How the financial system is the pipes to the economy, not the economy

Made the chart myself from my notes from various classes during my MBA. That is the financial system in a nutshell; not so difficult.

As the headline indicates the financial system is not the economy, it is the pipes that bring money from savers to entities who will invest the money. The investors will purchase capital and sell a product or service, portions of those earnings plus the initial investment will be returned, hopefully, to the savers. Now the genius of this system, at least before the financial crisis was its ability to securitize certain loans so that additional entities on the right side could purchase them. Thus more investment could be made and thus more capital added to the system and therefore productivity could be higher which increases the GDP of the country.

So before securitization, banks would loan money to a homeowner with the house as collateral. Unfortunately, there was a limit to the amount of loans the bank could make. This is because of its capital requirements imposed by the Federal Reserve and also because it was exposing itself to a concentrated risk in a particular market. Imagine, that the bank is in Detroit, given the well noted decline in the prospects of that city, the bank would have died just extending loans to commercial and residential real estate in the greater Detroit area.

So in the early 1980's a process was discovered to create a pool of loans and sell them to investors. Of course, Fannie Mae and Freddie Mac had been created to do this according to their charter. These entities tried to create a national mortgage market, thus money given to them through debt and equity offerings was used to purchase mortgages from all over the country. The thinking was that a property's value was tied to its local economy and by diversifying their risk by investing in all locales, plus the implicit government guarantee would allow investors to buy the bonds and equity that they offered. This market was a lucrative monopoly that investment banks broke into by the creation of sophisticated models.

This created a nefariously named "shadow banking system." That is mutual funds, hedge funds, pension funds and insurance companies now owned mortgages and other loans that had been pooled, which had previously been the domain of banks only. Banks I might add that were under the regulation and protection of the Federal Reserve and the FDIC.

The problem that was run into in this crisis is one as old as banking itself. Basically, a ___ [bank, mutual fund, hedge fund, insurance co] will use money [CD, savings account, mutual fund share, claim, policy] that is of a short maturity to buy an investment that is of a longer duration or maturity. [commercial real estate loan, residential real estate loan, private equity loan] This is done to take advantage of a normal interest rate environment where longer maturity investments earn an increasing rate of return the further out in maturity that one moves out. This spread between short-duration, low interest rate and long-duration, higher interest rate is how _____ [bank, mutual fund, hedge fund, insurance co] make money to return to their investors. So when I leave 10,000 dollars at Bank of America, it turns around and offers a loan of 90,000 dollars to a couple buying a home in Omaha. (This is the money multiplier that is a an effect of the reserve requirement affected by the Federal Reserve, I am assuming a 10% requirement.)

Here is the visualization:

The green is the money the entity makes by "playing" the spread.

The problem comes about when savers panic. Maybe the have been lied to by rating agencies charged with deciding how "safe" a security is, maybe regulators are asleep at the wheel, or the regulators have been "captured" by the industry in which they patrol or the investors have been lied to by the firm selling the security. Thus the right side calls in its claims and invest directly into the government securities, the so called return of principal instead of caring about return on principal. Or they could just hold cash under the mattress or spread their money about in various accounts at different banks making sure not to breach the protection offered by the FDIC. Of course consumers are not the only ones, companies will also do not with the FDIC but instead by moving their funds into the Treasury market.

This leads to no one purchasing the previous securities and the securities value falls precipitously and possibly more than the actual underlying value of the investment. As always "Res tantum valet quantum vendi potest," or an item is only worth what some one else will pay for it.

The allocation of capital, a scarce resource, is vital to the economy. However, the value it creates versus the losses it makes in bad times may net out or even be negative. Moving forward, elected officials must discern a more virtuous manner in which to allocate monies; the system cannot be seem to be based upon an expectation of bailouts.

Later, I plan on writing about National Income Accounts and the market for funds.

A study of Economics

I started up a post about the difference in thinking between economists who advocate a Keynesian or modified Keynesian response to a recession and those who propose to do little to interfere with an economy as a government response would be inefficient and lead to loss of freedom. However, it wasn't too far into the post that I realized my thinking was not as clear as it should be. Thus, over the past few days I have been reviewing my macroeconomics textbook and will place my notes and examples up here. It is a fairly lengthy section of the book almost 300 pages, so this may take more than a few posts.

In the beginning... there was Jin. He resides on an island in the South Pacific; and for this example is completely alone. Thus, he is the sole source of GDP, he makes all the income and consumes all the goods and services. Adam Smith would hope that Jin could recruit people to join him, dividing up labor and creating more than one person could do alone, but this is not to be the case.

So how much can he consume, what is the nation of Jin's GDP? It all depends on his productvity. You can see that he is only one person and thus labor will be held constant in this economy. So whether, he gets to eat like a king or pick through barnacles all depends on how well Jin can hunt, fish, gather or grow. If Jin fishes with a wooden spear he carved, he may catch a fish a day and subsist. However, if he can tie tree vines together to create a cast net he might be able to catch 3 fish a day. Then he could either eat a more kingly meal or only fish every third day; hopefully the latter so that he might be able to create a distress signal for his rescue.

There are 4 basics determinants of productivity in Jin's case, there is his capital, his labor, his natural resources and his knowledge or technology. So capital would be his spear or his net. His labor includes any skills or knowledge he has acquired up to this point; if he had participated in Outward Bound he would be more productivity than if he had not. Natural resources are the fish stock, the tree limbs and vines, and the beach or cove that he fishes from. Finally there is the technology or knowledge. This is very closely related to labor, but with one slight difference. Knowledge would be akin to the quality of the instruction, the books, the programs that Jin learned. Whereas his labor knowledge is putting that experience to work.

Finally, there has to be a diminishing return to the inputs put into the economy and there is. This graph is complex but we need only focus on a few points for this next idea.



So if we look where Y1 is relative to Y0 you can see a very large leap in the Y value by adding one unit of K or capital. However, if you look at Y2 versus Y0 you can see that adding an additional amount of capital does not garner the same amount of productivity, that is the difference between Y2 and Y0 is far less than Y0 and Y1.

In Jin's case giving him another net to cast does not help his productivity because he can only throw one cast net at a time.

Till next time, Cheers!

Inflection Point

This was the "it" term before green shoots. The 'ah but the change in the second derivative is changing positive. When discussing economics at a cocktail party hosted by my father, one of his mates blindly referred to the inflection point changing. I murmured approval and then asked him what he meant by it and quickly a pen was found and it was like high school all over again drawing sin graphs. I have supplied a graph below, its a gif so it moves.


When you are looking at it pay attention when the point nears the x-axis near 1.6. As the color of the tangent line changes from green to red to blue, the red is the inflection point. This also works as an analogy for the economy. When economists, talking heads and policy wonks parroted the inflection point mathematical jargon what they were saying was that the steepness of the decline was lessening and that we would approach bottom. Here is an example with the employment to population level.



So you can see that the wonks were correct, at about January the ratio stopped dropping as steeply. However, if you refer back to the graph above you can see that it would be no where near the nadir of the curve.

Then bad news in the guise of good news came from the labor report on the 11th. In truth it is good news, productivity jumped 6.4% annualized, 1.6% for the quarter, meanwhile labor costs fell -5.8% annualized or -1.45% for the quarter. Which, when employing deductive reasoning means that the employment ratio will grow slowly as companies squeeze more out of their labor. It follows then that they would then increase part-time workers to full time before finally bring aboard new hires.

All in all, it will be quite a long while before we hit the next inflection point.

Bounded Rationality piquing my interest

I was reading an article this weekend talking about the microfoundations of macroeconomic theories having series structural issues. The author maintained that uber-rational homo economics does not exist, and that people do not have perfect foresight, or even optimization skills. The author invoked bounded rationality. This led me to think about a book I haven't thought of in years, Max Bazerman's "Judgement in Managerial Decision Making." I recommend the book; it is very accessible. There are plenty of surveys and games that you can play with others to see just how limited our cognitive functions are, and it is, dare I say, fun.

Basically Bazerman theorizes that humans have two thinking states: the 1st is based on simple rules of thumb and allow you to make quick decisions. These rules are created by you either through your own experience or training. The second type of thinking is the rational version of deliberate debate, weighing the pros and cons of an action on several measures, such as: defining the problem, creating alternatives, weighing trade-offs. The reason humans have these two systems is that if we had to base every decision with the superior method of system two we would take a disproportionate amount of time choosing between different brands of Frosted Flakes.

Here is a quick example of what Bazerman terms an availability heuristic. You receive a newsletter in the mail and it states that the stock market will go up over the next 6 months. You ignore it. 6 months hence the market has gone up and you receive another letter that states that market will go down over the next half year. 6 months hence the market is down and you receive another letter stating that the market will go up. This time you consider the letter for awhile, maybe it sits on the coffee table for a week, but you still throw it away. 6 months go by and the market is up and you receive another letter stating that the market will go up again. This time you thoroughly read the letter and send your money into the broker who has been sending you the letter for two years. You never hear another word and lose 10,000 dollars. What happened?

Well imagine instead you are this deceptive broker. You have a list of 100,000 people. Every 6 months you send out the letter to everyone, except that only half get the market goes up letter. The other half get the market goes down letter. So in the first half only 50,000 are correct. Then 25,000. Then 12,500. Finally, the last letter 6,250. The broker gets 10,000 from each he walks away with 62,500,000 dollars. Not bad for two years work. This is also what people call survivorship bias, which happens in the mutual fund industry. Not that I am calling them crooks, but when you read stats like 90% of our funds have been up every year, well that is with the caveat that the poor performing funds are dead. Thus, no longer in the reported data.

Correlation on draft day?

I was building a data set for an upcoming football draft. What I am going to attempt to do is set up a draft heuristic that tells you what position you can go the most from by drafting it at any particular moment in the draft. So if QB's are a hot commodity this year, it tells you what performance remains on the draft board and whether you will have better performance from drafting a QB or a running back in your draft slot. So its essence is to instead of taking the best player on the draft board, which analyst will tell you to do because you can trade (of course this analysis ignores how hard it is to trade and what happens if you end up with 5 RB's, which depending on your gift of gab may not be the ideal foundation for making trade propositions,) instead shows you relative outperformance for each subset of positions. So if you can get a +5 over the median/mean QB but you can get a +7 RB you would or should take the RB. The analysis will also be helpful in making trades to complete your team.

However, when investigating the data set I came upon an unsettling set of numbers. Here is the first set in graph form.


So what I was seeing was tiers of players. You can see distinctly the upper echelon of players, then a another, then another, setting up a power law. A regression puts the R-squared at 72%. So then I wondered about the format in which a draft is set up. The normal way in which I have participated is a serpentine format that goes from 1 to 12 and then 12 to 1. So I ran those numbers below.

It definitely shows a two-tiered system of haves and have-nots with the first 5 draft positions able to parlay the superstars outperformance versus the mitigating lower second round draft pick. This leads me to believe that auction drafts, as many claim, have more fair outcomes than the serpentine method. Something to consider as draft season approaches. Good luck out there.

Same Store Sales Growth

Catchy title, eh?

I saw this chart in the Wall Street Journal Today and it really crystallized an idea in my head that I have held for a long while. So let me first start off by describing what same store sales are and why this chart is great, except I would have it do one additional calculation column.

There is not really a great definition, more of what it is not and then a nebulous gray area that remains is what it is. So here is my ad-hoc definition: A store that has been open for a year, then compares their month on month figures and this shows the same store sales growth or decay. So if I open a new Starbucks on July 1, 2008, I will not be able to do this analysis until the end of July 2009. If I open on the 15th of July the first month that I could do this comparison would be August '08 versus August '09.

What does it consist of? Well it is sales, which is another name for revenues, which are prices paid for merchandise times the number of items sold. So just two dimensions prices and volume.

If you followed the link you would see my chart is slightly different than the Journal's chart. See I broke the Same Store Sales growth into its two components so that it could be easier to decipher. Now we can see who dropped their prices to maintain their revenues and if anyone followed any other strategy.

So look at Aeropostle and BJ's. Two different strategies are afoot. BJ's kept their pricing the same and their volume suffered but they maintained positive growth. Aeropostle dropped their pricing by 7% but more than made up for it in pushing volume through.

Pricing is probably the more important story at thi spoint. It is almost a given that the US consumer will be tightening the belt until there are better economic winds blowing across the land. However, prices that fall portend deflation because it relies upon the consumers to spend. If consumers do not spend it is because they have less employment or are more cautious about the future (thus, saving more.)

I am going to follow up on this more at length and will probably grab these firms latest figures to do a quick DuPont analysis to see how these figures compare to their strategy.

Serial Correlation

So I am looking at the S&P500 index for the year. The index is currently up about 10% on the year. I am looking at my own investment portfolio and it is only up about 0.3%, should I be worried that I am losing my touch. Have I lost the alpha control on trading the index? No and no is the resounding reply.

Here is why.

What this two tables show is the return of the S&P and then below the return of the trading strategy. Then the following table tracks your investment dollar from the beginning of 2000 to the current date. So it shows that I have missed out on the rally from the March lows, but it also shows that I missed the carnage in 2000, 2001, 2002 and 2008. Meanwhile in bull years I lead in 4 out of the 5 years of the sample.

The main point is that one cannot be remiss if one misses out on the beginning of a market run. You must stick to your plan and trade your plan only. When you start deviating to "correct" your trades to what you are seeing in the market is when you will really start to lose money. That is why I like to look at this chart and know that my money grew 60% over the past 9 1/2 years and a buy and holder of the S&P 500 has lost 20%. It steadies my feet when I want to start buying options to lever and catch up.