Tuesday, June 16, 2015

Review of Panic: The Betrayal of Capitalism by Andrew Redleaf and Richard Vigilante

The best book on the 2008 crash is Panic: The Betrayal of Capitalism by Wall Street and Washington by Andy Redleaf and Richard Vigilante. It started out as a rebuttal of the efficient market hypothesis but had not been published when the crash happened, so they discuss how widespread adherence to the tenets of modern finance contributed to the crash.

Redleaf is founder of Whitebox Advisors - I mentioned their "Enduring Market Principles" earlier this year. Notice the first principle: "the source of investment return is the efficient reduction of risk." 

That is in direct opposition to the EMH principle that the source of investment return is risk. If you remember Falkenstein's Missing Risk Premium, the idea (from every CFA or MBA curriculum!) that return is a function of risk has been very thoroughly debunked. There are many, many examples of the relationship between risk and return actually having a negative sign.

The point of Panic is that orthodox modern finance is not just dumb, it is dangerous. (Especially since it is government sanctioned or even required of regulated capital allocators.) As the authors explain,

"Just as the core theory of equity indexing was that diversification could substitute for exhaustive (and perhaps unreliable) analysis of the underlying companies, the core theory of structured finance was that by combining large piles of individual credits into tradable securities, the packager would eliminate the need for a great deal of expensive and imprecise valuation of individual credits. Once again, thanks to the magic of diversification, a few highly formalized (i.e., information-impoverished) metrics substituted for actually knowing which mortgages one was buying.

The essence of modern investment theory is to ascend to a level of abstraction that makes fallible individual judgment irrelevant. Unfortunately, in the course of rendering such judgments irrelevant, one may also make them impossible."
Different size investors operate at different levels of abstraction. An enormous institutional investor might say "small caps seem cheap, let's give a billion to small cap value managers." While we say "Conrad is the cheapest, best small cap that we can find, let's buy that." One reason for different levels of abstraction is that if you are big you need to ignore certain smaller details in order for your work to be manageable.

Someone interested in finding rare coins can get rolls of them from the bank at face value and sort them. On average, he may find enough rare pennies that are worth 1000x face value to make the activity worthwhile. But, a bank is just concerned about keeping the cash drawers stocked. To them, a penny is a penny and they don't care if they accidentally let some rare ones go. It's because the bank is operating at a different level of abstraction than the coin collector. As Redleaf says,
"Arbitrage, as an ongoing business, is possible not only because most of the world is less price sensitive than most of the world's arbs but because most of the world is right to be less price sensitive than the arbs. […] Coin collector makes a living by being sensitive to price anomalies that do not interest most users of pennies."
Levels of abstraction are actually a computer science concept.
"An abstraction [is] a simplification of something much more complicated that is going on under the covers. As it turns out, a lot of computer programming consists of building abstractions. What is a string library? It's a way to pretend that computers can manipulate strings just as easily as they can manipulate numbers. What is a file system? It's a way to pretend that a hard drive isn't really a bunch of spinning magnetic platters that can store bits at certain locations, but rather a hierarchical system of folders-within-folders containing individual files that in turn consist of one or more strings of bytes."
That was from Joel Spolsky. He goes on to talk about when abstractions fail.
"Law of Leaky Abstractions: All non-trivial abstractions, to some degree, are leaky. Abstractions fail. Sometimes a little, sometimes a lot. There's leakage. Things go wrong. It happens all over the place when you have abstractions. […] the only way to deal with the leaks competently is to learn about how the abstractions work and what they are abstracting. So the abstractions save us time working, but they don't save us time learning."
Compare with Panic. Their point is that the securities markets are driven by investors operating at a very high level of abstraction, very far removed from any knowledge of what they have invested in or to whom they have lent money. It makes it easy for them to buy (because they don't do any work), but it also makes them inclined to dump everything and run when things get tough.

It is not just big institutions buying "triple-A" mortgage paper that abstract away details that turn out to be trivial. Think of all the retail investors who, afraid of potentially rising interest rates, have poured money into corporate bond funds. Or who have poured money into yieldy MLPs or even royalty trusts trading at triple the asset value. All that these investors know is the category of what they have bought (bonds, energy infrastructure) and not the ugly details of what has gone into the blender. If you wonder who buys ridiculous debt deals like a Mexico century bond or a private equity holdco PIK toggle note, it is agents buying to put in the sausage for the principals.

Academics historically have not believed in absolute return investing strategies because these strategies defy the most rigorously scientific tests. There is a reason that these academics conclude that you cannot make money using a strategy that makes money: they would only consider an arbitrage strategy valid if it applied across an entire market segment previously defined in some arbitrary, nonbiased way. But, as Andrew Redleaf and Richard Vigilante observe in Panic,
"This is exactly what adroit market practitioners do. We assume that potentially profitable anomalies appear and disappear as market conditions change. We assume that such anomalies are almost certain to be more powerful and profitable for some sets of securities than for others. We look into the nooks and crannies of the market for trends that we can exploit profitably with some securities for now."
As they conclude, "it is impossible to address the question of whether good judgment can produce excess returns through research methods that exclude the possibility of judgment."

This being an idiocracy, the book seems to not even be in print any longer. Why would anyone care to read a thoughtful discussion of how trillions of dollars evaporated and billions were shuffled into the pockets of investment banker cronies - all thanks to grievously flawed modern financial theory that still reigns?!

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads.

Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion.



Viennacapitalist said...

your reviews are excellent and a great source when looking for new reading material.
Thank you!

bjdubbs said...

Great review, as usual. Any idea why Redleaf/Whitebox performance is so abysmal?

Nathan said...

Great post!

Re: leaky abstractions

Widely reported economic indicators strike me as leaky abstractions. It's attractive to view economies at that level of abstraction, but after GDP, house prices, and unemployment became subjects of political interest they lost their informational value. College education and single-family homes are modern-day backyard furnaces.

I cringe whenever I read about how (dollar-denominated) household wealth has reached a new record. Any rational definition of "wealth" would be tied to the idea that people can satisfy their needs and wants efficiently. Household wealth, particularly house prices, growing faster than wages is contrary to that notion, yet it's reported as an unalloyed good.

Anonymous said...

Is it abysmal? What performance numbers are you seeing?

CP said...

A Waddell & Reed Financial Inc. junk-bond fund has sold some of its safest investments to meet a wave of investors’ redemption requests since last July, leaving fund investors holding a far riskier mix of securities...

Assets under management in the fund have shrunk 33% to $8 billion since July, when Waddell & Reed fired the manager of the Ivy High Income Fund, William Nelson, for undisclosed reasons. [...]

Over the same period, the fund’s holdings of the riskiest junk bonds—those rated triple-C or below—have grown to 47% of assets, from 35% before the redemptions, according to Morningstar.

The fund now has a higher ratio of triple-C bonds than any of the 100 largest high-yield bond funds, which averaged a 14% allocation...


Anonymous said...

" If you wonder who buys ridiculous debt deals like a Mexico century bond or a private equity holdco PIK toggle note, it is agents buying to put in the sausage for the principals."

I really liked the shipping man. Not for the ship parts, but the way he described the people buying into these bond offers. You really got a look behind the scenes in the investment banking scene and how those people are who buy those shitty bonds.

CP said...

Speaking of:

"I cringe whenever I read about how (dollar-denominated) household wealth has reached a new record."

In the most recent Hussman:
Now, one might object that a high value of financial assets relative to disposable income is actually a good thing, and that it reflects greater saving by households. Unfortunately, since 2000, saving as a fraction of household income has plunged to half the savings rate observed in the previous half-century. No, the elevated level of financial assets reflects extreme valuations, not an increase in the rate of financial investment.

Still, one might argue that these elevated valuations are somehow a good thing - that these richly valued financial assets represent spendable “wealth.” But again, the true “wealth” represented by any security is in the stream of future cash flows it delivers over time, and in the value-added production that produces those cash flows. Until those cash flows are delivered, security prices only reflect the relative eagerness of investors to trade claims on those future cash flows. Put another way, in order for the holder of any security of spend out of that investment, the security has to be sold to another investor who locks in the identical amount of funds (Iron Law of Equilibrium). Extreme valuations don’t equate to higher wealth; they just mean that buyers are probably giving up too much current purchasing power for their claim on future purchasing power. Depressed valuations don’t equate to lower wealth; they just mean that sellers are probably giving up too much future purchasing power in order to obtain current purchasing power.