October Snow

As predicted Ossining has received a substantial snowfall. It started snowing heavily around 1 PM Saturday and it appears we have gotten at least 6 inches. That amount this early is quite unusual. The power has flickered a few times but come back. Hopefully the snow will melt quickly.

The picture was taken from the small second floor deck on the back of my townhouse.

Yankees lose

I was a bit sorry to see the Yankees eliminated from the baseball playoffs Thursday night. I used to root against the Yankees but I eventually realized that I enjoy listening to their games on the radio and when they lose in the playoffs they aren't on anymore. Also I prefer warm weather and associate it with the baseball season. So this is a reminder that winter is coming.

I don't have much to say about the games except to note that as usual the commentators are ignoring the importance of luck. The Yankees outscored the Tigers in the series 28 to 17 but lost 3 games to 2 because they lost all the close games while winning the blowouts. This is mostly likely explained as due to bad luck and not a lack of heart or character.

Goodnight Irene

I was working on a post last Sunday evening about how tropical storm Irene wasn't that bad where I live. Then the power went out and stayed out for about a day. There had been a lot of rain early Sunday morning and the power had flickered a few times but stayed on. But apparently the wind on the backside of the storm was the final straw for the local power grid. So not quite as innocuous as I had thought. And some areas were hit worse of course.

The photo was taken Sunday morning after the rain had mostly stopped and shows water flowing over the top of the dam which creates the pond behind my condo. And over a service road in the background. This is not a normal condition but has happened before. It seems to have been fairly harmless and conditions quickly returned to normal.

Jefferson Valley Mall

I visited the Jefferson Valley Mall for the first time in a while on Saturday. I was a bit startled by the amount of unoccupied space, clearly more than could be explained by normal turnover. This was particularly noticeable in the food court, a bad sign as it suggests customer traffic in the remaining stores is also down. Maybe this is just more evidence that the economy is still not very healthy. Or perhaps the mall has started to fail. Two other enclosed malls that I used to shop at when I worked at IBM, the Dutchess Mall and the South Hills Mall , fell on hard times and slowly died.

On the Brink

I recently read "On the Brink" an insider's account of the recent financial crisis by Henry M. Paulson Jr. who was secretary of the Treasury in the last years of the Bush administration. I found it more compelling than Robert Rubin's memoir of his time as Treasury secretary under Clinton which I didn't manage to finish. I expect this is mostly because Paulson served in more interesting times (per the purported Chinese curse) as opposed to any greater literary talent on Paulson's part. The book largely consists of a day by day account from Paulson's point of view of the events of 2008. It comes across as reasonably honest, albeit self-serving. Paulson makes it clear that he often found the Democrats in Congress easier to work with than the Republicans. And Obama is depicted more favorably than McCain. Paulson seems well meaning but in over his head. He admits that although when he took office he had vague worries about some sort of impending financial crisis (because there hadn't been one for a while) he didn't see it arising in the housing market. Throughout the crisis he seems to have been in firefighting mode, dealing with each successive problem as it arose, and hoping for the best (which as the saying goes is not a plan). His signature Troubled Assets Relief Program (TARP) proved unworkable. Fortunately things eventually stabilized. Of course while it is easy to criticize Paulson in hindsight it is unclear that anyone else would have done significantly better. Perhaps this is why Obama did little to change course. Bernanke was retained as Federal Reserve chairman and Paulson was replaced with Geithner, New York Federal Reserve Bank President, who had worked closely with Paulson and Bernanke during the crisis.

So in summary this is a reasonably entertaining insider account which is weak on the big picture.

All the Devils are Here

I recently read "All the Devils are Here" another book about the recent financial crisis by Bethany McLean and Joe Nocera. McLean was a coauthor (with Peter Elkind) of "The Smartest Guys in the Room" a book about the Enron debacle which I didn't particularly like . I thought this book was better. Although not as entertaining as the Michael Lewis book, "The Big Short", (which I read shortly before reading this book) it is wider in scope. And even more than the Lewis book it brought home to me just how bad the conduct of the rating agencies was. The rating agencies are often slow to react when a security they have rated starts to go bad sometimes waiting until a company is on the verge of bankruptcy to downgrade its securities. This is not good but is somewhat understandable as the agencies are being paid for the initial rating and keeping the ratings up to date for the life of the security is a lot more work. However the results of the agencies reluctance to revise their initial ratings downward were truly perverse when it came to rating synthetic mortgage securities whose components were already existing (and rated) mortgage securities. Wall Street found creating these synthetic securities profitable because the long side could be sold for more than the payment required to get speculators (like those in the Lewis book) to assume the short side. The long side was attractive to naive buyers because the rating agencies would give it a good rating. The short side was attractive to speculators to the extent that the ratings were obviously inflated. The ratings were obviously too high because it was the policy of the rating agencies not to revisit the ratings of existing mortgage securities even when they were included as components in newly created synthetic securities for which a new rating was being requested. So by including existing mortgage bonds which were obviously overrated (because the observed default rates on the underlying mortgages were much higher than the expected rates used to generate the original rating) but which the agencies had not downgraded one could create synthetic mortgage bonds which the agencies would rate highly but that a informed speculator could tell were very likely to quickly default and hence were actually worth little. So Wall Street firms like Goldman Sachs created such securities (sometimes with the assistance of shorts), obtained inflated ratings on them from the rating agencies, used these ratings to sell the long side to naive buyers and passed the proceeds (minus their cut) on to the speculators assuming the short side. The securities quickly went bad, the buyers lost most of their money and the shorts made a fortune. It is difficult to overstate the degree of willful stupidity on the part of the rating agencies that this required. And it is dismaying that they have suffered few ill effects from it.

The book has some faults, some subjects were treated more kindly than others in a way that left me wondering if this had more to do with how helpful they were to the authors than how culpable they were. And the book ends rather abruptly with the collapse of Lehman Brothers, some coverage of subsequent events would give a more complete picture of what happened.

In summary I think this is a better than average account of the roots of the financial crisis but I am hoping a more definite account will eventually be written after more of the dust has settled.

The Big Short

I recently read "The Big Short" by Michael Lewis. It tells the story of some of the people who were able to foresee the end of the housing bubble and made a lot of money shorting (or otherwise betting against) mortgage backed securities. I thought it was pretty good.

In part this is simply because I find Lewis an entertaining writer, I also quite liked two of his previous books, "Liar's Poker" and "Moneyball". And I find the idea of making a lot of money by seeing through a bunch of lies appealing. However I also thought the book was an instructive, albeit somewhat narrowly focused, account of the recent financial crisis. It left me feeling I understood aspects of what had happened a bit better.

One of these aspects was the effect of misratings by the bond rating agencies like Moody's. These agencies were giving inflated ratings to complicated mortgage securities which naive buyers foolishly trusted. It was if the agencies were declaring $5 bills to be worth $10 and this allowed them to be sold for $10. Obviously this allowed the Wall Street firms assembling such mortgage securities to profit, and the larger the discrepancy between the agency ratings and the true values the larger the profits. So this encouraged the creation of the most misvalued mortgage securities. So much so that there was a shortage of actual lousy mortgages to assemble into these overvalued mortgage securities. However Wall Street got around this by constructing synthetic mortgage securities using credit default swaps. A credit default swap is like insurance on a bond, in exchange for periodic premiums you are paid off if the bond defaults. So selling credit default swaps (or writing such insurance) is like owning the bond you get periodic payments but lose a lot of money if the bond defaults. So by selling credit default swaps on overvalued mortgage bonds to mortgage market bears (like the people portrayed in this book) the Wall Street firms were able to construct the equivalent of these overvalued bonds which the bond rating agencies would again bless and which could also be sold at inflated prices to naive buyers.

Another aspect was just how foolish these buyers were. Wall Street firms obtain their largest profits by taking advantage of their customers. Wall Street firms like complicated and illiquid securities because it is easier to sell them at inflated prices. So any naive buyer should never buy anything but the simplest, most liquid, most straightforward securities as otherwise they are almost certain to overpay.

There is a bit of a danger with an entertaining writer like Lewis that you will give undue credence to his point of view simply because he is such a good story teller. Lewis has been criticized along these lines but for the most part I think his books get the big picture (if not every detail) correct.

This book does portray its subjects sympathetically. One them was a hedge fund manager, Michael Burry. Many of Burry's clients were upset with him for using what they thought was to be a stock picking fund to make a massive bet against mortgage backed securities. Although this bet eventually turned out very well the clients were not actually being all that unreasonable in objecting.

In summary I liked this book quite a lot. However if you don't already know a bit about financial markets you may find it a little confusing in places and it is not a comprehensive account of the crisis.

A Random Walk Down Wall Street

I recently reread "A Random Walk Down Wall Street" by Burton G. Malkiel. I had read an early edition (perhaps the first which came out in 1973) of this book long ago and liked it quite a bit so when I saw the "revised and updated" 10th edition ((c) 2011) in my local library I checked it out. I was a bit disappointed. While some material has been added the basic themes are the same and the ideas which were new and interesting to me when I first encountered them were considerably less so some thirty years later.

Which is not to say these ideas are wrong, I think the book has held up pretty well in that respect. Malkiel's main argument is that it is generally a bad idea to pay people to pick stocks for you because there is little evidence that there are professional stock pickers who consistently do any better than chance, throwing darts at the stock page in the newspaper being the traditional analogy. Which means they will tend to lag the market after you deduct their fees. There was and is considerable evidence that this is true. It isn't too surprising that the average performance of professionals is just average because professionals dominate the market so their performance as a group will not vary much from the performance of the market as a whole. However over any given time period some professionals will do well and others poorly. So perhaps we should just be sure to pick a manager who has done well in the past. Unfortunately (and a bit more surprising) the performance (good or bad) of portfolio managers shows little consistency over time. A manager might perform relatively well over a 5 or 10 year period and then relatively poorly over the next 5 or 10 year period. In fact the evidence is quite consistent with variations in performance being primarily due to luck and not differences in skill. This makes Malkiel's recommendation, low cost index funds, an attractive alternative to actively managed funds. As Malkiel points out in addition to their lower management fees index funds will also incur lower trading costs and will tend to be more tax efficient. And in fact index funds have grown greatly in popularity since the first edition of this book.

So why is it so hard to beat the market? One obvious possibility is that stock market prices being the weighted opinion of many intelligent and knowledgeable people are largely "correct" reflecting everything that is publicly known about a company's prospects. This is the efficient markets hypothesis (EMH). The EMH gets ridiculed a lot as the market's collective judgement sometimes seems quite far off the mark as with the bubble in internet stocks. However the EMH still seems like a reasonable explanation (even if it is not entirely correct) for why it is difficult to beat the market consistently as it is lot harder to identify market irrationality at the time rather than in hindsight.

One argument in the book that I didn't find entirely convincing is that riskier (with respect to nondiversifiable risk) stocks will have greater expected returns. This seems logical but Malkiel quotes a study which found otherwise and does not adequately explain why he doubts it.

In summary if you are unfamiliar with the case for index funds this book is probably a good introduction but more knowledgeable readers may find little new in it.

Amos Walker

I recently read "Amos Walker: The Complete Story Collection" and "The Left-handed Dollar" by Loren Estleman. Amos Walker is a fictional Detroit PI introduced by Estleman in a 1980 novel ("Motor City Blue"). "The Left-handed Dollar" is the latest of 20 novels (many of which I have also read) in the series. I found it typical, solid but in my opinion somewhat below the level of the best in the genre. I liked the short story collection a bit more. It collects the 32 previously published Walker short stories and adds a new story and an introduction by Estleman (totaling some 600+ pages). I found the stories curiously addictive, it was tempting to read just one more (sort of like potato chips). I generally don't like short stories that much but a series of short stories like this is a bit different in that it is sort of like a very episodic novel. I found I rather liked the form. The early PI writers Hammett and Chandler wrote numerous short stories which I also liked when collected but the short story seems to have largely fallen out of favor since (for market reasons with the decline of the pulp magazines).

The stories have some faults and aren't for everybody. As is traditional in the genre they exhibit a rather dark view of human nature which didn't bother me but some readers might find a bit wearing particularly when repeated for 600 pages. The plots sometimes don't hold together if you think about them too much. Walker is prone to sociological asides which I sometimes found bizarre and others might find offensive. And I didn't like the way the stories were ordered. Estleman says in the introduction that they are arranged roughly chronologically but they still jump back and forth in time a lot which I found a bit jarring. I would have preferred a strict chronological order. However I liked the collection and if you also like PI stories (of the traditional "hard-boiled" variety) you might give it a try.

Chuck Tanner RIP

As I was driving home Friday night I heard on the radio that Chuck Tanner had died . I was a bit sad to hear this as I had followed his career from a distance since playing a game of postal chess with him long ago when I was a teenager and he was a minor league baseball manager. Shortly thereafter he had made the jump to managing in the big leagues where he was moderately successful including leading the 1979 Pittsburgh Pirates to a World Series Championship.

I believe our game was in one of the Golden Knights tournaments. About the only detail I remember is that at one point he wrote something about not liking the fact that in chess you could concentrate for hours and than spoil a game with a small oversight and I had made some reply about dropping a pop up in the ninth inning.

Grading Teachers

This post is a follow up to my earlier post criticizing a paper, "The Economic Effect of Higher Teacher Quality", by Hanushek in which I address an issue raised in the comments.

Evaluating teachers based on how well their students do academically is difficult because teachers aren't (currently in the US) the only or even the most important factor in student success. So to properly measure the effect of teachers you first have to account as best you can for the other important factors. This is typically done by constructing a model which predicts how well a student will do based on everything besides their current teacher and then comparing this to their actual performance. This prediction will assume in effect that their current teacher is average. Any difference in actual performance is then attributed to the teacher being above or below average (depending on whether the student did better or worse than predicted). Clearly this will be very unreliable for a single student but the hope is that when averaged over many students the errors will tend to cancel out allowing differences in teacher quality to be detected.

What do these models look like. The most important factor in how well a student does is the characteristics of the student themself. This means things like how smart they are (in terms of IQ), how well educated their parents are, what their household income is etc. Such differences among students are far more important in predicting how well they will do academically than differences among their teachers. Since we are generally interested in evaluating the effect of a teacher over a school year another important factor is how well the student has done previously. If you are evaluating a third grade teacher and at the beginning of third grade a particular student is 4 months above their predicted grade level this must be accounted for when predicting where that student will be at the end of third grade (assuming an average teacher). Empirically students doing better or worse than expected at the beginning of a school year will still be doing better or worse than otherwise expected at the end of the school year but not by as much. So for example the student 4 months ahead of their predicted grade level might be expected to be 2 months ahead of their predicted grade level a year later. Similarly a student 4 months behind might be expected to be 2 months behind a year later. Models typically account for this by including a decay factor r so a student x months ahead of their expected grade level at the beginning of a school year will be predicted to be r*x months ahead of their otherwise expected grade level at the end of the school year. Note such models predict the difference n years later will (r**n)*x, this is a consequence of iterating the model predictions.

Hanushek uses such a model in his paper but does not appear to understand the implication noted above that any good or bad effects of for example 1-3 grade teachers will have largely decayed away by the time their students leave school and enter the work force. Hence as I noted before he does not appear to be correctly computing the predicted economic effects based on his own model assumptions.

Enron

I recently read "The Smartest Guys in the Room" by Bethany MacLean and Peter Elkind a 2003 book about the rise and fall of Enron Corporation which went bankrupt in late 2001. I found it a bit disappointing. I already knew the general outline of the Enron story, how Enron had used shady accounting methods to appear successful for a time until inevitably it all came crashing down, and I don't feel this book added much to my understanding of what happened. Nor did I find the author's recounting of the history all that entertaining. The book is quite long (400+ pages) and at some point the stories of greed and stupidity become repetitive and boring. It reminded me of the saying about not being able to "see the forest for the trees" . I would have preferred a much shorter book that concentrated more on the big picture and less on the sordid details.

So in summary unless you have an insatiable demand for stories of business professionals behaving badly I would skip this book.