Often wrong but never in doubt - credit crunch

There were a few items on the credit crunch or "market turmoil" this week. I pulled a few quotes that reflect the errors in thinking that led people to lose so much money, so we can look again at how to reduce these in the future. It would be good to learn from experience!

From Housing Haven to Foreclosure Leader (Stockton, CA)
New York Times 8/13/07
Jesse McKinley
xx

STOCKTON, Calif., Aug. 11 —...

Once considered a safe alternative to the overheated Bay Area real estate market, Stockton and its streets are now filled with “For Sale” signs and evidence of foreclosures. While hundreds of thousands of people nationwide are being affected by troubles in the lending market, Stockton has the highest foreclosure rate of any city in the country, according to RealtyTrac, a real estate data firm.

“It is disturbing, there’s no question about it,” said Mayor Edward J. Chavez, who himself has two houses on the market, with no sales in sight. “A year to two years back, this area was seen as being affordable compared to other areas, the Bay Area, the South Bay. But what was once a vibrant market has kind of hit a brick wall

But those deals quickly soured for new homeowners when higher monthly payments kicked in after two or three years.

“It’s gone from the most liberal financing I’ve ever seen a few years ago to the most foreclosures and delinquencies I’ve ever seen now,” said Art Godi, 71, a longtime Stockton real estate agent and the former president of the National Association of Realtors. “And there’s a connection between those two things, obviously.”

When the housing market was hot a couple of years ago, Mr. Godi said, house prices here were increasing 20 percent a year. Now, he said, the prices are falling as much as 10 percent to 12 percent a year.

“We made bad decisions,” said Ms. Neri, ... We just didn’t see the downturn coming.”

Six California cities rank in the top 10 nationwide for foreclosure rates, according to RealtyTrac, with the top three spots — Stockton, Modesto and Merced — situated in the Central Valley, where longtime agricultural towns have turned into small residential cities.

California has the third-highest rate of foreclosures in the country, RealtyTrac says, behind Nevada and Colorado. In July, another real estate data firm, DataQuick, reported that the state had its highest level of foreclosure in two decades, with nearly 54,000 notices of default sent to delinquent homeowners in the second quarter of 2007.

In May, the California Reinvestment Coalition, a nonprofit group which seeks to promote access to credit in low-income families, wrote to lenders asking for a moratorium on foreclosures.

“Immigrants, seniors and people of color are more likely to have been victimized by bad lenders,” said Kevin Stein, the coalition’s associate director. “But what’s evident looking at these numbers is that the problems being faced are cutting across racial and ethnic lines.”

In June, several state leaders called for a forum in Stockton to help people avoid foreclosures, but most people had dallied too long to address the problem. “There’s denial,” said State Senator Michael J. Machado, a Democrat whose district includes Stockton and who is chairman of the Banking, Finance and Insurance Committee. “People get into these homes, it’s the American dream, and then they wait too long to go to the lender to say they’re having problems.”

I added the emphasis (bolding.) So, even with conspicuous evidence of people around them running into trouble, people don't see their own. And even though the mortgage contract says the rates will go up in 3 years , people can't figure out that means that in 3 years, the rates will go up. Or ask "by how much?" and demand a credible answer. Desire clearly can overcome logic, and tens of thousands of consumers can see no better than one what is happening even when it is happening, or particularly when it is happening and they are "in denial."

Hmm. Surely the professionals are not subject to such flimsy reasoning, right? Apparently not.
Again we see here how a lack of "diversity" can suck even bright people into a vortex of behavior they can't "see" their way out of, resulting in the same "stay the course" error that the homeowners in Stockton displayed.

Pack Mentality among Hedge Funds Fuels Volatility
NY Times
Landon Thomas Jr.
8/13/07

On Wall Street, there is a rage against the machine.

Hedge funds with computer-driven or quantitative investment strategies have been recording significant losses this month.

The managers of these funds are the products of the trading desks of the big investment banks, like Goldman Sachs and Morgan Stanley, both of which have investment operations that use computer models.

The cross-fertilization has raised fears among some analysts that it is not only the hedge funds that are being hit, but the trading desks at the banks as well.

“These guys all know each other, and they all have the same strategies,” said Ernest P. Chan, a quantitative trading consultant who has done computer-driven research at Morgan Stanley and Credit Suisse. “They came from the same schools, and they get together for drinks after work.”

As the quantitative system has come to underpin the investment approaches of some of the largest hedge funds, its use has grown sharply.

Moreover, bankers and investors say, the strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility and, for some hedge funds, has led to losses in the last month.

Wild swings in stock prices have become the norm as fears about the mortgage securities market have expanded into the broader markets. Last week, the Dow Jones industrial average was sharply higher on Monday and Wednesday, only to drop 387 points on Thursday, eventually ending the week about where it began.

A common thread has often been a rise or fall in prices late in the day, a pattern that many analysts attribute to computer models, which are driving a much larger volume of the trading.

Mr. Chan said this predilection for lemming-style buying or selling from investors using similar computer models could turn what would normally be a market setback into a wider contagion.

Despite the large sums of money involved, ranging from $250 billion to $500 billion, according to industry estimates, the club of quantitative investors is a small, exclusive one that bridges the trading desks of investment banks and some of the country’s largest hedge funds.

Hedge funds as a whole have grown exponentially and now manage about $1.7 trillion, more than double the amount five years ago.

In one respect the swoon of these computer-reliant funds is the result of managers, who are faced with a deluge of investor money seeking accelerated returns, using their models to make higher risk market bets by following day-to-day trends. It is an approach that seems to run contrary to the original philosophy underlying a quantitative approach, called statistical arbitrage.

But such strategies rarely promise high returns, so quantitative investors have broadened their computer models to include strategies for investing in more risky areas like mortgage-backed securities, derivatives and commodities.

“You can build a computer model for anything that is tradable,” Mr. Chan said. To some extent, that explains the outbreak of losses in these funds.

With many of these new assets being highly illiquid and with the funds themselves having used considerable amounts of borrowed money to enhance their returns, losses have been magnified as worried investors have demanded to pull their money out.

“We cannot predict the duration of the current environment,” Mr. Simons wrote. “But usually such behavior causes first pain and then opportunity. Our basic plan is to stay the course.”

So, again we see the all to human tendency towards magical thinking and the concept that, if an error is not "recognized" or "admitted" it is somehow less "real."

There is the well known error of investing to figure "I see that this went down instead of up, so I will just hold on a little longer until it goes back up to where I started so at least I can get out without a loss. "

Loeb wrote a book on how he got rich on the opposite strategy, of course - namely, if it is going down, sell the sucker, and "stay the course" only when it is going up.

This seems a more rational strategy. Drop your losers, hang onto your winners.
Humans, however, are not driven by rationality, judging from observation. They desperately seek to avoid "having been wrong", even when everyone else around them can already see that they were wrong.

Again, let me cite a prior post and the brilliant work of John Gall.
Failure is Perhaps our Most Taboo Subject

====== I"ll requote it here since it's in my prior weblog (cscwteam.blogspot.com) and
a search here might miss it. We should note as well that the use of computers has amplified this problem, not made it go away. There is no magic bullet, aside from facing up to the fact that we are frail, faulty reasoning units that only can deliver reliable results when we
(a) work together and
(b) maintain as great a diversity of views as possible so we don't get stuck in the same hole
at the same time.

==============================
As John Gall says:

"At the very least it is hoped that this little book may serve as a warning to those who read it, thus helping to counter the headlong rush into Systemism that characterizes our age...

SYSTEMISM n. 1. The state of mindless belief in Systems; the belief that Systems can be made to function to achieve desired goals. 2. The state of being immersed in Systems; the state of being a Systems-person."

(John Gall, "Systemantics - How Systems Really Work and How they Fail.)

Gall, continues

Systems-functions are not the result of human intransigence. We take it as given that people are generally doing the very best they know how. Our point, repeatedly stressed in this text, is that Systems operate according to Laws of Nature, and that Laws of Nature are not suspended to accommodate our human shortcomings. There is no alternative but to learning How Systems Work... Whoever does not study the Laws of Systemantics and learn them that way is destined to learn them the hard way...

S. Freud, in his great work on the Psychopathology of Everyday Life, directed attention to the lapses, failures, and mishaps resulting from forces operating within the individual. We, on the other hand, are intestesed h those lapses, failures, and mishaps that are attributable to the (mal)functioning of the Systems surrounding the individual, within which the individual is immersed, and with which he or she must interact and attempt to cope in everyday life.

Specifically, we are interested, not in the process of forgetting to mail a letter, but in the Post Office Box that is too full to accept the letter.

...

And like those lapses followed up by Freud, these lapses have a way of eluding us, of disappearing from our consciousness once the painful event is over. Failure is perhaps our most taboo subject.

...

When Memory is thus deliberately frustrated in its basic task of protecting us from too much awareness, we see what we had hitherto failed to notice: that malfunction is the rule and flawless operation the exception.

...

The advent of the Computer Revolution merely provides new opportunities for errors at levels of complexity and grandiosity not previously attainable.

...

The world may largely consist of Fuzzy Systems, but fuzzy thinking is definitely not the way to Cope with them, let alone to Prevail.

Comment - John Gall's book is, in my mind, one of the most delightful and yet profound books on "Systems" ever written. I have made a point to reread it at least once every year since 1975, and to buy copies for all my staff and friends at the slightest excuse.

Based, presumably, on his experiences as a physician at the University of Michigan, be captures with humor the best attitude any of us can hope for to take and use to frame the indelicate problem of "systems" in our lives, or, God forbid, systems we are part of and partly responsible for.

A very brief sampling of his summary rules is here. Wikipedia has many more, but I heartily recommend the trip to Amazon to get the latest updated version of his wit and wisdom.

Some of his Rules:

REALITY IS MORE COMPLEX THAN IT SEEMS.

Under precisely controlled experimental conditions,a test animal will behave as it damn well pleases.

THINGS AREN'T WORKING VERY WELL (and never did).

SYSTEMS IN GENERAL WORK POORLY OR NOT AT ALL.

(The behavior is often an unexpected way of failing.)

NEW SYSTEMS MEAN NEW PROBLEMS.

SYSTEMS TEND TO EXPAND TO FILL THE KNOWN UNVERSE.

THE SYSTEM ALWAYS FIGHTS BACK.

THE OLD SYSTEM IS NOW THE NEW PROBLEM.

A LARGE SYSTEM, PRODUCED BY EXPANDING THE DIMENSIONS OF A SMALLER SYSTEM,
DOES NOT BEHAVE LIKE THE SMALLER SYSTEM.

TO THOSE WITHIN A SYSTEM, THE OUTSIDE REALITY TENDS TO PALE AND DISAPPEAR.

THE CHART IS NOT THE PATIENT.

Unfortunately, this slogan with its humanistic imlications, turned out to be misleading. The nurses were neither attending the patients nor making notations in the charts. They were in the hospital auditorium, taking a course in Interdisciplinary Function. (The art of correlating one's own professional activities more and more with those of other professionals, while actually doing less and less. )

"In cold fact, a SYSTEM is building ships, and the SYSTEM is the shipbuilder."

PEOPLE IN SYSTEMS DO NOT DO WHAT THE SYSTEM SAYS THEY ARE DOING.

THE SYSTEM ITSELF DOES NOT DO WHAT IT SAYS IT IS DOING.

and, "Closely related to Orwellian Newspeak and Doublethink, The confusion of Input and Output."

A giant program to Conquer Cancer is begun. At the end of five years, cancer has not been conquered, but one thousand research papers have been published. In addition, one million copies of a pamphlet entitled "You and the War Against Cancer" have been distributed. These publications will absolutely re regarded as Output rather than Input. The cancerous multiplication of paperwork will not be regarded as a malignancy.