Michael Lewis on Michael Burry

Michael Lewis, whose writing I generally enjoy, has a new book out. It’s not about the financial crisis per se, but about a handful of traders who made huge amounts of money from the crisis. There’s an excerpt available on the Vanity Fair website, in which Lewis talks fairly admiringly about one such trader, Michael Burry.

I haven’t read Lewis’ book beyond this extract, nor do I know Burry personally (though I do know the trade he executed – it was a simple yet powerful idea, and full credit to him for conceiving it). But I do want to emphasize a couple of points that the VF article glosses over:

First, any story of this sort suffers from a huge amount of survivorship bias. For every Michael Burry or John Paulson who foresaw the crash and made money off it, I can name ten – nay, a hundred! – hedge fund managers who knew full well that there was a bubble in the housing market but could not get their timing right, and hence went bust¹. (Either they bled to death on the negative carry, or their investors got impatient and pulled their money). Of course none of these other managers got their stories recounted in Vanity Fair, which is where the bias comes in. Lauding survivors for their investment acumen is meaningless without knowing the a priori probability of survival. Hindsight is always twenty-twenty.

And why are the odds of survival so very low? This brings me to my second point. The way the article describes it, Michael Burry was in the perfect position to do the subprime-CDS trade. Over previous years he had outperformed the S&P by huge margins, in good years as well as bad; by not looking to maximize his AUM he could pick and choose his investors; said investors loved him and hung on his every word; and his funds were structured with long lockup periods. If anyone had the wherewithal (deep pockets as well as credibility) to take a few quarters of losses while waiting for the big payout, it was Michael Burry.

But no. Quoting Lewis:

[Burry] assumed he’d earned the rope to hang himself. He assumed wrong ... He had told his investors that they might need to be patient ... They had not been patient ... Many of his investors mistrusted him, and he in turn felt betrayed by them ... To keep his bets against subprime-mortgage bonds, he’d been forced to fire half his small staff, and dump billions of dollars’ worth of bets...

If even a trader in Burry’s strong position was forced to the very brink by irrational investor behavior, what hope for lesser souls?

My point here is that traders do not operate in a vacuum. If your investors are myopic and greedy, that forces you to be myopic and greedy as well. If your colleagues are picking up nickels in front of a steamroller, then you have to go after those nickels as well. In Wall Street’s current “quarterly-earnings-are-everything” mindset, you simply cannot afford to sit back and be patient if you want to keep your job.

Of course the equilibrium is unhealthy: decisions that are rational at the micro level for individual traders, add up to an irrational macro market situation. In other words, a bubble. Quelle surprise!

Footnotes

# ¹Conversely, I know plenty of hedge fund managers who either did not recognize, or chose not to recognize the bubble. For the most part these folks banked big bonuses pre-crash, and they haven’t had to return the money post-crash. Does this make them any dumber than Burry or Paulson, or any worse traders?

Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).

The Regulator's Dilemma

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery.

If only it were that easy!

Imagine that you are the regulator in charge of the banking industry. What are your aims?

Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”.

On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors should withdraw their money from badly-run banks, and you don't want to stand in their way. You don't want to bail out the incompetent; that’s deeply unfair to the competent, and it messes up incentives all through the system. (To quote one famous investor, “Bailouts are bad morality as well as bad economics”).

Unfortunately, these two aims are fundamentally incompatible. Because smart bankers will simply pile into precisely those trades which pose systemic risks!

Why should a banker take the trouble to build a unique portfolio, thus exposing himself to all sorts of idiosyncratic risk factors? If these idiosyncratic factors go against him, he will appear (uniquely) stupid, and will probably not be bailed out. It’s much better for him to pile into the same trade as everyone else¹. Then if things go sour, it will be a systemic crisis and so everyone will be bailed out, including the banker in question.

(This insight is nothing new; it is merely the compensation dynamic for 1 trader on a desk of 10 traders, applied to 1 bank in an economy of 10 banks, with bailouts substituting for bonuses.)

In fact the situation is even more perverse than it appears. A standard measure of trade quality is the risk-reward ratio: the lower this ratio, the better the trade. But if systemic crises and consequently bailouts are in play, then the reasoning becomes inverted. Losses from low-risk trades are, by definition, small; hence low-risk traders are unlikely to be bailed out. Conversely, losses from high-risk trades are, by definition, large and potentially life-threatening; hence high-risk traders will often be backstopped by the government. This is moral hazard at its most pernicious.

It gets worse. The more enthusiastically people herd into one (systemically risky) trade, the higher the odds of a bailout; the higher the odds of a bailout for a particular trade, the more people will want to enter that trade. Yes, it’s our old friend, positive feedback!

So what’s a well-meaning regulator to do? There are only two coherent choices, really: put an end to bailouts, or put an end to bank proprietary trading.

Sadly, I don’t see either of these happening.

Footnotes

# ¹ Throughout this post I use ‘trades’ as a convenient short-hand for ‘institutional strategic decisions’.

Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.

Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.

But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.

Ultimately of course rates will have to go up. If something cannot last forever, it will not.

Big Brother meets Ben Bernanke

[We interrupt our regular schedule of abstract pontification to bring you this quick note on price action]

All summer long, asset markets boomed while the US economy (in my opinion) more or less stunk. Why? Because of central bank policy.

Then on Friday we had a strong payrolls number (just 11k jobs lost, much better than expected).

I think this makes the Fed on the margin more likely to hike interest rates.

Sure enough, asset markets have been going down since the number came out.

It's almost Orwellian: war is peace, good news is bad news, strong numbers are weak numbers.

But that's what happens when you let asset prices be determined (supported) by central banks instead of by economic fundamentals.

Anyway, I'll go out on a limb and say that last week was the high for 2009 and we'll sell off into 2010.

This move will be reinforced by year-end risk reduction. Also, for what it’s worth, most technical indicators look really exhausted.

I have sold [EM] stocks aggressively over the last 3 days and now have plenty of [dollar] cash. Let’s see how things play out.

[Clarifications in square brackets added on 17 Dec; also, note that I currently own no US stocks.]

Buyers' Strikes and the Debt Treadmill

Here’s what I wrote last week:

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:

There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projections.
...
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt ... [But] the Chinese keep grumbling that they have far too many Treasuries already.

And here’s progressive economist Paul Krugman:

Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful) ... This is truly amazing. It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days, even though you’re currently able to sell long-term bonds at an interest rate of less than 3.5%.

Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.

The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.

Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about¹.

They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.

It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.

But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead².

The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.

(Source: UBS, via FT Alphaville; more here)

Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.

But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.

Footnotes

# ¹Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.

Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.

# ²As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.

The Next Bubble: Are We There Yet?

My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.

Nonetheless there are certain indicators that suggest we may be entering bubble territory.

Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:

1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead¹. Central banks are also less independent than before². Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them³. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.

2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.

3. The momentum towards lower global trade barriers seems to have turned; there are ugly signs everywhere of growing protectionism, higher tariffs, and incipient trade wars.

4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States⁴.

5. The commodity supercycle is now in its bullish phase.

6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.

Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.

Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!

What’s going on here?

Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).

But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.

First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.

Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.

(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)

Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.

A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.

Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.

Footnotes

# ¹ We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.

# ² Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.

# ³ A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.

# ⁴ Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.

Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.