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OUR CONFEDERACY OF DUNCES

            The Darwin Award confers mock recognition on individuals killed by their own stupidity, thereby improving the gene pool by removing themselves from it. If there existed such an award at the national level, the U.S. of today would be ...

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RIP Credit as Money


Wednesday January 28, 2009

by Eugene Linden

The drumbeat about the Obama administration’s plans to fix the banking crisis has reached fever pitch. Over the past week, what appears to be a carefully choreographed series of leaks has raised expectations that the administration has something very big planned (my guess is that it would have been announced right after the inauguration, but for the delay in Timothy Geithner’s confirmation as Treasury Secretary). Various newspapers and blogs have speculated on the details, some of which would be truly dramatic: e.g. an omnibus take-over of a raft of banks, a process that would include wiping out existing shareholders, converting debt to equity (to avoid the new N-word – nationalization), the FDIC providing a backstop for deposits, and, to restore trust in bank balance sheets, the establishment of a new entity to buy, hold, and trade trillions of dollars in now-suspect bank assets.

Clearly something needs to be done, and just as clearly the banks have gotten wind of the proposals and are trying to head off the scariest parts of the plan (I interpret the trumpeted insider share purchases by Chase’s Jamie Dimon and execs at B of A to be a message: “hey, no need to nationalize us, we believe in our equity value!”). Ignored by much of the commentary, however, has been a small but crucial change in the proposed composition of the much-discussed new entity to buy toxic bank assets. Moreover, if this entity comes to pass, it will serve as the grave for a widely shared, but very dangerous artifact of the bubble years: the confusion of money as credit.

First the new wrinkle in the “bad bank” concept. Last week on CNBC Sheila Bair, the outgoing and incoming head of the FDIC, remarked on the possibility of setting up an entity funded by both public and private money to buy toxic assets. The involvement of private money is new, and the timing of this announcement begs many questions. In the CNBC interview Bair said, “One approach we think might have some merit is what we call an “aggregator bank” where you would set up a facility capitalized through some portion of the T.A.R.P. fund to acquire troubled assets…” So far so good, the basic idea has been floated many times over the past year. But then she remarked that the new structure would… “also require those institutions selling assets into this facility to contribute some capital cushion themselves…”

The suggestion about lenders having a stake in the entity is both crucial and new -- at least new to the Bush administration (a number of observers, including me, suggested such an entity at the beginning of the crisis in Aug. 2007: http://www.huffingtonpost.com/eugene-linden/collapse-of-a-fiat-curren_b_60562.html). Forcing banks to have skin in the game alongside taxpayers makes it less likely that financial institutions will try to screw the taxpayers. Having the government involved also provides adult supervision in the setting of the ground rules.

Why then didn’t the Bush administration put forth this key provision before the very end? Someone must have suggested it -- after all, it’s little more than common sense. If it’s a good idea in the full teeth of the crisis, why wasn’t it a good idea at the outset? That it will be the Obama administration that launches this entity implies that the Bush administration was loathe to push for the self-policing aspects of having the banks provide capital.

And then, there’s the end-of-an-era aspect of plan. Whether it’s called a “bad bank” or “aggregator” or “RTC II,” the new entity represents an explicit admission that no one else is willing to accept trillions of dollars in credit instruments that two years ago were treated as interchangeable with money. Thanks to the ingenuity of Wall Street’s rocket scientists, so-called structured credit products proliferated wildly during this decade, backed by mortgages and other obligations (or by other credit instruments that in turn were backed by assets). With credit rating agencies blessing these products as AAA, these instruments were treated almost as money, and provided much of the liquidity that spurred the illusion of wealth creation during the bubble years.

Now, pension funds, hedge funds, endowments, and financial institutions that confused money and credit have discovered -- in the most brutal fashion -- that the value of anything deemed to be money-good rests entirely on the willingness of someone else to accept it. With no one but the government willing to accept these assets, this former currency will be retired as scrap. RIP money as credit.

Unfortunately, the story does not end there. While officials cross their fingers that these disgraced credit instruments will remain quarantined, this nuclear waste could still leach into the financial system, particularly if the prices paid are above market (whatever that is!). The scale of this pollution is such that the sum total of government guarantees and obligations may impact the value the rest of the world puts on the U.S. dollar, the linchpin of the global financial system. In the end then, money and credit do turn out to have some something in common: the value of either depends entirely on the trust of strangers.

contact Eugene Linden

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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