The First Snowfall

This will be a shameless plug.  However, just maybe an example will also show why I think insurance can be so interesting!

The first snow hit Lake Tahoe this week.  That's good news.  Why?  Everyone begins to worry about winter.  That's where my new company comes in, and why this is a shameless plug.

[Don't forget the disclaimer: I am not advising you on insurance or derivatives transactions.]

Most people I know will very soon cut a deal with their landscaper to plow their walks and driveway.  Your landscaper charges you one of two ways.  Either a fixed price for the whole season, or a variable price based on how much it snows.

With a fixed seasonal contract, if it snows very little, you feel ripped off, and your landscaper has a windfall for no work.  If it snows too much, you have a windfall, if your landscaper actually clears your driveway for that tenth blizzard of the year.  Only in a narrow band of snowfall do you both feel "okay". 

The per event or per inch contract is just as bad.  You have no idea how much you'll have to pay.  Your landscaper (if he's like my kids) sleeps with his pajamas inside out with pennies on the windowsill all winter, hoping he can pay his mortgage.

In fact, the seasonal contract you bought amounts to buying insurance against snowfall from a guy whose primary systematic risk in his life depends on snowfall.  By design, you have to overpay him for this.  If you go with the variable cost, you have potentially massive budget uncertainty.  (This is exactly like my past discussions about why you cannot hedge the ultimate financial disaster!)

"Massive" could be an exaggeration for you personally, but for plenty of businesses, it matters.  Imagine you have a really big driveway--more like a parking lot.  You must keep it clear at all times.  You get the idea.

You wouldn't buy car insurance from your landscaper, so why do you buy weather derivatives from him?

So, what do you do?  You need a third party.  Ideally, this third party understands snowfall risks, but doesn't really care much.  They take lots of different risks.  Your bit of snow matters little.  That's where insurers come into the picture.  As much as people love to hate insurance companies, they're in business to bear risk the rest of us cannot take.

Unreasonable Claim of the Week

There's a standard strategy in emerging markets hedge fund investing that too many investors seem to be willing to tolerate: Go long emerging markets equities, which are viewed as "long term attractive" at the same time as they tend to be very "risky", and "hedge" with developed markets positions with better liquidity.

Think that sounds silly?  Think that sounds like your front airbags deploying when you're hit from the side?

In a story from Pension and Investments on emerging markets investment strategy we hear from the experts:

PIMCO limits losses in its [emerging markets] strategy at 30% — or 1.5 standard deviations from the long-run average volatility in emerging markets equity of 20% — but doesn't give up any returns to do so, Ms. Gordon  [executive vice president and lead portfolio manager in emerging markets equity at PIMCO in London] said. “You're not giving up upside; you're capping downside,” she said.

That's because PIMCO looks for the cheaper ways to hedge against major losses. One example is the Australian dollar: AUD options won't hedge against minor performance bumps in the road, “but it is an asset that correlates with a rise in risk aversion in a global meltdown,” Ms. Gordon said.

Translation?  PIMCO doesn't actually limit losses at 30%, and PIMCO does limit upside.  Instead of buying high expected return emerging markets equities, they buy hopefully correlated, liquid, cheap and low expected return stuff that they think might have high returns if emerging markets crash. 

For you home chefs, here's a recipe for your own emerging markets hedge fund:

Start with $100,000:

• Buy $50,000 of EEM, the iShares Emerging Markets Index ETF.
• Pick three emerging markets countries or regions you think are cool places you'd like to visit that have single country ETFs.  Looking for inspiration?  Here's a list.  Invest $10,000 in each three.
• Buy $2,000 worth of three month, 30% out of the money puts on the S&P500.  (That means you own the right to sell the S&P500 at a price 30% below where it is the day you buy, for about three months.)
• Every month, buy more of the options the same way, and rebalance your long positions to 50% EEM, 10% each of your three hot picks.

If you are successful, please send 2% management fees, and 20% performance fees.

Nickel Mania

In 1980, when I was eleven, the U.S. Mint announced pennies would no longer contain 100% copper, starting in 1982.  I started hoarding pennies.  I saw certain wealth in my future. Being the sentimental sort, the first roll I sealed into a plastic tube, inscribed with "Donot Open Until 2000".  That roll appears in the image above.  My wife says this proves I was a lunatic at a very early age.

Before I went to college in 1987, I schlepped approximately $800 worth of pennies to my local bank.  That's a lot of copper.  And, a surprised bank teller.  I gave up on my copper trade: I had hoarded copper through some ridiculously high interest rates, most certainly losing money.

Yesterday, I had lunch with a friend thrilled with the nickel trade.  In case you are unaware, the metal value of a nickel is now about seven cents.  He explained that an unnamed hedge fund manager is out marketing with a picture of a vault full of nickels.  This is his actual strategy.

Aside from the legality of melting down US currency, let's think about expense.  If my brother the chemistry PhD student kept reasonable hours, I'd have the exact answer already as to how much energy is required to melt a nickel coin, separate the copper and nickel, etc.  (I know, specific heat, melting point, yada yada yada...I'll miss some detail in scaling it up and wasting energy in the process...I'll follow up with relevant details later.)

Clearly, you're better off reconstructing my 1980 penny hoard.  Those pennies are worth almost three cents today.  Pure copper will be easier to work with than the copper-nickel alloy of nickels, so I'm guessing the melt down expense may actually cover for the substantially higher storage cost of nickels versus pennies.

You want a better trade?  All donations to the strategy will be accepted via Paypal.  [This is not an offering to sell securities!  You will lose money, but I'm happy to accept your contributions!]

I have completely secure storage (in a safe deposit box) and clean title (I purchased direct from the issuer!) to U.S. government backed inflation indexed securities in small denominations.  Not only are they indexed to inflation, they carry an accrued premium above inflation based on the implied inefficiencies of one of the worst functioning government programs.  Equally importantly, storage costs are a mere fraction of coinage storage.  In the space required for a roll of nickels, I can hold almost $200 face value of these securities.

Want more information?  Here you go...Forever Stamps good for 1oz of first class postage, well, forever.  The best part of the current "Forever" stamps, truly appropriate for gambling on inflation?  The image is not Lady Liberty, but the Las Vegas replica!  (Note: not worth 1 of your 20 if you're counting.)

Questions You Never Thought You'd Ask

Hold on to your hats:  Are more efficient markets really that good for us?

I know, I cannot believe I wrote it either.

Let's be precise.  If we define "efficient markets" as a full complement of Arrow-Debreu securities, (these are securities that have a payoff of one in a single, particular state in the future, and pay off zero otherwise..pause and think about this...that's a whole heck of a lot of securities!) then we can accept the fact that "efficient markets" is a theoretical construct.  All we can strive for are "more efficient" markets by constructing more an more useful securities.  Useful being the operative term.

Why are a complete set of Arrow-Debreu securities useful?  If we had them, we could hedge anything.  Because we don't, we can't always hedge.  This means messy states of the world will exist.  Think May's "Flash Crash".


In this story, we learn about one after the fact solution to the Flash Crash.  A husband and wife pair of market micro-structure experts, working with a high frequency trading practitioner at Tudor, have developed a measure called VPIN, for "volume-synchronized probability of informed trading."  Apparently this measure predicts movements in volatility, and could have predicted the Flash Crash. 

The researcher at Tudor has applied for a patent on the measure, with the logical next step of a futures contract on it.  We can only assume options on VPIN follow shortly thereafter.  The VIX (volatility index) followed a similar securitization path.

So, how could I be opposed to such a securitization, which only serves to reduce market inefficiencies?  Safety measures have consequences.  Sam Peltzman's research on seat belts tells us everything: Drivers who wear seat belts drive more recklessly. 

Since the Flash Crash likely had roots in lousy liquidity, I find the situation ironic.  Design securities with lousy liquidity to hedge a liquidity driven crash!  

How do I know VPIN based securities will have lousy liquidity?  No one wants to be long VPIN risk.  In a very simple sense, this means you lose a whole bunch of money when a disaster hits the equity market.  (I wrote here about hedging catastrophic market events.  Providing insurance for truly catastrophic events requires massive amounts of capital and very high fees: you have to be certain you'll have capital after the event happens, but at the same time you have to be paid enough to have your capital doing nothing at other times so you don't lose it in the crash.) 

There are no natural buyers of VPIN risk.  (Who wants to agree to lose money in a liquidity driven crash?)  Lot's of sellers means some combination of lousy liquidity and horrible volatility imbalances in options of VPIN...until someone constructs futures (and options!) on VPIN volatility!  That way market participants magically hedge the VPIN illiquidity!  You see where this goes?  Rinse and Repeat.

We'll keep hiding the risk in more and more esoteric derivatives, but the risk doesn't go away.  As much as it pains me to say this, I can't quite see how more securities really makes us better off.

Buy a House? The "Best Leading Indicator" Says Yes!

I've owned three houses in my life.  They've all been terrible "investments", including the one I'm sitting in right now, and I haven't a clue when I'll sell it.

Think about a house as an investment.  Historically, residential real estate returns maybe two or three percent annually, after inflation.  That's actually not terrible, especially if you don't owe taxes on the sale.  But it will cost you at least five percent in various transaction costs.  We're not selling IBM shares, after all. While you own this "investment" you risk fast depreciation, (it burns down,) and slow depreciation, (the roof wears out.) Those are real dollars to keep the investment "working for you," as they say.

More abstractly, you severely limit your career.  You can't move cross country with this asset.  You also can't inexpensively change your child's school.  I know, you bought the house for the good schools.  That was ten years ago.  They had a great kindergarten!  The high school is full of hoodlums. 

Moishe's Moving and Storage

Henry Hu posits the idea of "empty creditors" as the source of the financial disaster that he successfully predicted:

...a bank lends money to a company but uses derivatives to eliminate any exposure if the company goes bankrupt. Mr. Hu calls the bank in such a case an "empty creditor," and says it is dangerous because it undermines a basic assumption in financial markets: that creditors act in the interests of the debtor's survival.

 Moishe's may be as recognizable in New York City as H&H Bagels.  Moishe's knows more about finance than most of the world.  Moving and Storage.  Which do you think is better business?  Storage requires warehouses.  Big ones.  Expensive, secure and well protected ones.  Moving requires beat up old trucks, and hourly labor.  Cheap.  Flexible.  Little capital, lots of profits.  That's all there is to know about banking.

Give Well, don't Guide Star, and how to respond to Haiti

In this post, I propose hedging catastrophe risk in emerging markets via reinsurance transactions.  I argue it's cheap because most emerging market catastrophes are uncorrelated with developed market catastrophes, and they are small risks, relatively speaking.  I argue it's more efficient because it prevents crowding out of more effective, higher success rate development aid programs. (Let's be realistic: Search and rescue teams in Haiti are not "free" in any sense of the word.  Their cost per lives saved, unfortunately, is very high.  We'd save many more lives buying mosquito nets.)

This brings me to the Red Cross, and my suggestion to them.  Millions of people of generously texted their $10 to the Red Cross, a genuinely generous act.  However, they should know there is no guarantee most of these contributions go to Haiti.  I for one don't think that matters.  However, I'd imagine many of these contributors want their money to be for disaster relief.

What, in theory, could the Red Cross do?  They could take these contributions and buy catastrophe insurance on other potential emerging markets disasters.  They will very likely occur.  They will stretch the resources of the Red Cross and others.  They will crowd out longer term projects that may be substantially more cost effective.

Attempting to prevent financial disasters is too costly

What does it mean to prevent financial meltdowns?  Suppose you could buy an insurance policy against a financial catastrophe.

Let's keep this very simple, for a concrete example.  Suppose you want to buy a binary security linked to GDP for one year.  Such a security pays the holder $1 if U.S. GDP drops by 10% or more in a calendar year, zero otherwise.  That's what we'll define as a financial meltdown.  The price of this security is the insurance premium for one year of financial disaster protection.

Suppose a household needs $1 million of this security to hedge their exposure to the risk.  This $1 million payoff presumably must cover (the net present value of) losses to financial assets, employment income, real estate, etc. if such an event occurs.

In addition, the buyer of the insurance must be confident that the provider of this protection will be able to pay off the $1 million if the event happens.  That's a serious concern.