Yesterday, my frustration level reached higher than usual levels with some recent articles that have come out. But instead of just complaining, I’ve always held the opinion that you really have no right to complain unless you offer some suggestions to improve things. In the post

IHT: Is America too big to fail?

I voiced some of my thoughts on

• Public Transportation
• Banks
• Defense
• Natural Resources
• Infrastructure

The blurb about “banks” was focused on the mortgage lending model, but did not address another important problem concerning what to do with home “owners” who are about to be foreclosed on.

Rather than foreclosing, the loan under consideration should be sold to a bank at a discount (maybe 70% as suggested in the article below) and then the bank rents the home back to the person who would have otherwise been foreclosed on. The “home owner” becomes a “renter”. After all, they never really were owners to begin with if they paid no principle and had an IO or “neg am” loan.

Becoming a “property manager” would be a lot less expensive and a lot more politically swallowable than kicking people out of homes whether they owned them or not. Plus, it would be better for the communities that suffer when their neighbors foreclose and the house is no longer kept up.

This idea seems to have had some success in NJ according the the following NYTs article via naked capitalism:

Struggling, but Staying in a Home

If you feel as strongly as I do about the sad state of our decision makers’ current financial policies, sign this petition:

Petition To STOP THE BAILOUTS!

Found this International Herald Tribute article via naked capitalism:

Is America too big to fail?

This is another one to get my blood boiling.

The central banks of China and Japan are on the hook for hundreds of billions of dollars worth of Fannie’s and Freddie’s bonds - debts they took on assuming that the two companies enjoyed the backing of the American government, argues Brad Setser, an economist at the Council on Foreign Relations.

Commercial banks from South Korea to Sweden hold investments linked to American mortgages. Their losses would mount if American homeowners suddenly couldn’t borrow. The global financial system could find itself short of capital and paralyzed by fear, hobbling economic growth in many lands.

So… FRIGGIN… WHAT?!

If this “prosperity” was built on false premises, it SHOULD come to an end. Artificially propping up a dead horse will get nothing done. The word is… ECONOMIC DARWINISM. Evolution works because species (businesses) that are not fit to survive don’t. When you use valuable resources to prop up businesses and economies that are not fit to survive on their own, you take away from what could otherwise be healthy growth and innovation.

Trust me. Americans will find a way to get through an episode of reality. Bailing out Fannie and Freddie is the LAST thing our government should do with what preciously scarce resources we have.

Here are some ideas to try to get the ball rolling. If you care, please critique these ideas or add your own. We can make a difference and change the path to ruin we are currently on.

Public Transportation

Every major highway in the US should have a train running up and down the middle of it. Instead of adding more lanes, we should be REDUCING lanes. Chicago is a great model for this. You can get from downtown to O’Hare via a nice train that goes right down the middle of the freeway. I repeat every major freeway in the US should have a train running up and down the middle of it.

The money that will ultimately be used to bail out Fannie and Freddie UNNECESSARILY could easily pay a big portion of this bill. Los Angeles is a prime example. Everytime I find myself stuck on the 405, I find myself asking, “WHY THE F*** ISN’T THERE A TRAIN RUNNING DOWN HERE?”

Sorry Californians, the days of everyone having their own vehicle are numbered. The sooner we embrace this, the better.

Banks

I suspect that this will be the end result of the current financial turmoil, but I think the model of

1. Deposit
2. Loan
3. Securitize
4. Sell
5. Go to 2

are over. Loans will and SHOULD remain with the bank that made the loan. “Originate to Sell” made a lot of people rich, e.g. Angelo Mozillo and Henry Paulson for that matter, but other than that, I think the net result was a big negative for most Americans and the economy.

Defense

Get out of Iraq and put a full court blitz on Afghanistan. Find Osama and hang him on live TV. It is inexcusable that guy is still breathing.

Take Russia seriously in regard to the ballistic missile defense system. It cannot work without them. Either make them a partner or drop it. The concept is flawed in the first place and the only reason we’re doing it is to give us a false sense of security.

Play hardball with North Korea. We should have gone there instead of Iraq because they pose the greater threat. Oh yeah! They have no oil. I forgot.

Natural Resources

Make the search for alternative energy a national priority on par with the race for space and the race for the nuclear bomb. It is no less important.

Also, make the search for cheap desalination a priority. Right now, oil is in the spotlight, but in 5+ years, more and more attention will begin to focus on the inavailability of drinking water. This is a serious issue that hasn’t gotten enough attention.

Infrastructure

Our highways, bridges, sewers, pipes, etc are all in shambles. Decades of neglect will soon catch up to us.

Also, telecommunication infrastructure. This is SERIOUS. The innovation cycle begins with a great idea that will change the world. Then people slowly realize that the idea will change the world and try to monetize it. This creates a bubble. Expectations are not met in the short term even though the idea is still a good one. The bubble bursts and everyone assumes the idea was a dud. Eventually technology catches up to the idea and it does change the world in ways that no one cold have ever foreseen even at the height of the bubble.

This innovation cycle applies to the internet. The internet will change the world in ways that few, if any, have ever dreamed. The dot com bubble bursting was not an indication that the dream of the internet was a dud. It was just that technology did not adapt fast enough to make the ideas materialize immediately. SLOWLY technology is catching up and we will soon see a second internet revolution. Sadly, at this rate, the US will miss out on it. The US needs to realize, and soon, that the future economy is a knowledge economy. We will need to have fiber optics available to each and every home in the United States.  This will require a massive investment in infrastructure that doesn’t seem to be on anyone’s radar.

Currently, we are wasting a lot of energy on building out wireless networks at the expense of fiber. This poor decision will continue its course for at least the next few years. Only then will people begin to realize the limitations of wireless. These limitations cannot be solved with clever engineering and are fundamental limitations that can be traced back the Heisenberg uncertainty principle of physics. There is only so much bandwidth that wireless can support and that bandwidth will soon be exhausted leaving us with the realization that we SHOULD HAVE BEEN BUILDING OUT FIBER. By then, the US will be very late to the game and Europe and Asia will be even more dominant than they are today.

THAT should be enough to get things started for now…

Found this NYT article via The Big Picture:

Trouble at Fannie Mae and Freddie Mac Stirs Concern Abroad

This got my blood boiling. Here’s a particularly frustrating paragraph:

Also at stake is Americans’ future ability to gain access to credit. If foreign companies and governments abandon United States investments, home, auto and credit card loans will be much more difficult to come by.

So… FRIGGIN… WHAT?!

It is the easy access to credit that got us here in the first place. We NEED to get back to reality and we NEED access to credit for investment, home, auto and credit card loans to be difficult to come by. Gramm was right to a certain extent, but it is not the people that are whiners so much as the people on Wall Street!

Hannover Re, Germany’s second-largest reinsurer after Munich Re, said it held 125 million euros, or $199 million, in securities issued by Freddie Mac and Fannie Mae. “We are not worried about the exposure,” said Stefan Schulz, a spokesman for the company, “because we expect the U.S. government to step in if there is any problem.”

Come on America!!

Did you see the animation Wall-E? All the humans turned into fat glutinous blobs of flesh with no backbones due to a lifetime in space. Guess what? That is US! We are a country of fat glutinous blobs of flesh, BUT we are still Americans! We haven’t totally succumbed to the virtual life. We CAN still work hard. We CAN still innovate. We CAN still kick @$$ when we need to. Now is the time we need to.

Don’t let Paulson and his goons at Goldman Sucks sell us to these @ss holes at Hannover Re.

The US should send a big “F*** YOU” to the world and get busy making our lives better with hard work and sweat. The way this country was built in the first place.

I am the eternal optimist I claim to be and know that we, as a country, can pull out of this as soon as: 1.) most American learn that our “leaders” are bending over backwards to protect China and Russia so that we can maintain our credit-based spending spree which benefits most Wall Street goons and 2.) we remember that this country was built on elbow grease, i.e. blood, sweat, and tears.

Wake up America!

Is it time to get angry yet?

How Much of Fannie/Freddie Paper is Held Overseas?

I think so! The model is broken. Let’s fix it.

While I’m walking down memory lane, another thing I’m missing these days is being a part of Nuclear Phynance. It’s been about a year now since the fallout with my former comrades that started with this discussion

Will there be a financial market contagion caused by ABS CDO woes?

Looking back, I still stand by almost everything I said during that time. As I said in my inaugural post, I really am an optimist, but even an optimist has to be somewhat realistic. Back then, I was pretty concerned about the situation in credit markets even aside from mortgages. Valuations in fixed income were irrational even if mortgages were not in the picture.

I’ve expressed some of my more dire thoughts here

• FT: Moody’s warns on US sovereign rating

• Flight to non-USD quality revisited

• More questions on “safe haven” status of USD

• Flight to non-USD quality

One of the underlying points in all those posts is that one day investors, including sovereign wealth funds, will realize that US treasuries might not be the safe haven it once was. I got a lot of flack for expressing that opinion. Anyway, I’m not suggesting that doomsday has arrived, but Accrued Interest has an interesting article. It is short enough, I hope he won’t mind me reproducing it here:

Maybe it’s another drill

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long time readers know I’m not an alarmist type, and I’m sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for “risk-free” assets.

Draw your own conclusions. I’ve drawn mine.

I find myself “missing the good ol’ times” a lot these days. I was at the top of my field (computational electromagnetics) after finishing graduate school and spent two years at MIT Lincoln Lab as a professional scientist working in ballistic missile defense. At the time, I was already a scientific mut with a highly interdisciplinary background in physics, engineering, and mathematics. Then I got the bright idea (after “gentle” nudging by Mrs Phorgy) to consider a career in phynance. I pushed back for the longest time before I finally opened a mathematical finance book for the first time just prior to defending my thesis. It was love at first sight! Phynance offers everything I loved about science, but was even more challenging and (supposedly) more rewarding.

I got my break in 2005 when I went to work on Wall Street doing risk management. Like most physicists who spend their lives thinking about space and time, I had very little concept of real life space and time, i.e. I was a classic absent minded professor. I wasn’t on Wall Street long before, for personal reasons (baby on the way, family, etc) decided to move back to California, where I got my first job in asset management at a truly phenomenal company with truly phenomenal people. I knew I found my home and was happy with the thought of staying there forever.

But I made a mistake…

During my interview, my soon-to-be mentor wanted to introduce me to his wife. I thought it was a bit unusual but very nice. So we walked out to his brand new fancy sports car and drove to his beautiful humongous house. Remember, this is during the interview. I think that is when $ signs started blurring my vision. For the first several months as an analyst, we were paraded around to other people’s huge and beautiful houses and attended company research offsites in beautiful locations. This only added $ signs to further blur my vision.

In the meantime, our daughter Sophia was born and I was looking for a house to start our family. I knew very little about the markets at the time and asked many of my new colleagues who were phenomenal investors with decades of experience for advice. Each and every friend suggested that I stretch when buying our house. The implication was that I will be able to afford it in a couple years. So with $ signs blurring my vision and with the advise of my new colleagues, I bought a house that was out of our reach in the sense that we had no financial cushion. In fact, we would be barely breaking even each month. This was a tad more rational than it may seem at first because I had made many friends on Wall Street and had a pretty good idea of my own personal “market value”. I didn’t expect to reach that personal market value because the place I was at was pretty conservative in that regard, but didn’t need to reach it. Just getting a little closer would have made things work out.

So I threw myself into the work. Those first two years were amazing. It was a deep immersion into the world of asset management and I loved it. I found my passion.

Unfortunately, my mistake came back to haunt me. I worked very hard during my first two years and believe I made very significant contributions to the company, but was something of an enigma. I was a quant in a non-quant (even anti-quant) environment. The people I worked closely with could attest to my contributions, but for those I didn’t work closely with, my contributions were a mystery. I later learned that several people I did work with did not contribute to the evaluation process, which ended up in me receiving a less than stellar second year review. Under normal circumstance, I could have taken it constructively, found ways to improve the situation, and made the following year much better. However, having bought the house under the influence of $ signs blurring my vision, another year of being paid less than I was four years earlier as an engineer was not an option. I could not ask my wife to suffer one more year when I could easily double my income by going somewhere else.

I did try to raise the issue with my managers, but doing so was somehow seen as sacrilegious. I had no choice. The first place I interviewed gave me an extremely attractive offer I could not refuse. FINALLY, I could pay my mortgage and have the cushion I wanted. Maybe I could even take my wife on a vacation after being married for 10 years!

So, I left a company I loved and I left colleagues behind that I deeply admired. If I could go back and change one thing, I would not have bought our current house. I would have had less pressure to make $ and would have been able to work through any issues at work. Not to mention I wouldn’t have a mortgage that is about 30% underwater. Not a great first investment. Hopefully things get better from here!

On the bright side, I am coming around. I’m gaining confidence in my abilities in asset management and do not have any doubt I’ll reach the level in phynance that I achieved in physics and beyond. I’m already well on the way.

Some interesting articles came out today that reminded me of an old discussion. Just over a year ago, on July 5, 2007, I wondered aloud:

Ok. I’ve got a crazy idea…

The entire concept of “loose monetary policy” couldn’t happen under the old gold standard. Since oil is already priced in USD (mostly… although I seem to remember reading that changing somewhat), why not introduce an “oil standard”?

Yeah, I know that is lame and would lead to the same problems of the gold standard (only faster), but conceptually, what could be done to force some discipline between prices of physical versus financial assets?

In the ensuing discussion, I learned that Benjamin Graham had similar ideas. It’s nice to be in good company!

Well, this morning, the subject came up again over on Econbrowser.

UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil

It’s definitely an interesting idea. Later, Brad Setser picked up the theme pointing to some of his earlier papers:

The FT joins the chorus arguing against the Gulf’s dollar peg

In the latter article, Brad points to one of his papers that I also liked very much:

The Case for Exchange Rate Flexibility in Oil-Exporting Economies

I like the idea of pegging currency to a basket that includes commodities. In particular, oil.

When I first wondered aloud about an “oil standard”, I was thinking of the US. The articles above refer to smaller oil exporting countries. The case is quite obvious there, but I still do think that including some kind of oil price into monetary/currency policy in the US might make sense as well. I’m not sure how it would work, if at all though.

Inflation in the US, although on the minds of most consumers, is relatively tame compared to most other places in the world today.

One thing that has contributed to relatively low inflation in the US is globalization, or something related I like to think of as “exporting inflation” or equivalently “importing deflation”.

Now, however, places that have traditionally imported our inflation, e.g. China and India, are experiencing their own inflation pressures. Most places across the globe are now net producers of inflation pressure and there are fewer places that can absorb that pressure. The only possible result? Increased global inflation.

But why are places that have traditionally imported our inflation suddenly started exporting their own inflation? One reason I can think of: currency pegs.

What if Bernanke is actually an evil genius? What if countries begin dropping their currency pegs?

At first, it would seem to be quite painful. Inflation along with treasury yields would likely shoot through the roof. Longer term? I’m not sure, but I’m thinking that shaking countries off their dollar pegs might eventually lead to fairer competition, which would ultimately be good for the US.

What do you think?

Update:
I don’t know what I was thinking. Bernanke is not evil and he is not a genius. Generally, I would prefer at least one of those two characteristics in a person, but not having either is bad. He really is just trying to bailout Wall Street at the expense of everything else.

In the last article, I showed how the Black-Scholes PDE is equivalent to a Wick-rotated Schrodinger equation describing a charged particle in an electromagnetic field. Here, I will expand a little bit on that.

In quantum mechanics, the “momentum operator” for a point particle is

.

To account for the interaction of the (charged) particle with an electomagnetic field, the momentum operator is augmented by the vector potential. The effect of this vector potential is to deform the wave function by a “gauge” factor

for some curve .

The gauge connection for the Black-Scholes PDE is given by

.

Inserting the corresponding gauge factor

into the Black-Scholes PDE results in

,

which is simply the heat equation from physics!

Therefore, the quest to categorify Black-Scholes is effectively a quest to categorify the heat equation.

What we want to do I think is to contruct a “yield curve space” in analogy to “loop space” where a point in yield curve space corresponds to a yield curve in some base space. We want to study Brownian motion on yield curve space under constraints of no arbitrage, which can hopefully be formulated as a statement about curvature.

Update:

In a comment, Blake Stacey points out this book. Digging a little bit turns up these arxiv papers and the author’s web page. It now appears likely that the author has done what I set out to do, but perhaps did not quite make the connection to “categorification” which is just a minor point. I’m tempted to order the book, but will definitely have a look at the arxiv papers in the meantime.