Thanks to Barry Ritholtz at The Big Picture for posting some truly fantastic videos of CNBC’s Squawk Box. It’s the first time I’ve heard either Einhorn or Ackman speak and it was a treat. THAT is what I want to be like when I grow up.
Risk management is a topic I’ve discussed here a bit. In particular, on March 16, 2006, I wondered aloud
When I look out at the world, one of the major risks to the markets that I see is, ironically, risk management. I suspect that one of the primary employers of junior quants in the last 5 years has been in risk analytics (HHs, please correct me if I’m wrong). If there is any truth to that, it means there is literally an army of quants who have not lived through a business cycle building risk systems on markets that no one really understands, e.g. CDS/CDOs.
[snip]
If things are at all like what I have seen, then we’ve got a bunch of fairly clueless risk managers out there with an army of fairly green quants developing sophisticated risk models that are probably pretty useless in a crisis. Nonetheless, there seems to be this completely ludicrous false sense of security.
Across the boards, vols seem to be historically low which would mean that most VaR engines are saying “smooth sailing”. What happens if vol increases? Everyone’s VaR model is going to start sending out little red flags. Assets are going to start getting reallocated. Since everyone has almost identical VaR models, the signals will be pretty much identical at all firms. I know it is not an original argument, but this could easily lead to a negative feedback. A small red flag due to increased VaR could signal everyone to make very similar reallocations. If everyone does it at the same time, the market will obviously be affected. In essence, the impact of risk management could actually increase systemic risk in the markets and amplify vol movements.
With that in mind, you can probably imagine how much I enjoyed this article by Avinash Persaud at VoxEU:
Why bank risk models failed
Avinash Persaud
4 April 2008
I also enjoyed his 2000 article referenced in the above paper
Sending the herd off the cliff edge:
The disturbing interaction between herding and market-sensitive risk
management practices.Avinash Persaud
December 2000
Both are well worth reading.
When I left my first job in asset management back in July, I had 5 weeks to sit around and read blogs and listen to streaming Bloomberg TV all day (I know I’m a nerd) before starting the new gig. Mind you, this was during the early stages of the snowballing credit crisis. One thing I found is that the quality of analysis that can be found on blogs is surprisingly good and timely. For veterans, that is probably not news, but it was eye opening for me.
Another example of a fantastic markets blog is a relatively new one I recently stumbled upon. I’ve already added it to my blogroll and subscribed to the feed and am looking forward to following it with keen interest. I like it so much so far, I wanted to specifically point it out to anyone who hasn’t seen it yet:
Welcome to the blogosphere and thanks for the fantastic commentary!
Physicists learn at an early age (sometimes while still in diapers) about vectors. In fact, I supported myself financially through undergrad largely by explaining vectors to physical therapy students. Physics was the “weeder” course and PT students basically needed an “A” to get into the program. Tutoring them was quite lucrative, but that is another story. Here, I present a very neat way to visualize market risk in terms of arrows… err… I mean vectors.
A vector can be thought of conceptually as an “arrow”.
What is the information contained in an arrow? There are two basic bits of information contained in an arrow
In terms of direction, probably what is more useful than “absolute” direction, is the “relative” direction, which can be quantified as the angle between two arrows.
The next thing you need to know about vectors is that you can multiply a vector 
Multiplying a vector by a number merely “rescales” the arrow, i.e. changes its length, while keeping the direction unchanged.
Next, given two vectors 
Alternatively, but equivalently, you can draw the vectors “head to tail” and the new vector is the arrow pointing from the tail of the first arrow to the head of the second arrow as shown below
It doesn’t matter which you choose. Just remember that the addition of arrows is a little funky and involves parallelograms.
If I haven’t lost anyone up to this point, I will be quite impressed if you stick around for what comes next.
Both the length and relative direction of a vector, or arrow, can be determined by something that we lovingly refer to as the “dot product”. Later in academic life, I learned that the “dot product” was actually a twice covariant symmetric non-degenerate tensor, but I digress. For our purposes, we just need know that the dot product takes two arrows and spits out a number (in a bilinear fashion). In other words, if
then
A fundamental property of the dot product is that when you take the dot product of a vector with itself, the result is the square of the length of the vector, i.e.
Therefore, the dot product provides us with one of the most important characteristics of a vector: it’s length. To whet your appetite a little, I hope that the expression above makes you think of “variance” or more specifically “standard deviation/volatility”. That is no coincidence!
The dot product of two distinct vectors also gives some very useful information
or
Note that 
Once you start doodling with a bunch of arrows, you may start to think about the relationship between two arrows and, like a shadow, how might one arrow project onto another as shown below
If you recall a bit of trigonometry, the length of 
which may be written in terms of the dot product as
How about the ratio of that projection? That is determined by simply dividing the above by |A|, i.e.
This ratio is particularly of interest in finance, as I will show below, and is related to “portfolio beta”.
Now the fun starts and I hope at least one person in the universe reads this far down 
The return of a portfolio is a vector.
What?!?
Well, hear me out. Consider a portfolio consisting on 
where 
Hmm, the security returns are multiplied by numbers and then added together. That sounds a whole lot like a vector to me!
Ok. If returns can be thought of as arrows, what are the meanings of the length and relative directions of two returns?
As we saw above, to determine the length and relative direction, we needed a dot product. What would be a good dot product for the vector space of security returns?
Technically speaking, covariance does not satisfy all the axioms of a dot product, but fortunately physicists like to shoot from the hip and tend to be right under most practical circumstances and in exotic cases where we are not right, we can usually change things around a bit so that we are right. So technical arguments aside, I am simply going to tell you that covariance can be thought of as a dot product on the vector space of security returns.
Woohoo! That is great. Why? Because all the nice pictures above can be re-interpreted in the context of portfolios of securities.
Here is an arrow depicting the return of a portfolio
What information is conveyed by the length of this arrow? Recall that
but if the dot product is covariance, then we get the very interesting association
i.e. the length of the arrow is the volatility of the return.
Next, consider the return of a benchmark against which this portfolio is to be measured. The benchmark return can similarly be represented as an arrow and we have
What is the meaning of the angle between the “portfolio arrow” and the “benchmark arrow”? Recall that
However, we also just learned that
so that the above expression can be rewritten as
which you might recognize as the definition of correlation. The correlation between the portfolio return and the benchmark return is the cosine of the angle between the portfolio arrow and the benchmark arrow.
That is pretty neat, eh? We now have a nice way to visualize both the volatility and correlation of security returns. The length of a “return arrow” is its volatility and the angle between two returns relates to their correlation. I couldn’t make up a better story if I tried
But what can we do with this knowledge?
The excess return of a portfolio of its benchmark is simply
which we can trivially rearrange as
The right hand side of the equation of above represents the addition of two arrows, which we already described above. Therefore, we can represent the expression visually as
This little trick seems kind of neat, but fairly trivial, so what did it give us? Recall that the length of an arrow is its volatility. Recall also that tracking error is defined as the volatility of the excess return, therefore we have the very cool consequence
We have a very concise way to visualize tracking error that captures both the volatility of the portfolio and the volatility of the benchmark as well as the correlation between the two in one simple diagram.
“Now how much would you pay? But wait! There’s more!”
The same diagram above that gave you tracking error also gives you your portfolio beta. To see this, simply recall the definition of the projection of an arrow along another arrow and reinterpret that in terms of returns
or
where 
Next, if we consider the ratio of this projection to the length of the benchmark arrow, we have
which you might recognize as the definition of the portfolio beta! Therefore,
We’ve demonstrated, first, that returns can be visualized as arrows where the length of the arrow represents its volatility and the angle between two arrows represents the correlation of the two respective returns. Second, by comparing the portfolio and benchmark returns pictorially, we automatically get a very informative picture of both tracking error and portfolio beta (in one shot) that also contains information about the absolute market risk in terms of the volatilities (lengths) of the portfolio and benchmark arrows as well as the correlation between them.
People that I know and admire know and admire Jeremy Grantham. So although “knowing” is not necessarily transitive, “admiring” often is.
I’ve enjoyed reading Grantham’s stuff for almost a year now and he’s had a definite impact on the way I think about things.
Financial Armageddon points to a recent Barron’s interview with Grantham:
He’s got some choice words for Bernanke and Greenspan. I particularly agreed with his thoughts on the coming massacre in corporate bonds.
Hello!
It’s been a while. Things are pretty wild over here these days. Not only are the markets exciting, but I’ve made yet another career move.
I started life after physics on Wall Street in 2005 doing risk analytics for a BIG bank. i.e. I started phynance life on the sell side. Soon after, I hopped coasts (when Sophia came) and worked for a BIG asset management firm, i.e. on the buy side. In 2007, I jumped ship again and went to work on the sell side again as more of a pure quant. Now… I am moving back into asset management.
I have to say I am pretty excited about the new job, but it wasn’t easy leaving my last job. The group was phenomenal. Super smart people. It was a great environment to work in. Unfortunately, market events took a turn for the worse (if that is possible) and the likelihood that I might lose my job reached unacceptable levels (considering both my wife and I worked at the same place!).
Anyway, today was my last day on the old job and I start my new job on Monday. Wish me luck!
In this fun thread, on July 4, 2007, I wrote about one of Bernanke’s speeches:
This latest wind bag empty rant of his is almost laughable
The Financial Accelerator and the Credit Channel
June 15, 2007He speaks of his model results as if they represent reality without question. It is notable that he only references papers that support his arguments without a nod to the opposing viewpoint. The more I read this guy’s stuff, the more upsetting it gets. I may have only been thinking about credit markets for the past two years, but I’ve been a researcher for a lot longer than that and I’ve developed a nose for BS and Bernanke’s articles reek of it.
Then, in response to doctorwes’ comment, I said (emphasis added in bold):
For example, he suggests that if many homeowners have little equity in their homes, and there is a decline in home prices, there might be a more negative impact on the economy than people would otherwise expect.
More than who expected? Sounds like a lame excuse to me. The proponents of the BIS view certainly saw it coming and several NBER papers are there (including Scwartz’) to prove it, which he conveniently chose to disregard. Sorry, you can’t take one side of a debate and when it turns out you’re wrong, claim to be ignorant of the other side.
In addition to my apocalyptic predictions, I also predict that Bernanke will be removed from his post in the not-so-distant future (say post Nov ‘08 ).
We’ll see if he lasts until after the elections. I doubt it.
Financial Armageddon points to the Reuters article:
Worried about inflation? Just wait
where he argues that deflation is the next big worry. I have to humbly disagree. Sort of.
I do agree that financial asset prices are due for a massive correction, but the economy is made of more than just financial assets. Financial assets will see deflation, but physical assets will see inflation.
During the “New Economy”, financial assets have soared in value and I believe, like Jeremy Grantham, that financial assets throughout the globe have experienced a bubble.
Like I’ve said in a comment or two on Panzner’s blog, during past corrections in the financial sector, China and India were absorbing inflationary pressures. That structural shift is what will make this time different. Today, China and India are net exporters of inflation and loose monetary policy in the US will create domestic inflationary pressures that have no where to go this time.
This is the rift I saw between physical and financial assets when David Richards asked me what I thought about the markets back in December of 2006. That rift has been partially corrected with the rise in commodity and energy prices since then, but I think there is a long way to go before things are neutral. As usual, things usually will not reach a nice equilibrium and stay there. Inertia will carry it through neutral and beyond. Significantly beyond.
Wow. When I first began voicing my opinion about the Fed and monetary policy in a public phorum, it didn’t take long for me to be drawn to some papers by Anna Schwartz. On July 3, 2007, when I was asked what I would have done if I was in charge of monetary policy, I said:
If I were in charge from 2000-2007, I probably would have surrounded myself by smart people like Anna Schwartz, who wrote this gem (in 2002)
Asset Price Inflation and Monetary Policy
Abstract:
It is crucial that central banks and regulatory authorities be aware of effects of asset price inflation on the stability of the financial system. Lending activity based on asset collateral during the boom is hazardous to the health of lenders when the boom collapses. One way that authorities can curb the distortion of lenders’ portfolios during asset price booms is to have in place capital requirements that increase with the growth of credit extensions collateralized by assets whose prices have escalated. If financial institutions avoid this pitfall, their soundness will not be impaired when assets backing loans fall in value. Rather than trying to gauge the effects of asset prices on core inflation, central banks may be better advised to be alert to the weakening of financial balance sheets in the aftermath of a fall in value of asset collateral backing loans.
Now, she takes both Greenspan and Bernanke to task in this scorching article at the Telegraph:
Anna Schwartz blames Fed for sub-prime crisis
The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.
“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.
That is a great article and although I should probably be a little more dignified that proclaiming “Bernanke sucks”, it is good to know that Anna Schwartz is also not a particularly big fan of those at the Fed right now.
A while back, I was sitting in a meeting with some bankruptcy attorneys that were helping the investment group understand some new bankruptcy laws. After the meeting, I asked one of the attorneys a pretty open-ended question that tends to get surprisingly honest answers:
In the long term, what is your biggest concern for the US economy?
Her answer was immediate and without hesitation:
I can’t see how the US is going to be able to afford healthcare costs for the coming wave of retiring babyboomers.
Not exactly what I was expecting her to say, but the apparent honesty left an impression on me. That is one of the reasons why, when I began voicing my gloomy opinions for the coming credit crisis (even though I’m an optimist!), I said some fairly radical things.
I’ve quoted part of the discussion here when I first learned of the amount of US debt held outside the US.
Looking out over the horizon, say 10 years or more, it was hard to imagine the US being able to pay its obligations. On July 26, Aaron Brown said:
I’ve never understood the argument that foreign ownership of treasuries is a threat to the US. If everyone who didn’t like me lent me money, I’d be happy. I’d be even happier if I got to pay them back with paper I wrote myself. In the 60’s and 70’s, the US sold a lot of debt to foreigners and inflated its way out of repayment. In the 00’s, the US sold a lot of debt to foreigners and devalued its way out of repayment. But people keep lining up to buy more. I don’t see that changing.
I admire Aaron a LOT. He is super knowledgeable AND super helpful. He has uncanny patience and is willing to walk even thick-skulled people like me through technical explanations. What he is suggesting above is that when the US’ obligation become unmanageable, we can simply inflate our way out of it. Sure. That is one solution, but when your obligations are both internal and external, inflating your way out of an obligation to a retired senior citizen doesn’t seem to be the most politically correct thing to do.
What is an alternative?
I suggested that, since much of the US’ obligation is to its retiring senior citizens as well as foreign debtors, one solution would be for the US to default on its external debt *gasp*
Here is my direct quote on July 26:
I’m not sure I’m so enthusiastic about the idea of inflating your way out of foreign debt obligations. That wouldn’t be so great for the domestic economy. Something like what Russia did, i.e. a flat out default, as crazy as it sounds, is seeming like more of a possibility to me though.
The deep and insightful comment from Skillionaire followed:
Eric, I’ve been disagreeing with your views for the past couple of days in this thread, but I believe with this statement you might’ve officially gone off the deep end with this apocalypse stuff you’ve been pushing.
To which I replied:
The good thing about these phorums is that they have time stamps. Sure, today the idea seems crazy. It’ll probably seem crazy for the next 5 years or more. Ten years? Anything is possible. We’ll see. Care to wager on it?
Wager: Within the next 10 years, i.e. before July 26, 2017, a major news source will carry a headline indicating the US may default on a foreign debt obligation.
No one took me up on it It’s only been 5 months, but the first cracks in the long term credit quality of US sovereign debt has surfaced
This is from the Financial Times
Moody’s warns on US sovereign rating
The US is at risk of losing its top-notch triple-A credit rating within a decade unless it takes radical action to curb soaring healthcare and social security spending, Moody’s warned on Thursday. The warning over the future of the triple-A rating - granted to US government debt since it was first assessed in 1917 - reflects growing concerns over the country’s ability to retain its financial and economic supremacy. It could also further pressure candidates from both the Republican and Democratic parties to sharpen their focus on healthcare and pensions in the run-up to November’s presidential elections. Most analysts expect future governments to deal with the costs of healthcare and social security and there is no reflection of any long-term concern about US financial health in the value of its debt.
I’ll repeat, I don’t see any real threat of a US sovereign default in the next 5 years, which is probably beyond the horizon of most investors and so might be considered irrelevant. But 10 years? 15 years? 20 years?
