The Big Investment Lie

Quants, hagiographized, get their comeuppance

In response to what amounts to a hagiography of quants in the investment industry in Wall Street Journal reporter Scott Patterson’s new book, “The Quants,” I wrote a review that appeared recently in the online journal Advisor Perspectives (may require registration to view).

A few excerpts:

“Before reading [the book] I even thought twice because I had first read an excerpt in a column in The Wall Street Journal. The column was drenched in the hyperbole that seems, for some reason, to be obligatory when talking about quants in the investment field: ‘brainy math whizzes’; ‘theoretical breakthroughs in the application of mathematics to financial markets’; ‘brain-twisting math’; ‘superpowered computers’; ‘advances that had earned their discoverers several shelves of Nobel Prizes’.”

“… of the quants … only a very, very few actually make money … by beating the other players. The rest of them, I believe, the overwhelming majority, make money because of the fees charged by their companies, and because of the arcane and sophisticated images they help their companies to project, the better to charge high fees.”

“There are larger errors. For example [the book] says, ‘theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes, [were applied] to the highly practical, massively profitable practice of calculating predictable patterns in how the market moved and worked.’ This is essentially false. The Nobel Prize-winning theories pretty much all rest comfortably with a random walk model of the market, and can’t be applied to calculate predictable patterns in how the market moves. Yet this misconception seems often to prevail.”

“One problem … is that there are too many pseudo-mathematicians in the field. Most of the pseudo-mathematicians don’t really know the difference between a discrete process and a continuous process, and when it is reasonable to believe that a continuous process can be assumed for theoretical purposes because the (real-world) discrete process converges to it, and when it is not… And they don’t know basic probability theory well enough to apply simple forms of it that don’t rest on too many assumptions, and that would be more transparent to practical analysis. Instead, they revert rapidly to the more ‘sophisticated’-looking, but more opaque, techniques of regression analysis or Ito’s lemma, or the like.”

What the financial industry needs is a C. Everett Koop

A journalist asked recently, “Is it ever OK for a financial advisor to sell a bad investment?”

It’s a provocative question. If an advisor is a fiduciary then no, it is never acceptable for the advisor to sell an investment that he or she believes is bad.

The problem of course is, except in hindsight, there just isn’t any investment (or hardly any) that is unequivocally bad.

At some point we’ll need to carefully review the work of economist Israel Kirzner. A lot of his work provided justification for a self-interested economic agent not revealing relevant information to a trading partner (read, “client”).

For example, if the economic agent is able to discover a source for a product that her client wants at a price that is much lower than the client expects, the agent is entitled not to disclose the source to the client, or the source’s price, but to disclose only the agent’s own marked-up price.

Does the argument apply if the product (investment) the client wants is something the client wants only because it was sold to him by the advisor, who himself/herself, in his/her heart of hearts, suspects is a bad investment?

I certainly don’t think so, but I think the industry in effect extends the Kirzner argument to justify this.

The ultimate justification of the bad practices in the industry is that “it’s what the client wants”. But what the client wants is what the industry has gone to great pains—by means of what could be called a conspiracy of misinformation—to persuade the client into wanting (or at least not to educate the client into not wanting).

It’s a moral labyrinth. Which is why I think it’s time for a “daddy state” to impose a moral framework, if it can possibly do so without going overboard.

What the financial industry needs is a C. Everett Koop—the Surgeon General who looked like a wrathful God in uniform, and pushed a major government-led crackdown on the mendacious and injurious tobacco industry. The crackdown included outlawing misleading forms of advertising, as well as requiring very forceful warnings on cigarette packs.

Something like that kind of campaign to bring the financial industry to heel is needed.

“Much of the financial industry has become a racket”

Good quote: “For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors. And if we don’t lower the boom on these practices, the racket will just go on.”

Good questions

With the opening today of the federal government's official Financial Crisis Inquiry Commission, at which the CEOs of the four biggest banks — Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Bank of America — will be the first star witnesses, the sport of asking people what questions should be posed to them has intensified.

The New York Times assembled a distinguished group of contributors, who pose an excellent list of questions.

The single best question, surprisingly, comes from David Stockman, Ronald Reagan's then-wunderkind Director of the Office of Management and Budget from 1981-1985, who was "taken to the woodshed" by the President after being quoted in an Atlantic article as saying, "None of us really understands what's going on with all these numbers," among other seemingly incredibly naive things. Stockman's question is:

"Without the Troubled Asset Relief Program, Wall Street banks would not have survived the shock to the financial system that occurred in September 2008. Nor would they have subsequently accrued large profits and bonus pools in 2009. Shouldn’t a substantial share of those bonus pools be sequestered on bank balance sheets for several years to increase the banks’ capital levels and shield taxpayers against another bailout?"

The rudest questions — because terse and right to the point — come from Simon Johnson of MIT:

1. Describe in detail the three worst investments your bank made in 2007 and 2008 — that is, those transactions on which you lost the most money. How much did the bank lose in each case?

2. What was the total compensation of each manager or executive supervising those three transactions — including yourself — in 2007 and 2008?

3. Are those executives still with your bank? What investments do they supervise today? How much will they be paid for 2009, including their bonuses?

But the best, lengthier elaboration of those terse questions comes from consultant Yves Smith. Read it all here.

The Financial Crisis Inquiry Commission

The Financial Crisis Inquiry Commission, a commission appointed by Congress to investigate the causes of the financial crisis, will hold hearings this week starting Wednesday, with four witnesses who are CEOs of the largest Wall Street banks. Some of the ten commissioners are trawling for suggestions of questions that they should ask the witnesses.

More information will be posted by Tuesday, the 12th, on the Commission's web site, www.fcic.gov.

One view of the objectives of the hearings -- with which I sympathize -- is presented today by columnist Frank Rich in The New York Times. Let us hope the hearings will have as dramatic an impact as the Senate-sponsored hearings led by Ferdinand Pecora in the 1930s to investigate the causes of the Crash of 1929.

SEC hires purveyor of Suckers of the Future game

I wrote earlier about financial literacy, and how it was a good idea but could too easily be captured by the sales culture of the financial industry and bent to its own objectives.

Susan Antilla of Bloomberg.com highlights just that concern in an excellent article, titled "Suckers of the Future Groomed With Stock Game". Antilla points out that the Securities and Exchange Commission's new deputy director of investor education, Kathleen M. Floyd, was formerly executive director of the Stock Market Game, "a virtual-investing program that’s given hundreds of thousands of students a $100,000 make-believe portfolio to play with."

"Her employer was a foundation financed by the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group. Floyd’s hiring brings new attention to the popular Stock Market Game, which gets money from donors like Morgan Stanley, Merrill Lynch and A.G. Edwards."

This game, however, educates students not to be investors, but gamblers on short-term stock prices -- in other words, to be brokerage firms' dream customers, their Suckers of the Future.

One commentator in Antilla's article says, “You could teach kids the basic rules of blackjack and have a more lasting and beneficial impact.” Well yes, more beneficial for the kids perhaps. But teaching the game will have a lasting and beneficial impact for its Wall Street sponsors, providing them with an endless parade of future suckers.

Eliot Spitzer comes roaring back — and he's got a Bombshell

THIS IS MY EFFORT to help ensure that an op-ed piece, and a proposal, by Eliot Spitzer and two co-authors goes viral.

The op-ed piece in question is in the December 20 New York Times.

The proposal is that before US taxpayers allow the 80% of A.I.G. that they own to be sold, they should insist that A.I.G. release all e-mails and documents pertaining to the financial crisis caused by A.I.G. and its Wall Street counterparties.

The key portions of the op-ed piece are as follows:

"When A.I.G.’s financial products division collapsed — ultimately requiring a federal bailout of $180 billion — those who had been prospering from A.I.G.’s schemes scurried for taxpayer cover. Yet, more than a year after the rescue began, crucial questions remain unanswered. Who knew what, and when? Who benefited, and by exactly how much?

"...[We] cannot answer these questions now. But we know where the answers are. They are in the trove of e-mail messages still backed up on A.I.G. servers, as well as in the key internal accounting documents and financial models generated by A.I.G. during the past decade. Before releasing its regulatory clutches, the government should insist that the company immediately make these materials public...

"Once the documents are available for everyone to inspect, a thousand journalistic flowers can bloom, as reporters, victims and angry citizens have a chance to piece together the story...

"We would like to understand whether the leaders of A.I.G. understood that they were approaching a financial Armageddon, and whether they alerted their counterparties, regulators and shareholders to the impending calamity.

"We would like to see how A.I.G. was able to pay huge bonuses to its officers based on the short-term income they received from counterparties for selling guarantees that, lacking adequate loss reserves, the companies would never be able to honor...

"[W]hile small shareholders of public corporations generally do not have the right to force publication of internal documents, in this case one shareholder — the taxpayer — holds an 80 percent stake. Anyone with such substantial ownership has effective control over corporate decisions...

"The documents should be released — without excuses, or delay."

The Voice of Wisdom

The Wall Street Journal published a special Future of Finance report in which Paul Volcker refreshingly weighed in.

Volcker was the titan who, as Fed Chairman, single-handedly stopped galloping US inflation in the early 1980s, after a risible campaign in the '70s called Whip Inflation Now—or WIN (complete with lapel pins)—failed completely.

Now Volcker at 82 is an elder statesman with true wisdom who can say what he wants and speaks the plain truth.

It is well worth reading his entire contribution to the Journal's report. The coverage of Volcker begins with the question, "Does financial innovation contribute to economic growth?" Volcker responded that the ATM was the only financial innovation he could think of that has improved society.

Other key excerpts:

A few years ago I happened to be at a conference of business people... The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun.

Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them...

I was just talking to a high-tech company about the immense attraction to go into finance when both Britain and the United States are suffering from a basic inability to produce things competitively, to keep up with the new economy. Is this a result of financial innovation that we should be really worried about?...

I do not know if something happened that suddenly made these innovations essential for growth... we had greater speed of growth [in the 1950s and '60s] and... did not put the whole economy at risk of collapse.

Help for Goldman

An article in today's Wall Street Journal says that Goldman Sachs played a major role in helping AIG to "insure" the scores of billions of dollars of mortgage assets—like CDOs—that AIG covered with credit default swaps (CDSs).

We put "insure" in quotes because AIG didn't have the assets to back up the insurance, so there really was no insurance.

Nevertheless those that bought the insurance—Goldman foremost among them—got paid in full, as if AIG did have the assets to back it up. They were paid by the Federal government.

Some think Goldman shouldn't have received full payment, on the principle of caveat emptor—let the buyer beware.

That's not the way Goldman sees it. According to the article, "A Goldman spokesman says that up until AIG was rescued by the government, the insurer 'was viewed as one of the most sophisticated financial counterparties in the world. It wasn't until the government intervened in September 2008 that the full extent of AIG's problems became apparent.'"

In other words, how could Goldman have known AIG would default? Oh, come on! — a little due diligence please?

But Goldman received another advantage. According to the WSJ article, "The trades [of CDSs] ... gave Goldman a unique window into AIG's exposure to losses on securities linked to mortgages."

Funny, Goldman is known to have made money for its own account by selling securities with exposure to falling housing prices, while at the same time facilitating purchases—for a fee—of those same instruments by clients. Nothing like a window on the trading world is there? That's what puts Goldman in its leading position to make so much money.

But as they—or their spokesman—sees it, AIG "was viewed as one of the most sophisticated financial counterparties in the world." What the spokesman means is: viewed by those not in the know—but undoubtedly not by Goldman itself.

Active vs. Passive: Going on for years

We got a query from a journalist who wanted "a fund company or wealth manager to explain why actively managed funds are better than ETFs or index funds.This is an argument that's been going on for years."

The journalist will never get anyone to claim that actively managed funds as a class are better than ETFs or index funds—unless of course the respondent is a fraud. Overwhelming and irrefutable evidence shows that actively managed funds on average do worse, after fees, than lower-cost passively managed funds. (It’s only the fees that make the difference—otherwise the average pre-tax performance of actively and passively managed assets would be the same.)

The big question is whether some actively managed funds, or even only a very few actively managed funds are better than index funds, and in particular—the big, big question—whether it’s possible to identify the actively managed funds that will perform better in advance.

Unfortunately, there’s no clear statistical evidence that this is possible, though just enough to keep the hope alive. That’s where the debate lies.