Sunday, April 26, 2015

Is Finance Eating The World?

In 2011, venture capitalist Marc Andreessen wrote a much vaunted essay in the Wall Street Journal entitled "Why Software Is Eating The World". The phrase "XYZ is eating the world" has become standard fare for explaining how some new technology is disrupting old ways, and improving the lives of consumers in the process. Generally, this is seen as a good thing. Sophisticated (i.e. non-Luddite) commentators rightfully fret over the effects of technology on employment and inequality, but it is virtually unheard of for anyone to criticize the improvements offered by advances in technology.

Finance, on the other hand, continues to be reviled as an industry. It's pretty difficult to get the Tea Party and the most left-leaning wing of the Democratic Party in the US to agree on anything, but suspicion of, and antipathy towards, the financial industry seems fairly unanimous. Some of this is self-inflicted, through a never-ending series of scandals and understandable concerns about the power of the finance lobby. But we rarely hear the mainstream media articulate things the industry does well, or even the notion that finance can disrupt staid industries for the better. Take, for example, a steady drumbeat of positive press about the solar industry. My impression is that potential disruption to the archaic utility model is widely considered a good thing, with interlopers like SolarCity generally garnering positive coverage. Rarely covered, though, is that finance (and its red-headed stepchild, securitization) is an intrinsic part of SolarCity's business model. The company itself dutifully discloses in its annual report, "Our future success depends on our ability to raise capital from third-party fund investors to help finance the deployment of our residential and commercial solar energy systems." One might go so far as to argue that SolarCity is in the business of creating safe assets, and solar systems are merely an input in the process. So maybe, then, it's finance that's eating the world.

I can't imagine many people would be comfortable uttering that last sentence. The entry of finance into hitherto pristine fields such as commodities (that's sarcasm) has given rise to an ugly word, "financialization". The debate continues as to whether financialization has contributed to heightend volatility in these markets. To some extent, it seems clear that a common investor base increases the covariance of assets. But financialization may be getting a bad rap when it comes to creating increased volatility. In an excellent article on Keynes's approach to endowment management, Chambers and Dimson highlight his sensitivity to liquidity risk. Ever incisive, Keynes wrote, "Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair grey. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one." Financialization may merely reveal the underlying volatility of asset classes such as real estate and commodities, which is unsurprising given the long known inelasticity of supply and demand. Did a move to spot market pricing create the vicious fluctuations in the iron ore market, as has been argued by some industry executives? I, for one, am skeptical. Furthermore, financial players clearly provide liquidity and produce information for markets. 

Finally, a common criticism is that financial players are merely engaged in rent-seeking, rather than generating genuine social value. A recent article by Harvard economics professor Sendhil Mullainathan captures these concerns, which I share. Mullainathan's balanced treatment does, however, do a nice job of addressing the ambiguity of what constitutes rent-seeking. Thankfully, this doesn't need to be decided in a court of law by a Solomonic judge. The market is a wonderful device for decentralizing this judgment, and it usually works quite well. Broadly speaking, I think we have passed the days when the average person in finance made extraordinary sums disproportionate to his value (and a damned good thing too!). As examples, this has manifested itself in industry job losses and unceasing pressure on fees to investment managers. At a higher level, the combination of government regulation and investor pressure have convinced most large financial firms that simpler, more robust structures are preferable. The market, in other words, has penalized firms for being unwieldy and producing little value in return for increased complexity. 

None of this should be misconstrued as my saying that the industry is omniscient or morally unblemished. It merely means that we should continue to encourage the expansion of finance, even though mistakes will be made. Experimentation is a messy affair, and is particularly challenging in financial markets, which are complex adaptive systems that can be highly unpredictable. But as Mullainathan writes, "I hope [students going into finance] realize that they have the potential to do great good and not simply make money. It may not be how the industry is structured now, but idealism and inventiveness are two of the best traits of youth, and finance especially could use them." I'm reasonably optimistic that creative finance and dynamic technology will continue to disrupt stale models of thinking, benefiting end consumers. After all, if finance is eating the world, perhaps the world is ripe for eating. 

Sunday, April 19, 2015

Doing The Greatest Good (Philanthropy As Investing)

John Arnold isn't a household name, but those involved in the US energy markets will recognize him as an incredibly successful energy fund manager. Arnold cut his teeth as a trader at Enron, and then started Centaurus Advisors, an energy-focused hedge fund in Houston, reportedly building up a net worth of $4b. It thus came as a surprise to many observers when he announced his retirement from Centaurus in 2012 at the age of 38.

In typical Arnold fashion, he appears to be flying under the radar in his second career - though, again, with the occasional big bang. In May 2013, Arnold and his wife were featured in the WSJ for their philanthropy - not simply for writing big checks, mind you, but for taking a keen interest in the efficiency of their contributions, and for being willing to fund projects of uncertain value with potentially large payoffs. As the WSJ reports, "The Arnolds want to see if they can use their money to solve some of the country's biggest problems through data analysis and science, with an unsentimental focus on results and an aversion to feel-good projects - the success of which can't be quantified."

This type of philanthropy isn't new. Bill Gates seems to be the prototype for a guy who's made a lot of money in one field and hurls himself into the weeds of philanthropy. But it does seem to be catching on. No doubt there are various reasons for this, but one can easily point to the increased sophistication of programme evaluation, the larger influence of business and finance types as donors, as well as a general wave of enthusiasm for all things "evidence-based" (evidence-based medicine, evidence-based journalism, evidence-based investing... all good, but what were people doing before?). In their book Poor Economics, Duflo & Banerjee highlight the growing use of randomized controlled trials in development economics. Their line of thinking proposes that "it is possible to make very significant progress against the biggest problem in the world through the accumulation of a set of small steps, each well thought out, carefully tested, and judiciously implemented."

I find this way of thinking very appealing, particularly for its potential to compare the payoffs from competing development or philanthropic strategies. It's no surprise that we often let affinity and empathy obscure our thinking in these issues. By this I mean that we find it easier to contribute to our own communities and countries, even though there are often considerably greater needs once we cast our gaze slightly further afield. Rigorously collecting and evaluating data seems to offer a path to quantify the costs of myopic charitable giving.

As a result, I've been wrestling over the past few months with how to frame philanthropy as a form of investing. The aim should be to maximize the net present value of charitable giving. But there are two weaknesses with this approach. First, this sort of philanthropy is probably much easier for the very rich, who have the means to guide recipients into providing reams of data. My sense is that it is quite hard, as a small donor, to get much insight into the full working of organizations. And, second, the truth is that even if the data were available, I've struggled mightily with how to think about the incremental benefit of donor dollars, and the appropriate discount rate.

In his book The Life You Can Save, Peter Singer makes the point that "there are many organizations doing good work that offer opportunities worth supporting, and not knowing which is the very best shouldn't be an excuse for not giving to any of them." In fact, he goes so far as to argue that "some uncertainty about the impact of aid does not eliminate our obligation to give." 

I disagree with the last assertion. If we have an obligation to give, we have an equal obligation to ensure that we are giving well. Angus Deaton disagrees at an even more fundamental level. In his book The Great Escape, he surprisingly denounces most forms of charitable giving, particularly foreign aid. "What surely ought to happen is what happened in the now-rich world, where countries developed in their own way, in their own time, under their own political and economic structures... We need to let poor people help themselves and get out of the way - or more positively, stop doing things that are obstructing them."

Yet he doesn't think all forms of giving are unhelpful. Deaton goes on to make two distinctive arguments for giving to universities. I've often thought of giving to universities (especially one's own alma mater) as a form of vanity giving, particularly with the thriving endowments many universities have today. But Deaton makes two good counter-arguments:

1)  "As the economist Jagdish Bhagwati has argued, it is hard to think of substantial increases in aid being spent effectively in Africa. But it is not so hard to think of more aid being spent productively elsewhere for Africa." In particular, Deaton suggest funding basic research on health and agriculture.

2) "The effects of migration of poverty reduction dwarf those of free trade... A helpful type of temporary migration is to provide undergraduate and graduate scholarships to the West, especially for Africans. With luck, these students will develop in a way that is independent of aid agencies or of their domestic regimes." (In similar fashion, see Michael Clemens on why migration should be a major part of the UN's Sustainable Development Goals).

More importantly, perhaps, the notion of doing the most good with any specific type of giving is probably unnecessary. One of the basic tenets of investing is diversification. Similarly, it probably makes sense to think of charitable giving as a portfolio, mixing bets of different individual risk, reward, and with little overlap (i.e. low covariance). 

Finally, just as I wouldn't suggest a complete novice spend his time on security analysis or asset allocation, perhaps novice donors don't need to spend copious amounts of time dissecting philanthropic organizations. Intermediaries such as GiveWell have made it easier to learn about NGOs who are doing important work.

These may not seem like the most exciting, or even the most personally satisfying forms of philanthropy. But just as disciplined investing isn't always exciting, I'm starting to believe that philanthropy can quite reasonably be seen as a way to combine a rigorous view of individual organizations with the benefits of diversification to obtain the best long-run outcome with one's giving. 

Sunday, April 5, 2015

Learning From The Greatest Trade Ever

It's slightly surprising that it's taken me this long to get to it, but I finally read Gregory Zuckerman's "The Greatest Trade Ever", which documents John Paulson's multi-billion dollar score in the real estate crisis of 2007-2009. Zuckerman puts Paulson & Co.'s winnings at $15b in 2007 (with astonishing gains of 590% and 350% in its two credit funds), and a further $5b in 2008 and early 2009. I'm actually glad I waited a few years to read this, because it affords some historical perspective on the trade itself and Paulson's results since then.

A quick review of the book is in order before I launch into some lessons learned. It's a scintillating read, and captures the boom and bust in real estate and associated securities, as well as prior episodes of market mania. It is certainly a difficult task to write a page-turner about credit derivatives, but Zuckerman succeeds admirably. In addition, he seems balanced and even-handed in his treatment of the colourful array of characters, offering wonderful snapshots of the mania that pervaded investment management, and the ensuing collapse.

Now, on to some of the many things I learned from the book:

1) Macro matters. It won't surprise you if you've read other posts of mine, but yes, macro matters. This was essentially a macro bet. Contrary to some views that decried Paulson as a "tourist" from the merger arb space, he had proven to be "gutsier, playing the merger game differently than his peers. He began to short companies set to be acquired when he deduced that their merger agreements might collapse." This penchant for a more creative approach led Paulson to his most famous set of trades. 

Zuckerman lays out the (not always totally correct) macro framework that guided Paulson's thinking:
- In 2004, Paulson became concerned about who would be exposed when the Fed began raising interest rates.
- In early 2005, as Paolo Pellegrini suggested shorting mortgage securitizations, Paulson decided the Fed wouldn't want to lower rates to help borrowers because it might weaken the dollar further and stoke inflation.
- In late 2005, Paulson "trimmed holdings that seemed especially sensitive to the economy and shorted the bonds of others".
- By late 2007, Paulson recognized the impact a real estate and credit collapse would have, shorting shares of banks with significant exposure to the credit card business and those making commercial real estate, construction, and other risky loans. He also shorted Fannie and Freddie on the same premise.

2) Luck matters. There's no doubting the brilliance of the trade, and the nerve that it took to pull it off, but luck played a healthy role too. Paulson was early enough to have time to refine his trade, and late enough not to suffer excessively while the housing market stood firm. It's remarkable that Paulson started from knowing nothing about CDS in Oct 2004, and had time to revise his trade several times. In November 2005, "the Paulson team's original thesis, that a spike in interest rates would cause problems for home owners, seemed dead wrong." Paulson sold his original CDS protection after concluding that it covered mortgages on homes that already had enjoyed so much appreciation that refinancing would be easy. This seemed to happen again in 2006, but they were able to roll protection into the latest vintages. As Zuckerman writes, "Paulson had dodged a bullet." The trade also evolved as the team's views on housing matured. Incredibly, until early 2006, "Paulson's team hadn't put much thought or research into whether housing prices were bound to tumble

But, fortunately for him, he wasn't too early. Zuckerman notes that, "Paulson also had good fortune on his side: By the time he determined that the housing market was in a bubble in the spring of 2006, prices had begun to flatten out, making it the perfect time to bet against the market. Others who had come to a similar determination much earlier were licking their wounds because they had placed wagers against real estate too early and suffered as it climbed further."

Finally, Paulson was lucky to be an outsider. "It was fortuitous that Paulson was a merger pro, and not a veteran of the mortgage, housing, or bond markets. He wasn't deterred by the dismal track record of those who already had bet against housing, and wasn't fully aware that his bearishness wasn't especially unique."

That said, I don't want to overstate this element. It obviously took a tremendous amount of work to get up to speed on an arcane market. Other prominent managers demurred at taking such an outsized bet. "Paul Singer of Elliott Management Corp. and Seth Klarman of Baupost Group bought some CDS insurance contracts on risky mortgages but chose to buy small portions of it and not go overboard." "Buying so much was a reputational risk," Klarman says, "It wasn't a no-brainer." Zuckerman also details how Paulson avoided getting cold feet in 2007 when the trade seemed to have worked partially. Furthermore, he successfully played both sides of the trade, profiting on the long side by 2009. Others, like John Devaney, faced serious losses by re-entering the market too early. All in all, this was the confluence of luck and skill, with Paulson correctly reading macro forces, real estate-specific drivers and investor sentiment.

3) Lucky or not, being an outsider helps sometimes. Zuckerman quotes Bertrand Russell: "The fact that an opinion has been widely held is no evidence whatsoever that it is not utterly absurd; indeed, in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible." One stunning example Zuckerman cites is the "discovery" by Deutsche Bank analyst Eugene Xu that "home prices had been key to loan problems for more than a decade, including during the mini-downturn in real estate in the early 1990s." If you're scratching your head that this should be a revelation, Zuckerman goes on to say that "at the time it was quite a radical viewpoint. Most economists and traders figured that a range of factors, including interest rates, economic growth, and employment, determine the level of mortgage defaults." I found it interesting that two outsiders, Paulson and Greg Lippmann, were communicating and helping to reassure one another. Sometimes this is the path to breaking through dogma; sometimes it results in an unhealthy echo chamber. It's hard to know which is which. In a world where things seem to be getting ever more complicated and specialized, we rely on gatekeepers more than ever. Perhaps the skills most needed are common sense and critical thinking.

4) There are ethical grey areas in investing. Zuckerman duly notes the ethical grey area of Paulson working with bankers to create risky investments. But we shouldn't allow hindsight bias to excessively colour our judgement. "In truth, Paulson and Pellegrini still were unsure of their growing trade would ever pan out." Furthermore, Paulson was betting against supposedly sophisticated investors. 

Similarly, Jeff Libert reveals the ethical quagmire he found himself in as he "discovered an odd impulse: He found himself rooting for a rash of home owners to run into problems paying off their mortgages."

5) The emotional strain of a great trade may not be for everyone. Zuckerman vividly describes the strain the trade took on Michael Burry, Jeffrey Greene, Pellegrini and Paulson. Some examples:
- "[Jeff Greene's] very reputation and sense of self-worth seemed tied up with the trade." "If [the trade] doesn't work, I'm cooked", he confided to Jeff Libert.
- Despite a gain of 150% in 2007, Michael Burry was deeply exhausted. "Burry couldn't enjoy his belated success...still weary from the battles with investors and too sensitive to ignore their unhappiness."

Those with lavish lifestyles, such as Pellegrini and Jeff Greene, placed some self-imposed stress on themselves. Perhaps Paulson's earlier decisions to alter his lifestyle provided him with the equanimity to see the trade through.

Most of us will never experience the nerve-wracking strain of a trade like this, and perhaps that's for the best. One of the funniest paragraphs in the book describes Greene meeting his future wife, Mei Sze Chan. Zuckerman writes, "Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.

A few months later they were engaged."

Most of us will have to be content with matrimonial bliss, rather than Paulson's stupendous financial gains. Given the strain he and others underwent in their pursuit of profit, it is a gentle reminder that some of the greatest trades we make happen outside the financial arena.