The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Monday, August 27, 2007

More on the Credit Crunch

Hopefully, all of you have read my last blog post -- Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money' (Aug. 16, 2007). In that blog post (among other things), I outline a major factor in the credit crisis and market fall that is being ignored (or misunderstood) by most commentators -- credit derivatives.

I found several articles in the most recent New York Times that relate to the current crisis in the credit and real estate markets (and their knock-on effects to the financial markets in general). I don't think they get to the heart of the matter (credit derivatives), but they do talk about issues that are nonetheless important to any attempted explanation of what is going on now.

Drop Foreseen in Median Price of U.S. Homes by David Leonhardt and Vikas Bajaj (Aug. 26, 2007) : In the last few years, almost every real estate 'expert' dismissed the idea of a nationwide decline in housing prices across the U.S. Guess what? ... It's happening!

Inside the Countrywide Lending Spree by Gretchen Morgenson (Aug. 26, 2007): With many mortgage banks/lenders at deaths door (either closing down or dramatically reducing their mortgage lending operations), Countrywide's recent bailout from other banks ($11.5 billion credit line had to be drawn down 2 weeks ago and Bank of America recently took a 16% stake in Countrywide for $2 billion) is emblematic of the recent crisis in the credit and real estate markets.

A Psychology Lesson From the Markets by Robert J. Shiller (Aug. 26, 2007): Yale financial economist and author of Irrational Exuberance comments on what is happening in the most recent market crisis.

Will the Credit Crisis End the Activists’ Run? by Andrew Ross Sorkin (Aug. 26, 2007): Speculates that credit crisis will reduce the ammunition needed by activist hedge funds to ply their trade.

Just How Contagious Is That Hedge Fund? by Mark Hulbert (Aug. 26, 2007): Hulbert cites research by 3 financial economists (the most prominent being Rene Stulz of Ohio State University) arguing that hedge fund strategies may be correlated with each other. This is flies in the face of hedge funds' advertised goals of using strategies that are unique and distinct from one another. What this means is that if the strategies of a few hedge funds fail, then there is a good chance that others will fail as well. To some extent, we are seeing some of this with the credit derivatives bets made by some hedge funds.

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Thursday, August 16, 2007

Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money'

Regulars to this blog may be familiar with my preference to not comment on contemporaneous events occurring in the markets. The basic reason for this is that I'd prefer to let the dust settle before I say anything about movements in the financial markets (if I have anything to say about it at all). I am making an exception to this general 'rule,' because the credit market meltdown that we are currently experiencing in the global financial markets just happens to coincide with a book review I wanted to write for a long time.

So what is this book I wanted to review that seems ironically (or, perhaps, appropriately) to be the perfect companion to the bursting of the credit/real estate bubble? The book I want to review today is titled Traders, Guns & Money (Knowns and Unknowns in the Dazzling World of Derivatives) written by financial derivatives expert and veteran trader, Satyajit Das.

The most succinct endorsement (obviously, I will give a more detailed endorsement below) I can give to this book is by comparing this book to two of the books -- Fooled By Randomness and The Black Swan -- written by one of my favorite authors, Nassim Nicholas Taleb. In a nutshell, Das' book takes many of the ideas developed and espoused in NNT's books and applies them, in a clinical and detailed (but accessible) way, to the world of financial derivatives.

But a stronger one-line endorsement of this book was given by Frank Partnoy (author of FIASCO: The Inside Story of a Wall Street Trader and Infectious Greed) : "When 'derivatives' and 'f******' appear together on every other page, you know someone has written the truth about financial innovation." (It's worth noting that Partnoy exaggerates the amount of profanity used in the book ... but his basic point is well put.)

In Traders, Guns & Money, Satyajit Das dissects and analyzes almost every aspect of the derivatives industry with the same level of skill and care as an expert crime scene investigator combs through the scene of a crime. No part of the derivatives world escapes the attention of Das. Sell side, buy side, over-the-counter (OTC) derivatives, risk (mis-)management, 'quants,' structured products, equity derivatives, credit derivatives (much more on this later), and even more exotic derivatives (like weather and carbon emission derivatives) are covered in this fascinating book.

Das uses several underlying themes or frameworks throughout this book. One of these themes/frameworks is his use of semi-fictionalized narrative -- presumably, based on his own long career in the derivatives industry -- to highlight the dark side(s) of the derivatives world. This is reminiscent of the style used in NNT's books (Das even has his own 'Nero'; although Das' Nero is more like NNT's Fat Tony ... in fact Das' Nero would make Fat Tony look like a debutante). Das' 'war stories' are salacious, but, more importantly, they serve the purpose of exposing the real world workings of the derivatives industry to naifs.

Another theme/framework Das employs throughout his book is a somewhat Popperian one: 'knowns' and 'unknowns.' Das categorizes the workings of financial derivatives into one of four categories based on permutations of knowns and unknowns. There are the 'known knowns' -- things that we know that we know and, thus, can have a high degree of certainty about. The second category is 'known unknowns' -- things that we don't know but we know that we don't know them; this adds a degree of uncertainty but it is manageable uncertainty (similar to NNT and Benoit Mandelbrot's "mild uncertainty").

The third category is rather fascinating to me when I first heard it: 'unknown knowns.' These are things that we know but we do not realize (or, many times, we don't want to realize) that we know it! This may sound far-fetched, but I think Das is correct to articulate this category. An example that Das cites to illustrate 'unknown knowns' is the idea of greed and fear that underlies the derivatives game. No matter what people may say (and even believe, to some extent) about derivatives as a tool to hedge risk, add liquidity to markets, etc., the almost unsaid truth is that the motivation behind trading derivatives is greed and the fear of missing out on greed. This is an 'unknown' known because the players have incentives to not admit this to others (or even to themselves) because it is, at the very least, impolitic to 'know' this known.

The last category are the 'unknown unknowns' -- the "things that you did not know you did not know" (p. 12). This is the most problematic category because the degree of uncertainty in this category is virtually unbounded. This is like NNT's "Black Swan" (or "wild randomness").

Lest one is tempted to think this is all idle philosophizing, as the book highlights along the way, both the 'unknown knowns' and 'unknown unknowns' seems to pervade the derivatives industry.

One of the 'unknown knowns' that Das book does a great job of exploring is the mythology of financial 'engineering.' Many business schools and economics departments would like to beatify quantitative finance by removing the messy realities of the real world and 'cleaning' (over-simplifying) it up so that it resembles something like civil engineering. Academic and industry naifs would like people to believe that Black-Scholes, Cox-Rubenstein, Miller-Modigliani, etc., turn derivatives valuation into something akin to bridge building (and, as the recent tragedy in Minnesota shows us, even bridge building is a lot messier in the real world than in textbooks).

Das does a lot to explode these myths. Yes, Das would concede, fancy quantitative models can help, but there are serious weaknesses with copulas, implied correlations, dynamic delta hedging, etc. In other words, model risk, basis risk (basically, comparing apples to oranges), marking-to-model or to a market when there is no liquid market for the instrument, liquidity risk and flight-to-quality, etc., will forever doom even the geekiest and 'greekiest' models to getting blind-sided by negative Black Swans.

Along the same lines is how Das' book exposes the dark underbelly of many derivatives contracts. Many (if not all) the textbooks and technical literature on derivatives seem to think that derivatives are created and structured by Mother Theresa's Sisters of Mercy. These other books/papers will describe vanilla call, put, forward/futures, swap contracts but will have next to nothing on 'exotic' derivatives, structured products, special purpose vehicles, credit derivatives, etc. Even books/papers that touch on OTC and exotic products tend to take an unrealistic and unworldly view of things; i.e., they seem to unskeptically accept the propaganda of sell side traders/derivatives salesmen that they are 'client-centric' and that they would 'never' try to hide anything or slip in financial equivalents of ticking time bombs into their derivatives products.

Fortunately, Das -- having been on both the buy and sell side of the business -- doesn't believe that derivatives salesmen and traders have taken a vow of chastity. Das exposes many of the hidden details in real world -- as opposed to the idealized models one sees in textbooks -- derivatives contracts/products. And, not surprisingly, these details show that derivatives aren't the seemingly innocent ways to make markets more 'efficient' as we've been led to believe. There is sketchy accounting, hidden leverage (often massive), outlandish terms, and other ugly and sordid details.

For example, one semi-fictional example of contractual shenanigans that Das gives is almost comical (if you have a mathematical bent) if billions of dollars weren't at stake. One swap contract would have had a near-bankrupt company pay $4 million a month to a dealer in exchange for the investment bank paying the company an amount based on the following formula/algorithm (adapted from pp. 10-11):

Max[0; $600 million * {7 * [(LIBOR^2 * 1/LIBOR) - (LIBOR^4 * LIBOR^-3)]} * days in the month/360]

If you know basic algebra, then you would realize that this term will always equal zero! [Hint: The LIBOR terms.]

There are many other aspects of this book that I can highlight and praise, but the remainder of this post will focus on the intersection between Das' book and the current turbulence in the markets: namely, credit derivatives. The current market meltdown -- as summarized in the current issue of The Economist -- revolves around collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and mortgage backed securities (MBS) [for the purposes of our discussion, we can consider all three to be virtually interchangeable]. It just so happens that Das' book contains the best overview of credit derivatives that I am aware of.

The problem that credit derivatives products are causing right now in the markets are complex and hard to describe in the limited space of this blog. However, I can very briefly outline the problems below:

(1) Credit derivatives, like CDOs, are causing problems right now, in part (again, it's much more complex than what I can get into at this point), because they are basically untradeable and unhedgeable at this point. Why? Because the assets underlying these credit derivatives -- for the most part real estate mortgages (but there are other kinds of debt, like corporate debt, at play here too) -- have tanked in value because of the rising levels of defaults and the increase in the (subjective) probability of defaults.

(2) That's not the only problem. The other problem is that investments in these credit derivatives vehicles/products are structured into what are called tranches. That is a fancy way of saying that different classes of investors in credit derivatives will get paid in different ways. The 'equity' and 'mezzanine note' holders are taking a bath on this freefall in the CDO 'market' (I use that term loosely, since much of this is OTC) since they had lower priority in cases where some of the holdings in the credit derivatives portfolio defaulted (i.e., they took the risk in return for the rewards, and the chickens have come home to roost). The catch here is that senior note holders who had the highest priority are also taking a beating. This came as a surprise to them (but, according to Das and to my way of thinking, maybe it shouldn't have been) because most of these CDOs are structured so that the senior notes will get the highest possible ratings by credit rating agencies -- AAA. Now, the senior note holders are finding that AAA might as well be FFF.

(3) To make matters even worse -- and this happens in virtually every market crash (bursting of asset pricing bubbles) -- investors, banks, etc., are compelled to sell assets in order to limit losses and/or hedge risk. The problem is that this is either hard to do and/or makes things even worse. Obviously, they want to get rid of non-performing and/or illiquid assets, but they can't right now (if ever) because they're heading toward worthlessness. So they have to sell off 'good' assets, which means that prices of assets that at first blush seems to have little to do with CDOs, MBSs, mortgages, lending, banking, etc., also fall precipitously. I.e., correlations are created when there was little or none before!

(4) To top it all of, there is a LOT of leverage involved (both explicit and implicit). Leverage makes downturns even worse. For example, the need to meet margin calls is what is causing the sell off that I described in point (3).

That's a nutshell description of what is happening now in the financial markets. Like I said, it is much more complicated than that I'm sure, but if you can follow what I just wrote, then you're probably more knowledgeable than the vast majority of the people who bought and sold CDOs over the years.

Getting back to Das and how his book relates to the current tremors in the markets ... Das' book is the only book that I'm aware of that gives an accessible account of the workings and structure of credit derivatives, including both financial and legal issues surrounding them. Chapter 9 of his book -- considering the mess we're in -- is well worth the price of the book in it of itself (although the rest of the book is just as great if not better)! I would go so far as to say that Das essentially predicted the current crisis over a year ago (the book was published last year, 2006).

The intersection between Das' book and the market meltdown brings us back to the theme of knowns and unknowns. Goldman Sachs has admitted that its hedge funds -- keep in mind that hedge funds have been big buyers of credit derivatives -- have been "hit by moves that its models suggested were 25 standard deviations away from normal" (from The Economist article). This is, in terms of standard Gaussian mathematical statistics, akin to saying that it was impossible for these losses to take place. Guess what ... the losses took place!

Apologists for hedge funds, investment banks, credit agencies, and investors may claim that these are what Das might call 'unknown unknowns.' How can anyone think that a (negative) 25 sigma event would take place? How can anyone know that credit rating agencies' grades are not worth the paper they're printed on when you need to count on them the most? Etc.

The problem with this line of argument is that these 'unknown unknowns' were actually known .. we just didn't want to admit that to ourselves. Nassim Nicholas Taleb, Benoit Mandelbrot, and -- as this blog post outlines -- Satyajit Das, have been warning us about these kinds of Black Swans for quite a while. Chance of a 25 sigma event taking place? Impossible from a 'normal,' bell curve perspective. Quite likely, from the Black Swan way of thinking.

The lesson we can learn from the NNTs and Das-es of the world -- those rare individuals who can combine sincere humility with the courage to face and embrace inconvenient truths -- are that the 'unknown unknowns' are really 'unknown knowns.' We actually know that 'impossible' events can take place because we should know that our pretentious models and heuristics are vulnerable to the messiness of the real world. The problem is that we don't know -- or, more accurately, we don't want to know -- that we know. That kind of self-knowledge is too painful to our ego, too inconvenient, and too humbling.

But ask yourself the question: Isn't it better to feed yourself humble pie rather than having it hurled at your head as is happening to so many traders and bankers now?

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Thursday, August 09, 2007

Catastrophe Bonds

Catastrophe bonds -- or "cat" bonds -- are bonds (normally issued by insurance companies) that have high yields but lose their value when natural disasters (such as earthquakes, floods, hurricanes / typhoons, etc.) take place. In the past, the vast majority of cat bond investors were large institutional investors like pension funds and hedge funds. Recently, however, a mutual fund has allowed retail investors an 'opportunity' to gain exposure to this seemingly exotic alternative asset class.

The benefits of investing in cat bonds is that (a) it has yields that are substantially higher than most junk bonds and the sovereign debt of emerging countries, and (b) it (supposedly) has low correlation with other asset classes (of course, those touting cat bonds are tacitly assuming that natural catastrophes are not linked to market catastrophes). The problem is that these benefits come with a high price: Investors in cat bonds are implicitly writing (selling) options to insurance companies when they buy cat bonds.

If you know anything about financial options, you should know that the writers (sellers) of options -- which, counter-intuitively in this case, aren't the issuers of cat bonds, but the investors of cat bonds -- can lose their entire investment, and, in some cases, have virtually unlimited losses. If investments in cat bonds involve a lot of leverage -- which would not be surprising given that cat bonds are essentially another form of exotic financial derivatives -- then losses for investors can get quite ugly.

Cat bonds is another example of exotic derivatives and financial products that are finding their way to retail investors. Creators and marketers of these products are increasingly motivated to offer these products to the retail market because: (a) they have access to greater liquidity (thousands of 'little old ladies from Pasadena' can rival institutional investors when it comes to chasing liquidity), and (b) they provide a way to further (re-)distribute risk.

More on point (b) ... re-insurers -- who provide insurers with insurance against catastrophic risk -- are the obvious alternative to cat bonds. Unfortunately for insurance companies, re-insurers (and, for that matter, insurance companies) are like Mark Twain's proverbial bankers: "They give you an umbrella when it's sunny, but take it away when it's raining." In other words, re-insurance is plentiful when there aren't too many natural catastrophes, but they tend to dry up when it is most needed.

Cat bonds -- especially if retail investors get in on the act -- can be a way for insurance companies to obtain more 're-insurance' than they otherwise could. Unfortunately, for retail investors, these cats may not have nine lives when disaster strikes.

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Friday, August 03, 2007

International Investing and China in the NBER Digest

I came across a couple of interesting items in the July issue of the National Bureau of Economic Research's NBER Digest.

The first item that caught my eye was The Declining Gain from International Portfolio Diversification (by Les Picker). That article describes a NBER Working Paper by Karen Lewis, a financial economist at Wharton, where she examines the puzzle of why investors tend to disproportionately weight their investment portfolios to domestic securities and assets. This tendency is a 'puzzle' because this tendencymeans that investors forego the possible gains -- including lower correlated risks, higher returns from riskier foreign investments, etc. -- from international diversification.

Prof. Lewis finds that (a) international equity markets have become more correlated over the years (although she didn't find them to be as highly correlated as others have suspected them to be), and (b) foreign stocks that are listed on U.S. exchanges have become highly correlated with the U.S. market(s) over time. Thus, the potential gains from international portfolio diversification have been declining, and there seems to be relatively little to be gained in the way of diversification from investing in domestically listed foreign stocks.

The second item of interest in the NBER Digest is The Return to Capital in China (also by Les Picker). This article discusses research by professors Bai, Hsieh, and Qian, on what affects (if any) China's high investment rate (over 40% of GDP) has on returns to capital. The researchers found that (adjusted for various factors) China has relatively high returns to capital. It should be noted that this is an interesting finding because high investment rates can often mean lower returns to capital.

One of the plausible reasons why China's return to capital seems to be higher is -- despite misallocation of capital in many cases -- that China's economy has been moving rapidly toward more capital-intensive industries and techniques and away from purely labor-intensive industries of the past.

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