The Right Perspective on AIG

I couldn’t agree more with Michael Lewis’ thoughts on AIG bonuses. It’s a quick read, but he makes these key points:

Apart from Andrew Ross Sorkin at the New York Times, it occurs to no one to say that a) the vast majority of the employees at AIG had as little as you or I to do with its quasi- criminal risk taking and catastrophic losses; b) that the most- valuable of those employees can easily find work at AIG’s competitors; and c) that if the government insists on punishing those valuable employees they will understandably leave, and leave behind a company even less viable than it is, and less likely to give the taxpayer back his money.

And also — oh, yes — that if the government can arbitrarily break contracts made by firms in which it has taken a stake no one in his right mind will ever again make a contract with one of those firms. And so all of the banks in which the government has investment will be damaged.

He draws, I think, fairly rational conclusions:

From this episode we can observe several general truths about the financial crisis, and the attempt to end it:

1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. (The trillions we owe foreigners, for example.)

2) As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy.

But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.

3) The complexity of the issues at the heart of the crisis paralyzes the political processes’ ability to deal with them intelligently. I have no doubt that, by the time this saga ends, we will all know what happened to every penny of that $165 million in bonuses and each have our opinion of the morality of it.

For those wanting a slightly different perspective, I recommend this recent resignation letter from an AIG executive vice president. I found it poignant and personal. It reminds us that this credit crisis is impacting all of us, even those we villify and accuse of incompetence.

 

 

 

Barro: 20% of depression

Many thanks to Robert Barro in a recent WSJ article for doing two things.

First, definiing a “depression.”

Could we even experience a depression (defined as a decline in per-person GDP or consumption by 10% or more)?

Second, I particularly enjoyed Robert Barro’s use of data to inform the unending debate about whether this is a “depression” or just a severe “recession.”

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a “minor depression” (macroeconomic decline of 10% or more) will occur when there is a stock-market crash. There is a 9% chance that a “major depression” (a fall of 25% or more) will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes (our data show the probability is 92%).

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today’s prospects by consulting the history of nonwar events — for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes — 69% for minor depressions and 83% for major ones.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

Ok dok — thanks for bringing facts to the debate. I find this quite useful. I also like comparing today’s price action to former bear markets — there is a nice chart making the rounds that looks something like this.

History of Bear Markets

Peter Bernstein on Stocks for the Long Run

Fantastic op-ed in the Financial Times by one of my favorites, Peter Bernstein. He argues that “Stocks for the Long Run” is a misnomer, because the Long Run depends heavily on where you start.

The cold statistics have hardly been encouraging for the traditional view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts.

These data are not to be taken lightly.

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent  a year.

He goes on to make the point that stock market returns are not independent observations from a trending data series. In fact, they depend heavily on policy decisions, regulatory framework, and a whole host of other variables that determine returns.

There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.

This, of course, leads to some scary logic. Given where we are today, how do we think about the long run return from stocks? Massive fiscal deficits, burgeoning entitlements, questions about the very core of capitalism (credit, private property, etc.) all mean that we are currently, in the first quarter of 2009, presented with a new and dangerous set of initial conditions.

Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.

For what it’s worth, the father of Stocks for the Long Run, Jeremy Siegel, recently published an op-ed in the Wall Street Journal arguing that from a long-term perspective, stocks are exceptionally cheap. Basically, he argues that earnings from Citi, BofA, and other failing banks are weighing down the S&P core earnings, making earnings look artificially low and therefore, P/E multiples artificially high.

I tend to agree with John Mauldin, who argues that this line of logic is a bit off-the-mark. At the end of the day, these earnings matter, and though figuring out how to weight them is hard, you still need to give them some weight in the S&P index earnings.