The Delusional Mind and Investing

Over the past two weeks most of the news focus in the U.S. has been on the shooting tragedy that occurred in Arizona.  Some positive news concerning the prognosis of U.S. RepresentativeGabrielle Giffords  has mitigated some of the nation’s mourning.  Some of the news coverage has also begun to focus on the shooter Jared Loughner.  By most accounts he is delusional, but it is still unclear if he technically meets any definition of mentally ill. 

The Myth of Rational Thinking

So what does the potential mental illness of a killer have to do with finance and economics.  Well technically nothing.  But, since this is a financial and economic column, we find a way to transition.  Actually it is worthwhile to focus on the so-called normal mind and identify some of the traits that can trip us up when we try to make decisions especially ones that will impact our future and financial well being.   When we start taking a hard look at how we humans analyze the world it turns out that the rational mind assumed by most economic models is a delusion of our own making.  The reality seems to be more consistent with the many oddities encountered by Alice after falling through the rabbit hole.

A lot of the new knowledge uncovered regarding the brain’s methods of analyzing the world has not yet been tied neatly back to the investing paradigms.  So we must sometimes look to books and articles residing outside the investment literature.  One such book that sheds light on some of the oddities of a normal mind is A Mind of Its Own.  Author Cordelia Fine does a good job of distilling some of latest research and putting it into terms that a layman can understand and digest.  Many of the insights have relevance to how we go about digesting the economic news and make financial decisions.  

I Knew That Already

Over the next few weeks MM will enlighten you on some of the surprising features of your mind.  Some of the operational features may seem obvious to you.  However, this may be due to one of the more persistence delusions that we all share.  Once information is revealed to us, our egotistical mind acts as if we knew it all along.  As they say hindsight is 20/20.  And, at this point your brain is reassuring you that you have always been aware of this feature of your mind.  It is so obvious.  Just like the internet bubble, and housing bubble seems so obvious in the post event analysis.  Next year we all may be talking about how clear and obvious it was that gold was overvalued. 

Herd Behavior and the Wisdom of Crowds

So, we have now established our great intellectual prowess to understand events after the fact.  So, what happens to our so-called analytical mind as events are unfolding with the myriad of complex and conflicting information?  When faced with critical decisions, particularly ones involving our personal finances, most of us would say that we weigh the most critical factors with an open mind and make an enlightened decision.   The reality is that we quickly latch onto whatever notion is presented to us by our peers or is most prevalent in the public press.  We then hang onto this hastily developed conclusion even if bombarded by contrary evidence. 

Many of us have watched the show Who Wants to be a Millionare, which was highlighted in the movie Slumdog Millionaire.  So we know that the lifeline that allows one to survey the crowd is fairly reliable.  However, the more difficult the question the less reliable is the crowd’s consensus answer.  Yet as a player lacking any knowledge of the correct answer we have only the choice of the crowd ringing in our ears.  It seems almost foolhardy to question the crowd and select a different answer.  This willingness to go with the crowd appears to be hardwired into our brain.  This is the case even when our senses or powers of calculation tell us something different. 

Pressures to Conform

Part of the run with the crowd phenomenon seems to include a certain degree of peer pressure or unwillingness to be the odd man out.   A number of psychological experiments have confirmed that something as simple as noting which line drawn on a page is longer can be materially influenced when the majority (accomplices of the staged experiment) has publicly weighed in with the obviously wrong answer.  The effect is more material if we also have to provide our answer publicly, but it also manifest itself even if we can maintain confidentiality with regard to our own answer.

Of course this tendency to trust the wisdom of the crowd is what underlies the many economic and financial excesses, such as the internet stock craze, and the most recent housing bubble.  Almost all investment bubbles have some grain of validity, and you can make a lot of money running with the crowd.   Momentum investing is based on the tendency for everyone to simply keep pushing the cart in the same direction.  Most professionals that are involved in momentum trading understand that they are riding the currents produced by the madness of crowds, which is why there is such a rush for the exits once there is a hint that the crowd has become cured of its madness.  But knowing the point of inflection is more a game of psychology than quantitative finance. 

Dangers of Momentum Investing

One recent example of this phenomenon is the over 21% plunge in the stock of F5 Network on Thursday.  The company released earnings results the previous evening, which were generally positive, although with mediocre forward guidance.  The news seemed to set off a chain reaction of selling.  Since many of the active traders of this stock are most likely momentum investors, any slight drop in price would create a mass dumping of the long positions.  The company remains well positioned in the field of cloud computing and is still expects strong growth, but in the age of high frequency computerized trading, one small change in a company’s financial picture can cause a cascade effect that in a blink of an eye translate to a large move in the stock price.

F5 Network - 5 Day Chart

Anyone dabbling in the markets needs to understand not only finance and economics, but also how human psychology interacts with the new trading techniques.  Stay tuned to MM for additional insights into how our minds work, and how to avoid falling into common errors in judgement.

The U.S. Mortgage Mess

Just when you thought the U.S. mortgage market was on the mends, we hit another glitch.  This time it has to do with the mundane process of real estate foreclosures.  Of course each foreclosure is a very traumatic and personal event for the home owner, but for mortgage lenders it is just one of the routine processes of the business. Millions of foreclosures are carried out every year even in good economic times.

So how could we hit a stumbling block on such a routine process?  Well for one, in the U.S. it turns out that the foreclosure process is subject to local laws and customs.  For this reason, personnel handling this function must be knowledgeable about the local rules, and when foreclosures surge in one local, it is difficult to just throw more employees into the fray to keep up with the ballooning workload.  Secondly, the same sloppiness that created the bad loans in the first place was not just isolated to the credit decision.  In fact, during the peak of the real estate boom, the back offices were so strained and under pressure from the sales division, it became impossible to keep up with the workload without cutting some corners.  The other snag is the cumbersome requirements set forth in many jurisdictions. In many cases a single individual, who is named in the original documentation, is responsible for reviewing the validity of thousands of mortgage documents prior to submission to the courts for foreclosure.

The other factor contributing to the current problem is that during the mortgage boom many mortgage lenders decided, in the name of efficiency, to replace paper documents with imaged records.  Of course, mortgage lenders had their legal staffs provide opinions on the court acceptability of imaged records.  However, with the decentralized courts system it was impossible to assess how each local jurisdiction would react.  In cases where courts have demanded original documents, banks have had difficulty locating or retrieving them.

So, where does all this confusion leave us?

It is unlikely that the sloppy documentation will actually save a delinquent debtor form losing their home.  However, it does change the timing and the cost of the foreclosure process, which is one reason why bank stocks have declined in value.  The additional cost to banks will come from a number of angles. For the loans that are held on the banks books, they will not only incur higher legal fees, but will also be forced to hold the non-earning assets longer.  The incremental cost for this portion of the problem is probably not material enough to have caused the recent decline in bank stocks, particularly since all of the loss reserves for most banks have grown to relatively conservative levels.  The aspect of this fiasco that has the biggest potential for new losses for the banks is the potential for loans sold into mortgage backed securities to be repurchased by the bank.

The legal arrangement between mortgage lenders and the trustees of a MBS includes a provision that forces the bank to take back any improperly documented loan.  In most cases this due diligence clause is invoked based on inadequate documentation relating to the credit decision, i.e., no credit report, inadequate verification of income, etc.  It would also clearly cover instances where the bank is unable to foreclose due to inadequate recordation.  However, it is less clear if the sloppy documentation that simply causes a delay in the foreclosure process legally requires the bank to repurchase the loan.  This lack of clarity will be dealt with only through extended legal battles. Since the foreclosure process is decentralized and errors are often idiosyncratic, it will be difficult to resolve the legal disputes in generalized terms.  As a result, there will be lots of skirmishes fought between banks and MBS investors.

NY Fed Seeks To Cut MBS Losses

One ironic twist is that the NY Fed may push to have banks buy back loans held in MBSs that are part of a portfolio acquired by the Fed from Bear Sterns and AIG in its attempts to avoid a financial meltdown.  I guess now the Fed is feeling a little less generous, and is seeking ways to cut its losses.  However, this seems to run counter to the current efforts to create an environment that will promote banks to resume normal lending activities.

FDIC Chairman Bair noted that the problems with foreclosures may need a global solution that would include some type of safe harbor for foreclosures on vacant houses. However, it is unclear how to implement an arrangement that would override the existing legal framework, which is governed by local laws.  Some other comments by Chairman Bair have the potential to create additional headaches for banks.  Many of the large banks have loss sharing arrangements with the FDIC due to the assumption of mortgage portfolios from failed banks.  Chairman Bair has indicated that losses associated with improperly executed foreclosures would not be eligible for loss-share arrangements until problems are appropriately remediated.

Probably the worst part of this for banks and their investors is the diversion of attention.  Just when it seemed that bank management could turn their attention to the growing the business in a risk focused manner, they must reclaim their fireman uniforms and fight another firestorm.  Not only do they have the business end of the problem to deal with, there is a public relations nightmare that is almost as troublesome as the original credit crisis.  The U.S. news airways are awash in stories about homeowners awoken to sounds of someone changing their locks.  It doesn’t matter that many of these stories don’t make sense; what is important is that Goliath is going to lose out in the PR game, every time David tells his story.  In addition, many of the more liberal groups have leveraged the bank foreclosure problems to renew their push for delaying foreclosures in the hopes that it could give some home owners an opportunity to eventually retain their home.

Is there any silver lining to this latest chapter of the financial crisis?

Perhaps there is some upside for holders of MBS, who will have an opportunity to force banks to repurchase some of the bad loans.  For savvy investors with the time and expertise to pick through the rubbish of subprime MBSs there may be some unrecognized value related to this recent mortgage mess.  However, this investment angle is not for the faint of heart, especially since there are some experts that are warning that there may exist flaws in the process of assigning mortgages from the mortgage lender to the MBS.

It is interesting to note that the IMF and various economists have focused on how some third world nations are hampered by the lack of a clear legal framework for financial transactions.  Perhaps the U.S. policy makers need to study some of this literature.

About Bernanke, the Fed and its New Mandate: Regulation

There is a lot of fuss and discussion lately about Bernanke and his last speech at the ASSA meeting in Atlanta, where he finally gave his views about the responsibility of the fed in the housing bubble. What an interesting timing! The speech can be summarized with this sentence:

That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.

To confront Bernanke’s view, the Wall Street Journal surveyed economists, all members of the National Bureau of Economic Research’s Monetary Policy Program and asked them whether low interest rates caused the housing bubble. What a strange idea to survey those economists when it is very likely that most of them did not see it coming. And surprisingly, in response to the question most respondents point instead to regulatory failures. Indeed, those economists have no expertise in regulatory reforms, so clearly it must have been the big problem, because otherwise, if it was “classical” monetary policy, they would have spotted it! Not to blame them though, just look into any macroeconomics textbook and you will see that only one page (at most) is devoted to the subject. So, by shedding the light on regulation, Bernanke’s speech is actually ground breaking. At last, economists are going to get interested in regulation and supervision, which then would take a much bigger chunk in textbooks. To me, that may be the biggest achievement of that speech.

Yes, because unfortunately, the big objective was different, namely to justify what the Fed did in the past. But frankly, is it really what we should expect from the Fed chief? As far as I’m concerned, I don’t want him to look into the rear mirror and keep arguing on who is right or wrong on that matter (see Dino’s article posted almost two years ago !). People often criticise Wall Street pundits for their super ego and that is fully justified. But, what about economists? Economists are never wrong. There will be always an explanation that will prove their theory or saying. They will come back to you with a new argument each time, and the debate could go on and on forever (think about the efficient markets hypothesis). That’s what Bernanke did with this speech :”I’m going to prove John Taylor that his rule and criticism are unfounded. The Fed was right”. In that process, however, the fed chief only looks at the research and the data that prove him right. That’s way different from tackling the subject with full objectivity. And clearly, we don’t want this type of economist at the helm of the Fed.

Moreover, Bernanke only looked at one side of the coin; the big debate is about the asymmetric policy that the fed has pursued since Greenspan took office in 1986 : Bubble denials with no pre-emptive actions,  which contrasts with unconditional bailout (almost) of big banks and then moral hazard. On the first point, while he mentioned several times the word “bubbles”, he did not clearly say that they exist ex ante and never acknowledged that this would be possible to spot them. If you don’t try, clearly you won’t succeed! And worse even if they wanted, as Krugman noted, the Fed may be still using some of the flawed methodology that helped it miss the bubble. On the second subject, not a word in his last speech, but since the beginning he’s been backing Greenspan idea that given this difficulty in identifying bubbles ex ante, the priority is to clean up the mess unconditionally after they self-identify by popping. And, I’m afraid that they will continue to do that. Nothing will change on that front. Moral hazard survived another crisis (despite  Obama’s bank tax). Now don’t misunderstand me, I’m not saying that the fed did everything bad, I tend to agree with Paul Volcker himself has said the Fed took “actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central-banking principles and practices.” , today is no time to self patting, quite the opposite, the Fed needs to look forward and objectively assesses what can be the optimal monetary policy in the months, years to come.

Actually, this speech makes him look like a real politician. Well, he may have filled the shoes of one lately since his reappointment will soon be voted on by the full Senate (following the Senate banking committe’s confirmation last December). And, one should know that attack is the best form of defence. This is what he’s doing now by waving his new flag named regulation. This speech was the start of a battle against the senate efforts to strip the Fed from banking supervision. Indeed, the biggest threat for the Fed moving forward is to see its role as bank regulator be superseded by a new uber-systemic risk regulator. In a must read report addressed to the Congress, he strongly makes the case that the central bank should play a leading role in the new regulatory regime. The first part of the report looks like a letter of recommendation to the Congress and shows why the Fed is the best armed to strengthen regulatory and supervisory performance. Here are the punch lines with some plain english translations:

Bottom line 1:

“Supervision by financial regulators, including the Federal Reserve, clearly had significant shortcomings in the period leading up to the financial crisis”.

We were not the only ones who failed; all the other regulatory institutions did (FDIC, HUD, SEC, OCC…)

“The Federal Reserve is also making changes designed to fully employ its expertise to effectively supervise large banking firms”.

We were behind the villains in the past, but the next time we’ll be ahead of them. Moreover, we know how to handle those big banks now . So, no need to break up the banks. We’ll handle them. Don’t worry about too big too fail!

Bottom line 2

“Elimination of the Federal Reserve’s role in supervision would severely undermine the Federal Reserve’s ability to obtain in a timely way and to evaluate the information it needs to conduct its central banking functions effectively”.

We may have been wrong in the past (but we’ll never say it), and worse if you congress deprive the central bank of information, it’s going to be even worse next time, i.e. we may not be able to bail out everyone and save the banking system. Do your really want that to happen?

Conclusion

With an almighty Fed or with no Fed (as desired by Jim Rogers), there will be always bubbles and crises. Nonetheless, the issue is still to move forward and improve monetary policy. Having better regulatory tools at the Fed is a good step towards that objective. Favouring reaction against prevention was not and is still not the right policy.

Message To All Doomsayers

It´s time to remind some market participants of the fact that this is not the first time in market history when bubbles are bursting. This is a message to an investor generation that is facing such a crisis for the first time and to investors that are too driven by adrenalin for thinking rationally.

First of all. Read Charles Kindleberger´s classic “Maniacs, Panics, and Crashes” as a start. Quoting smartmoney.com “It will tell you what it was like to live through a mania and what inevitably happens when the market comes back to earth.”

As investors we should be aware that “rise and fall” fluctuation is inherent to any system the homo sapiens is involved with. Expressed in the language of finance it sounds like Hyman P. Minsky (in “Stablizing an Unstable Economy”): “turbulence, especially financial instability, is normal in a capitalist economy. […} There is no possibility that we can ever set things right once and for all; instability, put to rest by one set of reforms will, after time, emerge in a new guise.”, or like John Kenneth Galbraith (in “A Short History of Financial Euphoria“): “Yet clearly the speculative episode, with increases provoking increases, is within the market itself. And so is the culminating crash.”

If rise & fall, J-curve effect, economic cycle, boom & bust or however you name it, is just the normal way of how trends are developed, we should stop thinking of them as situations to be avoided. Once we accept them, we can start to think about how to manage up & downswing exaggerations.

Let´s have a closer look at the current situation. Right now we are facing two bubbles that are nearly overlapping in their bursts.

The housing/credit crisis bubble

Between Jan´91 and Jan´06 the number of annualized housing starts increased from 800k to 2300k – a multiple of 3. This annual increase of 7,2% was significantly higher than the increase in household starts. Between 1996 and 2001 the real estate prices soared by 42%, in the following four years by 64%. More and more households were lending money on their property, assuming that the value increase of the underlying will exceed the mortage costs … we know the result.

The oil bubble

Between Dec´85 and Dec´01 the barrel was priced at an average of USD 19,95. Volatility around this niveau was moderate. Today the barrel is priced at USD 145. In the previous 6,5 years the price appreciation was on avg more than 30% p.a. The nominal national product of the world increased during the same period “only” by 7.9% (IMF). Oil prices increased faster by a multiple of 4!

Two complementary scenarios of how to handle the current situation without meeting trouble halfway but choosing the constructive approach:

REGULATORY CHANGE

I don´t need to re-invent the wheel after having read Larry Summers´ ideas to this topic that deserves to be endorsed. He published them on Jun 1st in the FT  Six principles for a new regulatory order (below a short summary):

1. no regulatory arbitrage
2. no self-regulation of financial institutions
3. Rather than judging where and when the next crisis will occur (inability to predict), regulators need to try to assure the resilience of the system with respect to economic shocks or problems in any one sector or institution.
4. the focus of regulation must shift from the prudential practices of individual institutions to the health of the financial system.
5. any regulatory regime must address the risks arising from “parallel banking activities” in a realistic way.
6. regulatory policy must to the maximum extent possible create a situation in which the failure of an individual institution is not itself a source of systemic risk.

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STRUCTURAL CHANGE

For me it seems as if we have reached global capacity constraints. Consequently inflation is caused by a lack of productivity reserves. In other words: a part of the production capacity has to be mothballed as it could be only used under the old input-cost-relation between energy, capital and wages.  Under the current crcumstances we do not need productions plants for vehicles with hillarious gasoline consumption, for houses with lacking heat insulation or carriers with business models that are depending on cheap kerosene. Given these contraints, the productivity potential might be lower as we have thought.

The solution is to understand the situation as an opportunity for modern structural policy. This new policy bets on a permanent renunciation of energy-intense production processes. The high energy prices extort anyway a reaction from us. Let`s seize the opportunity and follow a pro-active than re-active approach. We have to restructure the supply and demand side of the energy market. Apart from lower / more stable prices, we can benefit by

• – freeing our dependency from states we would not like to see too powerful
• – slowing global warming
• – becoming more independent from non-renewable energy sources
• – fuelling global community thinking (political effect)
• – … many more

Increasing interest rates is not the only answer to a rising inflation rate. In my view it is the least effective answer at the moment.

MY ADVICE TO ALL DOOMSAYERS.

STOP WHINING. START WORKING ON THE IMPLEMENTATION OF THE TWO CHANGES. THE NEXT UPSWING IS AHEAD. THE LONGER WE WAIT, THE DEEPER THE PERIOD OF CONSOLIDATION WILL BE.