Crude Oil Prices

Six months ago the Brent crude oil price was about $110/barrel and the WTI (West Texas Intermediate) price was about $100/barrel.  The current prices are about $60 and $55 respectively.  So the price has fallen dramatically and unexpectedly.  As I have mentioned before I believe oil prices are likely to generally rise over time as the earth's supply is exhausted (peak oil).  The recent price action doesn't totally contradict this as there was no reason to believe the rise would be smooth and monotonic.  Because both oil supply and demand react slowly to price changes small mismatches between production and consumption can cause wild price swings.  Still the recent price action is at least a reminder that in investing being right in the long run doesn't mean you can't lose a lot in the short run.  

Given that one still expects rising crude oil prices in the long run what is an appropriate investment strategy at this point?  It is tempting to look for bargains among the oil stocks which have fallen the most.  But this is in effect a bet that crude oil prices will recover before the highly leveraged companies in question go bankrupt (as a stock which is going to zero is never cheap along the way). So this is not an appropriate way of investing based on a long run view.  It is better to look at those companies that are most likely to be around for the long run.  However such companies are currently only cheap relative to the market as a whole.  I bought some ExxonMobil (XOM)  and some ConocoPhillips (COP) a couple of years ago and while their stock prices have fallen substantially in recent months they are still above my basis (while the market as a whole is up about 50%).  So I don't see a compelling reason to add to my positions.  Perhaps this will change over time if the crude oil price remains depressed.

Fact Checking

Recently New York Magazine published an amazing story about a Stuyvesant High School student who had purportedly  made $72 million in the stock market.  When I read it I was pretty sure it was nonsense as in fact it soon turned out to be.  As the magazine admits its fact checking was obviously inadequate.  I expect this was caused in part by a failure to realize just how unlikely this story was and the implications for the appropriate level of fact checking.   Suppose for example that there are a million false claims like this for every true account.  Then fact checking sufficient to catch 99.9% of the false claims is totally inadequate as 99.9% of the surviving claims will still be false.   As the saying goes "Extraordinary claims require extraordinary evidence".

New York Magazine stated:

... As part of the research process, the magazine sent a fact-checker to Stuyvesant, where Islam produced a document that appeared to be a Chase bank statement attesting to an eight-figure bank account. ...

But this is very ordinary fact checking.  Anybody can fake a bank statement.  The whole point of a bank reference is that you can verify it with the bank.  If New York Magazine had insisted on doing this they would likely have avoided this fiasco.

Rape Fantasies

Last month Rolling Stone published a story about rape on college campuses which began with a lurid account of a University of Virginia coed being gang raped at a frat party.  Doubts were raised almost immediately about whether this account was accurate and as I write this Rolling Stone is not standing behind their reporting.  I didn't read the story before it was discredited but in hindsight it does read like something Stephen Glass (famous for inventing a whole series of stories for the New Republic catering to liberal biases) would have come up with.  Which means Rolling Stone should been wary and extra careful with their fact checking.  Which they do not appear to have been.

Some people find it hard to imagine a woman inventing a story like this.  I don't.  It is fairly common for men who have never been in combat (or in some cases even in the military) to invent stories about their horrific combat experiences (and the post traumatic stress which continues to affect them).   The motive of course being to attract the attention and/or sympathy that such stories naturally elicit (when believed).  I don't find it hard to believe that some women would invent rape stories for similar reasons.  And because rape accusations are fairly rare it doesn't take a large proportion of such women among the general population to make false rape accusations a significant fraction of all rape accusations.

As for Rolling Stone I suspect the problem is that among their staff it is generally believed that only "bad" people would ever question a woman's account of being raped.  This makes it hard for normal journalistic skepticism and fact checking procedures to operate properly.  If actually hiring a more ideologically diverse staff is too horrible for Rolling Stone to contemplate perhaps for each story they should designate a devil's advocate to bring up the objections that people are suppressing for fear of being thought sexist pigs (or whatever depending on the story).  This advice of course applies to any institution where there is a danger of legitimate questions being suppressed because of pressure to conform to a party line. 

Goodell Management

NFL commissioner Roger Goodell's handling of the Ray Rice affair came under scrutiny again last Friday when an arbitrator reversed his indefinite suspension of Ray Rice from the NFL for punching his then girl friend (now wife). While Goodell's various decisions in this matter are certainly questionable the real problem is he shouldn't be making these decisions in the first place. There are two reasons for this. First it is not a good use of his time. Goodell's salary is about $40,000,000 a year. Assuming Goodell works 2000 hours a year this amounts to $20,000 per hour. It is unclear to me why the NFL owners think he is worth such a salary but it is surely not to personally conduct disciplinary hearings. The NFL could instead hire experienced respected professional arbitrators who could be expected to do a better job for a fraction of the cost (probably $1000 per hour or less). Second it exposes Goodell (and by extension the NFL) to needless bad publicity. These decisions will never please everybody but by assuming personal responsibility for them Goodell is providing critics with a ready target and focus for their anger. This is something that could and should be delegated and Goodell's failure to this reflects badly on his management ability.

Ferguson

As you may have heard a grand jury recently declined to bring charges against Ferguson police officer Darren Wilson who fatally shot Michael Brown on August 9, 2014. Most of the evidence the grand jury heard before reaching this decision has been released and is available here.  I have not examined this evidence in great detail but the case that Wilson acted criminally appears weak making the grand jury's decision unsurprising. 

Some people have doubted Wilson's account because Brown's actions (as related by Wilson) seem unlikely based on their experience of typical human behavior.  This objection basically makes no sense.  Getting shot by a cop is an unusual event and there is no reason to expect that the typical behavior of people about to get shot by a cop is similar to the typical behavior of people in general.  Particularly in this case as we know Brown was actually acting abnormally shortly before the shooting when he robbed the store. 

The prosecutor also acted abnormally by presenting the case to the grand jury without a recommendation.  It seems clear he did this because he didn't want to indict Wilson as if he had wanted to indict Wilson it is hard to see why he wouldn't have proceeded in the usual way.  The usual way being for the prosecutor to investigate the case, decide what charges he wants to bring and then present enough evidence to the grand jury to establish probable cause to bring these charges.  Probable cause basically means it that is more likely than not that the accused is guilty.  Since prosecutors generally don't want to bring charges that they don't think they can prove beyond a reasonable doubt at trial (and because grand jury decisions to indict don't have to be unanimous) it is rare for grand juries to reject the prosecutor's recommendation and refuse to indict.  By proceeding as he did the prosecutor risked having the grand jury unexpectedly bring charges leaving him in the awkward position of having to prosecute a case he didn't believe should have been brought but as a practical matter that was unlikely to happen.

I have seen suggestions that in cases like this the prosecutor should obtain an indictment whenever they can and let the trial jury decide the case.  In my view this is dangerous nonsense.  It seems obvious that it is completely unethical for a prosecutor to attempt to convict a person the prosecutor believes to be innocent.  So at least probable cause (in the prosecutor's view) is required.  Further in my opinion a prosecutor should not pursue cases in which they have reasonable doubt regarding guilt.  And of course a prosecutor has discretion to refuse to bring any case. 

That Wilson's actions were not criminal does not imply they were beyond reproach.  Opinions about politicized cases like this tend to become polarized leading to the "fallacy of the excluded middle" in which intermediate possibilities are ignored.  So for example a police shooting may be neither criminal nor a "good" shoot.  In my opinion criminal sanctions for police shootings are only appropriate for really egregious cases which this does not appear to be.   Attempting to impose criminal sanctions in borderline cases may even be counterproductive if it leads to police departments focusing on keeping their officers out of jail when police shootings occur rather than on reducing the number of police shootings.

According to this 2011 NYT article police shootings in New York City have dropped drastically in the last forty years.

The 33 instances in which an officer intentionally shot at a suspect last year represented a 30 percent decrease from the year before. But it reflected a far greater drop since the department began keeping these records in 1971, a year in which the police in New York City fatally shot 93 people and injured 221 others.

Last year, the police shot and killed 8 people and injured 16.

So it is possible to reduce police shooting without (so far as I know) sending a lot of officers to jail.  The article is based on the New York Police Department's (NYPD) annual firearms discharge report.  I suspect that just compiling this report annually by itself encouraged a reduction in police shootings.  (NYPD shootings have increased a bit since 2010 but remain way below the levels of 40 years ago).

In general mild sanctions widely imposed are a more effective means of altering behavior than harsh sanctions which are rarely imposed.  But of course harsh sanctions often have more political appeal.

The Money Culture

I recently reread another Michael Lewis book, his 1991 collection of magazine articles, "The Money Culture". While I generally like Lewis as a writer I didn't much care for this book. The pieces are dated and for the most part not all that great to begin with. Give this book a pass.

Procedure Codes

Back in March I went to the dentist for a routine cleaning. A week or two later I was reimbursed by my dental insurance (after my dentist submitted the claim directly). I noticed that as usual the insurance paid most but not all of the bill but otherwise paid little attention. I went back to the dentist in October for another routine cleaning. This time I paid a bit more attention when my reimbursement check arrived (because coincidentally dental insurance reimbursement rates had recently come up in conversation) and noticed it was more than the earlier check. My first thought was that my insurance company must have raised its reimbursement rates. This was a small part of the explanation but examining the respective explanation of benefits statements showed that most of the difference was because in March I had been reimbursed for procedure code D0190 (screening of a patient) whereas in October I was reimbursed for procedure code D0120 (periodic oral evaluation) which my insurance covers for a larger amount. (In both cases I also was reimbursed for procedure code D1110 (adult cleaning)). So my next thought was that my dentist had coded my claim suboptimally (from the point of view of maximizing insurance reimbursement) but my March bill showed the D0120 code and when I went into the dental office a couple of weeks ago with my bill and the insurance statement of benefits they insisted the insurance company would have received exactly what was on my bill. But they also offered to try and straighten things out. And Monday I duly received an additional reimbursement check from my insurance company.

So what happened? This is a bit puzzling as it seems everything should have been handled by computer with little room for human error given that the original entry into the system was done correctly as it appears it was. It seems unlikely that MetLife is randomly recoding procedures (to reduce reimbursements) and hoping nobody notices. I suppose a short lived computer software bug is the likeliest explanation but who knows. In any case when receiving explanations of medical benefits it seems it can pay to take a moment to compare the procedure codes to those on your bill from your provider.

Flash Boys

As I mentioned in my previous post I recently read "Flash Boys" a 2014 book by Michael Lewis. Most of this book is about the creation of IEX, a recently formed dark pool (private stock exchange) which claims to be fairer to its clients than other stock trading forums.  A couple of chapters are devoted to the case of Sergey Aleynikov a computer programmer for Goldman Sachs who was criminally charged for allegedly stealing computer code after he quit to take another job.  His federal conviction was overturned on appeal but he still faces New York State charges.  These chapters have little to do with the rest of the book.

The founders of IEX have apparently constructed a narrative in which the previously existing US stock markets were rigged and corrupt inducing the outraged founders to create IEX to clean things up.  Lewis appears to have bought into this entirely and his book reflects this.  As I said in my review of Lewis's earlier book, "The Big Short":

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.

Lewis remains entertaining but in this book I don't believe he has gotten the big picture correct.  He doesn't seem to realize that if you try to buy or sell a large amount of a stock you will move the price against you (up if you trying to buy, down if you are trying to sell).  This is just how markets work by balancing supply and demand and doesn't mean they are corrupt or rigged.  But Lewis seems to think there is something nefarious about this process. 

On page 109 Lewis writes:

... After the market was computerized and decimalized, in 2000, spreads in the market had narrowed--that much was true.  Part of that narrowing would have happened anyway, with the automation of the stock market, which make it easier to trade stocks priced in decimals rather than in fractions. Part of that narrowing was an illusion: What appeared to be the spread was not actually the spread.  The minute you went to buy or sell at the stated market price, the price moved.  ...   

First decimalization narrowed spreads because as part of decimalization the tick size was reduced from .0625 (1/16) to .01 (not because decimal fractions have some inherent superiority to binary fractions).   It became apparent that the larger tick size had been keeping spreads artificially high and they narrowed when it became possible for them to do so.  Second the smaller tick size (and resulting narrower spreads) made it possible to observe stock prices to greater precision.  Which made it possible to observe smaller changes in stock prices.  In particular it became easier to observe the price changes induced by a moderate sized order which a larger tick size might have obscured.  This doesn't mean the narrower spread isn't real, it is quite real for small scale traders like most individual investors including me.

On page 114 Lewis writes:

... The algos had names like Ambush and Nighthawk and Raider and Dark Attack and Sumo.  Citi had one called Dagger, Deutsche Bank had Slicer and Credit Suisse had one named Guerilla, ... , Their very names made Rich Gates wary; he also didn't like how loudly the brokers selling them told him they'd come to protect him.  Protect him from what?  Why did he need protection? From whom did he need to be protected? ...

Although Lewis doesn't bother to explain it appears these programs mostly just disguise large orders by splitting them into smaller orders (enabling a better average price to be obtained).  As for from whom Gates needed to protected, apparently he needed to be protected from himself, from revealing his intent to buy or sell a large block of stock before he had to and thereby getting a worse price.

No doubt there are many ways US stock markets could be improved, the big players are all seeking private advantage.  But this unbalanced book while entertaining is not in my view a reliable guide to the issues.

Stock Prices

I recently read "Flash Boys", a 2014 book by Michael Lewis about stock trading.  I intend to review it but for now just wish to discuss one point, the issue of what a "fair" price for a stock trade is.  Consider the market for IBM stock.  Suppose for example the market bid and offer prices are $159.99 and $160.01 (per share).  So there are people offering to sell shares for $160.01 and others offering to buy shares for $159.99.  So it seems plausible that a fair price is $160.  And if you should happen pay $160.01 or receive $159.99 the penny a share profit to a market maker providing liquidity doesn't seem outrageous to me. 

But this analysis only makes sense if the amount of stock you are buying or selling isn't enough to move the price significantly.  Suppose there are a billion shares of IBM stock outstanding and the elasticity of demand is 1 for IBM stock (this is just an illustrative example, the actual values will vary).   Then a small order like one thousand shares can be expected to move the price by one part in a million (since one thousand is one part in a million of one billion) or $.000160.  Since this is small compared $.01 it won't materially affect a market maker's profit.  But a large order like a million shares will move the price by one thousand time as much or $.16.  This is enough to turn an anticipated $.01 per share profit into a $.15 per share loss if  a market maker should be so unwise as to sell a million shares at $160.01 (or buy a million shares at $159.99). 

So what is a fair price for a large order?  It seems to me that it is the midpoint between the before and after prices.  Or $160.08 if you are buying, $159.92 if you are selling.  If you could obtain better prices than this then you could profit by repeatedly buying (driving up the price) and then selling (at a higher price) a large block of shares.  And you should be able to obtain near to this price just by splitting up your order and feeding it into the market slowly buying (or selling) at gradually increasing (or decreasing) prices.    

Much of the behavior of high frequency traders that Lewis complains about in this book just seem to be attempts of market makers to protect themselves from being blindsided by large orders.  Without endorsing every specific tactic this doesn't seem unreasonable in general.  And it benefits small investors (like myself) as the alternative is larger bid ask spreads (like for example $159.90 bid, $160.10 asked). 

My Vast Fortune

My local library had another Andrew Tobias book, his 1997 "My Vast Fortune", which I also checked out and reread.  I have mixed feelings about this book.  When Tobias keeps a light touch I find him an entertaining writer.  But when he gets all earnest and serious I find him less entertaining and sometimes actively annoying.  Much of this book humorously  chronicles Tobias's financial triumphs and misadventures and I generally liked that part.  But a big part of the book is devoted to Tobias's ill-fated crusade for no fault auto insurance which culminated in a 1996 California proposition which lost overwhelmingly.  He goes on at tedious length about the purported benefits of a no fault system and the perfidy of those, Ralph Nader foremost, who opposed it.  Even granting his case it is hard to understand why he thought logic and reason would count for much in a political fight and eventually his outraged sense of betrayal becomes a bit hard to take.

I also was a bit annoyed by Tobias's position that liberal programs like free legal services for the poor are fine ideas but they just need to be administered with a little discretion so as not to inconvenience people like Tobias.  I have no problem believing a case brought against Tobias by a former tenant was baseless but Tobias's proposal that legal services "settle" the case by having Tobias denote money to charity was ridiculous.    

I noticed a curious inconsistency between this book and "The Only Other Investment Guide You'll Ever Need".  In the earlier book Tobias recounted (p. 168-169) his investment in a research and development venture that was bought out by Johnson & Johnson doubling his money but leaving him (and some of the other limited partners) dissatisfied both with their return (they felt under the terms of their investment they should have tripled their money) and with the lawyer they had hired to sue to enforce their contract (who appeared to have lost interest).  But in this book he reports (p. 33) tripling his money in this deal.  So one is left wondering what happened.  Did his lawyer sudden spring to life and obtain a better deal or what?  I suppose it's probably just a mistake (possibly caused by confusion between a profit of double your investment and doubling your investment) though.    

So in summary I found this book too flawed to recommend but I did find some of it entertaining.

The Only Other Investment Guide You'll Ever Need

Having recently reread "Money Angles" by Andrew Tobias I decided to see what other books of his were in my local library. His book "The Only Investment Guide You'll Ever Need" was supposed to be there but apparently has been lost or stolen. But I checked out and reread the 1987 sequel "The Only Other Investment Guide You'll Ever Need". Although it is similar in some respects to "Money Angles" I didn't like it as much. One problem is the book comes across as more badly dated because it offers more of the kind of specific advice that depends on the details of things like current tax laws and many such details have changed. For example the book mentions at one point (p. 225) a tax on mutual fund advisory fees (which were to be included in income). But this tax on "phantom income" proved so unpopular it was repealed before it ever actually took effect.  Also I have read enough personal finance books that another version of fairly standard advice is not very interesting to me. 

I didn't hate the book, it does have some of the same sort of amusing stories I liked in "Money Angles".  And some of the advice is still good.  But if you are looking for a guide to personal finance I think you would do better with a more recent less dated book.    

Election Day 2014

I voted Tuesday on my way to work. This was easy as my polling place is conveniently located just off my usual route and there was no line. I didn't find the electronic voting machines being were used very confidence inspiring (as regards my vote being correctly recorded and counted) but I suppose this is partly a function of unfamiliarity.

I am registered as unaffiliated but like most independents tend to lean one way, in my case towards the Republicans. So I was pretty happy with the results especially the (apparent) defeat of the loathsome Martha Coakley in the Massachusetts Governor's race. It will be interesting (although of course almost totally meaningless) to see how the financial markets react Wednesday.

Goetz v. Zimmerman

Although I have no interest in "Gamergate", I found this essay by Ezra Klein on increasing political polarization interesting.  One point that struck me was Klein claims that while polls showed no difference between Republicans and Democrats in their opinions about the 1984 case in which Bernard Goetz shot 4 young black men on a New York City subway (only 15% disapproved) there was substantial disagreement about the recent (2012) incident in which George Zimmerman shot Trayvon Martin with 20% of Republicans (vs. 68% of Democrats) dissatisfied with the verdict (Zimmerman was acquitted).  I haven't tried to verify Klein's claim but if the quoted polling data is even close to accurate this is pretty striking as by any objective standard Zimmerman was far more justified in shooting than Goetz was.

If you don't remember the case, Goetz shot a group of 4 young black men on a New York City subway after one of them approached him and aggressively asked for $5.  While no doubt annoying and possibly intimidating it is really doubtful that this was sufficient legal justification for pulling a gun and shooting all 4 of them.  Goetz apparently realized this as he fled the scene.  But the jury saw it differently convicting Goetz only of a weapons charge (he was carrying illegally) a verdict that is difficult to defend in strictly legal terms.

Zimmerman on the other hand shot Martin (with a gun he was carrying legally) because Martin was sitting on his chest and punching him in the face.  Zimmerman didn't flee the scene and the jury properly found him not guilty.

One can speculate about the reasons for the difference in public opinion about the cases but one factor seems clear.  The initial press coverage was sympathetic to Goetz but hostile to Zimmerman and to quote Mark Twain "A lie can travel half way around the world while the truth is putting on its shoes.”

Money Angles

I recently reread "Money Angles" a 1984 book by financial writer Andrew Tobias. This book was derived from magazine articles Tobias had written on the general subject of money, investing and personal finance. It is little uneven but overall I liked it.   Tobias moves in moneyed circles and the book contains numerous entertaining stories about the financial lives of his friends and acquaintances with which Tobias illustrates his generally sound advice. It is 30 years old so I found it a little dated in places but not too badly. It did help that I am old enough to have lived through a time when for example "... A 9 percent fixed-rate mortgage is a treasure. ..." (p. 79).   But while the details of things like tax laws or current prices have changed the big picture hasn't changed that much.  There are still many ways to go wrong financially and this book warns about some of them.

This is not a good introductory book to personal finance and investing, it assumes some basic familiarity with the subject and it doesn't attempt to be comprehensive. And I can't really recommend you make a special effort to read it but if you happen to run across a copy you might give it a try.

Oddball

Yesterday (Tuesday) the market was down as were all of my stocks except for one.  Today the market was up as were all of my stocks except for one.  In both cases the oddball was Ensco (ESV) which seems a little strange.

Ensco owns and leases out offshore drilling rigs.  I bought some earlier this year because the stock (with a 6% yield and low PE) seemed cheap.  This isn't looking like a great pick as the stock has recently gotten quite a bit cheaper.  In hindsight I overlooked a couple of things.  First while a company like ExxonMobil may not suffer too badly post peak oil production as you would expect decreased volume to be offset by increasing prices it is hard to see a company like Ensco prospering post peak drilling as you would expect fewer leases and lower lease rates (as the surplus of rigs pushes prices  down).  Second a low PE doesn't mean much if it is based on inflated earnings.  The earnings a company like Ensco reports are highly dependent on how fast it is depreciating the expensive drilling rigs it is leasing out.  Ensco recently wrote down the value of some of its rigs which means it hadn't been depreciating them fast enough and therefore that its reported earnings have been too high (and hence its real PE was not actually as low as reported). 

Union Square

I recently spent a month on vacation.  Among other things I attended a wedding in San Francisco.  While there I stayed in the Saint Francis Hotel on Union Square in one of the less fancy rooms.  The hotel has some historical memorabilia in the lobby.  I was bit surprised to see the Fatty Arbuckle affair mentioned.  (Fatty Arbuckle was accused of assaulting (and fatally injuring) Virginia Rappe during a 1921 party at the hotel.  He was tried three times and eventually found not guilty after two hung juries.)  This seems like the sort of thing a pretentious hotel might prefer to ignore but I guess they think it's just history at this point.  The hotel is also where Sara Jane Moore attempted to assassinate President Gerald Ford in 1975 as he was leaving.

The photo shows Union Square.  The hotel is on the corner out of the frame to the left.

Climate Change Evidence & Causes

I recently read "Climate Change Evidence & Causes", a short (32 page) pamphlet produced by the National Academy of Sciences (US) and the Royal Society (UK) which I was sent with a suggestion that I review it. I couldn't find a copyright statement or date but it appears to be recent. As might be expected it is a summary of mainstream scientific thinking regarding anthropogenic CO2 (and other greenhouse gas) emissions into the atmosphere and their predicted effects on the earth's climate. I am familiar with the subject and didn't find anything particularly original or compelling about this write up although it comes of course with the imprint of whatever authority you are prepared to grant to the National Academy and the Royal Society.
 
The report is rather narrowly focused on climate science. The question of what if anything to do about the predicted warming involves many other issues which the report does not address. For example the most alarming projections are based on an emissions scenario called RCP8.5 in which CO2 levels peak at around 2000 ppmv.  This scenario (which isn't original to this report) is generally labeled "business-as-usual" however it has been criticized as being alarmist and essentially impossible as it assumes burning fossil fuel resources (especially coal) which are not currently (and may never be) economically feasible to extract.  See here and here.  I am not sure who is right but the dispute is important and it isn't addressed at all in this summary.  Another important issue is to what extent active mitigation measures are feasible which the report just mentions in passing " ... or they can seek as yet unproven 'geoengineering' solutions ...".  And of course any attempt to seriously limit emissions will involve a host of complicated political and economic questions.

So I am not sure what this report really contributes to the political debates about climate change.  Most people are aware of the conventional wisdom but don't perceive any imminent threat to themselves personally and so aren't willing  to make any great sacrifices to avert climate change.  So little is likely to get done.

So in summary I doubt this report will have much impact and I don't see any reason to make a special effort to read it.

Blog list changes

I have made some more changes to my blog list. I have deleted the links to Vox and FiveThirtyEight as they aren't blogs and perhaps more important I am disappointed in both sites. There are occasional exceptions but most of their content is of little interest to me. I have updated the link to Sailer to reflect his move to the Unz review. Unfortunately the link isn't working properly. The link to Kevin Drum has a similar problem. When I added the link to Drum I thought this problem had been fixed but apparently not. It seems the gadget software is deleting the portion of links after the first /.

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.

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.

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. 

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.

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. 

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.  

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.

GM Valukas Report

I recently read the report (119 MB pdf download) by Anton R. Valukas to the GM board of directors about GM's recent recall of millions of cars with defective ignition switches.  Because of a poor design the torque (twisting force) required to turn the key and move the switch position from "Run" to "Accessory" is unduly small enabling unintended accidental shutdowns of the engine while driving.  This causes loss of the power assists to steering and braking although in most cases the car will remain controllable.  Less obviously it also means the airbags will no longer activate in a crash.  This long (325 page) report is by an outside lawyer tasked with determining why the mistake was made and why it took GM so long (10+ years) to realize there was a safety problem and issue a recall. I found the report interesting (although I just skimmed it in a few places) and think it raises a number points worth noting.

The first point is why GM thought it best to assign this report to a lawyer rather than an engineer.  This suggests that they feel the legal aspects are more important than the engineering aspects.  They are probably correct (especially going forward) but this means the report (in my view at least) somewhat neglects the engineering aspects.  The report also seems to avoid asking questions which might aggravate GM's legal problems.

The GM engineer responsible for the ignition switch design had inherited the design from another engineer.  When the first prototypes from the outside supplier (Eaton which was later purchased by Delphi) failed to meet the torque requirement he chose to waive it.  It appears he did so because he did not focus on the role of the requirement in preventing unintended operation of the switch while driving.  The report (and others) have emphasized the fact that the switch didn't meet GM's requirement but this seems just a matter of semantics to me.  GM could just as well have changed the requirement rather than waiving it.  The requirement doesn't appear to have been based on any sort of careful analysis of what was required to prevent unintended operation of the switch.  It would not surprise me if it had just been copied from an earlier design. 

After the car went into production it soon became apparent there was a problem.  There were numerous complaints about inadvertent operation of the switch while driving.  This seems to have occurred most often when the driver had a key ring with lots of things on it and bumped them with their knee.  This is not a rare situation, currently I have 8 keys (besides 2 car keys) on my key ring and they are normally in contact with my knee as I drive.  I have never had the impression for my current car (or any of my previous cars) that this was risking accidental operation of the switch and I certainly would be extremely annoyed if I bought a car where this was a problem.  In my case although I have a bunch of keys on my key ring there is sufficient space for the key ring to hang freely from the ignition key.  This limits the torque you can exert by pulling on the other keys (because the lever arm is so short).  I have vague recollections of seeing people with key rings so tightly packed with stuff that they might not hang freely which would greatly increase the lever arm and the potential for a problem.  The report does not discuss this apparently assuming the weight of the key ring is the only important factor.  Nor does the report perform any sort of comparison with other ignition switches, it would interesting to know how much of an outlier the switch really was.

At this point GM decided the problem was a customer satisfaction issue rather than a safety issue.  While it is true that inadvertent operation of the switch would not always (or even usually) cause an accident it obviously is potentially hazardous.  But there seemed to be a feeling that something wasn't a safety issue unless it contravened some specific government safety regulation and the government has neglected to specify torque standards for ignition switches.  Of course the government has specified standards for airbags but apparently no one was alert to the fact that shutting down the engine also turns off the airbag actuator.  This would not have been a major problem if inadvertent operation of the switch and serious accidents were uncorrelated rare events as in that case having both happen at the same time would have been extremely unlikely.  However there is no reason to believe these events are uncorrelated.  There is clearly potential for unexpected operation of the switch to trigger an accident although it is unclear how likely this is.  GM received numerous complaints about unintended operation of the switch but the report doesn't mention (as I recall) that any claimed that this had caused an accident.  Of course if the driver is killed in the accident he isn't in a position to complain but if accidents are being triggered I would expect non-fatal accidents to be much more common.  Another possibility is for the accident sequence to trigger unintended operation of the switch prior to the final impact.  This could occur for example if the driver lost control and ran off the road for some distance before hitting a tree.  The bumpy ride before the final impact could operate the switch, turn off the engine and deactivate the airbags (if there is sufficient delay prior to the final impact, the final impact itself should not deactivate the airbag actuator before it triggers).  Apparently this scenario is consistent with several serious accidents in which the airbags unexpectedly failed to deploy.

An issue here is the somewhat artificial distinction between customer satisfaction problems for which cost benefit analysis is deemed appropriate and safety issues which are supposedly fixed regardless of cost.  Since in reality cost will always be a consideration this encourages a hidden cost benefit calculation which results in classifying safety problems that don't seem to be worth fixing as customer satisfaction  issues.  While this may have legal and public relations benefits the double think involved is likely causing a misallocation of resources with some safety issues receiving too much attention and others too little.

Eventually GM started to be sued over serious or fatal accidents in which airbags unexpectedly failed to deploy.  It took GM a very long time to realize that this was likely a consequence of inadvertent operation of the ignition switch.  According to the report this was due in part to the fact that many of the people involved either didn't know or didn't appropriately consider the fact that switching off the ignition also (after a slight delay) deactivates the airbags. 

A complicating factor was the switch was modified after a few years in a way that alleviated the problem.  Much has been made of the fact that the GM engineer that approved the modification (the same one responsible for the bad design) didn't assign a new part number and later claimed (including under oath in a lawsuit) no changes had been made.  Perhaps this was all part of a conscious cover up by the engineer of his original error but I am not totally convinced.  Another report suggested the change was initiated by the part's supplier and the GM engineer just signed off on it.  In which case it is vaguely plausible that several years later he would have forgotten doing so.  The part number issue also doesn't seem totally clear cut, I expect parts are changed all the time in apparently minor ways without a new part number being assigned.  Suppose for example the part supplier had itself changed spring suppliers (a spring within the switch held the switch in position, the modification seems to have been basically use of a stronger spring).  Would this have required a new part number?  However it does appear clear the GM engineer was not eager to acknowledge his original error in waiving the specification.  In any case this delayed GM's recognition that the switch was the problem as the investigators didn't understand how the switch could be responsible for a problem that had gone away if the switch hadn't been changed.  Although perhaps they put undue weight on the GM engineer's claim that no changes had been made.  It seems like double checking with the supplier at least would have been prudent. 

An issue here is that it is impractical for car companies to initiate a recall without understanding the problem enough to have a fix in place.  It is not very feasible to provide millions of loaner cars while GM tries to figure out what the problem is and how to fix it.  However it is clear that GM didn't give this sufficient attention.

It is in fact unclear whether GM even now really understands the problem.  While GM contends the modified switch is safe they also have recalled hundreds of thousands of cars just because of a slight possibility that the cars may have had a repair in which the new switch was replaced with the old switch.  GM claims it is not practical to tell the switches apart (which is in tension with their claim that a new part number was clearly required).  But it should be easy to measure how much force is required to operate the switch.  Even if there is some overlap between the old switches and the new switches this should distinguish between safe switches and unsafe switches which is the important point.  However setting a cutoff point between safe and unsafe would involve the sort of cost benefit analysis that GM doesn't want to acknowledge conducting with regard to safety issues.  Even though no switch is going to be totally safe (incapable of inadvertent operation under all circumstances no matter how unlikely).

GM has reportedly fired 15 people in connection with this incident.  Based on the report this seems rather harsh in cases where as the report acknowledges the failures were largely due to systematic problems rather than individual lapses.  This doesn't apply to the engineer responsible for the design who (assuming the account in the report has some relation to reality) seems to have failed in multiple ways, approving a bad design and then failing to step up and get the problem fixed.  I was initially sympathetic for the top GM lawyer involved who seems to have been fired largely for failing to tell his boss about the issue as I doubt this would have made a difference.  But upon reflection Warren Buffett tells his managers that he hear wants to learn about serious problems in their domain from them and not by reading about them in the newspapers which makes sense to me so I suppose the lawyer did have a responsibility to recognize the potential magnitude of the problem and inform his boss (GM's general counsel).  However I have trouble with coming up with 15 people who deserved being fired.  Of course GM can claim that public outrage demanded some scapegoats and they have little real choice than to provide them.  Sufficiently generous severance arrangements (which haven't been made public as far as I know) could mitigate some of the unfairness involved. 

In summary this long report won't be of much interest to many people but I found some of the issues raised thought provoking.

Irrational Exuberance

I recently read "Irrational Exuberance" by Robert  J. Shiller.  This was the 2005 second edition which added some material about housing prices to the 2000 first edition which was about the stock market.  Schiller's thesis in both cases was that prices were high by historical standards making expected future investment returns poor.  Unfortunately although Schiller proved to be correct I didn't find this book very interesting. 

One problem is that the book is dated.  Arguments about whether we are in a stock market or housing bubble are less interesting ten or fifteen years later when we know the answer.  There wasn't a lot in this book that was new to me.  Another problem is that Shiller sometimes makes his arguments in a somewhat simpleminded way.  For example he cites (p. 47-49) the rise of 401(k) plans as a factor increasing demand for stocks.  But of course traditional defined benefit pension plans also invested in stocks.  So it is not clear that shifting to defined contribution plans makes much difference. As another example Shiller claims (p. 177) that "... the efficient markets theory asserts that all financial prices accurately reflect all public information at all times."  But this is the most simplistic form of the theory, a more sophisticated version allows for some imperfections that can only grow to the point where they can be profitably exploited by the smartest best capitalized investors.  This deals with Shiller's later objection (p. 179) that without some profitable trades the smart money would not stick around to keep prices in line.

Shiller spends considerable time dealing with the objection that we can't be in a bubble because bubbles are impossible.  Apparently this isn't really a strawman as it seems there are reputable economists who believe something like this.  Still I find it hard to take this objection seriously and am not that interested in lengthy refutations.  In general I thought the book was too long, that the main ideas could have been presented more concisely.  I also found some of the advice unconvincing.  Schiller is big on hedging as a form of insurance.  But insurance generally costs money and may not be worth it.

In summary although Shiller is correct in his major claim that asset prices can get out of line I didn't find this book very compelling and so can't recommend it.   

Mad Men

On May 23, 2014 Elliot Rodger went berserk and killed 6 people before committing suicide.  For several reasons the incident received an unusual amount of publicity and various people with axes to grind have attempted to draw lessons from it.  However I think the main lesson is just that crazy people sometimes do crazy things. 

Most incidents like this are perpetrated by mentally ill people and this case doesn't appear to be an exception.  Of course there is some danger of circular reasoning when there is little independent evidence of mental problems prior to a killing spree.  However that was not the case here.

I would define mental illness as mental abnormalities which cause problems for the subject.  By this standard it was clear to many of the people around him that Rodger was mentally ill.  What was not so clear was that he was dangerous.  It may also be that his mental illness was not of a common type like paranoid schizophrenia but this does not mean he wasn't mentally ill at all.  He was obviously abnormal.

It is a mistake to ascribe too much meaning to the actions of a crazy person.  Their erratic random actions will sometimes by pure chance appear carefully planned.  This doesn't mean they were.  In this case Rodger achieved great notoriety in death but I am unconvinced that was his plan.

The Buy Side

I recently read "The Buy Side", a 2013 Wall Street memoir by Turney Duff. Duff tells the story of his Wall Street career which was reasonably successful until he was brought down by abusing drugs. I didn't care for it. Much of the book is devoted to his struggles with drugs (especially cocaine) and I have never found drug fiends particularly sympathetic or interesting.

I am more interested by the business aspects of Wall Street and Duff doesn't offer much insight into them. Duff worked on the "buy side" (hence the title of his book) which meant he was employed by hedge funds to trade their portfolios, buying and selling stocks. Sometimes he was told what trades to make, at other times he had discretion to establish his own positions. In both cases for reasons that are unclear to me (and which Duff makes no attempt to explain) the hedge funds that employed him were willing to pay millions of dollars in inflated commissions. Naturally this made Duff a very popular man with his counterparties on the "sell side" as their incomes were directly tied to how much of his trading Duff chose to do with them. They showed their appreciation by extravagant entertaining which included in Duff's case supplying drugs. Duff proved unable to handle the drugs in the long run perhaps in part because he wasn't really happy with his job even when he was doing well (1.8 million in his best year by his account). Duff ended up in rehab twice when his drug abuse rendered him unable to perform adequately at (or even at times show up for) work. By his account he still had employment possibilities on Wall Street even after his second stint in rehab but chose to try and become a writer instead.

Duff worked for a time for Galleon Group which has since been brought down by an inside trading investigation which led to Galleon's founder, Raj Rajaratnam, being convicted and sentenced to 11 years. Duff didn't like Rajaratnam and depicts him as engaging in a variety of questionable behavior. But fortunately for Duff he had left well before Galleon got in trouble with the law. Duff himself admits to performing acts at work (at Galleon and elsewhere) of dubious legality. At times he is worried that this (or his drug use) is under investigation and will get him arrested but it appears these worries were unfounded (possibly just drug induced paranoia). Duff doesn't appear concerned that his book will cause him legal problems and as a practical matter having left Wall Street he is probably not a high priority for prosecution.

The main point I would take from this book is that there is a lot of extravagance and waste on Wall Street ultimately funded by excessive client fees. Fortunately these fees can often be avoided (or at least substantially reduced) if you are on your guard which I would certainly recommend when dealing with Wall Street.

While this book contained a few points of interest I don't recommend it. It is pretty long and I didn't find it compelling. Michael Lewis's Wall Street memoir "Liar's Poker" is much better and I also liked "A Colossal Failure of Common Sense" more although I didn't recommend it either.

Property Tax

Thomas Piketty in an interview for a British think tank suggests property taxes should be assessed based on your equity in a property (value less debt) not on value:

But it is perfectly possible at the national level to transform our traditional forms of property taxation, which are typically proportional and which do not take into account financial assets and financial liabilities, because they were set up in the nineteenth century when most property was real estate property, so they do not take into account financial wealth and liabilities. This can be turned into a progressive tax on net wealth, which basically would be a way to reduce property tax –council tax in the UK – for the vast majority of the population. Typically, if you have a house that is worth £500,000, but you have a mortgage of £490,000, you are not rich – you have a net wealth of £10,000, so you should pay less than someone who has no mortgage or who paid off his or her mortgage many years ago. 

This makes little sense for US property taxes on owner occupied housing as I will explain.  Piketty is correct that someone with a mortgage on their house is less well off than someone who owns their house free and clear.  However this is already taken into account in the US tax code through the mortgage interest deduction in the federal income tax code.  Although this deduction is often cited as a loophole it has always made sense to me.  But I don't think it makes sense to provide a second reduction in your taxes for having a mortgage.  In fairness to Piketty many countries don't have a mortgage interest deduction in their income tax code in which case his equity argument above has more force.  But in those cases a simpler fix is to add a mortgage interest deduction.

I had previously though the real loophole regarding taxes and owner occupied housing was that the imputed rent on an owner occupied house is not included in income.  But while thinking about this it occurred to me that property tax is roughly equivalent to an income tax on imputed rent.  (This idea is not original to me but I had not encountered it before.)  So besides the practical problems in trying to assess and tax imputed rent as income there is a theoretical case for excluding it as well.  Of course if property taxes are a surrogate for income tax on imputed rental income they should ignore mortgage debt as this doesn't affect the imputed rental income you are receiving by living in your house.

A complication in thinking about tax breaks on owner occupied housing is that any benefits tend to be reflected in selling prices and hence make less difference to new buyers than might be expected.

FiveThirtyEight

Nate Silver launched a new version of his FiveThirtyEight website on ESPN a couple of months ago. I liked the previous versions (most recently associated with the New York Times) which mostly covered the horse race aspect of national politics but find the new site a disappointment. In my view the problem is the new site doesn't make enough predictions. Making (and explaining) predictions is useful because it encourages you to develop models that focus on what's important. And it has the commercial advantage of driving traffic as people check back to see how the predictions are changing. During the Presidential election campaign I would check the FiveThirtyEight website regularly to get the Silver's latest odds.

It would have been straightforward to extend FiveThirtyEights politics coverage model to sports. The four major US team sports (baseball, basketball, football and hockey) crown a champion every year. So each year you have the equivalent of a Presidential election campaign. And FiveThirtyEight could offer regularly updated estimates of the chances of each team advancing to each level on the way to the championship. Along with the predictions FiveThirtyEight could have posts explaining the models used to generate them. I would find this interesting just as I found the analogous politics coverage interesting. And from a commercial point of view more people care about sports than politics.

Extending the coverage model to areas other than sports is a bit harder as you don't have the same campaign analogs. And often the data isn't as good. Still there are plenty of things you could try to predict. How will stock prices, federal tax receipts, oil prices etc. evolve over time?  It should be possible to find a variety of things about which interesting predictions could be made.

But instead of systematically developing models and using them to attempt to predict things that people care about FiveThirtyEight has too many posts like this one on how Americans like their steaks cooked.  The internet is full of random data like this and it is unclear why we are expected to find it of particular interest. 

So to sum up, in my opinion the new FiveThrityEight has changed for the worse.

Target

Target's CEO, Gregg Steinhafel, recently resigned under pressure. Megan McArdle doesn't approve.  I find her arguments unconvincing.  First while Steinhafel was not directly responsible for the data breach as CEO he bears a general responsibility for everything that happens at Target.  It was his job to see that Target's data systems were staffed by competent people and that they were given sufficient resources to keep Target's systems secure.  Second the data breach is not Target's only problem.  Their expansion into Canada has not been successful to date hampered by what appear to be multiple failures to execute.  Again this is the general responsibility of the CEO even if some of his underlings were more directly responsible.  And there may be additional non-public issues.  For example the board may have lost confidence that Steinhafel was giving them accurate reports.  Naturally it is difficult for an outsider to evaluate Steinhafel's performance.  Perhaps he has just been unlucky.  But as a Target shareholder I am not going the second guess the board's apparent decision that a change at the top was needed.

Of course changing the CEO is a drastic move which shouldn't be undertaken lightly.  It suggests the board thinks Target is facing serious problems.  So it is not surprising the stock dropped on the news that Steinhafel was out.  As I noted back in January I had kind of lost faith in this stock pick.  I considered selling but didn't pull the trigger.  Perhaps I should have but at this point I think I will wait and see a bit.  Which is my natural inclination anyway. 

Annual Funding Notice

Last week I received the Annual Funding Notice for the IBM Personal Pension Plan (which is paying me a pension). Rather than require companies to adequately fund their pension plans Congress instead makes them send all participants annually a report on their plan's financial status. This is pretty pointless as most people won't get much from the disclosure. Pension accounting is inherently complicated and to make matters worse current rules are full of loopholes which can make a plan appear to be in better shape than it actually is. So the report is pretty opaque. And even if your plan is currently in good shape the weak regulations mean it may not stay in good shape. So I expect most people pay little attention to this notice and just hope for the best.

This year I actually tried to understand the report. Although the IBM plan is relatively easy to evaluate because it was frozen some years ago (which means participants are no longer accruing benefits) this proved rather difficult. Besides the notice for this year (2013) I looked at prior year notices, the 2013 IBM annual report and documents on the Department of Labor website for 2012 (the documents for 2013 aren't available yet). As best I can tell the only numbers in the notice worth paying attention to are in the "Fair Market Value of Assets" section. For IBM this says:

As of December 31, 2013, the fair market value of the Plan's assets was $53,953,692,333. On this same date, the Plan's liabilities were $47,920,350,174.

The key points here are that the valuation date is at year's end (as opposed  to 1/1/2013 or earlier elsewhere in the notice) so is relatively recent.  The assets are valued at fair market value which is fairly straightforward as opposed to elsewhere in the notice where a bogus accounting value can be used (although IBM does not do this)  based on what the assets would have been worth if the plan had achieved its expected rate of return.   Valuing the plan liabilities is a bit less straightforward as you have to figure the present value of future obligations which requires choosing a discount rate.  This should be determined by looking at the current yields of safe bonds which is not that complicated.  However elsewhere in the notice an artificially high discount rate is used which makes the plan liabilities look smaller than they really are.  This artificially high rate is a recent loophole created by Congress to allow companies to reduce their contributions to their pension plans while pretending they are adequately funded.  The notice for 2012 in the Fair Market Value section using a realistic (or at least more realistic) discount rate valued the plan liabilities at $52,939,309,074 (at 12/31/2012) while the artificially low discount rate used elsewhere in the 2013 notice gave a plan liability value of $40,044,112,196 (at 1/1/2013) which illustrates the magnitude of the loophole.  The actual discount rates used in the Fair Market Value section are not stated in the notice.  The IBM annual report lists discount rates of 4.5% and 3.6% for year end 2013 and 2012 respectively which may be the rates being used.  As best I can tell the present value of future plan administrative costs aren't included in plan liabilities which means they are understated a bit.  Still the IBM plan appears to be in reasonable shape.  And since it is frozen it less dependent on regular additional funding from IBM than active plans.

IBM assumes an 8% annual return on its US pension fund investments.  This is too high in the current environment but doesn't affect the above liability numbers as IBM (as a private company) is not allowed to discount plan liabilities using this rate.  In contrast public entity pension plans can and do discount their liabilities using their assumed rate of return (which is typically in the 7% to 8% range) thus grossly understating their actual liabilities.  IBM's assumed rate does affect IBM's reported earnings.

Utility Functions and the CAPM

A basic concept in classical economics is that given certain plausible assumptions it is possible to define utility functions which measure how desirable economic actors find possible states of the world.  Rational actors will then try to maximize the expected value of their utility function.  For example most people will have an utility function which gives an additional two million dollars less than twice the value of an additional one million dollars.  Hence they will prefer a sure million dollars to a 50% chance of two million dollars as this will maximize the expected value of their utility function.

The Capital Asset Pricing Model (CAPM) uses considerations of this sort to predict that risky assets will sell at a discount to their expected future value (as computed in dollars) and that the amount of the discount will increase as the amount of future uncertainty increases.  As without such discounts investors would prefer to buy only the safest assets.  It follows that risky investments will have greater expected return.  Note risk here is referring to non-diversifiable risk.  Risk particular to individual assets can be essentially eliminated by buying a diversified portfolio of such assets.  However some risks (such that the economy as a whole will do badly) are not particular to individual assets and cannot be eliminated by diversification. 

In the case of stocks it is reasonable to divide the risk (uncertainty in future returns) into two parts.  That due to idiosyncratic factors particular to individual companies and that due to uncertainly about the general future trend of stock prices (as stocks tend to move up and down together).  Stocks vary in how sensitive they are to general market movements.  Some might tend to move up and down twice as much as the market, others only half as much as the market.  The Greek letter beta is conventionally used to denote how sensitive the price of a particular individual stock is to a general change in the level of stock prices normalized so that a stock with a beta of x will tend to move up or down by x% when the general market moves up or down by 1%.  High beta stocks will have more non-diversifiable risk and are predicted by the CAPM to have greater expected returns.

The CAPM is quite elegant mathematically.  However that does not mean it is correct. Eric Falkenstein has extensively criticized it in books and his now dead blog, Falkenblog, which I mentioned earlier this month. Falkenstein's criticism (I don't know to what extent it is original, for the most part it is new to me) comes in two parts.

He claims that empirically high beta stocks have historically performed worse than low beta stocks which is a bit strange if their expected returns were actually higher.  A big part of this seems to be due to the highest beta stocks performing badly with returns otherwise pretty flat with respect to beta.

On the theoretical side he points out the usual utility function framework is inadequate as it neglects the fact that people care about how they are doing relative to others.  So they are going to prefer seeing their stocks go up 20% when the market is up 10% to seeing their stocks go up 20% when the market is up 30% although their personal return is the same in both cases.  To the extent that people care more about relative returns than absolute returns (or as Falkenstein puts it are driven more by envy than by greed) the predictions of the CAPM will be flawed.  For the so called risk free rate of return (often taken to be the interest rate paid on government bonds) is not actually risk free if people care (as they often will)about missing out on a big move upward by the stock market.  The risk free investment for such people will be an index fund which guarantees them the average market return.  Which means in effect that all risk is diversifiable and that there is no reason to anticipate greater expected returns when voluntarily assuming risk by deviating from the market average portfolio. 

Net Neutrality

Vox has an article blaming Congress rather than the FCC for the apparent demise of net neutrality regulations.  In my view this is wrongheaded, according to Vox's own coverage, Congress has given the FCC adequate authority to impose net neutrality regulations.  The FCC simply has to classify broadband internet provision as a "telecommunications service" rather than as an "information service".  This seems more logical and would allow the FCC to enact common carrier regulations.  Instead the FCC has tried to impose common carrier regulations while classifying internet provision as an "information service".  Since this is not allowed by the relevant law the Courts have rejected these attempts. 

Apparently the FCC is reluctant to classify broadband internet as a "telecommunications service" because they fear this would prompt a political backlash from industry groups.  But expecting Congress to be more willing to take political heat than a federal agency seems crazy to me.  The real reason net neutrality is dying is that its advocates haven't mustered enough political support to overcome industry opposition. 

As for my opinions on net neutrality itself, I don't think internet providers should be allowed to discriminate based on content but I am sympathetic to the view that they should be able to charge extra for high bandwidth usage and other behavior which stresses the network.

High Pay

Piketty's book is mostly about increasing inequality in the distribution of capital (and hence in income from capital).  However income from labor is also becoming less equal.  One aspect of this is the emergence of a group of extremely high earners.  Piketty's explanation for this is as follows.  This group largely consists of highly paid top corporate executives.  They are in positions where they can strongly influence their own pay.  This gives them some ability to overpay themselves and the reduction in top marginal income tax rates gives them more incentive to do so.  The natural result is very high rates of pay, well above economic value. 

I agree that top corporate executives in general are currently substantially overpaid.  Piketty's  account certainly seems plausible and is probably part of the explanation.  However it is not the entire story as there are lots of high earners who aren't negotiating their pay with themselves.  Krugman brings this up in his review:

 ... Also, I don’t think Capital in the Twenty-First Century adequately answers the most telling criticism of the executive power hypothesis: the concentration of very high incomes in finance, where performance actually can, after a fashion, be evaluated. I didn’t mention hedge fund managers idly: such people are paid based on their ability to attract clients and achieve investment returns. ...

However I think Krugman is also confused in that it isn't actually any easier to evaluate the performance of hedge fund managers than the performance of corporate executives.  In both cases you can look at how well they have appeared to do in the past but this won't predict their future performance very well.  This is because how well they do is highly dependent on luck and other factors outside their control.  But people tend not to adequately allow for this.

So I think another part of the explanation for unjustified high pay is that employers have a natural tendency to overestimate their ability to predict future performance.  So they are willing to pay more to attract their preferred candidates than is justified by actual differences in expected performance.  As a result it is quite plausible that top corporate executives would be overpaid even if their pay was negotiated with truly independent boards of directors.  Just as hedge fund managers as a group are obviously overpaid even though their clients could readily obtain better expected performance (after fees) in low cost index funds.