Monday, October 15, 2012 - Coffee First Then the Prize

Coffee First Then the Prize

-by Sinclair Noe

DOW + 95 = 13,424
SPX + 11 = 1440
NAS + 20 = 3064
10 YR YLD un = 1.66%
OIL- .11 = 91.74
GOLD – 16.90 = 1738.40
SILV - .78 = 32.80
PLAT – 14.00 = 1646.00

Americans Alvin Roth and Lloyd Shapley were awarded the Nobel economics prize on Monday for research that helps explain the market processes at work when doctors are assigned to hospitals, students to schools and human organs for transplant to recipients.

The Royal Swedish Academy of Sciences cited the two economists for "the theory of stable allocations and the practice of market design."

Roth, 60, is a professor at Harvard. Shapley, 89, is a professor emeritus at UCLA.

"This year's prize concerns a central economic problem: how to match different agents as well as possible," the academy said.

Shapley made early theoretical inroads into the subject, using game theory to analyze different matching methods in the 1950s and '60s. He examined "pairwise matching”. Roth took it further by applying it to the market for US doctors in the '90s.

"Even though these two researchers worked independently of one another, the combination of Shapley's basic theory and Roth's empirical investigations, experiments and practical design has generated a flourishing field of research and improved the performance of many markets," the academy said.

While I think it's safe to say most of us believe that capitalism is the best economic system, in part because of the ability to efficiently allocate resources, it turns out that there are ways to improve the efficiencies of allocation.

Signing up to attend high school used to be a big mess for more than 90,000 New York City students. That is, before Alvin Roth and his team overhauled New York City high-school admissions in 2003, eighth-graders would select up to five of the city’s more than 500 high-school programs, send their preferences in the mail and wait. Principals would rake through applications and apply their individual filters. Schools had different admissions practices: some schools were open-admission, others gave priority to those who live nearby, some evaluated students individually and still other schools had quotas.

In this first round of admissions, principals would send offers to about 50,000 students. Many students wouldn’t get a single offer from any high school, while about 17,000 students received multiple offers. Students would accept an offer, and schools would go through another round of offers.

Many students would end up disappointed; about 30,000 would be automatically assigned to schools that weren’t in their top five, they were sent wherever there was an opening. What Roth and co-researchers realized was that the system was congested.

In 2003, the city decided enough was enough. They asked Roth, whose specialty was non-traditional markets, and his colleagues to try to create a system similar to one they’d designed to match medical-school students to resident programs.

They created an algorithm that would allow students to rank up to 12 schools. Then a central clearinghouse for applications would match students to schools based on multiple, internal rounds of application and acceptance. Instead of going through only one round of internal applications and rejections before making offers, the city would run an algorithm and try to get as many matches as possible between where the students wanted to go to school and which students the schools wanted to accept.

For fall 2004-2005 admissions, the first year the new system was in place, about 3,000 more students received one of their top five preferences than before. In addition, only 3,000 students were automatically assigned to a high school that wasn’t on their original list.

Is it a perfect system? Far from it; critics say it is complicated and it doesn't work for all students, but even the critics admit it is vastly superior to the old system.

Maybe more important than the practical application of getting students to class, were practical applications that save lives, including pairing kidney donors with recipients. Kidney-exchange programs using Roth's algorithms have already saved hundreds of lives in the U.S. Judging from his research, they could save more -- and save a lot of money on dialysis costs -- if Medicare covered the expenses of kidney donations.

Roth said he was sleeping when he got the call from the prize committee in California, where he is a visiting professor at Stanford University.

"I'm sure that in class this morning my students will pay more attention," he told a news conference in Stockholm by phone.

Asked how he would celebrate, he said: "I haven't made any plans yet; coffee."

All I can say is this guy deserves the Nobel prize.

Elsewhere, last week the IMF switched sides. For years the IMF and the World Bank have been of the opinion that when a country ran up too much debt, the answer was to impose harsh, sometimes crippling austerity. The game plan was to typically announce the sky was falling, demand bailouts for banks, crush the public sector, sell-off large chunks of national holdings, and privatize others.

So has the IMF suddenly woken up the fact that demanding every government slash spending and raise taxes is, in many cases, counter productive because they have underestimated the fiscal multiplier in government spending ?  No, the IMF along with its new President have been well aware for some time that their theories on expansionary fiscal contraction have underestimated the negative effects of attempting government sector austerity at a time of private sector de-leveraging, specifically in a fixed currency environment.

Tightening fiscal policy in the absence of increased private sector investment or external surpluses leads to weaker growth, which in turn worsens public finances further. Without external debt relief and/or the ability to externally devalue this becomes a spiral downwards as domestic retrenchment adds to this counter-productive dynamic. Again, this is the IMF game-plan  why the change in policy? I suspect the driving force was that Spain wasn't going to play ball. The Spanish people took to the streets in overwhelming numbers, and that forced the Spanish government to reject the bailouts and austerity plans. And the Troika of the IMF and World Bank and European Central Bank may be very powerful, but not enough to risk the wrath of millions of people in the streets of Madrid.

Of course the ECB is waiting in the wings with its OMT and this latest ratings downgrade could be the trigger that finally forces Rajoy to seek external help. And while the IMF may have switched away from austerity, it is still popular among the Germans. As the economic weakness continues to spread across the Euro-zone, even the most stringently fiscal responsible countries might change their tune. Last week the Euro-union won the Nobel prize for peace. Maybe they should remember that after the first war, the plan was austerity for the vanquished. It did not work out well. After the second world war, the plan was called the Marshall Plan; it called for massive investments at a time when nobody in Europe could pay for anything. We know what works and what doesn't. Maybe, the Nobel Prize people were just trying to get people thinking again.

When a bank, at least a really big bank, reports earnings you can ask “how money did they make on fees?” and “how much money did it make on selling mortgages?” and that's nice.

If you asked those questions of Citi, you might or might not get answers that might or might not be useful, but you’d be hard pressed to translate them into the headlines on Citi’s earnings. Big banks are bundles of accounting legerdemain, and this is never more apparent than at earnings time and it doesn't have much correlation to the real world of economic activity.

Today, Citigroup reported third quarter earnings. Here are a couple the stories:

Citigroup Inc.’s third-quarter profit fell 88% as the bank took charges tied to the value of its debt and the sale of a stake in its brokerage joint venture …

OK, then there was another report that said:

Citigroup Profit Beats Estimate on Bond-Trading Gains ...

Take your pick! It is fun to say things like “non-cash accounting charges are fake and you should back them out and concentrate on recurring items with economic significance” but that’s just, like, your opinion man.

Goldman Sachs issued it's own opinion in a quick research report this morning on Citi's earnings.

Basel 3 capital increased to 8.6% from 7.9% last quarter on capital accretion from the MSSB sale, continued runoff in Citi Holdings and retained earnings. Encouragingly, Citi is now within range of it’s fully phased in Basel requirement after factoring in additional capital accretion to come from the remaining MSSB sale (~+40bp). …We expect shares to respond favorably today given strong top-line performance, positive operating leverage, and better than expected Basel III capital.

It was positive response because Citi has been trying to raise dividends, but was stymied by its regulators’ view that doing so would leave it without enough capital to deal with stress. Now that it has more capital than expected, it has a better chance of raising dividends. I just can't figure out how they did it.

If you wanted a model of how to react to Citi’s earnings you could I suppose build one based on your special and unique comprehension of real economic factors. Things like actually growing sustainable lending businesses would look good; I couldn't find that stuff in the earnings report. Citi uses things like debt valuation adjustments, or DVA, which turns debt into profit. It tends to twist logic. I think it has something to do with alchemy.