Sunday, July 15, 2007

Mark to model vs. Mark to market

An excerpt from a study of valuations -- market pricing vs. fair pricing:
What is the common theme among Franklin, the Granite Funds and LTCM? All three depended on exploiting deviations in market value from fair value. And all three depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, these fund managers convinced their stakeholders that because the fair values were hedged, it didn't matter what happened to market values in the short run — they would converge to fair value over time. That was the reason for the "Long Term" part of LTCM's name.

The problem with this logic is that capital is only as patient as its least patient provider. The fact is that lenders generally lose their patience precisely when the funds need them to keep it — in times of market crisis. As all three cases demonstrate, the lenders are the first to get nervous when an external shock hits. At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations. This starts the fund along the downward spiral: illiquid securities are marked-to-market; margin calls are made; the illiquid securities must be sold; more margin calls are made, and so on. In general, shareholders may provide patient capital; but debt-holders do not.

Saturday, July 07, 2007

Why people do things

Insightful excerpt on utility:
Vast amounts of human behaviour can be explained not by causal utility but by symbolic utlity, to use Nozick's distinction. We do many things not because they improve our (or others) objective well-being, but to signal who we are.
For instance:
  • Running in a race for cancer, world hunger, or child education

Monday, July 02, 2007

Improving democracy

Excerpts from a book review in the New Yorker on how to improve democracy in order to get better government and improve policy making:
... voters cherish irrational views on many issues ... relevant to economic policy. The average person, he says, has four biases about economics—four main areas in which he or she differs from the economic expert. The typical noneconomist does not understand or appreciate the way markets work (and thus favors regulation and is suspicious of the profit motive), dislikes foreigners (and thus tends to be protectionist), equates prosperity with employment rather than with production (and thus overvalues the preservation of existing jobs), and usually thinks that economic conditions are getting worse (and thus favors government intervention in the economy). Economists know that these positions are irrational, because the average person actually benefits from market competition, which provides the best product at the lowest price; from free trade with other countries, which (for American consumers) usually lowers the cost of labor and thus the price of goods; and from technological change, which redistributes labor from less productive to more productive enterprises.

People do not ... vote their self-interest: ... “Precisely because people put personal interests aside when they enter the political arena,” Caplan says, “intellectual errors readily blossom into foolish policies.” People really believe that the country would be better off if profits were regulated, if foreign goods were taxed, and if companies were prevented from downsizing. Politicians who pander to these beliefs are more likely to be elected, and the special interests that lobby for protectionism and anticompetitive legislation are the beneficiaries—not the public. The result, over time, is a decline in the standard of living.

... [M]ost economists peg the optimal level of government involvement in the economy too high, because they overestimate the virtues of democracy. ... some suggestions for fixing the evils of universal democratic participation: require voters to pass a test for economic competence; give extra votes to people with greater economic literacy; reduce or eliminate efforts to increase voter turnout; require more economics courses in school, even if this means eliminating courses in other subjects, such as classics; teach people introductory economics without making the usual qualifications about the limits of market solutions.

Sunday, July 01, 2007

Magazines get it late.

The annals of obvious research presents this bit: Are cover stories effective contrarian indicators?

Apparently by the time magazine covers feature a company outperforming its competition, most of the trend is over. Well, isn't that blindingly obvious? A magazine article is supposed to analyze past events and make for interesting reading, and almost any event is best explained in hindsight when all the facts are available, not in real time while it unfolds and some or most of the key facts are hidden from public view.