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