours accounting for their winnings on their tax returns. The hassle prompted some people to cash out and leave the investment pool, Mr. Harvey said. The tax hassle was one reason that the MIT group, which began with 40 to 50 people, dropped to a couple dozen participants in the years after graduation and ended with 10 members at the conclusion of Cash WinFall earlier this year.

As a result, while some people did indeed essentially treat Cash WinFall as a full-time job, it wasn’t necessarily a particularly lucrative or easy job for any given individual: it would take one couple ten hours a day, for ten days, to sort through their tickets to find the winners, the proceeds from which would then be shared among 32 consortium members. On top of that, every member of every consortium could reasonably expect to be audited by the state Department of Revenue every year. Which isn’t exactly fun.

It’s worth underscoring that although the professional bettors made a profit on Cash WinFall, that doesn’t mean for a minute that the lottery made a loss. Quite the opposite: the lottery profited from those bettors to the tune of millions of dollars. In Cash WinFall, the lottery kept just 40% of the amount bet; 60% is returned to bettors in the form of winnings. That 60% never belonged to the lottery; it was always going to go to bettors, one way or another. In many weeks, bettors ended up receiving less than 60% of the amount bet, because the jackpot wasn’t claimed. That just meant they had another chance, the following week, to win the money in the jackpot. And in roll-down weeks, thousands of bettors would share the jackpot money between them. The professional consortiums dominated those pools, but they still, always, saw 40% of their money going directly to the lottery.

It’s worth quoting Sullivan’s conclusion at some length, if only because Estes is so mealy-mouthed about it:

I have concluded that Cash WinFall was a financial success for the Lottery. It generated about $300 million in ticket sales, with nearly $120 million of that going to Lottery operations and the pool of funds distributed to cities and towns. The high-volume bettors were a financial boon to the Lottery, collectively buying roughly $2 million in tickets for a typical roll-down drawing – 40 percent of which the Lottery would keep to redistribute to cities and towns.

Cash WinFall was designed to attract a huge influx of betting by distributing a windfall to bettors whenever the jackpot reached $2 million. The emergence of individuals and groups buying large volumes of tickets was legal and financially advantageous to the Lottery… No one’s odds of having a winning ticket were affected by high-volume betting. Small bettors enjoyed the same odds as high-volume bettors. When the jackpot hit the roll-down threshold, Cash WinFall became a good bet for everyone, not just the big-time bettors.

At the margin, the more professional consortiums there were playing Cash WinFall, the more money the lottery made. What’s more, the biggest problem with most lotteries is that they act as a highly-regressive tax on the poor. In this case, however, Cash WinFall was also a 40% tax on the rich professional bettors who played only during roll-down weeks. (And of course those bettors had to pay income tax on their winnings, as well.)

I’m not a fan of lotteries in general. But it seems to me that if you’re going to have a lottery, then it’s better to have one which extracts money from the rich and the poor than it is to have one which extracts money only from the poor. The tone of the Globe’s reporting was unfortunate here: I can easily see a world where some other reporter might have celebrated the plucky consortiums who had worked out how to make money from the game, causing lots of other well-heeled punters in Massachusetts to follow suit. Even if they didn’t have a particularly high chance of winning, I can definitely see a lot of over-educated Cambridge types dropping a hundred bucks or so on lottery tickets during roll-down weeks, just because they could afford to lose the money and they knew that statistically their expected payout was going to be positive.

Instead, the whole thing turned into a silly scandal, with the Globe and the state worrying about picayune transgressions of the rules, like whether tickets were paid for before or after they were printed. Eventually, Estes even extracted an apology from Massachusetts state treasurer Steven Grossman, underscoring the idea that Cash WinFall — a lottery designed to be gameable — was some kind of scandalous failure, when in fact it turned out, by lottery standards, to be a success.

If I were running the Massachusetts lottery, I’d look at what happened in Cash WinFall, and create a game designed to be as attractive as possible to consortiums and the rich. Make it really easy to buy hundreds of thousands of dollars’ worth of tickets at a time; maybe even have e-tickets which can have hundreds of thousands of lines, and which can be redeemed individually. Tell the rich that if they get their timing and strategy right, this is a way they can make real money. While, of course, appealing to regular weekly punters as well. You’d essentially be broadening the lottery tax base, and increasing revenues, by appealing to the people who can most afford to play.

But that’s not going to happen: the likes of the Boston Globe editorial board would inevitably call such a game “fatally flawed” since the strategic element would appeal to the rich more than to the poor. But the rich like games combining luck and strategy. Why not give them what they want?

COMMENT

“Cash WinFall was also a 40% tax on the rich professional bettors who played only during roll-down weeks”

Sorry but that is 100% wrong.
If you are down 40% then you can’t be up 15%.

Cash Windfall was an EVEN-MORE highly-regressive tax than other lotteries.

This is a terrible post.

The losers from non-jackpot weeks were subsidising the professionals.

If the professionals hadn’t played then the regular non-professionals would have shared more of the tickle-down from the had-to-be-won jackpot money.

This is very simple maths.

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Counterparties: Can poor nations manufacture wealth?

Peter Rudegeair
Aug 9, 2012 21:48 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

Dani Rodrik has a provocative piece for Project Syndicate arguing that the quest for growth has gotten more elusive over the past few years. During the second half of the 20th Century, he says, if poor countries wanted to grow up to be rich (and didn’t have the patrimony of natural resource wealth), they would have to first “move their labor from the countryside (or informal activities) to organized manufacturing”. Manufacturing industries are relatively easy to replicate; they create rapid growth in productivity and incomes “regardless of the quality of domestic policies, institutions, or geography“.

That world is gone now. Achieving an Asian Tiger-style growth miracle is trickier for a couple of reasons:

Technological advances have rendered manufacturing much more skill- and capital-intensive than it was in the past, even at the low-quality end of the spectrum … It will be impossible for the next generation of industrializing countries to move 25% or more of their workforce into manufacturing, as East Asian economies did.

Second, globalization in general, and the rise of China in particular, has greatly increased competition on world markets, making it difficult for newcomers to make space for themselves. Although Chinese labor is becoming more expensive, China remains a formidable competitor for any country contemplating entry into manufactures.

Ryan Avent points us to a recent column in the Economist that reaches the opposite conclusion: “[m]odern supply chains are making it easier for economies to industrialise”. In a blog post, he finds Rodrik’s concerns wanting:

For the moment, Mr Rodrik’s concerns appear somewhat unfounded. Chinese manufacturing is very capital intensive, and yet employment in industry there has been remarkably consistent over the past two decades. Admittedly, this is partly due to declining employment in old state enterprises offsetting rising employment in new, export-oriented firms. But across the rich and emerging world, falling labour intensity in manufacturing does not appear to limit the contribution of industry to prosperity.

Rodrik and Avent disagree over the extent to which manufacturing can spark catchup growth, but both seem to take it as a given that it’s still the best path to follow for countries that want to get rich. It’s at least a much more empirical view than Deirdre McCloskey’s thesis that countries get rich once their citizens “stopped sneering at market innovativeness and other bourgeois virtues”. – Peter Rudegeair

On to today’s links:

Regulators
SEC drops mortgage charges against Goldman – DealBook

Asset Classes
Lessons in lobster pricing – NYT

Compelling
“Turning bad jobs into good jobs is arguably as important as creating more jobs” – Demos

Price Points
Calm down, the drought will not have much effect on America’s already low food prices – WSJ

MF Doom
Jon Corzine is just waiting for anyone with a Bloomberg terminal to get in touch – Zero Hedge

Quote of the Day
“[Federal] agencies will be asked to test complex or lengthy forms … by seeing if people can actually understand them.” – White House

Housing
Record low mortgage rates could be even lower “if banks were satisfied with the profit margins of just a few years ago” – DealBook
Charts: how low mortgage rates and even lower bond yields mean increased profit margins for mortgage originators – DealBook
Arizona and California, epicenters of the housing crisis, now have foreclosure rates below the national average – WSJ
Own to rent: a pilot program allows homeowners to avoid foreclosure by renting their homes – WSJ

New Normal
Fear-driven productivity gains: Scared workers are putting in extra, unreported hours – Businessweek

EU Mess
“We can do it alone”: cutting Italy’s debt by convincing Italians to pre-pay their taxes – FT

COMMENT

If you actually wanted to grow GDP in these countries at a rate which will have them catching up to the developed world you are going to have to set up protectionist barriers/currency manipulations/and massive state investment in key industries. That is how every country has industrialized. None of them have used the “free market”/”globalization”. Globalization is to your benefit once you already have the lead, it doesn’t help you catch up.

And if you want to increase GDP/capita at a notable rate you are indeed going to have to stop the unwashed masses from breeding like rabbits as OotS said.

Even in the US we have this problem. When you really examine urban poverty in the us, or even white rural poverty and look at the outcomes what you will see is that even though our social programs are good enough to raise up 40% of the poor children from little families started by teenagers with no prospects, the problem just gets worse because they are having 4 and 5 children.

So you “solve” poverty at a slower rate than the poor make more of themselves and thus it “grows”.

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Prepaid debit-card datapoints of the day

Felix Salmon
Aug 9, 2012 19:20 UTC

Almost everybody interested in extending banking services to the unbanked and underbanked is looking very closely at prepaid debit cards. They can do much of what checking accounts do, without the unpredictable fees, the annoying hours, and the general feeling that if you don’t have a lot of money you’re not welcome.

But now the Philly Fed is out with by far the most detailed research I’ve seen on how people actually use prepaid debit cards, in practice. And sadly for anybody wanting to get into this market, they’re not using them as checking-account replacements.

Using an anonymized dataset covering some 3 million cards and 280 million transactions, the Philly Fed did find that prepaid cards are making significant inroads, especially in poorer areas, as you might expect. Employers, in particular, very much like prepaid cards when their employees don’t have direct deposit: give every employee a single card once, and then just deposit their pay directly onto that card, rather than having to deal with thousands of checks every two weeks. It’s a perfectly sensible way of doing things, and in some counties there is more than one payroll card for every 100 people:

blue3.png

But the lesson of this study is that even if your paycheck is being paid straight onto your card, you’re still not going to use your card like you would a checking account. Most importantly, people just don’t use them for very long: the lifespan of a prepaid card ranges from about 5% to 15% of the lifespan of a typical checking account. If you buy your prepaid card in a shop, you’ll use it for about two months; if you’re given it by an employer, you’re likely to have it for about four months. Which implies that either these jobs tend to be very short-lived, or else that once someone has had a job for four months, they’re likely to get around to opening a bank account.

Or, to put it another way, there’s no evidence here that people are “moving their money” from bank accounts to prepaid debit cards; if anything, it looks like once you start moving decent amounts of money, you graduate from prepaid debit cards to a checking account. Which is probably as it should be, assuming you choose a good bank or credit union which doesn’t rip you off.

If you add up the dollar volume of purchases made on prepaid cards over the card’s lifetime, the sums you get to tend to be very small: the median purchase volume starts at around $25, and peaks around $1,000. That’s not the size of the median purchase, mind: that’s the median size of all purchases on any given card combined.

And when it comes to putting cash onto the cards, or taking it out via an ATM, the transactions tend to be much less frequent than they would be with a checking account, for the very good reason that you generally have to pay for each such transaction. In fact, fees for withdrawing cash from ATMs are the main way that issuers of prepaid cards make money. As a result, prepaid cards, in practice, turn out in this crucial way to be less convenient than a checking account, which always comes with an ATM card you can at least use fee-free at the bank’s own ATMs.

Here’s the chart showing the fees levied by cards used in payroll programs: as you can see, cardholders spend a very substantial amount of money essentially converting their paycheck into cash. Some things you can do with a debit card, but cash still rules. And if you want to be able to move cash around easily, prepaid debit cards are not your friend.

fees.tiff

On average, a prepaid card will cost you about $4.88 per month if you have direct deposit, and about $10.72 a month if you don’t: there’s no way to avoid paying substantial fees for putting money onto your card if you don’t have direct deposit. Those numbers are not enormous, but they’re entirely in line with the sums that entry-level checking accounts charge.

The good news, I think, which isn’t in this paper, is that fees are coming down: the rip-off cards are being recognized for what they are, and cheaper, better cards are replacing them. The bad news, however, is that there’s really no indication at all that prepaid debit cards are really being used as checking-account replacements. It’s still possible: maybe the short life of the cards in this study is a function of people switching from bad cards to good cards. But I suspect we’re still a long way from a card issuer where most people hold the same card for years at a time. Unless you count Simple, of course.

(h/t Finkle)

COMMENT

Felix: Look again.

Prepaid cards are mostly used as small gifts. They get one-offed by kids (or adults) taking the cash put on them . . .off.

But another major use for them is money laundering. Prison gangs use them a lot and drug gangs have reportedly used them to transport cash–as they are less bulky than the cash they hold. Sen. Lieberman got his undies in a bunch about this a couple years ago, but the card industry pushed back. [ http://citypaper.com/news/seeing-green-1 .939205 Don’t know how it settled.

However it settled, the proliferation of these in “poor areas” likely reflects both the usual corporate blood-sucking AND the popularity of these things in the shadow economy.

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How many U-turns can a bank fit inside a loophole?

Felix Salmon
Aug 9, 2012 14:42 UTC

The NYT has two excellent articles about the Standard Chartered affair today. Read this one first, about the law which may or may not have been broken; and then move on to this one, about the reaction to the case in London.

Up until 2008, the US law governing banking transactions with Iran fell short, shall we say, from what you might expect from a perfect model piece of legislation. Banks in New York couldn’t do such business — unless the money just came in to the US and then immediately left again — but even then there were lots of rules surrounding disclosures and the like which tended to slow such business down. The big argument in this case is not whether the transactions took place, but rather whether Standard Chartered illegally circumvented the disclosure rules, by stripping lots of information from the transactions before they reached New York.

In other words, this whole thing is a fight over the size of a loophole. Standard Chartered defends its actions on the grounds, in the NYT’s words, that they “fell squarely within that loophole” — while Benjamin Lawsky sees the loophole as being much smaller, and the StanChart transactions as falling outside it.

Viewed from across the pond, all of this seems a little bit silly. London has always been a more freewheeling and international banking center than New York; moving money around the world is what London banks do. And so the English are seeing a war on London here:

John Mann, perhaps the most strident critic of Britain’s banking culture in Parliament, said in an interview on Wednesday that the Standard Chartered allegations reflected an anti-Britain bias by American regulators, who he said were trying to bolster Wall Street at the expense of the City of London.

This is silly; I’m quite sure that Lawksy doesn’t have some kind of hidden agenda to boost the fortunes of Goldman Sachs or BofA. But the US rules are definitely written in a world where the US can and will advance its own geopolitical agenda by imposing regulations on domestic institutions, as well as foreign institutions with a US presence. And since it’s impossible to be an international bank without having a US presence, the US geopolitical agenda ends up being imposed on every major bank in the world.

The London view of things is different: it sees itself more a global financial center, rather than a UK city, and historically has tried to be as welcoming as it can be to foreign institutions and capital flows. Hence the now-famous quote from an English StanChart executive, complaining about where the “fucking Americans” get off telling the rest of world what they can and can’t do when it comes to Iran.

What’s more, while London regulation is principles-based, US regulations are rules-based — which means that if Standard Chartered could find a way of moving money around the world while remaining within the four corners of the law, it would happily do so. There’s very little doubt that StanChart’s actions violated the spirit of the law; Lawsky’s assertion is that they violated the letter of the law, as well. But that remains to be seen. In London, and in general, StanChart would generally avoid taking refuge in loopholes like this. But New York is different, and in New York, StanChart played by different rules.

So while Lawsky’s suit isn’t a matter of bolstering Wall Street at the expense of the City, it is a matter of trying to impose the US (and, indeed, NY) vision of finance on every global financial institution. When it comes to things like capital adequacy, regulators around the world have interminable meetings in boring cities to try and build a global framework they can all agree on. When it comes to things like money transfers, however, every country has different rules, and the US has no compunction in declaring that, say, all flows in and out of Iran are money laundering and/or terrorist finance unless proven otherwise.

Up until now, US bank regulators have taken a relatively sanguine view of such matters. They understand that New York is an international financial center, and so long as banks are making a good-faith effort to stay within the letter of the law, they’re often given the benefit of the doubt. Some might call that regulatory capture; others might simply see New York regulators triangulating towards international norms.

Lawsky, on the other hand, clearly doesn’t care a whit for international norms or the global nature of finance. He sees behavior which on its face involves trading with Iranians and making hundreds of millions of dollars in profit from activities no US bank would want to touch. He has every right to go after StanChart, which has a major New York presence. And he also — crucially — has the right to take away StanChart’s banking license here, which would basically kill the bank entirely. What he sees as the moral high ground looks to Londoners very much like judicial bullying.

The US tightened up its loophole in 2008, and when it did so, StanChart’s U-turns came to an end: they thought they were within the loophole, and when that loophole went away, they stopped what they were doing. In other words, we’ve already had the US action which put an end to StanChart’s behavior: in fact, we had it four years ago. What extra purpose is served in going so aggressively after StanChart now? That’s the question that London is asking; I’d be interested to hear Lawsky’s answer.

COMMENT

@FS – you might care to re-examine the wisdom of your ascribing benign intentions to StanChart’s management after you closely consider this -

http://www.reuters.com/article/2012/08/1 0/us-standardchartered-iran-privilege-id USBRE8791AT20120810?feedType=RSS&feedNam e=topNews

IMO the documents cited in the article establish a strong ‘prima facie’ case of the bank knowingly engaging in transactions which it understood to be highly likely to be in violation of US law. Equally gag-inducing is the apparent blatant complicity of the bank’s attorneys in the planning and execution and concealment of the improper activity. This is unambiguously out-of-bounds – and every lawyer knows it. The traditional attorney-client privilege has no application to such a matter – just ‘cause your partner in crime is a lawyer doesn’t get your conspiratorial conversations any special legal status.

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Counterparties: Green shoots in the housing market

Ben Walsh
Aug 8, 2012 21:47 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

It’s now five years since August 2007, which means that the US is now halfway into its very own lost decade. There is, however, a bit of good news coming from the housing market, as the WSJ’s Nick Timiraos reports:

Prices rose by their largest percentage in at least seven years during the second quarter, propelled by low inventories of properties for sale and high demand for bargain-priced foreclosures… Prices rose by 2.5% in June from a year ago, and by 6% from the previous quarter, said CoreLogic Inc., a Santa Ana, Calif., data firm. The quarterly jump was the largest since 2005… Separately, Freddie Mac, which uses a different methodology, said home prices during the second quarter jumped by 4.8% from the previous quarter. That was the largest jump since 2004.

It’s been long enough since we last saw this kind of rise in home prices that Bill McBride of Calculated Risk thinks it’s worth remembering the economic effects even modest gains in home prices can have. There’s increased profitability at Fannie and Freddie, fewer homeowners with negative equity, lower mortgage delinquency rates, fewer fear-driven sellers adding to excess inventory, and increased private residential investment. That last data point, McBride says, is the “the best leading indicator for the economy”.

Still, that doesn’t mean that younger Americans are going to become home buyers en masse anytime soon. Not only does student debt loom over many first time buyers, but as Bloomberg’s Caroline Fairchild notes, median wages for college graduates fell 10% from 2009-2011 compared to 2007. As a result of this decreased cash flow, the workforce’s newest entrants prefer to rent; they’re delaying making other large purchasing decisions like cars, too.

That isn’t necessarily a bad thing. A less-indebted and more mobile population should be a source of economic strength. But if, as Felix thinks it will, the housing crisis lasts a full decade, those benefits will largely be wasted in a sputtering economy. We really need a housing recovery: let’s hope Calculated Risk is right, and Felix is wrong. – Ben Walsh

On to today’s links:

Tax arcarna
“Should I be preparing to leave the country?”: France’s wealthy react to proposed 75% top marginal tax rate – NYT

Alpha
The market is one step ahead: as earnings growth slows, stock returns increase – Market Watch

Wonks
Popular tax break silly, possible sign of national failure – Matt Yglesias

Good Ideas
Forget congestion pricing. Instead, pay commuters to drive outside rush hour – Arstechnica

Light Touch
Morgan Stanley pays $4.8 million to settle electricity price-fixing that cost consumers an estimated $300 million – Reuters
Treasury and the Fed would prefer “public shaming kept to a minimum” re allegations of banking rogue states – Reuters

China
Report: 16% of China’s wealthy have already left the country and 44% intend to soon – Economist

New Normal
Extended unemployment benefits weren’t “designed to deal with a stagnating labor market of the sort the US” now has – WaPo

The Fed
Bernanke’s “prolonged low interest rate environment has been hurting US households” – Credit Writedowns

COMMENT

“Green shoots in the housing market”
The housing market gets measured, and measured, and measured, every day, in every way, with the hope that it is BIGGER.
Kinda of reminds me of a friend who bought…male enhancement” pills (OK penis pills). And he measured every day, in every way, with every type of measuring device, his penis. But the chicks don’t lie. Don’t buy the penis pills….

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Why investors should avoid hedge funds

Felix Salmon
Aug 8, 2012 21:05 UTC

At the beginning of January, Simon Lack published The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True. It basically does for hedge funds what the Kauffman Foundation did for private equity, and shows that while fund managers can do extremely well for themselves, fund investors would be better off avoiding the asset class entirely.

The book was well received (see reviews by Jonathan Ford and Jonathan Davis, in the FT, and James Pressley, for Bloomberg), and even Andrew Baker, the chief executive of the Alternative Investment Management Association, said that “much of the book is sensible advice for investors in hedge funds about the need to be well-educated about the industry”. Baker did quibble with the message of the book, saying that it revealed “more about investor behaviour than manager performance”. But if managers really cared about their investors, they would surely take that message to heart, rather than simply keep on trying to maximize their own performance and pay. Baker concluded with figures showing capital flowing back into hedge funds, and concluded not that those investors were being foolish, but rather that “many investors consider hedge funds not a mirage, but an oasis.”

Fast forward to this week, however, and now Baker is singing a very different tune:

Many of us in the industry looked at the arguments in the book with initial interest, and then growing scepticism. Many of the most sensational claims appeared not to be backed up by any figures. Where there were figures, the methodology was slapdash or flawed, and further undermined by simple errors. We, in the Alternative Investment Management Association, began to wonder if The Hedge Fund Mirage was itself an illusion.

Baker and the AIMA have in fact now published a 24-page paper entitled “Methodological, mathematical and factual errors in ‘The Hedge Fund Mirage’”, seeking to debunk the book. But a close reading of the paper reveals that there’s much less there than meets the eye.

In fact, the AIMA paper has convinced me of the deep truth of Lack’s book in a way that the book itself never could. Reading a book, it’s often very hard to judge just how reliable the author is, or how cherry-picked the data might be. But if a high-profile hedge-fund industry association spends months putting forward a point-by-point rebuttal, and that rebuttal is utterly underwhelming, then at that point you have to believe that the book has pretty much got things right.

AIMA kicks off by responding to the first sentence of Lack’s book: “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good”. They come out fighting, saying that “extraordinary as it may seem, nowhere in the subsequent 174 pages is this central claim supported by clear evidence”. And of course they say that the claim is not in fact true:

What our own calculations, using the same core data and time period as the book, in fact show is that investors allocated $1.24 trillion into hedge funds between 1998 and 2010 and have $1.78 trillion to show for it, a 44% return, while the same amount invested in T-bills over the same period would have produced $1.52 trillion, a 23% return. So to paraphrase the book’s opening line, if all the money that had been invested in hedge funds had been put in T-bills, the results would only have been half as good.

Read on a little bit, however, and it turns out that AIMA can — and did — replicate Lack’s results. The group publishes two tables (Table 1 and Table 4): the first one, which attempts to reproduce Lack’s methodology, concludes that between 1998 and 2010, hedge fund investors lost $6 billion, while T-bill investors made $309 billion. That’s even worse than what Lack says! The second table, using AIMA’s own methodology, does indeed show hedge funds outperforming T-bills between 1998 and 2010. But, it’s worth noting that even the AIMA-methodology table shows T-bills outperforming hedge funds between 1998 and 2009.

After having replicated Lack’s results, AIMA then attempts to explain that there are “five fundamental flaws” needed in order to obtain them. But all those “flaws” seem like very sensible assumptions to me.

Firstly, AIMA takes much umbrage at the fact that Lack is looking at the returns to investors, rather than at internal hedge-fund returns. In the jargon, Lack’s figures are “dollar-weighted”, which means that he looks at what happens to actual dollars as they are actually invested in hedge funds. AIMA’s preferred figures are “time-weighted”, which is much less helpful. If a tiny unheard-of fund has a couple of spectacular years, attracts lots of money, and then sees only mediocre performance, then the dollar-weighted returns will be low while the time-weighted returns will be high.

AIMA’s argument is that it’s not up to the fund manager when external investors choose to invest their money in a fund, and that therefore if you’re measuring the performance of fund managers, you should use a time-weighted series rather than a dollar-weighted series. That’s reasonable. But Lack isn’t trying to measure the performance of fund managers, here. He has no interest in trying to work out how good John Paulson is, for instance. Instead, he’s attempting to measure the performance of hedge funds, in aggregate, and is trying to work out whether investing in hedge funds is a good idea. And for that purpose, a dollar-weighted series is absolutely the right one to use.

This is actually AIMA’s fourth beef as well: they don’t like the fact that Lack is using the HFRX Global Hedge Fund Index to measure hedge-fund returns, as opposed to other indices which show higher returns. But what they don’t say is that there’s a reason HFRX returns are lower than other indices — which is that HFRX is dollar-weighted and the other ones aren’t.

The next two flaws that AIMA complains about surround Lack’s idea of what exactly is meant by “profit”, from the point of view of a hedge-fund investor. Obviously, it doesn’t include fees paid to the fund manager. But according to Lack, the sensible measure of profit to use is “profits in excess of treasury bills, the riskless alternative”. After all, if you can take no risk and make more money than a hedge fund, it’s a trivially easy decision to do just that.

AIMA doesn’t like this:

This is mistaken because it replaces real dollars going to investors (hedge fund returns figures are post- fees) and replaces them with an arbitrary and flawed definition of what is “real”. For example, if an investor earned $10 from hedge funds when he could have earned $2 from Treasuries, the “real” money he received was still $10, not $8 ($10-$2).

I’m with Lack on this one: hedge funds should not be taking credit for risk-free returns that an investor could have gotten by investing in Treasury bills. The value added by hedge funds is excess return, and T-bills are a very good proxy for the risk-free rate.

AIMA also dislikes the way that Lack corrects for survivorship and backfill bias in published hedge-fund returns. These are huge, well-known problems: survivor bias is the way that funds stop reporting their returns — and eventually fizzle out entirely — when they perform badly, while backfill bias is the way that funds often only get included in indices once they have a string of decent returns, which then get added in to the index retroactively. Put the two together, and you find that hedge-fund indices are generally overstated by about three percentage points; it’s entirely reasonable to account for that when working out the actual returns to investors.

But here’s the thing: Lack only includes survivor and backfill bias in his calculations once in his book, in the table on page 64. All of the other tables and calculations exclude it, and they still show utterly pathetic returns to investors, compared to enormous profits for fund managers. Now to be fair to AIMA, those utterly pathetic returns are still positive. So for instance, here’s one of Lack’s main sum-it-all-up charts:

44.tiff

The main thing that you’re looking at here is the final line. If you look at the money that investors made by investing in hedge funds, it comes to $70 billion — a number substantially smaller than the $379 billion that the hedge funds managed to skim off in fees. Now the $70 billion is profit over and above the risk-free rate of return on Treasury bills. But it’s not the end of the story. Because funds-of-funds were very popular for most of this period, investors also paid some $61 billion to them. Which left them with the grand total of $9 billion in profits, compared to the $440 billion that the hedge-fund industry took in fees.

And even that overstates the amount of money that hedge-fund investors wound up with. There are lots of other fees, too, going to hedge fund consultants, family offices, and the like. On top of that, the fees in this table are actually understated, by some unknowable amount. I’ll let Lack explain, from his book:

Estimating fees on the industry as if it’s one enormous hedge fund does include one simplification, in that it excludes any netting of positive with negative results. To use a simple example, if an investor’s portfolio included two hedge funds whose results cancelled out (one manager was +10 percent while the other was −10 percent) the investor’s total return would be 0 percent and for our purposes here we’ll assume that no incentive fee was paid on the 0 percent return. However, in reality the profitable manager would still charge an incentive fee. It’s not possible with the available data to break down the returns to that level of detail, so the fee estimates derived are understated, in that it’s assumed incentive fees are charged only on the indus try’s aggregate profits, whereas in fact all the profitable managers would have charged incentive fees with no offset from the losing managers.

On top of that, Lack assumes that all hedge funds were below their high-water mark for the entire post-2008 period, and charged only management fees with no performance fees at all. It’s a very conservative assumption: of course some hedge funds were charging a performance fee as well as their management fees. So total fees are surely higher than Lack calculates here.

In any event, while AIMA tries to reverse-engineer Lack’s comparison of hedge-fund returns to T-bill returns by looking at his chapter on fees, that’s not actually what Lack was doing when he wrote his opening sentence. Instead, if you look at page 7 of his book, he explains that over the time period in question, T-bills returned 3% annualized, while hedge fund investments returned 2.1%. That calculation isn’t based on fees at all: it’s simply based on assets-under-management figures from BarclayHedge. It’s hardly surprising that there’s a very wide range of reported returns and assets for hedge funds: the industry is secretive and there’s no central clearinghouse for such figures. So no one can know for sure what total investor returns for the asset class have been. But there’s certainly no reason to believe that higher figures are more reliable than lower figures, as AIMA seems to do.

AIMA concentrates very much on Lack’s fee calculations, which doesn’t serve it well. Its complaints on that front are decidedly niggling: the worry, for example, about the fact that the fees that hedge funds charge should not be considered to be profits. But AIMA doesn’t actually look at the biggest costs of hedge funds — things like rent, or Bloomberg terminals — to see whether such things are taken out of headline returns, or whether they’re paid entirely by the fund manager. Maybe because they wouldn’t like the results.

AIMA also complains that average fees in the industry “are closer to 1.75% and 17.5%” than they are to 2-and-20. I’d take that complaint a bit more seriously if they weren’t at the same time trying to make the opposite point, that Lack’s survivor-bias and backfill-bias calculations should be offset by the fact that “some of the largest and most successful hedge funds choose not to report to databases for a variety of reasons”. Those large and successful hedge funds, of course, are the ones most likely to be charging more than 2-and-20. (Renaissance, for instance, charges 5-and-44.)

AIMA’s complaints aren’t only about fees. It also tries to say that Lack isn’t being realistic about how hedge funds are used in reality: they’re not designed to replace stocks and bonds, they say. Indeed, they say, “a hedge fund (a market-neutral fund, in particular) is not designed as a stand-alone investment but as a diversifier for an equity portfolio”. As such, the proper thing to look at is not hedge-fund returns versus various combinations of stocks and bonds, but rather various combinations of stocks and bonds, on the one hand, versus various combinations of stocks-and-bonds-and-hedge-funds, on the other. They then trot out familiar charts showing that hedge funds give you lovely diversification benefits, even if they underperform the stock and/or bond markets.

This argument is directly addressed on page 159 of Lack’s book. He points out that diversification benefits are generally calculated using the most generous hedge-fund index that can be found, using returns going back as far as possible — since hedge-fund returns in the 1990s, when the hedge fund industry was much smaller than it is today, were significantly higher than what we’ve seen of late. On top of that, the returns used are the returns of the average fund, not of the average investor. If small funds outperform large funds, on average — and they do — then average investor returns will be significantly lower than average fund returns. AIMA’s pretty chart showing a portfolio with hedge funds outperforming a portfolio without hedge funds — that’s not based on actual returns to actual investors, it’s all based on theoretical returns to theoretical investors.

Of course, some hedge-fund investors do manage to do quite well. That’s a statistical inevitability. But we’re not talking about the art of picking outperforming hedge funds, here, we’re talking about whether it makes sense, in general, to invest in hedge funds at all. Which is why AIMA’s epilogue is so annoying:

Consider the following quotes:

“Some of the most talented investors in history run hedge funds.”

“There are plenty of investors that are happy with their hedge fund investments.”

Those are not taken from an AIMA document, but from ‘The Hedge Fund Mirage’. The book, at times, is prepared to acknowledge that certain investors in hedge funds have done very well from their investments – a conclusion that is seemingly at odds with the claims made elsewhere in the book.

This is just silly. Of course there’s no conflict between saying that some hedge fund managers have done very well, and even that some hedge fund investors have done very well, but that in aggregate the managers have done much better than the investors, to the point at which the investors would have been better off not investing in hedge funds at all.

Indeed, if AIMA has been reduced to this rather pathetic game of “gotcha”, that says to me that there really is no robust refutation of Lack’s book. There are huge risks involved in investing in any hedge fund: they’re illiquid investments, and can blow up through bad luck or bad faith or old-fashioned bad investing at any time. In order to compensate for those risks, investors should be getting substantial excess returns. They’re not. So they should stay away.

COMMENT

The study was long overdue. Per “Hedgeman,” yes: hedge funds are a lot more fun for hedgies to play with than are “vanilla strategies.” That’s why you’re getting 2+20 though, right? ‘Cause you have so many more tools than those twerpy index guys plus the mad skilz required to use them.

So it’s probably news to most investors that hedgers are “not just looking for returns,” now that the economy has gotten difficult.

And . . . thanks for whining about how tough it is out there for y’all whiz kids. That very well confirms what a lot of us always thought about you.

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Dennis Kelleher, Libor, and high-frequency trading

Felix Salmon
Aug 8, 2012 06:03 UTC

Dennis Kelleher of Better Markets has responded to my post in which I said, inter alia, that he was wrong about high-frequency trading. He, of course, says that I’m wrong — indeed, that I’m “over the top and just plain wrong in many ways”, and that the post is “self-discrediting”. Blogfight! So, fair warning: this post is my response to his response to my post; if you’re not into that kind of thing I fully understand, and you’re probably much more grown-up than either of us. Anyway.

First, Felix totally overlooks the fact that some of the biggest banks in the world knowingly committed multiple very serious crimes by rigging the Libor rate.

It’s true I didn’t dwell on this, because it really wasn’t the subject of my post. My point was that whenever something scandalous or unacceptable happens in the financial markets, it’s not enough that the activity is scandalous or unacceptable: the financial press also feels the need to demonstrate that the little guy was being ripped off somehow. Even if he wasn’t. In this case, I’m perfectly happy to agree with Kelleher that rigging Libor was a very serious crime.

Kelleher accuses me of ignoring other things, too, like the difference between the two separate parts of the Libor-rigging scandal. Again, yes, I didn’t mention that. I also didn’t mention Standard Chartered, or HSBC money-laundering, or, for that matter, the Olympics badminton scandal. Kelleher has made it his life’s work to rail against such things, so maybe he feels that I should mention them in every post I write. But I can hardly be wrong about something if I didn’t even mention it.

He does, however, say that I’m “dead wrong that no one was harmed by the banks rigging the Libor rate”. This is a bit of a nasty accusation, because if I’d said that no one was harmed by the Libor rigging, then indeed he would be quite right to call me wrong. But I never said anything like that. He also says that I don’t understand interest-rate swaps, and proceeds to give a perfectly accurate explanation of how they work. And again, his explanation doesn’t contradict anything I said. But I do think he misses my point, so let me try again.

Kelleher uses an example of a municipality which has entered into an interest rate swap and is paying a fixed rate while receiving a floating rate linked to Libor. Such swaps are designed to protect borrowers from rising interest rates; the flipside of the deal is that if rates fall, then the borrower will end up losing money. And as it happened, rates fell, and the borrowers ended up losing money.

Now here’s the thing: the municipalities didn’t insist on linking the interest-rate swap to Libor because their borrowing costs are particularly bank-like. They just used Libor because it was the market standard, a proxy for interest rates more generally. The Libor scandal — and, yes, it is a scandal — is that the banks ended up printing a rate for Libor which was closer to prevailing interest rates than it should have been. Because Libor is tied to the interest rate on unsecured bank debt, it can actually rise when interest rates are falling, if the credit spread on bank debt rises fast enough. From the point of view of borrowers engaging in interest-rate swaps, that’s a bug, not a feature. What they want is a simple proxy for interest rates; they don’t want a proxy for interest-rates-plus-financial-sector-credit-spreads.

So Kelleher is right, in a narrow sense, when he says that if you were receiving floating-rate interest payments linked to Libor, then you got less money than you should have got. Because according to the contract, your payments should have included that extra bank-credit-spread component, on top of the interest-rate component. But my point is that no one ever entered into an interest-rate swap because they were making a bet on bank credit spreads rising. As a result, the losses here are losses of windfall, unexpected revenues. And of course there are just as many borrowers who entered into floating-to-fixed interest-rate swaps: they ended up winning just as much as the fixed-to-floating borrowers ended up losing.

It’s worth taking a step backwards here. In the grand scheme of things, borrowers gained rather than lost from the Libor manipulation, because it meant that they paid less interest on floating-rate debt. The real losers here are investors who bought floating-rate debt, and who should have been paid more than they were. My point is that if you’ve found someone claiming to have lost money as a result of the Libor manipulation, and they’re a borrower rather than an investor, you’re pretty much scraping the barrel. The Libor scandal is scandalous for many reasons, first and foremost that it involved banks lying in order to manipulate a hugely important interest rate. You don’t need to show borrowers losing money in order for there to be a scandal here: there would be a huge scandal even if no borrowers lost any money at all.

Kelleher then moves on to the main subject of my post, which was high-frequency trading. I said he was wrong when he said on a TV show we were on that shops like Knight rip off small investors. He replies:

Mr. Kelleher distinguished between high speed trading (really high speed market making) and predatory high frequency trading (HFT). Maybe not the most precise way to talk about these activities, but not too far off the mark for a general audience. It was the later practice not the former that Mr. Kelleher said rips off small investors, frequently referred to in the market as dumb money. (Not mentioned was that, because shops like Knight pay for order flow from retail brokers and pick off what they want, there are fewer natural buyers and sellers in the market and only professional or toxic retail flow actually gets to the market.)

OK, let’s make a distinction between high-speed market-making, on the one hand, and HFT, on the other. If you’re making that distinction, then Knight absolutely falls into the former category: it’s one of the helpful market-makers, rather than one of the predatory algobots. This part of the show hasn’t made it onto the internet, but I can assure you that Kelleher never explained that his distinction, at the margin, actually makes Knight look better rather than worse.

But in any case, the high-frequency algobots don’t rip off small investors, because the two never come into contact with each other. If a small investor puts in a stock trade, it ends up being filled by Knight, or one of the other high-speed market-makers. The algobots are whale-hunting: they’re looking for big orders from institutional investors, which they can game and front-run and otherwise prey upon. If small investors ever found themselves naked in the open oceans of the markets, the same thing might happen to them, but they don’t: they’re protected from those waters by companies like Knight, which will give them exactly what they want at the national best bid/offer price.

You’d think that Kelleher, having made the distinction, would be happy that small investors don’t end up being picked off by predators, but he’s not: he reckons that because they’re not out in the open ocean, that means “there are fewer natural buyers and sellers in the market”. Well, you can’t have it both ways. And frankly if retail investors did return to the market, it wouldn’t help matters: there wouldn’t be more volume or more liquidity or any visible positive effect.

So why did Kelleher even make his distinction in the first place? Just so that he could then come out and say that “HFT is a liquidity taker, not a liquidity provider”. In order to say that, he needs to exclude high-speed market-makers like Knight, who clearly do provide liquidity to retail investors. When I said that high-frequency shops provide liquidity to the market, I was very much talking about Knight, and I can assure Kelleher that everybody who was watching TV on Monday night thought that he was talking about Knight as well. After all, it’s Knight that’s in the news right now.

Finally, Kelleher pushes back against my “anti-regulation stance”, which is quite hilarious; he also informs his readers that “Felix also sees HFT as nothing but a force for good.” Maybe he didn’t see my post on Monday, where I talked about how HFT is “quite literally out of control”. I concluded that post by saying that “the potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.” So obviously I don’t consider HFT to be “nothing but a force for good”.

The fact is, however, that I don’t need to go back to Monday’s post to demonstrate my anti-HFT bona fides. In the very post that Kelleher’s responding to, I write this:

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous.

Kelleher, then, is a man who, immediately after reading those words, can turn around and describe me as someone who sees HFT as nothing but a force for good. It’s very hard to know how to respond to such a person, but I guess that does at least explain why he thinks I said so many things I never said. He might think he’s responding to me, but in fact he’s just creating a straw man and putting my name on it. Which, frankly, is a little bit annoying.

COMMENT

This and other topics that are relevant for speed traders and institutional investors will be discussed at High-Frequency Trading Leaders Forum 2013 London, next Thursday March 21.

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