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On the value of Trading, Shorting vs Doctors, Inventors and other do-gooders
Prompted by talking with a friend, the long running debate online about whether financial business has become too large in our economy and recent posts between Felix Salmon and John Hempton about the value of shorting — here is my view on valuing human activity and bold claims such as:
But equally he could quit his job and do something genuinely productive instead, and that would surely benefit society much more than he’s doing right now. In fact, Hempton’s part-time lifeguard gig is clearly better for society than his day job is.
Similarly, my friend/coworker Chris suggested that rather than proprietary trading, my time would be more efficiently allocated towards inventing or running a real business (insert your favorite example here, it doesn’t matter).
Before we proceed, we must agree on a couple things. First, a distributed, capitalistic model of resource and labor allocation is more efficient in our modern society and on large scales than a command and control model. This may not apply to certain things like national defense, education, etc. only because of externalities, widely distributed costs/highly concentrated benefits, etc. but in general capitalism > socialism is the rule, not the exception. The implication here is that the market, the invisible hand, collects the (often times simple) opinions and knowledge of a wide variety of diverse participants and combines them in non-obvious and almost always very complicated ways. Please read Eric Falkenstein’s brief overview of this concept before proceeding if it is not clear why a group of diverse and yet simple opinions can allocate resources much more efficiently than even the most brilliant wizard.
Now, our system is not a perfect free market economy. Very far from it in fact. So when people present to me the argument that resources are not allocated efficiently, there can be only two implications in my eyes:
1) The market has failed or at least has not yet succeeded in allocating those resources efficiently. This is tantamount to saying the market is wrong but I’M RIGHT. Free markets are efficient, that does not imply that they are always “right”. It implies that they will be sub-optimal intertemporally (time is always flowing, there is never an equilibrium we are always shifting from one to another) but there is no way for humans to figure out in which direction they are sub-optimal. This surely can not be what intelligent people refer to when they say the market has misallocated resources as it is tantamount to saying MSFT is too cheap, the price should be higher.
2) The market is being kept from functioning properly, typically as a result of rules imposed on the system by government or a failure by the economic agents to act in a sufficiently rational manner. The latter is a sticky subject since we are all human and identifying specific cognitive biases and their direct effect on market prices is tough in practice. The former is more straight forward and can be used to argue that resources are misallocated.
Given this framework, we can look at the simple example of shorting publicly traded stock. The beauty is that we don’t need to start from scratch and deduce why buying stock can be considered ”good” (for example, it could help provide capital for entrepreneurs to fund businesses which make the world better, more efficient, whatever) and why the opposite may be “bad” because there are dozens of potential arguments filled with nuance and exceptions here. When we get down to the core, publicly traded corporate equity creates widely disseminated and generally better signals of price/value than the alternatives. In a market, more information, and more accurate information, is strictly better given enough participants and some other basic prerequisites.
These market prices serve as signals and effect the allocation of resources in an almost unlimited variety of potential ways. This is why markets work — they can perform incredibly complex calculations and allocation decisions that no one individual could ever divine. A publicly traded stock does not merely help the company raise equity to pursue new projects, but it gives competitors an idea of how well they are doing relative to their peer (which has direct consequences on the decisions they make themselves), a signal as to what kinds of activity is being viewed as profitable/unprofitable in the future which can trigger a literally infinitely complex chain reaction response of resource allocation and reallocation. A simple example of “socially beneficial, good, efficient” shorting is trivial to come up with. Anything which moves the price towards a more efficient representation of value is efficient, good, and socially beneficial! If the market believes that MSFT is currently overvalued but there is a lack of selling pressure from current holders, shorts are able to drive the price down to a more accurate representation of value. Here comes the infinite cascade of reallocation; falling MSFT prices, which required the added effort of shorts since long holders were insufficiently informed or more likely institutionally limited to create the necessary supply, signal to competitors and future enterprises a potentially failing business model. Venture capitalists will be less interested in investing in firms that plan to behave like MSFT, or maybe even in software companies as a whole! As jobs move towards other industries, labor also adjusts. Some students at some universities choose a finance concentration in the business school instead of electrical engineering and computer science in the engineering school. And so it goes. The point is, price signals have incredibly complex and rich effects on a large and diverse economy (such as ours). The large and more diverse the economy, the more profound and important the effects of those signals are and the more critical it is that our prices are as efficient as can be.
Going back to the simple framework outlined above, it is easy to see that if anything there is not nearly enough shorting going on due to the many regulations and limitations placed on the activity. The consequences of this are disastrous. Stock prices as a whole are surely more likely to be inefficient, more frequently overvalued than undervalued, and less quick to adjust to new equilibria overtime. We can conjecture that this would cause overinvestment over time, as a guideline. Maybe if shorting was easier and more prevalent, economies would identify an oversupply of investment/capital sooner in economic cycles leading to more frequent but more modest recessions without the debt overhang of bailouts? What about those evil shorts who drive potentially salvageable companies into ruin thanks to malicious rumor? Aleph blog touched on this a few times during the crisis, the point being a solid firm should/will not be vulnerable to short term swings in equity prices. If a firm is vulnerable, that is a risk that they took and should be held accountable. If a financial firm relies on a stable equity price to do business, they should face the consequences of the risks they take that may jeopardize that. Indeed, they should also face the consequences of the risks their peers take which may also harm their equity price due to the opacity of their activity and inability of market participants to distinguish good from bad apples.
It is pretty straightforward to extend this anywhere in the economy. Would I do more good to society as a doctor rather than an exploiter of extremely short term mispricing in fixed income markets? I am better compensated by the market doing the latter. The barriers to entry to doing the latter are also drastically smaller. In fact, the explicit goal of limiting the admission into med schools is to keep the supply of doctors artificially low and therefore keep their wages up. It is difficult to compete in that market, there are limits to free trade! If anything, this is a signal that doctors are overpaid relative to freer segments of our economy — such as proprietary trading of financial markets by individuals or other self-funded entities, or more simply, say, computer programmers. I don’t want to extend this to investment banking or hedge funds, at least not in this post, since it gets more nuanced when you introduce the principal-agent relationships and conflicting utility curves. Is it fair to say that because doctors are paid less than some successful proprietary traders that they are less socially useful? Of course it is. Life can be assigned a value, the statistical value ranges in the few million dollars+ and is a function of age, health, education, income etc. If the argument is about intangibles, I say bullshit and anything can be assigned a range of tangible values. If the argument is that certain occupations create enormous positive externalities and are therefore socially good (like John Hempton as a lifeguard), I say this is a market failure and you saying they are socially good is equivalent to saying people should do you favors without compensation.
What about inventors? Should I quit my job and try to invent something new to change the world, or start a business? Most of these ventures fail, the vast majority. It’s not an easy path to take. It is definitely the riskier one. Yes I may be very intelligent, but I am also quite risk averse. Given my utility function and the payoffs available to me by taking different occupations and financial risks, it is up to me to calculate those trade-offs. As long as the barriers to free trade are removed, in the case of new ventures I feel like we are OK in this regard, the market will be most efficient at allocating the amount of resources (in new venture funding and even grooming/support of young entrepreneurs as done by start-up incubators).
The big takeaway is that the impact of price signals are not obvious and very wide-reaching. Be cautious when making claims about certain occupations/industries being overcompensated. Unless there is a barrier to free trade (typically in the form of regulation) which is causing this, it is safe to say we are doing the best we can.
World of Education
Talking to Mike recently about the addictive factors in modern computer games, it became clear that they same tricks can be applied in every day lives. The typical tricks are a social environment to promote status/achievement comparisons, providing rewards (virtual and sometimes purely aesthetic — this can be a status indicator to others in the virtual world, but typically useful in some way in the game world), setting up achievement treadmills — rewarding repetition of sometimes arbitrary tasks — of exponentially growing difficulty, reducing the correlation between effort and instantaneous reward (proven to increase dopamine vs predictable results), and some amounts of complexity/richness to the world.
These games are so popular and addictive because they serve as an escape from our multi-dimensional realities. In the real world we do not have clear paths to success, instantaneous reinforcement and rewards, or clear lines drawn between cause and effect.
I will use the specific example of our education system. Most children, except for the truly intellectually curious, find school a chore and a necessary evil. The system could drastically improve if students wanted to learn as much as they wanted a suit of armor in World of Warcraft, and put in the requisite effort. A push vs pull inversion would require a complete re-imagining of the system. There are some educational games out there but they lack many (or all) of the components above which trigger our dopamine receptors and motivate our desires. Here are some simple ideas for how to manipulate the minds of students into learning, the same way they are manipulated into wanting to collect virtual gold coins to buy a virtual pair of pants:
social aspect: A system to publicly and regularly compare the progress (intertemporal) and raw (as well as relative) achievement levels of each student vs their class, school, etc. A standard metric system would need to be developed but this would grow out of the challenges/rewards set up throughout the system
reward system: Some rewards can be purely aesthetic, such as official titles signifying various levels of achievement in different academic subjects. Others would be actively useful in the system, such as extra time on an exam.
achievement treadmills: Whether we like it or not, a strong fundamental education is built off of repetition in order to deeply ingrain basic concepts such as multiplication, grammar, the law of gravity, etc. into our minds. This is perfect for a hedonic treadmill; we just need a system which marks levels of achievement from repeatedly solving problems of varying difficulty over and over with slight differences each time. Once a student has mastered a concept, they get to unlock a more complex concept and restart the cycle of learning, mastering, proceeding, etc. The key to making this enjoyable vs. a chore is the ability to go at your own pace (the more effort you put in, the faster you advance) and to compare your progress to your peers to foster competition.
The same tricks can be used in many facets of our lives, even after entering the “real world”. It just becomes up to us to setup the correct treadmills and reward systems to experience the hedonic effects necessary to stimulate the self-reinforcing “addiction effort-reward” cycle
Goldman SLP Conspiracy
Tyler‘s ongoing crusade against Goldman and NYSE SLP program has begun to spread, and frankly I’m really confused. What exactly are you accusing them of? I love your blog man but I don’t see the logic here.
SLP is a liquidity provision program, participants get paid to provide liquidity (not as much as DMM’s, but the quoting requirements aren’t as stringent either – as a side note, you can’t simply say one program is BETTER than the other, there are many other factors). Goldman is one of the few houses on the street not reeling in pain, more volatility creates more opportunity for liquidity providers and as one of the few players able to deploy capital they have stepped up. If you look at the program trading volumes, Goldman has essentially taken up the slack of the other houses (and hedge funds who has also been in pain) and the additional increase can be accounted for by the subsidy from SLP as well as the higher profitability environment for market making.
As far as pushing the market around, that’s hard to do when providing liquidity. Theoretically they could be supporting the market, but SLP trading could not account for 100,000 futures being bought at market — if anything GS was the one taking the other side of these large swings. And making huge money as they have been coming back the next day…
Consequences of market manipulation
The Fed has maintained a counter-cyclical monetary policy because it is thought (I contend our sample size isn’t large enough, but in a few years I think we’ll get a good feel…) that “leaning against the wind” leads to less volatility and less overshooting in the long run for the economy and interest rates. I think it merely allows marginal companies to survive, rather than flushing the system of debt and reallocating resources more efficiently but with pain, and weakens our banking system over time as it is encouraged to take more risks.
But, there is a limit to the amount of damage the Fed can do by setting targets for the front end. While the rest of the curve and other interest rate products tend to follow, they also are free to have a mind of their own (especially further out in duration). The Fed has lowered front rates as far as they’ll go, but now wants mortgage rates lower so as to hopefully arrest the fall in housing prices. I think Ben knows what he’s getting himself into, and the final result (which he likely foresees) is that we will have a slow grinding adjustment in housing prices rather than a quick and violent one. With mortgage rates being held artificially low, an artificial demand for housing will exist in the market until the manipulation is halted and rates are allowed to return to market clearing levels. Theres a lot of benefits to this approach — it gives banks time to earn their way out of this mess and hopefully recapitalize faster than losses mount (I think it’s debatable whether slowing price drops at this point will make much difference, maybe he foolishly thinks he can turn the whole market without destroying the dollar…)
There are a lot of drawbacks too, and Fed purchases of MBS and suggestions by Felix and others that they should purchase other assets further out in duration than current programs, like Corporates, will only compound these drawbacks. The Fed is essentially replacing market forces, the invisible hand, with its own thoughts on asset valuations. Sure, right now we have banks that are essentially backstopped by the Gov’t allocating this capital, why not just let the Gov’t themselves do it (I think Interfluidity recently brought this up also) and ignore the profit motive? Profit is what makes capitalism work; even if it’s a call option instead of pure equity it’s certainly better.
Maybe these assets are undervalued right now (I would disagree vehemently, even though liquidity is so low) and they are correct in buying, but when will they sell? Models & Agents, a blog that’s new to me, is also concerned about the way the Fed is beginning to dictate who gets credit and who does not. The real cost of these programs is not the gross $ amt spent to purchase MBS or bonds, or even the net $ amt after taking into account sales prices and coupons (whenever they are sold, or likely held to maturity) , but rather the impossible-to-measure impact these false, manipulated, market prices has on the pricing of other assets. And with manipulated asset prices, we open ourselves to the certainty of misallocation, further misallocation might I add, of resources in our economy.
At this point I’m convinced we are headed to a slow grinding decline, both economically and politically. The Fed will continue trying to hold up asset prices to the detriment of our fiat currency. It is a sad state of affairs when the leaders of capitalism become too scared to take the associated pain that comes with the territory and think there is no drawback to taking pain killers and continuing on their merry way. We need to flush the system out, or we’ll be stuck making shitty cars and building McMansions 100 miles from civilization for the foreseeable future.
Negative Basis Opportunity?
Felix suggests that a great place for the government to deploy some funds is into CDS negative basis trades since it seems clearly mispriced (due to liquidity) and seemingly free money. The Zero Hedge article, a good primer to CDS negative basis trades, doesn’t put nearly enough emphasis on cross-correlations (between protection sellers and negative basis issues) and therefore counterparty risk. Some of the comments to Felix’s post correctly bring this point up. There is a very good reason CDS protection trades so cheap to the yield on cash, and cash being expensive is only part of the puzzle.
This is essentially pricing in the cost of corporate bond repo right now — there’s a reason why the cash is so illiquid; the positions are much more difficult to finance than before. The last thing we need is the US government sitting on huge slugs of corporate debt in bankruptcy; the economy would be much better off with holders that have real experience with such things.
Furthermore, Felix mentions that the Gov’t could buy the CDS protection through the new exchanges/clearing houses being proposed. Assuming it is an exchange, I find it hard to believe that it will be based on contracts that settle physically — these are rare enough OTC as it is. Without a physical settlement, the Gov’t will be stuck holding the bonds (now equity) after bankruptcy with major uncertainty as to final payout when/if the entity emerges. Don’t suggest recovery swaps either, the market isn’t there. If the Gov’t merely relies on a new CDS clearinghouse, the result is likely to be higher rates on the CDS (making the trade less attractive) since counterparty risk will be likely reduced vs. OTC via higher margin requirements, etc.
You have a lot of good ideas Felix but this one I just don’t see
Thain
Why is everyone so pissed about $20k curtains? This guy did the best job anyone could in his position, and pulled off a miracle for MER shareholders. Shit I wish he was the CEO of everything I own; I’d bonus him out of my own pocket. This is capitalism at it’s finest people, pay attention.
Rates Can’t Stay Low Forever
I’m currently half way through A History of Interest Rates, highly recommended for fans of economic and fixed income history, and couldn’t help but wonder if we are about to relive the 1800′s.
“By 1892, the great bull market in British funds [perpetual debt of the empire] was at least seventy-five years old. There had been brief reversals in times of financial crisis…The experience of several generations of British investors proved that market declines in the funds were always temporary, that new high prices always eventually rewarded the patient holder, and that every sharp decline in price was just one more opportunity to buy which probably would never recur. Three percent is now considered a high return for Her Majesty’s funds. It was worthwhile to buy funds in spite of the low yields because the buyer was virtually sure of a handsome capital gain.“
From 1800 to 1900, the rates on funds dropped from around 5% to a low of 2.5% (in 1888 Chancellor of the Exchequer Goschen was able to convert all outstanding debt into new 2.5% consols). The decline was slow and steady, leading to the popularly held beliefs mentioned above.
This was in a time of gold standard and procyclical monetary policy. There was no attempts at engineering modest inflation as in modern times. Retail prices ended lower at the end of the century (http://www.measuringworth.org/graphs/graph.php?year_from=1800&year_to=1900&table=UK&field=CPI&log=LOG) but was merely a pause in a long term climb (http://www.measuringworth.org/graphs/graph.php?year_from=1700&year_to=2000&table=UK&field=NOMINALEARN&log=LOG). The steady decline and historically low rates was common throughout Europe and abroad, although at slightly higher rates than the British.
I’m currently short bond futures in my personal account — I think Bernanke is too afraid of sustained deflation and will do anything he can (and succeed) to engineer inflation, for better or worse. Long rates will go up sooner rather than later. But would it really be so bad to relive the 1800′s?
Has Buffet gone senile?
Since BRK has not been required to post collateral on their short puts, the counterparty is hedging their exposure through the CDS. As the puts go more in the money, there is more mtm p/l exposed to BRK credit and so more protection must be purchased. Watch for the CDS to collapse once we rally off the lows.
30 year swap spreads negative
Some people have taken note (namely alea most recently here and John Jansen daily) of the 30 year swap spread which has gone very negative recently. Sure there are definitely technical factors at work here, but perhaps the market isn’t being completely crazy.
How is this possible? Well what if AAA multinationals are being priced as less risky than treasuries at this duration? There is the possibility of a US default (see: treasury CDS at 40 bp+). We can’t default? Really? In a situation where US simply forces certain treasury holders to take no or lower payments rather than the expected inflation-based default, any large corporations that are able to survive with non-USD revenues could very well be a safer bet.
