Marking To Mister Market
New York, and most of the rest of the eastern seaboard, felt the brunt of the storm today, leading to somewhat lethargic trading and drying up the news wires somewhat. The S&P closed -0.2%, although the 10y note contract dropped 10.5 ticks. Treasuries were weak mainly because lower prices were necessary to move $25bln in 10y note issuance to a thinner market; fortunately for the Treasury, the snow didn’t really arrive in New York until mid-day and the auction was no problem (although the results were a little soft compared to the norm). Bonds tomorrow! $16bln of big-duration stuff, but at least the sturm (if not the drang) should be behind us by then.
Bernanke didn’t speak today, but his testimony was released anyway and it contained unveiled hints that the Fed might someday seek to tighten monetary policy. Clearly, before the FOMC even considers tightening policy (right before a 10% tax hike next year when the Bush cuts expire) they must prepare the market for the eventuality. That will take time, and so it isn’t surprising to see him starting to hint about raising the discount rate, for example, which has only symbolic significance most of the time (moreover, since technically the regional Fed Presidents request an increase or decrease in that rate, it is a good place for Bernanke to yield – no pun intended – some rhetorical ground to the hawkish Members from the regional banks without actually doing anything important to restrict monetary liquidity. Indeed, the Chairman went out of his way to state that these changes “should not be interpreted as signaling any change in the outlook for monetary policy.”
I also saw that Bernanke said the Fed doesn’t expect losses on Bear and AIG: “The Board continues to anticipate that the Federal Reserve will ultimately incur no loss on these loans as well.” Unless my memory is faulty, I believe they have already experienced losses on Maiden Lane. The use of the word “ultimately” seems to suggest that he recognizes that there is a (pretty sizable) mark-to-market loss, but he thinks the securities in question will ultimately pay off. Those of us who are traders recognize this non-trader mindset. The current price is the best estimate of the value. While there may be occasional differences in the net present value of expected future cash flows (value) compared to the market price, especially for large positions where liquidity discounts are applicable, it is very dangerous to hold a position that one feels is “worth more” than Mr. Market is paying for it, because you think it will come back. The Chairman, of course, is an economist and not a trader, which is one reason why the Federal Reserve was never supposed to take trading positions.
Why Capitalism Should Be Preserved
Not that capitalism needs me to defend it, but I find the populist message, that the fat cats at the top are ripping off the little guy, to be as tiresome as I think most of us do by now…even those of us who are little guys! We recognize it (while having some element of truth, to be sure, as most slanders do) as an argument designed to preserve a certain power structure that doesn’t involve fat cats or little guys, but fat little guys (the ones on Capitol Hill). But it is dangerous to attack the heart of the capitalist system, which is the concept that people who take risks may be rewarded.
I think most people focus on the “reward” part of this equation, but the reward – and the redistribution of wealth it implies – is there merely to induce people to take risks. And most folks have only a visceral concept of why some level risk is good for the system.
Not only that, a system that cultivates risk-taking is better for the little guy than it is for the big guy. You may think of an option analogy if you like: if you have a deep-in-the-money call option, you don’t want volatility because it may push you out-of-the-money; if you have a deep-out-of-the-money option, then volatility is good because it may push you into-the-money.
Let me illustrate this with a little simulation. I created a 1000-person population consisting of people whose initial endowment (wealth) is a normal distribution around $75,000, with a $100,000 standard deviation. That is, if you’re in this population and you are 3-standard-deviations wealthy, you start with 3 * 100,000 + 75,000 = $375,000. The minimum wealth is $0, since folks can always declare bankruptcy and have nothing. (n.b.: probably the distribution should be lognormal rather than truncated normal, but give me some slack for the purposes of illustration).
You can imagine everyone standing in a line, from poorest to richest. The poorest is someone with $0, at the 0th percentile; the richest is somewhere up there around $450,000 at the 100th percentile. But here is where it gets interesting.
I now subject each “person” to 30 random shocks of random size (standard deviation $20,000). Think of it as everyone having one “lucky” event per year – some of them lead to more money, some of them lead to less money; of course, we still have a $0 floor (and that’s important! Bankruptcy, as opposed to indentured servitude, is an absolute must in a capitalist society, which is one reason that the indentured servitude that bank employees are being forced to endure, for the sins of prior bank employees, is such a bad idea).
Before you look at the result below, consider whether you like this system if you are a fat cat, or if you are a little guy. If you are a fat cat, bad luck stands a far greater chance of hurting your position in society than good luck stands to hurt it. And if you’re a little guy…well, as Dylan said, ‘when you got nothin’, you got nothin’ to lose.’ So the result over time is that there is a lot of mixing of little guys and fat cats…fat cats who become little guys, and little guys who become fat cats. Now look at the chart, which shows each of those people standing in line where he started, but the height of the bar indicates what percentile he finished in. That is, the guy on the far left was at 0%, but many of these folks moved into 30%, 50%, even 80% percentiles! Most of the fat cats are okay, but even the ones on top slipped some.
Another way, perhaps a better way, to look at the mixing is shown below: the guys in green are the fat cats who started in the top quintile (80% and above), the guys in the reddish color are the little guys from the bottom quintile (20% and below). Look at how spread out both groups have become.
And note, by the way, that I am ignoring that many of the little guys are little because they are young, and likely to be moving up (and having more chances for luck over longer remaining lives) anyway. This is just the result of random mixing.
Now here’s the key point: I have done nothing to transfer the wealth from fat cats to little guys. The process was completely random, and the overall wealth of the population is roughly the same (slightly higher since I assumed anyone with sub-zero wealth defaulted back to 0, and there is no offsetting drain for that gain). That sort of mix happens, and it is powerful over time.
If I want a more egalitarian society, I want one in which that guy on the left has a chance to get to be the guy on the right, not one in which the guy on the left and the right meet in the middle. The reason I want this is because it is the little guy trying to be a fat cat who becomes Bill Gates. Okay, bad example because Windows sucks, but you get the point. Even a sucky Windows is better than paper and pencil.
So why not take this natural mixing and “augment” it with some involuntary wealth redistribution? The key input that determines the degree of mixing is the standard-deviation assumption I used above. That is, the riskier are individual decisions, the more society will mix. Will a too-risky society mean that no one takes risks? Not at all. The people at the bottom have nothing to lose. At some point, the people at the top might not take risks, but the people at the bottom should like that shot at the brass ring (which is why they are overrepresented among lottery ticket buyers). At some point, I suppose a society that is too risky becomes a society in chaos…but south of that point, more risk is good.
But if government redistributes wealth too much, the motivation to take risks is lessened, since the people at the top are having their “cushion of safety” taken away while the people at the bottom don’t need to take any risks to improve. Simply put: the more redistribution you have, the lower the standard-deviation (the smaller the risks people take). The combination may or may not result in more inter-quantile mixing, but it sure as heck means that the wealth of the population as a whole – the pie that ends up getting shared – is smaller.
On Thursday, the only economic data of note is Initial Claims at 8:30 ET (Consensus: 467k from 480k). Claims has certainly been more interesting of late as it has turned higher; the original explanation, that California needed to catch up with filings after being short-staffed during the holidays, turned out not to explain the next week’s rise (the state-by-state explanations are released with a one-week lag), and probably not last week’s either. While the Employment numbers were encouraging, that is only because of where we have been before. Without further improvement in Initial Claims, the Unemployment Rate will stay stubbornly high.