Saving Greece vs. The Finance Bailout

A lot of people seem to think that the way to save Greece is to treat them the same way financial companies were treated after the fall of Lehman Brothers, by giving them temporary freedom from the market. With financials, the freedom from the market was given in numerous ways.

  1. The discount rate was lowered to give banks access to funds at lower interest rates
  2. The Federal Reserve provided short term liquidity to banks by increasing the term of overnight loans to 90 days, creating the Term Auction Facility to allowed banks to borrow Treasuries against less liquid paper.
  3. Market participants were not allowed to be short financial companies for a period of time.
  4. TARP gave money to banks at rates better than they could get on the open market.
  5. Changes in accounting rules allowed banks to avoid reporting their losses.
  6. Banks could exit their AIG trades at favorable marks, giving them free money.

Since this seemed to work for the financial crisis, many of the same ideas are still around for dealing with Greece’s problem.  For one thing, there are people calling for the heads of speculators betting against Greek bonds by buying credit default swap protection on Greek bonds that they do not own.  Now, it looks like an aid package is going to be passed after the IMF and Greece work out a three year program. The main idea is to prevent Greece from having to go to the markets.  They are trying to get the package resolved before some Greek bonds mature on May 19th.  Once the package is resolved, the hope is that Greece won’t have to go back to the market for three years; the whisper number is that 120 to 150 billion Euros will be lent to Greece. The idea is that Greece will fix itself without having to deal with excess pressure from the market that raises their debt interest payments and drives them into a deeper hole.

Using the financial companies as a template for fixing Greece misses a fundamental difference: Greece is producing a large deficit while finance companies were profitable despite their insolvency. Protecting banks from the market worked because the banks could earn their way out of the hole that they were in. In some respects they were more profitable than normal because two of their competitors, Bear Stearns and Lehman Brothers, were basically taken out of the market so the illiquidity of the market provided huge rents to established market makers.  Greece is in the opposite situation. It is losing money and its GDP will take a large hit after austerity measures are implemented. Without a crisis to spur them on, it is questionable whether or not the unions will stop striking. When some of these unions include tax collectors, the Greek fiscal situation is only going to deteriorate further once the bailout puts the immediate crisis on hold.

Greece is still going to be in trouble, but maybe in the three years without a bailout the European banks holding Greece’s debt can earn enough money to prevent the inevitable default from driving them into bankruptcy.  More worrisome, if Greece’s situation doesn’t improve this could be bad for Portugal, Ireland and Spain. Their cost of funding is rather correlated to Greece’s CDS spread, especially for Portugal. If Greece’s CDS spreads get worth then their funding costs continue to go up and there is a possibility of a negative reflexivity loop where their cost of funding goes up so their fundamentals go down which causes their funding costs to go up and so on.

More on Dividends and Capital Gains Taxes

Earlier I suggested that high dividend stocks might outperform low dividend stocks in the wake of capital gains tax increases. This analysis didn’t properly account for changes to the dividend tax rate. According to the Wall Street Journal, the Senate Budget Committee passed a fiscal 2011 budget resolution that includes plans to raise the top tax rate on dividends to 39.6% from 15%.  Adding on the 3.8% surcharge on investment income from the health care bill raises the top rate to 43.4%. This change would completely counter any relative benefits high dividend stocks get from a higher capital gains tax.

Looking at the American Human Development Index

Bryan Caplan points his readers towards the intra-US Human Development Index. This Human Development Index is a measure that gives equal weight to life expectancy, educational attainment/school enrollment and median earnings.  Bryan Caplan’s critique of the very similar international version of the HDI is that it gives far too much weight to the educational measure and far too little weight to measures of GDP, which can only contribute a fixed amount to the scale.  With this fixed scale, rich countries are unable to improve their HDI scores via getting richer, even though this would obviously improve the lives of the population.  There are also good arguments against the absolute level of school enrollment being correlated to quality of life past a certain point. When looking at the international HDI Bryan Caplan concludes 

Scandinavia comes out on top according to the HDI because the HDI is basically a measure of how Scandinavian your country is.

However, the breakdown of the USA HDI is rather interesting. For one thing, we see that Asians consistently outperform Whites, who outperform African Americans and Latinos. Both of these groups are generally ahead of Native Americans. The report gives a breakdown of how well each ethnicity is doing in each state.

For Asians: The highest index score is for Asians in New Hampshire, the lowest Asian score is for those in Louisiana.

Potential Reasons: New Hampshire is relatively wealthy, and yet is less likely to be a first destination for immigrants to the extent of other states such as California and New York. The high score of Asians here might be a measure of second generation Asian success when the averages aren’t brought down by new immigrants. The low score in Louisiana is probably because it is relatively poor and potentially more likely to be racist.

For Latinos: They score highest in New Jersey and the lowest in Alabama.

Potential Reasons: New Jersey has a relatively high amount of non-Mexican Hispanics as well as a large Hispanic population relative to the population, which may bring up the average score of Latinos in this state. In Alabama, already a relatively poor state from a per capita perspective, there is a particularly low ratio of Hispanics in the population and many of them are both young and Mexican, lowering their average score.

For African Americans: The highest score is in Maryland and the lowest score is in Louisiana.  The African Americans with a job in Washington DC might be likely to be living in Maryland, which would raise the pay and educational attainment of the average population.

Native Americans: They score highest in California and lowest South Dakota.

Potential Reasons: South Dakota is not relatively wealthy or much of a tourist destination to begin with and the city of Deadwood legalized gambling, which competes with Indian casinos.

For Whites: The highest White score is for those in Washington D.C. while the score is lowest in West Virginia.

Potential Reasons: Washington D.C. has a large amount of government jobs which both pay more than private sector jobs and employ a large amount of people with humanities PhD’s, which are not highly valued outside of academia or governmental type agencies. This raises their median earnings score and their educational attainment score. Education is correlated to longevity, so this score is higher too, though educational attainment is the main outlier. The relatively large amount of colleges in D.C. should also help the scores. West Virginia has historically been the home to poor whites

More on Greece and the Markets

Greece’s troubles are getting worse, as S&P downgraded their rating to junk. Given that I’ve previously looked at the impact of Greece’s troubles on markets, I thought I would update some of the charts to see if the relationships still hold.

 

At the epicenter of the crisis, the Greek stock exchange has been massively hit by Greek troubles. The National Bank of Greece, now the second largest component of the index (Having fallen behind the Coca Cola Hellenic Bottling Company), has fallen almost 45% year to date.  There are many reasons for investors in Greek banks to be worried. First, these banks tend to hold a lot of Greek debt, which has been rapidly falling in value. Greek bonds with a duration of 10 years have seen their face value fall over 20% in the past two months alone.  Second, the tail risk of Greece leaving the Euro is becoming less tail and more real. If Greece leaves the Euro, there will almost certainly be bank runs on Greek banks as depositors try to prevent their accounts from being devalued.  Finally, even if crisis is averted it will be due to the imposition of extreme austerity measures by the Greek government. Cuts in spending and tax hikes will depress the economy and hurt the earnings of all Greek companies, including financial institutions.

Greek CDS & Athens Stock Exchange

 

The relationship between the S&P 500 vs. Eurostoxx in dollars seems to be holding up quite well. The euro has also been taking quite a hit.

Greek CDS & SPX/Eurostoxx (USD) & USD/EUR

 

When looking into which sectors should be most effected, banks seem like the obvious choice.  European banks should be hit harder than US banks for a few reasons. [Edit: The most obvious reason European banks hold more Greek debt than US banks is that banks can repo the bonds of European Sovereigns with the ECB.]  Due to home bias, European banks have larger investments in Greek bonds than US Banks. Home bias doesn’t quite explain their larger holdings; they also have a search for yield mentality. This search for yield is part of why European banks were buying subprime bonds from Goldman Sachs (Although IKB was also betting on the housing market going up in 2007), and this is why they currently hold a lot of Greek debt. According to BIS estimates provided by the Economist, the non-Greek euro area Banks own approximately 58% of the total outstanding Greek debt held by foreigners while US banks only own 5.3%. Since these banks are still recovering from the last financial crisis, the impact of a Greek credit event could be devastating.

S&P 500/Eurostoxx (USD), US Banks/Euro Banks (USD) and USD/EUR

Young Academic Creativity

Max Planck said “Science advances one funeral at a time.” He was implying that older scientists are too tied to the status quo to accept evidence challenging the view of the world that they helped shape. This means that younger scientists are often the key to advancing the frontier of knowledge, so I was very interested in the Core Economics blog post on youth creativity along with their links to an interesting WSJ journal article on the declining scientific productivity of younger scientists and a related paper on science policy by Benjamin F. Jones. 

The WSJ article highlights the inverted U of productivity, where a person’s creative productivity peaks sometime between the ages of 25 and 50.  For physicists, mathematicians and poets, the age of peak productivity has historically been closer to 25 than 50 as fluid intelligence peaks earlier.  For biologists, historians, philosophers and novelists, the peak age may be closer to 50 than 25, as crystallized intelligence is more important than fluid intelligence in these fields.  The current NIH grant system tends to give grant money to established scientists, which some worry means that many scientists are getting money only when they above the historic age of peak productivity causing the relative productivity of younger scientists to drop. 

In the paper, “As Science Evolves, How can Science Policy?” Benjamin Jones tries to paint these changes as a natural reaction to the changing state of the process of science and thus as nothing to be alarmed about. His main point is that a scientific advancement pushes forward the boundaries of knowledge, the natural result is for scientists to be more productive later in life and to be more productive in teams as each member can contribute their specialized knowledge. He is not worried as much about whether or not the grey ceiling and bureaucracy in academia is preventing progress, but sees progress by on average older people and teams as confirmation that the frontier of knowledge is harder to reach.

It is very possible that the expanding frontier of knowledge is making science more difficult for younger people, but the knowledge barrier might not be scientific but social and political.  The evidence presented in the paper can be used to suggest that the bureaucratic obstacles are getting more difficult to navigate. The first place the paper looked at was the increasing age of noble prize winning scientists’ first great achievement and inventors’ first parents.  Both of these have increased since 1900.  Both of these may be due to an increased cost in money rather than time to get to the frontier of knowledge.  Advances in the frontier often put specialized tools farther outside the reach of amateurs. More recently, it may be due to the lack of personal control many scientists who depend on grants have over their research until they get their own grants and labs at a later age.

The paper also focused on evidence of the increased effectiveness of teamwork. Rather than a sign of scientific specialization, increased teamwork can be a sign that certain people are specializing in some aspect of the bureaucratic process. (The paper also shows that between 1975 and 1993, individuals working on teams of patent applications are more likely to jump fields in patent applications than solo inventors while in 1975 they were both equally likely to jump fields. This evidence could suggest an increased role of specialization, or it could suggest that on the margin would-be patent trolls have found it much easier to monetize if they work in teams instead of individually.)

Jones also found that papers published by teams have a higher probability of a large amount of citations.  A hypothetical example of non-scientific specialization could work as follows: Maybe one member is really good at getting grant money, while the other is the one with the ideas and the experimentation process (the one who might otherwise be a solo author), another is good at writing up the paper in the proper form and another is good at getting people interested in continuing their line of inquiry, thus earning citations and recognition for their work. If citations are often a tit for tat social game that academics must learn to master and that is improved by having more connections, which is another barrier in the frontier of knowledge that is relatively unrelated to the accumulated advances science.  This team advantage has reversed the solo advantage in a number of fields since the 1950’s, so these fields may be evidence that once fertile fields have become more and more politicized.

There is definitely something going on in the changing process of science, but to focus solely on the frontier problem as the explanation for recent changes papers over important structural problems. Treating recent changes as the new status quo and implementing policies with goals such as encouraging more teamwork, like the paper suggests, may make it even harder for the scientist to out compete the bureaucrat... in science.

Creative Destruction in the Advertising Industry

The money spent on newspaper advertising as a percent of GDP has been declining since the 1950’s.  To some degree, this slow decline is expected as the industry gets more efficient and advertising demand takes up fewer resources relative to the rest of the economy. However, when looking at newspaper advertising revenue divided by GDP, there is clearly something more going on than a gradual improvement in efficiency.

Source: GDP data from the BEA, Newspaper ad data from the Newspaper Association of America. In 2003 forward online newspaper ad revenue was included in the calculation.

 

To put the drop from 2003 through 2009 in perspective, here is a chart of Google’s revenue (99% of which is from advertising) versus the advertising revenue of the entire newspaper industry:  These numbers are before netting out the cost of acquiring this revenue.

Google doesn’t incorporate all of new media, but it is interesting that one company in the same general industry of advertising is about to eclipse an entire industry. The death of newspaper ad revenue has been on horizon for a while. Newspaper ad revenue has been declining for retail and classifieds since 2000. Classified ad revenue has been hit the hardest by the free competition on the internet are at one third of their 2000 peak. The competing retail ads aren’t quite free, so they have declined at a slower rate and newspaper retail ad revenue is at 50% of their peak. Despite the competition from the internet, national advertising and online ad revenue combined to keep pushing up newspaper revenue until it peaked in 2005. Right now, the one bright spot for newspapers is online ad revenue, which has increased from 2.6% of total revenue when it was first measured to 10% today. Unfortunately, online revenue is still very small and it is not enough to support the industry in its current form.

Palin 2012?

The high value of Palin’s 2010 Republican nominee Intrade contract is probably more representative of the wishful thinking of certain Palin supporters than an unbiased prediction of future probabilities. This happened in the last election with Gore’s VP contract, so Palin supporters probably shouldn’t get too excited about this market’s prediction.

The Economic Freedom Index: Revisiting assumptions

Andrew Gelman links to an interesting piece by Dave Armstrong on the Heritage Foundation Economic Freedom Index. I have my own issues with some of the subtleties of the index, but the approach taken is a good example of how a quantitative approach can sometimes miss the qualitative point altogether.  In the analysis of the components of the economic freedom, the assumption of unidimensionality is made.

“Unidimensionality - that there is only one underlying source of variation. Here we are assuming that each indicator is an imperfect indicator of Economic Freedom and that once we take account of economic freedom, there is only random variation left over.”

By making this assumption, he can then decide that factors that aren't correlated to the common factor of the other variables do not actually measure economic freedom.  In the subsequent analysis, fiscal freedom, a measure of taxes, and government spending are found to be uncorrelated with the common factor of variables. This is where a quick qualitative check would have been helpful. The amount of money the government controls and taxes from the private sector is a priori related to economic freedom. Instead of assuming that government spending and fiscal freedom are not related to economic freedom, the assumption of unidimensionality should be reassessed. 

The new index created with the unidimensionality assumption that takes out government spending and taxes could be very interesting as a rule of law index, it just isn't an index of economic freedom.

The quantitative approach does yield some useful insights, as the article does make a good point about statistical significance of the change in rankings. The United States index score is still well within its historical range, so the United States's move off of the list of most free countries is not really statistically significant. The most relevant part of the ranking change is that over the ten year period certain countries have become more free, but that is a relative and not absolute US decline.

Thoughts on High Dividend vs. Non-dividend Paying Stocks

One of the aspects of the coming capital gains tax raise is that stocks that pay out their earnings in dividends become relatively more attractive when compared to stocks that retain their earnings or give money back to shareholders via buybacks and so are more likely to return value to shareholders via capital gains rather than dividends.

Low dividend/High Dividend Paying Stocks, unadjusted for dividends:

Note on creation of indices: (Done with Palantir Finance)

S&P 500 companies

Excluding lowest decile of 11 month return to filter out failing companies

High dividend stocks: Top Quartile of High Dividend Paying Stocks, current average dividend yield of almost 5%.

Low Dividend Paying Stocks: Bottom quartile, average dividend yield close to 0%

The big decline in 2000 through 2002 was the unraveling of the tech bubble.  The dip in 2008 looks cyclical, as companies at the closest to the epicenter of the boom and bust are less likely to be the ones returning money to shareholders. In the same way, the companies that outperform at the end of a crash are the companies who barely survived, and companies that barely survive are less likely to be distributing needed cash to shareholders.

What happened in the market today

Looking at the markets fall, there are three negative events that stand out as possible explanations: The ash cloud from Iceland’s volcano is still spreading over Europe, the University of Michigan released a lower than expected consumer confidence number and the SEC suing is Goldman Sachs (Suspiciously, on a day when there is news about how they ignored Allen Sanford’s Fraud in 1997).

1. The Ash Cloud: This seems back and should theoretically lower consumer spending and oil consumption temporarily, but the market didn’t really distinguish between European and US stocks today.

2. Consumer confidence surprised on the downside at 69.5 instead of an expected 75.0 and housing starts surprised on the upside. Here is a chart showing how little the U. of Michigan Confidence number seems to matter:

Lacking historical minutely data, I looked at the market close to market open futures data to determine if the U. of Michigan numbers have any market impact:

 

The impact looks rather negligible, perhaps because there are other more timely indicators of consumer confidence and divergences in this survey relative to expectations is as likely as not to noise. At the very least, any signal seems to be drowned out by the noise from earnings releases or other market data.

3. Today Goldman Sachs’s market capitalization fell from over 100 billion dollars to a little over 87 billion dollars on news that the SEC is suing them for fraud related to how they represented CDOs. No one thinks that Goldman is going to lose 13 billion dollars in the lawsuit, but because of the chance that it may be a tip of the iceberg type of event or that this negative news will hurt their credibility and therefore their business the market’s move may not be too excessive. Other financial stocks fell in sympathy, along will most other risk assets, either because of fears that these banks did the same, hedging by Goldman who knew of the lawsuit ahead of time, or because their regulation will be harsher if financial companies are perceived in a more negative light.

I’m glad that I don’t have to explain market moves every day, as usually “more buyers than sellers” or vice versa makes more sense than the majority of news stories coming out about market drivers.