No subcategory of mortgage companies makes more money during a boom and struggles more during a bust (i.e., is as volatile) as the subprime mortgage industry.   Subprime, or mortgage companies that make loans to people who cannot get loans through banks or other such channels, have been printing money over the last few years.  Fueled by a seemingly endless appetite among investors for for bonds that are secured by subprime mortgages, subprime mortgage companies have been growing dramatically since early in the decade. Subprime mortgage companies now are not just struggling (almost all of them are struggling), but they are going bankrupt and closing their doors just like their predecessors did in the last 1990s.  In the last few weeks, Ownit and ResMae have file for bankruptcy protection while New Century, Accredited and NovaStar have reported disappointing earnings or are suffering rating agency downgrades or even worse.

So, is this a black swan event or are these companies just not subject to any real rational limitations and taking stupid risks with shareholder money?  It’s the latter.  The crash in 1998 was more of a Black Swan event.  You can read about it in amazing detail in When Genius Failed.  When Russia decided to devalue its ruble in the midst of a global recession in 1998, no bond investor wanted anything but U.S. Treasury bonds.  Thos that were willing to invest in riskier bonds wanted a lot more money, so the “spread” (or the difference in price) between Tresuries and the bonds that mortgage companies sell in securitization transaction “gapped out” and the mortgage companies were left holding hundreds of millions of dollars in mortgages, that they had borrowed to make, without a way to sell them.

This time, though, it’s different but its the same basic underlying problem.  Subprime mortgage companies have been growing and growing while all the time making riskier and riskier loans.  They had no idea just how risky their business models were but they mortgage company down the street was all to happy to make the next riskier loan so they all jumped in.  Since mortgage companies are not regulated like banks are, they are free to take whatever risk they want limited only by the appetite for the bonds in the bond market and the shareholders’ willingness to finance them.  In 1998, subprime companies relied to aggressively on a certain type of accounting for securitizations and nobody realized how vulnerable they were to a shock like the Russian economic crisis.  Everyone had convinced themselves that risks were controlled and that because the market was willing to finance the risk that everything was OK, but it wasn’t.  The dot com boom experience was based on the same human failing…we set aside everything we knew about risk and justified it by just calling it a “new economy”. 

Now, mortgage banks are filing bankruptcy, laying off people and destroying shareholder value.  The bond markets this time are fine but management, fed by Wall Street, just shifted their reckless behavior to another easy target: underwriting.  Just like they piled on non-cash earnings in the late 1990s which, now in retrospect, obviously would come crashing down at some point, they lately have been making loans to people who should never be given someone else’s money and they are going down because of it.

The timing of the eventual collapse is clearly random (and it happens quickly).  However, the crash was very much predictable and not random.

I found myself struggling with this tension while reading a recent article in BusinessWeek about Barclay’s Global Investors, a money management firm.  Barclay’s has hired a world-class collection of very, very smart people who look for “signals” in markets that describe investment strategies that can generate alpha, or the amount of return in excess of the beta which is the market rate of return (or the return that you would get by just investing in an index fund tracking the entire stock market).  Barclay’s attempts to use this alpha-hunting strategy to “consistently beat the markets”.

One example is a signal identified by Richard Sloan, a Wharton business professor.  Sloan discovered the accrual anomaly which, in very simplistic terms, exists because stock market valuations have not historically distinguished between non-cash earnings (earnings that result from accruals) and cash earnings.  And, companies with cash earnings tend to be stronger companies and perform better than companies that depend on non-cash earnings.  The result, if you were to have invested in companies with strong cash earnings, is an alpha (or return above the market return) of an eye-popping 12% or more!

It’s hard not to read an article like this and run out and move all of your investments into funds controlled by super-smart people like this.  However, there are plenty of examples of super-smart people who blow up in the stock market.  The classic example is the story of Long-Term Capital Management described in another great business book, When Genius Failed.  LTCM, a hedge fund, thought they had found a signal that nobody else had recognized and they had two Nobel laureates involved in the company with massive amounts of data that pointed to the success of the strategy.  They leveraged themselves way beyond anything that is reasonable and, of course, the event that their models showed was so unlikely to happen as to be practically impossible did, in fact, happen.  LTCM was obliterated with almost $5 billion in losses because they failed to account for skewness (a win-loss record does not matter if a single loss has the ability to lose far more than an infinite number of wins) and almost took down the entire banking system with it but for an unprecedented intervention from the Federal Reserve.  The BusinessWeek article actually mentions the LTCM problem and Fooled by Randomness discusses it also.

It’s not surprising that Barclay’s does well in times of relatively rational markets and tanks when irrational markets prevail (e.g., the dot-com nonsense).  The title of the BusinessWeek article is “Outsmarking the Market”, but is it really possible to do that?  There seems to be so many factors that go into how the market reacts to things that even a strong signal like the accrual anomaly may not work again like the data suggested it did before.  That is the limitation of historical data and the risk of the black swan.  The problem that I have is that the tension between these two ideas has had me in cash for most of the recent run-up in the stock market and I am desperate for an investment strategy that takes all of this into account.

I don’t think it actually matters all that much who is president.  Most of the events (good and bad) attributable to the resident of the White House are largely the result of randomness, but I think a change in party would provide at least some superficial benefit like, for example, to make the rest of the world hate us just a little less.  However, I really don’t think that Hillary is the answer.  But I don’t think that any major candidate, on either side, will be able to really have any positive impact on our country and its standing in the world.  In Hillary’s case, if she were to run, win the nomination and the general election (and, if I were a betting man, I would bet against those chances as things stand today), the novelty of the first female president would quickly fade and I think we would soon realize that she, like any president of any gender or race, is really just a self-interested egomaniac except with a nasty habit for telling us how to live our lives.

I personally do everything I can to avoid going to Home Depot.  I much prefer Lowe’s and even my local Ace Hardware.  In my opinion, Nardelli should have done something about making his stores more appealing and focused less on services and selling to contractors (programs that he invested billions of dollars into).  I’m not the only one with these opinions and that is often the reason cited by “experts” as to why Lowe’s outperforms Home Depot in certain performance metrics, including stock price appreciation.

All that being said, I don’t feel too bad for stockholders of The Home Depot.  They had the ability to vote with their dollars and not invest in the stock if they didn’t like Nardelli.  What makes me mad is people like Barney Frank, the new Chairman of the House Financial Services Committee, who wants to use this issue (and a few other big pay packages for CEOs) as an opportunity to create some kind of legislation to address the issue.  Barney Frank had this to say:

“The action of Home Depot’s Board of Directors to simultaneously dismiss Robert Nardelli and provide him with $210 million in severance is further confirmation of the need to deal with a pattern of CEO pay that appears to be out of control.  Some defenders of CEO pay argue that CEOs are rewarded for increasing the stock or the overall value of the company, but judging by today’s market reaction, Mr. Nardelli’s contribution to raising Home Depot’s stock value consists of quitting and receiving hundreds of millions of dollars to do so.

Business leaders who are frustrated by the unwillingness of the American voter to be supportive of their agenda for economic growth should look to the contrast of Mr. Nardelli’s consolation prize and the resistance of business to raising the minimum wage.”

Please, Barney, don’t do us any favors.  Stockholders can decide for themselves and they ultimately pay the price if they overpay their CEOs.  Just leave them alone.  Why not focus on injustices that matter, like wasting taxpayer money.  Taxpayers can’t decide not to invest in the government anymore (well, I guess they could through Treasury bonds but that’s different).  If I don’t like the way the government is spending my money, I can’t elect to take my money elsewhere.  I am stuck investing in the most evil, greedy and wasteful corporation in the world and there is nothing I can do about it except select from lame choices of people who waste billions getting elected. 

I think it would be an excellent use of taxpayer money to pay a $210 million to Barney Frank if he would just resign from Congress but it would probably cost more than that to remove him.  At least Bob Nardelli actually can get fired.  Barney Frank has been a member of Congress since 1981, firmly entrenched enough to be, abset a sex scandal or something like that, largely untouchable.  Barney Frank should stop worrying about stockholders who are just fine, thank you, and worry about fixing the big, stupid corporation that he works for.  And, by the way, raising the minimum wage will cost stockholders a lot more than CEO pay package…by order of magnitude!

Today’s Games.  The Jets never really had a chance but the game was interesting until the end of the half.  It’s tough to win in Foxboro in January.  The afternoon game was far more interesting.  The Eagles won at the very end of the game with a field goal.  I was kind of hoping for the Giants to win because, even if they would have won, they would have provided a weaker opponent for the Bears next Sunday.

Useless Stats.  I don’t understand the historical head-to-head statistic or historical team records.  Like when the press says that a given team is 30-20 against another team in their history.  How is that at all relevant?  The teams that played against each other in 1965 have no relationship to the teams playing today so why is the historical head-to-head matchup statistic at all helpful?  In today’s Los Angeles Times, Peter Yoon picked New England over the Jets as follows:

It’s tough to pick against a team that has won three of the last five Super Bowls.

I understand this stat a bit more because the quarterback and head coach are the same.  However, many of the players and assistant coaches have turned over since they won their first Super Bowl.  So, what does the success of that team have to do with today’s game against the Jets?

Kansas City at Indianapolis.  Two stories here.  Could Peyton Manning overcome a career of MVP-quality regular season play with a terrible post-season record?  Apparently, yes.  Although both teams seems to struggle early on, trading field goals for the first half, Indy finally started rolling in the second half.  The second story was the Indianapolis worst-in-the-league run defense going up against Larry Johnson, one of the league’s best running backs.  I think the stats ended up being something like 30-40 yards on 13 carries for Johnson.  Indy obviously spent the week figuring out how to stop the run.  Now, would it be possible for Indy to lend the Bears their defensive coordinator or at least their defensive line coach for a week or so?  The Bears could stand some better run defense.

Dallas at Seattle.  Wow, what a bummer for Tony Romo.  I really feel bad for that guy.  After cleaning up from the party and taking some Advil for what will be a long night of back pain and fixing my TV (it turns out it was the stupid DirecTV DVR that had frozen and needed to be rebooted–DirecTV is on my list of companies that I can’t stand and I promise a blog post on that sometime soon).  Anyway, this game provided a really exciting finish and also showcased why I really love watching the NFL.  As the fourth quarter ticked away, the strategy possibilities seemed to changed with each play, several of which were unusual and/or crazy plays.  Dallas, though, had the game won with less than two minutes left, down by one and in field goal position at extra point range.  Then Tony Romo, the out-of-nowhere quarterback sensation from Dallas just flat out fumbles the placement of the snap (it was a clean snap and Romo caught it fine but it just slipped out of his hands).  I mean, that just never happens and certainly not in games like this.  I guess this would be a classic black swan event…so rare as to be almost impossible yet it still happens.  As Chris Berman from ESPN says “That’s why they play the games.”  I was just watching the post-game press conference and Romo had to fight back tears on a couple of occasions.  What a bummer for him.  I wonder if Bill Parcells is done?

The first game was lame and the second very exciting.  The games tomorrow are more interesting to me.  I like Philly over the Giants and I like New England over the Jets.

A former bond trader at Solomon Brothers, Lewis started his writing career with Liar’s Poker, a book that gave a behind-the-scenes look at some of the stuff that goes on on Wall Street, including a particularly nasty bond trading scandal that negatively affected a number of Wall Street big shots.  (One of my other top all-time favorite books is When Genius Failed by Roger Lowenstein, essentially a follow-up to Liar’s Poker because it picks up the story of the same central character John Meriwether, the former Solomon trader that almost blew up the entire banking system after leaving Solomon starting a company called Long Term Capital Management only to be completely fooled by randomness!) 

So, among other books after Liar’s Poker, Lewsi wrote and amazing book, Moneyball, which follows Oakland A’s General Manager, Billy Beane and tells the story of Beane’s use of statistics that are overlooked by most baseball experts to identify players that, while not fitting the traditional mold, managed to generate a lot of wins for the A’s for a lot less money than average teams.  (A Beane prodigy later used the strategy with money to win the World Series for the Boston Red Sox which another prodigy tried and failed to implement the strategy for the Dodgers). 

Lewis’ most recent book, The Blind Side (the Wikipedia link includes a link to an NPR interview with Michael Lewis), did the same thing for professional football that Moneyball did for baseball.  Specifically, The Blind Side points out something that should have been very obvious but which isn’t always so obvious: the fact that the left tackle position is probably the second-most important position in professional footbal after the quarterback.  I actually saw this in action earlier this year.  I was at Qwest Field for a Seattle Seahawks home game against the St. Louis Rams.  At one point in the game, Orlando Pace (who is mentioned in The Blind Side), St. Louis’ left takle was injured.  And, almost immediately, the Seahawks attacked the left side and consistently were able to pressure Marc Bulger in the second half of the game after not being able to get to him much in the first half when Pace was still in the game.  I was floored and probably would never have noticed that detail prior to reading The Blind Side.

A couple of items in the news and blogosphere this week made me think about this idea of things that are hidden in plain sight and their relationship to randomness.  The first is an article in Slate Magazine by Robert Weintraub about the hidden role of centers in the NFL.  Taking The Blind Side as a starting point Weintraub argues that centers actually put the other members of the offense, including the left takle, into position to make plays.  Given that they start each play and are responsible for calling out assignments and making as many as three different takles during the lightning quick pace of an NFL play, I can’t argue with him.  I do know, from watching Jay Cutler’s first few games where there were a number of fumbled snaps, that if the center and the quarterback are not in sync, the play can never evolve as planned.  This is interesting to me because as much footbal as I watch, until I read The Blind Side, I just paid attention to the headline grabbing “skill position” players.  With the playoffs starting today, I plan to spend more time watching this part of the game.

The other article that came to my attention and which touches on these topics was feature in yesterday’s Wall Street Journal about a guy in Northern California who has a crazy good record of predicting sports outcomes to the point where it is upsetting the odds in Las Vegas and causing some online casinos to take their sites down while they adjust the odds.  Since 1999, Bob Stoll has only had one year with a college football wagering record of less than the 52.4% rate against the spread needed to make money on sports wagering.  Can he keep it going forever or will mean reversion eventually catch up to him?  How much randomness is involved in his success?

Sports, and professional football in particular, involves a tremendous amount of randomness but I like being fooled by it.  Close, high-stakes games are much more fun and interesting to watch than sitcoms, or any kind of TV really, or most movies.  There is a reason why the NFL can make billions selling their product.  While I don’t want to ruin the experience for myself, I still wonder often about the role of randomness in it.