Tuesday, November 26, 2013

SEC Charges Detroit Firm For Deceiving Trustees of MM Fund

The Securities and Exchange Commission today announced fraud charges against a Detroit-based investment advisory firm and a portfolio manager for deceiving the trustees of a money market fund and failing to comply with rules that limit risk in a money market fund’s portfolio.  Money market funds seek to maintain a stable share price by investing in highly safe securities.  Under the federal securities laws, a money market fund may only invest in securities determined by the fund’s board of trustees to present minimal credit risk.

The SEC’s Enforcement Division alleges that Ambassador Capital Management and Derek Oglesby repeatedly made false statements to trustees of the Ambassador Money Market Fund about the credit risk in the securities they purchased for its portfolio.  Trustees also were misled about the fund’s exposure to the Eurozone credit crisis of 2011 and the diversification of the fund’s portfolio. 

“Money market fund managers must not hide the ball from a fund’s board,” said George S. Canellos, co-director of the SEC’s Enforcement Division.  “Ambassador Capital Management and Oglesby weren’t truthful about whether securities in the portfolio threatened to destabilize the fund, and they failed to operate under the strict conditions designed for money market fund managers to limit risk exposure and maintain a stable price.”

The enforcement action stems from an ongoing analysis of money market fund data by the SEC’s Division of Investment Management, in this case a review of the gross yield of funds as a marker of risk.  The performance of the Ambassador Money Market Fund was identified as consistently different from the rest of the market.  Upon further examination by the SEC’s Office of Compliance Inspections and Examinations, the matter was referred to the Enforcement Division’s Asset Management Unit for investigation.

For more information - SEC.gov | SEC Announces Fraud Charges Against Detroit-Based Money Market Fund Manager


The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actionsand representation of investors, financial professionals and investment firms, nationwide. For more information call 212-509-6544 or send an email.

Friday, November 22, 2013

Insiders Who Tip Outsiders Liable for Insider Trading

Providing outsiders with inside information can result in significant problems for the insider.
United States Securities and Exchange Commission
As securities lawyers know, but the public does not, providing inside information to others, even if you do not buy or sell the stock yourself, creates liability for insider trading. In fact, the insider may be liable for the profits obtained by the outsider - even if he did not share in the profits.

Yesterday the SEC charged a former employee at a Silicon Valley-based semiconductor company for his role tipping nonpublic information used in connection with Raj Rajaratnam’s massive insider trading scheme.

The SEC alleges that Sam Miri, who worked in the communications division at Marvell Technology Group, tipped confidential information about the company’s financial performance to former Galleon Management portfolio manager Ali Far.  He used the nonpublic information provided by Miri to trade Marvell securities on behalf of hedge funds that he founded after leaving Galleon.  Far and Spherix Capital, who were among those earlier charged by the SEC in the Galleon matter, earned hundreds of thousands of dollars in illicit profits based on Miri’s tips.

In exchange for the illegal tips, Far arranged four quarterly payments to Miri totaling approximately $10,000. Miri, who lives in Palo Alto, Calif., has agreed to settle the SEC’s charges by paying more than $60,000 and being barred from serving as an officer or director of a public company.

According to the SEC’s complaint filed in federal court in Manhattan, Miri tipped Far in May 2008 with inside information about Marvell’s plans to announce a permanent chief financial officer after a string of interim chief financial officers.  With an earnings announcement scheduled for later that month, Miri also revealed confidential information about Marvell’s sales revenue and profitability as well as projections of future earnings potential.  In the days leading up to the announcement, Spherix Capital hedge funds purchased approximately 300,000 shares of Marvell common stock.  When the stock climbed more than 20 percent after Marvell announced its quarterly financial results and new CFO on May 29, Far’s hedge funds reaped approximately $680,000 in ill-gotten gains.

The SEC’s complaint charges Miri with violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  Miri agreed to pay $10,000 in disgorgement, $1,842.90 in prejudgment interest, and a $50,000 penalty.  Miri also agreed to be barred from serving as an officer or director of a public company for five years.  Without admitting or denying the charges, Miri agreed to be permanently enjoined from future violations of these provisions of the federal securities laws.  The settlement is subject to court approval.

For more information visit http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540396057

The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actions. We represent investors, financial professionals and investment firms, nationwide. For more information call 212-509-6544 or send an email.
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SEC Charges Colorado Man with Elder Fraud

United States Securities and Exchange Commission
The SEC charged a self-described institutional trader in Colorado with defrauding elderly investors into making purported investments in government-secured bonds as he used their money to pay his mortgage.

The SEC alleges that Gary C. Snisky of Longmont, Colo., primarily targeted retired annuity holders by using insurance agents to sell interests in his company Arete LLC, which posed as a safe and more profitable alternative to an annuity.  Investors were told their funds would be used to purchase government-backed agency bonds at a discount, and Snisky as an institutional trader would use the bonds to engage in overnight banking sweeps.

However, Snisky did not purchase bonds or conduct any such trading, and he misappropriated approximately $2.8 million of investor funds to pay commissions to his salespeople and make personal mortgage payments.

In a parallel action, the U.S. Attorney’s Office for the District of Colorado filed criminal charges against Sinsky.

According to the SEC’s complaint filed in federal court in Denver, Snisky raised at least $3.8 million from more than 40 investors in Colorado and several other states. Beginning in August 2011, Snisky recruited veteran insurance salespeople who could sell the Arete investment to their established client bases that owned annuities. The majority of investors in Arete used funds from IRAs or other retirement accounts.
The SEC alleges that Snisky described Arete as an “annuity-plus” investment in which, unlike typical annuities, investors could withdraw principal and earned interest with no penalty after 10 years while still enjoying annuity-like guaranteed annual returns of 6 to 7 percent.  Snisky emphasized the safety of the investment, calling himself an institutional trader who could secure government-backed agency bonds at a discount and save middleman fees.

Snisky’s sales pitch was so convincing that even one of his salespeople personally invested retirement funds in Arete. The SEC alleges that Snisky created and provided all of the written documents that the hired salespeople used as offering materials to solicit investors.  Snisky also showed salespeople fraudulent investor account statements purporting to show earnings from Arete’s investment activity.

 Following an initial influx of investors, Snisky organized at least two seminars where he met with investors and salespeople.  He introduced himself as the institutional trader behind Arete’s success, and encouraged investors to spread the word.  Snisky hand-delivered fraudulent account statements to investors attending the seminars to mislead them into believing their investments were performing as promised.

The SEC’s complaint against Snisky seeks a permanent injunction, disgorgement of ill-gotten gains plus prejudgment interest, and a financial penalty. As always, investors are left on their own to recover their losses, as the SEC does not pursue individual investor claims.

For more information visit SEC.gov | SEC Charges Colorado Man in Scheme Targeting Elderly Investors
The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters. We represent investors, financial professionals and investment firms, nationwide. For more information call 212-509-6544 or send an email.
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Dow Industrials Close Above 16,000

I remember the day that Dow reached 10,000, and it doesn't seem that long ago, but yesterday the Down closed above 16,000 for the first time. Press reports say that economic data pointed to a slowly improving labor market and subdued inflation is responsible for the rise in the markets. Financial shares led the market to its first day of gains after three sessions of losses. Although investors remain unsure about the timing of the Federal Reserve's scaling back of its $85 billion per month in bond buying, some say the market will weather the eventual pullback in that stimulus.

For more information visit Dow ends above 16,000 for first time, boosted by data

Adobe Hack Exposes 150 Million Passwords

Last month, Adobe announced hackers stole login information for some 38 million of its customers. This month estimates have run as high as 150 million users.

Many Internet companies are now notifying their users to change their password. As we all know, despite the risk, we use the same password at different sites. If the hackers have your email address and password at Adobe, maybe they have your email address and password for Facebook, or LinkedIn, or Evernote, or Dropbox, or............the possibilities are endless.

You need to change your passwords. To make this a bit easier, you can check if your account was one of the ones obtained by the hackers - press reports say that if you have an account at Adobe, your information was stolen, it is that bad.

Information on how to find out if you were includes is at http://www.zdnet.com/find-out-if-your-data-was-leaked-in-the-adobe-hack-7000023065/

Change your passwords!

For more information visit After Adobe Hack, Other Sites Reset Passwords - Digits - WSJ 

Tuesday, November 19, 2013

JPMorgan $13 billion mortgage settlement expected Tuesday

JPMorgan Chase Tower (Dallas)According to Reuters, JPMorgan Chase & Co is expected to announce a $13 billion agreement with the U.S. government on Tuesday to settle claims it overstated the quality of mortgages sold to investors during the housing boom,
The civil settlement would mark the end of weeks of negotiations between JPMorgan Chase, the largest U.S. bank, and government agencies that were under pressure to hold banks accountable for wrongdoing that led to the housing crisis.
Even after the settlement, the bank faces at least nine other government investigations, covering everything from its hiring practices in China to whether it manipulated the Libor benchmark interest rate.

For more information - JPMorgan $13 billion mortgage settlement expected Tuesday
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After the ACA -- Crafting an Alternative to Obamacare

I gave a talk at Hoover, encouraging those of us who are less than fans to speak up and outline the alternative to Obamacare. Podcast here.

Repeal and status quo is not enough. We need to listen, and point out how a radically freed and competitive system will address the genuine concerns that motivate many to support the law despite its flaws -- preexisting conditions, health care for the poor, outrageous cost and so forth.

The essay "After the ACA" lays it out in some detail.  The talk is a lighter discussion of where we are, but emphasizes how sitting back and letting the ACA unravel will just lead to an even more expensive and incorherent system. Stand up and state the alternative.

Court Can Require Social Media Records To Be Produced, But Request Should Be Narrowly Tailored

Facebook logo Español: Logotipo de Facebook Fr...
From Craig McLaughlin's SmartProperty Blog - question before the court was whether a plaintiff could be compelled to produce his entire Facebook account.

Court Can Require Social Media Records To Be Produced, But Request Should Be Narrowly Tailored
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Thursday, November 14, 2013

A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, "A limited central bank." It's especially noteworthy in the context of Janet Yellen's nomination, discussion between Congress and Fed about how the Fed should be run, the Fed's focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:
The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment....

When I talk to Fed types about this, the usual answer is a version of "well, yes, we don't really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?"

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit "availability" and perceived bubbles:
When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. ...

...We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

...Even though the [Fed's] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.
What should the Fed do?
I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.
The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current "dual mandate," but
The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.
You're getting a sense of what genies Charlie would like to put back in their bottles. It's a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed's legal authority.  Yet independence is a good thing:
Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 
... in exchange for such independence, the central bank should be constrained from conducting fiscal policy... [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.
What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:
One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.
Rules are important,
A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  
And for more reasons than usual: if the bank is following a rule, it's much less open to political criticism and able to preserve its independence:
Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals
...assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.
Charlie agrees: you can't have effective forward guidance without precommitment, and you can't have precommitment and discretion. Here is the slam at how taper talk roiled bond markets
My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.
In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the "mandate" includes "financial stability," and detailed discretionary direction of credit flows. Charlie:
Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort.... the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.
In fact, the bigger the fire house, the more the chance of fires:
I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.
I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next "fire sale."
And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.
"You can keep your bonds if you like them?"

The whole speech is good, I hope my excerpts get you to go to the real thing.

The SEC and Deferred Prosecution Agreements

Deferred Prosecution Agreements - where a wrongdoer agrees to cooperate with the government, and the government agrees not to prosecute the wrongdoer - are the stuff that television police shows are made of. We don't see them too often in our securities defense practice, but that may soon change.

The SEC announced the adopition of a DPA policy in 2010 as part of a series of initiatives designed to encourage individuals to cooperate and assist in investigations. The agreements are formal written agreements in which the Commission agrees to forego an enforcement action against a cooperator if the individual or company agrees, among other things, to cooperate fully and truthfully and to comply with express prohibitions and undertakings during a period of deferred prosecution. We have a sample SEC DPA at SECLaw.com.

However, it was not until over a year later, in May 2011 that the SEC entered into a DPA, and in that instance, the DPA was with a corporation. The corporation discovered FCPA violations in its foreign offices, notified authorities, agreed to cooperate with the SEC and federal prosecutors and to pay $5.4 million in disgorgement and prejudgment interest. (The company also agreed, in a separate agreement with prosecutors, to pay $3.5 million in criminal penalties). The SEC's press release regarding the case is at the SEC web site.

On November 12, 2013 the SEC announced its first deferred prosecution agreement with an individual. According to the SEC, a former hedge fund admi13nistrator who helped the agency take action against a hedge fund manager who stole investor assets.

While deferred prosecution agreements are designed to encourage individuals and companies to provide the SEC with forthcoming information about misconduct and assist with a subsequent investigation.  In return, the SEC refrains from prosecuting cooperators for their own violations if they comply with certain undertakings, it does not seem to be a very popular option, with only two such agreements in over 2 years.

For more information - SEC Announces First Deferred Prosecution Agreement With Individual

Wednesday, November 13, 2013

Who Are the Victims of Insider Trading?

DealBook.com has a very interesting article which raises this question, but not in the traditional sense. Those who believe that insider trading is a victimless crime certainly make an argument, but the guilty plea hearing last week in the SAC insider trading case brought the issue into focus. What made it interesting is that while federal statutes allow investors who bought or sold at the same time as the insider's trades to sue the inside trader, the Justice Department argued that those investors are not victims of the crime at all!

Which of course raises an interesting defense in the next investor insider trading suit.

For more detail, visit Determining the Victims of Insider Trading - NYTimes.com

The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actions and insider trading cases. We represent investors, financial professionals and investment firms, nationwide. For more information call 212-509-6544 or send an email.

Tuesday, November 12, 2013

Prosecutors Investigating SEC Staff

In an interesting twist, the Wall Street Journal is reporting that federal prosecutors and the office of the inspector general of the U.S. Securities and Exchange Commission are conducting an investigation of the SEC's New York office for the possibility of improper investments.

According to Reuters, investigators are checking whether the employees' investments comply with SEC internal rules that prohibit trading shares of companies under investigation.

The article claims that the investigation appears limited to the New York office of the securities regulator, and there is no indication of widespread flouting of the rules, according to the report.

For more detail, visit U.S. authorities probing New York SEC staff investments -WSJ | Reuters

Friday, November 8, 2013

New vs. Old Keynesian Stimulus

While fiddling with a recent paper, "The New-Keynesian Liquidity Trap" (blog post), a simple insight dawned on me on the utter and fundamental difference between New-Keynesian and Old-Keynesian models of stimulus.

Old-Keynesian. The "Keynesian cross" is the most basic mechanism. (If you are worried that I'm making this up, see Greg Mankiw's Macroeconomics, p. 308 eighth edition, "Fiscal policy and the multiplier: Government Purchases.")

Consumption follows a "consumption function." If people get more income Y, they consume more C

C = a + m Y.

Output Y is determined by consumption C investment I and government spending G

Y = C+ I + G.

Put the two together and equilibrium output is

Y = a + mY + I + G
Y = (a + I + G)/(1-m).

So, if the marginal propensity to consume m=0.6, then each dollar of government spending G generates not just one dollar of output Y (first equation), but $2.5 dollars of additional output.

This model captures a satisfying story. More government spending, even if on completely useless projects, "puts money in people's pockets." Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.

New-Keynesian. The heart of the New-Keynesian model is a completely different view of consumption. In its simplest version

Here consumption C, relative to trend, equals the sum of all future real interest rates i less inflation π i.e. all future real interest rates. The parameter σ measures how resistant people are to consuming less today and more tomorrow when offered a higher interest rate.

(This is just the integrated version of the standard first order condition, in discrete time
People in this model think about the future when deciding how much to consume and allocate consumption today vs. tomorrow looking at the real interest rate. I've simplified a lot, leaving out trends, the level and variation of the "natural rate" and so on.)

In this model too, totally wasted government spending can raise consumption and hence output, but by a radically different mechanism.  Government spending raises inflation π . (How is not important here, that's in the Phillips curve.) Holding nominal interest rates i fixed, either at the zero bound or with Fed cooperation, more inflation π means lower real interest rates. It induces consumers to spend their money today rather than in the future, before that money loses value.

Now, lowering consumption growth is normally a bad thing. But new-Keynesian modelers assume that the economy reverts to trend, so lowering growth rates is good, and raises the level of consumption today with no ill effects tomorrow. (More in a previous post here)

Comparing stories

This new-Keynesian model is an utterly and completely different mechanism and story. The heart of the New-Keynesian model is Milton Friedman's permanent income theory of consumption, against which old-Keynesians fought so long and hard! Actually, it's more radical than Friedman: The marginal propensity to consume is exactly and precisely zero in the new-Keynesian model.  There is no income at all on the right hand side. Why? By holding expected future consumption constant, i.e. by assuming the economy reverts to trend and no more, there is no such thing as a permanent increase in consumption.

The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don't think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

Models and stories

Now, why is Grumpy grumpy?

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people's pockets, and then they go and spend, and that puts more money in other people's pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It's just not economics. A 40 year quest for "microfoundations" came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation -- but they had not been able to publish any of their models in peer-reviewed journals for 35 years.

What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it's also fashionable to use new-Keynesian models as holy water. Something like "well, I didn't read all the equations, but Woodford's book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again." Cognitive dissonance allows one to make these contradictory arguments simultaneously.

Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: "The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow's consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier," sorry, our new models have no such effect, and we'll stand up in public and tell any politician who uses this argument that it's wrong."

That, at least, would be honest. If not particularly effective!

You may disagree with all of this, but that reinforces another important lesson. In macroeconomics, the step of crafting a story from the equations, figuring out what our little quantitative parables mean for policy, and understanding and explaining the mechanisms, is really hard, even when the equations are very simple. And it's important. Nobody trusts black boxes. The Chicago-Minnesota equilibrium school never really got people to understand what was in the black box and trust the answers. The DSGE new Keynesian black box has some very unexpected stories in it, and is very very far from providing justification for old-Keynesian intuition.

Wednesday, November 6, 2013

The Work Behind the Prize: Video and Text

This is a link to the "Work Behind the Prize" event from Monday Nov 4. Our charge was, explain to the community of scholars at the University of Chicago, what Lars Hansen and Gene Fama's research was that won them Nobel Prizes. Jim Heckman and John Heaton talk about Lars Hansen's work, Toby Moskowitz and I talk about Gene Fama. 10 minutes each. I start at 33:50.

Here is the text of my remarks. (Faithful blog readers will note some recycling. Let's call it "refining.") A pdf with embedded pictures is here. The video on youtube is here

Eugene Fama: Efficient markets, risk premiums, and the Nobel Prize

In 1970, Gene Fama defined a market to be “informationally efficient” if prices at each moment incorporate available information about future values.
A market in which prices always `fully reflect’ available information is called `efficient.’” - Fama (1970)
If there is a signal that future values will be high, competitive traders will try to buy. They bid prices up, until prices reflect the new information, as I have indicated in the little picture. “Efficient markets” just says that prices in a competitive asset market should not be predictable.

“Efficient markets” is not a complex theory. Think Darwin, not Einstein. Efficiency is a simple principle, like evolution by natural selection, which organizes and gives purpose to a vast empirical project.

That empirical work is not easy. The efficient market hypothesis has many subtle implications, most of them counterintuitive to practitioners, especially those who are selling you something.

For example, efficiency implies that trading rules -- “buy when the market went up yesterday”-- should not work. The surprising result is that, when examined scientifically, trading rules, technical systems, market newsletters, and so on have essentially no power beyond that of luck to forecast stock prices. This is not a theorem, an axiom, a philosophy, or a religion: it is an empirical prediction that could easily have come out the other way, and sometimes does.

Efficiency implies that professional managers should do no better than monkeys with darts. This prediction too bears out in the data. It too could have come out the other way. It should have come out the other way! In any other field of human endeavor, seasoned professionals systematically outperform amateurs. But other fields are not as ruthlessly competitive as financial markets.

43 years later, “efficiency” remains contentious.

Some of that contention reflects a simple misunderstanding of what social scientists do. What about Warren Buffet? What about Joe here, who predicted the market crash in his blog? Well, “data” is not the plural of “anecdote.” These are no more useful questions to social science than “how did Grandpa get to be so old even though he smokes” is to medicine. Empirical finance looks at all the managers, and all their predictions, tries to separate luck from ex-ante measures of skill, and collects clean data.

Another part of that contention reflects simple ignorance of the definition of informational “efficiency.” Every field of scholarly research develops a technical terminology, often appropriating common words. But people who don’t know those definitions can say and write nonsense about the academic work.

An informationally-efficient market can suffer economically inefficient runs and crashes -- so long as those crashes are not predictable. An informationally efficient market can have very badly regulated banks. People who say “the crash proves markets are inefficient” or “efficient market finance is junk, you did not foresee the crash” just don’t know what the word “efficiency” means. The main prediction of efficient markets is exactly that price movements should be unpredictable! Steady profits without risk would be a clear rejection.

I once told a reporter that I thought markets were pretty “efficient.” He quoted me as saying that markets are “self-regulating.” Sadly, even famous academics say things like this all the time.

There is a fascinating story here, worth study by historians and philosophers of science and its rhetoric. What would have happened had Gene used another word? What if he had called it the “reflective” markets hypothesis, that prices “reflect” information? Would we still be arguing at all?

Starting in the mid 1970s, Gene started looking at long-run return forecasts. Lo and behold, you can forecast stock returns at long horizons.

The blue line is the ratio of dividends to prices. Think of it as prices upside down. It goes down in the big price booms, such as the 1960s and 1990s, and goes up in the big busts such as the 1970s. It also wiggles with business cycles. You see the astounding volatility of stock valuations, which Bob Shiller shares the Nobel Prize for pointing out.

The red line is the average return for the 7 following years. So, times of high prices, relative to dividends are reliably followed by 7 years of low returns. Times of low prices are reliably followed by high returns. This pattern is pervasive across markets – stocks, bonds, foreign exchange, real estate.

Even more surprising are the dogs that don’t bark: Times of high prices are not followed by higher dividends, earnings or profits.

Does this fact imply that markets are inefficient? No.
“The theory only has empirical content, however, within the context of a more specific model of market equilibrium,…” [Fama (1970)]
Gene’s 1970 article emphasized that you can get better returns, by shouldering more risk, and the reward for bearing risk can vary over time and across assets, and that’s how he interprets these facts. Discounted prices should be unpredictable. So how you measure discount rates is crucial. 

For example, in December 2008, prices fell and expected stock returns rose. In this view, typical investors answered: “Yes, I see it’s a bit of a buying opportunity. But stocks are still risky, and the economy is falling to pieces. I just can’t take risks right now. I’m selling.” Many university endowments did just that.

The facts still imply a huge revision of our world view: Business-cycle related variations in the risk premium, rather than variation in expected cashflows, account entirely for the volatility of stock valuations. This view changes everything we do in finance and related fields from accounting to macroeconomics. ["Discount rates" is an essay on this point.]

There is another possibility: perhaps people were irrationally optimistic in the booms, and irrationally pessimistic in the busts.

And a third more recent challenge: perhaps the institutional mechanics of financial intermediation cause variation in the risk premium. When leveraged hedge funds lose money, they sell. If not enough buyers are around, prices fall.

These views agree on the facts so far. So how do we tell them apart? Answer: we need “models of market equilibrium.” We are not here to tell stories. We need economic models, psychological models, or institutional models, that tie price fluctuations to more facts, in a non-tautological way. And, that is exactly what a generation of researchers like myself spend a lot of its time doing, a sure sign of how influential these facts are.

Financial economics is a live field, asking all sorts of interesting and important questions. Is the finance industry too large or too small? Why do people continue to pay active managers so much? What accounts for the monstrous amount of trading? How is it, exactly, that information becomes reflected in prices through the trading process? Do millisecond traders help or hurt? How prevalent are runs? Are banks regulated correctly? The ideas, facts and empirical methods of informational efficiency continue to guide these important investigations.

Gene’s bottom line is always: Look at the facts. Collect the data. Test the theory. Every time we look, the world surprises us totally. And it will again.

Court Questions SAC Capital Advisors Settlement.

In an interesting twist to the historic settlement of charges against Steven Cohen's hedge fund entities, Judge Richard Sullivan has not approved the settlement, saying he needs more information about the accord's fairness.

Citing the recent judicial "debate" about how closely to scrutinize regulatory settlements, U.S. District Judge Richard Sullivan directed SAC and the U.S. Department of Justice to address at a hearing on Wednesday morning what standard he should use to evaluate the civil forfeiture portion of the accord.

Separately, Sullivan's colleague, U.S. District Judge Laura Taylor Swain, scheduled a Friday hearing to review the criminal portion of the settlement in which SAC agreed to plead guilty to five fraud counts.

For more detail, visit U.S. judge won't rubber-stamp SAC insider trade decision 

Monday, November 4, 2013

The Impact of the SAC Capital Advisors Criminal Guilty Plea

In what will surely be viewed as a controversial outcome, SAC Capital Advisors will plead guilty to criminal fraud charges, stop investing money for others and pay $1.8 billion — the largest financial penalty in history for insider trading — to resolve criminal and civil claims against the hedge fund giant, the government announced Monday.

The controversy will revolve around the impact of convicting a corporation of a crime. After all, you cannot put the corporation in jail. Further, since a criminal conviction effectively puts the corporation of out business, the impact of that conviction impacts all of the customers, employees and vendors of the corporation. 

While I firmly believe that it is a mistake to charge a corporation with a criminal offense - for exactly the reason stated above, this case is a bit different. 

First, many of its traders have been indicted for insider trading. Second, although Mr. Cohen was not indicted, he is, and remains, the subject of an SEC case for failing to supervise his employees. Third, with all of the negative publicity, the press conferences and Internet sites calling the firm "a magnet for cheating" and having "a culture of law-breaking" we can assume that the firm would not have lasted much longer, with or without an indictment. Finally, despite the marginal merit to the claims against Mr. Cohen personally, I would expect to see a settlement with the SEC any day now.

So, the firm was out of business, regardless of the indictment. But does that make it right? I will leave the academic discussion to the academics - I am just a securities litigator - but threatening to put a corporation out of business because of the wrongful conduct of employees - not necessarily the owners or executives - is not a path that we want to go down. The government has enough power over us - using the criminal process to force change inside of private companies by threatening to put them out of business is not a process that we should be encouraging.

The plea does end the case, and most of the related cases. Acccording to CNN,  prosecutors told the Judges presiding over the pending cases, that the "proposed global resolution" of the criminal and civil cases against SAC Capital Advisors and related companies also includes an agreement that SAC will cease operating as an investment adviser and will not accept any additional funds from third-party investors.

So, SAC Capital Advisors is out of business, with or without a criminal record. In addition, the company will pay a $900 million fine and forfeit another $900 million to the federal government, though $616 million that SAC companies have already agreed to pay to settle parallel actions by the U.S. Securities and Exchange Commission will be deducted from the $1.8 billion.

For more information - Hedge fund giant SAC Capital to pay $1.8B penalty

The Work Behind the Prize

This afternoon (Monday November 4) a panel of four will try to explain the research that Gene Fama and Lars Hansen did to win the Nobel Prize for the University of Chicago community.

This is classic University of Chicago, community of scholars stuff: Yes, we've congratulated you.  Now, let's talk seriously about the ideas and the research.

My job: Explain efficiency, long run returns and volatility in 10 minutes flat. Wish me luck. John Heaton and Jim Heckman will describe Lars Hansen's work, and Toby Moskowitz will join me on the Fama panel.  Gary Becker will moderate

The announcement is here; RSVP if you want to attend as seating is limited. The event will be web-cast here

Monday, October 28, 2013

SEC Examing Mutual Funds Re: Puerto Rico Bonds

The SEC is conducting nationwide, “limited scope examinations” of certain mutual funds that invest in Puerto Rico securities, according to a document obtained by The Bond Buyer and knowledgeable sources. On-site interviews are being conducted Thursday at an investment management firm with exposure to Puerto Rico through its mutual funds, according to a letter from the SEC’s San Francisco Regional Office. The letter was obtained by The Bond Buyer with the recipient’s name redacted.

The exams, which are being carried out by the SEC’s Office of Compliance, Inspections and Examinations and its regional offices, are intended to make sure the commission is up to speed on how much of Puerto Rico’s $70 billion of outstanding debt is held by funds in the U.S. and what those funds are telling their shareholders about the risks involved.

Our firm has been reviewing claims for investors regarding losses in bonds issued by Puerto Rico and in particular the sales practices of large broker-dealers, including UBS, who may have inappropriately marketed the funds. For more information on our work, visit our web site, or call us at 212-609-6544

For more information - SEC Probing Funds Holding Puerto Rico Debt 

The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actions. We represent investors, financial professionals and investment firms, nationwide. For more information contact Mark Astarita at 212-509-6544 or at email us

The Next Obamacare Fiasco

Thousands Of Consumers Get Insurance Cancellation Notices Due To Health Law Change Kaiser Health News

Some health insurance gets pricier as Obamacare rolls out Los Angeles Times

Health plans are sending hundreds of thousands of cancellation letters to people who buy their own coverage,...The main reason insurers offer is that the policies fall short of what the Affordable Care Act requires starting Jan. 1

Florida Blue, for example, is terminating about 300,000 policies, about 80 percent of its individual policies in the state. Kaiser Permanente in California has sent notices to 160,000 people – about half of its individual business in the state. Insurer Highmark in Pittsburgh is dropping about 20 percent of its individual market customers, while Independence Blue Cross, the major insurer in Philadelphia, is dropping about 45 percent.

LA Times:
Blue Shield of California sent roughly 119,000 cancellation notices out in mid-September, about 60 percent of its individual business. About two-thirds of those policyholders will see rate increases in their new policies....
Middle-income consumers face an estimated 30% rate increase, on average, in California due to several factors tied to the healthcare law. Some may elect to go without coverage if they feel prices are too high. Penalties for opting out are very small initially. Defections could cause rates to skyrocket if a diverse mix of people don't sign up for health insurance
This is interesting. Obamacare could actually increase the number of people without insurance, because you are not allowed to keep (consumer) or sell (insurance company) simple cheap insurance.

If you're healthy and have been paying for individual insurance all along -- largely because you know people with preexisting conditions can't get insurance, and you want to lock in your right to continue your policy should you get sick -- there is now a strong incentive to drop out.

The government has just wiped out the value of those premiums you paid all these years -- you don't need the right to buy health insurance anymore, as you can always get it later. You're seeing a large increase in premiums for benefits you don't want and to cross-subsidize other people. The mandate penalties are almost certainly going to be pushed back, they penalties are a good deal less than the cost of health insurance (which you can always get later if you get sick), the IRS has already said it's not going after people who don't pay them. Dropping out of individual health insurance starts to make a lot of sense.

This was bad enough on its own. But if insurance companies cancel these people's policies, all at once,  it's dramatically worse. It would be hard to design a more effective "nudge" to get such people to think about it and conclude that dropping health insurance is a good idea.

The overall numbers may not change. Other reports suggest that poor and sick people have been signing up in droves, mostly to get on the expanded medicaid. But it's an obvious fiscal disaster if Obamacare only attracts the poor and sick, does not attract the young and healthy -- and now drives away the healthy people who were provident enough to buy individual health insurance!

Why is this happening? A curious tidbit
All these cancellations were prompted by a requirement from Covered California, the state's new insurance exchange. The state didn't want to give insurance companies the opportunity to hold on to the healthiest patients for up to a year, keeping them out of the larger risk pool that will influence future rates.
The destruction of the off-exchange individual insurance market is deliberate.

The best quote of the bunch, from the LA Times
Pam Kehaly, president of Anthem Blue Cross in California, said she received a recent letter from a young woman complaining about a 50% rate hike related to the healthcare law.

"She said, 'I was all for Obamacare until I found out I was paying for it,'" Kehaly said.
This realization will come soon to millions more.

Wednesday, October 23, 2013

SEC Releases Crowd Funding Proposal

Seal of the U.S. Securities and Exchange Commi...
The Crowd Funding proposal has been released by the SEC today. If adopted, entrepreneurs and start-up companies looking for investors will be able to solicit over the Internet from the general public, a historic change in the regulatory structure regarding fund raising. Current regulations effectively limit solicitation of accredited investors - those with a net worth of at least $1 million, excluding the value of their homes, or annual income of more than $200,000. The crowdfunding rule would let small businesses raise up to $1 million a year by tapping unaccredited investors

We will have more once we review the proposal, but for those who can't wait, the proposal is here - SEC Crowd Funding Proposal. The SEC's Press Release - SEC Issues Proposal on CrowdFunding is at their site, as is their site to Submit Comments on CrowdFunding.

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Ex-Merrill Broker Sentenced to Three Years for Sales Practice Violations

A federal judge in the U.S. District Court for the Eastern District of Missouri sentenced Greg J. Campbell on charges that he had siphoned off almost $2 million from client accounts, including that of an 85-year-old client with dementia, for personal use.

According to press reports, Campbell was ordered to repay $1.8 million in restitution and forfeit property purchased with client funds. Campbell’s scheme began in September 2007 while he was a broker working for Merrill Lynch, according to a court filing by the U.S. Attorney’s office in St. Louis, Mo.

The reports continue sayin that he opened and oversaw Loan Management Accounts, which are credit lines collateralized by securities held in customer accounts, under his clients’ names and then used those funds for down payments on a personal residence, mortgage payments, vehicle lease payments and living expenses, the filing said. He hid the activities by falsifying signatures on letters of authorization, replacing balances at one account with those of another client’s, and sending account statements to unrelated addresses to which only Campbell had access, according to the complaint.

More details are available at Ex-Merrill Broker Sentenced to More Than 3 Years 

Wall Street Profit May Drop 37% Bitten by Laws, Congress

Wall Street’s profit may fall 37 percent this year, hurt during the second half by rising interest rates, legal costs and budget turmoil in Washington, New York State Comptroller Thomas DiNapoli said. DiNapoli forecast securities industry earnings at $15 billion in 2013 compared with $23.9 billion the year before, while employment has fallen near a post-recession low.

A drop in profit may crimp bonuses, which reached an estimated $20 billion for 2012, he said. “The political gridlock in Washington may take a bite out of the securities industry’s profits for the fourth quarter,” DiNapoli, 59, said in a statement. “Washington’s inability to resolve budget and fiscal issues is bad for business.”

An impasse over spending and raising the nation’s borrowing limit led to a partial shutdown of U.S. government operations this month, as Republicans in Congress fought with Democrats over paring back Obamacare. The resulting turmoil rocked equities and pushed prices higher in the $4.1 trillion market for federal debt. That may lower earnings in the securities industry, which helps drive the city’s economy, DiNapoli said. “Failure to resolve the federal budget and debt ceiling impasse could disrupt the economy and hurt New York City and New York state,” said DiNapoli, a Democrat. Congress put off both issues with short-term fixes setting new deadlines next year.

For more information - Wall Street Profit May Drop 37% Bitten by Laws, Congress - Bloomberg


Is the JPMorgan Settlement a Template for Other Bank Settlements?

J.P. Morgan Chase’s settlement is just a template for more settlements on Wall Street. According to an article at MarketWatch, the Justice Department is planning to use the reported $13 billion settlement with J.P. Morgan as a blueprint for other similar settlements. 

The deal to settle investigations by prosecutors into the firm’s issuance of bad mortgage investments to investors before the financial crisis could just be the start of many large settlements in the banking industry. The Justice Department plans to use a 1980s law which carries a lower burden of proof and gives prosecutors 10 years, instead of the standard 5 years, to pursue these cases. Some of the settlement money would have to go directly to struggling consumers, under the new model.

J.P. Morgan has been accused of selling troubled mortgage securities, many of which originated from its acquisitions of Bear Stearns and Washington Mutual. Almost every major Wall Street firm issued similar mortgage securities before the crisis and could become targets under this new approach by prosecutors. 

When the housing boom crashed five years ago, investors lost billions on their investments and the banks were accused of intentionally selling bad mortgages. Now five years later, banks, including Bank of America Corp. and Citigroup, have been saddled with ongoing litigation from the regulators, prosecutors, states and investors.

This switch in prosecution theories, which effectively extends the statute of limitations, will undoubtedly result in longer investigations, and more uncertainty for targets and potential targets of those investigations.

Tuesday, October 22, 2013

How the JPMorgan deal could curtail credit

The Justice Department's potential $13 billion settlement with JPMorgan may go a long way toward appeasing consumers' anger at big banks for the financial crisis, but it probably won't help those same consumers get a mortgage. In fact, it may make it harder.

For more information - How the JPMorgan deal could curtail credit


BofA Said to Face Three More U.S. Probes of Mortgage-Bond Sales

Bloomberg is reporting that Bank of America Corp., sued by U.S. attorneys in August over an $850 million mortgage bond, faces three additional Justice Department civil probes over mortgage-backed securities, according to two people with direct knowledge of the situation.

U.S. attorneys offices in Georgia and California are examining potential violations tied to Countrywide Financial Corp., the subprime lender Bank of America bought in 2008, said the people, who asked not to be identified because the inquiries aren’t public. U.S. attorneys in New Jersey are looking into deals involving Merrill Lynch & Co., purchased by the firm in 2009, the people said.

If claims are brought, Bank of America would join JPMorgan Chase & Co. (JPM) in facing Justice Department demands that it resolve liabilities inherited while buying weakened rivals at the government’s urging during the credit crisis. JPMorgan, the biggest U.S. bank, reached a tentative $13 billion agreement last week to end civil claims over mortgage-bond sales, including those handled by Bear Stearns Cos. and Washington Mutual Inc. operations purchased in 2008. Bank of America, led by Chief Executive Officer Brian T. Moynihan, 54, is being examined for violations of the Financial Institution Reform, Recovery and Enforcement Act of 1989, a relic of the savings-and-loan crisis known as FIRREA, according to the people. The Justice Department cited that statute in its August lawsuit against the firm, which is the nation’s second-largest lender after JPMorgan.

For more information - BofA Said to Face Three More U.S. Probes of Mortgage-Bond Sales - Bloomberg


The attorneys at Sallah Astarita & Cox include veteran securities litigators and former SEC Enforcement Attorneys. We have decades of experience in securities litigation matters, including the defense of enforcement actions. We represent investors, financial professionals and investment firms and brokers nationwide. For more information cotact Mark Astarita at 212-509-6544 or at email us

Thursday, October 17, 2013

SEC Loses Mark Cuban Suit

Years ago, in what we viewed as a far too convenient allegation, the SEC accused billionaire Mark Cuban of insider-trading. The allegations were odd - the SEC alleged that the CEO in question told Mr. Cuban, that he had confidential information to provide to him, and that Mr. Cuban agreed to keep it confidential. That allegation raises the question, can the CEO of a public company voluntarily provide material, non-public information to someone, and prevent that someone from trading? Is so, it is a great way to keep your largest shareholder from selling his stock - call him up and give him some inside information.

Seal of the U.S. Securities and Exchange Commi...I have a number of blog posts on the case. All are collected in Mark Cuban SEC. All predicted a loss for the SEC, given the sheer lack of legal weight to the claims.
But that is not often enough. It is an unfortunate part of our society that the government often wins cases simply because the target of its ire does not have the ability to fight back. There are countless examples of small brokerge firms, investors and individual brokers who settle SEC, or FINRA cases simply because they cannot afford to fight, even though they are right.

I had the pleasure to represent a broker who did not back down from a fight with FINRA, who  refused to settle with them when he was right and FINRA was wrong. It was a time consuming and expensive fight, but we won, and FINRA lost.

It was therefore a pleasure to watch Mark Cuban fight back. He certainly has the financial ability, but he also had the nerve to do so. And, after only a few hours of deliberation, much of which was probably discussing football, so as to not embarass the SEC, the jury in federal district court in Dallas said that the Securities and Exchange Commission failed to prove the key elements of its case, including the claim that Cuban agreed to keep certain information confidential and not trade on it.

During an impromptu news conference outside the courthouse, Mark Cuban angrily denounced the SEC and its lead trial attorney, Jan Folena, saying that they lied about the evidence and targeted him because of his fame.

Mr, Cuban acknowledged that  defendants of lesser wealth could have been bullied.
''Hopefully people will start paying attention to how the SEC does business,'' Cuban said. ''I'm the luckiest guy in the world. I'm glad this happened to me. I'm glad I'm able to be the person who can afford to stand up to them.''
For more information - Jury says Cuban did not commit insider trading 
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Wednesday, October 16, 2013

Puerto Rico Seeks To Calm Rattled Muni Bond Investors

Puerto Rico officials sought to soothe the fears of edgy investors Tuesday as the market continues to price risk into the tropical island’s widely held municipal bonds. “These are not just constitutional obligations, but also moral obligations,” said Governor Alejandro Garcia Padilla in an investor webinar, reaffirming the island’s intent to make good on its debt obligations.

South view of the building, located in the Pue...Puerto Rico has roughly $70 billion in outstanding municipal bonds, which hold the lowest investment grade rating from major rating agencies. Its debt has long been held in municipal bond funds because its bonds are exempt from local, state, and federal taxes, but investor concerns have grown.

Another aspect of this bond debacle is marketing of the bonds by some brokerage firms, notably UBS. We are prosecuting and investigating claims against UBS for those practices, as well as other broker dealers, who may not have properly disclosed the risks in the Puerto Rico bonds.

For more information - Puerto Rico seeks to calm rattled muni bond investors

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Tuesday, October 15, 2013

Bob Shiller's Nobel

As with Lars Hansen and Gene Fama, Bob Shiller has also produced a span of interesting innovative work, that I can't possibly cover here. Again, don't let a Nobel Prize for one contribution overshadow the rest. In addition to volatility, Bob did (with Grossman and Melino) some of the best and earliest work on the consumption model, and his work on real estate and innovative markets is justly famous.  But, space is limited so again I'll just focus on volatility and predictability of returns which is at the core of the Nobel.

Source: American Economic Review
The graph on the left comes from Bob's June 1981  American Economic Review paper. Here Bob contrasts the actual stock price p with the "ex-post rational" price p*, which is the discounted sum of actual dividends. If price is the expected discounted value of dividends, then price should vary less than the actual discounted value of ex-post dividends.  Yet the actual price varies tremendously more than this ex-post discounted value.

This was a bombshell. It said to those of us watching at the time (I was just starting graduate school) that you Chicago guys are missing the boat. Sure, you can't forecast stock returns. But look at the wild fluctuations in prices! That can't possibly be efficient. It looks like a whole new category of test, an elephant in the room that the Fama crew somehow overlooked running little regressions.  It looks like prices are incorporating information -- and then a whole lot more!  Shiller interpreted it as psychological and social dynamics, waves of optimisim and pessimism.

(Interestingly, Steve Leroy and Richard Porter also wrote an essentially contemporary paper on volatility bounds in the May 1981 Econometrica: The Present Value Relation: Tests Based on Implicit Variance Bounds, that has been pretty much forgotten. I think Shiller got a lot more attention because of the snazzy graph, and the seductive behavioral interpretation. This is not a criticism. As I've said of the equity premium, knowing what you have and marketing it well matters. Deirdre McCloskey tells us that effective rhetoric is important and she's right. Most great work emerges as the star among a lot of similar efforts. Young scholars take note.)

But wait, you say. "Detrended by an exponential growth factor?" You're not allowed to detrend a series with a unit root. And what exactly is the extra content, overlooked by Fama's return forecasting regressions? Aha, a 15 year investigation took off, as a generation of young scholars dissected the puzzle. Including me. Well, you get famous in economics for inducing lots of people to follow you, and Shiller (like Fama and Hansen) is justly famous here by that measure.

My best attempt at summarizing the whole thing is in the first few pages of "Discount Rates," and the theory section of that paper. For a better explanation, look there. The digested version here.

Along the way I wrote "Volatility Tests and Efficient Markets" (1991) establishing the equivalence of volatility tests and return regressions, "Explaining the Variance of Price-Dividend Ratios" (1992), an up to date volatility decomposition, "Permanent and Transitory Components of GNP and Stock Prices" (1994) "The Dog That Did Not Bark" (2008), three review papers, an extended chapter in my textbook "Asset Pricing," covering volatility, bubbles and return regressions, and last but not least an economic model that tries to explain it all, "By Force of Habit" (1999) with John Campbell. And that's just me. Read the citations in the Nobel Committe's  "Understanding Asset Prices." John Campbell's list is three times as long and distinguished.  

So, in the end, what do we know? A modern volatility test starts with the Campbell-Shiller linearized present value relation
Here p=log price, d=log dividend, r=log return and rho is a constant about 0.96. This is just a clever linearization of the rate of return -- you can rearrange it to read that the long run return equals final price less initial price plus intermediate dividends. Conceptually, it is no different than reorganizing the definition of return to
You can also read the first equation as a present value formula. The first term says prices are higher if dividends are higher. The second term says prices are higher if returns are lower -- the discount rate effect. The third term represents "rational bubbles."  A price can be high with no dividends if people expect the price to grow forever.

Since it holds ex-post, it also holds ex-ante -- the price must equal the expected value of the right hand side. And now we can talk about volatilty: the price-dividend ratio can only vary if expected dividend growth, expected returns, or the expected bubble vary over time. 

Likewise, multiply both sides of the present value identity by p-d and take expectations. On the left, you have the variance of p-d. On the right, you have the amount by which p-d forecasts dividend growth, returns, or future p-d. The price-dividend ratio can only vary if it forecasts future dividend, growth, future returns, or its own long-run future. 

The question for empirical work is, which is it? The surprising answer: it's all returns. You might think that high prices relative to current dividends mean that markets expect dividends to be higher in the future. Sometimes, you'd be right. But on average, times of high prices relative to current dividends (earnings, book value, etc.) are not followed by higher future dividends. On average, such times are followed by lower subsequent long-run returns.

Shiller's graph we now understand as such a regression: price-dividend ratios do not forecast dividend growth. Fortunately, they do not forecast the third term, long-term price-dividend ratios, either -- there is no evidence for "rational bubbles." They do forecast long-run returns. And the return forecasts are enough to exactly account for price-dividend ratio volatility!

Starting in 1975 and continuing through the late 1980s, Fama and coauthors, especially Ken French, were running regressions of long-run returns on price-dividend ratios, and finding that returns were forecastable and dividend growth (or the other "complementary" variables) were not. So, volatility tests are not something new and different from regressions. They are exactly the same thing as long-run return forecasting regressions. Return forecastability is exactly enough to acount for price-dividend volatility.  Price-dividend volatility is another implication of return forecastability-- and an interesting one at that! (Lots of empirical work in finance is about seeing the same phenomenon through different lenses that shows its economic importance.)

And the pattern is pervasive across markets. No matter where you look, stock, bonds, foreign exchange, and real estate, high prices mean low subsequent returns, and low prices (relative to "fundamentals" like earnings, dividends, rents, etc) mean high subsequent returns.

These are the facts, which are not in debate. And they are a stunning reversal of how people thought the world worked in the 1970s. Constant discount rate models are flat out wrong.

So, does this mean markets are "inefficient?" Not by itself. One of the best parts of Fama's 1972 essay was to prove a theorem: any test of efficiency is a joint hypothesis test with a "model of market equilibrium." It is entirely possible that the risk premium varies through time. In the 1970s, constant expected returns were a working hypothesis, but the theory long anticipated time varying risk premiums -- it was at the core of Merton's 1972 ICAPM -- and it surely makes sense that the risk premium might vary through time.

So here is where we are: we know the expected return on stocks varies a great deal through time. And we know that time-variation in expected returns varies exactly enough to account for all the puzzling price volatility. So what is there to argue about? Answer: where that time-varying expected return comes from.

To Fama, it is a business cycle related risk premium. He (with Ken French again) notices that low prices and high expected returns come in bad macroeconomic times and vice-versa. December 2008 was a recent  time of low price/dividend ratios. Is it not plausible that the average investor, like our endowments,  said, "sure, I know stocks are cheap, and the long-run return is a bit higher now than it was. But they are about to foreclose on the house, reposess the car, take away the dog, and I might lose my job. I can't take any more risk right now." Conversely, in the boom, when people "reach for yield", is it not plausible that people say "yeah, stocks aren't paying a lot more than bonds. But what else can I do with the money? My business is going well.  I can take the risk now."

To Shiller, no. The variation in risk premiums is too big, according to him, to be explained by variation in risk premiums across the business cycle. He sees irrational optimism and pessimism in investor's heads. Shiller's followers somehow think the government is more rational than investors and can and should stabilize these bubbles. Noblesse oblige.

Finally, the debate over "bubbles" can start to make some sense. When Shiller says "bubble," in light of the facts, he can only mean "time-variation in the expected return on stocks, less bonds, which he believes is disconnected from rational variation in the risk premium needed to attract investors." When Fama says no "bubble," he means that the case has not been proven, and it seems pretty likely the variation in stock expected returns does correspond to rational, business-cycle related risk premiums. Defining a "bubble," clarifying what the debate is about, and settling the facts, is great progress.

How are we to resolve this debate? At this level, we can't. That' the whole point of Fama's joint hypothesis theorem and its modern descendants (the existence of a discount factor theorems). "Prices are high, risk aversion must have fallen" is as empty as "prices are high, there must be a wave of irrational optimism." And as empty as "prices are high, the Gods must be pleased." To advance this debate, one needs an economic or psychological model, that independently measures risk aversion or optimisim/pessimism, and predicts when risk premiums are high and low. If we want to have Nobels in economic "science," we do not stop at story-telling about regressions.

One example: John Campbell and I (Interestingly, Shiller was John's PhD adviser and frequent coauthor) wrote such a model, in "By Force of Habit". It uses the history of consumption and an economic model as an independent measure of time varying risk aversion, which rises in recessions. Like any model that makes a rejectable hypothesis, it fits some parts of the data and not others. It's not the end of the story.  It is, I think, a good example of the kind of model one has to write down to make any progress.

I am a little frustrated by behavioral writing that has beautiful interpretive prose, but no independent measure of fad, or at least no number of facts explained greater than number of assumptions made. Fighting about who has the more poetic interpretation of the same regression, in the face of a theorem that says both sides can explain it, seems a bit pointless. But an emerging literature is trying to do with psychology what Campbell and I did with simple economics. Another emerging literature on "institutional finance" ties risk aversion to internal frictions in delegated management, and independent measures such as intermediary leverage.

That's where we are. Which is all a testament to Fama, Shiller, Hansen, and asset pricing. These guys led a project that assembled a fascinating and profound set of facts. Those facts changed 100% from the 1970s to the 1990s. We agree on the facts. Now is the time for theories to understand those facts.  Real theories, that make quantitative predictions (it is a quantiative question: how much does the risk premium vary over time), and more predictions than assumptions.

If it all were settled, their work would not merit the huge acclaim that it has, and deserves.

Update: I'm shutting down most comments on these. For this week, let's congratulate the winners, and debate the issues some other day.

Lars Hansen's Nobel

Lars has done so much  deep and pathbreaking research, that I can't begin to even list it, to say nothing of explain the small part of it that I understand.  I wrote whole chapters of my textbook "Asset Pricing" devoted to just one Hansen paper. Lars writes for the ages, and it often takes 10 years or more for the rest of us to understand what he has done and how important it is.

So I will just try to explain GMM and the consumption estimates, the work most prominently featured in the Nobel citation. Like all of Lars' work, it looks complex at the outset, but once you see what he did, it is actually brilliant in its simplicity.

The GMM approach basically says, anything you want to do in statistical analysis or econometrics can be written as taking an average.

For example, consider the canonical consumption-based asset pricing model, which is where he and Ken Singleton took GMM out for its first big spin. The model says, we make sense of out of asset returns -- we should understand the large expected-return premium for holding stocks, and why that premium varies over time (we'll talk about that more in the upcoming Shiller post) -- by the statement that the expected excess return, discounted by marginal utility growth, should be zero
where Et means conditional expectation, beta and gamma capture investor's impatience and risk aversion, c is consumption and R is a stock or bond return and Rf is a bond return. E(R-Rf) is the premium -- how much you expect to earn on a risky asset over a riskfree one, as compensation for risk. (Non-economists, just ignore the equations. You'll get the idea). Expected returns vary over time and across assets in puzzling ways, but the expected discounted excess return should always be zero.

How do we take this to data? How do we find parameters beta and gamma that best fit the data? How do we check this over many different times and returns, to see if those two parameters can explain lots of facts? What do we do about that conditional expectation Et, conditional on information in people's heads? How do we bring in all the variables that seem to forecast returns over time (D/P) and across assets (value, size, etc.)? How do we handle the fact that return variance changes over time, and consumption growth may be autocorrelated?

When Hansen wrote, this was a big headache. No, suggested Lars. Just multiply by any variable z that you think forecasts returns or consumption, and take the unconditional average of this conditional average, and the model predicts  that the unconditional average obeys
So, just take this average in the data. Now, you can do this for lots of different assets R and lots of different "instruments" z, so this represents a lot of averages. Pick beta and gamma that make some of the averages as close to zero as possible. Then look at the other averages and see how close they are to zero.

Lars worked out the statistics of this procedure -- how close should the other averages be to zero, and what's a good measure of the sample uncertainty in beta and gamma estimates -- taking in to account a wide variety of statistical problems you could encounter. The latter part and the proofs make the paper hard to read. When Lars says "general" Lars means General!

But using the procedure is actually quite simple and intuitive. All of econometrics comes down to a generalized version of the formula sigma/root T for standard errors of the mean. (I recommend my book "Asset Pricing" which explains how to use GMM in detail.)

Very cool.

The results were not that favorable to the consumption model. If you look hard, you can see the equity premium puzzle -- Lars and Ken needed huge gamma to fit the difference between stocks and bonds, but then couldn't fit the level of interest rates.  But that led to an ongoing search -- do we have the right utility function? Are we measuring consumption correctly? And that is now bearing fruit.

GMM is really famous because of how it got used. We get to tests parts of the model without writing down the whole model. Economic models are quantiative parables, and we get to examine and test the important parts of the parable without getting lost in irrelevant details.

What do these words mean? Let me show you an example. The classic permanent income model is a special case of the above, with quadratic utility. If we model income y as an AR(1) with coefficient rho, then the permanent income model says consumption should follow a random walk with innovations equal to the change in the present value of future income:

This is the simplest version of a "complete" model that I can write down. There are fundamental shocks, the epsilon; there is a production technology which says you can put income in the ground and earn a rate of return r, and there is an interesting prediction -- consumption smooths over the income shocks.

Now, here is the problem we faced before GMM. First, computing the solutions of this sort of thing for real models is hard, and most of the time we can't do it and have to go numerical. But just to understand whether we have some first-order way to digest the Fama-Shiller debate, we have to solve big hairy numerical models? Most of which is beside the point? The first equations I showed you were just about investors, and the debate is whether investors are being rational or not. To solve that, I have to worry about production technology and equilibrium?

Second, and far worse, suppose we want to estimate and test this model. If we follow the 1970s formal approach, we immediately have a problem. This model says that the change in consumption is perfectly correlated with income minus rho times last year's income. Notice the same error epsilon in both equations. I don't mean sort of equal, correlated, expected to be equal, I mean exactly and precisely equal, ex-post, data point for data point.

If you hand that model to any formal econometric method (maximum likelihood), it sends you home before you start. There is no perfect correlation in the data, for any parameter values. This model is rejected. Full stop.

Wait a minute, you want to say. I didn't mean this model is a complete perfect description of reality. I meant it is a good first approximation that captures important features of the data. And this correlation between income shocks and consumption shocks is certainly not an important prediction.  I don't think income is really an AR(1), and most of all I think agents know more about their income than my simple AR(1). But I can't write that down, because I don't see all their information. Can't we just look at the consumption piece of this and worry about production technology some other day?

In this case, yes. Just look whether consumption follows a random walk. Run the change in consumption on a bunch of variables and see if they predict consumption. This is what Bob Hall did in his famous test, the first test of a part of a model that does not specify the whole model, and the first test that allows us to "condition down" and respect the fact that people have more information than we do. (Lars too walks on the shoulders of giants.) Taking the average of my first equation is the same idea, much generalized.

So the GMM approach allows you to look at a piece of a model -- the intertemporal consumption part, here -- without specifying the whole rest of the model -- production technology, shocks, information sets. It allows you to focus on the robust part of the quantitative parable -- consumption should not take big predictable movements -- and gloss over the parts that are unimportant approximations -- the perfect correlation between consumption and income changes.  GMM is a tool for matching quantitative parables to data in a disciplined way.

This use of GMM is part of a large and, I think, very healthy trend in empirical macroeconomics and finance. Roughly at the same time, Kydland and Prescott started "calibrating" models rather than estimating them formally, in part for the same reasons. They wanted to focus on the "interesting" moments and not get distracted by the models' admitted abstractions and perfect correlations.

Formal statistics asks "can you prove that this model is not a 100% perfect representation of reality" The answer is often "yes," but on a silly basis. Formal statistics does not allow you to say "does this model captures some really important pieces of the picture?" Is the glass 90% full, even if we can prove it's missing the last 10%?

But we don't want to give up on statistics, which much of the calibration literature did. We want to pick parameters in an objective way that gives models their best shot. We want to measure how much uncertainty there is in those parameters. We want to know how precise our predictions for the "testing" moments are. GMM lets you do all these things. If you want to "calibrate" on the means (pick parameters by observations such as the mean consumption/GDP ratio, hours worked, etc.), then "test" on the variances (relative volatility of consumption and output, autocorrelation of output, etc.), GMM will let you do that. And it will tell you how much you really know about parameters (risk aversion, substitution elasticities, etc.) from those "means", how accurate your predictions about "variances" are, including the degrees of freedom chewed up in estimation!

In asset pricing, similar pathologies can happen. Formal testing will lead you to focus on strange portfolios, thousands of percent long some assets and thousands of percent short others. Well, those aren't "economically interesting." There are bid/ask spread, price pressure, short constraints and so on. So, let's force the model to pick parameters based on interesting, robust moments, and let's evaluate the model's performance on the actual assets we care about, not some wild massive long-short ("minimum variance") portfolio.

Fama long ran OLS regressions when econometricians said to run GLS, because OLS is more robust.  GMM allows you to do just that sort of thing for any kind of model -- but then correct the standard errors!

In sum, GMM is a tool, a very flexible tool. It has let us learn what the data have to say, refine models, understand where they work and where they don't, emphasize the economic intuition, and break out of the straightjacket of "reject" or "don't reject," to a much more fruitful empirical style.

Of course, it's just a tool. There is no formal definition of an "economically interesting" moment, or a "robust" prediction. Well, you have to think, and read critically.

Looking hard but achieving  a remarkable simplicity when you understand it is a key trait of Lars' work. GMM really is just applying sigma/Root T (generalized) to all the hard problems of econometrics. Once you make the brilliant step of recognizing they can be mapped to a sample mean. His "conditioning information" paper with Scott Richard took me years to digest. But once you understand L2, the central theorem of asset pricing is "to every plane there is an orthogonal line." Operators in continuous time, and his new work on robust control and recursive preference shares the same elegance.

The trouble with the Nobel is that it leads people to focus on the cited work. Yes, GMM is a classic. I got here in 1985 and everyone already knew it would win a Nobel some day. But don't let that fool you, the rest of the Lars portfolio is worth studying too. We will be learning from it for years to come. Maybe this will inspire me to write up a few more of his papers. If only he would stop writing them faster than I can digest them.

Source: Becker-Friedman Institute
I won't even pretend this is unbiased. Lars is a close friend as well as one of my best colleagues at Chicago. I learned most of what I know about finance by shuttling back and forth between Lars' office and Gene Fama's, both of whom patiently explained so many things to me. But they did so in totally different terms, and understanding what each was saying in the other's language led me to whatever synthesis I have been able to achieve. If you like the book "Asset Pricing," you are seeing the result. He is also a great teacher and devoted mentor to generations of PhD students.

(This is a day late, because I thought I'd have to wait a few more years, so I didn't have a Hansen essay ready to go. Likewise Shiller, it will take a day or two. Thanks to Anonymous and Greg for reporting a typo in the equations.)

Update: I'm shutting down most comments on these posts. This week, let's congratulate the winners, and discuss issues again next week.