Bright Rights

Do Hedge Funds Earn Abnormal Returns?

2010-01-11T19:53:00.001-08:00

The industry, as expected, claims they do. As a University of Chicago product, I am generally skeptical of claims that hedge funds, on average, produce alpha. It is certainly possible that the extra returns (if there are any) are due to increased risk. From the NYT:

Based on Mr. Malkiel’s studies and other academic work, hedge fund investors should probably assume that reported industrywide returns are really as much as four percentage points lower, which makes hedge fund managers look much less special. This problem of voluntary reporting adds to what is known as survivorship bias, by which poorly performing funds that shut down drop out of the index.

It is still tough to say what this ultimately proves, but it seems clear that until more transparency is adopted in the industry, one should be skeptical of the claim that hedge funds, on average, produce higher risk adjusted returns than alternative investments.

I am not sure how I feel about the skills of individual managers. It is true that some managers might produce superior returns consistently due to their investing skill, but it is hard to know for sure. For mutual funds at least, Eugene Fama has found that just by luck alone, there should be more successful managers than exist today. But the jury is out on hedge fund managers. Of course, if you are a hedge fund manager collecting your 2/20 fees, transparency is the last thing you want. That is what regulation is for though.

Full Disclosure: If someone was willing to give me a chunk of money with a 2/20 fee structure to try to produce alpha, I would give it my best shot. Of course, I am arrogant so I think I could do it, but people always overestimate their own abilities.

Interview with Rahuram Rajan

2010-01-11T19:37:00.001-08:00

Mark Thoma’s summary is here, and the full interview is here if you are interested. Rajan offers some great information on economic development, the financial crisis, and financial regulation.

He is a University of Chicago professor if anyone was wondering. Despite the general attitude of the blogosphere, there still is great stuff coming out of the school.

The Racist Right and Terrorism

2010-01-10T10:49:00.001-08:00

I suppose the reaction was predictable, but “profiling” of Muslims at airports is a terrible idea. From Matthew Yglesias:

The United States is a gigantic, diverse country that does business and policy all around the world. Air travel in this country is as safe as it’s ever been. Taking reasonable steps to make it safer would be nice, but cutting ourselves off from a huge swathe of the world and poisoning relations with 1.5 billion Muslims is going to be much worse than an exploding airplane.

People on the right need to stop just standing up for liberty, freedom, and small government for affluent whites. Profiling of Muslims would clearly curtail the freedom of Muslims. Any attempt to think about the costs of such a “profiling” policy makes the idea irrelevant very quickly.

Goodbye Pete Carroll

2010-01-10T10:33:00.001-08:00

ESPN is reporting that Pete Carroll is going to the NFL to coach Seattle.

Maybe Notre Dame will have a shot against USC in the future.

Bubbles – The Point of No Return

2010-01-10T08:34:00.001-08:00

I was reading this recent blog by Paul Krugman about bubbles and I was reminded of this article from Christian Leuz in Forbes, published about a year ago. In it, Professor Leuz gives one of the clearest descriptions of why bubbles exist I have come across.

During speculative bubbles, there is a point at which sophisticated players lose the incentive to correct a trend away from fundamentals and instead benefit from going along with it.

I am sure many of you have heard the phrase “the market can stay irrational longer than you can stay solvent”, but Leuz’s description doesn’t just describe why it is hard to profit by betting against bubbles, it describes why people that might normally bet against bubbles start to play along with the irrational price appreciation.

Even more importantly, I think this helps to describe one of the biggest problems with our financial system today. If one bets against the bubble and loses, everybody thinks that person is dumb. But if one bets with the bubble and loses, that person just did what all the “smart” people were doing too, so they can’t be dumb. If one works in finance then, it seems pretty clear that betting against the bubble results in a much higher probability of being fired. But there really isn’t much of a downside to playing along with the bubble in the short term.

Unfortunately, I am not sure how to fix this with regulation. It is more of a behavioral problem. I think the best way to fix behavioral problems is to continually make people aware of them. That might make it more socially acceptable to bet against the bubble without the consequences of looking dumb if the bet was made too early.

Big Bonuses Make Financial Reform Easier

2010-01-09T20:39:00.001-08:00

Wall Street is set for another round of good earnings, courtesy of the US government, and huge bonuses.

My top legislative priority is not health care. It is financial reform, and Congress is moving too slow for my tastes. The longer they wait, and the farther away the economy gets from the recession, the harder financial reform will be.

But Wall Street may be helping me out. Each and every financial institution on Wall Street is alive today because of government assistance. So seeing them carrying on as if it was 2005 frustrates me. But maybe Wall Street’s stubbornness will create the kind of public backlash we need to motivate faster and more complete financial reform.

The Health Care Negotiations Should Not Be Televised

2010-01-09T09:27:00.001-08:00

I find the claim that the health care negotiations should be televised ridiculous. An open and honest discussion would be impossible with the cameras there. And Republicans who claim that the negotiations remove them from the process should have thought of that over the last year when they decided their strategy of saying no to everything was their best way to win the majority back.

Strategically, I understand the move. And if all I cared about was having Republicans in power I would support the move. But I care about having Republicans in power that will govern the country in a reasonable way. This Republican party is not it.

Republican Contradictions

2010-01-09T09:21:00.001-08:00

Republicans love to claim that the government can’t possibly do better than individuals with economic choices, and in most cases I agree. But when it comes to moral issues, many Republicans seem to think they know better than the public. The libertarian (and the atheist) in me finds this contradiction incredibly frustrating. And when Republicans use their perceived moral superiority to not only attempt to affect the decisions I am allowed to make, but to hurt the effectiveness of the government as a whole, I can’t help but get angry. From Pat Garofalo:

Sen. Jon Kyl (R-AZ) evidently doesn’t like online gambling very much, and in 2006, he helped craft a law banning the processing of online wagers…but the Obama administration and the Federal Reserve pushed back the start-date until June. Kyl doesn’t like the decision and is making his displeasure known by placing holds on pending nominations to the Treasury Department

Full disclosure: I hate the restrictions on internet gambling so this might bother me more than most. I understand the moral sensitivities of things like abortion, but when it comes to internet gambling and other activities with little or no harm caused to others, this is just big brother stepping in to control our lives more than they should.

The Fed and the Financial Crisis

2010-01-04T20:37:00.001-08:00

Pete Davis, at Capital Gains and Games, discusses Bernake’s recent speech, where he argues, pretty effectively in my opinion, that the Fed’s interest rate decisions were not a major cause of the crisis.

Mr. Bernanke attacked the notion that the Fed could have taken the air out of the housing bubble before it damaged the economy. He showed that housing prices rose far more than be explained by monetary policy alone and that cross-country evidence “shows no significant relationship between monetary policies and the pace of house price increases.” Failure to regulate lax mortgage lending practices was the real culprit.

While I agree that the Fed's interest rate moves were a minor contributor to the crisis, I think it is hard to argue that lax regulation, was not a major cause, as Bernanke acknowledges. And the Fed definitely contributed to the atmosphere of lax regulation.

Of course, the Fed, the rest of the regulators, and the general market (myself included), all fell for the same fallacy that "this time was different": financial innovation, by spreading risk around to those who could bear it, had made the financial system safer. In order to prevent this regulatory capture of the Fed, I think we need to change the way we view, and regulate, financial innovation.

Financial Innovation

2010-01-03T12:11:00.001-08:00

As a capitalist society, we tend to view all innovation as a good thing. And I think in most industries, other than finance, this is generally correct.

During the dot com bubble, innovation was rampant. Many of the new businesses and websites were redundant, unnecessary, or unwanted, and as a result many of them failed. But no bailouts were necessary. Pets.com didn’t require government funds. And the fallout from the failure of start-ups didn’t take the rest of the economy down with them. The ideas, business, and jobs that grew out of the dot com bubble were beneficial after the dust settled. Thus, I think it is fair to say that innovation deserves the benefit of the doubt in most industries.

However, this crisis showed that in finance, innovation should not be given the same free pass.

Many people who blindly support innovation in finance cite the correlation between economic growth and growth in the finance sector throughout history as proof. And in fact, I support this claim, but only up to a point. I don’t think it is clear that the relationship is linear. It might be, but there also may be diminishing returns, where once we get to a point, each subsequent innovation may be worth very little. Also, not all innovation is clearly beneficial. Innovation that increases transparency (decreases the level of asymmetric information) and avoids moral hazard and tail risk is usually a good thing. But of course, this kind of innovation is much less profitable than the innovations that take advantage of asymmetric information and moral hazard.

My conclusion then, is we, as a society, should be skeptical of financial innovations. Our regulators need to switch the burden of proof to the finance industry, and make them show that each individual innovation increases transparency and avoids moral hazard and tail risk before it is allowed to be implemented.

Let’s Make a Deal Statistics

2010-01-03T09:40:00.001-08:00

I just saw a commercial for a new Let’s Make a Deal game show, and it reminded me of the fascinating Monty Hall problem.

Suppose you're on a game show, and you're given the choice of three doors: Behind one door is a car; behind the others, goats. You pick a door, say No. 1, and the host, who knows what's behind the doors, opens another door, say No. 3, which has a goat. He then says to you, "Do you want to pick door No. 2?" Is it to your advantage to switch your choice?

As the player cannot be certain which of the two remaining unopened doors is the winning door, most people assume that each of these doors has an equal probability and conclude that switching does not matter. In fact, in the usual interpretation of the problem the player should switch—doing so doubles the probability of winning the car, from 1/3 to 2/3.

Read the Wikipedia article, at the very least so you can feel a sense of intellectual superiority if you ever find yourself watching the show.

Obama on the “War on Terror”

2010-01-03T08:06:00.001-08:00

I have been please with Obama’s commitment to fighting al-Qaeda since he has taken office. And I agree with the way he has changed the way the government refers to the war. Conservatives like to call him weak because he doesn’t use the phrase “war on terror”. But Obama does say we are at war with al-Qaeada, which is not only more clear, but more accurate.

Yglesias explains if you want more details.

The Tragedy at Duke Continues

2010-01-03T06:55:00.001-08:00

The accusation of the Duke players being falsely accused of rape a while back was a tragedy. One would think that Duke, being the high-quality institution of higher learning that it is, would recognize its errors and rectify them as soon as possible. Instead, they are making it easier for false accusations to occur in the future, and they are making it harder for the suspects to defend themselves. From Paul at Power Line:

The revised policy requires the involvement of the University's Women's Center (about which more below) in the dispciplinary (sic) process for all known allegations of sexuall (sic) misconduct, and empowers the Office of Student Conduct to investigate even if the accuser does not want to proceed.

Moreover, according to Taylor, Duke's rules define sexual misconduct "so broadly and vaguely as to include any sexual activity without explict (sic) 'verbal or nonverbal' consent, which must be so 'clear' as to dispel 'real or perceived power differentials between individuals ]that] (sic) may create an unintentional atmosphere of coercion.'" One wonders what consent could be clear enough to dispel "perceived power differentials" in the mind of the ideologues responsible for this definition.

Finally, Taylor says the disciplinary rules deny the accused the right to have an attorney at the hearing panel or to confront his accuser. The accuser is also permitted to make opening and closing statements, but the accused is not.

I was appalled when I read this. The ambiguous definition of “perceived power differentials” is scary. But, thankfully, later in the post, we are informed as to what this is meant to mean:

Ada Gregory, director of the Women's Center, argues that "higher IQ males" like those who populate Duke are particularly effective at "manipulation and coercion." Hence their ability to "rape" women without them even realizing it.

I laughed out loud when I read this. First it is completely inaccurate as it relates to hooking up with women. Maybe she needs to watch a season of “Beauty and the Geek”, or just go hang out in a high school honors class to see if on average, the smarter students have more or less social skills than the less intelligent students. Second, doesn’t Duke also have “higher IQ females”? I guess the extraordinary abilities of the male students outweighs the abilities of the female students to thwart the males’ intellectual manipulations. Interesting quote from the director of the Women’s Center.

All in all, this is a crazy response from a school whose gut reaction to erroneous rape accusations almost ruined the lives of a number of their male students.

More on Ted Gayer and Efficient Markets

2009-12-30T20:50:00.001-08:00

Ted Gayer responds (not to me, but to his more prominent critics).

I think it is fair to be skeptical of “negative costs” for greenhouse gas abatement activities for the reasons Ted Gayer mentions. In fact, it is probably the right place to start. If companies aren’t doing it, maybe there is a better reason than the fact that they just don’t know about it, or are ignoring it. Ted Gayer is not just skeptical though. He dismisses it out of hand because it doesn’t fit within the theory of efficient markets. This seems unreasonable to me.

And his defense that the cost of acquiring the information related to the cost savings would offset the savings seems like an ex post defense, rather than an argument based on some sort of ex ante analysis.

Efficient Markets Conundrum

2009-12-30T18:00:00.001-08:00

Brad DeLong and others have already posted on this, but I find it very annoying when people use the efficient markets theory so blindly. From Ted Gayer:

But Krugman oversells the affordability claim by linking to a widely cited report by McKinsey & Company. The main point of the McKinsey study is provided in their Exhibit B, which illustrates a rather peculiar finding that there are a significant number of pollution abatement options that can be achieved at “negative cost.” This finding violates the basic principles of economics. If firms (or consumers) could reduce emissions at negative cost, then they would do so. To say otherwise is to say that they are willingly or ignorantly passing up profits...

But if Krugman is wrong then people (being rational) wouldn't read him, The New York Times wouldn't employ him, and his blog wouldn't exist. Looks like we have ourselves quite the efficient market conundrum here.

Andrew Samwick Responds

2009-12-29T18:39:00.001-08:00

Andrew Samwick responds to my comments on his recent post regarding the tax on Cadillac health plans.

It is true that the income tax exclusion of the health insurance premiums does tend to favor those with high expected health expenditures, but the way to address that issue is through a comprehensive system of ex post risk adjustment for the premiums, as I discuss here and here with regard to the House and Senate bills.

I would definitely like the “tax” better if it incorporated the risk adjustment measures proposed by Andrew Samwick, and arguing for this change is well worth the time. But I am willing to accept a weaker proposal in order to start to address the tax problems of the current employer provided health care structure. I gather From Mr. Samwick’s response, that he is not.

I am left wondering where we disagree though. Do we disagree on the magnitude of the benefit of the “Cadillac tax” in its current form, or do we disagree on the cost of disadvantaging those who hit the cut-off level for legitimate risk reasons. It is probably a combination of the two.

The Individual Mandate is Constitutional

2009-12-29T17:57:00.001-08:00

Matt Jacobson, at The Next Right, revisits a standard complaint from the right on the individual mandate.

The healthcare bill in congress is not compliant with the 10th Amendment. It forces every citizen in the country to purchase a private product (health insurance) as a condition of citizenship. This type of top-down, Washington-based solution is not good for the country.

There are two separate arguments here. The second point, that it is bad for the country, is an opinion, and while I disagree with that opinion, a reasonable argument can be made in its favor. As for the fist point, regarding the constitutionality of the mandate, while it could be argued that this is an opinion as well, it is an opinion in which only nine people ultimately get a vote: The Supreme Court Justices. And it looks like precedent is pretty clearly on the side of the constitutionality of the individual mandate. From the Constitutional Law Prof Blog:

The Supreme Court may be on a path to limiting congressional authority under the Commerce Clause, the Taxing Clause, or any clause. But even so, the individual mandate all too squarely falls within the recent and settled jurisprudence.

Or for a more thorough review, see this piece from Mark Hall.

One can certainly believe that the country would be better off if more authority was left to the states, but if one truly wants to find an argument against health care reform, I don’t think constitutionality is the way to go about it.

I Love the Tax on Cadillac Health Plans

2009-12-28T16:24:00.001-08:00

The tax on Cadillac health plans is, in my opinion, one of the best ways to eventually “bend the curve” in the Senate Bill. Andrew Samwick, from Capital Gains and Games, disagrees.

The argument does not miss that point. It simply questions why the "Cadillac tax" raises the after-tax cost of health insurance for groups that are more expensive to insure along with groups that have chosen a more expensive way to structure their health insurance.

I understand the argument, but in my opinion, this is a situation where political realities bump up against ideological stances.

From an ideological point of view, I agree with the first point. I think it is unfair to disadvantage those groups who require expensive health care as opposed to those who do not. Each group should have the same tax advantages as it relates to their health care expenses.

But I disagree with the second point about groups that have chosen to structure their compensation with lower salaries and more generous health care benefits. The reason these groups have chosen to do this, as I understand it, is mainly because one dollar of health care benefits is greater in after-tax value than one dollar in salary because the health care benefits are not taxed. And from a corporate perspective, both expenses are tax deductible, so companies are largely indifferent. If this is the case, then really the groups were just using the tax code in their favor to ultimately give themselves a higher total compensation package. I am not faulting them for this, but I also don’t think it is unfair when the government changes the tax code to avoid this sort of behavior. The “Cadillac tax” is really just trying to remove the inequities in the tax code. That is why I am not sure I understand how one can make the first point and the second point at the same time. The first point attempts to argue for an equitable tax law as it relates to health benefits, but the second point seems to be against a change that attempts to make the tax law slightly more equitable.

But it seems like Andrew might agree, as I do, that a very beneficial change to our current health care system would be making all health care benefits taxable. In my opinion, this would significantly “bend the curve” in the future as the general public would become much more aware of how much their total employer provided coverage is costing them and thus put the kind of pressure on premiums and costs that doesn’t exist today. If one agrees with this, then one has to decide if a small step, like a tax on “Cadillac” plans is worth the unfair treatment mentioned in the first point. A tax on Cadillac plans, in my opinion, is a clever way to tax health care benefits in the future, as long as the cut-off level increases less than inflation. Taxing all health care benefits would be better, but because Obama made this politically impossible by opposing the measure in his campaign, I am forced to weigh the political realities of what can be done today, versus my ideological position of what should be done. I think the benefit of putting something in place today that might eventually get the tax code to a more equitable position in the future is worth the sacrifice.

James Galbraith on the Crisis

2009-12-06T09:10:00.001-08:00

If you have the time, this video, posted by Mark Thoma at the Economist’s View, is well worth it.

An Interesting Perspective on the AIG Payouts

2009-11-29T11:36:00.001-08:00

Ever since the report on the AIG bailout, there has been much attention paid as to whether or not the Fed and the Treasury should have tried harder to negotiate haircuts on the AIG payouts. I haven’t heard many people defending the government, but John Berry does just that, and offers an interesting perspective:

The report acknowledges that the New York Fed tried to negotiate such a haircut and that one creditor, UBS, offered to knock off 2 percent if all the other creditors would as well. But the French banking regulator said it would be illegal for the two French institutions involved to take a haircut unless AIG was in formal bankruptcy, and the Fed said it had to treat all the banks the same way.

I don’t understand why the Fed had to treat all the banks the same way, and I also don’t understand why more effort couldn’t have been made to get the French banking regulator to support a haircut given the circumstances. I understand the AIG bailout was done in a panicked environment, but the tragedy of it all, was that the government was forced to provide so much assistance to the entire financial industry, but because it was done in the form of contractual payouts from AIG, the government wasn’t able to demand the concessions that they could have had they just given the banks capital. And, the public was left largely uninformed. And now you have banks that survived, like Goldman Sachs, operating as normal, when without government support, either through the AIG payouts or other means, the banks wouldn’t have survived.

Why Do We Continue to Support Home Ownership?

2009-11-29T11:23:00.001-08:00

Government policies continue to promote home ownership regardless of the consequences. From Robert Pozen in WSJ.com:

We all want to help first-time buyers acquire homes and support the depressed U.S. housing market. Without real down payments, however, new homeowners are likely to default on their mortgages, and the FHA will probably need a taxpayer bailout.

I am not sure that we do want to support the depressed housing market. Whether we want to do this depends on whether we think the housing market is below its natural equilibrium. I think that is a tough argument to make. If we are supporting the housing market to a point where it is above its natural equilibrium rate, then government policies are simply postponing the inevitable fall that will occur when the government support goes away. Maybe there is a benefit for this fall to be gradual instead of sudden, but I don’t think so. It is more likely these are the kind of polices that just keep our economy treading water, instead of solving the real problems.

Cheney or Palin in 2012?

2009-11-29T11:06:00.001-08:00

The “Draft Dick Cheney 2012” movement has begun. From Christopher Barron, one of the organizers of the movement:

“The 2012 race for the Republican nomination for President will be about much more then who will be the party's standard bearer against Barack Obama, the race is about the heart and soul of the GOP,”

If 2012 is about the heart and soul of the GOP, and Cheney, or for that matter, Sarah Palin, end up winning the nomination then any hope for a reasonable Republican Party over the next four to eight years will be lost. I definitely couldn’t support either of them, and while I wouldn’t defect to the Democratic Party indefinitely, I would be seriously questioning my short-term allegiance.

Scott Sumner on Health Care

2009-11-29T10:43:00.001-08:00

Scott Sumner offers his view on proper health care reform here. It seems pretty similar to my recent post, just without the mention of eliminating the tax subsidy for employer provided plans. Given his post and his general political views, I assume he supports this idea as well. But he also provides a model where the theoretical solution has worked in the real world: Singapore.

Let’s pretend there is a country very similar to the US from both the perspective of per capita GDP and Gini coefficient. And let’s assume that government spends only a bit over 1% of GDP on health care subsidies. And let’s pretend that country achieves all of the goals outline above, with a system of very low taxes on labor and no taxes on capital. Let’s call this imaginary country “Singapore.”

I admit I don’t know much about the Singapore model for health care. But given that Scott Sumner and I agree on how we should treat health care, I need to look more into it.

Would AIG Payout Negotiations Be Viewed as a US Default?

2009-11-28T13:09:00.001-08:00

Matthew Yglesias, in light of the Dubai World’s debt payment restructuring, seems to think it would have been.

The only way to achieve this would have been for the US government to credibly threaten to default on the debts of a US state-owned company. It looks like the world financial system probably can process the default of a Dubai-owned company without that unduly impairing the ability of major sovereigns to borrow. But still people are clearly at least somewhat nervous. An American default scenario would have posed much bigger risks and would have done so at a period when the whole world looked more vulnerable to shocks.

I find it hard to believe that the markets would have interpreted AIG payout negotiations as a US government default. The government took over AIG because it would have gone into bankruptcy absent government intervention. Dubai World was state-owned before its difficulties. I buy the US default story for Fannie and Freddie, even though these weren’t state-owned before the crisis, but not for AIG. The government could have paid out less than the full value of the contracts without causing the panic that would be associated with a US default.

Is the Tobin Tax a Good Idea?

2009-11-28T12:54:00.001-08:00

Whenever I hear about the idea of a tax on financial transactions I really like the idea. If we lived in a world where the tax could be implemented in every country at the same time I would support it. Paul Krugman believes this is not an issue.

On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair…This centralization keeps the cost of transactions low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes these transactions relatively easy to identify and tax.

Greg Mankiw disagrees:

Even if most transactions are now settled in one place, that need not be the case in the future after a significant change in the policy environment…The finance industry is set up to take advantage of very small price differences. If London became ever so slightly more expensive, wouldn't contracting and settlement quickly migrate elsewhere?

I side with Greg Mankiw on this. Maybe there is a way to make the Tobin tax work. I would love it if there were, because I support the general idea of it. But I can’t get past the implementation issue.