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Book Review: “Panic” by Andrew Redleaf and Richard Vigilante

May 14th, 2010 by Guest Posts
Finance is not Physics.
A Review of Panic, by Andrew Redleaf and Richard Vigilante
Friedrich Hayek’s 1974 Nobel Prize lecture, “The Pretense of Knowledge,” concerns the “failure of [Keynesian] economists to guide policy more successfully.” Hayek believed that failure was “closely connected with their propensity to imitate as closely as possible the procedures of the … physical sciences.”  Hayek’s point, to simplify, is that the desire to create mathematical models of economic behavior inevitably leads to the exclusion of critical factors that cannot be easily quantified.  The result is an elegant, but not accurate, model. Speaking of the Keynesian policies of the 1960s and 1970s, Hayek hypothesized that “an almost exclusive concentration on quantitatively measureable surface phenomena has produced a policy which has made matters worse.”
Andrew Redleaf and Richard Vigilante make a similar argument in Panic, their account of the mortgage meltdown, financial panic and recession of 2007-09.  To Redleaf and Vigilante, the root cause of the mortgage bubble and its collapse was “the ideology of modern finance,” the belief that prices in financial markets accurately reflect all available information about the value of the underlying assets.  This was coupled with a belief that sophisticated mathematical models could measure, and therefore enable institutions to manage, financial risk effectively.  If the models were wrong, prices in an efficient market should have exposed the errors on an ongoing basis.  Because of these beliefs, most of our political and financial leaders ignored the reality, obvious on its face to Redleaf, Vigilante, and others (but not, at the time, to me), that the residential real estate market was, by the middle of the last decade, wildly overpriced and headed for a fall.  When that fall came, the models of how mortgages would perform turned out to be hopelessly wrong, and as a result the entire financial system was put at risk.
I have two strong personal connections to the issues discussed in Panic.  One is that I attended law school at the University of Chicago, and the “Chicago School” developed modern portfolio theory in the 1960’s.  In fact, I have joked on more than one occasion that “my entire legal education was based on the efficient markets hypothesis.”  And I remain true to my school. Second, the mortgage industry has been a major part of my life since 1990.  During most of that time I practiced law, where the mortgage industry was a large part of my business.  But from 2003-08 I worked for a mortgage company.  I was there at the peak of the market.  And I stuck around for the collapse.  So I know the history recounted in Panic from intense, and sometimes painful, personal experience.
The authors of Panic understand the mortgage market of the boom years and the mechanics of its fall as well as or better than anyone who has written on the topic.  A lot of the language used in discussions of the financial industry, particularly in recent years, is Greek to most English speakers, and sometimes even to those of us fluent in legalese.   This has helped keep the causes and effects of the recent financial crisis from being well understood.  Panic is written in English.  For example, it provides lucid definitions of the terms “securitization” and “structured finance.”  In discussing financial topics, fancy words are frequently used to convey understanding where there is none.  Redleaf and Vigilante don’t do that; they know what they are talking about, and they explain it in plain English.  This aspect of the book makes it both enjoyable and interesting.
But what makes Panic stand out is its perspective.  Many books on the crisis focus on “Wall Street greed,” which is the rough equivalent of saying that water causes tsunamis.  Others focus on influences outside the mortgage industry (monetary policy, international funds flows, etc.).  Still others focus on the regulatory environment, arguing either than the mortgage business got out of control because it was unregulated or that the mortgage business got out of control because it was too heavily influenced by government (the latter is much closer to the truth).  All of these are important issues, and Panic addresses most of them.  But they do not explain why intelligent, supposedly sophisticated investors came to believe that securities backed by mortgages made to borrowers with bad credit histories, or made to borrowers with good credit histories on economically unsustainable terms, were a safe investment.  Why rating agencies, which live in large part off of their reputations for credit analysis (and in large part off of a government-created oligopoly position which gives them the keys to certain very large vaults of investment capital), decided that they could give AAA ratings to 80% or more of the bonds backed by pools of decidedly non-AAA mortgages.  Or why government regulators around the world, charged with protecting the “safety and soundness” of the financial system, permitted the banks under their supervision to invest massive amounts in these same securities, or insurance companies under their supervision to insure these securities, without holding enough capital to protect against the inevitable losses.
The answer, according to Redleaf and Vigilante, is that the key players fooled themselves into believing they understood the risks they were running, based on their underlying beliefs about how financial markets work.  Bankers used sophisticated mathematical models built on data about the historical performance of mortgages to analyze mortgage risk.  These models assumed that mortgages would continue to perform as they had throughout the post-war period, even as the characteristics of the loans and the relationship between housing prices and income changed dramatically.  Bankers, rating agencies and regulators persuaded themselves that the packaging and structuring of the securities had appropriately diversified and mitigated the risks in the underlying mortgages sufficiently to make the “AAA” securities nearly risk free.  Under modern portfolio theory, diversification is the key to creating an investment portfolio that maximizes return for any given level of risk.  All of this analysis and structure was reinforced by the belief that prices in financial markets accurately reflect all available information about value.  When prices for these securities stayed close to their face value despite the rise in housing prices and deterioration of credit standards, it validated the belief that the risks were appropriately understood and addressed.  Redleaf and Vigilante argue this confluence of beliefs enabled the boom to continue until the bubble was large enough to put the entire financial system at risk.
The authors point to their personal experience as investors as well as history and common sense in challenging the conventional wisdom embodied in the “ideology of modern finance.”  Redleaf is a hedge fund manager, and in perfectly efficient markets there would be no role for hedge funds.  In the best part of the book, the authors demonstrate that the idea that investors are primarily compensated for taking risks (plus the cost of their capital), rather than for making judgments in the context of uncertainty, is contrary to the experience of everyone who has ever started a business, or helped a friend or relative finance a business, or invested in a venture fund or a private equity fund.  In the “real” economy, investors are compensated for investing in good people with good ideas, not simply for taking risks.
I never understood the efficient markets hypothesis to mean that nobody could make money by identifying good new ideas and bringing them to market, or even by identifying places where market prices deviated from real value. In fact, it was always my understanding that smart investors made the market efficient by identifying and taking advantage of those opportunities, and made money for themselves in the process.  My understanding was always more limited – that like me, people who do not have any deep insight into or particular knowledge of underlying asset values and prefer to spend their Sunday afternoons watching baseball instead of developing those insights and that knowledge, cannot beat the market.  That’s why I stick with index mutual funds.  Panic clarified my prior understanding in many respects, in particular by demonstrating why, famously, mutual fund managers do not consistently beat the market by enough of a margin to pay their fees, while still leaving room for true hedge funds and value investors to profit from market anomalies.
On the broader points of whether market prices or any given dates are a reliable indication of underlying value and of the utility of quantification and modeling in understanding risk, history is on the side of Redleaf and Vigilante.  From tulips in Holland in the 1630s to homes in the United States (and around the world) in the 2000s, history contains many examples of situations where asset prices reflected not knowledge or information about the value of the underlying assets but speculation about the price of those assets in the near future, when the buyers hope to reap a quick profit.  That speculation has repeatedly taken prices above any reasonable estimate of the true value of the assets, and has repeatedly led to collapses when speculators changed their mind about the likely future direction of prices. Furthermore, statistical analysis of any phenomenon depends on having all of the relevant factors in the analysis and properly predicting the relationship between those factors.  But you can never have all factors in a statistical analysis of human behavior, because, not all factors are quantifiable.  You can never have all the relationships right I a model of human behavior, because they change.  In the case of the models of mortgage behavior, when one critical assumption came unstuck (specifically, that home prices would not fall on a national basis because it hadn’t happened since the 1930s), the models became useless.  The diversification in mortgage pools was illusory.
But the best thing about Panic is summarized by its subtitle, “The Betrayal of Capitalism by Wall Street and Washington.”  The mortgage bubble and resulting financial crisis and economic downturn may undercut the conventional wisdom in finance over the past generation, but they do not constitute a “crisis” of capitalism.  The important thing about markets is not that they are efficient, but that they are free.  That freedom allows people with new ideas to bring them forward and test them, and investors with good judgment about people and ideas to back the good ones.  Stated otherwise, markets coordinate the collective judgments of society in a way that benefits everyone, even though they don’t get every single decision right (or even close).  It is this aspect of markets that enables a Watt, an Edison, a Ford or a Gates to introduce revolutionary changes that improve the lives of everyone, and make a fortune for themselves (and the investors who back them) in the process.  Market prices do not always reflect underlying value.  They sometimes overvalue bad ideas (Pets.com sold for $11 a share in February, 2000; it went into liquidation 10 months later and investor recovered less than $0.25 per share) and sometimes undervalue good ones (the original $100,000 invested in Google in 1998 was worth $1.5 billion in March, 2007).  What they do is enable people to try new ideas, relatively freely, and reward those who through the exercise of diligence and judgment turn those ideas into products and services of value to others.  Markets do not always make specific asset allocation decisions correctly, but neither can any other human institution.  Efficient decision-making was, in the middle of the last century, one of the supposed advantages of socialism.  That didn’t exactly turn out to be true.  The problem is that no human decision-making processes can ever be “efficient,” since humans are not omniscient (at a minimum, we don’t know what the future holds) and cannot make judgments in a completely disinterested manner.  These limitations also falsify extreme versions of the efficient markets hypothesis.  Free markets, through the coordinating mechanism of prices, permit decisions to be tested in an environment that provides incentives for making them well, not perfectly.  That freedom, not efficiency, is why markets promote growth, and are ultimately good for all of us.
Tom Kelly is a partner at Dorsey & Whitney LLP, and Chairman of the Board of the Minnesota Free Market Institute.

Panic By Andrew Redleaf and Richard VigilanteFinance is not Physics.

A Review of Panic, by Andrew Redleaf and Richard Vigilante

Friedrich Hayek’s 1974 Nobel Prize lecture, “The Pretense of Knowledge,” concerns the “failure of [Keynesian] economists to guide policy more successfully.” Hayek believed that failure was “closely connected with their propensity to imitate as closely as possible the procedures of the … physical sciences.”  Hayek’s point, to simplify, is that the desire to create mathematical models of economic behavior inevitably leads to the exclusion of critical factors that cannot be easily quantified.  The result is an elegant, but not accurate, model. Speaking of the Keynesian policies of the 1960s and 1970s, Hayek hypothesized that “an almost exclusive concentration on quantitatively measureable surface phenomena has produced a policy which has made matters worse.”

Andrew Redleaf and Richard Vigilante make a similar argument in Panic, their account of the mortgage meltdown, financial panic and recession of 2007-09.  To Redleaf and Vigilante, the root cause of the mortgage bubble and its collapse was “the ideology of modern finance,” the belief that prices in financial markets accurately reflect all available information about the value of the underlying assets.  This was coupled with a belief that sophisticated mathematical models could measure, and therefore enable institutions to manage, financial risk effectively.  If the models were wrong, prices in an efficient market should have exposed the errors on an ongoing basis.  Because of these beliefs, most of our political and financial leaders ignored the reality, obvious on its face to Redleaf, Vigilante, and others (but not, at the time, to me), that the residential real estate market was, by the middle of the last decade, wildly overpriced and headed for a fall.  When that fall came, the models of how mortgages would perform turned out to be hopelessly wrong, and as a result the entire financial system was put at risk.

I have two strong personal connections to the issues discussed in Panic.  One is that I attended law school at the University of Chicago, and the “Chicago School” developed modern portfolio theory in the 1960’s.  In fact, I have joked on more than one occasion that “my entire legal education was based on the efficient markets hypothesis.”  And I remain true to my school. Second, the mortgage industry has been a major part of my life since 1990.  During most of that time I practiced law, where the mortgage industry was a large part of my business.  But from 2003-08 I worked for a mortgage company.  I was there at the peak of the market.  And I stuck around for the collapse.  So I know the history recounted in Panic from intense, and sometimes painful, personal experience.

The authors of Panic understand the mortgage market of the boom years and the mechanics of its fall as well as or better than anyone who has written on the topic.  A lot of the language used in discussions of the financial industry, particularly in recent years, is Greek to most English speakers, and sometimes even to those of us fluent in legalese.   This has helped keep the causes and effects of the recent financial crisis from being well understood.  Panic is written in English.  For example, it provides lucid definitions of the terms “securitization” and “structured finance.”  In discussing financial topics, fancy words are frequently used to convey understanding where there is none.  Redleaf and Vigilante don’t do that; they know what they are talking about, and they explain it in plain English.  This aspect of the book makes it both enjoyable and interesting.

But what makes Panic stand out is its perspective.  Many books on the crisis focus on “Wall Street greed,” which is the rough equivalent of saying that water causes tsunamis.  Others focus on influences outside the mortgage industry (monetary policy, international funds flows, etc.).  Still others focus on the regulatory environment, arguing either than the mortgage business got out of control because it was unregulated or that the mortgage business got out of control because it was too heavily influenced by government (the latter is much closer to the truth).  All of these are important issues, and Panic addresses most of them.  But they do not explain why intelligent, supposedly sophisticated investors came to believe that securities backed by mortgages made to borrowers with bad credit histories, or made to borrowers with good credit histories on economically unsustainable terms, were a safe investment.  Why rating agencies, which live in large part off of their reputations for credit analysis (and in large part off of a government-created oligopoly position which gives them the keys to certain very large vaults of investment capital), decided that they could give AAA ratings to 80% or more of the bonds backed by pools of decidedly non-AAA mortgages.  Or why government regulators around the world, charged with protecting the “safety and soundness” of the financial system, permitted the banks under their supervision to invest massive amounts in these same securities, or insurance companies under their supervision to insure these securities, without holding enough capital to protect against the inevitable losses.

The answer, according to Redleaf and Vigilante, is that the key players fooled themselves into believing they understood the risks they were running, based on their underlying beliefs about how financial markets work.  Bankers used sophisticated mathematical models built on data about the historical performance of mortgages to analyze mortgage risk.  These models assumed that mortgages would continue to perform as they had throughout the post-war period, even as the characteristics of the loans and the relationship between housing prices and income changed dramatically.  Bankers, rating agencies and regulators persuaded themselves that the packaging and structuring of the securities had appropriately diversified and mitigated the risks in the underlying mortgages sufficiently to make the “AAA” securities nearly risk free.  Under modern portfolio theory, diversification is the key to creating an investment portfolio that maximizes return for any given level of risk.  All of this analysis and structure was reinforced by the belief that prices in financial markets accurately reflect all available information about value.  When prices for these securities stayed close to their face value despite the rise in housing prices and deterioration of credit standards, it validated the belief that the risks were appropriately understood and addressed.  Redleaf and Vigilante argue this confluence of beliefs enabled the boom to continue until the bubble was large enough to put the entire financial system at risk.

The authors point to their personal experience as investors as well as history and common sense in challenging the conventional wisdom embodied in the “ideology of modern finance.”  Redleaf is a hedge fund manager, and in perfectly efficient markets there would be no role for hedge funds.  In the best part of the book, the authors demonstrate that the idea that investors are primarily compensated for taking risks (plus the cost of their capital), rather than for making judgments in the context of uncertainty, is contrary to the experience of everyone who has ever started a business, or helped a friend or relative finance a business, or invested in a venture fund or a private equity fund.  In the “real” economy, investors are compensated for investing in good people with good ideas, not simply for taking risks.

I never understood the efficient markets hypothesis to mean that nobody could make money by identifying good new ideas and bringing them to market, or even by identifying places where market prices deviated from real value. In fact, it was always my understanding that smart investors made the market efficient by identifying and taking advantage of those opportunities, and made money for themselves in the process.  My understanding was always more limited – that like me, people who do not have any deep insight into or particular knowledge of underlying asset values and prefer to spend their Sunday afternoons watching baseball instead of developing those insights and that knowledge, cannot beat the market.  That’s why I stick with index mutual funds.  Panic clarified my prior understanding in many respects, in particular by demonstrating why, famously, mutual fund managers do not consistently beat the market by enough of a margin to pay their fees, while still leaving room for true hedge funds and value investors to profit from market anomalies.

On the broader points of whether market prices or any given dates are a reliable indication of underlying value and of the utility of quantification and modeling in understanding risk, history is on the side of Redleaf and Vigilante.  From tulips in Holland in the 1630s to homes in the United States (and around the world) in the 2000s, history contains many examples of situations where asset prices reflected not knowledge or information about the value of the underlying assets but speculation about the price of those assets in the near future, when the buyers hope to reap a quick profit.  That speculation has repeatedly taken prices above any reasonable estimate of the true value of the assets, and has repeatedly led to collapses when speculators changed their mind about the likely future direction of prices. Furthermore, statistical analysis of any phenomenon depends on having all of the relevant factors in the analysis and properly predicting the relationship between those factors.  But you can never have all factors in a statistical analysis of human behavior, because, not all factors are quantifiable.  You can never have all the relationships right I a model of human behavior, because they change.  In the case of the models of mortgage behavior, when one critical assumption came unstuck (specifically, that home prices would not fall on a national basis because it hadn’t happened since the 1930s), the models became useless.  The diversification in mortgage pools was illusory.

But the best thing about Panic is summarized by its subtitle, “The Betrayal of Capitalism by Wall Street and Washington.”  The mortgage bubble and resulting financial crisis and economic downturn may undercut the conventional wisdom in finance over the past generation, but they do not constitute a “crisis” of capitalism.  The important thing about markets is not that they are efficient, but that they are free.  That freedom allows people with new ideas to bring them forward and test them, and investors with good judgment about people and ideas to back the good ones.  Stated otherwise, markets coordinate the collective judgments of society in a way that benefits everyone, even though they don’t get every single decision right (or even close).  It is this aspect of markets that enables a Watt, an Edison, a Ford or a Gates to introduce revolutionary changes that improve the lives of everyone, and make a fortune for themselves (and the investors who back them) in the process.  Market prices do not always reflect underlying value.  They sometimes overvalue bad ideas (Pets.com sold for $11 a share in February, 2000; it went into liquidation 10 months later and investor recovered less than $0.25 per share) and sometimes undervalue good ones (the original $100,000 invested in Google in 1998 was worth $1.5 billion in March, 2007).  What they do is enable people to try new ideas, relatively freely, and reward those who through the exercise of diligence and judgment turn those ideas into products and services of value to others.  Markets do not always make specific asset allocation decisions correctly, but neither can any other human institution.  Efficient decision-making was, in the middle of the last century, one of the supposed advantages of socialism.  That didn’t exactly turn out to be true.  The problem is that no human decision-making processes can ever be “efficient,” since humans are not omniscient (at a minimum, we don’t know what the future holds) and cannot make judgments in a completely disinterested manner.  These limitations also falsify extreme versions of the efficient markets hypothesis.  Free markets, through the coordinating mechanism of prices, permit decisions to be tested in an environment that provides incentives for making them well, not perfectly.  That freedom, not efficiency, is why markets promote growth, and are ultimately good for all of us.

Tom Kelly is a partner at Dorsey & Whitney LLP, and Chairman of the Board of the Minnesota Free Market Institute.

Posted in Guest Post | 1 Comment »

Health Care: A Titanic Misrepresentation

September 10th, 2009 by Guest Posts

mEDICAL bANKRUPTCY

A Guest Post by Randy Ammon

As I’ve been listening to various talk radio programs I’ve heard the following new talking point proffered by national health care supporters at least four times in the past 48 hours: We have to pass a government option! Two-thirds of the bankruptcies in the US are caused by medical bills!

The basis for this argument is found in this recent study in the American Journal of Medicine. A snippet of the conclusion of the study is as follows: Using a conservative definition, 62.1 percent of all bankruptcies in 2007 were medical; 92 percent of these medical debtors had medical debts over $5000, or 10 percent of pretax family income.

At first look you’d have to say “Wow!” Can nearly two-thirds of bankruptcies be caused by the results of medical costs? The answer, after you look at the study and some other information is “No.”

Brett J. Skinner, director of bio-pharma, health, and insurance policy at the Fraser Institute, does a great job of deconstructing the noted study. His article, here, notes several items that left the study’s conclusions suspect.

First, Skinner makes the logical comparison with Canada. With the bankruptcy law very similar in the two countries, and Canada having a government provided health care system, if the studies conclusions are correct, we should expect to see significantly lower bankruptcy rates in Canada. We don’t. In both 2006 and 2007 Canada had a higher bankruptcy rate per population than we had in the US.

Secondly, Skinner looked at other studies done on the topic. One of those analyses, done by the Department of Justice, found that medical debts accounted for only 12 to 13 percent of the total debts among American bankruptcy filers who cited medical debt as one of their reasons for bankruptcy.

So here’s the question: “Is it possible to reconcile the study with the data Skinner found or is the study a fraud?” Thanks for asking. Yes, the two can be reconciled.

Going back to the original study we find that the mean negative net worth (the excess of debt over assets) of those who claimed to file bankruptcy due to medical reasons was $44,622 (Table 1). We also see on page 4, that the average total, out of pocket medical costs for those that filed bankruptcy for medically bankrupted families were $17,943. If we assume that the entire amount of out of pocket costs were left unpaid and counted in the negative net worth (it wouldn’t be but let’s use it for a moment), that would still leave a negative net worth of approximately $27,000 that resulted from other reasons.

A negative net worth of $27,000 would typically not be from a home mortgage as most borrowers are not be allowed to borrow more than the equity (the study was done in 2007 before the current melt down and reduction in home values). A negative net worth could be partially incurred from a vehicle as most new vehicles are upside down in equity for the first year or two of ownership. However, with the average mean income reported as only $30,000, one wouldn’t expect a whole lot of really expensive new vehicles included in the negative net worth of this sample. A negative net worth of $27,000 likely comes from one place — credit cards or other uncollateralized loans.

While the current study didn’t break it out this way, another study shows that the average person who claims they filed for bankruptcy because of medical reasons also had significant credit card debt. In a study done on 2003 Delaware bankruptcies, Ning Zhu from UC Davis found, that compared to a control group, those who filed bankruptcy had a slightly higher mortgage debt, nearly the same debt for vehicles but had a mean of over $25,0000 of credit card debt compared to less than $2,500 for the control group.

Regarding the possibility of an “adverse event” like medical costs causing bankruptcy, Zhu concludes: “Although adverse events surely trigger the filing of some personal bankruptcy cases, our evidence suggests that excessive consumption is a very important cause for personal bankruptcy that has not received due attention.”

Based on Zhu’s analysis and the large negative net worth that was not attributable to medical costs, medical costs were simply the “straw that broke the camel’s back.” The straw could have been any of a number of other things i.e. a major car repair, a major home repair or any number of other unexpected items.

Rather than any one specific issue, like most other bankruptcies, the folks that this study samples had a series of issues with the last one in line, for them, medical expenses, being more than they could handle. In each case, medical costs were just one of the issues that led them to bankruptcy. To say medical expenses were the reason that these folks filed for bankruptcy is about as accurate as saying that the Titanic sank because it was holding too much water.

Randy Ammon is a self-employed business consultant. He was campaign manager for Dave Thompson in his run for Chair of the Republican Party of Minnesota.

Posted in Guest Post, Randy Ammon | 2 Comments »

Guest Post: Where Have All the Leaders Gone?

June 18th, 2009 by Guest Posts

by Brandon Ferdig, Minneapolis Expression

Leadership2We begin with a definition.

American Leader: An individual who gives of their time to serve as leader and representative of their constituents; a person who serves to protect freedoms that will steadfastly be challenged by countless sources, foreign and domestic; an individual with the strength to hold this position, the integrity to maintain it, and the moral insight to understand it—all motivated to protect this land for their love of humanity.

Over the last century, we have witnessed an exodus of the American Leader. The American Leader has left and the void has attracted those who want the power to dictate to us where to spend our money, what behaviors are allowable, and how to conduct our private business.

What true American Leader wants to force citizens to give their money to another country’s citizens, military, or government? What true American Leader wants to enforce racism via legislation whether it is affirmative action or the first drug laws? What true American Leader wants to take from the citizens to subsidize a specific industry or a specific company? The true American Leader understands the immorality of enacting policies that take from some citizens to give to others, that slow down racial equality, and that hinder productive investment.

As America grew more prosperous, the pressure from within to enact such policies, to give, to take and manipulate this power became too much, and the American Leader broke…Leaders left the realm of public service.

As the role of politics in America continued to drift (resulting from perpetual exiting of qualified leadership) it attracted those whose motives were not in line with what is necessary to maintain the integrity of our system of government and preserve our individual freedom. It attracted those who were interested in control over others.

Today, we have a political system that attracts and elects people who know very little about the basic tenants of the American Republic. Their complete lack of consideration of the natural processes that freedom allows means they become inhibitors of freedom and so create delay in attaining the goals they attempt. Today, the representation in government and politics from the city council to the White House is a sharp contrast to the true American Leader.

The American Leader has become more distant than ever. The ill-fit leaders of the past 100 years have laid the groundwork for a system incompatible with the true American Leader. It seems only the ill-fit can play.

Involvement with politics is a discouraging and challenging prospect for the American Leader: How would/could an American Leader work with today’s politicians? Could they even be elected today?

Despite this, the American Leader must return.

Until true leaders step up, the ill-fit, present-day politicians will continue to manipulate power because they know no other way.

Until American Leaders return and volunteer, their own freedoms are in danger, theirs and their children’s way of life is compromised. If they do not do the job, false leaders will seize the opportunity. This country offers its citizens unlimited potential; but with great reward comes great responsibility. This country requires the special individuals who understand the combination to our country’s success. One must know it to protect it.

Only an American Leader can do the honor of serving because only they can do it in the one way it can be done—not with short-gained power and wealth in mind, but out of genuine love for themselves and their fellow citizen. It is necessary to have such conviction, integrity, morality and strength, that they may keep the inappropriate from entering, damaging the defense, and to refuse the constant requests from countless well-meaning and no-so-well-meaning people seeking others’ money for “the good of the country.”

Theirs is a leadership not of power but of the inner-strength to refuse power. Like taking a turn to stand guard at night, this country has always been charged with having these American Leaders, the ones who can grasp the morality and logic of the Constitution, to watch and protect this way of life.

The American Leader was mistaken for ever giving up the duty and for their subsequent refusal to fight. The longer they are away the harder it is to reclaim the country, giving it back to the people, and the more damage the ill-fit leaders will have caused.

Step up, American Leaders, whether wanted by the public or not. Plant the seed and prime the pump.

People are beginning to listen.

Brandon Ferdig is a local writer/blogger for www.MinneapolisExpression.com. He hosts a local cable access program by the same name, in which he interviews local figures. Contact him at Brandon@MinneapolisExpression.com.

Posted in Blog Posts, Brandon Ferdig, Guest Post, Limited Government | No Comments »

Guest Post: Cap and Trade Draws An Ace – Rebuilding The House of Cards

June 16th, 2009 by Guest Posts

by Doug Williams, Bogus Gold

The scariest thing you’ll read this week is something you’ll probably be tempted to overlook. It is this:

Carbon Emissions Linked To Global Warming In Simple Linear Relationship

Damon Matthews, a professor in Concordia University’s Department of Geography, Planning and the Environment has found a direct relationship between carbon dioxide emissions and global warming. Matthews, together with colleagues from Victoria and the U.K., used a combination of global climate models and historical climate data to show that there is a simple linear relationship between total cumulative emissions and global temperature change.

bogusgold-burning-earth-in-flames-thumb4978184-smallBig deal, you might say. All those already upon the Global Warming bandwagon have been acting like this was already known for a couple of decades now. That’s how we came up with the “carbon dioxide is pollution” nonsense. That’s how we got ideas floating around like “carbon taxes” and “Cap and Trade” schemes.

Well yes, but… No one is seriously proposing a flat out carbon tax simply because opposition to it is a political no-brainer. People like to vote for taxes on other people. It’s political suicide to be the politician (or the party) who wants to raise everyone’s taxes.

Which is the whole reason Cap and Trade has been the preferred route for democratic governments to go in their attempt to restrict carbon emissions. It cloaks massive new taxes under a veneer of markets and trading and capitalist enterprise. When higher prices are subsequently passed on to consumers, they never get to see a direct correlation between the defacto carbon taxes and the resulting increase in consumer prices.

But implementing Cap and Trade is not as easy as it sounds, and especially so in a litigious society like our own. The problem with the entire philosophy underlying Cap and Trade is that it has always been very, very complex to measure the true impact – and therefore the measurable value – of carbon emissions versus offsetting activities. The climate is not a linear system after all. It’s complex and chaotic. How do you set the definitions around your basic tradable commodities if there isn’t a simple, quantifiable and therefore measurable basis underlying the whole thing? You’d end up in endless and expensive legal disputes over the relative impact of carbon in one case versus another based on all kinds of potentially offsetting conditions. That has been a formidable barrier to the successful implementation of Cap and Trade from the start.

So how does this seemingly innocuous and virtually redundant study change things? I’m so glad you asked. From the same article linked above:

Until now, it has been difficult to estimate how much climate will warm in response to a given carbon dioxide emissions scenario because of the complex interactions between human emissions, carbon sinks, atmospheric concentrations and temperature change. Matthews and colleagues show that despite these uncertainties, each emission of carbon dioxide results in the same global temperature increase, regardless of when or over what period of time the emission occurs.

MenuGlobalWarmingSo there’s this incredibly complex relationship running between carbon dioxide emissions and global warming running through all sorts of complicated factors. This very complexity has previously prevented a simple basis for bundling all the different circumstances of carbon dioxide emissions together to determine their impact. But now, suddenly, through clever use of modeling against a particular set of climate data, we now have that previously elusive formula by which we can take a single variable – in this case carbon dioxide emitted – ignore every other related factor and state with certainty what its proper impact in the overall “global warming” scheme will be! Amazing!

Why, that means it will be a snap to get this Cap and Trade thing under way. We now have a reliable means allowing us to ignore all the complicated uncertainties that could otherwise derail things.

Now where have I ever heard of anything like that before? Hmmm…

Oh yeah! It reminds me of a similar great discovery in the financial sector not too long ago. Remember this?

It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

That’s from Felix Salmon’s brilliant article explaining how a single model built to simplify correlations of risk between different securities based on mortgages lead directly to the recent financial implosion. But of course, this model didn’t operate in a vaccuum. In order to allow such a simple thing to wreak maximum damage throughout all the world’s finances, one more thing was necessary.

No one knew all of this better than [the model's inventor] David X. Li: “Very few people understand the essence of the model,” he told The Wall Street Journal way back in fall 2005.

“Li can’t be blamed,” says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

So what happened to the financial markets was:

A. A model was discovered which made previously impossible correlations simple and quantifiable.

B. The model was seized upon by people who didn’t really understand it so that they could use the resulting quantification to commence buying and selling in areas previously too complex for them to attempt.

C. This model was adopted universally, meaning any flaw within it would have a universal impact.

D. When the underlying reality hit a situation the model couldn’t handle the entire house of cards collapsed.

Interesting parallel, you might be thinking. But surely these things are so unalike as to make any such comparison irrelevant. After all, what would buying and selling carbon permits and offsets have to do with buying and selling mortgages?

The answer may surprise you.

You’ve heard of credit default swaps and subprime mortgages. Are carbon default swaps and subprime offsets next? If the Waxman-Markey [that's the main Cap and Trade legislation - ed.] climate bill is signed into law, it will generate, almost as an afterthought, a new market for carbon derivatives. That market will be vast, complicated, and dauntingly difficult to monitor. And if Washington doesn’t get the rules right, it will be vulnerable to speculation and manipulation by the very same players who brought us the financial meltdown.

bogusgold-house-of-cards-smallThat article linked above is only really scratching the surface here because, while noticing the financial peril by identifying some of the same specific financial instruments as were involved in the housing crisis, it misses the larger picture: Cap and Trade requires a means to simply and universally quantify economic activity surrounding carbon dioxide in a way that translates into “warming impact.” Only once this is determined can the market mechanism underlying the concept begin to work. And the way it would work (the way it is intended to work it should be noted – this is by design, not a loophole) is to issue emissions permits and offsets which subsequently market forces could buy and sell and trade and do whatever else it wants with them.

Obviously this would require some kind of regulation. And that is already taking shape.

Cap and trade would create what Commodity Futures Trading commissioner Bart Chilton anticipates as a $2 trillion market, “the biggest of any [commodities] derivatives product in the next five years.” That derivatives market will be based on two main instruments. First, there are the carbon allowance permits that form the nuts and bolts of any cap-and-trade scheme. Under cap and trade, the government would issue permits that allow companies to emit a certain amount of greenhouse gases. Companies that emit too much can buy allowances from companies that produce less than their limit. Then there are carbon offsets, which allow companies to emit greenhouse gases in excess of a federally mandated cap if they invest in a project that cuts emissions somewhere else-usually in developing countries. Polluters can pay Brazilian villagers to not cut down trees, for instance, or Filipino farmers to trap methane in pig manure.

Let’s think about those two main instruments for a moment: carbon allowance permits and carbon offsets. They’re based on the same metric, one stated as a positive and the other as a negative. An allowance permit covers situations where carbon is emmitted – added. An offset covers situations where the warming impact of carbon is countered – subtracted. Which one is more valuable? Neither one, obviously. They are of equal value because they’re both expressions of exactly the same thing – warming impact. How is this measured? By converting carbon dioxide into a single “warming” metric.

What’s so important about that single “warming” metric is that you need it to allow any business to determine how many permits or offsets – in any combination – they would require to engage in a planned activity. That number will drive their demand. And the aggregation of that demand throughout the entire economy would create a tremendous new market for permits and offsets – which would susequently create the opportunity for incredible fortunes to be made in speculating upon their value. That is not just “kind of similar” to what happened in the mortgage market, that is exactly what happened in the mortgage market.

For the sake of clarity I’ll draw the parallel more explicitly. In the case of mortgages the complex element in need of a single quantifiable metric was “default risk.” In the Cap and Trade market, that element is “warming impact.”

In the case of mortages the complexity was overcome, not by solving for the complexity, but rather by finding a model which allowed them to ignore it entirely. In the case of cap and trade that very same kind of model is the “grand discovery” being trumpted in the article I noted at the beginning of this post.

In the case of mortgages the availability of this newly quantifiable metric spun off dizzying arrays of new financial derivatives greatly amplifying the importance and reach of all transactions based upon the certainty of their key measure – “default risk.” In the case of cap and trade – well things are shaping up exactly the same. The only difference is the metric itself is “warming impact.” And surely the model producing that could never prove prone to error.

In the case of mortgages the model achieved maximum impact throughout the financial system by its near universal adoption by those who scarcely understood the model itself. In the case of Cap and Trade that same effect is intended to be achieved by legislation mandating the adoption of such a model by implication. Think this is overstatement? Then try to think how a market would react to a wandering and arbitrary standard driven by political whim rather than predictable formula. That kind of uncertainty would kill this thing in the cradle. The only way to get this plan off the ground is to base it in the certainty of science and mutually agreed upon fact (or at least a compelling illusion of the same). That’s why this “simple linear relationship” between carbon emissions and warming cited at the top of this post is so significant. It hands legislators a tool which doesn’t require them to understand anything about the climate itself – they just need to measure one single thing. Once they have that legislated… Voilà! The market will do the rest.

Beware of conclusions that go searching for their supporting research. Double plus beware of such conclusions when trillions of dollars are on the line. And triple plus beware when the subsequently discovered supporting research relies upon speculative modeling in lieu of solid evidence. Taken together these have a collective quality of wish fulfillment. But genies belong in fairy tales and not our markets.

So whether you’re the greenest of the green, or a card carrying global warming skeptic, you have plenty of reason for alarm. Another house of cards is being built before our eyes before we’ve even recovered from the collapse of the last one.

Cross-posted at Bogus Gold. Comments welcome. Reprinted with permission.

Posted in Blog Posts, Climate Change, Doug Williams, Guest Post | 5 Comments »

Rep. Matt Dean on Bonding for State Buildings

April 3rd, 2009 by Guest Posts

Responding to our post on the bonding process, state Rep. Matt Dean from Stillwater, an architect by trade, sent the following comments. Dean notes that the state does need to spend money on public buildings — and not “cheap ugly-ass buildings that do not work well and fall apart quickly.” It’s not the need, but the process that Dean questions.

What do you want to build? Why? And how do you propose to take care of it? Those are the questions legislators ought to address says Dean, but seldom do. Instead, the state builds new and expands rather than repairs and maintain just what it needs. Dean has a solution.

–Craig Westover

As an architect, I like to see stuff get built. But as a conservative, I hate to see the state waste money. As a conservative architect, I get pissed off when I see the state spend money on cheap ugly-ass buildings that do not work well and fall apart quickly.

The state does need to spend money on public buildings. We also need to spend money to keep them up. Bonding makes the most sense to pay for it. The real questions are: What do you want to build? Why? And how do you propose to take care of it? We have traditionally set our budget at no more than three percent of general revenue. This year, after scolding the GOP for attempting to break the limit in the past (credit card spending) the DFL wants to blow by the limit generally accepted by the bond houses as fiscally prudent to keep our rating.

Staying below the three percent level makes sense to me. That means we really can not spend the $300M-plus. Not even the $250M proposed by the house. Typically when the senate proposes $300M and the house $250M, they usually come together at $550M.

Vitruvius wrote that a building should have “firmness, commodity, and delight.” In other words, it should be durable, it should meet its purpose, and it should be pleasing to look at.

We need to focus on his first part, “firmness.” Where we have fallen down in the past is on the proportion of money we spend to maintain buildings. Why fix a building up when you can build a new one? This trend has given the state more square footage of building space (because we do not tend to sell buildings either) and a sicker stock of poorly maintained buildings.

If they were vacant, I would not be so troubled. Problem is, we keep filling them with more folks who collect money from the government. As we litterally grow government (buildings), I am convinced there is a natural reaction to fill them with government people.

The second area where we can do better is in the area of spending the money. No, I’m serious. We have hundreds of millions of dollars let by the legislature that agencies are sitting on to implement their schemes in the future.

Today I am offering an amendment to the house bonding bill that does two things. First, it cancels a whole bunch of previously bonded projects that the agencies are sitting on (from trails to the theatre-mobile in Mpls. Next, it spends the money on only ugly projects like roof repairs, road installations, flood clean upand roof replacements.

This Guest Post was written by Rep. Matt Dean of Stillwater.

Posted in Commentaries, Guest Posts, Limited Government | 5 Comments »

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