mattlantz

The Formula that Blew Up the World

The Wired cover story this month is really good.  It's about the Gaussian Copula formula that was behind the explosion in the CDO, CDS and sub-prime mortgage markets.  The focus of the article is an actuary (oh no!):

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmottwrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

While Rome Burns and the Long Term for Stocks

This is an absolutely great letter that was on the Big Picture blog.  It is written by John Mauldin.

He first talks about the troubles in Europe, which are actually worse than our troubles:

However, this more sobering note from Strategic Energy was sent to me by a reader. It nicely sums up my concerns:

“It is East Europe that is blowing up right now. Erik Berglof, EBRD’s chief economist, told me the region may need e400bn in help to cover loans and prop up the credit system. Europe’s governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.

“The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan — and Turkey next — and is fast exhausting its own $200bn (e155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country — facing a 12% contraction in GDP after the collapse of steel prices — is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia’s central bank governor has declared his economy “clinically dead” after it shrank 10.5% in the fourth quarter. Protesters have smashed the treasury and stormed parliament.

“‘This is much worse than the East Asia crisis in the 1990s,’ said Lars Christensen, at Danske Bank. ‘There are accidents waiting to happen across the region, but the EU institutions don’t have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU.’ Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4% in the fourth quarter. If Deutsche Bank is correct, the economy will have shrunk by nearly 9% before the end of this year. This is the sort of level that stokes popular revolt.

And then he talks about the long term in stock investing and how to easily spot when to buy into the market:

Why is that important? If the P/E
ratio doubles, then you are paying twice as much for the same level of
earnings. The difference in price is simply the perception that a given level
of earnings is more valuable today than it was 10 years ago. The main driver of
the last stock market bubble, and every bull market, is an increase in the P/E
ratio. Not earnings growth. Not anything fundamental. Just a willingness on the
part of investors to pay more for a given level of earnings.

Every period of above-9.6% market
returns started with low P/E ratios. EVERY ONE. And while not a consistent
line, you will note that as 20-year returns increase, there is a general
decline in the initial P/E ratios. If we wanted to do some in-depth analysis,
we could begin to explain the variation from this trend quite readily. For
instance, the period beginning in 1983 had the lowest initial P/E, but was also
associated with a two-year-old secular bear, which was beginning to lower 20-year
return levels.

Look at the following table from my
friend Ed Easterling’s web site at www.crestmontresearch.com
(which is a wealth of statistical data like this!). You can find many 20-year
periods where returns were less than 2-3%. And if you take into account
inflation, you can find many 20-year periods where returns were negative!

Look at the 20-year average returns
in the table above. The higher the P/E ratio, the lower (in general) the
subsequent 20-year average return. Where are we today? As I have made clear in
my last two letters, we are well above 20. Today we are over 30, on our way to
45. In a nod to bulls, I agree you should look back over a number of years to
average earnings and take out the highs and lows of a cycle. However, even
“normalizing” earnings to an average over multiple years, we are still well above the long-term
P/E average. Further, earnings as a percentage of GDP went to highs well above
what one would expect from growth, which is usually GDP plus inflation.
Earnings, as I have documented in earlier letters, revert to the mean. Next
week, I will expand on that thought.

George Will's Lies

This is just awesome, from Hilzoy at Washington Monthly:

If Will actually read these two articles, it's hard to see how he's not being deliberately deceptive by citing them as he did. If, as I suspect, he just got them from some set of climate change denialist talking points and didn't bother to actually check them out for himself, he's being irresponsible. All those people who supposedly fact-checked Will's article as part of the Post's "multi-layer editing process" -- "people [George Will] personally employs, as well as two editors at the Washington Post Writers Group, which syndicates Will; our op-ed page editor; and two copy editors" -- should be fired, either for not doing their job or for doing it utterly incompetently. These are hard times for newspapers; I wouldn't have thought they could afford more than one layer of an editing process that produces no discernible improvement in quality.

CDS

A good article from theglobalist.com on Credit Default Swaps and AIG:

One of the least understood aspects of the financial crisis — but potentially the most damaging — is the market for over-the-counter derivatives and particularly one type of derivative known as a credit default swap (CDS). The losses at American International Group (which was the recipient of a vast public bailout last year financed by the Fed of New York for the benefit of Goldman Sachs and the other large CDS dealers banks) stem in large part from CDS contracts. And there are many other AIG-type situations festering in the United States and Europe that will burst into bloom in coming months.

FDR Caused the Great Depression

Another great post from Steve Benen (Washington Monthly) and Matt Yglesias:

First, Austria's argument is a reminder of why negotiations between the White House and congressional Republicans aren't going to go well -- ever. On the one hand, we have a president who seems to care a little too much about engaging the minority party in good-faith policy discussions. On the other, we have a party comparing itself to the Taliban and publicly arguing that FDR created the Great Depression. Between sanity and craziness, there is no common ground.

And second, Austria later backtracked, saying, "I did not mean to imply in any way that President Roosevelt was responsible for putting us into the Depression, but rather was trying to make the point that Roosevelt's attempt to use significant spending to get us out of the Depression did not have the desired effect."

Austria is, of course, wrong about this, too. The New Deal was wildly successful, and only faltered when Roosevelt started listening (temporarily) to the same arguments conservatives are spouting now.

Jason Linkinsreminded me of this graphic that Rachel Maddow used on the air the other night, which helps drive the point home nicely:

Charlie Munger Again Says Something Very Intelligent

I wanted to save this quote from Charlie Munger that The Big Picture posted today:

“Sensible reform cannot avoid causing significant pain, which is worth enduring to gain extra safety and more exemplary conduct. And only when there is strong public revulsion, such as exists today, can legislators minimize the influence of powerful special interests enough to bring about needed revisions in law.

Many contributors to our over-the-top boom, which led to the gross bust, are known. They include insufficient controls over morality and prudence in banks and investment banks; undesirable conduct among investment banks; greatly expanded financial leverage, aided by direct or implied use of government credit; and extreme excess, sometimes amounting to fraud, in the promotion of consumer credit. Unsound accounting was widespread.

There was also great excess in highly leveraged speculation of all kinds. Perhaps real estate speculation did the most damage. But the new trading in derivative contracts involving corporate bonds took the prize. This system, in which completely unrelated entities bet trillions with virtually no regulation, created two things: a gambling facility that mimicked the 1920s “bucket shops” wherein bookie-customer types could bet on security prices, instead of horse races, with almost no one owning any securities, and, second, a large group of entities that had an intense desire that certain companies should fail. Croupier types pushed this system, assisted by academics who should have known better. Unfortunately, they convinced regulators that denizens of our financial system would use the new speculative opportunities without causing more harm than benefit.”

Here's a link to the full piece.

 

The Big Fix

From Sunday's NY Times magazine, by David Leonhardt:

Olson’s book was short but sprawling, touching on everything from the Great Depression to the caste system in India. His primary case study was Great Britain in the decades after World War II. As an economic and military giant for more than two centuries, it had accumulated one of history’s great collections of interest groups — miners, financial traders and farmers, among others. These interest groups had so shackled Great Britain’s economy by the 1970s that its high unemployment and slow growth came to be known as “British disease.”

Germany and Japan, on the other hand, were forced to rebuild their economies and political systems after the war. Their interest groups were wiped away by the defeat. “In a crisis, there is an opportunity to rearrange things, because the status quo is blown up,” Frank Levy, an M.I.T. economist and an Olson admirer, told me recently. If a country slowly glides down toward irrelevance, he said, the constituency for reform won’t take shape. Olson’s insight was that the defeated countries of World War II didn’t rise in spite of crisis. They rose because of it.

The parallels to the modern-day United States, though not exact, are plain enough. This country’s long period of economic pre-eminence has produced a set of interest groups that, in Olson’s words, “reduce efficiency and aggregate income.” Home builders and real estate agents pushed for housing subsidies, which made many of them rich but made the real estate bubble possible. Doctors, drug makers and other medical companies persuaded the federal government to pay for expensive treatments that have scant evidence of being effective. Those treatments are the primary reason this country spends so much more than any other on medicine. In these cases, and in others, interest groups successfully lobbied for actions that benefited them and hurt the larger economy.

Socialism for the Rich Continues Under Obama Administration

Krugman's column in the NY Times shows that not much has changed in the continuing history of socialism for the rich in the US:

Will there at least be limits on executive compensation, to prevent more of the rip-offs that have enraged the public? President Obama denounced Wall Street bonuses in his latest weekly address — but according to The Washington Post, “the administration is likely to refrain from imposing tougher restrictions on executive compensation at most firms receiving government aid” because “harsh limits could discourage some firms from asking for aid.” This suggests that Mr. Obama’s tough talk is just for show.

Meanwhile, Wall Street’s culture of excess seems to have been barely dented by the crisis. “Say I’m a banker and I created $30 million. I should get a part of that,” one banker told The New York Times. And if you’re a banker and you destroyed $30 billion? Uncle Sam to the rescue!