People, especially Americans, started believing that they can live on other people's money. And more and more so. First other people's money in your own country. And then the savings rate comes down, and you start living on other people's money from outside. At first it was the Japanese. Now the Chinese and the Middle Easterners. We--the Chinese, the Middle Easterners, the Japanese--we can see this too. Okay, we'd love to support you guys--if it's sustainable. But if it's not, why should we be doing this? After we are gone, you cannot just go to the moon to get more money. So, forget it. Let's change the way of living. [By which he meant: less debt, lower rewards for financial wizardry, more attention to the "real economy," etc.] (...) So I wondered, How do I explain derivatives?, and I used the model of mirrors. First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, "I don't have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!" Okay. That's a stock certificate. And then someone else says, "I have another mirror--I can sell a mirror image of that mirror." Derivatives. That's fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go. When I told the State Council about the mirrors, they all started laughing. "How can you sell a mirror image! Won't there be distortion?" But this is what happened with the American economy, and it will be a long and painful process to come down. (...) Many of the brightest youngsters come to me and say, "Okay, I want to go to the U.S. and get into business school, or law school." I say, "Why? Why not science and engineering?" They say, "Look at some of my primary-school classmates. Their IQ is half of mine, but they're in finance and now they're making all this money." So you have all these clever people going into financial engineering, where they come up with all these complicated products to sell to people.
We--the Chinese, the Middle Easterners, the Japanese--we can see this too. Okay, we'd love to support you guys--if it's sustainable. But if it's not, why should we be doing this? After we are gone, you cannot just go to the moon to get more money. So, forget it. Let's change the way of living. [By which he meant: less debt, lower rewards for financial wizardry, more attention to the "real economy," etc.]
(...)
So I wondered, How do I explain derivatives?, and I used the model of mirrors.
First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, "I don't have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!" Okay. That's a stock certificate. And then someone else says, "I have another mirror--I can sell a mirror image of that mirror." Derivatives. That's fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. "How can you sell a mirror image! Won't there be distortion?" But this is what happened with the American economy, and it will be a long and painful process to come down.
Many of the brightest youngsters come to me and say, "Okay, I want to go to the U.S. and get into business school, or law school." I say, "Why? Why not science and engineering?" They say, "Look at some of my primary-school classmates. Their IQ is half of mine, but they're in finance and now they're making all this money." So you have all these clever people going into financial engineering, where they come up with all these complicated products to sell to people.
But please read this one in full: The End of the Financial World as We Know It (continued as How to Repair a Broken Financial World): it's written gy Michael Lewis (of Liar Poker's fame), who has an amazing capacity to write clearly on the topic of finance and is, once again, spot on:
OUR financial catastrophe, like Bernard Madoff's pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today's financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that's the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest. (...) SAY what you will about our government's approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers. (...) Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we'll be in recession for some time to come. Our leaders have framed the problem as a "crisis of confidence" but what they actually seem to mean is "please pay no attention to the problems we are failing to address."
SAY what you will about our government's approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.
Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we'll be in recession for some time to come. Our leaders have framed the problem as a "crisis of confidence" but what they actually seem to mean is "please pay no attention to the problems we are failing to address."
Do read the whole thing. In the long run, we're all dead. John Maynard Keynes
NYT - Joe Nocera - Risk Management
Indeed, Ethan Berman, the chief executive of RiskMetrics (and no relation to Gregg Berman), told me that one of VaR's flaws, which only became obvious in this crisis, is that it didn't measure liquidity risk -- and of course a liquidity crisis is exactly what we're in the middle of right now. One reason nobody seems to know how to deal with this kind of crisis is because nobody envisioned it. In a crisis, Brown, the risk manager at AQR, said, "you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people's intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic."
In a crisis, Brown, the risk manager at AQR, said, "you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people's intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic."
... the chief executive of RiskMetrics ... told me that one of VaR's flaws, which only became obvious in this crisis, is that it didn't measure liquidity risk -- and of course a liquidity crisis is exactly what we're in the middle of right now. One reason nobody seems to know how to deal with this kind of crisis is because nobody envisioned it.
European Tribune: Lazy Quote Diary: This Should Never Have Happened by Migeru on December 25th, 2007
The first of the books I want to quote from is John C. Hull's Options, Futures and Other Derivatives. The last (30th) chapter of the book is called Derivatives mishaps and what we can learn from them. Clearly what can be learned has not been learned because the book says the following:... Do not ignore liquidity risk Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ... This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous. ...... it is all there in this chapter of the book everyone is supposed to have read! (Admittedly, this chapter was added to the 5th edition in 2003, but still...) ... The second book I want to quote from is Nassim Taleb's 1997 Dynamic Hedging: Managing Vanilla and Exotic Options which is nowadays marketed as "Taleb on Risk". This is a very technical practical book but it is also full of qualitative insight of a general nature. And it has been in print (and sold very well) for the past 10 years. So, unlike that last chapter of Hull which was only added in 2003, veteran risk managers cannot claim that they were not aware of the stuff in Taleb's book. And yet... ... Liquidity and Risk Management It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
... Do not ignore liquidity risk Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ... This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous. ...
Do not ignore liquidity risk
Financial engineers usually base the pricing of exotic instruments and instruments that trade infrequently on the prices of actively traded instruments. ...
This practice is not unreasonable. However, it is dangerous to assume that less-actively traded instruments can always be traded at close to their theoretical price. When financial markets experience a shock of one sort or another there is often a "flight to quality". Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Trading strategies that assume large volumes of relatively illiquid instruments can be sold at short notice at close to their theoretical values are dangerous.
...
The second book I want to quote from is Nassim Taleb's 1997 Dynamic Hedging: Managing Vanilla and Exotic Options which is nowadays marketed as "Taleb on Risk". This is a very technical practical book but it is also full of qualitative insight of a general nature. And it has been in print (and sold very well) for the past 10 years. So, unlike that last chapter of Hull which was only added in 2003, veteran risk managers cannot claim that they were not aware of the stuff in Taleb's book. And yet...
Liquidity and Risk Management It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
It cannot be stressed enough that liquidity is the most serious risk management problem. A substantial part of unforeseen losses is due either to market jumps caused by illiquidity or to liquidation costs that substantially move the market against one's position. Liquidation costs tend to be usually underestimated since operators usually "fade" when someone is forced into a market action
Not to speak of the fact that both books contain criticism of VaR (stronger and more pointed in the case of Taleb). Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
As they wrote elsewhere the problem with VaR is that 99% of the time that's the most you can lose, but ever so occasonally it's the least you will lose. So you'd better have other analysis going on and the point being that, most of the time, VaR was all they had.
btw taleb gets a starring role in the article keep to the Fen Causeway
naked capitalism: Woefully Misleading Piece on Value at Risk in New York Times
By neglecting to expose this basic issue, the piece comes off as duelling experts, and with the noisiest critic of VaR, Nassim Nicolas Taleb, dismissive and not prone to explanation, the defenders get far more air time and come off sounding far more reasonable. It similarly does not occur to Nocera to question the "one size fits all" approach to VaR. The same normal distribution is assumed for all asset types, when as we noted earlier, different types of investments exhibit different types of skewness. The fact that VaR allows for comparisons across investment types via force-fitting gets nary a mention.
Shouldn't someone tell the markets that as long as you do a little statistical diddling VaR works just fine?
The last year has been a lot of fuss over nothing, clearly.
2009 Could Be Better Than You Think Never mind those campaign calls for higher taxes on the wealthiest Americans. Truth is, no politician is going to push for general tax increases in the midst of a severe recession. You may wonder: How is the government going to pay for that trillion-dollar stimulus package? Or the multitrillion-dollar bailout of financial institutions, auto companies and anyone else sideswiped by the current crisis? Or the continued wars in Iraq and Afghanistan? Or the (still) rapidly rising cost of the baby boomers' retirement? Well, that's the sweet secret of the current crisis. While the American people are learning to live within their means, the new American government has discovered an unlimited (for now) line of credit. The United States may have led the world into this crisis, but the world now seems more than willing to lend us unlimited amounts of money to lead the way out. This, too, is unsustainable. A reckoning will come. But that's a problem for 2010 and beyond.
Never mind those campaign calls for higher taxes on the wealthiest Americans. Truth is, no politician is going to push for general tax increases in the midst of a severe recession.
You may wonder: How is the government going to pay for that trillion-dollar stimulus package? Or the multitrillion-dollar bailout of financial institutions, auto companies and anyone else sideswiped by the current crisis? Or the continued wars in Iraq and Afghanistan? Or the (still) rapidly rising cost of the baby boomers' retirement?
Well, that's the sweet secret of the current crisis. While the American people are learning to live within their means, the new American government has discovered an unlimited (for now) line of credit. The United States may have led the world into this crisis, but the world now seems more than willing to lend us unlimited amounts of money to lead the way out.
This, too, is unsustainable. A reckoning will come. But that's a problem for 2010 and beyond.
It's interesting to note the indirect acknowledgement in the WSJ that not increasing taxes on the rich is unsustainable even if the point they're ostensibly making is that "taxes are unlikely to be raised this year, yippee"... In the long run, we're all dead. John Maynard Keynes
If taxes have to be raised, then it's better to get started now than carry on and making things worse later on. To suggest otherwise is irresponsible, even Murdoch must realise that. keep to the Fen Causeway
But who cares bout tomorrow? In the long run, we're all dead. John Maynard Keynes
Do you need more? In the long run, we're all dead. John Maynard Keynes
