Boston Notebook

28 Oct 2008

There’s no place like home.

No stranger to economic history, Yale professor and housing guru Robert Shiller, told an audience here today that the current situation in the housing market had strong parallels not to the Great Depression as many are beginning to assume, but to the depression of the 1890s.  He explains that a US banking crisis came out of nowhere in 1893 and quickly led to deflation,  unemployment and eventually (and somewhat ominously perhaps) to labor unrest.  Policymakers responded by implementing complex changes to the monetary system.  Some of these policies were met with so much skepticism, explained Shiller, that a thinly-veiled political critique was authored in the form of a children’s book.  The book is said to have juxtaposed the wizardry of these new policies with those involving more traditional hard assets such as gold and silver.  The book was called “The Wizard of Oz“.

Unfortunately, Shiller found that housing price data for the 1890’s is hard to come by.  But he suspects that overall, it was a bad time to flip that suburban Atlanta duplex.

The 1990’s, however, was obviously a better time to do this.  In fact, the only time in recorded housing history that rivals the last decade’s house price increase was the immediate post-war period.   During WWII, explained Shiller, you couldn’t build a house without special wartime permission – leading to serious pent up demand.  The recent boom followed no such pent-up demand,  suggesting that higher prices were never sustainable in the first place.

Shiller prescribed three things to create long-term stability in the housing market:

  1. Subsidies for finance advice: an ardent advocate of “financial democracy”,  Shiller says that everyone – particularly lower-income sub-prime borrowers should have access to objective advice.  Taking direction from mortgage brokers, he said, was like receiving medical advice from a drug company.
  2. More robust financial markets: Shiller has pioneered the development of housing futures.  The market for these futures, he pointed out, had been pointing to a downturn well before the housing market crested.
  3. Better retail lending products: By creating more flexible ways for retail borrowers to manage their risks (such as “continuous work-out mortgages”), policymakers can achieve the same result as this week’s other hot news topic, “income redistribution.”

Distress Call

NYU’s Ed Altman is a well known academic and a distressed debt enthusiast.  As he joked last year, he and his wife used to crack open a bottle of champagne every time a company went belly up – and as a result, they spent most of 2002 drunk.  With high yield debt default rates pushing 5% this year (up around 5x over last year), attendees were likely a little surprised to see him sober this time around.

But even with defaults on the rise, Altman warned the conference that the number could rise even further.  He uses three separate methodologies to forecast future default rates.  While each methodology yields a different outcome, the numbers are all concerning.  According to Altman’s calculations next year’s default rate could be anywhere between 5% and 16%.

For those who are into this kind of thing, he’s expecting recovery rates (which are inversely proportional to default rates) to come in somewhere between 35% and 45%.

Altman’s forecast at this event last year caused us to run the following subtitle (no kidding – click to check it out):

“Altman: Enjoy the Olympics America, then get ready for economic mayhem”

Fundamental Indexation for Fixed Income?

While we’re on the topic of credit strategies, the author of a critically-acclaimed book “The Origin of Financial Crises: Central bank, Credit Bubbles and the Efficient Market Fallacy” provided one interesting explanation/factor for the credit bubble.  George Cooper, a principal at head fund manager BlueCrest Capital, said that passive investing in debt using market-weighted indices had the effect of allocating more capital to those companies that borrowed more – not always the best fundamental strategy.  (Regular readers may remember that a similar argument is put forward by advocates of “fundamental” indices.  Market-weighted indices, they say, cause investors to allocate more capital to over-valued securities – also not necessarily a good strategy.)

Questionable Behavior”

MIT’s Andrew Lo framed his remarks today by first quoting Barack Obama who is fond of proclaiming “It’s all about you!”.  As Lo stresses, today’s financial calamities have roots deep within the cognitive processes and related biases of the human mind.

Lo’s interest in the human brain began a few years ago when he spent the summer reading up on cognitive psychology.  During the course of the summer, says Lo, he became convinced that human beings were “likely the stupidest animals alive”.

One instance of this “stupidity” is the propensity of humans to fear uncertainty even more than they do “risk”.  A simple experiment makes the point, said Lo.  Students were given the opportunity to bid money to play a game where they had a 50/50 chance of winning $10,000.   As you might guess, most students bid around $5,000 to play the game (the expected value).  But when the students were told that the actual probabilities were now unknown, they bid considerably less.  However, the expected value of that unknown probability remained 50/50.  Concluded Lo, “fear of the unknown is the strongest fear there is.”

Far from being random musing of an MIT professor, though, this observation can easily be applied to today’s financial markets.  Lo posits that uncertainty resulting from the upcoming US elections has dramatically enhanced the level of fear in financial markets.

Another one of our serious cognitive foibles is our inability to see things for which we’re not looking out.  Lo says that rational behaviour required “blinders” to help us focus on the immediate tasks at hand.   But these blinders can also cause us to miss important, although unrelated, things.  Lo covered some of the same themes addresses in these slides delivered to the IAFE in 2007.

Lo went on to say that research in the past decade shows that rationality and emotion are not as dichotomous as we might assume.  In fact, he says that we need to be able to feel emotion in order to be “logical”.  In other words, emotion and logic are two sides of the same coin.  Medical research reveals that brain-injured individuals lack the ability to use heuristics to navigate the complexity of daily life.  Doctors say that these patients spend inordinate amounts of time on minute tasks like picking fonts for a Word document, or picking what to wear in the morning.

From a cognitive standpoint, these heuristics can only be created by experiencing pain.  Ergo, concluded Lo, the recent problem in financial markets is a result, in part, of the fact that investors have felt no pain.

Regulation, he argued, may seem misguided when we are fully able to use our higher-order “Homonid Brain”.  Lo said that in times of panic (such as when someone yell’s “Fire!” or, say, “Lehman!”) we are only able to use our lower-order “Mammalian Brain”.  So regulations – from financial rules to fire codes – must be designed for a different state of mind.

And it’s lucky no one yelled “Fire!” here today.  Although we were well into our 10th hour of lectures and panels by Lo’s 5pm presentation, the conference room here in Boston remained jammed with at least 300 people.

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  1. Denise Shull M.A.
    October 29, 2008 at 11:09 am

    “Lo went on to say that research in the past decade shows that rationality and emotion are not as dichotomous as we might assume. In fact, he says that we need to be able to feel emotion in order to be “logical”. In other words, emotion and logic are two sides of the same coin. ”

    Hallelujah! Someone with more academic cred than I have says the same thing that Trader Psyches teaches. Who cares how emotional you are? It is only the action you take that matter. One of our credos of Psychological Capital = “The quickest way to get rational is to be emotional.”

    Check out Seo and Barrett 2007 –

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