Phorgy Phynance

A few people have commented about the methodology used to produce the charts in my last post. Keep in mind, I threw those together quickly for Felix based on charts already put together for a seminar at UCLA. If you want to see what I actually look at on a regular basis, I put the following chart together:

This is the 99%, 1-day VaR using a weighting scheme that places more weight on the most recent data.

Again, note the divergence between the two charts in recent months. Risk systems (like most third party vendors) based on normal distributions are likely indicating that risk continues to decrease. However, the stable distribution indicates the opposite, i.e. risk has begun increasing again.

For Felix:

And the last 10 years…

Update: Felix has updated his post with a link to my charts above, but makes some comments that I thought I should address.

If we use a shorter horizon that better captures what is going on at this moment, we see that risk plateaued in June and has actually ticked up significantly in the past several weeks as measured via the “stable” distribution. On the other hand, volatility has actually decreased during the past several weeks. What this means, i.e. the discrepancy between “stable” and “normal” is that the tails have become fatter recently.

Also keep in mind that although risk appears to have decreased since the beginning of the year, it is still at extremely high levels. We would have to go back to 1934 to see comparable risk levels, so it is no time to become complacent.

My last post:

Why do scientists go into finance?

started out as an introduction to this post, but grew a life of its own.

I am quite fed up with all the quant bashing we’ve seen in the media since the current crisis began. A recent article by Felix Salmon appeared in Wired Magazine:

Recipe for Disaster: The Formula That Killed Wall Street

I actually thought the article was quite good. I did take a small exception to the last paragraph though:

In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years’ worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

I think this statement exaggerates the situation. I took it as a minor deviation from an otherwise good article. Unfortunately, he gleefully followed up his article with a reference to Paul Wilmott in:

When Quants Don’t Think

Wilmott is quite right that quants need to stop being so passive. But he also knows full well that they won’t be. It’s far too easy for them to go along with what everybody else is doing — and that’s exactly why the copula function turned out to be so disastrous.

As I alluded to in the last post, it really has nothing to do with going “along with what everybody else is doing”. It is more about doing what your boss tells you to do. It is wrong to point the finger at the quants when the real culprit was upper management. The quants had absolutely no authority and no incentive to reel in excessive risk taking. As I’ve said, the quants know quite well the strengths and the weaknesses of the models they employ. If you asked them if the models satisfactorily represented the risks in CDOs, they would quite plainly say “no”. Did anyone ask? Of course not. They were paid to build models and that is what they did. When the models expressed risk beyond what upper management thought it should be, the quants were forced to dumb down the models. Period. They were making too much money. In fact, as I’ve said in

CDOs and Risk Management,

CDOs were great because they represented a blind spot in existing risk management systems based on VaR. VaR essentially defines what a “tail event” would be given a particular financial model of a portfolio. Typically, this “tail event” is the loss at which you are not likely to exceed on average 1 out of 100 times. One out of 100 times, a CDO is not likely to lose ANYTHING. Hence, it’s risks do not show up on any risk system. This is what I refer to as “risk management arbitrage”. What these models do not tell you is the loss you can expect “if a tail event occurs”. As we now know, if a tail event occurs, a CDO can lose EVERYTHING.

Talking heads like Nassim Taleb are extremely unhelpful and are, in fact, counterproductive. He has been on the war path for years telling us that securities do not follow a normal distribution. HELLO!! We know that already. There is not one risk model I have ever seen (except some third party models that are not worth the disk space they use up) that is based on the assumptions that Nassim Taleb is attacking. This whole idea that quants assume normal distributions is completely bogus. Taleb has always been irritating to quants for his completely content-free rants and his straw man arguments. Now that we see him on Bloomberg almost every day, it is time someone puts him in his place.

It is true that the Black-Scholes model assumes returns are normally distributed, but that is pretty irrelevant. What the Black-Scholes model allows you to do is to convert a price into another number called “implied volatility”. The implied volatility shares a purpose similar to the yield of a bond. It helps you compare related securities. If two similar companies have outstanding bond issues with similar coupons and similar maturities, the yield of the bonds help determine which is the better value. Do people go on rants about how meaningless the “yield” is? No. The yield on a bond is based on a flimsier model than Black-Scholes and no one seems to care. To compute yield, you must assume the issuer is going to make every interest payment and that you can reinvest that interest payment at the same rate throughout the life of the bond. The yield is then the discount rate under this pretty bogus model that matches the theoretical price to the market price of the bond. When you really think about it, the yield of a bond is a pretty bogus concept. However, it does help make informed decisions about the relative valuation of bonds. The implied volatility serves precisely the same purpose. A fairly bogus model spits out a number that helps make informed decisions about the relative value of derivatives.

For Nassim Taleb to go on the media circuit complaining about black swans and the fallacy of normal distributions, it is as if a former bond trader suddenly decided to go on multi-decade crusade against the use of bond yields. Ok. We get it already.

It would be less disturbing if we didn’t see Paul Volcker going on the circuit parroting things that Taleb says. Toward the end of the video I posted on

A Call to all Finance Bloggers

we see Volcker referring to “black swans” and goes on a rant about financial engineers. His words are clearly straight out of Taleb’s mouth. They probably had dinner together at Davos or something. So now that Volcker has been infected by these bogus ideas, that is worrisome because Volcker obviously has a line to President Obama. The last thing we need is to get distracted by going after the quants.

Before leaving, let me turn some attention to Paul Wilmott. His recent turn against his own, i.e. his recent quant bashing, is disturbing. Paul Wilmott wrote some decent books on mathematical finance and derivatives pricing. But what he is probably more known for these days is his quant forum at Wilmott.com. Currently, there are over 66,000 registered users signed up at Wilmott.com. Long ago, I was a member myself and I even published my first finance-related research paper there. At the time, it was a decent place populated by knowledgeable quants. I got my first job on Wall Street due to the help of a friend I met on that forum. Unfortunately, in the last 5 years or so, the place has turned into a zoo. It is impossible to have a decent conversation there anymore as there is no form of moderation. He doesn’t care, just as long as more eyes turn to his web site. It is little more than a PR campaign.

Both Nassim Taleb and Paul Wilmott are opportunistically spouting nonsense about quants that really do a disservice to some really quite intelligent, experienced, and knowledgeable people who happen to be friends of mine.

Market turmoil is still quite fascinating to me and I still believe the current environment will be one for the history books and I’m still trying to take as much as I can from this learning experience.

My professional work experience is in fixed income. For two years, I was very “plugged in” to the markets and was meeting regularly with some of the greatest thinkers out there, but now I’m more of a pure “quant” and most of my news comes from blogs, web news, etc. Unfortunately, I’m not yet spending as much time with the traders as I’d like (but that should change soon I hope). Most of the major news sources, e.g. Bloomberg, seem to concentrate more on equity markets than credit and fixed income. I pay more attention to the Dow now than ever before. That is why I am so perplexed by the stock market. I thought stocks were supposed to be easier than bonds, i.e all the smart guys are in fixed income, right?

So while the credit markets seem to be imploding, stocks are doing just dandy. Maybe people are taking cues from the market cheat sheet?

Anyway, I’ve blabbered quite a bit on this blog (and at my former employer) expressing my opinion of CDOs. I even managed to upset quite a few people while expressing my opinions as well. No regrets though. I’m happy to have this hugely public diary, both here and on NP, to later look back and see how I did in regards to thinking events through. Occasionally, I still like to poke my nose in over at NP and I see kr is still giving out the occasional nugget. Here is one of his latest:

A few thoughts:
- If you took all the writedowns at a single med-to-large bank rather than seeing them across the street, you could have reduced that entity’s equity to ZERO. For instance, MER has only something like USD54bn of mkt cap and USD39bn of book equity.
- If the view is that there will be another round of writedowns in the same amount as Q3 then you will have banks desperate to raise equity (i.e. it is not just the monolines). Who would buy that equity right now? Prince Alwaleed for example has floated his own holdings so I see him more as seller than buyer for example. I don’t see guys like JC Flowers or Cerberus well positioned for this job – in retrospect, even Barclays/RBS have not been with respect to ABN, as can be seen by the action in their share price and cost of jr capital.
- Another possibility would be the downgrade to BBB like the Japanese banks, with all the implications that brings with it. I.e. serious change in business model. That has contagion and macro effects. One example is that flow trading of financials has cost people a lot.
- I think investors will call foul on the FAS157 Level-3 assets, and it will hit guys like GS seriously as their L3 reporteds are a big multiple of their mkt cap.
- There was a funny comment in this month’s BBG mag about “nobody really knows how desks are hedging the CDO assets.” That is bull – the answer is that most people were NOT HEDGING AT ALL, BECAUSE THEY COULDN’T. Stuff was originated to sell, and the exit has vanished, or, it was originated to live forever on a trading book even though people tried to avoid saying that, and there is no decent MTM approach so instead banks are showing huge volatility, mostly to the downside.
- Implications of SIV / CDO / CP demise are pretty vast. There seem to be an increasing amount of trade receivables on the market, b/c there are no conduits to fund them… means corp cost of cap is going up in unexpected areas.

My hunch is that the fed cuts on the 11th b/c liquidity is dropping again, especially with year-end. It is out of control – specifically Ben’s control. It looks like political support for the various subprime fixes has stalled. What I think is that liquidity of all things financial (i.e. non-corporate) is going to get weaker and cause a full-on crisis for a market-traded institution. The talk about Citi cutting their div is one tremor, trading activity in Barclays is another, and the fact that even AFTER all the reported loss numbers, people still don’t feel comfortable, is yet another.

I think vols are still cheap, maybe looking to buy some.

All the while I was complaining about CDOs, I was coming at it from the angle of a “quant”, i.e. thinking about how to model CDOs and how those models are used in risk management, asset allocation, etc. Too bad I didn’t understand more about the legal/accounting aspects of CDOs. The term everyone has now heard of is SIV. I was blabbering about off balance sheet leverage and fair value accounting, but didn’t realize that the entire CDO market was (to a jaded eye) a big play on accounting in addition to the obvious play on ratings agencies. If I had known about SIVs, I might have been able to do more to help some who may have now lost a lot of money. Maybe not. That’s all in hindsight. But what am I missing now? Where is the next weakest link? How are corporations hiding off balance sheet debt? Has anyone looked at “Level 3″ assets in corporate, i.e. non-financial, balance sheets? Are they as scary as the big banks?

I’ll say it again… this is not a subprime issue. Subprime contagion does not explain the current environment. Subprime was just the first to blow. We are experiencing the blowup of a global fixed income bubble. In fact, some would say we’re experiencing a general global asset bubble.

Who’s going to get hurt? Financial institutions for sure. Anyone who depends directly on the value of paper assets.

Who’s going to win? People whose wealth depends on physical assets.

I’ve already lost all hope in Bernanke. He is not going to let his monicker “Helicopter Ben” go by the wayside in a “time of need”. Bernanke is going to lower rates and weaken the USD until oil exporters are forced to break the peg to the USD and inflation skyrockets. I predict that all these gloom mongers about home prices dropping by 30% will turn out to be wrong in nominal terms even if they are correct in real terms. In other words, home owners are going to be saved by the dropping value of the USD. All those on Wall Street who were so gleeful every time rates dropped are suddenly going to feel the pain when the value of their paper securities go up in smoke.

Watch out for the “happy stage of inflation”, i.e. wage increases. It will be interesting to see what the world will look like when oil is priced in EUR and the USD is no longer the world currency. Fortunately, I still have faith that we’ll come out of the current mess stronger as a country, but there will certainly be pain felt at the higher end of the wealth spectrum.

I’m actually ironically optimistic about the outlook for suburban and rural economic development. A weaker dollar will make outsourcing less attractive. That will bring manufacturing jobs back home. I can imagine a boon in suburban and rural development. Just imagine if communities developed decent broadband via fiber-to-the-home/business. Suddenly, there will be attractive jobs and living standards in affordable places.

Maybe a weak dollar is what this country needs, i.e. a good kick in the pants. Pain is the best teacher, right?

[Edit: PS, the title of the post was inspired by a great article on Financial Armageddon, but I never got around to explaining why, but have a look and it might be obvious.]

This is bound to end up badly.

From the Wall Street Journal:

Seeking Hidden Losses, Regulators Comb Books Of Wall Street Titans

Here are some excerpts (my emphasis in bold):

The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds, the same people said. The concern: that the firms may not be marking down their inventory as aggressively as assets held by clients.

[snip]

… few big Wall Street firms have reported big subprime losses despite the turmoil roiling the markets.

[snip]

“No one really knows how to price asset-backed securities and CDOs and that’s a real problem in the market now,” says Ann Rutledge, principal of R&R Consulting, a structured finance consultancy in New York.

[snip]

The pricing issue is crucial for brokers and banks, some of which hold significant amounts of mortgage or CDO securities on their books. Analysts said it was common in past years for Wall Street underwriters to keep portions of the securities of CDOs or mortgage bond deals they arranged.

The SEC’s market-regulation division has been in touch with all big brokerage firms to ensure their risk-management systems are up to speed in light of the quick deterioration in the subprime market. The asset-pricing inquiry is being conducted by the agency’s office of compliance, inspections and examinations.

This is all part of a bigger picture we are discussing here

• Risks of risk management
• BNP Paribas and fair value accounting
• GS Global Alpha Fund
• Fair value accounting
• Voodoo analysis: Goldman Sachs in trouble
• “Mark to model”
• Conspiracy of silence
• CDOs and Risk Management
• “The End is Near”

Some of the best quants in the world are hotly debating appropriate methods for pricing CDOs. When I hear their arguments, the only conclusion I can come to is that NOBODY KNOWS how to price these things. If you can’t price them to determine the value of fund shares and if you can’t value them for GAAP accounting and if you can’t price them for the purposes of allocating capital for risk management purposes, then what does that mean? It means people have been flying blindfolded for years. Who knows where we will end up, but my suspicion is that the place will not be pretty.

Oh yeah, don’t forget I’m an optimist

If you ever talk to quants *gasp* or traders, you may occasionally hear them refer to structured securities such as CDOs using terms like “ratings agency arbitrage”. As usual, the word “arbitrage” is totally inappropriate in this context. What they essentially mean is that the structures are designed to take advantage of the weaknesses in the way the ratings agency do their job. This is part of what a former colleague of mine refers to as the “quant arms race”.

Now we are beginning to see how inappropriate the ratings agencies methods are in the context of subprime CDOs (see here and here). With ratings agencies rethinking the ratings on these securities, there will obviously be market impacts as some institutions become forced sellers, etc etc, but the thing on my mind is risk management.

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