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Lazy Quote Diary: This Should Never Have Happened

by Carrie Tue Dec 25th, 2007 at 11:37:10 AM EST

Over the past six months or so we have had numerous discussions of the unfolding subprime crisis and of the credit crunch and liquidity freeze that have gripped the financial markets since the summer. It is not unlikely that in the coming year we will see some banks fail, the bottom fall out of the housing market in several countries, a recession and possibly even a depression if things get really out of hand. And out of hand they might well get. The media and the blogs are awash with commentary on the failure of the US Federal reserve to make a dent in the credit/liquidity crisis even with interest-rate cuts which would be quite bold on their own but seem outright desperate when there is a widely acknowledge risk of inflation. Only even bolder (the FT called them shocking) money injections by the European Central Bank have been able to ease the interbank markets, but only until the New Year.

In these discussions we have touched on the problem of over-reliance on mathematical models, including extrapolating them to regimes where the parameters haven't been calibrated (using a model in "uncharted waters") and valuing large chunks of banks' balance sheets by marking to model, that is, with no reference to a market price because in some cases there just isn't a market for the assets. We have also learned that the US has accounting rules that require companies to classify their assets into "levels", of which "level 3" is "valued using management's best estimate" and that some of the most powerful banks have more "level 3" assets than net equity (in other words, if the level 3 assets turn out to be nearly worthless, the banks would be technically bankrupt).

For this reason it is nothing less than infuriating to look at some of the textbooks that those of us at the bottom of the quantitative finance food chain have to read in order to make it through an interview and find that clearly worded warnings about all this are right there in black and white on the pages of these books. It makes me wonder whether people, including senior people, just read the books for the formulas and eschew the qualitative insight.

Follow me below the fold for some quotations that show that it needn't have been this way.

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 blindly trust models

Some of the large losses in Table 30.1 [Big losses by financial institutions] arose because of the models and computer systems being used. ...

If large profits are being made by following relatively simple trading strategies, there is a good chance that the models underlying the calculations of profits are wrong. Similarly, if a financial institution appears to be particularly competitive on its quotes for a particular type of deal, there is a good chance that it is using a different model from other market participants, and it should analyze what is going on carefully. ...

Be conservative in recognizing inception profits

When a financial institution sells a highly exotic instrument to a nonfinancial corporation, the valuation can be highly dependent on the underlying model. ... In these circumstances, a phrase used to describe the daily marking to market of the deal is marking to model. This is because there are no market prices for similar deals that can be used as a benchmark.

Suppose that a financial institution manages to sell an instrument to a client for $10M more than it is worth—or at least $10M more than the model says it is worth. The $10M is known as inception profit. When should it be recognized? ... Some [investment banks] recognize the $10M immediately, whereas others are much more conservative and recognize it slowly over the life of the deal.

Recognizing inception profits immediately is very dangerous. It encourages traders to use aggressive models, take their bonuses, and leave before themodel and the value of the deal come under close scrutiny. ...

Do not sell clients inappropriate products

It is tempting to sell corporate clients inappropriate products, particularly when they appear to have an appetite for the underlying risks. But this is shortsighted. ... The [particularly risky] products worked well for [Bankers Trust]'s clients in 1992 and 1993, but blew up in 1994 ... The bad publicity hurt BT greatly. The years it had spent building up trust among corporate clients and developing an enviable reputation for innovation in derivatives were largely lost as a result of the activities of a few overly aggressive salesmen. ...

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.


Beware when everyone is following the same trading strategies

It sometimes happens that many market participants are following essentially the same trading strategy. This creates a dangerous environment where there are liable to be big market moves, unstable markets, and large losses for the market participants.

Hmm... "contagion" caused by one distressed player "unwinding" positions which many other players are holding as well? Liquidity squeezes? Problems caused by Mark-to-model in its many forms? Problems caused by inappropriate accounting recognition of profits and losses? Blind trust in models, including using them outside the domain where they have been calibrated? We've seen it all in the last six monthsten years, and 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...

Here's, for starters, Taleb's take on inception profit. Compare the practitioner's approach with the professor's above.

Market Making and the Illusion of Profitability

Market making in complex products can show immediate rewards and future thorns. Mostly profits are shown after the trade because the mark-to-model process generally implemented derives security prices off a mid-market. Traders usually find a fair value and mark the derivative up, then recognize most or all of the difference between fair value and the selling price as a profit. This method does not allow for the future costs incurred in the management of an option book. The more complex the security, the more subsequent dynamic hedging will be required, and that in more than one market ... Heavy slippage will be incurred when the position attains some large size. All this would eat up the initial profit, but would often be concealed from the trader who receives a steady flow of such profit-booking trades. It would be difficult for the trader to espouse a more aggressive stance and reduce transaction costs by observing the different behaviour of the multifaceted components. Market makers are crippled by the size of their positions in relation to their appetite for risk.

it's all there, isn't it? The dangers of mark-to-model, the hidden long-term costs of complex financial products very profitable in the short term (this, again, brings up issues of accounting practice). The fact that it is hard to resist getting into too large positions when the market demands it and the initial profit is large... And this is in the introductory, least technical part of the book.

We then come to liquidity risk. Taleb devotes an entire chapter to liquidity risk, to the way that liquidity holes take market behaviour outside the scope of standard models of market behaviour, and to the way liquidity can be manipulated by traders.

If one were to summarize what trading (as opposed to investing) is about, the best answer would be adequate management (and understanding) of liquidity. Liquidity is the source of everything related to markets
So far, so good. Now remember what Hull says: do not underestimate liquidity risk.
Liquidity Holes
  • A Liquidity hole or a black hole is a temporary event in the market that suspends the regular mechanics of equilibrium attainment. It is an informational glitch in the mechanism of free markets, one that can cause considerable damage to firms. In practice, it can be seen when lower prices bring accelerated supply and higher prices accelerated demand.
I guess the point is that this is not a rare event. Markets are punctuated by these shocks on a regular basis. Only sometimes the size of the jolt is large enough to make the news.
Liquidity holes are attributable to the way information initially affects a market. Typically, liquidity holes occur when operators are aware of a major piece of information (an event, or a size order in the market) but cannot gauge its size and possible impact. Information causes anxiety, conspiracy theory, and price conflicts. Most often, operators need to interpret information. Markets are supposed to move to the extent of the difference between news and initial expectations but the latter are usually unknown and difficult to estimate properly.
No theory survives first contact with experiment?
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

Some of you may remember that the credit crunch started in the summer with a lot of "turbulence" in the markets caused by hedge funds exposed to subprime meeting margin calls by selling off positions in liquid assets which moved everyone else's portfolios (see above "beware of everyone following the same strategy") in the wrong direction triggering more margin calls and further liquidations. When Taleb talks about "operators fading" he means this:
When a stop-loss is executed ... operators freeze as they become aware of the order without further information as to its magnitude Many suspend their trading temporarily, thus causing the market to gyrate even further.
This is because withdrawing from the market lowers the liquidity and the lower the liquidity the more sensitive the market price is to individual orders, that is, noise.

Taleb then gives an example of a trader manipulating the market by using his knowledge of a stop-loss order by a client, and deliberately causing a liquidity hole in the process, as if it were the most normal thing in the world. To me, this example give a whole new meaning to Chris Cook's distinction between systematic and systemic market manipulation. [See, for instance: Acceptable Market Manipulation by ChrisCook on November 9th, 2006]

But the scary bit comes next, when Taleb argues that exotic options just make matters worse!

Much of the recent [1993-6?] market volatility was caused by the triggering of barrier options. As these are starting to abound, so are unexplainable gaps in the markets beginning to appear. In the previous example, we saw that a large stop was a free option. However, a stop can be canceled, or given to a trader too late for him to be able to utilize it properly. A trigger option will offer none of these mitigating features: it will be there offered to the market maker far in advance and by its nature is noncancellable.
I call this a Lazy Quote Diary because I don't have much of my own to say except that the more I learn about this stuff, the more shocked I am that anyone could be shocked at what has been happened in the financial markets over the past six months, least of all people who write for a living on the pages of the financial press.

Well, somebody's been doing his xmas day homework.  Thanks for bringing these primers to our attention.

"Life shrinks or expands in proportion to one's courage." - Ana´s Nin
by Crazy Horse on Tue Dec 25th, 2007 at 12:36:54 PM EST
The thing this highlights for me is:

  1. Most critically, regulators have not read these books.

  2. On top of that, we have lost, as a society, the understanding that regulation of financial markets to preserve stability is a necessary action. It may drag on efficiency, but the downside is so large that regulation is always needed.

We have forgotten that (probably because the last big lesson was 1929) and so we've based our deregulations on the notion that ideally, there would be no regulation at all, that freedom of action is a "good" which can only be constrained where it crosses the line into clear criminality (if that.)
by Metatone (metatone [a|t] gmail (dot) com) on Tue Dec 25th, 2007 at 12:50:28 PM EST
can earn ten times more money working in a bank of hedge fund than they can working for the regulator...

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Tue Dec 25th, 2007 at 02:24:49 PM EST
[ Parent ]
That is funny. Just reading the book doesn't get you a job as a trader, but anyway I think Metatone's point is that it costs a regulator about €50 to buy the book. Now I feel inclined to buy a book on Basel II and quote it side by side with Taleb's opinions on VaR in Dynamic Hedging.

And since we're talking about traders' salaries, I'll say that I also left out Taleb's discussion of the perverse effects of performance-based compensation of traders, both on the profitability (or, rather, lack thereof) of banks' proprietary trading desks [in plain English: a clear explanation of why hedge funds make money but banks trying to deploy the same strategies don't], and on encouraging traders to artificially increase the volatility of their portfolios.

We have met the enemy, and he is us — Pogo

by Carrie (migeru at eurotrib dot com) on Tue Dec 25th, 2007 at 03:16:00 PM EST
[ Parent ]
don't seem to be doing so badly. Just like hedge funds, and asset management in general, there seems to be a small number of people that really are a lot better than the market, and lots of wannabes who end up being no different from noise.

The stars create the mystique for the industry, and lots of money are poured in with no measurable result.

But a lot of money is poured, and remunerations follow that, and my point about regulators losing their good people to an industry that can afford to pay competent huge paychecks is a systemic issue. I expect that until you get regulators that get paid millions to do the job, you won't have good enough regulation.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Tue Dec 25th, 2007 at 03:23:25 PM EST
[ Parent ]
I expect that until you get regulators that get paid millions to do the job, you won't have good enough regulation.

Then I will want to be a regulator ! the office would be a dream, paid millions just to slap the traders, duh !


by Pierre on Tue Dec 25th, 2007 at 03:37:58 PM EST
[ Parent ]
I don't know that many regulators, but from the ones I do know, I have to say I think that (2) (from my post) is the biggest problem. It doesn't seem to me that this stuff is that hard to understand, nor that the regulators I've met are incapable of understanding it.

Regulators live in "learned ignorance" of the gamut of hedge fund (and CMOs, CLOs, mortgages etc. etc.) operations, because the banks and hedge funds have formed a powerful political lobbying force to keep the regulators out of even looking at them.

by Metatone (metatone [a|t] gmail (dot) com) on Tue Dec 25th, 2007 at 06:21:23 PM EST
[ Parent ]
You used to have a lot of good people in administration. But with 30 years of relentless propaganda against government being the problem, and people working there being lazy and useless, and the money being elsewhere, the result is a bit inevitable.

Deregulation good - thus keeping government out of our business good, including in areas where government intervention saved the day in the past because of systemic risk.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Dec 26th, 2007 at 06:19:34 AM EST
[ Parent ]
If you fill government up with people who don't believe that government can be good you naturally end up with bad government.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Dec 26th, 2007 at 06:23:04 AM EST
[ Parent ]
It's a problem of politics, not algorithms.

You can't expect a planetary economy that's being run like a giant video game for the benefit of a few thousand players to make any sense at all.

Slightly more technically, a core structural problem is that markets seem to believe that risk in the abstract creates value - if only because that's how salaries and bonusses are slanted.

So there has been constant pressure to increase and disguise risks, with the results we see today. People like Taleb are exceptionally insightful about the small details, but miss the bigger picture, which is that not all risky value is equal (windmills are more valuable than piratical asset stripping), and that some market feedback loops - like downward pressure on wages, which makes foreclosures more likely - have as much of an influence on risk as direct lending practices.

You can't solve these problems by tinkering with lending mechanisms. As long as markets believe that risk = value, there will always be pressure towards increasingly risky transactions and away from the creation of socially useful value.

This is a moral issue - a crisis of values - and has to be fixed at that level. The New Deal and the other examples of post-war consensus made a start in that direction, but were easy to subvert because they never stated the goal explicitly enough for it to sink into popular consciousness.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Wed Dec 26th, 2007 at 07:33:58 AM EST
[ Parent ]
Here is some evidence that regulators are incompetent. Or maybe it is evidence that industry self-regulation doesn't work, I don't know. But in the latter case the regulators are incompetent for allowing industry self-regulation.
Jerome a Paris:
A contingent commitment is still a commitment. How on earth did these disappear?
According to US GAAP (Generally Accepted Accounting Principles),
Footnotes [to financial statements] also contain disclosures relating to contingent losses. Firms are required to accrue a loss (recognize a balance sheet liability) when both of the following conditions are met:
  • It is probable that assets have been impaired or a liability has been incurred.
  • The amount of the loss can be reasonably estimated.
If the loss amount lies within a range, the most likely amount should be accrued. When no amount in the range is a better estimate, the firm may report the minimum amount in the range.
SFAS (Statement of Financial Accounting Standards) 5 defines probable events are those "more likely than not" to occur, suggesting that a probability of more than 50% requires recognition of a loss. However, in practice, firms generally report contingencies as losses only when the probability of loss is significantly higher.
Footnote disclosure of (unrecognized) loss contingencies is required when it is reasonable possible (more than remote but less than probable) that a loss has been incurred or when it is probable that a loss has occurred but the amount cannot be reasonably estimated. The standard provides an extensive discussion of loss contingencies.
In other words, a mess.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Dec 26th, 2007 at 03:42:12 PM EST
[ Parent ]
Well, to some extent, we're always going to be screwed, because the public is never going to swallow paying regulators millions of dollars, unless Halliburton and Blackwater have gotten into the regulation business, in which case the suits will just cover it up and the public will not pay attention.

Put it this way:  Federal employees in America were promised a 20% pay increase to bring them up to level with private-sector workers back during the first Bush's presidency.  To this day, Congress is still punting it, Friedman after Friedman, for fear of public outrage.  I'd guess it'd be about $8-12k per employee per year if it was ever pushed through.  And you think the voters are going to pay financial regulators millions?

Wall Street has a lot more money, anyway, so we're never going to be able to keep up with all of it.  The best we can hope for is beefing up the regulators when crises like this hit.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Tue Dec 25th, 2007 at 06:57:54 PM EST
[ Parent ]
It may drag on efficiency

'Efficiency' should never be allowed to be mentioned without asking: efficiency at what? This is quite important whenever 'efficiency' is put forward as a benefit of the 'free market'. Implicitly, it means efficiency of Capital growth, or growth of corporate profits. But hardly efficiency of worker salary growth or environmental progress. If one is to discuss optimization, it is helpful the mention which parameter is being optimized, and to what end.
by someone (s0me1smail(a)gmail(d)com) on Tue Dec 25th, 2007 at 03:33:26 PM EST
[ Parent ]
On top of that, we have lost, as a society, the understanding that regulation of financial markets to preserve stability is a necessary action. It may drag on efficiency, but the downside is so large that regulation is always needed.

This is really the key point.  It's not about hating on banks and investment houses and wealthy people.  It's about making sure their actions don't inadvertently take the entire economy down when things go wrong.

The regulators are, frankly, useless.  We have the foxes guarding the henhouse.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Tue Dec 25th, 2007 at 06:45:35 PM EST
[ Parent ]

by Pierre on Tue Dec 25th, 2007 at 02:14:04 PM EST
Corrected in one place, thanks.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Tue Dec 25th, 2007 at 02:33:47 PM EST
[ Parent ]
I basicaly always quote toerh people works.. I hava had soem relevant contributions where I did nto copy completely ... theya re my papers.. je jeje

Brilliant diary Mig.

A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Tue Dec 25th, 2007 at 03:04:24 PM EST
Well, one conclusion I drew from this is that I understand more Japanese than financial-ese...

*Lunatic*, n.
One whose delusions are out of fashion.
by DoDo on Tue Dec 25th, 2007 at 05:43:42 PM EST
Anything specific or just the whole thing?

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Tue Dec 25th, 2007 at 05:55:03 PM EST
[ Parent ]
I had to look up or at least think about several terms along the way. Stop-loss, marking etc. But I did get to the end of it :-)

*Lunatic*, n.
One whose delusions are out of fashion.
by DoDo on Tue Dec 25th, 2007 at 06:28:26 PM EST
[ Parent ]
You underestimate the role of deliberate malice.  For those running the scam, it has all been very lucrative.  

The collapse of a Ponzi scheme is really not such a problem, for those who have already cashed out.  

What Ponzi scheme?  Since 1980 we have seen the progressive elimination of restrictions on finanicial creativity specifically designed to keep fraud and ensuing economic collapse from happening.  This was not an accident, but perhaps I am taking too abstract a way of looking at it.  How about a low-level techie's-eye view (from Cryptogon) . . .

First, the background;    

Second, how our low level techie got to be in the belly of this beast;  

Third, by way of example, some outer-world  . . . uh, . . . ramifications;  

And finally, my comment, specifically, that:  I have never heard of an economics designed specifically to model and predict the behavior of crime families, but if you want an economics for the 21st century, that is what it is going to have to do.  

The Fates are kind.

by Gaianne on Tue Dec 25th, 2007 at 09:32:18 PM EST
Never assume malice when you can assume incompetence.

Though when you see things like Goldman Sachs advising the British Government on what to do about Northern Rock, it is definitely a case of foxes guarding the henhouse.

We have met the enemy, and he is us — Pogo

by Carrie (migeru at eurotrib dot com) on Wed Dec 26th, 2007 at 05:20:50 AM EST
[ Parent ]
knew exactly what it was doing, took precautions to disguise its activities and made preparations to cash out of the scam before it exploded.   (This cannot be done by accident, and it certainly wasn't incompetence.)

I know, not malice, just business.  Same thing.  

And your economics does not model it.  

The Fates are kind.

by Gaianne on Wed Dec 26th, 2007 at 07:33:13 AM EST
[ Parent ]
What it all comes down to . . .
by NBBooks on Thu Dec 27th, 2007 at 01:11:27 PM EST

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