AMR Files for Bankruptcy

I did see this coming a few months ago.  At that time, the CEO of US Airway (LCC) spoke in public that he was expecting a merge or acquisition of the company.  I was puzzled by the M&A anomalies, so I looked into the financial statements of LCC and even other major airline companies (including AMR) and I laughed...  Who were you fooling?

I was right.  The stock price per share of LCC was about $9 back then.  Look at how much it is now: less than $5.  Actually, if there is no major improvement in LCC, I am not surprised at all if it becomes another AMR in the near future.  Too bad that I am still too risk averse to open a short sale account, or maybe too busy to think about it.

I am so happy that what I learned in finance works in practice.  One of my high-school classmates is working in a hedge fund.  I asked him the other day what their attitude is to the CAPM model.  He said "ignore...".  I think it is time to have some major break-through in asset pricing.  I would expect the next break-through comes from the financial market frictions.  I found that someone has already worked on it: http://www.frbatlanta.org/filelegacydocs/erq307_degennaro.pdf.  But I have not read it in details, so I cannot make any comment yet.

Back to the topic, I think airline is a very interesting industry.  If you look into its history, there were so many bankruptcy cases.  It feels like they are so familiar with the bankruptcy procedure that they do not care having another one.  Would this fact affect their reputation and thus investor sentiment?  I wonder whether anyone has researched on this topic.  Most papers focus on the possibility that shareholders take advantage of debtholders (such as agency problems), but this case looks like the debtholders are taking advantage of the shareholders by playing bankruptcy games.  I saw a post in a stock forum: a poor individual investor of AMR was asking where his money went.  Believe or not, finance should be a mandatory curriculum in high schools nowadays.

What was wrong with "Free Market"?

Let me begin this post with the definition of "free market" from Wikipedia:

"A free market is a competitive market where prices are determined by supply and demand. "

There was a long debate on "Free Market" Vs. "Regulation".  Scholars who believe in "free market" are strongly against regulation or any other government intervention because they think the market could heal itself by competition and whatever powerful mechanism it already has by itself.  However, other scholars argue that the market is not as powerful as the "free market" hypothesis claims and needs government intervention to make it more efficient.

You may notice that I used the past tense above when I mentioned the debate.  As far as I understand, this debate was before Stiglitz and a few other Nobelists brought to our attention the information imperfection and other market frictions.  I thought, after that, this debate was at least partly, if not fully, resolved by the agreement on the existence of market friction.  However, I am often surprised by how many times this "free market" argument is raised in seminars in an ambiguous way.  So I write this post to explain my understanding, and I really appreciated it if you could let me know whether I miss something in the big picture.

Most obviously, in a market with imperfect competition, the "free market" assumption is violated by its own definition: "a competitive market", not to mention other market frictions such as private information, agency problem and transaction costs.

However, regulations could be helpful under two circumstances.  First, it may help mitigate the impact of some market frictions and bring the market closer to the first-best efficient world.  Second, if you believe in the behavioral story, regulations could also help market participants make rational decisions and make the world a better place as a whole.  The first scenario rationalizes the "Regulation" hypothesis to reconcile with the "Free Market" story, and that's what I believe in.  Correct me if I am wrong, but I think what most "free market" believers are strongly against is the second case.

In many papers I read, the authors either stand in the extreme side of the debate: market is fully efficient or market participants are irrational, or simply avoid the argument by not talking about it.  Often time I figure that those results could be easily rationalized by a story in a market with frictions, but it is a puzzle to me why they choose the ambiguous alternatives.

If I am right, the reason could come from the deficiency of research on market with multiple frictions, especially in the theoretical sides.  Of course, this type of research could be very complicated due to multiple constraints.  If you have already seen some dealer market models in the market-microstructure literature, you know how complicated this type of models could become.  However, I believe this would be an interesting and potentially fruitful trend of research due to the following reasons:

First, different market frictions usually interact with each other.  Some papers have already shown that they may sometimes cancel out each other in equilibrium and make the market more efficient.  This could lead to the same results as shown in the "Free Market" hypothesis, yet with more realistic assumptions.

Second, it is a challenge to the theorists to come up with a simple model that could explain the complicated situations.  I believe simple is beauty, not only in mathematics but also in economics and finance, or any other science.

Third, I am always skeptical about the behavioral stories.  I admit that not every person is rational and even rational people could make mistakes, but I think it is irresponsible to attribute every abnormally to the behavioral story.  Please allow me to use the medical metaphor again: this path of research is like to find out medical diagnoses for a complicated disease with mixed symptoms instead of simply calling it a miracle.      

   

Altruism, A Pathological Symptom, or Irrationality? -- The Importance of "Economically Significant"

I love watching TV shows of doctors, medical doctors, such as "Grey's Anatomy" and "House".  I wanted to be a doctor for such a long time, because I am often fascinated by their rationality with rigorous logical analysis, and of course the fact that it could save people's life.

Although I ended up to do finance and economic study, I still feel very excited when I find any connection between medical research and economic research.  At least, they have the same subjects -- human being.  Doctors are looking for pathological symptom to justify their diagnosis, while economists are trying to explain "abnormal behaviors" based on their assumption of rationality.  They both need a benchmark to start with.  Economists' benchmark is obviously any rational behaviors, and doctors' benchmark should be written in those medical books that I am not familiar with.  But I am sure these benchmarks are both under debate.  Altruism, for example, could be an interesting topic in both these two areas.

This idea is motivated from the new episode of "House".  A rich man wants to give away all his money to charity, and of course, House thinks of this extreme altruism as a pathological symptom.  And as usual, he is right at the end.  While I was watching this episode, I could not stop thinking about the similar debate in economics whether altruism could be rationalized using some special utility function.  If Doctor House meets an economist, would they agree on the statement that "Irrationality is a pathological symptom: the brain is not functioning very well"?  I guess they would be both happy to accept it since it can solve both of their puzzles.  Of course, that is just a joke and I do not have a final answer for it, but what I do learn from this episode is the importance of "Economically Significant".

In this episode, the doctors finally agree with House's diagnosis after the rich man says "yes" when he is asked to give away both of his kidneys to two sick strangers.  It is like in an economic research, when you show something that is "Economically Significant", then you could claim that your research is indeed interesting and important.  Before that, you may be the crazy guy if you send a person to hospital simply because he gives away some money to the charity.  Doctor House is charming because he can always think of these seeming crazy but effective ideas.  My point is, to have an unclear or ambiguous benchmark does not mean that you cannot do anything about it, you could still examine the extreme cases where people could usually achieve an agreement.  So I think if we could find some extreme examples to show our results, our research would be more accurate and more persuasive. 

Sellers' Conspiracy

As the number of "unread" in my email inbox increases faster and faster, almost exponentially, I realize: here it comes this year's shopping season.  I love shopping season, not only because of the coupons and discounts I get, but also because it is fun to guess and find out different companies' competition strategies.  It is like to watch a free and live game show, sometimes it could also be a drama.

I am supposed to be relatively rational since I have been studying classical Economics for more than 10 years.  However, I am often surprised by my irrational first reaction when I see some new promotions.  For example, I sometimes feel uncomfortable to get a good deal (something I really need and at a reasonable price) if I find that there was a better deal recently that I missed.  I consider this as irrational because it is usually difficult to predict future promotions and there probably is no better deal in the future.  Some "hard-core rational" economists may argue that this is still rational but my utility function has a unique shape to rationalize this reaction.

But usually I do nothing after the first reaction and think deeper before I move.  That's why I cannot be a "Thanksgiving shopper" who needs to move fast without thinking.  And I do not regret because I think of the "Thanksgiving style" as one of the tricks that merchants could "steal" money from people's pockets.  To believe that you are getting the best deal ever and to buy fast without thinking is exactly what the merchants would like to see, so they exhaust their brain power to create all types of new ideas to trick buyers into this crazy circle: compete to buy no matter what --> feel good about getting the "deal" --> buy more aggressively and irrationally...... 

I do not rule out the possibility that someone did get some very good deals out of this crazy shopping season, but on average, I believe the firm surplus is definitely higher than the consumer surplus.  And I am not sure whether the total surplus is positive.  If you think of the people who blow their credit cards just to get some "good deals" and turn out to own something useless and a heavy debt, you may start to believe that this may even be one of the reasons of the financial crisis.  Not to mention those Thanksgiving tragedies in history (crazy people trample on innocent shoppers just to get into the store...).  One of my favorite episode of "Grey's Anatomy" (a TV show of doctors) happens in Thanksgiving shopping season.

I am always wondering what the optimal strategy is for a company to survive the competition during this season.  Are those also benefit the society as a whole? (In economic lingo: Are the social welfare also optimized?)  Are there any other regulations to make this world a better place?

This may be a topic that is too big for me to talk about.  But I would like to point out two interesting fact in this year's shopping season.  

The first one was started with a while ago by a company called "Groupon".  You would be amazed to find out how many similar companies are there in the world nowadays.  Name a few: Livingsocial Deals, Eversave, Savemore, Plum District, ...  Do they look familiar?  You probably have seen these names a lot in your junk mails.  Their business models are all the same: to help merchants advertise by offering discounts to consumers.  This business model has certainly brought a lot of money to these companies , and Groupon is about to IPO soon.  But you want to talk about whether it brings value to the society?  I will have a start a new long discussion in another post.

The other fact is American Express (Amex)'s new move to support small business.  Google "Amex, Small Business" and you will find tons of discussions on their numerous promotions.  I think this could be potentially a smart move, because in this economic down-term period, it is hard for the "big guys" to recover and small business may be a way out.  But nothing is guaranteed, we will have to wait and see, and at the same time, keep our figure crossed. 

What is behind the CEO's resignation?

CECO, a for-profit education stock, had a sudden price drop of more than 60% last week.  Two pieces of news are related to the price drop: one is the CEO's resignation and the other is the bad news in Q3 earnings.  But the company did not yet disclose the exact reason why the CEO resigned.

I think this could make an interesting case study, for both asset pricing and corporate finance.  I am wondering which bad news contributes more to the price drop and how they interact with each other.  Does the news of the CEO's resignation make the bad news of earning look even worse or is it considered (by the investors) a relatively good news to pull back the stock price?

If it was the former case, why would the company choose to announce such news at this time (earning announcement season)?  Was there an agreement between the CEO and the company?  Or was it a revenge from the CEO if it was a forced turn-over?

If it was the latter case, we may be able to find some evidence of the CEO's bad performance from the past history.  I doubt this explanation because I watched this stock a while ago and found it performed quite well.  This news is quite a surprise to me.  Although I am aware of the regulatory uncertainty of the for-profit eduction industry, I do not think this concern is big enough to account for the huge price shock.

Let's keep an eye on CECO and see what happened next.