The illusion of stability, part 2: What fuels bubbles?

Blame It on Taylor

"It wasn't me. It was the one-armed man. Alright, alright, I confess. I did it, you hear? And I'm glad, glad, I tell you! What are they going to do to me, Sarge? What are they going to do?"

"Sorry, son, that's not my department."
- Jim Carrey in the The Mask

As if to respond to my 2009 year in review post, Ben Bernanke came up with a huge speech (please do not smile; I wrote “as if”) outlining why zero real interest rates have had no effect on the housing prices. With this groundbreaking discovery, he opened 2010 by declaring war on common sense and possibly laying claim to the Noble Prize. Yes, you heard it right, zero interest rates do not affect housing prices.

Let's consider some of the Chairman’s arguments:

The Taylor Rule

Bernanke invoked a formula called the Taylor rule which purports to proscribe appropriate monetary policy to strike a balance between economic growth and inflation of asset bubbles. Bernanke suggested that if forecasted inflation rate is used as an input into the Taylor rule then Fed’s policy of zero real interest rates in the years when the housing prices were exhibiting explosive growth then the rule suggests that the policy was appropriate. Taylor himself responded to Bernanke explaining that he misinterpreted and misused the rule. Without getting into any mathematical detail, the first question to ask is, "How valuable can a rule be, if different inputs can be used to provide any result you want?" Imagine a space engineer whose creation crashed and injured the public proclaiming that he used a different gravity constant and therefore was correct. The point is that economics is not physics and a heavy dose of common sense is needed. Even Taylor himself said that mathematical discussions should not obscure the plain fact that interest rates were ZERO.

Smoke and Mirrors

"The fact that our econometric models at the Fed, the best in the world, have been wrong for 14 straight quarters does not mean they will not be right in the 15th quarter." - Alan Greenspan in a testimony before Congress

In the second argument, Chairman Bernanke made a similar attempt to cloud economic discussion with equations carrying a boatload of assumptions which will give most any answer desired. He referred to a set of econometric models developed at the Fed based on the technique called Vector Autoregression. Using past values of housing prices, interest rates and other economic variables, the model can be coaxed into showing what values are reasonable for any one of the variables given the actual values that were observed for the rest (conditional distribution). Using that technique, it can be shown that only about half of the explosive housing growth can be attributed to the Fed’s policy. In addition to eschewing common sense, there are fairly obvious and fatal statistical problems with Bernanke analysis:

• The model was calibrated during the period of non-zero interest rates and then linearly extrapolated into the zero interest rate period. It assumes that the relationships between variables are linear and constant, that there is nothing inherently different about zero interest rate environment and that only changes in variables matter. Needless to say, all these assumptions are flawed, and this is a perfect example of the fallacy of linearity of which I have written here.
  
• The range of housing prices conditional on the interest rates was limited to two standard deviations. Even using Bernanke’s own heroic assumptions there is still 32% of the distribution remained outside. When looking at the graphs at the end of the speech, it become fairly obvious why two standard deviations were used. Simply put, three standard deviations would not give the desired answer; the line would be too close to the actual housing line, thus suggesting that even with all its flaws the model rather contradicted the speaker.

Adjustable Rate Mortgages and Rates

The third argument was that the problem stamped from lax regulations not from zero interest rates. Here is one quote from the speech:

“Moreover, less accommodative monetary policy would not have had a substantial effect on ARM payments…Clearly, for lenders and borrowers focused on minimizing the initial payment, the choice of mortgage type was far more important than the level of short-term interest rates.”

Here, the Chairman is partially right, and his call to create a systemic risk agency can only be applauded. However, to argue that low interest rates had nothing to do with the proliferation of creative mortgage lending is to ignore the reason why people took on ARM mortgages in the first place. They did so because housing prices were rising at a tremendous pace for a number of years before. As Bernanke himself shows, ARM mortgages did not become popular until 2006, which was closer to the end of the bubble. Without zero interest rates, we would not be talking about them.

More Smoke and Mirrors

“'You might just as well say that "I see what I eat" is the same thing as "I eat what I see"!'

'You might just as well say,' added the March Hare, 'that "I like what I get" is the same thing as "I get what I like"!'

'You might just as well say,' added the Dormouse, who seemed to be talking in his sleep, 'that "I breathe when I sleep" is the same thing as "I sleep when I breathe"!'

'It is the same thing with you,' said the Hatter …” - Lewis Carroll, Alice in Wonderland

Bernanke's last point confuses the whole matter even more:

“In particular, we need to understand better why some countries drew stronger capital inflows than others. I will only note here that, as more accommodative onetary policies generally reduce capital inflows, this relationship appears to be inconsistent with the existence of a strong link between monetary policy and house rice appreciation.”

Essentially, what this passage is saying is the following: Countries with real estate bubbles exhibited higher capital inflows. Since higher capital inflows usually happens when interest rates are high and not when they are low all this is very confusing. The interest rates must not have been low after all.

This kind of reasoning implicitly assumes that economics can be described by the same functional relationships as Newtonian physics, i.e., that if high interest rates cause capital inflows then high capital inflows will not occur when interest rates are set too low. It assumes a kind two-way relationship that is called one-to-one correspondence in mathematics.

Why did the Chairman have to avoid considering the possibility that capital inflows can be caused by reasons other than high interest rates? Is it not the obvious conclusion that the capital inflows were caused by the very presence of the various bubbles that Alan Greenspan and Ben Bernanke then denied? Who cares about a few percentages in interest rates when values of assets are doubling?

What does all this mean for a risk manager? It means that Ben Bernanke sees no inherent problem in zero interest rates as long as Consumer Price Inflation stays low. This in turn means that we are in for another decade of Black Swans. Buckle up.

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Notes from the IPARM conference in Hong Kong, part 2

A day full of fascinating discussions at the Third Annual Investment Performance Analysis and Risk Management Asia 2010 (IPARM) conference at the Kowloon Shangri-La in Hong Kong, China. Hope you've been enjoying my live tweets from the conference.

Kicking the event off was Trevor Persaud, the Head of Investment Risk Oversight and Performance at Prudential Asset Management in Singapore. Trevor's topic was redefining the roles and responsibilities of performance analysts and risk managers to better support the investment management teams. Trevor started off his presentation by asking the audience whether the portfolio manager at their respective firms was the only person at the firm who can say exactly what is going on in a particular portfolio. While Trevor acknowledged that this was expected since the PM should have the expertise, he questioned whether this lack of challenge and oversight is healthy for the fund. From his experience, he has found that independent expertise of a fund helps moderate the action a PM might otherwise undertake.

Having worked in both Europe and Asia, the first question asked of Trevor by the audience was what were the big differences between the risk management function in the two regions? Trevor cautioned his response by saying this was not a sweeping statement, but he thought that in Asia, up until recently, the role was purely operational, very limited independence and oversight. However, of late, he has noticed that in Asia, there is a thicker layer of senior management (compared to Europe where the Portfolio Manager is king), and management has been more receptive to risk managers looking to take a more active role and becoming more than just serving a pure operational function. In Europe, Trevor thought that risk managers have taken on more responsibility than their Asian counterparts, but that a risk manager's ascension is capped, there comes a point (and I hope he was speaking from personal experience) when the risk manager is at peril of overstepping his or her bounds in the hierarchy of a European investment management firm.

Daniel Wallick, Principal in the Investment Strategy Group at Vanguard, gave an equally interesting talk and got everyone's attention when he equated risk management with the Allegory of the Cave from Plato's The Republic.

For those who haven't read the book since high school, Daniel's analogy was that risk is similar to man looking at the shadows on the wall in the cave; we are not really sure what we are looking at. Daniel's talk expanded into the two reasons why we need risk management (people are imperfect and crises happen) and ended with four interesting fundamentals that are followed at Vanguard:

1. Risk management is an integral part of the investment decision making process.
2. An enduring value-added investment program in good ties and (crucially) in bad.
3. Top-down qualitative judgment/rigor + discipline in quantitative measures.
4. No substitute for the judgment and experience of the risk management and investment teams.

Daniel's session ended with a question from the audience on his assessment of the current risk environment in the U.S. given his experience and focus there. Daniel replied that he was not specifically concerned near term with inflation (in the U.S.), but what concerned him was how exactly should the Fed back out of what it has been doing and how/when do they do that.

There were a couple of additional speakers today who covered topics that I will take up in a future blog post. As for tomorrow, we have an equally interesting set of speakers and topics coming up in day two of the conference, some that have caught my attention include:

• Dr. Stan Uryasev, Editor-in-Chief of The Journal of Risk, who will be seeking alternatives for VAR as risk measure.
• A panel discussion on finding the right risk model and measurement system that is appropriate for your investment decision process, particularly interesting since my colleague covered this topic in a blog post last month.
• Peter Urbani, CIO at Infiniti Capital who will be revisiting risk management and performance measurement for hedge funds.

Please check back early next week for a recap on these interesting topics.

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Notes from the IPARM conference in Hong Kong, part 1

Greetings from Hong Kong! I will be attending the Third Annual Investment Performance Analysis and Risk Management Asia 2010 (IPARM) conference at the Kowloon Shangri-La later this week. The past two events have had an excellent range of speakers and I am looking forward to sharing some of the more interesting talks with you from the 21 speakers from all over the world who will be headlining the event.

In particular, I am looking forward to hearing from:

• Trevor Persaud, the Head of Investment Risk Oversight and Performance at Prudential Asset Management in Singapore (and Chair of the conference) who will discuss redefining the traditional role of risk managers.
• Dr. Lincoln Rathnam, CFA, Gloal Head of Investment Management at EM Capital Management who will be giving a talk on stress testing.
• Jean-Marc Sabatier, Head of Risk Management Asia for Credit Agricole Asset Management who will be speaking on data management best practices.
• Daniel Wallick, Principal in the Investment Strategy Group at Vanguard who will be examining some of the key challenges of risk adjusted performance measurement in the current market.

Watch this blog later in the coming week as I post on some of the interesting topics covered at the IPARM two day conference.