Saturday, July 26, 2014

Reign of Error

I recently read "Reign of Error" a 2013 book by Diane Ravitch about American public schools.  There are two main factions in US education debates.  The traditional educational establishment as exemplified by the teacher unions which largely supports more of the same and the "reformers" who believe that major changes are needed including replacement of many of the current teachers.  In this book Ravitch presents the establishment case, defending the status quo and attacking the reformers and their proposals.  As long time readers of this blog know I am not a fan of either side in this debate.  Nor did I particularly like this book.  While I generally agree that the reform proposals are wrongheaded I sometimes found her arguments against them unconvincing.  And I don't think her own proposals make a lot of sense.

The problem with the traditional educational establishment is that they have a grossly inflated opinion of themselves.  They believe teachers are very important and therefore deserving of lots of pay and respect.  While these views are understandable in union leaders it makes it difficult for them to respond effectively to the reform arguments that since teachers are so critical to the educational process society should expend much more effort in identifying and weeding out bad teachers and that this would significantly improve our schools.

In truth however teachers aren't very important in that (within the range commonly found in US schools) they have little influence on results.  It matters much more who the student is (again within the range commonly found in US schools) than who the teacher is.  Peers also have more effect on outcomes than teachers.  This means it is difficult to distinguish between below average and above average teachers and that the payoff for replacing below average teachers with above average teachers is not all that large.  So the reformer's obsession with replacing large numbers of current teachers makes little sense.  Slightly below average teachers are difficult to identify and are not doing much harm anyway.   

One way in which differences among students matter is that some students are brighter than other students.  The establishment (including Ravitch in this book) ignores this (apparently for political correctness reasons).  Of course any system for evaluating teachers that doesn't take ability differences into account will be grossly unfair but the establishment's unwillingness to acknowledge that ability differences exist handicaps their response. 

As noted above I didn't always think Ravitch made the anti-reform case very well.  She goes on about how factors beyond a teacher's control (like a parental divorce) can affect student results and that how this makes evaluating teachers on the basis of results unfair.  But this is unconvincing.  What matters is how the inevitable random noise compares to the differences in teaching ability you are trying to detect.  As it happens because these differences are relatively small random noise is a significant issue making ranking individual teachers problematic.  Note student rankings are subject to random noise too but because the differences in performance are relatively larger they are more reliable.

Ravitch also goes on about how charter schools can be more selective about their students.  This is a legitimate point in so much as if charter schools are only admitting bright students this should be accounted for in evaluating their results.  But if charter schools are gaining by excluding disruptive students this is a legitimate advantage which should not be discounted. Keeping disruptive students in mainstream public school classes is a policy decision that could be reversed.  If it has bad effects it is perfectly legitimate to count them against public schools.  Similarly placing students of widely varying ability in the same classes is a policy decision.  If charter schools can do better by tracking again this is a legitimate advantage that should be acknowledged.

I also wasn't convinced by Ravitch's own proposals.  She goes on and on about all the things schools should teach besides the basic reading, writing and arithmetic skills students need to function as adults.  This is fine for the top students who can pick up the basic skills quickly and with little effort but problematic for those who can't.

Ravitch also advocates expanded preschool programs the benefits of which are not as well established as she claims.  She cites the Perry Preschool Project in a misleading way:

... At the time, many people assumed that IQ was fixed and that interventions made no difference.  Weikart set out to prove them wrong.

One might think from this and her subsequent discussion that the Project had succeeded in raising IQ.  But in fact while the Perry Preschool Project claims many wonderful results raising IQ (permanently) is not one of them.  See the discussion at page 16 here:

It is true that the High/Scope Perry Preschool program had a statistically significant effect on children’s IQs during and up to a year after the program, but not after that.  ...

As for the other results one small 50 year old study is not entirely convincing.  Some replications would be nice.

And Ravitch wants to reserve certain positions for professional educators.  But being a professional educator is a lot like being a professional astrologer.  There is no underlying generally accepted scientific body of knowledge involved.  So I see no reason to give "professional educators" and their politically correct fad theories of the moment undue deference.

The book did have some interesting material.  For example it presented data showing that test scores have improved somewhat over the last 30-40 years.  If correct (I have not attempted to independently evaluate and verify this claim) this is a worthwhile corrective to the widespread gloom and doom stories.

But overall this book is pretty long and I didn't find it very interesting.  I don't recommend it.

Thursday, July 17, 2014

No Money Down

Felix Salmon recently revisited an argument (Stern v. Salmon) he had with Linda Stern 3 years ago about buying a house with little money down.  Without attempting to address every point in dispute I believe Stern is largely correct.  If it makes sense for you to buy a house, but you haven't saved a large down payment, but you can get a mortgage on reasonable terms anyway, then it generally makes sense to buy a house now with little money down rather than waiting to save a large down payment.

Salmon's biggest mistake is a complete failure to understand that the main effect of a larger down payment is to protect the lender (and society at large) not the borrower.  It does so by reducing the value of the "homeowners put" (the option to walk away from an underwater mortgage, which contrary to Salmon you don't have to be broke to exercise (at least in no recourse states)), which like any put is more valuable when the market price is close to the strike price.  This means low down payment mortgages should be very expensive or unobtainable.  They aren't because they are subsidized by the government.  Salmon ignores this subsidy which obviously affects the analysis when he claims that banks are not charitable institutions.

This doesn't mean everyone who can obtain a mortgage should buy a house, transaction costs are extremely high so you should be confident that you won't need or want to move soon.  But if buying a house with 20% down would make sense then I expect it will usually still make sense with a lower down payment.

Friday, July 11, 2014

The Frackers

I recently read "The Frackers" a 2013 book by Gregory Zuckerman which is mostly about men who backed the development of hydraulic fracturing (aka fracking), a technology which has produced large unexpected increases in domestic (US) oil and natural gas production.  I found the book somewhat disappointing.  It basically is a collection of stories about some of the colorful figures involved.  It jumps from person to person and back and forth in time in a way that I found a bit confusing.  And it seems very weak on the big picture, in the mass of detail it is hard to tell which events were significant and which turned out to be unimportant.

One point I found of interest is that many of the investors in the technology appeared to be driven more by blind faith than any rational calculation of the odds.  And in some cases they were curiously blind to the fact that if the technology was as successful as they hoped the resulting increases in production would drive down prices particularly for natural gas (whose market is more local to the United States).  As a result a couple of them got badly overextended and didn't do as well from the success of the technology as one might have expected.

Overall however while this is an important story I don't think this book does a very good job of telling it.  Too much human interest detail and not enough big picture analysis. 

Sunday, June 29, 2014

Lehman Valukas Report

While poking around on the internet in connection with the Valukas report to GM I was surprised to find that Anton Valukas was also the Examiner in the Lehman Brothers bankruptcy and had produced a long report about the firm's demise.  Since this is a subject of interest to me I went through the report.  I don't recommend this, the report is over 2000 pages long, full of legalese, sometimes repetitive and rather narrowly focused on who if anybody could the bankruptcy estate sue to try to recover some of Lehman's losses.  Still I felt it gave me a better idea of what had happened. 

Based on the report, the root cause of Lehman's failure was a disastrous 2006 decision by its CEO, Richard Fuld.  At a time when cracks were appearing  in the financial world, especially with regard to residential real estate, and other financial institutions were getting nervous, Fuld decided to vastly increase Lehman's exposure in the areas that were starting to appear shaky.  This involved making a lot of risky, illiquid investments.  (An illiquid investment is one which is expensive to sell, they tend to have the nasty habit of becoming especially illiquid (expensive to sell) at exactly the times you are most likely to need the money.)  Just the sort of poison a highly leveraged firm like Lehman doesn't need on its balance sheet in bad times.  The report calls this course of action a countercyclical strategy which appears to be an euphemism for a reckless gamble.  Of course as the report points out Lehman was in the business of taking risks.  However managing a firm like Lehman is all about limiting risk, trying to ensure that a little bit of bad luck or a single bad decision isn't catastrophic.   So Fuld's decision was bad in two ways, he misjudged the severity of the coming problems and less excusably he risked far too much on his judgment being correct endangering the firm.

Of course the initial decision wasn't fatal in itself, Fuld could have changed his mind and reversed course the next day and little harm would have been done.  But as the decision was implemented in 2006 and 2007 the risk to Lehman mounted. Eventually Lehman stopped adding to its exposure but didn't take any effective steps to reduce it.  When the markets moved against Lehman in 2008 bankruptcy (absent a government bailout) became inevitable.  It is unclear when the point of no return was passed.  Perhaps the Lehman could have survived (albeit severely damaged) if suitably decisive action had been taken early in 2008.  But this would have required Fuld to face up to the fact that he had made a horrendous blunder which seems to have been beyond him.  So instead Fuld seems to have tried to keep up appearances as long as possible while hoping for a market turn in Lehman's favor or a government bailout neither of which was forthcoming.

When Lehman did go bankrupt and its assets were liquidated there turned out to be a big gap between the value of the assets as recorded in Lehman's books and what they could actually be sold for resulting in large losses for Lehman's creditors.  I had been of the general opinion that this indicated some sort of huge fraud had taken place.  But according to the report this may be wrong.  There are several other potential explanations.  First fair market value for accounting purposes is defined as the price a willing buyer and willing seller would agree on.  It is not intended to reflect the price that could be obtained in a distress sale.  Nor does it reflect sales expenses.  This is fine if the asset holder intends (and has the financial capacity) to hold the asset indefinitely but means for illiquid assets there is likely to be a big gap between the value in the accounts and what can be realized in a forced sale.  That said it also appears that near the end when potential buyers were given access to Lehman's books they were not pleased with what they found although it is a little unclear whether this was just because they found Lehman's assets hard to value rather than definitely over valued.  It is inherently difficult to value illiquid assets with few comparable recent sales.   The report does acknowledge a few instances where Lehman's marks (values assigned to Lehman's assets in the accounts) were definitely inflated (outside even the wide range of possible good faith values for illiquid assets).  But this seems to have mostly reflected a failure to keep up with rapidly deteriorating market conditions rather than conscious deliberate fraud.

The rapidly deteriorating market also meant considerable loss of value could occur between the appraisal valuation dates reflected in Lehman's books and the dates Lehman's assets were liquidated.  Of course a substantial part of this loss of value was caused by Lehman's bankruptcy itself.

Another issue was winding up Lehman's derivative contracts.  A derivative contract is basically a bet between two parties about future events.  The parties post collateral to guarantee payment.  When one party goes bankrupt the other party is generally allowed to terminate the contract early and claim the current contract value.  This value can be hard to assess objectively so the initial claim will often be on the high side so as to establish a negotiating position.  This seems to have been the case with Lehman's contracts with the Lehman estate ultimately able to obtain more favorable settlement values than initially offered by its counterparties.  It seems possible there was still some loss of value though, the rules are not set up to favor defaulting parties.  

Finally Lehman as a going concern was an intricate web of relationships (with for example many legally distinct corporate entities some operating under foreign law).  Sorting out the mess when it all came crashing down was unavoidably expensive requiring millions in fees to be paid to people like Valukas, his law firm and the financial advisors he hired to help compile his report.

So perhaps the gap between the value of Lehman's assets in Lehman's books and what they realized when sold was not generally due to fraudulent books.  Still I would like to see somewhere a detailed explanation of how the gap arose.  This is not to be found in this report or anywhere else that I am aware of.

As the report explains under the business judgment rule the courts generally don't second guess business decisions even stupid ones which work out badly.  So the government couldn't prosecute Fuld for being an idiot.  But according to the report during 2008 Lehman attempted to make use of an accounting loophole to disguise how leveraged they were.  By performing a series of transactions (with no economic purpose) they could avoid listing some their debt on their balance sheet reducing the amount Lehman appeared to be leveraged.  It is unclear whether Lehman actually managed to satisfy the conditions of the accounting rule they were attempting to exploit but as the report points out it doesn't really matter, there is a general accounting rule that you can't report materially misleading accounts even if you are arguably in technical compliance with the more specific rules.  So it appears that high Lehman officials (including Fuld) could have been prosecuted for fraud (for deliberately reporting materially misleading results) if the government had chosen to do so.  But for political reasons I have never really understood the Obama administration gave Fuld (along with most everybody else) a pass for potentially criminal behavior in the lead up to the financial crisis. 

However this bad behavior wasn't a major cause of Lehman's collapse, it occurred after Lehman was already in big trouble.  Perhaps you can argue it was a contributing factor in that it was a form of denial without which Lehman might have been more likely to take the drastic painful steps needed to give it a chance to survive.   This seems pretty speculative however.  The misleading public statements did of course hurt anyone who relied on them to invest in Lehman which is all you need to prosecute.

In short this report fills in some of the details regarding Lehman's collapse but it is not a good big picture account for the interested layman.  As far as I know no such account has yet been written.

Friday, June 27, 2014

Account Numbers

Last night I logged on to my bank's website to pay my water bill.  For some reason I happened to notice that the account number on my bill didn't match the information on my bank's website (which I had entered several years ago when I added the water company as a payee after moving into my new townhouse).  Upon investigation I found the water company (New Jersey American Water) had changed my account number last November at the same time they changed the format of their bills.  An inconspicuous statement to that effect (advising that account numbers on bank bill payment systems should be updated) was included on the bill but I hadn't noticed.  The payments had been going through anyway but presumably would have started failing at some point.  So it seems that if you use bank bill payment systems you should check every so often that the payee information is up to date.

I also was a bit startled to see that my 2014 New Jersey tax refund had been electronically deposited earlier in the week.  I had filed a paper return and had been anticipating a paper check.  However upon checking I found TurboTax had included my bank account information on my return.  I don't remember telling it to do that but I was originally intending to file the New Jersey return electronically (like my federal return) but was then prevented from doing so for some reason I don't remember.  So I guess TurboTax didn't remove the bank account information when I switched to paper filing.  I suppose no harm was done and I did get the New Jersey refund a month earlier than last year.  Still very slow though, the federal refund took about a week. 

Sunday, June 22, 2014

The Caterpillar Way

I recently read "The Caterpillar Way" a 2014 book by Craig T. Bouchard and James V. Koch about the recent history (since 1980 or so) and prospects of the Caterpillar corporation.  I picked if off the new book shelf of my local library because I bought some Caterpillar stock last year without actually knowing much about the company.  If this largely laudatory book is correct I made a good investment.  Unfortunately the book isn't entirely convincing.

The authors were looking for a success story to write about and chose Caterpillar.  So it isn't surprising that on the whole Caterpillar performed well over the period covered by the book.  After bouncing around under 10 (split adjusted) in the 1980s the stock has risen to over 100 today. Of course the market as a whole was also up sharply from 1980 to 2000.  The authors' attribute Caterpillar's performance to a combination of good luck (in the form of favorable economic trends like a depreciating dollar) and excellent management.  The problem being of course this makes some regression to the mean likely.  Warren Buffett has been quoted to the effect that he preferred to invest in companies that were in such a good business that they could be successfully managed by an idiot (by which he means of course someone from the bottom portion of the range of CEO talent).  Expecting a company to always select above average CEOs seems a bit unrealistic. 

At the end of the book the authors make projections for Caterpillar's stock price in 2020 based on 3 scenarios which I will call no-growth, growth and hyper-growth to which they assign probabilities of 15%, 70% and 15% respectively.  Since they project (reasonably) that the stock will stagnate in the first case (no-growth) but do well in the other cases they judge Caterpillar to be a good investment.  However I would assign the probabilities more like 50% and 50% and 0%.  The authors believe the infrastructure and raw material needs of rapidly growing so called emerging economies will continue to increase demand for Caterpillar's products.  But I am less optimistic, such demand has already increased a lot in recent years and may not have much room for further growth.

Also as the authors acknowledge Caterpillar is in a cyclical  industry and will have bad years.  The stock dropped more than 70% in less than a year in 2007-2008 and similar drops cannot be ruled out in the future.  The stock may prove to be a good investment but it is hardly a sure thing.

The book wasn't officially sponsored by Caterpillar but the authors received high level access and appear reluctant to be too critical.  Caterpillar sells all its products through dealers and the authors portray this as a great and difficult to reproduce advantage for the company.  No doubt this is the company line but I doubt the case is totally one-sided.  The dealer networks of the domestic auto companies are widely seen as a burden that the companies can't easily get rid of (because of state laws protecting dealers).  So I expect there are downsides (or potential downsides) for Caterpillar also.

In summary I doubt this book will be of much interest to people who don't own the stock or have some other connection with the company.  

Monday, June 16, 2014

Requirements

In my earlier post on the Valukas report about GM's ignition switch problems I questioned whether there was much difference between waiving a requirement and changing it.  Upon reflection I think this is wrong.  It is better to weaken a requirement if necessary than to waive it.  The problem with waiving a requirement is then you are left with nothing.  So the supplier no longer has any incentive to pay attention to that characteristic and performance may continue to deteriorate as the design is finalized and the part moves into production.   Also quality control problems which mean that some parts perform very badly may not get picked if that aspect of performance is not being measured.  The Valukas report didn't discuss how much the ignition switches varied, perhaps most of the problems were from switches with exceptionally bad performance.  Of course specifications ideally provide a safety margin so that even below average parts still perform satisfactorily.

Another advantage to not allowing a complete waiver is it might have caused the GM engineer to focus on the fact that there was a point where reduced effort to operate the switch becomes completely unacceptable.  In the process of determining where that point was he might have realized the switch was getting uncomfortably close.