Archive for the ‘Markets’ Category
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 🙂 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 🙂 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:
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.
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.]
Way way back a long time ago (in August), I clarified a semantic issue regarding one of my market forecasts (more like voodoo analysis) I made on July 24 here:
Here is a snippet:
But regarding that quote above from my last post, there is something I wanted to clarify. Particular the chain of events that I outlined, i.e.
subprime CDO imploding -> HY repricing -> CLO slowing -> LBO stopping -> private equity choking -> equities tanking -> M&A increasing -> ???
At the time I wrote that, we were only on step two, i.e. subprime had imploded and HY had repriced (a bit). I think their is still long way down to go for credit, but at the time I wrote that CLOs hadn’t been hit yet, LBOs were not on the radar screen (of most anyway), and the idea that private equity was in trouble seemed ludicrous. How about now?
Now, everything has occurred except “M&A increasing”. At the time I wrote that I was distinguishing LBOs from M&A, but have since learned that many people include LBOs under the M&A umbrella, so I thought I would clarify what I meant by that last item before the “???”.
LBO activity was driven by (at least) two factors: easy credit and value in acquiring companies. The first factor is now gone, which is why private equity is hurting. The second factor remains. Easy credit made it difficult for real-money people to take advantage of the value in acquiring companies because of competition from private equity. With easy credit gone and private equity struggling to get LBOs done, now people/corporations with real money on hand can take advantage of the situation.
By “M&A increasing” I meant that mergers and acquisitions that are not dependent on leverage, i.e. by people/corporations with “real money”, would increase. This, I thought, would prop up equities for a while longer. For example, on July 25, I said:
Since I expect LBO activiate to be significantly hampered, if not halted, and since there is value in stripping some of the companies, I expect more M&A activity to replace LBO activity.
I meant “non-leveraged” M&A. So watch for this. The first sign of this happening that I’ve seen comes from Bloomberg in regard to Warren Buffett. Certainly a “real money” guy.
Here’s an excerpt:
Berkshire Hathaway Inc. Chairman Warren Buffett is ready to spend $40 billion to $60 billion on an acquisition, and his opportunities are expanding as stocks fall and leveraged buyouts dry up.
Shares of health insurers, steelmakers and department stores are as much as 22 percent cheaper than in May, when Buffett said he would “figure out a way” to come up with $60 billion for the right deal. WellPoint Inc., Nucor Corp., Kohl’s Corp. and dozens more companies are now closer to meeting his investment criteria.
It seems we are approaching the faintest regions of that earlier “prediction”. Real money seems to be stepping up and it is not necessarily from the obvious candidates. Watch out for sovereign wealth funds to keep things propped up for a while longer.
A bit dated due to my reduced blogging pace:
and a bit more recent via a guest appearance on Brad Setser’s blog
Michael Pettis seems to think sovereign wealth funds can prop up the market for years to come. I tend to agree with him (but not sure if the time span is years… or months). By the way, as a sidenote, when I asked someone at work about the possible positive influence of sovereign wealth funds on structured finance, I was shot down pretty publicly. It was brutal. Friendly new colleagues seemed to get a kick out of it and still rib me about it to this day. Pick on the new guy! 🙂 Oh well. I’ve decided to keep my mouth shut about markets and economies during high-profile meetings. After all, I’m not an economist or even a market analyst. I’m a quant. As a quant, I am quite competent and should just stick with what I know when it comes to my actual career. On the “quant” front, however, I’ve recently developed some massively cool technique for rapidly producing analytics, e.g. OAS, OA duration, etc for a large pool of securities. In the “privacy” of my own blog, I can say whatever I want though 😉
Even before things in credit markets went completely haywire, there were technical concerns about the building pipeline of new high yield issues that were feeding into CLOs, which were in turn spurring the LBO boom. My own quantitative analysis had shown that high yield was particularly vulnerable going back to September 2006 (which my models were unfortunately only completed in March-April). That is why I was so certain that July 16 would be a big day. That was the day Bear Stearns was to report their hedge fund losses.
I think we all know what happened after that, but I still think not everyone is aware of the huge buildup of high yield issues that have resulted from delays as brokers “hope” things get better. This has created a bifurcation in the primary market (which is essentially non-existent) and the secondary market. Just as holding of CDOs will eventually be forced to face the music, the high yield market will need to face the music and eventually issue some new bonds. That will (in my opinion) bring in a pretty clear “mark to market” in high yield and there very well could be another general repricing.
Apparently, next week is the first real test as First Data issues $24B of debt ($16B in loans and $8B in bonds)
All Eyes Are On First Data
September 10, 2007
If I were a high yield investor (which I’m not, so don’t take my armchair analyst advice too seriously), I would not be eager to get back in just yet. I think things will still get worse before they get better, but like they say “only monkeys pick bottoms”, so I would certainly be shopping for bargains, while keeping in mind that the definition of a “bargain” has changed. For example, the assumption of continued historically low default rates should be discarded imho.
Another 16 hour day! Phew! Kick @$$!!
Anyway, although I should be sleeping, I decided to compose another stream of consciousness over at NP.
“In my opinion, the CDO market is history.”
[From RRP:]Eric, this is the kind of stuff that you say that drives me nuts.
Come on. Admit it. This is exactly the worry that has driven you to drink and you know it
Look at it from the flip side. You’re a pension fund or university endowment. Why would you invest in CDOs? Because they have a good credit rating and provide an attractive yield compared to other AAAs. Do you really think these guys are going to continue falling for the same joke? Do ratings agencies have any credibility left? How can a pension fund manager look at their retired investors in the eyes and tell them that CDOs are as good as GE debt? Senior citizens are losing their livelihoods. That smells like political action to me.
The ONLY reason for the existence of CDOs as far as I can tell is “ratings arbitrage”. That boat has sailed.
There is no doubt the underlying cashflows are good, but the justification for the existence of tranches is diminishing. Why invest in something that the smartest people on the planet do not understand when you could invest in the same cashflows with less hokus pokus, i.e. untranched structured products, e.g. vanilla MBS, ABS? In crises, it seems the more exotic fringe products disappear and the surviving assets will eventually become commoditized.
I think the CDO market is going to effectively disappear because the newly found liquidity premium will swamp out even the most optimistic present value analysis making it uneconomical to issue. I could certainly be wrong.
I do not know the mechanism by which this could occur, but just thinking aloud, it makes a certain amount of sense for a servicer to repackage a CDO into a more palatable structure. That way, they could at least make a market even if it isn’t selling voodoo to senior citizens.
Having said all that, if the liquidity premium does force a drastic reduction (or complete halt) in CDO issuance, then those with the guts to buy up whatever is left at bargain basement prices will make a total killing as long as they have the patience (and freedom) to sit back and collect the cashflows (with no intention of selling). If I had the luxury of a lot of cash sitting around, I would be circling over head.
Good night and keep up the good fight!
[From RRP:]First of all, best wishes to your daughter on her birthday. One of the benefits of living in Southern California is close proximity to Disneyland.
Thanks dude. We had a blast. There must have been a “Goth” convention nearby or something because 10% of the people in the park looked like they were straight out of deathrock concert or something. An interesting contrast to Cinderella
Sorry if I misinterpreted your comments, but things like
“you should do it here, in the phorum instead of running to your blog”
“If you weren’t so self congratulatory on all of your “calls” about the market”
“you’re coming across, to me at least, as a dilettante who has never taken a risk position in his life”
“this is not some random trash bin on the internet where anyone can say whatever pops into their head and not have to defend it”
“The problem I have with second guessers is that they generally are the last to the party and the first to point out how shitty it is”
do not seem very conducive to a decent conversation. Not only is it grossly inaccurate, but I think we can all do without sheah like that. I really hope that it stops, but if you want to continue, please do so on the blog so that it does not pollute this phorum. I’m more than happy to answer there. It’s not running to the blog. It’s more like trying to filter sheah like that from here.
Like I said in my <tj>, I’m happy to answer to comments here, but just consider that others may not be interested in our tete a tete and think about taking it elsewhere (you know where).
Anyway, so here’s your comment:
Dude, what started me on this thread was some throw away comment you made about Bernanke at least not being as bad as Greenspan. I asked you to elaborate, you responded about how Greenspan would have cut the rate 1% already. My response was to post data that shows the fed reaction in 1998, which I felt to be mos t similar to this crisis; 3 cuts starting 2 months after the onset of the crisis. You countered that 2001 was the best comp to this market, now I didn’t agree with you on that, and I told you why 1998 felt more like this than 2001. If you want to believe that I’m just saying you’re a n00b and should shut up, your perogative. What I’m really meaning to say is that you’re totally lacking perspective in most of your views. Perspective that comes with experience. It is showing plainly.
When you lack direct perspective, the best you can do is to pay attention to others who have perspective. I didn’t post a link to the source of some of my thoughts because I’ve been accused of posting links simply to suport my arguments. WTP. In grad school, I called that citing references, but I guess that doesn’t fly in the real world of old timers.
kr picked up on it. No surprise. I was referring to Roubini’s latest stuff. Sure he is a certified bear and has been for a long time. In fact, he’s so gloomy even I had to unsubscribe from his RSS feed because I couldn’t handle it any more. Just because he’s gloomy doesn’t mean you shouldn’t pay attention to him once in a while though. He is a super sharp guy and hearing him speak on BBG TV did impress me. He is certainly not a whack job.
That is a fantastic article and I agree with him wholeheartedly. When you held up 1998 as a comparison, I was immediately skeptical because it’s in direct contrast to someone else that I think knows his stuff better than either of us.
It really sucks when you compare me to these “second guessers” or those “late to the party”. Have a look at what I wrote here:
I was concerned (for good reason) about credit markets going back to no later than December last year. It wasn’t until the following March-April that I actually had my models built to give some empirical support. I started trying to make a case and practically begged my research directors to let me work with the high yield analysts, but was shot down because of other high-priority projects going on. When Bear Stearns’ HFs imploded things were obvious.
Now, I know I’ve said that at least twice now and some are definitely sick of hearing it, but PLEASE do not think I’m being self congratulatory. I said some things which irritated some people who were probably losing money and then started seeing some baseless judgements coming down on me. I think I’m entitled to stand up and try to set the record straight without these straw man jabs.
There are MANY valid reasons to criticize me, but “self congratulatory”, “second guesser” and certainly “dilettante who has never taken a risk position in his life” are not among them. You yourself named a particularly strong counter example. Yeah, I am %$#%ing scared about my career decision. I left a cushy place working with fantastic people. I had my own plush office with a great view and my own phriggin secretary for Cartan’s sake, but I had my reasons. Now I couldn’t find a post-it note to save my life, but I’ve got a good title with a good company with a significantly better mark to market. We’ll see how I pull through, but one thing I know about myself is that I’m a survivor. I’ve come a long ways from the days of being practically homeless, living in the physics study room and surviving off microwaved potatoes.
Anyway, I hope you are somewhat satisfied with my previous post regarding some of the differences between today and 1998 (which were borrowed heavily from Roubini… no apologies for that). It’s not like subprime mortgages are such a huge part of the markets (they obviously are not) and we’re seeing “contagion”. It’s more like a bunch of sand castles of lax credit standard be swallowed one by one in a rising tide of risk premium. Subprime was the first such sand castle to go. High yield is probably next.
The “I warned you” comment was certainly tongue in cheek, but what happened? The market did shut down, right? It’s good you got those two deals out in July, but where are they trading now? In my opinion, the CDO market is history. Existing (tranched) deals will probably need to be unpackaged into the more vanilla (untranched) structured products from which they were born. Is there any precedent for that? Has a CMO ever gotten deconstructed into its constituent assets? [Not a rhetorical question. I’d like to know.]
Anyway. Wild times. I may be out of a job sooner than you know, but even if that were to happen, I would still think I made the right decision to leave my previous place.
[Note: Here I am joining the flocks of bloggers pointing to their prior words of wisdom. My apologies!]
On Saturday, I wrote
Over the last few weeks, being on “garden leave” has given me a great opportunity to watch recent events unfolding from the sidelines. In that time, I’ve made a lot of comments. Some of them I hope make some sense. Some of them have probably been fairly ludicrous. I’m an admitted amateur and even the pros are struggling these days. One of the most ludicrous things I’ve said was on July 25 over on NP:
I also suspect that a “sovereign” flight to quality will not be a flight to US treasuries and in fact may be a flight away from US treasuries into EUR denominated government bonds. So as the credit market turns, the typical safe haven will not be available as even treasuries get whacked from sovereign sellers.
Even worse! I’m pointing to previous things I’ve said that reference even more previous things I’ve said. How long can this continue?! (Ad absurdum? 🙂 )
Anyway, since I am knee deep already I might as well trudge along. Along this theme of non-safe USD, Econocator points out some research from Barclay’s that I found interesting:
Could there be something to the idea? I think so, but what do I know?