Sunday, March 9, 2014

Near the End of the Business Cycle: the Skyscraper Indicator, the Chicago Spire, Subprime Auto Loans, China, and Batesian Mimicry

The most recent Prechter letter mentions that efforts have begun again to develop the Chicago Spire, the 2000 foot high, 150-story condo building that would be the second tallest building in the world and dwarf the already gigantic Sears Tower, Trump Hotel, and John Hancock building. Essential mood context:

"Completing the Spire is expected to cost more than $1 billion. That means, according to the Irish Times, that the 1,200 units in the tower would have to sell for at least $2,000 a square foot to be profitable. Nearby Trump Tower (currently the city's second tallest) took nearly a decade to sell its 486 luxury apartments at a comparable price. [...]

Chicago may need the kind of pick-me-up of that can only be found through a new super-tall structure."
I don't think that Prechter saw that last sentence, but it's classic social mood stuff. Why would a city building a 150 story, $2,000/sf condo tower need a "pick-me-up"? That's called a bearish divergence. We are at the beginning of a demographic depression, but temporary quantitative easing hysteria has given the top 0.2% a lot of money - through an asset price bubble - to throw around on $4 million downtown condos to visit once a year.

Speaking of bearish divergences, both we and Illusion of Prosperity blog have noticed that, despite the stock market nominal all time highs, cars, housing, and retail are all sputtering. A correspondent writes in,
"Everyone in my lower middle class neighborhood of new houses is driving a pretty new car: 2012-2014. Car loan credit stats confirm that they are having to lower underwriting standards to maintain sales. You can get a car loan in chapter 13 bankruptcy as long as you have a letter of approval from the U.S. Trustee's office. Gotta get to work!"
Another savvy correspondent has pointed out recently that the "lesson learned" from the 2008-2009 recession is that people always make their car payments because they need mobility. He cites a recent quote by a head of securitized products at Barclays,
"'Subprime auto kind of moved up the food chain of asset classes in terms of perceived reliability,' says Marty Attea at Barclays. 'Even bad credits pay their cars before mortgages – no one ever thought that before the crisis.'"
Of course, before the crisis, people thought that homedebtors wouldn't walk away from underwater mortgages, but we correctly predicted that people would walk away en masse, trading their credit scores temporarily for hundreds of thousands of dollars of debt relief.

What is funny is that these auto loans are now ending up in - you guessed it - securitized loan pools. From that same FT article:
"Automakers 'need to keep pumping products to keep the factories humming', Gagan Singh, chief investment officer of PNC Financial Services, said at a recent securitisation industry conference in Las Vegas. 'One way they’ve traditionally done that is to start providing financing for people who really can't afford a car and that’s where you have the troubles in subprime auto, and subprime anything.'"
The article also says that subprime auto finance companies have "mushroomed", something which is confirmed by the data we've seen. Our auto finance correspondent sent in this choice twitter exchange about auto loan securitizations:
@groditi Are all these billions in new subprime car loans securitizations getting done with a big block of AAA bonds in them ?
@_the_goose If i was a big bond buyer stuffed to gills in subprime auto AAA's , i'd be rushing for the exits
@DividendMaster most of the stuff is fine. Structure proved itself in crisis. I saw subs that went to $50 pay off at par a year later.
@_the_goose we shall see as loans been stretched out longer / higher debt balances . Recall subprime home loans was supposedly same
@DividendMaster apples/oranges
@_the_goose Moodys won't give the rental backed deals a AAA . I find them a steadier bet than subprime auto myself
@DividendMaster sure but rental homes unproven asset. Model all u want but no one knows.Id buy ur subprime auto subs all day (sub to credit)
@_the_goose i heard 100% same argument by $NFI $IMH etc back in day of subprime lending ... EXACT same argument
@_the_goose my money says people will pay rent before all else ( unlike a bank owned home mortgage ) . Your rental is your last stand
@_the_goose point is today's subprime auto loans are far larger and longer maturity than 5yrs ago . #Apples to #Oranges
@DividendMaster it's actually getting to be about the same. All structure prd trending same. Structure is what I buy in autos, also CLO.
@_the_goose I'd make book that the delinquincy/default/loss asumptions on these structures is MUCH higher in 3yrs
@_the_goose keep in mind i'm talking new deals .....not buying older deals secondarily
So what ties all of these things together? What causes, or allows, investors in subprime auto loan deals now to make the mistake that subprime housing loan deals made 10 years ago, that railroad investors made 150 years ago?

Eric Falkenstein has a very elegant theory of the business cycle that can explain this: his Batesian Mimicry explanation of business cycles. Batesian Mimicry is a concept of anti-predator adaptation in living species:
"[A] form of mimicry typified by a situation where a harmless species has evolved to imitate the warning signals of a harmful species directed at a common predator. It is named after the English naturalist Henry Walter Bates, after his work in the rainforests of Brazil."
Here is how Falkenstein translates this to business cycles:
"[B]usiness cycles are best understood though the framework of Batesian mimicry, an endogenous mechanism for booms and busts thru a misallocation in the horizontal structure of production. In ecosystems, Batesian mimicry is typified by a situation where a harmless species (the mimic) evolves to imitate the warning signals of a harmful species (the model) directed at a common predator (the dupe).

For example, venomous coral snakes have red, yellow, and black bands, while the non-venomous scarlet king snake has the same colors in a different order. Animals afraid of venomous snakes would do well to avoid 4 foot long snakes with red, yellow and black stripes, in the process avoiding the scarlet king snake (alternatively, one could remember the rule "Red on yellow, kill a fellow; red on black, friend of Jack").

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Once the number of mimics is sufficiently high, their valueless enterprises become too conspicuous and they no longer pass off as legitimate investments. Failures caused by insufficient cash create a tipping point, notifying investors that some of their material assumptions were vastly incorrect. Areas that for decades were very productive, are found to contain exceptional levels of fraud, or operate with no conceivable expectation of a profit. Everyone outside the industry with excessive mimics marvels at how such people—investors, entrepreneurs, and their middlemen--could be so short-sighted, but the key is that the mimics and duped investors chose those business models that seemed most solid based on objective, identifiable characteristics that were, historically, correlated with success."
Paul Krugman has never had a thought as brilliant as this. Once you have this concept in your "mental latticework," you start to find that it shows up everywhere. A correspondent points out,
"It resembles cargo cultism--copying a few features that are cheap to copy and misleading to investors (dupes). Some copying would be more cost-effective than others."
We've talked about cargo cultism before, in regard to the Chinese [1,2]. And wouldn't you know it, but the whole Chinese economy looks like one big Batesian ecosystem that is overrun with mimics. See for example, How China Fooled The World With Robert Peston:

As our correspondent observes,
"Features of the coming Chinese debt bubble debacle: enormous size, zero-reserve banking, unregulated banking, debt that cannot be repaid from income because there is no income Batesian mimicry of good collateral by bad collateral (empty shopping malls), cargo cult political leadership mimicking a few features of a market economy, cargo cult population with no experience investing in a market economy and thus unable to detect Batesian mimicry."
According to the China bulls, the 60 million residential units under construction there right now are needed, desperately needed, for people to live in. If that's true, then there must be a market price signal that these new units are needed and will be worth more than the resources used to construct them. In other words, the rental yield on existing Chinese residential units should be high.

Why, then, don't we ever hear about attractive opportunities to own Chinese rental property? Is it because vacancies would be a challenge in places where the home ownership rate is above 100 percent?


CP said...

P.S. Falkenstein's important conclusion:

"If mimicry is the essential driver of the misallocation of resources that inevitably must be corrected, it by definition occurs in places that do not have accurate quantitative signals; indeed, it preys upon areas where the essential data are beyond reproach (eg, mortgage underwriting supposedly did not matter to regulators, rating agencies, or investors prior to 2007). Safety creates risk in that eager overzealous entrepreneurs, once they figure out what sufficient statistics work on investors, quickly jump on these sectors with not merely excess capacity but business models that never stood a chance."


"This suggests focusing on robustness, as opposed to prediction, because the system works against rational expectations, especially those consensus ideas that come out of large bureaucracies. After all, what better sufficient statistic for a mimic to exploit than some well-known regulatory bullet point that supposedly ensures trivial risk? Recessions are not going away; they are endogenous because zero mimicry is not an equilibrium among insects, reptiles, or humans."

Stagflationary Mark said...

I posted this on a previous thread of yours but it really belongs here.

Office Employment Growth

In my opinion, we "need" more office construction about as much as a wounded polar bear needs a Jeff Koons's Dom Pérignon Balloon Venus.

According to the artist, this version, made from polyurethane resin, represents the link between past, present, and future vintages of Dom Pérignon, as well as the continuity of the human experience symbolized by Venus.

$20,000 gets you a replicated polyurethane vase? I don't know. Seems a bit pricey to me, but perhaps it is a hidden store of polyurethane value.

Nathan said...


Eric Falkenstein also had some interesting thoughts about the role of relative status in explaining seemingly irrational behaviors. For example, why people often vote against their self-interest and why people prefer riskier investments.


When telling your peers about how you made a 10x return on a biotech stock, what better way to impress your friends than to show them the $20,000 polyurethane vase you bought with the proceeds?

At least, I think that would be Falkenstein's explanation :)

Stagflationary Mark said...


And there's no reason to tell your peers that you only invested $1,000, made $10,000, and then put $10,000 on the credit card to buy the vase!

No big deal! You can always just repeat the process since stocks only go up again. ;)

Mr. Gotham said...

Another guy with the lesson learned from last cycle about car loans:

"The manager’s belief that Americans cling to their cars is
behind his bet on Ally Financial Inc., which makes auto loans.
Two of his top 10 holdings as of Dec. 31 were bonds of Ally
“Car lending is a very resilient business, ” said Notkin.
“People will give up the keys to their house before they give up
their car.”

Anonymous said...

Startups are a case study in Batesian mimicry