Lecture notes on the financial crisis

The lecture took place on October 1 and Sanders auditorium was jam packed with students, as threats to the job market are evidently a fantastic way to pique the curiosity of undergraduates. But I am probably being unfair, the crisis in general is fascinating, and Ms Johnson-Lans, Ms Pearlman, Mr Flynn, and Mr Johnson did an excellent job. Here are my notes:

Relevant History: 

• Banks have been regulated heavily ever since 1929
• The Glass-Steagall act of 1933 created a firewall between investment and commercial banks
• The Community Reinvestment Act passed in 1977, required banks to do a certain amount of housing loans in poor and minority neighborhoods
• In 1999 the Glass-Steagall act was repealed, leading to mergers and more complicated financial instruments, and ultimately contributed to our crisis (note that Alex Tabarokk at MR sees it differently, arguing than national banks with security affiliates are actually less likely to fail)
• Lending mortgages were offered with low interested rates, "suprime," because mortgage-backed secturities (commonly referred to as MBS) were able to make so much money

Financial system failure--what caused it:

• The process of securitization is a story of risk, as financial entities took on too much risk in order to maximize profit 
• Bank failures thus far this year are historically speaking low, only 13 this year compared to 100+ in the Savings and Loans crisis, however WaMu was much larger in scale (see here)
• Fannie Mae and Freddie Mac (as well as a few others) buy mortgages from banks, which are then bought by investment banks and packed into crazy MBSs
• Fannie Mae and Freddie Mac buy mortgages from banks. The point was not to make money but to create more homeowners (as Arnold Kling explains from his personal experience here)
• Pros of Freddie and Fannie: great for banks, can lend out cash once they sell the mortgage. Cons: No longer have to worry about default, because it transfers over to whoever bought the mortgage
• IBs bought secturies and combined them into complex MBSs. Due to "quick pricing methods" that caught on around 2000, more and more cash was channeled to these, and there was more and more incentives for banks to issue mortgages
• CDOs are a separate entity which allowed people to buy rights to the cash flow from mortgages. These states are called traunches, and there is an order of preference for the right to buy them. The lowest preference ones are what people talk about when they say "toxic waste"
• Lots of people bought tench positions in CDOs, many of which were incorrectly rated AAA by S&P and Moody's (rating agencies) -- they were wrong. They undervalued the level of risk, and have taken lots of heat (Barry Ritholtz appears to agree here)
• There was also protection of "credit default swaps"--you can buy insurance in case the mortgages fail to pay. this is what brought down AIG--they didn't have enough liquidity to back this insurance once they started to fail, even though it was only 10% of their business
• The point is that splitting up risk does not make it go away. People undervalue risk for two reasons: 1) Due diligence was passed off to many times, nobody was making sure that the people can actually pay back the loans, and 2) A rapid decline in house prices which nobody expected

Mortgate loans:

• Main problem is that banks are giving loans to people who can't pay them off
• If home prices keep rising, it doesn't matter if you can't pay back because they could always sell the house for a profit
• The government forced people to buy houses they couldn't afford
• Ratio of house prices to rent is a goodmeasure of whether house prices are off--it started getting huge in the 2000s.
• Price bubbles feed on themselves, everybody thinks that they may be stupid to buy into it, but that there will always be a stupider guy out there--until there isn't
• The tulip bubble is a fascinating example of this, Issac Newton lost his life savings in the South Sea Bubble. They have happened throughout history and will happen again, the housing bubble is another example, but why did it cause so much damage this time (mainly those crazy leverages, says Tyler Cowen)
• Community Law of 1977 updated very badly in 1995, after a racism study was reported by the Boston Fed, which was somewhat of a scandal
• The mortgage laws forcing banks to make loans to poor people is a bad thing, we should just let the market do it's thing instead (although Tyler Cowen thinks that this "minority lending" wasn't the main cause of our current problems)
• The problem is not that Wall Street is greedy (Wall Street is always greedy!), the problem is that generally there is fear to counterbalance the greed, but that vanished because IBs thought that they had eliminated risk with their complex instruments. They were wrong

Moving forward:

• State of financial institutions is not good, Wall Street as we know it is pretty much already gone
• State of credit markets is a problem: borrowing is very, very difficult. This makes it hard to determine what the value of assets are
• Banks can't lend money between each other, which is an essential part of the banking system (and why the FDIC needs to step in)
• The financial system produces "working capital," which is key to lots of business, without it businesses won't be able to operate, and unemployment will jump
• Recessions are very costly, it is estimated that the worst one since WWII caused a decline in real GDP of 30-40%, which is almost $4 trillion
• Paulson plan is to give $700 billion to banks and see what happens, or in other words buy $700 billion of assets from them. The problem is that we don't know what they're worth. The FED will probably pay too much for bad assests. It also may not work--reminiscent of what happened in Japan in the 1980s (The blogosphere has destroyed this plan, but the main problem is its tremendous capabilities to lose large amounts of money, see Arnold Kling here. It is the distribution of possibilities that we need to look at, not the probability of it making versus losing money.)
• The other extreme is to do nothing, and use $700 billion for fiscal policy in an attempt to mitigate the recession (if it comes) to build roads and other infrastructure which we need 
• Middle plan (in his view) is the Swedish plan, nationalization. It's guaranteed bank deposits. Use $700 to buy out shareholders and seize the banks, use to some money to run the bank, then walk away in 5-10 years. The problems in his view is merely scaling (Megan McCardle thinks the scaling issue is too great)
• Under the Swedish plans, we would need regulatory changes as well. One caveat for the US is that Sweden has higher quality governance, which got a chortle from the crowd.

I think it is a huge analytic mistake to spend too much time worrying about the bailout. In all likelihood your personal understanding of the current financial crisis means next to nothing, unless you are discussing your personal ability to profit from it in some way. However, if you are interested in a purely intellectual and quasi-entertainment sense, then this is fascinating stuff. It is remarkable to see such smart people disagree so intensely about such diverse topics, and what is incredible is how time sensitive all of the information is. If this lecture had been one week ago, it may have been completely different in structure. 

9/22 Minutes

With all that's going on with the markets right now, obviously there's a lot to talk about. That said, much of tonight's meeting centered around trying to put together an interdisciplinary panel of professors to put recent events in a historical perspective, and try to explain the reasons for and consquences of tightening credit markets, bank failures, bailouts, etc. It will be geared not only to us, but to the greater campus community who might not understand what's going on, or the importance of it, so when the time comes, bring your friends.

Also, next week will be when we vote on a new executive board (President, Vice President, Secretary/Treasurer) and formally decide what industries we want to cover, and set industry group leaders. That said, with all that's going on the markets, we may have to be flexible this year, as entire sectors might just become too risky for our purposes. If you're interested in running for a position, come to next week's meeting knowing what you want to do and why.

So, next week's meeting is a very important one, and you should come.

Minutes 9/15

• Current Events: We discussed Lehman Brothers’ Chapter 11 bankruptcy filing, Merrill Lynch bought by Bank of America, one of the worst financial days in history
• How does this affect our strategy? Consumers get hit before financials, so they could experience the rebound first? Has this already begun?
  
• Which financials would be worth buying? Smaller M&A firms? Independent Brokers? International M&A?
• Solar stocks: trading at lows, alternative energy an interest of the group, subsidies about to expire and will they be renewed?
• Books: some are available at the library, cdo, we can use our budget to buy more
  
• An update on speakers, including asking Professors to talk about their expertise and how it related to the market, possibly sponsoring a panel on energy and the economy, with Professors Paul Ruud and Challey?
  
• We discussed getting in touch with someone on the Endowment committee
• Group Portfolio: Wait until next week to discuss the framework (mix and max investment, structure, etc)
• Resume/cover letter review next week for underclassmen, so come prepared!
• The exec board has been updating the constitution in preparation for elections, so this will be addressed by the end of the month as well.

See you all next week at 8, New England 107.

9/8 Minutes

• Introduction to the club, our goals and structure for new members
  
• We talked about what kind of experience we have, and what we're interested in doing with the club
  
• Reorganization of industry groups and a new exec board is up for discussion, to be decided by the end of the month
  
• The meeting on the 22nd will focus on getting resumes and cover letters into shape for freshmen, sophomores, and juniors, with help provided by seniors
  
• We discussed an alternative investment idea outside of the club in which people would contribute personal funds and manage as a consortium to show dedication and gain further experience
  

Next group meeting will be next Monday, 8PM in New England 107.

The technology sector's view on the presidency

Currently, InTrade has the chances of McCain winning at 38.8%, and Obama at 61.0%. The way the system works is that currently you can buy a share of Obama's stock at $61, and if he wins you'll get back $100, but if he loses you get back nothing.

Is Obama's current lead a good thing for the tech sector? Sonia Arrison believes that it is not, and that McCain's proposals would be better for the technology industry. But isn't Obama a big aficionado of text messaging? How could his policies not be pro-tech?

In her article, she cites a few major issues, including Obama's proposals for increased capital gains tax, his relative reluctance to increase the number of H1-B visas, and his desire for more regulation on how companies manage their pipes. Time and time again it seems that McCain's policies are more in line with what the market is looking for.

No Free Lunch in Obamanomics

The problem with Mr Obama's tax and fiscal proposals is that he keeps changing it, as Glenn Hubbard explains. Earlier he had planned to make Social Security solvent by eliminating the caps on payroll taxes. Now his economic advisers plan to only unveil payroll taxes that affect the top 3% of earners, which is much more restrained, but he still plans to shore up Social Security. So which is it?

One argument is that either candidate's plan will go haywire once January 2009 rolls around, because they will be facing a macroeconomic crisis. But if judgment in times of (relative) calm predicts judgment in times of crisis, we may have reason to fear. This is an investment blog, so I'll make myself perfectly clear. Wall Street seems to prefer Mr McCain's economic proposals, and Wall Streets movements predict the success of the economy as a whole. You could argue that Mr Bush's terms proved that Republican economics is failing, but I would take issue with that counterfactual because you haven't controlled for any other variables.

The question becomes, how can Mr Obama make his policies more friendly to investors? Or perhaps more appropriately, will he do so?

The Streisand effect in analyst suits

In 2003 Barbara Streisand sued Pictopia.com for $50 in order to have satellite pictures of her beach front property taken down. The suit backfired, because as soon as the suit became public, the pictures became extremely popular on the internet. The explanation was that as soon as Streisand admitted she didn't want people to see the pictures, it made everybody else want to see them more.

Barry Ritholtz has a post today about MBIA, an muni bond insurance company, that is suing analyst Bill Ackman for making "untrue" statements about their solvency. As Ritholtz points out, it isn't a good sign for the company that they are reduced to suing their critics.

The parallels between this suit and the Streisand effect are obvious. In the internet age, the best way to deal with criticism like this is to downplay and discredit it. Overreactions such as this silly suit will only lend more publicity to the original criticism.

Marty Feldstein on the economy

He says that the Bush tax rebates from earlier this year has not been effective. The tax rebates in May gave $48 billion to consumers, and spending rose by less than $6 billion, while in June the rebates gave $28 billion to consumers, and spending rose by $5 billion. That equals a total of $76 billion dollars in rebates and just less than $11 billion in increased spending. If the original goal of the tax rebates were to boost consumer confidence and spending, it failed. Only 14% of the money infused was put back into the economy.

He goes onto explain how Obama's tax-rebate plan is based on similar tendencies. Based on these percentages, $65 billion dollars in rebates (which he proposes) will only yield $10 billion in increased spending. Perhaps Obama should rethink it.

Addendum: Greg Mankiw relays some analysis from a friend of his at the white house:

"Prof. Feldstein assumes that the growth in consumer outlays would have been flat had there been no stimulus. He then observes that consumer outlays actually grew by $12 billion more from Q1 to Q2 that they did in the prior quarter, and attributes that to the stimulus. Many observers think that, without the stimulus, consumer outlays would have grown more slowly in Q2 than Q1. If this is the case (and we believe it is), then the effect of the stimulus is bigger than $12 billion."

Interesting, but they are presupposing a pre-stimulus decline in consumer spending of $55 billion in May and June, which seems a bit excessive.

Assorted Links 9/29/08

Hey guys. Here's a few interesting links I've picked up the last few days around the internet:

1) Housing is still overpriced. Along with some pretty compelling graphs.

2) From good to great!... and then bankrupt. Many of the companies in the book Good to Great are doing terribly now, which forces you to question the original wisdom of the book. The companies include (!) Fannie Mae.

3) Quotes on investing. From Paul Graham, Warren Buffett, and Nassim Nicholas Taleb, among others.

Hope you are all having good summers. If you have something interesting to share but don't want to post it yourself you can e-mail it to me and I'll pass it along.

Campaign Contributions at Vassar

From the perspective of the contributor, donating money to a campaign can be seen as an investment. You are allocating assets in the hope of future will be to office.

Here's some interesting data from Fundrace.com on the campaign contributions from professors at Vassar:


It's almost an even split... between Obama and Clinton. Why have no professors donated to the McCain campaign? I have three hypotheses:

1) Professors at Vassar almost unanimously support Obama.

2) Professors at Vassar who may support McCain are afraid of being ostracized by their peers if they donate to a Republican candidate, so they either do not donate or do not list their profession as a Vassar Professor.

3) McCain supporters at Vassar are too pragmatic with their money to donate small amounts of it to a presidential campaign.

I'm leaning towards #1, but #3 is an intriguing possibility.

(Hat tip: Mads Vassar.)

Assorted Links

1) An article from Overcoming Bias on the biases involved in investing. Money quotes:

Basically, the totally rational investor won't count what he can't quantify, but much of the value in investing, or entrepreneurship, comes from an option value that is impossible to quantify. I know someone who built a product based on an optimization routine for superior investment strategy—the flagship idea failed, it never had a chance, but his system is now a popular risk management tool.

2) Venture capitalist Fred Wilson discusses the potential Yahoo and Microsoft merger. He calls it the "soap opera drama that won't go away." Indeed.

3) A new form of performance evaluation, using "matching" stocks to account for the fact that many of the stocks chosen by investors are not as large-cap as the S&P.

Minutes 4/28

Attendance:
1) Georg Machinist
2) Sean Murray
3) Arjun Agarwala
4) Brian Kim
5) Danny McBee
6) Dan Tan
7) Matt Fixler
8) Katy Mixter
9) Steve Donnelly
10) Robert Babbage
11) Chris Nieminski

We discussed opening up the mock portfolio over the next week to ten days, and the first stock we're putting on the watch list is Ford (F). Concerns were expressed about how to track dividends and stock splits using the yahoo portfolio tool, so if anyone knows 100% how to do this, that would be very helpful.

The account is vassarinvestmentclub@yahoo.com, and the password is [redacted], for future reference.

In the beginning of study week, the exec board is going to meet to vote on the stocks we've been researching, so aim to be finished by that week.

We also are going to hopefully have a guest speaker, a trader who Georg has worked with in the past, on May 8th. It will be low-key, question and answer, details to come.

Finally, we talked about trying to get some sort of physical location, and who and how is best to approach the VSA.

Minutes 4/14/08

Attendance:
1) Andrew Raz
2) Joe Davis
3) Danny McBee
4) Andy McKenzie
5) Steph Dini
6) Chris Nieminski
7) Nadia Jihad
8) Matt Fixler
9) Georg Machinist
10) Brian Kim
11) Stephen Donnelly
12) Katy Mixter
13) Dan Polhamer
14) Dan Tan
15) Arjun Agarwala

Agenda:
Georg, Dan, and Drew reported back on their meeting with Cappy. Basically, Cappy agreed to help us with the grant if we produce a few research materials with the resources we have. We will take a few of the best reports we produce in the next week, put them in a prospectus with a letter from Prof. Flynn and one or two of our models, and Cappy will take this to alums. Our mock portfolio will likely run for most of next year.

We discussed using our remaining budget for capital expenses and research materials, and we are going to purchase filing cabinets, a printer, and I will look into the prices for subscriptions to the financial times, the economist, and any other relevant monthly magazine. We are also looking to start a library of related books, and a few titles were floated around.

Georg and Dan presented a brief synopsis of how to value a company, including explanations for using P/E ratios, beta, the difference between long and short, gross margin, and other finer points of yahoo finance. Other tools people should use are dealbook.blogs.nytimes.com and themarkets.com, which is a good way to get a sense of a company's position within the market, as well as market trends on the whole.

Good work/attendance, and keep up with your reports.

Minutes 4/7/08

Attendance:
1) Stephen Donnelly
2) Drew Raz
3) Georg Machinist
4) Danny McBee
5) Nadia Jihad
6) Brian Kim
7) Andy McKenzie
8) Chris Nieminski
9) Matt Fixler
10) Dan Tan
11) Robert Babbage
12) Arjun Agarwala

We discussed making the changes to our constitution to reflect the group's changing executive board structure and voting procedures. Approval for these changes was not met with any resistance, and I believe Drew and Georg are going to make the necessary changes.

We also discussed moving meetings to New England Building, and this also was not met with any resistance, so our next general body meeting will take place in New England, in the first classroom to the left when you walk in.

Budgeting was the next point of discussion, with research materials being the major point of discussion for next year. Capital IQ, a Bloomberg Terminal, and a subscription to themarkets.com were the 3 services mentioned. Georg is going to see if we can get a grant for the Bloomberg terminal, and if educational discounts are available for all these services, before we decide what to pursue.

With the $875 currently in our account, it was suggested that we purchase filing cabinets to store our research materials, and finding a space for the filing cabinets would be the next step.

Andy suggested we post the minutes on the blog, and will be doing that from now.

Finally, we split into our industry subgroups to discuss possible companies/options and further meeting times.

Which market sectors stand to benefit from which potential presidents?

Obviously this is a rather ambitious post, but I figured that I might as well get the ball rolling a little bit. First of all, here's the probabilities that each of the candidates have had of winning this election, via InTrade:


Perhaps the whole year graph is a bit superfluous, but it is helpful to remember that there is a lot of volatility in the election and although Obama has the top spot right now there is no guarantee that he will hold onto it. The probabilities as of the close on March 31, 2008 are:

p (Obama) = 47.4
p (McCain) = 39.7
p (Clinton) = 11.2

That's the easy part. Extrapolating each of these presidents and trying to predict how the market will react is much more difficult. One way might be looking at their economic advisers. Yahoo Finance has a write-up of each of these candidate's chief economic advisers and a has a quick blurb on each of their policies.

Although this is too quick of a summary to draw any sort of conclusions, McCain's adviser seems to emphasize limiting fiscal spending (although Bush's presidency nominally ran on the same platform, while our country's debt speaks for itself), Obama's adviser seems to be against some supply side economics, and Hillary's adviser seems focused on reducing the income gap and working through the effects of globalization on the labor market. Any thoughts?

Minutes 3/31/08

Attendance:
1) Drew Raz
2) Brian Kim
3) Joe Davis
4) Andy McKenzie
5) Stephen Donnelly
6) Adam Ben-Avi
7) Danny McBee

The major topic of discussion was the skeleton for the mock portfolio, and the steps necessary to finish this project. We thought that of the six sectors, consumer-generalist, industrial, and biotech should receive a greater percentage of funds than real estate, media/telecom and fixed income.

We also split into sub-groups for the process of choosing investment vehicles for the mock portfolio. If you were not in attendance but expressed interest in a particular subgroup at our meeting before break, you will be meeting with that group. Assignments so far are as follows:

Real Estate: Danny M + Robert
Consumer/Generalist: Georg, Sean, Garrett
Fixed Income: Steve
Biotech: Drew, Joe, Andy
Media/Telecom: Brian, Arjun, Adam
Industrials: Dan Tan

There are still two spots open in industrials, and one in fixed income. If you are not on the list, email me by WEDNESDAY with your choice of sector, and I will put you on the list; first come, first served. If you weren't at the meeting, and absolutely hate where you've been placed, email me and we'll try to work something out. It will then be up to the subgroup chair to decide how exactly they want to divide up responsibilites. By next Monday, I think you should come in with a greater understanding of your industry and track the market leaders and current events.

By the end of the month, we'd like to bring in a speaker to help us firm up our knowledge with respect to allocation and selection, so it's important we've learned as much as we can before then. We also will consider buying research reports at that time.

I still get emails from the Middlebury Investment Club, and I found this in my inbox today, so if you're interested in oil, check this out. Have a good week, and get back to me if you're not in a subgroup.

More from Berkshire Hathaway

Following up on the recent post linking to Warren Buffet's annual report, here is a blog post summarizing some points made by Charlie Munger, his long-time partner and Vice President of Berkshire Hathaway. You can find the post by clicking here. It written by Mark Andreessen, a very well known entrepreneur from Silicon Valley, who, among other projects, co-founded Netscape.

This post analyzes some of the basic biases and tendencies of humans and applies them to the business world. Although it is primarily directed at entrepreneurs, it also talks about risk management and some other behavioral economics stuff.

I highly recommend the piece, it's been saved to the bookmark site del.icio.us over 300 times. You usually have to pay for writing like this.

Minutes 3/24/08

Attendance:
1) Georg Machinist
2) Stephen Donnelly
3) Brian Kim
4) Daniel Tan
5) Joe Davis
6) Andy McKenzie
7) Robert Babbage
8) Daniel McBee

Portfolio Structure and Contents:
1) 70% Equities (70% blue chip, 30% small and mid cap)
2) 15% Fixed Income
3) 15% Indices

Possible Investment Ideas-Equities:
Consumer: Buying basics, discount clubs
Biotech: Buying blue chips
Tech: Google?
Shorting luxury stocks (jewelrs, cruiselines, etc.)-if allowable

We discussed the state of the financial sector, and we generally think that the losses aren't over, and this would be a good area to avoid equities, and instead looked at a double-short financial indice, SKF

The group discussed the possible effects of the upcoming election on various sectors, and decided to see if anyone was interested in researching the 3 remaining candidates' stances with respect to the major sectors, as well as looking at the historical charts from past elections.


Our next task is to compile a list of possible equities, indices, fixed income instruments to research. E-mail your ideas to me with a name, ticker symbol if applicable, and a couple lines about why you think it's a good idea. I'll put together a list and send it back around, and we can work from there. In about three weeks, everyone should have picked a stock, put together a report, and be ready to deliver it.

Our next meeting will be next Monday, March 31st at 8PM.

Good reading material

Berkshire Hathaway released its widely read annual report recently.  It is written by Warren Buffett, one of the greatest investors ever, and is very helpful for both beginning investors and experts.

http://www.berkshirehathaway.com/letters/2007ltr.pdf

Test post

Hey guys, this is the first post on the beta version of our investment club blog. Feel free to try your own test posts. If you have any problems, e-mail Chris at chnieminski(at)vassar(dot)edu or myself at amckenz(at)gmail(dot)com.

Everybody else, thanks for visiting! This site will recieve more updates shortly. Potential topics include investment strategies, macro policy theory, and general news about the club. Please check back soon.

Minutes 3/3/08

Attendence:
1.Georg Machinist
2.Andrew Raz
3.Danny Mcbee
4. Arjun Agarwala
5.Bryan Kim
6.Josh Miller
7.Stephan Donnelly
8.Adam Ben-Avi
9.Garret King
10.Andy McKenzie
11.Joey Davis
12.Patrick Riggs (absent)
13.Sean Murray
14.Dan Tan (absent-proxy)
15.Chris Nieminski
16. Robert Babbage (absent-proxy)
17. Kartik Naram (absent-proxy)


Board Member Appointments:

Sec/Treasurer-Danny McBee over Joey Davis (vote of 7-5)
Consumer Generalist-Georg Machinist (vote 12-0)
Fixed Income- Steve Donnelly (vote 12-0)
Biotech/Healthcare-Drew Raz (vote 12-0)
Media/Telecomm-Brian Kim (vote 12-0)
Industrials-Dan Tan (vote 12-0)
Real Estate-Robert Babbage (vote 12-0)

*It was decided that at least 4 board members will have to vote in favor of a proposal for it to pass.


Stated Sector Interests:

Consumer Generalist-Georg Machinist, Sean Murray, Garrett King
Fixed Income- Steve Donnelly
Biotech/Healthcare-Drew Raz, Andy McKenzie
Media/Telecomm-Brian Kim, Joey Davis, Arjun Agarwala
Industrials-Dan Tan
Real Estate-Robert Babbage

*We should try to have at least 2 people in each sector to start with. Remember, you are always allowed to try out/switch sectors.


Future Plans:

Everyone needs to do extensive research on their sector(s) of interest over break. Look at market leaders and factors that allow certain companies to flourish, especially during volatile markets. Georg volunteered to create the research template before our next meeting. Chris will work on building the blog website and recruiting individuals who are interested in participating in it. Additionally, everyone should try to recruit new members. Georg and Drew will look into purchasing office supplies (ie a file cabinet) and research tools. Finally, the board will try to establish a meeting in the near future to meet with Cappy.


Future Meetings:

It was established that we will have general body meetings every Monday at 8pm in Rocky (currently room 308 but this is subject to change).