The Essential Difference: male and female brains and the truth about autism by Simon Baron-Cohen
Another book on the holiday list. Why was I interested in this? Recently Asperger's Syndrome (AS), a form of high-functioning autism, has become the chic condition of choice for geeks worldwide. Yes, kids who in the old days were simply math or computer nerds are now self-identified (often with pride!) as having AS. Silicon Valley is full of these people. The rest of us are mere "neurotypicals" :-)
Baron-Cohen is head of the Autism Research Centre at Cambridge, and a professor of psychology. He claims that male brains tend to be better at "Systematizing" (organizing or analyzing things which exhibit order), while female brains are better at "Empathizing" (understanding what others are thinking or feeling). A fair amount of experimental data (pretty convincing) is presented, which supports the claim that the distributions of S-ability and E-ability are different in the male and female populations. (Incidentally, the effect of testosterone on brain development is well known, leading to significant variations in the actual sizes of various areas of the brain between males and females.) Baron-Cohen also gives plausible evolutionary arguments for how this came to be - a bit better than the "girls were selected to be good mommies, boys to be good hunters" story, but you get the idea.
The novel part of his theory is that the autistic mind is an example of an extreme male mind - one that is obsessed with systematizing and very bad at empathizing. In a particularly amusing chapter he profiles a famous mathematician (Fields medalist) and some physicists (Dirac, Newton and Einstein) who he claims likely have or had AS. He even quotes a female physicist working at CERN saying that her male colleagues lack social skills and are arrogant obsessives :-) Well, what can I say, it is all true. But it doesn't mean we all have AS...
Not to be missed are the fun tests at the back of the book, which measure your S and E quotients!
Wednesday, January 05, 2005
Tuesday, January 04, 2005
Christmas reading - Kahneman and Tversky
I realize that the holiday season is over (boy do I realize it, since I am back in the classroom as of today), but I thought I would report on a couple of books I read over the break.
Choices, Values, and Frames
by Daniel Kahneman and Amos Tversky
This is a collection of papers on cognitive psychology as applied to economics and decision making. Kahneman and Tversky were pioneers in what is now known as behavioral economics. The papers are clearly written and offer a nice introduction to this field.
As you can tell from some of my previous posts mocking the idea of strongly efficient markets, I am not myself a big believer in the rationality or analytical power of individuals who make up markets. However, this does not mean I doubt the power of markets as aggregators of information, and on this subject I highly recommend Surowiecki's book The Wisdom of Crowds. Certainly, it is not excluded that a machine could function usefully even if many of its subcomponents are faulty :-)
I won't try to summarize everything in the book, which at minimum provides a nice compendium of cognitive quirks uncovered in surveys and laboratory observations. One that I found quite interesting is the prevalence of risk aversion, extending even to very small wagers. The typical person's utility function, as extracted from experimental observation, is not at all linear even for small amounts at risk - the pain of a loss exceeds the pleasure of a gain of equal size.
It seems reasonable to assume that individual utility functions are logarithmic - a gift of $1000 brings proportionally less pleasure to a billionaire than to a millionaire. But there is good evidence that this is not so, and indeed M. Rabin, in one of the papers, shows that the aversion to small losses cannot be accommodated by such a model of utility. It seems that our brains constantly set reference points ("zero points") relative to which we measure loss or gain.
If indeed our brains constantly (say on monthly to yearly timescales) reset their financial zero points, and are naturally risk averse, then volatility itself is a painful phenomena. One interesting idea of Rabin's is that this explains the (unnaturally?) high value of the equity risk premium.
In my opinion, investors have been trained in recent decades to believe that small losses are only temporary and that equity markets almost always go up over the long run. This makes them more resistant to loss aversion and leads to a smaller equity risk premium (and correspondingly high P/E ratios).
Choices, Values, and Frames
by Daniel Kahneman and Amos Tversky
This is a collection of papers on cognitive psychology as applied to economics and decision making. Kahneman and Tversky were pioneers in what is now known as behavioral economics. The papers are clearly written and offer a nice introduction to this field.
As you can tell from some of my previous posts mocking the idea of strongly efficient markets, I am not myself a big believer in the rationality or analytical power of individuals who make up markets. However, this does not mean I doubt the power of markets as aggregators of information, and on this subject I highly recommend Surowiecki's book The Wisdom of Crowds. Certainly, it is not excluded that a machine could function usefully even if many of its subcomponents are faulty :-)
I won't try to summarize everything in the book, which at minimum provides a nice compendium of cognitive quirks uncovered in surveys and laboratory observations. One that I found quite interesting is the prevalence of risk aversion, extending even to very small wagers. The typical person's utility function, as extracted from experimental observation, is not at all linear even for small amounts at risk - the pain of a loss exceeds the pleasure of a gain of equal size.
It seems reasonable to assume that individual utility functions are logarithmic - a gift of $1000 brings proportionally less pleasure to a billionaire than to a millionaire. But there is good evidence that this is not so, and indeed M. Rabin, in one of the papers, shows that the aversion to small losses cannot be accommodated by such a model of utility. It seems that our brains constantly set reference points ("zero points") relative to which we measure loss or gain.
If indeed our brains constantly (say on monthly to yearly timescales) reset their financial zero points, and are naturally risk averse, then volatility itself is a painful phenomena. One interesting idea of Rabin's is that this explains the (unnaturally?) high value of the equity risk premium.
In my opinion, investors have been trained in recent decades to believe that small losses are only temporary and that equity markets almost always go up over the long run. This makes them more resistant to loss aversion and leads to a smaller equity risk premium (and correspondingly high P/E ratios).
Saturday, January 01, 2005
Obstacles to China development
The possibility of social unrest in China due to widening inequality has been widely discussed. Here is some recent coverage from the Times.
But just as problematic is the vast misallocation of resources resulting from local government corruption, lack of transparency and absence of rule of law (i.e., "crony capitalism"). See here for an example involving the Apex scandal and export of TVs and DVD players. Apex is one of the largest distributors of DVD players and TVs in the US, and is primarily responsible for driving the price of DVD players below $50 dollars. Now it appears that Sichuan Changhong Electric Appliance, their main supplier, will report as much as $500M in losses due to lack of payment from Apex, stretching over a year. How could Apex get away with this? Who was paid off? The Times suggests that a Party boss and former Changhong executive was involved and has been sacked over the affair.
The head of a leading research institute in Beijing once said to me in this regard that "hardware is easy, software is hard" - meaning that it is easier to build factories, roads and airports than to implement a functioning market system and civil society with transparency and rule of law. The transition from a low-trust society (where the people don't trust their government, or even their neighbors) to a high-trust society (where things like the financial and legal systems are expected to work, and do) is difficult.
But just as problematic is the vast misallocation of resources resulting from local government corruption, lack of transparency and absence of rule of law (i.e., "crony capitalism"). See here for an example involving the Apex scandal and export of TVs and DVD players. Apex is one of the largest distributors of DVD players and TVs in the US, and is primarily responsible for driving the price of DVD players below $50 dollars. Now it appears that Sichuan Changhong Electric Appliance, their main supplier, will report as much as $500M in losses due to lack of payment from Apex, stretching over a year. How could Apex get away with this? Who was paid off? The Times suggests that a Party boss and former Changhong executive was involved and has been sacked over the affair.
The head of a leading research institute in Beijing once said to me in this regard that "hardware is easy, software is hard" - meaning that it is easier to build factories, roads and airports than to implement a functioning market system and civil society with transparency and rule of law. The transition from a low-trust society (where the people don't trust their government, or even their neighbors) to a high-trust society (where things like the financial and legal systems are expected to work, and do) is difficult.
Bandwidth costs and Internet broadcasting
I was researching the cost of bandwidth recently. Some interesting numbers I uncovered: backbone transport cost is $100 per month per Mbps, or about 30 cents per GB. ISPs and hosting services charge a bit more than this per GB, but as little as $.50 per GB. The bandwidth cost of servicing a typical residential cable or DSL broadband subscriber is only about $2 per month, so potential margins are large.
Mailing a DVD (4.8GB of data for the cost of a postage stamp) is still a cheaper method of data transfer than the Internet - albeit slower! When will NetFlix's inventiory management innovations become redundant due to Internet delivery of movies? Now that 50% of US Internet users have broadband, it will only be a few years before a similar business can be built around delivering movies directly over the wire. At 100kbps sustained, it takes 10^5 s - about a day - to download a movie.
What about running your own TV or radio station from your Web server? Even if bandwidth costs drop another order of magnitude, we'll still need distributed P2P like BitTorrent to make it affordable for individuals. BitTorrent stores copies of a file on multiple (volunteer) servers, and distributes the bandwidth burden by allowing a user to download via multiple streams. (It has been reported that BitTorrent alone currently accounts for about a third of all bandwidth usage!) Very soon, content distribution will be revolutionized by distributed P2P, with indie TV shows distributing their product via the Internet.
Mailing a DVD (4.8GB of data for the cost of a postage stamp) is still a cheaper method of data transfer than the Internet - albeit slower! When will NetFlix's inventiory management innovations become redundant due to Internet delivery of movies? Now that 50% of US Internet users have broadband, it will only be a few years before a similar business can be built around delivering movies directly over the wire. At 100kbps sustained, it takes 10^5 s - about a day - to download a movie.
What about running your own TV or radio station from your Web server? Even if bandwidth costs drop another order of magnitude, we'll still need distributed P2P like BitTorrent to make it affordable for individuals. BitTorrent stores copies of a file on multiple (volunteer) servers, and distributes the bandwidth burden by allowing a user to download via multiple streams. (It has been reported that BitTorrent alone currently accounts for about a third of all bandwidth usage!) Very soon, content distribution will be revolutionized by distributed P2P, with indie TV shows distributing their product via the Internet.
Thursday, December 30, 2004
Faltering meritocracy in America
Excellent article in the Economist. The data, though complex, seem to indicate that while income and wealth inequality are growing, social mobility has either not changed or decreased slightly. Also, the US does not seem to allow any more social mobility than european countries like Germany or Sweden.
Paradoxically, "...Members of the American elite live in an intensely competitive universe. As children, they are ferried from piano lessons to ballet lessons to early-reading classes. As adolescents, they cram in as much after-school coaching as possible. As students, they compete to get into the best graduate schools. As young professionals, they burn the midnight oil for their employers. And, as parents, they agonise about getting their children into the best universities. It is hard for such people to imagine that America is anything but a meritocracy: their lives are a perpetual competition. Yet it is a competition among people very much like themselves—the offspring of a tiny slither of society—rather than among the full range of talents that the country has to offer.
...America's great universities are increasingly reinforcing rather than reducing these educational inequalities. Poorer students are at a huge disadvantage, both when they try to get in and, if they are successful, in their ability to make the most of what is on offer. This disadvantage is most marked in the elite colleges that hold the keys to the best jobs. Three-quarters of the students at the country's top 146 colleges come from the richest socio-economic fourth, compared with just 3% who come from the poorest fourth (the median family income at Harvard, for example, is $150,000). This means that, at an elite university, you are 25 times as likely to run into a rich student as a poor one."
Paradoxically, "...Members of the American elite live in an intensely competitive universe. As children, they are ferried from piano lessons to ballet lessons to early-reading classes. As adolescents, they cram in as much after-school coaching as possible. As students, they compete to get into the best graduate schools. As young professionals, they burn the midnight oil for their employers. And, as parents, they agonise about getting their children into the best universities. It is hard for such people to imagine that America is anything but a meritocracy: their lives are a perpetual competition. Yet it is a competition among people very much like themselves—the offspring of a tiny slither of society—rather than among the full range of talents that the country has to offer.
...America's great universities are increasingly reinforcing rather than reducing these educational inequalities. Poorer students are at a huge disadvantage, both when they try to get in and, if they are successful, in their ability to make the most of what is on offer. This disadvantage is most marked in the elite colleges that hold the keys to the best jobs. Three-quarters of the students at the country's top 146 colleges come from the richest socio-economic fourth, compared with just 3% who come from the poorest fourth (the median family income at Harvard, for example, is $150,000). This means that, at an elite university, you are 25 times as likely to run into a rich student as a poor one."
Future investment returns
Some nice discussion related to equity risk premia in the Economist. "...Despite the slump in prices in the three years to 2002, price-earnings (p/e) ratios still look a bit high, notably on American shares, and share valuations are unlikely to benefit from falling interest rates in future. Meanwhile, lower inflation means that the pace of profits growth will slow. Assume that America's nominal GDP grows by 5% a year (3% in real terms, plus 2% for inflation). If the share of profits in GDP is constant, profits will grow at the same rate. However, profits could do much less well, because in America, Japan and the euro area their share of GDP is close to a record high. They might well be expected to fall.
Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.
Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor."
But, there is reason to believe that p/e ratios will remain higher than their historical average, due to investor confidence in the equity risk premium.
Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.
Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor."
But, there is reason to believe that p/e ratios will remain higher than their historical average, due to investor confidence in the equity risk premium.
Google Suggest and phishing attack
Google has a nice beta toy called Google Suggest, which guesses predictively as you enter search terms. What is interesting is the compact JavaScript on the page which communicates in real time with a Google server to generate the suggestions. The secret is the XMLHttpRequest object, used to communicate with a server and get new information or instructions without refreshing the page
I can see how such code could be used in a phishing attack: a phishing Web page, to which the user is directed via a fake email, can use similar JavaScript to transmit keystrokes to a remote server, even if the html post on the page submits the information (e.g., username and password) to the real authentication server. Anti-phishing technology which focuses on where the post data is sent (i.e., which is implemented on the firewall or TCP/IP level) will not detect a problem.
Anti-phishing technology like Whole Security's Web CallerID works by looking at the URL from which the potentially fake page is loaded. However, using the trick I've outlined above and some cross-site scripting the page can be served up from any number of locations - the only static component is the remote server where the keystrokes are sent. For an anti-phishing agent to detect this hack it would have to parse and understand the JavaScript on the fake page. Actually Web CallerID is weak for another reason - a phisher can use JavaScript to modify the "chrome" on the browser, replacing the Web CallerID toolbar with a fake one that gives the OK signal. (This is true for any toolbar.)
For those who don't follow Internet security, we are in the midst of a sea change right now. In the past, viruses and the like were built and released just for fun, for hackers to gain a reputation. We are now entering a period where much of the hacking is done by criminals for the purpose of financial gain. This means that the next virus on your machine may be more than just an annoyance - it may be watching while you log into your online banking account.
I can see how such code could be used in a phishing attack: a phishing Web page, to which the user is directed via a fake email, can use similar JavaScript to transmit keystrokes to a remote server, even if the html post on the page submits the information (e.g., username and password) to the real authentication server. Anti-phishing technology which focuses on where the post data is sent (i.e., which is implemented on the firewall or TCP/IP level) will not detect a problem.
Anti-phishing technology like Whole Security's Web CallerID works by looking at the URL from which the potentially fake page is loaded. However, using the trick I've outlined above and some cross-site scripting the page can be served up from any number of locations - the only static component is the remote server where the keystrokes are sent. For an anti-phishing agent to detect this hack it would have to parse and understand the JavaScript on the fake page. Actually Web CallerID is weak for another reason - a phisher can use JavaScript to modify the "chrome" on the browser, replacing the Web CallerID toolbar with a fake one that gives the OK signal. (This is true for any toolbar.)
For those who don't follow Internet security, we are in the midst of a sea change right now. In the past, viruses and the like were built and released just for fun, for hackers to gain a reputation. We are now entering a period where much of the hacking is done by criminals for the purpose of financial gain. This means that the next virus on your machine may be more than just an annoyance - it may be watching while you log into your online banking account.
Wednesday, December 29, 2004
Fannie Mae exits scandalous
The generous packages offered to CEO Raines and CFO Howard are ridiculous. I think the biggest problem today in US corporate governance is the cozy relationship between directors and management. It is obvious that directors are not incentivized properly to look out for the best interests of the company, but rather to maintain good relationships with the chief executive. Not only has CEO compensation become decoupled from actual performance, but "caretaker" CEOs who inherit existing public companies with strong brands and product lines are being compensated like entrepreneurs who actually create value out of nothing (see Michael Eisner and Disney for a great example). I don't see why a CEO should make $100M for anything short of a heroic turnaround - let alone lackluster performance.
For previous posts on Fannie, see here and here. Look for congress and OFHEO to claw back some of the largesse heaped on Raines.
From today's WSJ editorial by J. Stewart: "After pledging before Congress to hold himself personally accountable for any accounting errors, news reports suggest he embarked on a strenuous campaign to save his own job, huge salary and perks. Even after the Securities and Exchange Commission faulted the accounting and said Fannie Mae had misstated $9 billion in profits, Mr. Raines's benefit included an astonishing $1.4 million-a-year pension for life, not to mention a multimillion-dollar array of other goodies. Mr. Raines already is immensely wealthy; he earned more than $17 million from Fannie Mae in 2002 alone. I'm sorry, but harvesting a massive payoff for $9 billion in accounting irregularities doesn't constitute accepting responsibility for the errors.
This is all beginning to smell like the Richard Grasso pay and severance scandal at the New York Stock Exchange, with the massive payouts and cozy relationships between management and directors. There, too, a quasipublic institution lavished unseemly benefits on its top officer and is still embroiled in litigation and reform efforts meant to regain public trust.
Like the NYSE, the Fannie Mae affair goes to the heart of a serious problem, which is that a quasipublic institution that enjoys protection from the usual risks of the market, in the name of public service, has insisted on treating its top officers like their most highly paid peers in the far-riskier private sector."
For previous posts on Fannie, see here and here. Look for congress and OFHEO to claw back some of the largesse heaped on Raines.
From today's WSJ editorial by J. Stewart: "After pledging before Congress to hold himself personally accountable for any accounting errors, news reports suggest he embarked on a strenuous campaign to save his own job, huge salary and perks. Even after the Securities and Exchange Commission faulted the accounting and said Fannie Mae had misstated $9 billion in profits, Mr. Raines's benefit included an astonishing $1.4 million-a-year pension for life, not to mention a multimillion-dollar array of other goodies. Mr. Raines already is immensely wealthy; he earned more than $17 million from Fannie Mae in 2002 alone. I'm sorry, but harvesting a massive payoff for $9 billion in accounting irregularities doesn't constitute accepting responsibility for the errors.
This is all beginning to smell like the Richard Grasso pay and severance scandal at the New York Stock Exchange, with the massive payouts and cozy relationships between management and directors. There, too, a quasipublic institution lavished unseemly benefits on its top officer and is still embroiled in litigation and reform efforts meant to regain public trust.
Like the NYSE, the Fannie Mae affair goes to the heart of a serious problem, which is that a quasipublic institution that enjoys protection from the usual risks of the market, in the name of public service, has insisted on treating its top officers like their most highly paid peers in the far-riskier private sector."
Monday, December 27, 2004
Equity risk premium
In theory, stocks should provide a greater return than safer investments like Treasury bonds. The difference is called the equity risk premium: it is the additional return that you can expect from the overall market above a risk-free return. The historical value of this risk premium is about 4%. Currently, TIPs yields are about 2%, so one would expect real equity returns of about 6% going forward.
A paradoxical aspect of this risk premium is the following: once people realize that equity returns dominate bond returns, why should they continue to demand a premium for owning equities (assuming they have long time horizons)? Over the last 20 years, it has become conventional wisdom that one should own stocks, rather than bonds, for the long run ("stocks for the long run","buy and hold", even "buy on the dips"). Nothing wrong with this conclusion, as the data certainly support it. But as more investors accept this wisdom, the more the price of equities gets bid up, leading to large P/E ratios and, eventually, a smaller risk premium. To me, this is the most plausible explanation for recent secular increases in P/E ratios. However, it also implies that equity returns in the near future should lag the historical average.
The equity risk premium plays an important role in discussions of social security privatization - the particular value assumed makes all the difference in future projections. But we should remember that equities are like any other scarce resource subject to supply and demand. If demand for shares increases, their prices will also increase, even if there is no change in the "intrinsic value" = sum of future dividend payments. Eventually the supply of shares can increase, as perhaps the rate of business formation speeds up. But, it seems obvious that the growth in capitalization of the broadest index of equities cannot exceed GDP growth for any length of time, so it would be surprising if this rate of value creation could accelerate drastically.
From this perspective, it seems that social security privatization is likely to bid up equity prices and depress their future returns. Imagine the following analogy: one day, foreign investors wake up and decide to increase their portfolio allocation to US equities. The result may be a buoyant stock market, but to what extent does this increase real value creation in our economy? Does it create enough value (i.e. future earnings and dividend growth) to justify the amount by which prices are bid up? (An even simpler analogy: I have a chicken, which produces eggs at a fixed rate. Demand for egg-laying chickens increases, driving up the price of my chicken. Will it lay eggs any faster as a result of its increased price?)
A paradoxical aspect of this risk premium is the following: once people realize that equity returns dominate bond returns, why should they continue to demand a premium for owning equities (assuming they have long time horizons)? Over the last 20 years, it has become conventional wisdom that one should own stocks, rather than bonds, for the long run ("stocks for the long run","buy and hold", even "buy on the dips"). Nothing wrong with this conclusion, as the data certainly support it. But as more investors accept this wisdom, the more the price of equities gets bid up, leading to large P/E ratios and, eventually, a smaller risk premium. To me, this is the most plausible explanation for recent secular increases in P/E ratios. However, it also implies that equity returns in the near future should lag the historical average.
The equity risk premium plays an important role in discussions of social security privatization - the particular value assumed makes all the difference in future projections. But we should remember that equities are like any other scarce resource subject to supply and demand. If demand for shares increases, their prices will also increase, even if there is no change in the "intrinsic value" = sum of future dividend payments. Eventually the supply of shares can increase, as perhaps the rate of business formation speeds up. But, it seems obvious that the growth in capitalization of the broadest index of equities cannot exceed GDP growth for any length of time, so it would be surprising if this rate of value creation could accelerate drastically.
From this perspective, it seems that social security privatization is likely to bid up equity prices and depress their future returns. Imagine the following analogy: one day, foreign investors wake up and decide to increase their portfolio allocation to US equities. The result may be a buoyant stock market, but to what extent does this increase real value creation in our economy? Does it create enough value (i.e. future earnings and dividend growth) to justify the amount by which prices are bid up? (An even simpler analogy: I have a chicken, which produces eggs at a fixed rate. Demand for egg-laying chickens increases, driving up the price of my chicken. Will it lay eggs any faster as a result of its increased price?)
Sunday, December 26, 2004
Man in the middle phishing attacks
I posted before about phishing being the next big security problem, after viruses, worms and spyware. Protecting against viruses and worms has become a billion dollar a year industry, and now anti-spyware companies are being snapped up by Microsoft and other acquirers. I mentioned before that there is no easy solution to the phishing problem. This NYTimes article describes some anti-phishing measures being tested by banks, such as RSA's SecurID key fob. SecurID uses a cryptographic one-time password (OTP), which is synchronized between the chip on the fob and the algorithm running on the authentication server.
But, this method has an obvious vulnerability. The fake bank site that the phisher redirects the user to could easily proxy the real site:
User ------ phish proxy ------ real bank site
in which case, the OTP is simply passed through when the user types it in. Once the authentication is complete the phisher drops the connection to the user and continues with the banking session. The only drawback is that the phisher has to execute this attack in real time - he sits by his machine, which beeps when a new account is compromised. He has only one login session to do his dirty work, since he can only get the OTP by proxying.
But, this method has an obvious vulnerability. The fake bank site that the phisher redirects the user to could easily proxy the real site:
User ------ phish proxy ------ real bank site
in which case, the OTP is simply passed through when the user types it in. Once the authentication is complete the phisher drops the connection to the user and continues with the banking session. The only drawback is that the phisher has to execute this attack in real time - he sits by his machine, which beeps when a new account is compromised. He has only one login session to do his dirty work, since he can only get the OTP by proxying.
Buffet bearish on dollar
This is old news, but I found the March 2004 letter from Warren Buffet to Berkshire Hathaway shareholders, from which the following is excerpted. Buffet anticipated in 2002 the sentiment only now becoming conventional wisdom among US investors. However, he does note the tendency for people who bet against the US economy to get burned :-)
During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became increasingly bearish on the dollar. We have – and will continue to have – the bulk of Berkshire's net worth in US assets. But in recent years our country's trade deficit has been force-feeding huge amounts of claims on America to the rest of the world. For a time, foreign appetite for these assets readily absorbed the supply. Late in 2002, however, the world started choking on this diet, and the dollar's value began to slide against major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody's guess. They could, however, be troublesome – and reach, in fact, well beyond currency markets. As an American, I hope there is a benign ending to this problem.
Then again, perhaps the alarms I have raised will prove needless: Our country's dynamism and resiliency have repeatedly made fools of naysayers. But Berkshire holds many billions of cash-equivalents denominated in dollars. So I feel more comfortable owning foreign-exchange contracts that are at least a partial offset to that position.
During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became increasingly bearish on the dollar. We have – and will continue to have – the bulk of Berkshire's net worth in US assets. But in recent years our country's trade deficit has been force-feeding huge amounts of claims on America to the rest of the world. For a time, foreign appetite for these assets readily absorbed the supply. Late in 2002, however, the world started choking on this diet, and the dollar's value began to slide against major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody's guess. They could, however, be troublesome – and reach, in fact, well beyond currency markets. As an American, I hope there is a benign ending to this problem.
Then again, perhaps the alarms I have raised will prove needless: Our country's dynamism and resiliency have repeatedly made fools of naysayers. But Berkshire holds many billions of cash-equivalents denominated in dollars. So I feel more comfortable owning foreign-exchange contracts that are at least a partial offset to that position.
Thursday, December 23, 2004
Hedge funds or central banks?
Who is keeping long bond yields low? If it is self-interested Asian central banks, one can imagine the status quo continuing for some time. If it is hedge funds plying the carry trade, the status quo is very, very vulnerable. We noted in this previous post that hedge funds are the fourth largest holder of Treasury debt after Japan, China and the UK. In the article below it is claimed that hedge funds are more likely to be on the long end of the yield curve than foreign central banks.
From Bloomberg today: When one considers that the inflation risks are skewed to the upside, a 10-year note yield near 4 percent is puzzling. Even discounting the surge in oil prices that has boosted the year- over-year increase in the consumer price index to 3.5 percent in November, the core CPI, which excludes food and energy, is accelerating, any which way you look at it. The core CPI rose 2.2 percent in the year ended November, double the increase of a year ago.
...What happened to the higher expected yields that weren't? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can't convert them in the open market (China).
While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and privatei nvestors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased itsh oldings by 16 percent to $174.6 billion.
...The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.
``Don't make the mistake of confusing bonds with GDP futures,'' Bianco says. ``Financing rates are more important to bonds than the inflation rate.''
Easy money since the Sept. 11,2 001, terrorist attacks has encouraged ``a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,'' Bianco says, based on data from Hedge Fund Research in Chicago.
The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.
If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade's undoing. With core CPI up almost as much as the funds rate this year, there's been no change in the real cost of financing bond purchases so far.
Cheap money has been an incentive for more than leveraged trading. ``It was a big employment incentive, too,'' Bianco says. ``For hedge funds.''
From Bloomberg today: When one considers that the inflation risks are skewed to the upside, a 10-year note yield near 4 percent is puzzling. Even discounting the surge in oil prices that has boosted the year- over-year increase in the consumer price index to 3.5 percent in November, the core CPI, which excludes food and energy, is accelerating, any which way you look at it. The core CPI rose 2.2 percent in the year ended November, double the increase of a year ago.
...What happened to the higher expected yields that weren't? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can't convert them in the open market (China).
While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and privatei nvestors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased itsh oldings by 16 percent to $174.6 billion.
...The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.
``Don't make the mistake of confusing bonds with GDP futures,'' Bianco says. ``Financing rates are more important to bonds than the inflation rate.''
Easy money since the Sept. 11,2 001, terrorist attacks has encouraged ``a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,'' Bianco says, based on data from Hedge Fund Research in Chicago.
The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.
If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade's undoing. With core CPI up almost as much as the funds rate this year, there's been no change in the real cost of financing bond purchases so far.
Cheap money has been an incentive for more than leveraged trading. ``It was a big employment incentive, too,'' Bianco says. ``For hedge funds.''
Derivatives too complex for accounting?
Fannie buys mortgages. Some it repackages and sells, others it holds in its portfolio. Since borrowers can refinance and repay their mortgages early if interest rates drop, the income stream from a mortgage portfolio is hard to predict. You can think of numerous variables that might affect the refinancing rate: interest rates, level of consumer debt, employment rates, etc. Fannie wanted smooth, predictable earnings - investors would demand a risk premium for shares in a company whose earnings are volatile. CEO Franklin Raines and company smoothed earnings using derivatives to hedge the fluctuations in value of their portfolio. Or did they? Well, we don't know. And the SEC claims it won't know for a year or more as auditors go carefully over the books at Fannie. "Books" here really means software models with some intricate mathematics and questionable assumptions about stochastic interest rate fluctuations, prepayment rates, etc., etc.
At the moment we are in the dark as to whether the $8B charge Fannie will take over its incorrect use of hedge acounting reflects real losses by the company, or just lack of compliance with FAS 133. From the discussion below, taken from today's WSJ, even Raines himself (Harvard College, Rhodes Scholar, Harvard Law, former head of OMB, $40M or so in total compensation in recent years) didn't know what was going on. Who can you trust these days except a quant with a PhD?
According to people who attended the meeting, SEC officials described their findings about Fannie's accounting, which reinforced the views expressed previously by Ofheo. The biggest issue was Fannie's use of so-called hedge accounting for its derivatives, which allowed the company to spread out losses or gains over long periods. The SEC and Ofheo found that Fannie hadn't taken the steps needed to qualify for hedge accounting.
During the meeting, Mr. Raines took issue with the accounting rule for derivatives, known as FAS 133, at the center of the controversy.
"Many companies can and do comply with the rules," Donald Nicolaisen, the SEC's chief accountant, shot back, according to two participants. "Sir, hedge accounting is a privilege, not a right," he continued. "[It] is applied only under strict circumstances, and you did not comply."
Mr. Raines seemed shocked, participants say. He then asked how far off Fannie's books had been in relation to FAS 133. In response, according to one participant, Mr. Nicolaisen held up a sheet of paper and told Mr. Raines that if it represented the four corners of the rule, "you were not even on the page."
At the moment we are in the dark as to whether the $8B charge Fannie will take over its incorrect use of hedge acounting reflects real losses by the company, or just lack of compliance with FAS 133. From the discussion below, taken from today's WSJ, even Raines himself (Harvard College, Rhodes Scholar, Harvard Law, former head of OMB, $40M or so in total compensation in recent years) didn't know what was going on. Who can you trust these days except a quant with a PhD?
According to people who attended the meeting, SEC officials described their findings about Fannie's accounting, which reinforced the views expressed previously by Ofheo. The biggest issue was Fannie's use of so-called hedge accounting for its derivatives, which allowed the company to spread out losses or gains over long periods. The SEC and Ofheo found that Fannie hadn't taken the steps needed to qualify for hedge accounting.
During the meeting, Mr. Raines took issue with the accounting rule for derivatives, known as FAS 133, at the center of the controversy.
"Many companies can and do comply with the rules," Donald Nicolaisen, the SEC's chief accountant, shot back, according to two participants. "Sir, hedge accounting is a privilege, not a right," he continued. "[It] is applied only under strict circumstances, and you did not comply."
Mr. Raines seemed shocked, participants say. He then asked how far off Fannie's books had been in relation to FAS 133. In response, according to one participant, Mr. Nicolaisen held up a sheet of paper and told Mr. Raines that if it represented the four corners of the rule, "you were not even on the page."
Wednesday, December 22, 2004
Asia and America's debt trap
Martin Wolf has a nice column on the current account situation in today's Financial Times. It seems all analysts more or less agree on the figures and what has to happen for a solution to emerge. I think Wolf is crazy to think that non-Japan Asia is going to soon run large current account deficits (become net importers of capital), although I agree it is desirable both for the world and for their future development. My comments are in bold below.
Asia could solve America's debt trap
Financial Times, December 22, 2004
Structural issues on all sides:
It takes two to tango. This has been one of the twin themes of my recent columns on global current account imbalances (November 24 and December 1 and 8). The huge deficits being run by the US are the mirror image of the surplus savings of the rest of the world. But the dance is becoming ever wilder. That has been my second theme. It is necessary to call a halt before serious injury occurs. The "blame game" among policymakers is idiotic: they have created the problem together and must solve it together.
There is no disagreement on the numbers:
...How difficult would the needed adjustments be? The first step towards an answer is deciding what a sustainable US current account deficit might be. In a recent column (FT, December 15), Raghuram Rajan, the chief economist of the International Monetary Fund, argues that the US could sustain a current account deficit of 3 per cent of gross domestic product (half the current level) indefinitely. Given US potential growth, net external liabilities would stabilise at 50 per cent of GDP, against roughly 30 per cent today. Given the chronic savings surplus of Japan and several other high-income countries, such deficits and liabilities seem reasonable for the world's biggest and most dynamic advanced economy.
...Now turn to the required changes in real exchange rates. To achieve a fall in the current account deficit, at full employment, of 3 per cent of GDP, the increased domestic supply - and reduced domestic demand - for tradeable goods and services in the US would amount to about an eighth of current output in this sector. Some analysts suggest that the needed overall real exchange rate adjustment could be close to 30 per cent from the peak three years ago. This would imply a further depreciation nearly as large as the one so far.
Bretton Woods II - eventually the EU caves in?
...As economists at Deutsche Bank have argued, a new informal dollar area has emerged that contains countries that either run fixed exchange rates against the dollar (notably China) or at least intervene heavily in foreign currency markets. This new dollar area contains over half the world economy. But it will also run an overall deficit of about $260bn (£133bn) in 2004. It is not surprising the dollar area's currencies have been declining against the rest.
As the pain grows, argues Deutsche Bank, the eurozone may also embark on foreign exchange interventions and so join the informal dollar area, even in the teeth of opposition from the European Central Bank. Most of the world would then be underwriting the US external (and domestic) financial deficits. That would be a nirvana for US policymakers in the short term. But it would also postpone - and exacerbate - needed adjustments.
Asia to the rescue? Not likely soon...
...The world will only dispense with its dependence on the accumulation of mountainous US liabilities if non-Japan Asia - above all, China - play the role to be expected of the world's fastest growing and most populous countries. Continent-sized countries should not go on playing the mercantilist game of piling up reserves indefinitely.
Non-Japan Asia needs to become a large net importer of capital. Aggregate current account deficits of at least $150bn a year, in today's prices, would be very helpful. Facilitating the emergence of the efficient capital markets and dynamic consumer demand needed for this is much the highest priority in global macroeconomic policy. Such reforms not only offer the only durable escape from the US debt trap. They are also exactly the changes Asia needs for its own long-term development.
Asia could solve America's debt trap
Financial Times, December 22, 2004
Structural issues on all sides:
It takes two to tango. This has been one of the twin themes of my recent columns on global current account imbalances (November 24 and December 1 and 8). The huge deficits being run by the US are the mirror image of the surplus savings of the rest of the world. But the dance is becoming ever wilder. That has been my second theme. It is necessary to call a halt before serious injury occurs. The "blame game" among policymakers is idiotic: they have created the problem together and must solve it together.
There is no disagreement on the numbers:
...How difficult would the needed adjustments be? The first step towards an answer is deciding what a sustainable US current account deficit might be. In a recent column (FT, December 15), Raghuram Rajan, the chief economist of the International Monetary Fund, argues that the US could sustain a current account deficit of 3 per cent of gross domestic product (half the current level) indefinitely. Given US potential growth, net external liabilities would stabilise at 50 per cent of GDP, against roughly 30 per cent today. Given the chronic savings surplus of Japan and several other high-income countries, such deficits and liabilities seem reasonable for the world's biggest and most dynamic advanced economy.
...Now turn to the required changes in real exchange rates. To achieve a fall in the current account deficit, at full employment, of 3 per cent of GDP, the increased domestic supply - and reduced domestic demand - for tradeable goods and services in the US would amount to about an eighth of current output in this sector. Some analysts suggest that the needed overall real exchange rate adjustment could be close to 30 per cent from the peak three years ago. This would imply a further depreciation nearly as large as the one so far.
Bretton Woods II - eventually the EU caves in?
...As economists at Deutsche Bank have argued, a new informal dollar area has emerged that contains countries that either run fixed exchange rates against the dollar (notably China) or at least intervene heavily in foreign currency markets. This new dollar area contains over half the world economy. But it will also run an overall deficit of about $260bn (£133bn) in 2004. It is not surprising the dollar area's currencies have been declining against the rest.
As the pain grows, argues Deutsche Bank, the eurozone may also embark on foreign exchange interventions and so join the informal dollar area, even in the teeth of opposition from the European Central Bank. Most of the world would then be underwriting the US external (and domestic) financial deficits. That would be a nirvana for US policymakers in the short term. But it would also postpone - and exacerbate - needed adjustments.
Asia to the rescue? Not likely soon...
...The world will only dispense with its dependence on the accumulation of mountainous US liabilities if non-Japan Asia - above all, China - play the role to be expected of the world's fastest growing and most populous countries. Continent-sized countries should not go on playing the mercantilist game of piling up reserves indefinitely.
Non-Japan Asia needs to become a large net importer of capital. Aggregate current account deficits of at least $150bn a year, in today's prices, would be very helpful. Facilitating the emergence of the efficient capital markets and dynamic consumer demand needed for this is much the highest priority in global macroeconomic policy. Such reforms not only offer the only durable escape from the US debt trap. They are also exactly the changes Asia needs for its own long-term development.
Election eases Taiwan straits tension
Recent legislative elections in Taiwan went surprisingly well for the KMT. The pro-independence DPP and its allies only picked up a single seat. This leaves them far short of the 75% majority needed to call a referendum to modify the constitution and declare independence. It also suggests that the electorate is becoming less supportive of President Chen Shui-bian's aggressively pro-independence posture.
War between China and Taiwan, most likely resulting from a declaration of independence by Taiwan, is in my mind the single largest threat to development and growing prosperity in east Asia. The PRC government has made reunification with Taiwan a patriotic issue, and would have no choice but to react militarily to a unilateral declaration by Taiwan. The US would very likely be drawn into the conflict - which is why Washington has been bluntly warning Chen's government against any hasty action.
In a best case scenario, the status quo can continue for another decade or two, by which time China may be democratic enough that peaceful reunification can occur, embraced by both sides. In the worst case, Chinese civilization could be set back a hundred years in a conflict involving nuclear adversaries.
The last time tensions were high between Taiwan and China (during the 1996 Taiwan Presidential election), the US sailed a carrier group through the Taiwan strait with impunity. That would be a risky move now, given China's purchase of kilo-class quiet submarines from Russia, and advances in PLA missile technology.
War between China and Taiwan, most likely resulting from a declaration of independence by Taiwan, is in my mind the single largest threat to development and growing prosperity in east Asia. The PRC government has made reunification with Taiwan a patriotic issue, and would have no choice but to react militarily to a unilateral declaration by Taiwan. The US would very likely be drawn into the conflict - which is why Washington has been bluntly warning Chen's government against any hasty action.
In a best case scenario, the status quo can continue for another decade or two, by which time China may be democratic enough that peaceful reunification can occur, embraced by both sides. In the worst case, Chinese civilization could be set back a hundred years in a conflict involving nuclear adversaries.
The last time tensions were high between Taiwan and China (during the 1996 Taiwan Presidential election), the US sailed a carrier group through the Taiwan strait with impunity. That would be a risky move now, given China's purchase of kilo-class quiet submarines from Russia, and advances in PLA missile technology.
Tuesday, December 21, 2004
Morgan Stanley Global Economic Forum
They've outdone themselves with a lengthy year end report covering, well, the whole world. Thanks to Brad Setser's and Brad DeLong's blogs for the pointer.
Given the cautionary perspective of Stephen Roach (Morgan Stanley) and other well-known economists, I am amazed that (a) implied vol is at a multi-year low and (b) long bond yields are so low. The latter can perhaps be explained by foreign central bank buying (and hedge funds plying the carry trade), but why are equity markets so sanguine about the coming year? Perhaps there are structural forces at work there as well? Will realized vol in the coming year be much higher than the market is currently predicting?
Roach: Finally, the US also needs a further weakening of the dollar, in my view. On a broad trade-weighted basis, the dollar’s real effective exchange rate is down about 15% from its early 2002 peak. This is a relatively small decline for a US with a current account deficit that is expected to rise to at least 6.5% of GDP over the next year. Back in the latter half of the 1980s, when the current account deficit peaked at 3.5%, the broad dollar index fell about 30% in real terms. In other words, America today has a current-account problem that is almost twice as bad as it was in the 1980s but a dollar that has fallen only about half as much. For that simple reason, alone, I would argue that the dollar has at least another 15% to go on the downside. While a weaker dollar will not alleviate America’s imbalances, it could well trigger the interest rate adjustments that might — especially since the current-account conundrum means that marginal changes in US rates are increasingly in the hands of America’s overseas creditors.
A spike in interest rates would definitely cause an equities crash. Roach should put his money where his mouth is and buy SP puts - or at least advise his clients to!
Given the cautionary perspective of Stephen Roach (Morgan Stanley) and other well-known economists, I am amazed that (a) implied vol is at a multi-year low and (b) long bond yields are so low. The latter can perhaps be explained by foreign central bank buying (and hedge funds plying the carry trade), but why are equity markets so sanguine about the coming year? Perhaps there are structural forces at work there as well? Will realized vol in the coming year be much higher than the market is currently predicting?
Roach: Finally, the US also needs a further weakening of the dollar, in my view. On a broad trade-weighted basis, the dollar’s real effective exchange rate is down about 15% from its early 2002 peak. This is a relatively small decline for a US with a current account deficit that is expected to rise to at least 6.5% of GDP over the next year. Back in the latter half of the 1980s, when the current account deficit peaked at 3.5%, the broad dollar index fell about 30% in real terms. In other words, America today has a current-account problem that is almost twice as bad as it was in the 1980s but a dollar that has fallen only about half as much. For that simple reason, alone, I would argue that the dollar has at least another 15% to go on the downside. While a weaker dollar will not alleviate America’s imbalances, it could well trigger the interest rate adjustments that might — especially since the current-account conundrum means that marginal changes in US rates are increasingly in the hands of America’s overseas creditors.
A spike in interest rates would definitely cause an equities crash. Roach should put his money where his mouth is and buy SP puts - or at least advise his clients to!
More brain drain slowdown
We've been shooting ourselves in the foot with misguided security restrictions since 9/11. This article mentions some nutty screening process called "Visa Mantis" (probably Homeland Security), which delays entry to many Chinese students studying science and engineering.
NY Times: ...Foreign students contribute $13 billion to the American economy annually. But this year brought clear signs that the United States' overwhelming dominance of international higher education may be ending. In July, Mr. Payne briefed the National Academy of Sciences on a sharp plunge in the number of students from India and China who had taken the most recent administration of the Graduate Record Exam, a requirement for applying to most graduate schools; it had dropped by half.
Foreign applications to American graduate schools declined 28 percent this year. Actual foreign graduate student enrollments dropped 6 percent. Enrollments of all foreign students, in undergraduate, graduate and postdoctoral programs, fell for the first time in three decades in an annual census released this fall. Meanwhile, university enrollments have been surging in England, Germany and other countries.
NY Times: ...Foreign students contribute $13 billion to the American economy annually. But this year brought clear signs that the United States' overwhelming dominance of international higher education may be ending. In July, Mr. Payne briefed the National Academy of Sciences on a sharp plunge in the number of students from India and China who had taken the most recent administration of the Graduate Record Exam, a requirement for applying to most graduate schools; it had dropped by half.
Foreign applications to American graduate schools declined 28 percent this year. Actual foreign graduate student enrollments dropped 6 percent. Enrollments of all foreign students, in undergraduate, graduate and postdoctoral programs, fell for the first time in three decades in an annual census released this fall. Meanwhile, university enrollments have been surging in England, Germany and other countries.
Monday, December 20, 2004
Digital mania
It's boom times in the $10B per year videogame industry, which is now comparable in size to the film industry. (US box office receipts are about $9B, but worldwide box office plus DVD/VCR revenues total about $20B.) Development costs for sophisticated games now reach $10-20M, which, while only a fraction of the $100M cost of a Hollywood blockbuster, is easily enough capital for most tech startups to develop a software product and bring it to market.
$125 million: Value of total sales for the first 24 hours of Halo 2
$114 million: Opening-weekend gross for "Spider-Man," a Hollywood record
On a related note, Pixar is the most successful movie studio of the last decade, with a perfect 100% record of hits, earning $3B in revenues. Not bad for a company Steve Jobs paid only $10M for in 1986! The technical infrastructure created at Pixar is very impressive - for example, the ability to produce the water effects in Nemo required solving a number of challenging numerical simulation problems. Their campus in Emeryville, CA is nice, too!
$125 million: Value of total sales for the first 24 hours of Halo 2
$114 million: Opening-weekend gross for "Spider-Man," a Hollywood record
On a related note, Pixar is the most successful movie studio of the last decade, with a perfect 100% record of hits, earning $3B in revenues. Not bad for a company Steve Jobs paid only $10M for in 1986! The technical infrastructure created at Pixar is very impressive - for example, the ability to produce the water effects in Nemo required solving a number of challenging numerical simulation problems. Their campus in Emeryville, CA is nice, too!
Sunday, December 19, 2004
Brain drain slowdown
It used to be the case that almost all world class researchers in Asia were trained in the US, Europe or Japan. Lately I've begun to meet scientists whose PhDs were earned in China, Korea and Taiwan who are nonetheless at the cutting edge of research. It is becoming more common for the some of the most talented students to stay at home at leading institutions such as Tsinghua (Beijing) or Seoul National University or Taiwan National University (Taipei). Looking at undergraduate degrees, China already produces vastly more engineers than the US - some estimates say three times as many per year.
China tech segmentation
WSJ: Already in China it's possible to detect regional technology centers and competition for workers, similar to the rivalry between Silicon Valley, Boston and Seattle in the U.S.
Southern China's Guangdong province, dominated by the cities of Guangzhou and Shenzhen, is the center of most TV, stereo and computer assembly. Meanwhile, the city of Suzhou, not far from Shanghai, is home to a lot of notebook PC production, notably many of the operations of Taiwan's giant contract manufacturers.
A group of telecom-equipment makers is based in Hangzhou, which is also along the central coast near Shanghai. The country's biggest homegrown chip maker, Semiconductor Manufacturing International, is farther north in Tianjin, near Beijing, in facilities originally built by Motorola. Meanwhile, both Motorola and Intel are way out in the western city of Chengdu. They're taking advantage of access to engineering universities that for years offered support to the country's military contractors, located there by the government in the belief they would be insulated from attack.
Southern China's Guangdong province, dominated by the cities of Guangzhou and Shenzhen, is the center of most TV, stereo and computer assembly. Meanwhile, the city of Suzhou, not far from Shanghai, is home to a lot of notebook PC production, notably many of the operations of Taiwan's giant contract manufacturers.
A group of telecom-equipment makers is based in Hangzhou, which is also along the central coast near Shanghai. The country's biggest homegrown chip maker, Semiconductor Manufacturing International, is farther north in Tianjin, near Beijing, in facilities originally built by Motorola. Meanwhile, both Motorola and Intel are way out in the western city of Chengdu. They're taking advantage of access to engineering universities that for years offered support to the country's military contractors, located there by the government in the belief they would be insulated from attack.
Employee stock options and efficient markets
The FASB (Federal Accounting Standard Board) has decided that companies must count employee stock options (ESOs) as an expense on their balance sheets. This policy is of course eminently sensible (so agrees Warren Buffet), since ESOs dilute the value of pre-existing shares in the company. However, thanks to lobbying on the part of Silicon Valley and tech companies in general, ESOs have been off balance sheet until now.
Of course, a believer in (anything but the weakest version of) the efficient markets hypothesis would claim that whether or not ESOs are included in reported earnings is of no consequence, since they do already appear in the text of every public company's quarterly report. (Surely any rational, intelligent investor reads the text of quarterly statements? ;-) But pretty much every tech CEO and VC has been predicting imminent destruction of our marvelous innovation engine due to expensing of ESOs, so I guess they don't believe in efficient markets.
There are some technical issues to be addressed here. How should accountants value ESOs? One could plug the historical vol of the issuing company into the Black-Scholes model, but the timescale of the ESOs (usually one to several years) is much longer than the period over which one usually trusts historical vol. Also, many employees leave the company before their options vest, letting companies recover part of the value, which means employee attrition rates have to be part of any model. I see a consulting opportunity here for quants who want to help CFOs and accountants with this problem :-) I also see a further reduction in the quality (reliability) of the earnings numbers that we investors have to rely on.
Of course, a believer in (anything but the weakest version of) the efficient markets hypothesis would claim that whether or not ESOs are included in reported earnings is of no consequence, since they do already appear in the text of every public company's quarterly report. (Surely any rational, intelligent investor reads the text of quarterly statements? ;-) But pretty much every tech CEO and VC has been predicting imminent destruction of our marvelous innovation engine due to expensing of ESOs, so I guess they don't believe in efficient markets.
There are some technical issues to be addressed here. How should accountants value ESOs? One could plug the historical vol of the issuing company into the Black-Scholes model, but the timescale of the ESOs (usually one to several years) is much longer than the period over which one usually trusts historical vol. Also, many employees leave the company before their options vest, letting companies recover part of the value, which means employee attrition rates have to be part of any model. I see a consulting opportunity here for quants who want to help CFOs and accountants with this problem :-) I also see a further reduction in the quality (reliability) of the earnings numbers that we investors have to rely on.
Saturday, December 18, 2004
Contrarian macro numbers
Here are some numbers suggesting the US current account deficit is sustainable. They come from a 10/31 FT article by Richard Cooper, Harvard economics prof and former undersecretary of state for economic affairs.
Cooper assumes a continuing US account deficit of $500B, which is 5% of current GDP. (This year it is a bit bigger - at 6%, but going forward $500B is not implausible.) If US nominal GDP growth is 5% (3% real + 2% inflation), the fraction of US assets owned by foreigners as a consequence of the account deficit will rise over the years (due to payments), but not unsustainably.
From the rest of the world's point of view, the numbers are also not necessarily alarming. The ex-USA world produces $6 trillion per year in savings, so the account deficit means the US absorbs 10% of savings from other countries. Let's think about this a bit - if US GDP is $10 trillion, then ex-USA GDP is $30 trillion, so $6 trillion represents a world ex-USA savings rate of 20%. This seems a bit high to me (although the savings rate in China is reported as 40%!), but is confirmed by this Morgan Stanley report (How Depleted is the Global Savings Base?): ... the deterioration in the US C/A has been matched by an even larger accumulation of overseas savings. As a result, the US now absorbs a smaller share of the rest of the world’s savings compared to the historical trend. A related figure, which is often reported, is that the US account deficit absorbs almost 80% of foreign trade surpluses (usually the reports confuse foreign savings and foreign trade surpluses). Now, the US is 25% of the world economy, has 50% of marketable financial assets, and higher economic growth rates than either Europe or Japan, making it a desirable destination for investment. So perhaps absorbing 10% of foreign savings is sustainable. A portfolio manager might advise foreign investors to place at least that amount in US assets each year.
From this macro perspective, a meltdown is not inevitable. However, investor sentiment is a tricky thing. If foreigners become convinced that the dollar must decline in the coming years, they are unlikely to allocate 10% of their savings to US investments, even if we are a large and relatively dynamic component of the world economy.
Cooper assumes a continuing US account deficit of $500B, which is 5% of current GDP. (This year it is a bit bigger - at 6%, but going forward $500B is not implausible.) If US nominal GDP growth is 5% (3% real + 2% inflation), the fraction of US assets owned by foreigners as a consequence of the account deficit will rise over the years (due to payments), but not unsustainably.
From the rest of the world's point of view, the numbers are also not necessarily alarming. The ex-USA world produces $6 trillion per year in savings, so the account deficit means the US absorbs 10% of savings from other countries. Let's think about this a bit - if US GDP is $10 trillion, then ex-USA GDP is $30 trillion, so $6 trillion represents a world ex-USA savings rate of 20%. This seems a bit high to me (although the savings rate in China is reported as 40%!), but is confirmed by this Morgan Stanley report (How Depleted is the Global Savings Base?): ... the deterioration in the US C/A has been matched by an even larger accumulation of overseas savings. As a result, the US now absorbs a smaller share of the rest of the world’s savings compared to the historical trend. A related figure, which is often reported, is that the US account deficit absorbs almost 80% of foreign trade surpluses (usually the reports confuse foreign savings and foreign trade surpluses). Now, the US is 25% of the world economy, has 50% of marketable financial assets, and higher economic growth rates than either Europe or Japan, making it a desirable destination for investment. So perhaps absorbing 10% of foreign savings is sustainable. A portfolio manager might advise foreign investors to place at least that amount in US assets each year.
From this macro perspective, a meltdown is not inevitable. However, investor sentiment is a tricky thing. If foreigners become convinced that the dollar must decline in the coming years, they are unlikely to allocate 10% of their savings to US investments, even if we are a large and relatively dynamic component of the world economy.
Friday, December 17, 2004
Fed model reconsidered
The Fed model for equity valuation compares the E/P of stocks to the 10yr yield on Treasurys. The usual justification is that stocks and bonds are competing asset classes, and one should compare their future cash flows to obtain a relative valuation. When yields on bonds are low, investors will tolerate a lower E/P (or higher P/E) in equities. One subtlety here is future inflation, which seems to "pass through" to corporate earnings, but erodes the real returns on bonds. While E/P might be a plausible forecast of future real corporate cashflows, the 10yr yield is only in nominal dollars. Perhaps it would be better to substitute the 10yr yield on TIPS for the bond component.
I found some interesting analysis of the Fed model (and the following figures) in this paper by C. Asness. Figure 2 shows that the Fed model has been quite successful over the last 30 years, but not for earlier periods. I had always thought this discrepancy was explained by inflation - the Fed model was successful in the recent period when inflation was perceived to be under control (i.e., post Volcker). Asness has a different take. He fits E/P = a + bY + c v_s / v_b where Y is the bond yield, v_s the trailing 20y stock volatility and v_b the trailing 20y bond volatility, reasoning that the relative perceived vols will affect the attractiveness of stocks vs bonds. The result, shown in Figure 4, is quite nice. The best fit value of b is close to 1 (similar to the Fed model), and since the trailing 20y vol is by definition slowly varying, it seems the Fed model is not a bad rule of thumb for current valuation.
I found some interesting analysis of the Fed model (and the following figures) in this paper by C. Asness. Figure 2 shows that the Fed model has been quite successful over the last 30 years, but not for earlier periods. I had always thought this discrepancy was explained by inflation - the Fed model was successful in the recent period when inflation was perceived to be under control (i.e., post Volcker). Asness has a different take. He fits E/P = a + bY + c v_s / v_b where Y is the bond yield, v_s the trailing 20y stock volatility and v_b the trailing 20y bond volatility, reasoning that the relative perceived vols will affect the attractiveness of stocks vs bonds. The result, shown in Figure 4, is quite nice. The best fit value of b is close to 1 (similar to the Fed model), and since the trailing 20y vol is by definition slowly varying, it seems the Fed model is not a bad rule of thumb for current valuation.
Historical volatility smile
Thursday, December 16, 2004
Fannie Mae derivatives accounting
I posted on this some time ago. Fannie Mae, the largest buyer of home mortgages, has been ordered to restate earnings over the last four years, which will force it to recognize a $9B loss by marking the value of its derivatives portfolio to market.
WSJ: Fannie and Freddie, whose shares are traded on the New York Stock Exchange, were chartered by Congress to pump money into the housing market. They both buy mortgages from banks and other lenders, holding some of those loans on their books and selling others in the form of securities to investors.
Both companies' rapid growth has been fueled by the investing public's longstanding belief that the federal government would bail out the two enterprises if they ever ran into solvency problems. Federal Reserve officials in recent years have tried to quash such notions, though with little success. And today, the companies continue to enjoy far lower costs of capital than other financial institutions and are held to much looser capital requirements than commercial banks or dealers in government bonds. They currently have combined debt outstanding of around $1.7 trillion, about a third of it owed to foreign central banks and other overseas investors.
...The findings concern accounting rules known as Financial Accounting Standards 133 and 91. FAS 133 sets requirements for booking gains and losses on derivative contracts, which Fannie uses heavily to hedge against swings in interest rates. In accounting for those derivative contracts, both the SEC and Ofheo found, Fannie incorrectly applied the rules in a way that allowed it to spread out losses over many years rather than booking them immediately. Fannie used its own methodology to determine that it qualified for so-called hedge accounting, which would have allowed it to spread out losses. But the SEC said Fannie didn't take the steps necessary to qualify for hedge accounting.
Fannie is increasingly holding a lot of mortgages in its portfolio (rather than just reselling them), exposing it to huge interest rate risks. I never felt confident they were hedging properly against these risks - hedge funds in this business blow up all the time. There are implications for the dollar as foreign central banks (particularly PBOC) have been buying a lot of agency debt (Fannie, Freddie). Franklin Raines is toast. Stay tuned for more...
WSJ: Fannie and Freddie, whose shares are traded on the New York Stock Exchange, were chartered by Congress to pump money into the housing market. They both buy mortgages from banks and other lenders, holding some of those loans on their books and selling others in the form of securities to investors.
Both companies' rapid growth has been fueled by the investing public's longstanding belief that the federal government would bail out the two enterprises if they ever ran into solvency problems. Federal Reserve officials in recent years have tried to quash such notions, though with little success. And today, the companies continue to enjoy far lower costs of capital than other financial institutions and are held to much looser capital requirements than commercial banks or dealers in government bonds. They currently have combined debt outstanding of around $1.7 trillion, about a third of it owed to foreign central banks and other overseas investors.
...The findings concern accounting rules known as Financial Accounting Standards 133 and 91. FAS 133 sets requirements for booking gains and losses on derivative contracts, which Fannie uses heavily to hedge against swings in interest rates. In accounting for those derivative contracts, both the SEC and Ofheo found, Fannie incorrectly applied the rules in a way that allowed it to spread out losses over many years rather than booking them immediately. Fannie used its own methodology to determine that it qualified for so-called hedge accounting, which would have allowed it to spread out losses. But the SEC said Fannie didn't take the steps necessary to qualify for hedge accounting.
Fannie is increasingly holding a lot of mortgages in its portfolio (rather than just reselling them), exposing it to huge interest rate risks. I never felt confident they were hedging properly against these risks - hedge funds in this business blow up all the time. There are implications for the dollar as foreign central banks (particularly PBOC) have been buying a lot of agency debt (Fannie, Freddie). Franklin Raines is toast. Stay tuned for more...
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