Physics Envy in Finance

This represents my personal opinion, not the views of the SEC or its staff.

If all you have is a hammer...

I read a New York Times article a while ago on econophysics – the use of the tools of physics in economics – that featured the application of seismology to solve the problems of market crises. I can see the twists of logic that led to this approach: during an earthquake things shake around and fall, and during a market crisis things shake around and fall. Seismology predicts the former, so why not the latter?

This type of logical leap too far is nothing new. I remember the popularity of Kalman filters and the application of the principles of torque to measure the strength of market turns (I’m not kidding) in the seventies. Later came the emergence of chaos theory to model market dynamics and catastrophe theory to model market breaks, the logic being that markets look chaotic, and that market breaks are, well, breaks.

None of these work, and as I will get to in a bit, there is a reason they don’t work. But the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, there are not many jobs for physicist in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.

So if you are a physicist by training, what is more natural than to take to your new home with your physics hammer, especially if everyone wants you to look at everything as if it is a nail.

Boards don’t hit back

Andrew Lo and Mark Meuller have has a recent paper that addresses the issue of physics envy. They focus on the applicability of the tools of physics as the type of uncertainty becomes more profound, pointing out that while physics can generate useful models if there is well-parameterized uncertainty, where we know the distribution of the randomness, it becomes less useful if the uncertainty is fuzzy and ill-defined, what is called Knightian uncertainty.

I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well.

In the Bruce Lee movie, Enter the Dragon, Lee faces his arch enemy in a fight. To intimidate Lee, his opponent holds up a board, and splits it in two with his fist. Lee watches passively and says, “Boards don’t hit back”. That gets to the reason physics does not work in finance: markets do hit back.

The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

For example, I have seen this issue repeatedly in risk management, and it is one reason any risk management model will not cover all the risks. Once the risk model is specified, the traders will try to find a way around it. Are you measuring DV01 risk? Well, fine, then I will do DV01-neutral yield curve trades. Now are you measuring yield curve risk? Fine, then I will do DV01 and yield curve neutral butterfly trades. One of the problems with VaR – and for that matter with any complex model – is that it opens up all the more dimensions for such gaming, and for gaming in a way that is harder to detect. Maybe this can be put into a model, but if it can, it won’t look like how things are modeled in physics.

So it is not by chance that there are so many people trying to add complexity to the markets. Whatever rules are put in place, whatever metrics are devised, traders will try to find ways around them. In an engineering system, if you find a poorly designed valve in a nuclear power plant and replace it with a new and better deigned one, the new valve doesn’t try to figure out ways to make you think it is closed when it is really open. But traders will do that.

Lo and Mueller conclude their paper by considering that “the study of economics may be closer to disciplines such as evolutionary biology, ecology, and meteorology”. And indeed, an increasingly popular alternative to borrowing from the tools of physics is to push finance into a biological model. The argument is that in the biological sphere, there is the interaction and feedback that physics lacks. Evolution is the result of this dynamic, of one species changing over time to best another species, just as one trader will change strategies to best another trader. But this model also does not fit. Evolution is not a conscious process. It is a winnowing out of the poorly designed and emergence of the better designed on the basis of the process of natural selection. In contrast, in finance the process is conscious and intelligent.

A better analogy than physics or biology is a military one. The point is that there is a strategy of intelligent reaction to any action, an arms race to leapfrog one another in information gathering and technology, to know what others are doing, and to react in a way that they will not anticipate. This is the point where I could pull out quotes from The Art War about seeing into the mind of the enemy, attacking when your opponent believes you will retreat, and the like. That is not physics.

More on Soccer -- Changes for Improving the Game

There has been some comment on my recent post related to ways to make soccer less boring, and it appears some readers do not fully understand the direction I am trying to go.

For example, with regard to the idea of a Goal Tunnel: The point is that most of the time, as it is currently structured, soccer is stadium pinball. The proposal I made for a Goal Tunnel is intended to play off of that feature of the game. But the Goal Tunnel, the use of two balls, and these other approaches are only suggestions. It might be enough simply to allow free substitution, or increase the goal size.

Among the changes I proposed, free substitution should be non-controversial. When there is no substitution, the players cannot be as aggressive, because they know that they will still have to be out there even if they become fatigued. So you have a game that is slowed down and conservative. Most every team sport other than soccer allows substitution. Hockey, football, basketball, and lacrosse all have free substitution. Baseball is an exception, but fatigue is hardly an issue for anyone but the pitcher. And there, substitution is allowed.

But in this post, let me focus on another of these changes, an increase in the size of the goal, and show how this can not only increase the amount of scoring, but also make soccer a more interesting game. This illustration will also help with another important point: one change might require other, supporting changes.

Suppose we increase the size of the goal to span the entire goal line. Then it will be impossible for the goalie to cover the goal area, so he may as well move into the field, which means there will be eleven people in the field rather than ten. With so large a goal, it will be trivial to kick the ball past the goal line. So to overcome this problem, require players to carry the ball across the goal rather than simply kick it across. Which, of course, means the players finally get to use their hands, a long overdue improvement. Because the ball can be carried, it should be made smaller and shaped so that it can be tucked under the arm.

The Goal Tunnel can go, but the basic concept behind it, that of tackling, should still be allowed, at least tackling the person carrying the ball. And allow a pause in play whenever the ball carrier is down so that both teams can do any substitution, regroup and reassess their strategy.

A last problem that comes up with the enlarged goal is how to allow the other team to gain possession. If the ball is small and easily held, it will be hard for the other team to jar it loose. So perhaps if the team with the ball cannot advance it sufficiently after a number of “downs”, the other team should be awarded possession.

This is only one example of an improvement in soccer, derived from the simple first step of increasing the size of the goal. But I believe these changes could turn soccer into a much more engaging sport.

Making Soccer Less Boring: A Modest Proposal

Now that the U.S. team has been eliminated, and with it the thrill of having an emotional attachment to the World Cup, I can go back to reflecting on why soccer is so boring. The basic reason is not so hard to come by: there is not enough scoring. Because there is not enough scoring, the bulk of the playing time passes with no concrete result, and the outcome is unnecessarily random. Even when a great team is matched up against a mediocre team, if you were to replay just a few critical seconds out of the hour and a half of action, the outcome might be different. Yawn at the wrong moment and miss the meat of the game.

There is an analytical basis for determining the amount of scoring a sport should have, and soccer is well below the ideal.

First, the greater the number of scores, the lower the chance for a lucky win by a team that is inferior. The number of scores required to move this random component to an acceptable level depends on the nature of the game. For example, if I were up against a professional basketball player in a game that involved each of us taking shots from the foul line, there is a reasonable chance I would win if the game consisted of only one shot each. If we each took ten shots, I would almost never win. On the other hand, if I were up against a world-class sprinter, one race – one score – would be enough. Absent a hamstring pull, he would win a hundred times out of a hundred.

Countervailing the benefit of having the outcome determined by more scores is the negative effect of having too much scoring. Up to a point, the more scores, the more interest and engagement for the spectators. But there is a turning point. Create a game with too many scores and the individual scores become inconsequential.

So in designing the ideal scoring for a sport, you want enough scores to reduce the chance of one team wining by dumb luck. The more randomness in any one score, the more scores you will want, so that a clearly superior team will win most all the time. But you don’t want to overdo it with the scoring. I think that soccer and hockey have too few scores, basketball and tennis have too many, while baseball and American football are somewhere near the sweet spot. This sweet spot can be determined empirically. A sport has enough scoring if a team that, in a large sample of games, tends to lose to most everyone rarely beats a team that tends to beat everyone.

This is all preamble to a way to improve soccer: have more scoring. It will reduce the random component, and lead to more minute-by-minute excitement. Change the game so that a dominating team wins by 10 to 5 rather than 2 to 1.

Here are a few changes I might propose in soccer to increase its entertainment value and reduce the randomness of the outcomes.

1. Free substitution. Allow fresh players into the game. This will make for more aggressive and faster play, which should lead to more scoring. Free substitution will also allow better strategic use of players with special skills.
2. Shorten the field. The ball will then spend more time within striking distance of the goal.
3. Increase the size of the goal. The most direct way to increase scoring.
4. Slope the field. Have the field slope toward the nets, both from the sides of the field and the center of the field. This will keep the ball closer to the goal area. Furthermore, this change will lead to a host of new scoring strategies. If a team can be distracted from the game -- by, say, a staged fight or a naked fan running across the field -- the ball will just roll into the goal.
5. Use two balls. Having two balls in play will increase the number of shots, and spread out the defense. The balls can be color coded, with one ball being worth two points and the other ball one point.
6. Add a goal tunnel. Have a corrugated metal tube that runs into the goal from beyond the goalie area. If someone can kick the ball into the tube, it is an automatic goal, since the goalie cannot defend it. New and entertaining strategies can be added with this feature. For example, players can be "tunneled" by being slammed against the sharp metal edges of the tube, thereby increasing the physical component, and with it, the entertainment value of the sport.

It's Not Your Father's SEC

This Washington Post article discusses the push in the SEC to add more market expertise. It features my colleague Gregg Berman -- who ran the risk management part of RiskMetrics -- and me.

Deriviatives and the New Financial Legislation

A member of Congress asked me to provide my personal thoughts on the OTC derivatives portion of the Senate bill, S. 3217. Here are portions of my letter. The views here are my own, and do not necessarily reflect those of the SEC, its commissioners or staff.

Now that S. 3217 has passed the Senate, I am writing this letter in response to your request. I will focus primarily on the potential for that legislation to allow regulatory arbitrage and reduce transparency to the regulators.

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some – but not all – securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

As far as I was concerned, I owned the stock: I treated the swap transaction in my trading and risk management systems as if I held the stock, and my portfolio return was the same as if I held the stock.

If regulation allows equity index swaps to be under the CFTC’s regime and the stocks to be under the SEC regime, there will be the same potential for regulatory arbitrage. I can already envision a thriving new market developing for what might be called Index Spread Total Return Swaps. A fund that wants to hold a long equity position in IBM and P&G, but wants to do it under the CFTC regime, will have a broker give them a total return swap that pays the difference between a position in an index that holds the S&P 500 and another index that holds all the stocks in the S&P 500 except for IBM and P&G. This is a swap on indexes, and so will be under the aegis of the CFTC. Whatever equity positions the fund wants to hold, a swap can be created to fulfill its needs. With the push of a button, voila, the fund is effectively trading stocks – securities – under the CFTC rather than SEC umbrella.

This is a simple example of a broader point: a financial engineer could just as easily construct a position drawn from the equity market that behaves like a commodity, or create a currency swap that looks like a bond. In other words, under the proposed OTC derivatives regime, traders will be permitted to choose their regulators. In my view, these provisions should seek to eliminate regulatory arbitrage, not create it.

Another weakness of the bill is what it affords regulators in terms of transparency. As I stated in my 2007 testimony before your subcommittee, I believe that regulators should know the positions, leverage and web of counterparty connections across firms. I do not think regulators can fulfill their mission of protecting investors, the market or the economy at large without this information. The bill enhances the transparency of OTC derivatives both by improving price discovery and by pushing for greater simplicity and standardization, a critical step. However, the division of OTC derivatives oversight between the SEC and the CFTC moves us away from this objective. There is no ready mechanism envisioned within the bill to allow unfettered sharing of these data. This not only will create routes to hide abuse, but also, because what is essentially the same asset will end up in different buckets based on how it is constructed, neither agency will be able to readily amass this position and exposure information.

One last thought, based on my experience in risk management. Risk managers have the unfortunate tendency of fighting last year’s war, of developing tools and reports to prevent the crises that just occurred from happening again. Of course, the next crisis almost always comes from a different direction. To some extent, the financial legislation has a similar tendency. For example, much thought has been given to credit default swaps. It is likely, however, that the next major issue will spring from a new financial innovation. The nature of the markets is to exploit weaknesses and to find ways to work around regulation and other constraints. Because legislation can only address what has happened in the past and what is currently expected to occur in the future, the legislation must give the regulators the flexibility to address the unanticipated.

Common Sense Crisis Risk Management

All happy families are alike. Each unhappy family is unhappy in its own way. – Leo Tolstoy.

All days in a normal market seem the same, but when a crisis occurs, it seems as if we have never seen the likes of it before. Each crisis brings evocations of Black Swans with twenty standard deviation tails swimming in the waters of a hundred year flood. But of course, we have seen it many times before, or at least some aspects of it. The cause might be different, the initial market from which it propagates might take us by surprise. But the path a crisis takes, at least in broad strokes, hardly differs from one case to the other.

We all know the limitations of standard risk management methods in dealing with times of market crisis. And we are starting to get a sense of what is needed beyond these methods in order to see a market crisis coming, things like understanding who is under pressure, what sorts of positions they hold (and thus might be forced to liquidate) and who else is holding those positions (and thus who might get caught up in the propagation of the forced selling).

Common Sense about Market Crisis
Unfortunately, although we can hope that this sort of information will end up with those regulating the markets, it is beyond the realm of anyone in the private sector. But here are a few common sense things we know about the way markets behave during a crisis:

• Equities drop
• Volatility goes up
• Credit spreads widen
• Correlations rise
• Areas of low liquidity decline more than similar areas with high liquidity
• The yield curve flattens
  

Volatility goes up because everyone is jumpy, so any new piece of information leads to a big reaction, and also because there are fewer people willing to step up as liquidity providers, so prices have to move more to elicit the other side of the trade.

Correlations rise because people don’t care much about the subtle characteristics of one instrument versus another. Everything is either high risk or low risk, high liquidity or low liquidity. I think of the market during a crisis like in high energy physics, where matter melds into a homogeneous plasma when the heat gets turned up.

Because liquidity becomes critical, the less liquid markets – emerging markets, low cap stocks and the like – take it on the chin more than their more liquid cousins.

(Oh, and what about gold? Sometimes it responds, sometimes it doesn't. There is nothing intrinsic about gold that makes it part of the crisis/no-crisis equation. If it is a flavor-of-the-month market, it will respond positively, otherwise, it will simply act like a commodity, responding to economics).

Knowing this, it is not hard to take steps to protect against a crisis. Just move away from equities, avoid being short volatility, stay away from credit-laden debt, focus on the liquid markets, and watch those carry trades. Also, don’t trust diversification, because those low correlations you are depending on will not be there when it matters.

Or, if you want to be more sophisticated about it, create a variance-covariance matrix predicated on these sorts of relationships, and be sure to add a constraint to your portfolio optimization so that you will not breach a specified risk level under this crisis-based matrix. For example, if your usual risk constraint is to keep your portfolio volatility below twelve percent, perhaps you also make sure it won’t be higher than thirty percent in the case of crisis. Or, because we know the direction of these market effects, to make life simpler you can add a simple scenario test, and not allow the portfolio to lose more than, say, ten percent in that scenario. Doing this will guard against the tendency to over-rely on diversification, over-lever or put too much exposure into the markets that are particularly sensitive to a crisis.

The problem with this advice is that it is exactly the opposite of what will make sense when the crisis has yet to emerge. More to the point, it is exactly the opposite of what makes money as the market is building into a crisis.

Before a crisis (I won’t say “during a bubble”):

• Equities are rising
• Volatility is low
• Credit spreads are narrow
• Correlations are low
• The opportunities are in the hinterland markets of low liquidity
• The yield curve is steep
  

Volatility is low because everything is so rosy. Any new piece of information is No Big Deal, and liquidity is swarming around the market, so prices barely have to move to get an order filled.

Correlations are low because, in an attempt to find value in when every portfolio manager, trader and dentist is spending his time combing the hills for value, the slightest difference between otherwise similar instruments is worth mining. And with the languid pace set by the low volatility and money sloshing over the sides, people have the luxury of spending time in fine-tuning.

With so much money flooding into the market (and so much money means so much leverage), people start to scan the landscape for the less known – and less liquid – markets to find value.

Regime-switching models of market crisis
It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days. But they are not. It is following a different dynamic, a dynamic that we have seen enough to become familiar with. People sometimes look at periods of market crisis in the context of a regime switching model, and this gets more to the point. There are the normal times and then there are the crisis times. But what I am suggesting above is that there are (at least) three regimes. There are the crisis times, the normal times, and the pre-crisis times. The transition generally is not from normal to crisis, but rather from pre-crisis to crisis. And the move from the pre-crisis to the crisis regime is more gut-wrenching because in almost every dimension things are moving from one extreme to another.

The killer is that what protects you in a crisis is also what leaves money on the table pre-crisis. The best trades and market positions in the pre-crisis regime are the ones that cause the greatest losses in the crisis. The result is that those who take defensive actions will under-perform. So the the only way to stay in the game is to be as bold in the face of the crisis risk as others. As a result, in a variant of Gresham's Law, imprudence will drive out prudence.

This represents my personal opinion, not the views of the SEC or its staff.

The Accidental Egalitarian: Technology and the Distribution of Income

This represents my personal opinion, not the views of the SEC or its staff.

This month’s Institutional Investor AR magazine came out with its list of the highest compensated hedge fund managers. I already have expressed my doubts about the accuracy of their approach, though you can adjust the numbers by an order of magnitude and it is still off the charts. But for all that is being written about hedge fund managers and their poorer cousins, the banking elite, about the expanding income gap, and about the new frugality and the changing American dream, the differences between the very rich and the rest of us are shrinking.

Up until the last part of the 1900’s, F. Scott Fitzgerald’s observation that “the very rich are different from you and me” certainly was true. And it wasn’t only, as Hemmingway later quipped, that they had more money. It was how that money transformed their lives and how it variegated society. But no longer.

This might sound like a preposterous statement. But when we use the dollar differences in income to measure the gap, we are measuring it the wrong way. What matters is the practical impact, how the differences in income carry through to make a difference in how we live day by day, even hour by hour. A head to head income comparison does not measure that; it misses the effect of work habits and lifestyle, and, most critically, the effect of technological progress on filling in the income gap. Don’t stop with dollars earned. Ask how people earning those dollars spend their time.

There is one thing everyone has in common, no matter what their income: They have twenty-four hours in a day. So differences in income can only be expressed by what they do in those twenty-four hours, and how they do it. Let’s observe snippets of a typical day in the life of Billionaire Malcolm III and compare it to high-earning Professional Bob and think about how much the thousand-fold income differential between the two leads to differences in what they are doing and how they do it; how many minutes of the day their activities differ.

A starting assumption is that both Bob and Malcolm III work hard. You probably do, too. You wouldn’t run off to spend the rest of your life on a beach in the south of France, really, even if you could. If the lifestyle in the get-rich-quick infomercials of sitting with unbounded leisure time is your end game, then you are on a different fork of the road than where this discussion is heading.

Now let’s look at the time that Malcolm III and Bob spend on their workday activities and see what that extra billion does:

Sleep Time. Seven to eight hours of the day, they are both asleep. They have beds, black-out shades and a sound machine. So right off the bat around a third of the day is the same.

In the morning. They shower, shave and get dressed. We are past the age of butlers drawing baths and helping lay out clothes, so there is no differences in this realm. And it’s dress-down day at work, so they both have on jeans and a polo shirt. They grab a coffee and bagel for breakfast. For Malcolm III it is ready and waiting in the kitchen thanks to his housekeeper. Bob stops for his on the way to work – his live-in girlfriend has already left and forgot to turn on the coffee machine. Still no difference worth thinking about.

To the office. Malcolm III has a driver to take him to the office, Bob takes a taxi. Or drives himself. Bob’s car is an Acura TL Type S. Malcolm has, among other cars, a Porche 911 Turbo. On the open road, it can leave Bob’s Acura in the dust. Too bad they live in New York and not Frankfurt.

At work. They both are at their desks dealing with e-mails and then plan to spend some time polishing a presentation. Malcolm III has a team of administrative assistants outside his office to take care of his mundane tasks like travel and insurance. Bob has one secretary, and she does the same for him. Malcolm’s office is spacious with an antechamber, a sitting area and a lot of doo-dads and pictures with celebrities on his bookshelves. But look at what Malcolm and Bob are actually doing. They are engaged in the same sort of work with the same sort of equipment, and for all practical purposes they are occupying a forty square-foot world. For lunch they both eat a sandwich at their desk.

In terms of their workday, I am ignoring some characteristics that we associate with the Malcolm’s of the world, things that really don’t have to do with Malcolm’s wealth per se. For example, he oversees many people and he can order those people around autocratically. His underlings have to listen to his philosophical views about building an open work culture, which make their way into company-wide e-mails and a spiral bound volume that he hands out around bonus time. These are coincident to being a billionaire, but being a billionaire is not required to have these trappings. There are generals, CEOs and government bureau chiefs in the same situation. And army lieutenants and factory floor supervisors.

Evening Activities. Unwinding after work, they both happen to end up at The Modern, next to the MOMA, to meet business associates. Then off they go, home to have dinner, spend some time on the web, and then watch a movie. Malcolm III is doing this in a house that is five times the size of Bob's. Malcolm III’s house is a sprawling estate with a living room, dining room, library, sitting room, billiard room, sunroom, solarium, four fireplaces, a guest cottage and a pool. It has a large entry with a spiral staircase, marble floor, and mahogany woodwork. And so on.

But it doesn’t matter – he is in a 200 square foot room to the side of the kitchen sitting on his couch twelve feet from his big-screen surround sound set, beer in hand, just like Bob is.

Of course, there are some big differences, differences that will be manifest maybe twenty or thirty hours of any given month. Bob takes commercial flights, upgraded to business class, while Malcolm flies in his private jet. Malcolm shells out to be on various charity boards and spends time at gala events. In terms of pastimes, if Bob’s passion is breeding racehorses, the America’s Cup or collecting big name contemporary art, too bad.

Depending on their personalities and philosophical bent, even these differences might not matter all that much. For example, if Malcolm III is environmentally conscious, he doesn’t take a private jet. He drives a Prius rather than a Porche, and even takes the subway to work. If he is introverted or nerdish, then rather than hobnobbing at the black-tie events, his idea of a good social gathering is a small dinner with his friend who writes for Wired and the one who is researching nano biotechnology. And he will not care much about items of conspicuous consumption, because he doesn’t care about being conspicuous. Many in the technology sector have promulgated this ethos; it is an egalitarian side effect of the boom in technology.

The point of this is to illustrate that the day-to-day impact of wealth is lower today. A century or so ago, in F. Scott Fitzgerald’s era, there was little time during the waking hours when the activities of the very rich did not differ from those a rung or two down. Even if we look back a few decades we see that gaps have disappeared. Back then, only the wealthy could have a screening room in their home; drivers would stick fake antennas on their cars to impress passersby. Now Joe and Malcolm have the same computers, high-definition TVs, Blackberries and i-Phones, game systems, Kindles, cameras – and these are the things that occupy most of their non-sleeping, non-showering lives. In fact, in terms of hour-by-hour activities, my kids are more Malcolm-like in many respects than I am. They have iPhones, Tivos, large screen monitors, Playstation 3 game systems, and subscriptions to netFliks. I don’t.

This analysis is interesting as far as it goes. Indeed, that it only goes so far is what makes it interesting. What I did for Malcolm III and Bob could also be done for the professional versus the skilled salaried worker, the skilled salaried worker versus the unskilled hourly worker, and so on down to those in extreme poverty working for a dollar a day. But as you continue down the income ladder from the Professional Bobs of the world, another dimension beyond how people are spending their hours becomes of increasing importance.

Drop one more order of magnitude in income and compare Journalist Jamie to Malcolm III and Bob. The hour-by-hour comparisons will still work; Jamie will not differ that much from Bob in what he is doing with his time; certainly the differences will be far lower now than they would have been even a few decades ago. Even though Jamie does not have a secretary to help with his daily tasks, he can quickly dispatch most everything on line – except for the crazy time spent on hold with insurance and the cable company.

But Jamie has a lot to worry about that Malcolm and Bob do not. Malcolm will never have to worry about money, Bob has a large nest egg to protect him against a downturn in his work, but for Jamie, one false step, and he has no way to pay for his house, no health insurance, uncertain prospects that extend out to the future opportunities for his children.

The reduction in the practical implications of income differences at the higher end of the income scale has created a plateau where there used to be a hill. But that plateau has a stark cliff at the edge. Jamie might be on the plateau shared by Malcolm and Bob, doing much the same with his time as they are, but he is closer to that cliff. If Jamie loses his job he is no longer looking down at the abyss, he is over the edge.

The flatter the plateau and the more sudden and deep the abyss, the stronger the argument for social programs, because the costs of redistribution for those on the plateau are lower in practical terms, and the fall from the plateau is more crushing. In the limit, if the plateau is completely flat, so that there is no practical difference in income within the upper range, people should be indifferent about moving along that plateau toward the cliff if at the same time the cliff can be securely fenced off.

Put in other terms, more akin to the way we think about financial trade-offs, there is both the expected value of one’s income (measured by what it does for you in practical terms) and the uncertainty surrounding it. As the means from one person to the next converge, the uncertainty takes on increasing significance. As the “how you spend your time” differential shrinks, a reduction in uncertainty through an improvement in the safety net becomes of increasing importance. Indeed, in the limit, if everyone is typically spending their time doing the same things, reducing this uncertainty is all that matters.

The Municipal Market

This represents my personal opinion, not the views of the SEC or its staff.

My first blog post was in June, 2007. It was titled “What sorts of crises am I worried about now”. My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.

Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930’s style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

1. Problems occur when things get leveraged and complex (and thus opaque).
2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.

I appreciate comments, but will not be able to respond to them. Also, because this is a personal blog unrelated to my work, I will not be posting comments that do not respect that separation.

The Gold Bubble

This represents my personal opinion, not the views of the SEC or its staff.

I am not going to spend time here talking about how the price of gold is off-the-wall, that it is not just a bubble in the making, but a bubble waiting to burst. I don’t want to waste your time on that point.We all know it is a bubble.

George Soros has said “The ultimate asset bubble is gold”. Many of the top asset managers, such as Tudor and Paulson, are piling on; Paul Tudor Jones recently said gold “has its time and place, and now is that time.” The banks are echoing this view with their research. Goldman has a research piece that looks for gold to approach $1,400 in the next year. The more ebullient Charles Morris of HSBC has said, “I absolutely believe it’s heading into a bubble, but that’s why you buy it. ” He, along with a number of other professional and otherwise rational managers, looks for gold to move as high as $5,000 an ounce.

More interesting than this almost universal agreement is what that agreement tells us about the dynamics of the market.

The Naked Bubble

Usually the markets have the courtesy of giving cover for bubbles. We adorn the bubbles with some justification. Even if a guy is just after sex, he at least has the decency to act like there is some substance behind his interest. For the Internet bubble, it was that fundamental analysis based on the brick and mortar world did not bear relevance in the New Paradigm. For the Nikkei bubble, it was that the crazy P/E ratios were not considering one subtlety or another in the Japanese accounting system.

But with gold, no one seems even to care about giving a justification, other than “gold has been a store of value throughout 5,000 years of monetary history”. Which is fine as far as it goes, but that doesn’t say anything about what the price of that store of value should be.

Pump and Dump
Given that “hedge fund” and “highly secretive” are usually said in the same breath, don’t you get suspicious when so many of the top managers are so vocally out there about their gold investments? And when their positions are structured in a way that make them open to view? Paulson and Soros have huge positions in gold ETFs. We know that, because if you buy ETFs, they show up in your 13-F filing. Granted, with an equity investment you can’t help putting that information out into the market, but with an asset there are plenty of ways to take the position without signaling it.

That they are taking a highly visible route to their positions suggests the game that is being played is one of leading the herd. The 13-F reports positions with a big lag, so no one will notice if they quietly slip out the side door while the party is still hopping. And how about when the view is backed up by none other than Goldman Sachs? Will they let everyone know when they think it has gone too far before they get out. Or before they go short? Maybe they already have.

Herds, crowds, mobs, and the Top Ten
And yet, we follow the herd, as we have countless times in the past. Herding is a timeless and universal market behavior, but one that seems less than rational. It is broader than markets; think of the Top Ten phenomenon. We feel better if a lot of other people think that our favorite artist or actor is The Best. We like a song better if we know a lot of other people are liking it as well. Thus our love affair with lists. Magazines featuring the Ten Sexiest, the Five Best, the 100 Whatever are all best sellers, even if the list is the product of a story meeting between an editor and five reporters.

Herding can be explained as an artifact of what was rational behavior in earlier times, when we were running around as hunter gatherers. Back then, mob and herding behavior made sense. Mob behavior if attacking a competitive group or killing a large animal; herding behavior if protecting against predators or uprooting to a new location. Whatever it was that got started, you could be pretty sure there was safety in having a crowd on hand to finish it.

The very notion of mobs and herds evokes a certain spontaneity. But with the gold bubble, we are moving on to a concept of herding by appointment. Everyone seems to be happy in agreeing that this is a bubble, and we are all going to participate in this bubble in a rational, genteel way. We have all decided that this is going to be a number one hit, a Top Ten. Though we might want to ask who is leading this herd, because my bet is they will be stepping aside and cheering us over the cliff.