If you’re quick with a knife, you’ll find the invisible hand is made of delicious invisible meat…yes yes.
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The empirical erosion of our theoretical models
Apr 13, ’11
9:23 AM
Felix Salmon’s blog at Reuter’s is consistently the best financial journalism blog I read. It’s rather depressing, in a way – his work so good and topical, and timely, it takes the steam out of what I might write here. The activity on RM is a little bit inversely proportional to the quality of economic-ish writings elsewhere. I guess it turns out I am at least somewhat driven by, well, the same impulses driving many other bloggers.
And Salmon has been prescient on the decline of public stock markets, if not in the world, at least in the US (see, for example, here, here, here, here, here, Oh for goodness sake, just go subscribe to his blog already, will you?). The listing of public companies on US exchanges has been in a gliding secular decline, since the dot-com bubble of 2001. Exciting, and giant, private companies like Facebook and Twitter, are traded privately, with shares transacting among a small enough number of investors that they don’t trigger an automatic requirement to ‘go public’. Though FB presumably will at some point go public. Maybe. Maybe not.
This has had me thinking quite a bit about, of all things, Marx/Weber/Durkheim. The triumvirate of sociological patriarchs set the terms of the discipline, and they did so in response to the concerns of modernity. The contemporary edifice of Sociology is built on attempts to understand the shift from pre-modern to modern societies, and all that entails: growth of industrial capitalism, movement from small, rural towns to urban centers, decline of traditional society, increase in secularism, movement away from farms and towards factories. The theoretical tools we still use today are not completely derived from these empirical concerns; but I would nevertheless argue that there is a strong legacy effect in our theoretical tools that come from their usefulness in describing the rise of modern social life.
The work in organizations/occupations/work, likewise, was (and is, still) largely based on factory floor work. The lingering influence of Harry Braverman’s Labor and Monopoly Capital, and Michael Burawoy’s Manufacturing Consent are another demonstration. The point is obviously not that theory has not moved forward since Burawoy’s conception of ‘making out’ – but new work uses existing classics as touchstones and foundations, and Rachel Sherman’s examination of interactive service work in hotels (in Class Acts an excellent workplace ethnography) mobilizes ‘making out’ for service work. The theory survives, in modified form, still foundationally tied to factory work, in turn foundationally tied to the shift from pre-modern to modern, etc. Yes, yes, there are post-modern theorists, and I read them carefully. A good measure of post-modernity is a self-conscious attempt to rethink the empirical bases for the theoretical categories we use (see, e.g., Castells’ work on post-modernity as a historical moment defined by globalization, new information technology, real-time management of the economy, and the like). Yet, the point remains: there are no theoretical greenfields.
And so I am left wondering how much of our conception of finance, and of the economy, and of work, is based on the empirical fact of the public corporation. And as that empirical reality erodes, how long our theoretical models of the so-called ‘new’ economic sociology will be so quickly out of date. The decline of the public corporation is certainly not the last shift we will see in the empirical landscape (oh, and futures markets disappear too, you know).
Comparables, value, housing
Jan 1, ’11
9:40 PM
Interesting article from the Washington Post (although the fact that it was written by an attorney and a history professor on the opinion pages make me wonder how they know what the decision-making process was behind the scenes). The crux of the story is that a couple had trouble purchasing a round house, because the qualities that make the house unique are also qualities that make the house difficult to make comparable:
We were pre-qualified for a loan; with two professional incomes, good credit and enough cash for a 20 percent down payment, that would not be our problem. Yet two mortgage companies turned us down. The first did so after its investors – big banks with household names – rejected our application. The second mortgage company’s internal underwriters also rejected us. Their reasons were the same: The home, a customized modular house of internationally acclaimed design, built in 1989, is . . . round.
Being “unusual” or “unique,” it was deemed “not marketable.” Despite its evident worth and multiple independent appraisals, the lenders said they could not assign a value to the house because there were no comparable properties. And, with no “value,” there was insufficient collateral for a loan.
This is a kind of obvious example of how different qualities matter to different constituencies, but also that some interests are able to assert themselves a little bit more than others. If they can be believed, it was investors in two mortgage companies “big banks with household names” who turned their application down.
There is something banal here, of course. The models require data, and a small number of like houses make the risk too volatile. And when they say things like “The mortgage industry apparently only wants us to buy what everyone else has (or had),” it makes me think these two authors are kind of assholes who are deliberately taking potshots at what is an obviously more complicated issue than what “the mortgage industry” wants. Institutions are desperately seeking ways to manage their risks; in the face of massive criticisms over decades of old-fashioned, face-to-face treatment of clients, the industry moved to more formal risk models; the quantitative and data turn in finance meant that these models have more than a skosh of seemingly inflexible, rules-based tint to them.
What is interesting, however, is the inability for individual discretion to intervene. Though of course, I suspect that within hours/days/weeks of this article being written, the poor professionals were able to purchase their dream house, because of – what? – individual discretion. In the mortgage industry, for good and bad (and bad), evaluating individual level risk is hard, and in absence of the ability to sort through a client’s biography, instead the client is reduced to a case. And then the circular house becomes a problem.
'Prudent' pricing, the Pain Caucus, and the Protestant Ethic
Jul 23, ’10
12:11 PM
In his book Talking Prices, Olav Velthuis points out that the collapse of the art market in the early 1990s resulted in a widespread shift away from the ‘superstar’ pricing of the go-go 80s, and towards a ‘prudent’ pricing in the 1990s. Art dealers saw the watershed collapse of fantastic(al) prices as a moment not of panic, but of purification. Suddenly, the come-lately collectors from Japan and elsewhere who would buy dubious quality art at dubiously high prices would be forced out of the market.
Superstar prices would ruin artists’ integrity; superstar dealers “trample the morals of the market, treating an artwork overtly as a commodity, with status as well as investment overtones” (151). These dealers potentially further destabilize the art market, resulting in negative effects on everyone else.
That artists themselves would bear the brunt of the suffering as a result of lower prices was a feature, not a bug. True, these lower, more slowly rising prices for an artist’s work benefit collectors much more than artists. Prudent pricing would make artists more responsible. Velthuis also argues that “for most artists pricing prudently means that they cannot make a living form their work” (155). But for dealers, this moment of purification allowed them to re-establish control over art prices more broadly, and to do so within a moral framework.
There are parallels to the so-called Pain Caucus, so named because in the face of massive unemployment, these policy-makers and federal reserve chairpeople think that short-term deficits are the crises on which we should focus. There is a moral element here as well: that after the profligate borrowing and spending of the early ‘aughts, workers need to suffer some. Why it is workers who need to bear the brunt of this suffering, I leave to your own political imagination.
Financial planning
Jul 22, ’10
12:31 PM
Just in case you haven’t had the experience, there is nothing quite like a conversation with a financial planner to remind you just how inadequate your financial habits are. If Americans retain a bit of ‘I dunno, I kinda hope so, everything’ll probably work out ok’ about retirement, who can blame us? I mean we don’t get all ‘apres moi, le deluge’ or anything like the French, but still.
Oh, and explaining to a financial planner that you don’t really want or need insurance, for instance, feels about the same as explaining to your dentist that flossing is for suckers. You may be able to assert yourself, you may be better off for taking your own advice, but you’re certainly going to feel like a moron.
Performativ…stupidity, ATP Oil & Gas edition
Jul 22, ’10
9:36 AM
From Felix Salmon (whose blog is so good it makes me not want to write anything, just point a big finger at him) comes a story that pops up from time to time. Usually it is some kind of technical snafu, when a trader sits on the keyboard or accidentally keys in a sell rather than a buy order.
Though as a total aside, the recent May incident where P&G dumped 1/3 of its value, then rebounded (from $60 to $40 back to $60) in 4 1/2 minutes seems more complicated than an accidental trade. In fact, the joint SEC-CFTC report (that’s a .pdf) is something of a doozy:
The quantitative evidence presented above suggest that a confluence of economic events, market forces, and trading system functionality led to a significant dislocation of liquidity in the June 2010 E-mini S&P 500 futures contract sometime between 2:30 p.m. and 3:00 p.m. on May 6, 2010.
Prior to that time, a number of economic events and market developments led to a broad-based market desire to lessen risk exposures. This translated into a downward movement in prices across financial markets in conjunction with significant trading volume. At or about 2:30 p.m., the electronic limit order book in the E-mini S&P 500 futures market exhibited a significant imbalance of sell orders and buy orders. In the backdrop of declining prices, this imbalance appears to have contributed to a sudden liquidity dislocation despite increased trading volume. At approximately 2:45 p.m., several sell orders executed deep into the limit order book, which coincided with a significant loss of depth, triggering the Stop Logic functionality. The Stop Logic functionality in the E-mini S&P 500 contract has been triggered a number of times in the past few years, including several times during the financial crisis in the fall of 2008, when market conditions may have resembled those seen on May 6, 2010. Activation of the Stop Logic functionality on May 6, 2010, initiated a five second pause in trading in the E-mini S&P 500 futures contract. After the five second pause, the limit order book became more balanced, which is its typical state, and the price of the E-mini S&P 500 futures contract recovered.
This is being called the Flash Crash of May 6, 2010.
Anyhoozle, the ATP Oil & Gas Corporation. The analyst for JP Morgan who covers the company, named Joseph Allman (in case you want to know whose work you can’t trust down the road), calculated that the company would need $500 million in additional capital, more than its entire market capitalization. You can see what happened, on June 13, 2010:
That’s end of trading day Monday. On Thursday, JP Morgan put out a second note, as Salmon quotes: “In our July 13 note, we stated that it appeared that ATPG would need $500MM of external capital. This model corrects that error and reduces that need to $50MM.”
Oops.
The lessons Salmon draws are things like, yep, people read sell-side research and act on it, and yep, stocks are hella volatile nowadays, and you betcha, listening to sell-side research without doing your own homework is hazardous to your wealth.
To me, what’s amazing here is how time horizons are highly shortened, and market reflexes are hair-trigger, and trading technologies are tightly coupled. Add people, mix, and there will inevitably be periodic blowups.
HSX
Jul 15, ’10
3:27 PM
Since they’ve fired the staff (after having box office futures nixed by legislation), I just want to note that I am currently ranked 21,743rd in the Box Office rankings, putting me in the 84% percentile. If I were a hedge fund manager, I’d be telling you this from my big yacht in Barbados.
I thought Kay Scarpetta would be doing better, maybe some people don’t like Angelina Jolie? And once my Untitled Cameron Crowe Comedy (UCCRO) gets a name, that sucker will go through the roof.
Now for my IRA..
Moral hazard, via dumb commercials
Nov 25, ’09
12:42 PM
Another commercial which I’ve always wondered about is this one for Traveler’s insurance:
The trouble with the commercial is that the dog, after seeking out ways to protect his most prized possession, finds a solution in purchasing insurance. Keep it on your person? Too hard. Put it in a bank? Too risky. But with insurance, you can just leave it out in plain sight and go out to play.
This is of course a problem known as moral hazard. The shifting of risk from the original owner of an interest to an external organization causes the owner to act in ever more risky ways. Imagine if everyone just got insurance and then instead of protecting their business/car/house went outside to play. I mean, what the hell, if you’re paying for insurance you might as well not worry about it.
In the real world, insurance companies protect themselves against moral hazard by doing things like dropping you from your car insurance if you make more than 3 claims in a 5 year period. Or penalizing you (or dropping you) on your health insurance for gaining too much weight. In the finance world, we can arguably trace some of the roots of the 2007-now financial crisis to the fact that banks laid off their risks onto someone else, allowing them to take some fees and sleep better at night.
In short, the ad with the dog is almost exactly what insurance companies do not want you to do. What they want is for you to continue to act paranoid, but after doing everything possible to reduce your own risk, not worry about what’s left over. The thing is, carrying some risk – maybe a lot, maybe some – makes you more responsible. This crazy mutt has no more skin in the game…
Transparency and financial prices
Nov 15, ’09
9:14 AM
I want to talk about dark pools of liquidity, but to do so, I need to first talk about financial markets and how prices work. Bear with me for the background. The dark pools post is coming.
Prices in financial markets are not like prices in other kinds of markets. When you buy gas, you see prices posted for the various grades of gasoline. These prices are for buying gas; theoretically speaking, this is: a) a posted, fixed price – as opposed to a barter or negotiated price); and b) this is a market-taking rather than a market-making price – the price is for something that you can only buy, but not sell. You can only take what is offered, not make your own market.
By contrast, financial prices (and I’m going to use stock prices and financial prices interchangeably, though they are not necessarily interchangeable) are negotiated prices for a continuous auction. There is no single price for a futures contract, a stock issue, or a derivative. Instead prices consist of four main elements: bids, offers, bid quantities, and offer quantities. Buyers provide a price and quantity at which they would be willing to purchase a stock (a bid), while sellers provide a price and quantity at which they would be willing to sell (an offer). When these bids and offers “match” – if a buyer is willing to meet a sellers offer, or a seller is willing to meet a buyers bid – a trade will take place, until there are no longer any bids or offers at that price. If the bids and offers are not matched, there will be no trade, and the current “price” is understood to be the currently-best bids and offers.
For example, if there is a bid to buy 100 shares of Intel stock (INTC) at a price of twenty, and an offer to sell 50 shares at a price of 21, the current “price” is “twenty bid at twenty-one offer,” or 20-21. If the potential buyer and seller decide to stay at their respective prices, no trade will occur; the market will simply stay 20-21 for as long as they hold out. If, however, the buyer decides to raise her bid to 21, a trade will take place: she will buy the 50 shares that the seller was willing to offer, and have 50 shares left over still to buy. Those 50 shares left over would become the currently-best bid. The price would move to “21 bid.” If the next best offer were 22, the price would be 21-22. If the next best offer were 23, it would become 21-23. This process continues throughout the trading session, with the market constantly fluctuating depending on the bids and offers available to trade.
In this fashion, the last reported price is a useful piece of information, but much less than complete. More complete is to know the current best bid, best offer, and the quantities associated with them.
Even more complete would be to know the entire list of bids and offers behind the currently-best ones.
Why is that? Well, you could imagine that you think you’re looking at a market like the snaily one here:
If this were the case, perhaps you might say that there is mildly more shares on the buy side than the sell side, or upward pressure on the price. If you were a seller, deciding whether or not to take the best bid available (in the hopes that the share prices were falling, or simply trying to sell your existing shares at the best possible price), you might think you’re making a decision based on a relatively small bid. My willingness to buy or sell at a particular price is contingent not just on my own absolute feelings about the stock price, but also on how much I think I can get for it – which is a question about not just my intentions, but others’ intentions as well.
Because, what if you knew that the market looked like this snaily-cat one?
If this were the case, where there is relatively strong resistance at 19 (lots of people wanting to buy, or a single big buyer at 19), your decision-making process might be different. And knowing the intentions of buyers and sellers not yet in the marketplace makes a huge difference.
Each trade involves a trade-off, between being first and getting the price you want on the one hand, and signaling your intentions to the rest of the world on the other. Since most financial markets work with some version of a ‘First in, First out’ algorithm (or FIFO, meaning that at the same price, earlier orders get filled before later orders), making your intentions visible early gets you a good spot in the FIFO sequence, ensuring a better price.
But, any time you signal that you want to buy or sell something, other people can react to your desires, potentially changing their own in the process. This might get you a worse price, if you ‘tell’ other people you are a buyer, they might raise their offers as sellers. And vice versa. If you know that someone is itching to buy 10,000 shares of stock you own, you may decide to sell at a higher price. And so, better/faster price vs. signaling your intentions and getting a worse price.
How much of the total buy and sell orders are shown varies dramatically by market. Some exchanges only reveal the size at the best bid and offer, others show their book 10 or 20 prices deep. Here’s the trading screen from the Swiss Exchange:
Here you can see bids, offers, and quantities well above and below the current market price. Other places don’t show any bids and offers.
And it’s between transparency and non-transparency that the arguments about dark pools of liquidity. Dark pools are alternative trading systems that report trades but not bids, offers, and quantities. They are trying to solve the problem of large orders moving the markets too much in their execution. But they are doing it badly.
If you don't trust the seller, don't buy the product!
Nov 3, ’09
10:59 AM
First of all, kudos to McClatchy’s news service for running a slew of articles critical of Goldman Sachs during this financial crisis. The firm displays a disastrous combination of connectedness and high prestige on the one hand, and unconscionable financial practices on the other. They are not at all alone, or even the worst, but because they are seen as the best and brightest, they escape the same criticisms to which others are subjected. And their only real defense is to accuse anyone questioning their practices of sour grapes.
That said, I would take issue with this particular story about how Goldman sold tons of mortgage-backed securities to investors while shorting the housing market themselves. It is a problem endemic to any financial institution with both an investment banking function (packaging financial products to sell to investors) and a proprietary sales desk. Sometimes there have been walls between these two functions, sometimes not. But it’s unsurprising that the banks takes opposite positions to the ones it sells to clients. For goodness sake, there is evidence that they shorted their own position in the sub-prime derivatives market.
And here’s the thing: the ultimate responsibility for the losses incurred by purchasing products sold by Goldman Sachs resides firmly with the people who purchase products sold by Goldman Sachs. If you can not trust the seller, do not buy their product. Financial services companies are dependent to a shocking degree on just-too-smart-for-their-own-good managers of large pools of money all over the world. Pension fund managers, state comptrollers, corporate treasurers, there are too many people who grew up wanting to be in a prestigious investment firm just like Goldman Sachs. So when GS comes along with dog and pony investment shows, these investment managers fall for it all the time.
The book has not yet been written on how poorly these investment agents all around the world get routinely hosed by the likes of Wall Street, in turn subjecting the real economy to risks it does not want or need.