Eugene Linden
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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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The Ragged Edge of the World
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PLEASE TREAD ON ME (Updated)


A few weeks back, President Bush signed a budget measure that would effectively cut environmental protection spending by the EPA over the next year by about six percent. Score another win for the corporate Browns in their long-standing rivalry with the Greens in this latest game in the World Environmental Football League. Recurrent lopsided scores should not be a surprise in this league since the Browns are pros playing for money, while the Greens are amateurs playing for effete liberal ideas like the viability of the planet. The league itself has unusual rules and traditions. The Greens play touch, while the Browns play tackle. Moreover, leaving nothing to chance, the Browns buy the ref. Strangest of all; the Greens would not have it any other way. I was prompted to look into the rules of this bizarre set-up a few years ago. I attended a meeting of an international environmental group and listened as a highly motivated group of greens discussed plans to fund a pilot project on ecotourism in Quintana Roo, Mexico. The idea was to point the way towards nature-friendly projects in this beautiful but vulnerable stretch of Caribbean coast. I should have been swept up by their idealism, but I wanted to tear my hair. Fourteen years earlier, I had visited this very area and heard highly motivated greens discuss similar plans to raise money to fund pilot projects in ecotourism. In the interim, highly motivated developers have built real hotels, destroying mangroves, killing reefs, and fouling once-clear sinotes in the process. There are no pilot hotels. This was but one episode of a pas de deux of destruction now playing in the U.S. and around the world (the WEF is the world’s one true global league). While greens concoct pilot projects and scrupulously honor "process," developers develop, loggers log, and poachers poach. When a builder in Quintana Roo or a timber interest in the Tongass covets a piece of real estate, he does whatever necessary to get the necessary approvals, produces an environmental impact study that suggests that sewage is good for coral reefs, or cutting is good for forests, and then builds. When environmentalists find some natural treasure, they hold conferences, fund surveys and censuses, seek consensus with locals, and say things like, “after doing x,y and z we can begin to…” Greens are always beginning to do something or other. A green-run airline would have pilots perpetually training for flights that were forever delayed. When they need it, exploiters have an ace in the hole: corruption. Pay offs and muscle, ubiquitous in decisions affecting natural areas in the developing world, and more subtly used in the U.S., utterly trump the law-abiding, bureaucratic approach of greens. Mario Villanueva, the governor of Quintana Roo, accused of taking mordida to approve hotels, eventually went on the lam, but the damage was already done. When, during the ’97 Asian financial crisis, greens asked Treasury Secretary Robert Rubin to support making new loans to Indonesia contingent on environmental reform, he replied that the time to talk about environment was when the country was back on the path to prosperity. Wrong: it was when Indonesia was richest that its corrupt politicians and generals were the most destructive. Since Rubin’s remarks, Indonesia has become the most critical environmental catastrophe on earth as free-lance loggers, squatters, and poachers take advantage of the country's instability to invade the nation's protected areas and remaining forests. On some islands, even the legal amounts of timber allocated for cutting vastly exceed the remaining stands of trees, parks included. The mismatch between the Browns and the Greens offers one reason that decades of mounting environmental awareness have produced so little in the way of facts on the ground. The decline of earth's ecosystems has only accelerated despite a geometric growth in the number of environmental groups around the world. Perhaps the most aggravating aspect of this danse macabre is that even its victims accept it as the way it should be. As one environmentalist told me, "of course we have to do an assessment; how else can we make the case for what to save and where to put boundaries." He's right. But, doesn't it seem strange that even as we watch forests disappear, fisheries die, and creatures go extinct, we continue to agree that the burden of proof lies with those who would protect nature rather than those would exploit her? Greens do their studies before entering an area, while if a company is building a pipeline in Kamchatka or a road in the Amazon, they make their plans first and let others worry about environmental impact. The practical reality is that once a development project is announced, with all its promise of jobs and profits, it is very difficult to halt. Still, what seems like common sense today may go down in history as collective madness as the bills start coming due for the destruction of earth's life support systems. Greens need to toss their playbook, and find a legitimate way to level the playing field. The huge reservoir of environmental awareness in the rich consuming nations offers enviros a powerful weapon to bring to bear on corporations, financial institutions, and international lending agencies that control the flow of money to the developing world -- a point made by activists at every international globalization forum. This is a useful step. And please, no more pilot projects!

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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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