[edna_mode]

Ah, for scenario #2, you would have to assume the bank has the *authority* to renegotiate the loan! They may not own it anymore, despite still servicing (ie collecting payment) on the loan, because they repackaged it up like a bit of meat in a sausage and sold it as part of a mortgage-backed security (MBS). And picking out one tiny piece of meat to examine it more closely *after* it’s been made into a sausage is pretty difficult, no?

If you were the sausage-buyer, you’d be pretty pissed off if it turned out that due to the rising cost of meat, they substituted in sawdust, right? You paid for all-beef sausage, you want it to perform like an all-beef sausage.

Same thing for the MBS buyer. People bought it at a certain price on the expectation of a certain quality of product, ie that all the mortgages in it would say, be paid off in 30 years at 5.5%. You’d be pissed off if after paying a premium now for a future cash stream, people could just change the terms after your money’s gone, right? Just like biting into the sausage after the Del Mar Fair is over and finding what you can only hope is a green herb.

To complete the analogy, you are proposing trying to go back to the original butcher and complaining about the quality of his meat, which he had long ago sold off to the sausage maker. You may have a point, but the sausage maker was culpable for buying rotten meat. You can’t pin the responsibility for fixing the situation clearly on one party anymore. You’d have to get the butcher, the sausage maker and whoever sold this “all beef patty” to you all in the same room to discuss how to make it all better. Similarly, the responsibility for fixing the loan is diffused across too many parties for it to try to re-negotiate, and it’s not clear at this point who would have the authority to fix a contract that’s been handled by so many people.

[edna_mode]

Ah, for scenario #2, you would have to assume the bank has the *authority* to renegotiate the loan! They may not own it anymore, despite still servicing (ie collecting payment) on the loan, because they repackaged it up like a bit of meat in a sausage and sold it as part of a mortgage-backed security (MBS). And picking out one tiny piece of meat to examine it more closely *after* it’s been made into a sausage is pretty difficult, no?

If you were the sausage-buyer, you’d be pretty pissed off if it turned out that due to the rising cost of meat, they substituted in sawdust, right? You paid for all-beef sausage, you want it to perform like an all-beef sausage.

Same thing for the MBS buyer. People bought it at a certain price on the expectation of a certain quality of product, ie that all the mortgages in it would say, be paid off in 30 years at 5.5%. You’d be pissed off if after paying a premium now for a future cash stream, people could just change the terms after your money’s gone, right? Just like biting into the sausage after the Del Mar Fair is over and finding what you can only hope is a green herb.

To complete the analogy, you are proposing trying to go back to the original butcher and complaining about the quality of his meat, which he had long ago sold off to the sausage maker. You may have a point, but the sausage maker was culpable for buying rotten meat. You can’t pin the responsibility for fixing the situation clearly on one party anymore. You’d have to get the butcher, the sausage maker and whoever sold this “all beef patty” to you all in the same room to discuss how to make it all better. Similarly, the responsibility for fixing the loan is diffused across too many parties for it to try to re-negotiate, and it’s not clear at this point who would have the authority to fix a contract that’s been handled by so many people.

[edna_mode]

Also, I would be careful about going over $100,000 for the whole *household*, in case of death. I had heard about a widow nearly losing $100,000 in her husband’s name when a bank failed on the day her husband died. Since she had $100,000 already in her name, when her husband died, his account reverted to her name…fortunately, he died at 10pm, *after* the bank failed at 2pm, so technically she didn’t lose half her life’s savings!

Not that bank failures are that likely, especially coupled with a death, but if you’re going to spread your risk around, why rely on a technicality to save you?

[edna_mode]

Also, I would be careful about going over $100,000 for the whole *household*, in case of death. I had heard about a widow nearly losing $100,000 in her husband’s name when a bank failed on the day her husband died. Since she had $100,000 already in her name, when her husband died, his account reverted to her name…fortunately, he died at 10pm, *after* the bank failed at 2pm, so technically she didn’t lose half her life’s savings!

Not that bank failures are that likely, especially coupled with a death, but if you’re going to spread your risk around, why rely on a technicality to save you?

[edna_mode]

Also, I would be careful about going over $100,000 for the whole *household*, in case of death. I had heard about a widow nearly losing $100,000 in her husband’s name when a bank failed on the day her husband died. Since she had $100,000 already in her name, when her husband died, his account reverted to her name…fortunately, he died at 10pm, *after* the bank failed at 2pm, so technically she didn’t lose half her life’s savings!

Not that bank failures are that likely, especially coupled with a death, but if you’re going to spread your risk around, why rely on a technicality to save you?

[edna_mode]

I am not interested in debating whether or not this particular bubble will revert to mean. Regression to mean is a very powerful tool and one ignores it at one’s peril; I never indicated that I was in disagreement with you of this phenomenon. Nor do I appreciate being categorically lumped in with the mouth-breathing Visigoths who are unable to appreciate history as an educational tool. However being short of time, I will offer the following analogy:

The seasons turn in order from spring, to summer, to fall, to winter. There is a great deal of historical evidence to agree with the prediction that this cycle is a powerful one and is likely to continue into the foreseeable future. Any fool who watches the season turn from spring to summer and then declares a permanently high plateau of summertime temperatures would rightly be regarded as a fool. As would the person who asks what the mean yearly temperature is in Wisconsin; the answer would be, it depends on the season.

However, evidence that there has *always* been a cycle of seasons tells us nothing about the effects, if any, of global warming on the extremities of temperatures on each season. Human activities may be causing an changes in the mean temperatures in any given season from this point forward. Another example is that the climate of the Sahara has undergone enormous variation between wet and dry over the last few hundred thousand years, give an ice age or two and discussion the mean temperature of the Sahara over that time frame is meaningless. This evidence is not mutually contradictory with the force of yearly seasonal changes — rather, it is merely a matter of difference of scope (kinetics vs. thermodynamics). My suggestion of examining larger effects is neither a contradiction or a challenge to your analysis of kinetic effects, which I affirm in the highest — I agree with your identification of the kinetic main effects. I just would feel remiss in not adding to your analysis with this addition of scope.

Using evidence that fall and winter will surely follow the summer (which no reasonable person would dispute) cannot say anything about what the future long-term trends will be on any given season based purely on the information that the seasons change and they always follow that cycle. Perhaps an ice age is coming. Perhaps not. Of course Rich’s graph shows a situation so extreme that even returning to just the historical mean would be extremely painful, let alone overshooting. If we put a pencil with one end at the earliest time point on his graph so that it sits in the centre of the cycles, we can see that whatever points are furthest out in time (the future) will affect the angle of the pencil the most (points far out on the y axis have the greatest leverage on the linear regression). But it is such a huge distortion of prices over the past few years that maybe a better characterization of the system would be to break your pencil into line segments where each segment covers a full cycle. Then each mean for each cycle would be somewhat different. And your judgement about where to break your pencil (the edges of what you consider a cycle) could radically affect your conclusions.

The way to study longer term questions would be to examine the edges and the extremes of the seasons and try to identify what changes are due to causes that had not existed previously, whether or not those causes are likely to persist (credit liquidity, the game theory involved with international economic factors/trading incentives, saber rattling, etc), and even then there would be a great deal of uncertainty in the prediction.

And as in any chaotic system quantitative, specific predictions are hard to make with any reliability. Picture the gazelle that has been gravely wounded by the lion and then somehow managed to get free (eg the housing market wounded by change in sentiment), only to find itself now faced with a circle of jackals (inflation, monetary policy determined by a new Fed, credit liquidity, changes in the Bretton-Woods agreement (our currency is no longer gold backed and other countries may decide to stop pegging their currencies to ours)) — it may very well be impossible to judge which particular jackal leaps for the throat of the gazelle to make the final killing blow. So while it might be interesting to line up potential “jackals”, no one of them might be obviously strong enough to deal the killing blow — but the combination of them might be. Or there might be few enough jackals at the moment and the gazelle might manage to escape one more time, for now — and everyone who might benefit from eating gazelle tonight goes hungry for another day.

[edna_mode]

Madam, I did not mean to throw down a gauntlet down before someone I hold in such high esteem…however, since we find ourselves in a position of misunderstanding, please allow me to elaborate: I speak not of bubbles per se, but examples of overreliance of the reversion of the mean for future predictions, specifically with predictions of how long the system will take to revert to the mean, and especially on how to measure the mean (the chosen time frame, statistical methods and ways of grouping the data can materially affect one’s conclusions, for example). There is no objective way to do this process; honing one’s judgement in how to treat the data meaningfully is no less of an art than pre-meds spending much of their residencies examining perfectly healthy patients — they do this to calibrate their sensibility on what “the average healthy person” *is*, and is likely to be *in the future*.

I do not take issue broadly with any of your examples, or the analysis Rich or you have done to demonstrate that the recent housing market is vastly overpriced. I am however concerned that in the strong conclusions that I am hearing, there may be a lack of appreciation in how significant the difference of the sample mean might be from the population mean (ie how representative is your sample set in terms of describing the behaviour of the *whole* system, past and present), and also the difference between descriptive statistics (dissecting data from a specific sample set) and inferential statistics (projecting the analysis of your sample set onto a population, which is intimately related to my first point).

Since I started with _Against the Gods_ (mine is from 1996), I will continue from there…searching the index, “Regression to the Mean, overreliance, illustrations of”…ah, pages 182-183.

I’ll refer to the second of Mr Bernstein’s examples below (I hope my paraphrasing falls under “fair use” — but just to be sure, I encourage everyone to rush out to the public library, read through this book once for free and determine if it is worthy of a permanent place in your personal library):

Quote (p183-185, all words in [] are mine):

“Up to the late 1950s, investors had received a higher income from owning stocks than from owning bonds. Every time yields got close, the dividend yield on common stocks moved back up over the bond yield. Stock prices fell, so that a dollar invested in stocks brought more income than it had brought previously. That seemed as it should be. After all, stocks are riskier than bonds. Bonds are contracts…if borrowers default on a contract, they end up in bankruptcy, their credit ruined and their assets under the control of the creditors. With stocks, however, the shareholders’ claim on the company’s assets has no substance until after the company’s creditors have been satisfied. Stocks are perpetuities: they have no terminal date on which the assets of the companies must be distributed to the owners…the company has no obligation ever to pay dividends to the stockholders. Total dividends paid by publicly held companies were cut on nineteen occasions between 1871 and 1929; they were slashed >50% from 1929-1933 and ~40% in 1938. So it is no wonder that investors bought stocks only when they yielded a higher income than bonds. And no wonder that stock prices fell every time the income from stocks came close to the income from bonds.

Until 1959, that is. At that point, stock prices were soaring and bond prices were falling. This meant that the ratio of bond interest to bond prices was shooting up and the ratio of stock dividends to stock prices was declining. The old relationship between bonds and stocks vanished, opening up a gap so huge that ultimately bonds were yielding more than stocks by an even greater margin than when stocks had yielded more than bonds. [Discussion of how inflation underwent a serious inflection point around 1940: cost-of-living had risen an average of only 0.2% a year from 1800-1940 (140 years!!)] Under such conditions, owning assets valued at a fixed number of dollars was a delight; owning assets with no fixed dollar value was highly risky.

But from 1941-1959, inflation averaged 4.0% a year…The relentlessly rising price level transformed bonds from a financial instrument that had appreared inviolate into an extremely risky investment. By 1959, the price of the 2.5% bonds the Treasury had issued in 1945 had fallen from $1,000 to $820 [which] bought only half as much as in 1949!

Meanwhile, stock dividends took off on a rapid climb, tripling between 1945 and 1959…No longer did investors perceive stocks as a risky asset whose price and income moved unpredictably. The price paid for today’s dividend appeared increasingly irrelevant. What mattered was the rising stream of dividends that the future would bring. Over time, those dividends could be expected to exceed the interest payments from bonds, with a commensurate rise in the capital value of stocks. The smart move [at that point] was to buy stocks at a premium because of the opportunities for growth and inflation hedging they provided, and to pass up bonds with their fixed dollar yield.

Although the contours of this new world were visible well before 1959, the old relationships in the capital markets tended to persiste as long as people with memories of the old days continued to be the main investors. For example, [Bernstein’s] partners, veterans of the Great Crash, kept assuring me that the seeming trend was nothing but an abberation. They promised me that matters would revert to normal in just a few months, that stock prices would fall and bond prices would rally. [As of 1996], I am still waiting…”

***

So from this example we see how the noise of WWII hid the disequilibrium shift in inflation, which became the main factor in answering the question “should I buy stocks or bonds?” If we were to judge our mean based on 1800-1940, we would conclude one way; if we were to judge after WWII, we would conclude the opposite on a much smaller data set. The winds really had shifted for the foreseeable future.

I am not making any sort of prediction, with regards to housing, the economy or anything else. What I am doing, is pointing out that something as hugely distorting as the recent run-up in prices, largely due to irrational exuberance, may very well have also hidden more subtle yet persistent factors that could very well change the dynamics of the outcome. If sentiment is the kinetics of the system, then factors like monetary policy, inflation targets, the strategic importance of San Diego (militarily or economically to the country, affecting what kinds of incentives are created by private groups or the government for people to live here) that cannot be captured with a headline or a soundbite are the thermodynamics. And I am interested in characterizing each of these appropriately.

But your posts are highly educational, “I enjoy our visits” 😉

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