Phorgy Phynance

Archive for the ‘Credit’ Category

Quantitative Easing Explained

leave a comment »

Written by Eric

November 13, 2010 at 1:12 pm

Why do scientists go into finance?

with 2 comments

Why do mathematicians and physicists go into finance?

One reason people may sympathize with is mere survival. Job prospects for mathematicians and physicists in academics is horribly bleak. Each PhD program churns out 10s if not 100s of PhDs each year. How many PhDs do these same institutions hire each year? Less than 10 for sure. Most likely none. Scientists are a different breed. Most pursue higher education simply because they love what they do with little thought about what will happen after school. It is often not until a few months before being cut loose that many graduate students think to themselves, “Oh %$#%! What am I going to do now?” A good picture to keep in mind is the classic absent-minded professor.

Although Wall Street rolled out the red carpet to scientists in the 70’s and 80’s, I would suspect that the idea was not high on most graduate student’s minds at the time. When quantitative risk management systems began being deployed on a large scale in the 90’s coincident with significant improvements in computational power, that marked a turning point. By the mid 90’s, Wall Street was becoming a clear beacon for mathematicians and physicists about to hit the job market. Leading up to Basel II setting capital requirements based on value-at-risk measurements in 2004, banks literally went on a hiring spree of PhDs. I know that when I first tested the waters on Wall Street in 2002, each advertised quant opening was receiving no less than 30 PhD resumes. Most of these had prior work experience in finance. Today, many physics and mathematics PhD programs offer minors in finance. Clearly, Wall Street is a destination for many graduating scientists these days.

Is survival the only reason scientists go to Wall Street? Clearly not. The real and only important reason physicists and mathematicians go into finance is that they can potentially make lots of money doing very interesting and rewarding work. Who wouldn’t want to work in finance? I know I absolutely fell in love with finance at first sight. The first time I stepped foot on a trading floor, I knew I had found my calling in life. It was a truly transformative experience.

There are about as many different kinds of quants as their are scientists. I have been fortunate enough to have seen the quant world from many perspectives. I started finance life as a “risk quant” working at a large bank with a group of 12 other PhDs building risk models that spanned trading desks across the globe. These guys have been getting a bad rap lately and I’ll have more to say about that another time. Make no mistakes though. The risk quants know quite well the strengths and limitations of their models and given more authority, they could have and would have kept the credit bubble from getting out of hand. Unfortunately, the reality is that risk quants have been relegated to secondary roles whose purpose is often to massage numbers to tell the risk managers what they want to hear. For example, at one point, a friend told me that their risk manager did not like the numbers produced for a particular trading desk. This trader had significant influence. So the risk manager came back and told them to recompute the correlation matrix until it output what the trader wanted to see. Did the quant have a choice? Not if he wanted to keep his job. At another point, another friend was told that they needed to modify the risk numbers coming out of the models because they were too high which forced the bank to retain too much capital. He was warned that people higher up were becoming unhappy and that the entire group could be eliminated if they didn’t do something about it. Since the job market was so competitive and since the pay was quite good, there really was no incentive to rock the boat. This has absolutely nothing to do with poor models or “black swans”. It has everything to do with greed. Period.

There are some really good aspects of being a risk quant. Usually, it is a good entry point to other things since you get a general introduction to a large variety of securities. The typical entry requirements are often lower as well. The downside is that you are effectively a NARC with absolutely no authority. You may think your job is to reign in excessive risk takers, but the reality is that you are most likely a puppet for upper management.

As a byproduct of proliferation of risk management systems, clients and investors are becoming increasing demanding in terms of risk reporting. This has trickled down from investment banks on the “sell side” to money managers on the “buyside”. Traditional asset managers who previously had no interest in quants or their models are now being forced to hire quants simply due to client demands. This can be a very good place for scientists to end up. You will often come across as a super star rocket scientist regardless of what you actually contribute. The downside is that many traditional investors may view you as a necessary evil and don’t really want you there. It is a challenge in such an environment to demonstrate the value of the work you do. Yes, I am speaking from experience πŸ™‚ There are definitely good things to be learned from investors who are firmly “anti-quant” though. I value the experience obtained from attempting to understand the way traditional investors think and invest. It has had a definite positive impact on the way I look at things. My advice to any quants moving into traditional asset management is to try to find a way to “quantify” your contributions. Make it clear that you are doing things that few others could do. My biggest mistake was assuming that my hard work and the contributions I was making would be obvious and rightfully recognized. Make sure you have champions and make sure these champions speak up for you. Working on the buyside can be quite rewarding both scientifically and financially. I know it is where I belong.

Another type of quant is the “front-office quant” whose job it is to build derivatives models to assist traders directly. From my experience, this is where most quants would like to end up. It is often fast-paced and quite demanding. You have to be willing to be brutalized and cannot be sensitive to fowl language πŸ™‚ A part of me would love to work on a fast-paced desk. I almost look at these guys as the rock stars of quants. These guys can enjoy quite ridiculous compensation since they participate more directly in the profit sharing. Plus, the closer to the money you are, the better. This role can also lead to opportunities to become a trader. I think secretly (or not so secretly) most quants dream of becoming traders.

When I grow up, I hope to become a quantitative portfolio manager. I envision this as somewhat of a hybrid between the traditional asset manager and the traditional quant. People need some place to put their retirement investments. Traditional asset managers have let many retirees down in a bad way. They often charge high fees for unremarkable performance. Many asset managers saw the current crisis coming and positioned themselves appropriately. Others had their heads in the sand for far too long and ended up destroying a lot of hard-earned wealth.

I love finance. I do not feel like I’ve given anything up by leaving physics. The modeling is quite enjoyable and regardless of what some talking heads in the media would have you believe, can be quite valuable to investors. Any decent credit model was screaming that fixed-income securities were grossly overpriced leading up to the crash. I know that I literally begged my research directors to let me work with the high yield analysts when I saw the risk premium go negative in 2006. Every other quant I talked to knew it too. As long as the music plays, you need to keep dancing, right?

What do I think about markets now? I hope to say more in a separate post, but I started this blog on July 10, 2007 with a post entitled:

“The End is Near”

At the time, I claimed to be an optimist and I am. I was scared because very few others were scared. Now, everyone is scared as they should be, but I see that as the first step to recovery. You have to recognize how serious the situation is before it can get better. Spreads in fixed income have priced in some very gruesome scenarios. I think many of these gruesome scenarios will come to pass. Corporate defaults will obviously increase and this will put a strain on the CDS market. I was more scared about this before, but recent efforts to move CDS to clearinghouses has dramatically reduced my fears. There will be more blood before things hit a bottom, but investors are slowly beginning to see beyond it. We’re not out of the woods by any means and risks remain extremely elevated, but I am optimistic that in 2-3 years, the equity markets will be much higher than they are today regardless of how low they go in the interim.

Written by Eric

February 28, 2009 at 12:24 pm

Jeremy Grantham at it again

leave a comment »

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:

This Credit Crisis Has a Long Way to Run: Interview with Jeremy Grantham, Chief Investment Strategist, GMO

He’s got some choice words for Bernanke and Greenspan. I particularly agreed with his thoughts on the coming massacre in corporate bonds.

Written by Eric

February 9, 2008 at 8:16 pm

Posted in Credit, Jeremy Grantham

The word is out… it’s NOT about subprime

with 4 comments

Whenever I read about “subprime contagion”, I feel frustrated. When you get the flu, does the runny nose cause the muscle aches? No. Just because the runny nose came first doesn’t mean the flu can be described as “runny nose contagion”. The subprime mess was just the first symptom to appear in the bursting of a general credit bubble. The corporate high yield market saw very similar aggressive loan covenants. Commercial real estate. Emerging markets. You name it. We’ve been in the midst of a general fixed-income bubble since our friends at the Fed decided to keep rates far too low for far too long.

Think about this. Back in 2005, we were worried about the CDS market reaching $17 TRILLION notional. That is a HUGE number. But the notional amount is not indicative of overall exposure because of hedging, right?

If you want to see a perfect hedge, visit a Zen garden.

What is that number today? More like $45 TRILLION. That is insane. An entire new insurance industry has basically assumed that corporate defaults do not exist anymore. Not only that, a “hedge” can turn into naked exposure at the flip of a switch, i.e. what happens when the entity you bought insurance from no longer exists?

When I get a chance, I hope to start posting some more mathematical analysis of what’s going on (since that’s what I’m good at). For example, a primer on Leverage Mathematics 101 (which is partially complete) followed by Hedge Mathematics 101 would be a good start. In risk management, “hedging” basically means “let’s buy(sell) some similar securities so that we have more capital to buy other stuff.” In other words, hedging allows you to leverage yourself more.

Here is an article that may help spread the word, i.e. it’s not about subprime:

Straight Talk on the Mortgage Mess from an Insider

However, I would go even further. The truth is the current mess is not even about mortgages. Here is the word we should all be thinking about, “Fixed Income Bubble”.

Written by Eric

December 9, 2007 at 10:16 pm

Still talking about subprime

leave a comment »

Occasionally, I like to poke my nose in and see what my old comrades are up to over on NP. It seems the infamous thread is still alive and kicking.

However, it appears they are still talking about subprime. When are they going to realize that subprime was merely the first symptom of a massive global credit/asset bubble to surface? In economic terms, the dollar amount involved in any Treasury Dept bailout will be insignificant. However, when you multiply that amount by the insane leverage financial institutions have in, mostly off balance sheet, exposure, then things make more sense. Don’t be fooled. No policy maker cares about subprime borrowers. They are desperately trying to keep one, if not several major banks, afloat. Sorry Citigroup. The music has stopped.

Financial markets have a long way to go down still. The US economy will get whacked in a historical fashion, but we won’t be knocked out by any means. There are still strong sectors in our economy that will benefit from the coming “onshoring“. Pain is a good teacher and I, for one, will welcome the exorcism of complacency that is eminent.

Written by Eric

December 4, 2007 at 11:14 pm

Another proponent of economic Darwinism

with 2 comments

Just a quick note from MarketWatch before I hit the sack…

17 reasons America needs a recession

Here are some of my thoughts on the subject.

Good night and have a Happy Thanksgiving!

Written by Eric

November 21, 2007 at 10:28 pm

Another word for hedged… leveraged

with 2 comments

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.]