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Trump, the Toxic Legacy of the Financial Crisis

Today, the Lost Angeles TIMES published my oped as part of a a package on the first anniversary to Trump's election. Space was limited, so I tho...

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Trump, the Toxic Legacy of the Financial Crisis


Sunday November 05, 2017

Today, the Lost Angeles TIMES published my oped as part of a a package on the first anniversary to Trump's election. Space was limited, so I thought I'd put up the more fleshed out version here:


Ten years have passed since the beginning of the great financial meltdown, and perhaps the most toxic legacy of that crisis was the election of Donald Trump as President. I’ll get to that linkage in a moment, but even before Trump’s election there were signs that the crisis was part of a worrisome trajectory. The near meltdown fits within a recurring cycle in American capitalism in which generational forgetting and greed conspire to foster credit bubbles, which inevitably burst, ruining millions, but leaving intact the system and perverse incentives that in turn set the stage for the next turn of the cycle. In recent decades this cycle seems to have a period of eight to ten years – something to keep in mind on this tenth anniversary – but the wildly improbable Trump presidency suggests that wobbles in this cycle are becoming more extreme and spreading beyond the economic to the political. If we do not pay heed to the lessons of the financial crisis, the next phase of this cycle could be the last for America as a functioning democracy.
 
What are those lessons? The biggest, hiding in plain sight, is that the crisis is not over. The U.S. remains in what future economic historians will call a depression. We’ve had ten years of subtrend growth, and even today, the economy remains so fragile that the Federal Reserve is hesitant to raise interest rates from their unprecedented emergency levels. Taking per capita GDP (the most meaningful measure since it adjusts for population growth) from its previous peak in the fourth quarter of 2007, the annual growth rate over the past ten years has been a limp 0.50% per year. It seems that every year since the meltdown economic forecasters have predicted that the economy will break out of its doldrums, only to be disappointed and make the same bright prediction for the following year.
 
A principal reason for the subpar performance has been slack demand – people simply don’t have much money to spend. Trends in automation, globalization, and financial engineering have left the median American household little better off than it was 50 years ago despite the fact that participation by women in the work for has increased by more than 50%.
 
The average non-supervisory worker has actually lost a little ground since 1967, earning $743 a week as of August, versus an inflation-adjusted $792 a week fifty years ago. While the median family’s income has virtually flatlined, in that same interval U.S. real GDP nearly quadrupled.  
 
Consider events of the past few decades. Inflation decimated worker savings in the 1970s, and then the end of the Cold War unleashed forces that suppressed their wages. Outsourcing exposed American workers to competition from a global work force; unions lost their bargaining power; automation steadily worked its way up from blue collar to white collar functions, and the more recent explosion of ecommerce threatens the tattered remains of the bricks and mortar economy, eliminating not just retail jobs but the construction, real estate, and service functions that supported stores and malls.
 
Then 2008 hit, which threw nine million people out of work, put more than 3 million households in default on their mortgages, and ruined the credit of many millions more. Since then, many have gone back to work, but at lower paying jobs with fewer benefits, and no job security. Millions more simply gave up, and, as Alan Krueger of Princeton recently argued, many of those turned to opiods.
 
Against this harsh reality, the average family turns on the news and hears that the economy is at full employment, and that banks are again paying out fat bonuses. They also hear that some of these bonuses were the reward for pursuing predatory practices (such as the fake accounts and unnecessary auto insurance Wells Fargo forced on an estimated 3.5 million of its poorer customers). No wonder people are angry. 

The Trump phenomenon revealed that significant numbers ordinary people sense they are being screwed by the establishment. Millions have concluded that both political parties serve a shadowy nexus of financial and corporate interests. This nexus seems all the more sinister because it has no official status or organization -- which makes it fertile soil for noxious conspiracy theories. The “system” needs no organization because it is a commonly shared set of ideas about free markets, deregulation, the frictionless movement of money, and the role of central banks. To paraphrase the late Charles Reich, the elite don’t run the machine, they tend it.
 
The power of this nexus is undeniable. One act that set the stage for the financial crisis was the repeal of the Glass-Steagall act, which had previously prevented banks from risking depositor money in less conservative investments. Banks had been pushing for this for years, and in 1999 Bill Clinton, a Democrat signed its demise.
 
Unfettered, the big banks and other financial institutions plunged into the mortgage business, getting fees for placing loans with unqualified borrowers (remember NINJA loans?), and then stuffing these into securitizations to get them off their books as quickly as possible. For those who worried about the consequences, the revolting mantra of the day was “You won’t be here; I won’t be here.” In those days, volume was the key to riches, and so the lending ran amok, at least until the unqualified borrowers started to default and the entire pyramid collapsed.
 
The durability of this shared set of ideas has been astonishing. Despite the ‘08 near death experience, the paradigm of “getting government out of commerce” survived, just as it has survived the Savings and Loans crisis in the 1980s, when deregulation encouraged owners of these conservative institutions to take on excessive leverage. Now, ten years after deregulation and excessive leverage ruined millions, the Trump administration is again deregulating madly, and risk is creeping back into the financial system as investors embrace risk in the search for returns.
 
If you didn’t tell Trump voters that Thomas Piketty’s thesis was in spirit a Marxist analysis, most would probably agree with his  argument  that in the struggle between capital and labor, capital has emerged the clear winner. Ordinary people see it everyday in their own diminished prospects while the elite grab ever more of the pie. They, correctly, didn’t think Hillary would do anything to change the system, so they bet on a snake oil salesman who lied that he could. Instead, as we’ve seen, he’s busily handing the keys to Wall Street corporations, the wealthy and himself.
 
Trump’s first priority after inauguration, for instance, was to repeal Obamacare. The motivation behind this effort became clear as the GOP-controlled House’s original plan called for the repeal of surtaxes on the wealthy. Since by design, the plan had to be revenue neutral, such cuts could only be achieved by raising taxes on the less wealthy (and by cutting Medicare benefits, which make healthcare affordable for the Trump base). Now, Trump’s big push is to lower corporate tax rates. Over ten years, each percentage point of corporate tax rate reduction costs the Treasury an estimated $100 billion in receipts. If  Trump gets his way, this shortfall would run into the trillions, and the only ways to pay for that would be to raise taxes on individuals, or to cut government spending, over 60% of which currently goes to the poor and middle class in the form of benefits.
 
So, how will these passed-by workers react when they realize Trump is a false prophet? And how will they react when the next crisis hits, and their hard times get even harder? Some will go down the rabbit hole of far right conspiracy theories, while others will decide to take to the barricades to bring down capitalism from the left. In the past in the U.S. the center has held, but can we be sure that will be the case the next time around, particularly if desperation drives more people to the extremes and the center shrinks even further? Years ago, the late diamond magnate Harry Oppenheimer explained his progressive labor policies by saying, “If they don’t eat, we can’t sleep.” The elites of today would do well to heed this warning.
 

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Short Take

I’ve just read Black Edge, by Sheelah Kolhatkar, which is about the huge insider trading scam that characterized Steve Cohen’s SAC Capital at the height of its power. I’m going to offer the thoughts it prompted in two parts. The first will delve into the trade itself, and the second will explore the fallout from this insider trading scandal and subsequent events in the market.

Part One:

A good part of Black Edge focuses on one specific instance of insider trading at SAC Capital: Mathew Martoma’s quest for advance knowledge of the results of trials on the efficacy of Elan Pharmaceutical’s experimental drug to halt Alzheimer’s disease. The drug, bapineuzumab, was designed to attack the amyloid plaques that Elan’s scientists viewed as the cause of cognitive decline. In his quest for “black edge” (illegal inside information) Martoma and his compatriots compromised the integrity of the procedures for drug trials and ruined the life and reputation of a distinguished scientist.  Even that wasn’t enough for them. SAC also had access to vast amounts of biotech expertise, both from PhDs on their payroll, and the expert networks they paid handsomely to give them access to researchers with direct access to the studies and trials.

 

In the short run, this inside information paid off for SAC as Martoma’s advance knowledge of the results allowed the hedge fund to reverse a billion dollar position and make a profit of over $180 million versus certain losses of hundreds of millions had they not gotten advance information on a disappointing field trial. In the long run, while Steve Cohen skated, the insider cases led to $1.8 billion in fines, the dissolution of SAC, and jail time for Martoma.

 

In retrospect, it was all so stupid. SAC could have come to the conclusion that Elan’s drug was not going to work without resorting to anything illegal.

 

Instead of deploying all this massive intellectual firepower on getting advance word on the results of the trials, the analysts might have started by asking how solid were the assumptions on which the therapy was based: namely, whether attacking the plaques would halt or reverse the progress of the disease.

 

Even in 2008 and 2009, there were a number of researchers at distinguished universities who questioned that basic assumption. The alternate theory was that the plaques were not the cause of the disease, but rather an analogue of scabbing, the result of the body’s attempt to protect the brain from infection.

 

 In subsequent years, this alternate view has gained some traction, with some now arguing that Alzheimer’s is akin to an autoimmune disease in the sense that as the environment in developed countries has become more antiseptic, protective devices in the brain have turned on the brain itself as the infections they evolved to fight have disappeared. In any events a drumbeat of failed trials with drugs attacking amyloids has discredited this approach. As Tara Spires-Jones, of Edinburgh University’s Centre for Cognitive and Neural Systems put it in an interview with Britain’s Independent, “Most of the trials have been based on the assumption that amyloid is important in causing Alzherimer’s diseas, as opposed to something that happens alongside it. That assumption, I think, is probably wrong…”

 

Even in 2007, SAC’s analysts should have known that many attempts to fight Alzheimer’s by fighting the formation of plaques had failed. Given all the time the fund spent analyzing the drug and trials it must occurred to someone to ask whether Elan was barking up the wrong tree. Maybe someone there did just that, but there’s no indication that the decision makers ever questioned the assumptions upon which the drug was built.

 

Maybe that wouldn’t have mattered. SAC wanted certainty. Clearly, detailed advance knowledge of the results of a field trial is more compelling than a dissenting theory on the nature of the disease. Had SAC questioned the assumptions of the study, they never would have amassed a position in Elan, and they probably wouldn’t have had sufficient certainty to short the stock prior to the results being announced.

 

What can be drawn from this? There are implications about the pressures of the markets – SAC employees felt that had to cheat to maintain performance – but there are also implications about the culture of world of investing.  Alzheimer’s is a horrifying disease, but the book makes a strong case that neither Cohen, nor anyone else at SAC, gave a rat’s ass whether the drug worked or not; they only cared about knowing the results before anyone else and about how other traders would view the data when it came out.  The same probably applied to every other fund playing Elan.

 

It isn’t news that the markets are amoral, but this amorality has real world consequences. The punishment the market meted out to Elan (and other companies with failed trials) makes all but the largest companies risk averse about investing in therapies for difficult diseases. There is a short-term logic to this from an investor’s point of view, but, increasingly, the market sets research priorities, and the market’s priorities – controlling costs and maximizing short-term profits – may not serve the needs of society. Researchers know that breakthroughs often come from learning from failed previous attempts.  So where will breakthroughs come from as fewer and fewer companies risk failure?

 

Part Two:

 

Further thoughts on Black Edge by Sheelah Kolhatkar

The insider trading scandal at SAC confirmed a widely held suspicion among ordinary investors that Wall Street is a rigged game where powerful players can cheat with impunity.  Regardless of the truth of that suspicion, the widely held perception that this is the case has had its own reverberations. In a delicious irony, one of the derivative effects of the market crash and subsequent insider trading scandals has been to make more likely a future in which black edge is less useful.

 

Bear with me.

 

What happened with Elan revealed a contradiction at the heart of the markets. SAC was driven to seeking black edge by the ruthless competition of the markets. In the minds of their analysts and portfolio managers, access to publicly available information wasn’t enough because competing funds had their own PhDs pouring over the same information. Moreover, competing funds also had access to the same expert networks (which might be viewed as “grey edge”) as did SAC.

 

In such a situation, we’d expect that different analysts would take different perspectives on the prospects of the drug and the trials. I would have expected that at least some analysts would question whether the assumptions behind the drug were correct. The market says that wasn’t the case. Rather the hedge fund world was massively longs before the release of the trial results, and Elan’s subsequent 66% price drop suggests that the herd mentality applied on the way down too.

 

So market efficiency drove SAC and some others to seek black edge, while the subsequent drop exposed a herd mentality and deep inefficiency that made the market anything but a black box that continuously adjusts prices for all information.

 

The result for the markets is analogous to the evolutionary theory of punctuated equilibrium: markets will proceed smoothly until some event produces rapid change. Because, as the crash of 2008 demonstrated, the big price-change inducing event can come from any number of directions inside or outside the economy, many investors are giving up on analysis of individual stocks and moving to passive investment funds and ETFs. The size of this shift is staggering. The amount of managed money in passive strategies has risen from an estimated 6% in 2006 to as much as 40% today (these figures vary depending on definitions of what a constitutes passive strategy).

 

That latter figure may be larger given the relationship between value investing and money moved by algorithms and quantitative strategies.

 

Quantitative types try to beat their peers by focusing on changes in pricing or volatility, and/or seeking an edge through speed and data crunching, rapidly identifying anomalies, and then trading at warp speed. Many hundreds of billions of dollars now take this route into the markets. And results have proven that this approach can work; some of these funds have done fabulously well.

 

So, stepping back, it becomes clear that the trillions of dollars invested through passive strategies and ETFs basically piggybacks on the decisions of active managers relying on traditional analysis of individual companies and sectors. Moreover, the hundreds of billions of dollars of money invested in quantitative, momentum, derivative, and volatility strategies, also piggybacks and even amplifies, the decisions made by traditional investors as those decisions become evident in price movements.

 

So the response to the pain inflicted by past booms and busts and insider trading scandals has created a situation today where the huge amounts of money moves in sync with an ever smaller base of active managers. Value investing based on analysis of individual companies has become an ever-smaller tail wagging an ever larger dog.

 

Perversely, this, in turn, has created a situation where in the next crash, Steve Cohen, the quant and momentum funds, and even the Warren Buffets will ultimately have no edge. All it will take to set the next crash in motion is for a fair number of investors to say, “gee I think I should shift more to cash.” Then the passive investment funds will be forced to sell, and they will sell regardless of the merits of any individual stock. This will cause volatility to rise and the billions of dollars of investments tied to volatility will also start selling, and as this is happening, the algorithmic traders, the momo guys and the others looking for direction to exploit will jump in juicing the sell off.  The trigger might be some external event, or something as banal as a simple change in mood, but no insider will have any better insight as to when this occurs than anyone with access to a newspaper.

 

As a coda, it’s worth noting that Steve Cohen has now been cleared to manage other people’s money. At the end of Black Edge the author quotes a savvy market player as saying that the day Cohen could do that, money would come pouring in. Well, according to the New York Times, that day is here and money is not pouring in. Maybe this is because his fees are too high, or because the insider trading scandal has made him tainted goods. Or maybe, it’s because investors doubt that he can achieve his former results without black edge.



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