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.”

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.

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.

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.”

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?)

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.

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.

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.”

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 got this by 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.”

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.