Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

Meanwhile, the credit crisis slowly worsens

by Jerome a Paris Wed Feb 13th, 2008 at 04:53:06 AM EST

After years in which banks and investors have lent money on especially easy terms, "You've had the biggest credit bubble -- probably the biggest credit bubble we have ever had," says Jim Reid, credit strategist at Deutsche Bank AG in London. Part of the bubble has already been unwound, he says. The problem is, "nobody quite knows where that ends."

"Subprime was a symptom of the problem," said James F. Keegan, a bond portfolio manager at American Century Investments, a mutual fund company. "The problem was we had a debt or credit bubble."

The bursting of that bubble has led to steep losses across the financial industry.

Today's markets have ended on a positive note, buoyed by Warren Buffett's apparent call of a bottom in the market, through his announcement that he was willing to back municipal bonds. But this sounds more like desperation, clinging at any good news to avoid looking at the precipice.

Because frankly, Buffett is trying to buy really cheap assets that have no reason to see their price go down, because they are high quality. That his offer is not laughed off shows how far we have gone in mistrusting the value of whole chunks of assets - and that before the shit has even really hit the fan!

Mortgage Crisis Spreads Past Subprime Loans (NYT)

The credit crisis is no longer just a subprime mortgage problem.

As home prices fall and banks tighten lending standards, people with good, or prime, credit histories are falling behind on their payments for home loans, auto loans and credit cards at a quickening pace, according to industry data and economists.

The rise in prime delinquencies, while less severe than the one in the subprime market, nonetheless poses a threat to the battered housing market and weakening economy, which some specialists say is in a recession or headed for one.

This is what one calls a vicious circle, where bad news feed one another. And just like the previous cycle was all positive (with inflating asset prices allowing to back more debt, which could be used to bid more for assets, which increased in prices, generating income or profit along the way, after paying back the debt...), this one is all negative: falling asset prices make it impossible to pay back debt, defaults make banks tighten credit, causing buyers to lose purchasing capacity and jobs to be lost, further reducing their ability to borrow and buy assets or pay off previous debt; defaults increase and trigger forced sales, thus further depressing sale prices.

We're just at the beginning of that cycle, right now.

We had the biggest bubble ever; thus the bust that follows will be ... exactly what you'd expect after 30 years of an ideology that had as its main goal to eliminate all the policies set up over the previous half-century to ensure that economic cycles were not as violent as they were until the 1930s...

New Hitches In Markets May Widen Credit Woes (WSJ)

A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.

As could be expected (if you're not a cheerleader for the 'ownership society'), this is spreading to other asset classes, with the same results across the board - just on a much larger scale.

The Rise of the Mortgage 'Walkers'

Fitch Ratings, while telling investors last Friday to expect additional "widespread and significant downgrades" on $139 billion worth of subprime loans, has cited a new factor in their "worsening performance."

"The apparent willingness of borrowers to 'walk away' from mortgage debt," the analysts noted, "has contributed to extraordinary high levels of early default" on loans issued during the 18 months before the mortgage bubble burst. It expects losses to reach 21% of initial loan balances for subprime mortgages issued in 2006 and 26% for those issued in early 2007.

26 f-ing percent. If there was ever a need for proof that was happened in the past couple of years was insane, that number should cover it. Banks lost a quarter of their loans in less than a year! - Or created loans that lost a quarter of their value in the year after they were dumped onto naive/greedy/stupid/incompetent investors. Banks thought this was a fine business for them, but forgot that they were also lending to these investors...

But it's all coming back now. And banks now that they did insane stuff (hey, people were actually bragging about NINJA loans until not so long ago - the "No income, No Job or Assets" borrowers) and they, rightly, from their own internal experience, mistrust one another.

So the financial system is slowly choking on the toxic waste. Just like pollution a few decades ago, when the lesson of "the solution to pollution is dilution" was that everything turned toxic, we similarly see that the garbage assets spread around the financial system are eroding trust in every single kind of asset.

Thus the irrational response today to Buffett offering to back up securities that really don't need it. Even muni bonds are suspect today. And it's going to take a lot of coming clean to change that. Until then, credit is scarce, and business is no longer oiled up.


In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Tue Feb 12th, 2008 at 06:42:00 PM EST
Buffett only wants the muni part of the insurer's portfolios, this is really not part of the problem, it simply gives them some cash to ride out the storm a little longer. As far as the economics go, this would be a net positive because there's really no reason for institutions to dump high grade muni stuff simply because the underwriter got downgraded. Buffett's intermediation here stops the muni downgrades which would cause that to happen, which is a good thing. And, in Buffett's eyes, BH makes money and that's a good thing too.

Just do long as the 10-year doesn't decouple from USD deonominate mortgage rates and credit is reasonably ok to get (if a bit tighter) until I sell my damn house...

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Tue Feb 12th, 2008 at 06:48:23 PM EST
European Tribune - Meanwhile, the credit crisis slowly worsens
As home prices fall and banks tighten lending standards, people with good, or prime, credit histories are falling behind on their payments for home loans, auto loans and credit cards at a quickening pace, according to industry data and economists.
I can't see how falling house prices and tighter lending standards can make people fall behind on their payments, unless "tighten lending standards" means "raise interest rates" on existing variable-rate obligations, which is not exactly the same thing.

Lending standards are about new lending, not existing lending.

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

by Carrie (migeru at eurotrib dot com) on Tue Feb 12th, 2008 at 06:58:57 PM EST
... cars, white goods, business investment in productive assets ... which means a lower equilibrium national income, which means less income with which to meet ongoing obligations.

The old ...


... loop

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Feb 13th, 2008 at 02:32:05 AM EST
[ Parent ]
on Helocs (home equity line of credit) to fund your living standards, and suddenly that source dries up (and requires to be paid back), then consumption will take a dive.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Feb 13th, 2008 at 03:42:05 AM EST
[ Parent ]
Yes, but that doesn't mean you have to miss mortgage payments. You just have to cut back on discretionary spending.

Or are we saying that "prime borrowers" are maxed out and already had no discretionary spending, even using home equity withdrawals for essentials?

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

by Carrie (migeru at eurotrib dot com) on Wed Feb 13th, 2008 at 04:22:45 AM EST
[ Parent ]

Or are we saying that "prime borrowers" are maxed out and already had no discretionary spending, even using home equity withdrawals for essentials?


Go look at this blog, it's enlightening

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

by Jerome a Paris (etg@eurotrib.com) on Wed Feb 13th, 2008 at 05:03:25 AM EST
[ Parent ]
There's another explanation which also feeds this.

Many borrowers with good credit are nonetheless finding it impossible to refinance (when you are underwater loan to val, no matter your credit rating, you're not going to be able to refi). And they are stuck in their house for the very same reason loan to val is > 100%, ie you can't sell it for what you owe (ah, debtors prison, American-style. A gilded cage, perhapsm but a cage nonetheless...)

At the same time, rental rates haven't gone up anywhere near like real estate has, and that reasonably good credit will get them into quality rental housing. And, I think we can agree that when loan to val is greater than 100%, you don't own your increasingly less valuable house, the bank does and you are simply renting from them, at a rate both higher than you can afford and higher than the market rate for a similar property if you were to go out on the rental market.

It's simply a good business decision to walk away from the house, move everything and go find a good deal on the rental market.

In fact, this is the dynamic which scares the markets far more than the so-called "subprime" mess. It's not a subprime mess, it's an attitude shift towards default on the part of the vast middle class with an average FICO of "very good". An attitude shift which is really hard to model but nonetheless is very real. Thin layers of false consciousness stripped away, gradually.

It was never primarily a subprime issue. No one cares about the poor people and their crapppy credit, they never did and now's not the time to start. Small part of the market. Rule number two in the game of US politics: when someone is talking about an issue concerning the poor, there's something more to it, look between the lines and behind the rhetoric. It's not about the poor. It's either about the middle class, or about the inability of the wealthy to soak the poor. It's never about the poor.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 10:50:54 AM EST
[ Parent ]
Great comment.

you are the media you consume.

by MillMan (millguy at gmail) on Wed Feb 13th, 2008 at 12:58:40 PM EST
[ Parent ]

Coming back to Minneapolis/St Paul anytime soon? I have a nice house in a good, centrally located urban neighborhood for sale!!!

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 01:25:13 PM EST
[ Parent ]
I won't be moving back anytime soon, no. What neighborhood is it in though? I wanted to buy a condo in uptown in 2000 when I got out of school, and in retrospect it was possible, but even then I wasn't too keen on how rapidly prices had risen.

you are the media you consume.

by MillMan (millguy at gmail) on Wed Feb 13th, 2008 at 02:31:16 PM EST
[ Parent ]
It's in Mac/Groveland about midway between St Thomas and St Catherine's Universities, a couple of blocks off the river road.

We bought here before the big neighborhood turnaround, had been renters before right across the street. I bought from a friend who had to move for his job, it was really a handshake deal.

For some reason, the neighborhood just took off, a lot of older neighbors who've been here forever are struggling with how much their property tax bill has gone up in the past five years and are selling. My own county appraisal is now for almost three times what I paid for the thing. Not sure what that's worth, guess I'll have to wait to find out, but even if it's only in the ballpark, I think I'm going to buy some goat farm in the west var and lay low for a while....

Ironically, given neither my wife nor I are religious by any stretch of the imagination, it's in a Catholic parish (a very conservative one) which guarantees admission to a Catholic K-8 school, which itself guarantees admission to Cretin/Derham Hall in Saint Paul which somehow has become quite exclusive. So Catholics moving into the Twin Cities have been pushing up prices. I chalk this up to upper-middle class nostalgia, and hope it lasts a little more. Obviously I have no use for these catholic schools, but all the neighbor kids now go there.

Moral of the story, if you're Catholic and moving to the Twin Cities, I'm probably where you want to live.

OTOH, Uptown is nice, but then, you have to live in Minneapolis to be there. And for me, that's too much to ask.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 02:52:16 PM EST
[ Parent ]
Having grown up in the area, and noticing the differences between minny and st. paul, I never though they were particularly significant beyond a few pet peeves (plowing policy for example) that would never swing my decision on where to live.

That's a great neighborhood. My friends and I almost rented a house in that area for our last year of college. We ended up with a (cheaper) townhouse a few blocks from the cathedral down Selby Ave.

you are the media you consume.

by MillMan (millguy at gmail) on Wed Feb 13th, 2008 at 07:21:46 PM EST
[ Parent ]
Credit Suisse: $1.2 Billion in Write-Downs Never Looked So Good
Credit Suisse, Switzerland's second largest bank, said Tuesday that fourth quarter profit swooned 72 percent amid roughly $1.2 billion in write-downs spanning leveraged loans and mortgage debt. Fourth quarter earnings fell to $1.10/share (1.21 Swiss francs), compared to earnings of $2.08/share (2.29 francs) in the year-ago period.

The results, however, looked pretty positive in comparison to the losses posted late last month by Switzerland's largest bank, UBS AG, which took write-offs amounting to $14 billion for the same quarter.

by das monde on Tue Feb 12th, 2008 at 10:11:51 PM EST

Leveraged loans

The markets have been so transfixed by the horror show unfolding through subprime and collateralised debt obligations, they have not been focused on the banks' other crisis: leveraged loans. Optimists thought that once the loan pipeline slipped below $150bn, debt investors would be cheered by hopes of a logjam clearing and would pile in again. Wrong.

It has been a terrible period for leveraged loan prices - worse than for high-yield bonds despite the unsecured nature of the latter. Some of the reasons may be "technical", but somehow, that tag no longer has the comforting ring of a short-term blip.


S&P LCD estimate that default rates would have to rise to roughly 10 per cent to wipe out the excess risk premium priced into current US loans. That is a lot given the 2000 high of 8.2 per cent. But with corporate profits looking toppier than then, and gearing higher, loans may not recover soon. Banks hoping for a respite from their nightmare could face more writedowns yet.

Given how mild the 2000/1 recession was, and how much debt has been piled on since then, it would not be surprising that default rates go higher...

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

by Jerome a Paris (etg@eurotrib.com) on Wed Feb 13th, 2008 at 05:06:42 AM EST
Well, that means the investors lose a lot of money and people who never had a home will soon be able to buy a house for cheap. At some places houses were already sold for 1$.
I guess that is the American way of redistribute wealth and they got it even partially financed by other countries.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers
by Martin (weiser.mensch(at)googlemail.com) on Wed Feb 13th, 2008 at 09:17:06 AM EST
Is there any reasonable explanation for houses sold at $1 dollar, even in this crisis?
by GreatZamfir on Wed Feb 13th, 2008 at 11:38:17 AM EST
[ Parent ]
I don't find the link any more.
But it may well make sense in some special cases. What should a company do, if they do not believe they can sell the house in the next years. Not selling it costs the company money, e.g. property taxes, for selling it in some years they have to pay the upkeep and secure it.
In a region with high unemployment, where everybody wants to leave it isn't too absurd.
In other areas even new build houses are taken down, for preventing the whole quarter to become shabby.

This is not meant representative, but only anecdotal.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers

by Martin (weiser.mensch(at)googlemail.com) on Wed Feb 13th, 2008 at 12:21:05 PM EST
[ Parent ]
This is a good example of how foreclosed homes are managed when they are not occupied. Look at the bottom where they are looking for contractors to maintain the homes. This of course costs money. (Snow removal in Northern Michigan is pretty serious business btw, I spent the majority of my childhood there and i can tell it can easily bury a house. Not cheap.)

Here's a list of cities in Michigan where you can buy a house for a dollar. Select Detroit, and knock yourself out.

I wouldn't recommend buying one, though. A dollar might be too expensive.

Why might a home only cost a dollar? Well, if you're unsure of the viability of future basic municipal services like water, and there is no safe groundwater to tap anymore what is the value of the land for residential purposes? The American West is littered with ghost towns where there is no groundwater...

(And this is without even thinking about more intermediate concerns like schools or police and fire protection, also severe problems in American cities where the recession of 2000/2001 still continues, as it does in Detroit.)

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 12:48:53 PM EST
[ Parent ]
There is a village near the Lure mountain which moved lower in valley in the 1930's after the war had decimated the population. The local people didn't want to sell the land, (that wass not done in these parts at the time) so they tore down all the roofs in order to save on taxes. The houses would probably be still up if they hadn't done so...

Un roi sans divertissement est un homme plein de misères
by linca (antonin POINT lucas AROBASE gmail.com) on Wed Feb 13th, 2008 at 01:07:28 PM EST
[ Parent ]
neglect of cities and open warfare on workers since the late 1970's.

Here's a tour of Detroit:

Want to know why houses only cost a dollar in many parts of Detroit? Watch the video.

This is what anglo disease looks like when it enters terminal stage.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 01:23:21 PM EST
[ Parent ]
Ah. Point taken. You guys still have more land than people...
by GreatZamfir on Wed Feb 13th, 2008 at 01:53:43 PM EST
[ Parent ]
The first few scenes of the video look just like the place where I was born.  The differences were no crime, no rap/drama, and no one telling everyone how really poor they actually were.  Anglo disease has been around a long long time.

I can swear there ain't no heaven but I pray there ain't no hell. _ Blood Sweat & Tears
by Gringo (stargazing camel at aoldotcom) on Wed Feb 13th, 2008 at 03:12:24 PM EST
[ Parent ]

In developed countries, however, such scenes are quite the thing of the past. Even the worst parts are nothing like this.

With the notable exceptions of the English-speaking parts of it.

Thus the term Anglo-disease. Imho.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Wed Feb 13th, 2008 at 03:28:19 PM EST
[ Parent ]

I can swear there ain't no heaven but I pray there ain't no hell. _ Blood Sweat & Tears
by Gringo (stargazing camel at aoldotcom) on Wed Feb 13th, 2008 at 03:41:12 PM EST
[ Parent ]
The US may be a wealthy country but it does have 3rd-world levels of inequality. It's quite shocking.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Feb 13th, 2008 at 05:26:09 PM EST
[ Parent ]
Not the English speaking parts in general. I doubt that Canada, Australia or NZ have anything like Detroit and, while there are some blighted bits of Britain (Liverpool for example), there's nothing as grotesque as Detroit or Baltimore here.

This sort of abandonment of urban cores is an exclusively Stateside phenomenon I think.


-- #include witty_sig.h

by silburnl on Thu Feb 14th, 2008 at 07:56:32 AM EST
[ Parent ]
The desolation that is modern Detroit was one of the most shocking things I've ever seen.  I lived in Ann Arbor for several years, an isolated enclave of wealth supported by the university and the various industries it draws, but I made it out to Detroit on several occasions, and it is just shocking.

Seriously, neither China nor Thailand looked anywhere close to as bad.

by Zwackus on Wed Feb 13th, 2008 at 05:33:59 PM EST
[ Parent ]
It's a modern ruin. Various parts of the old industrial east look similar. Detroit is particularly bad as it was not successful in bringing in any modern industry (semiconductors, biotech, etc) when heavy industry started to die off. Detroit and Baltimore in particular no longer have a reason to exist, frankly.

Most of the wealth in the US is concentrating in a handful of larger cities. The wealth on display here in San Francisco and Los Angeles was very surprising to me when I first saw it, and I grew up in a city (Minneapolis) that went straight from an agricultural center to a white collar town and as such has maintained its health and prosperity for many decades.

you are the media you consume.

by MillMan (millguy at gmail) on Wed Feb 13th, 2008 at 07:39:51 PM EST
[ Parent ]

Scrap heap for financial models

From what appeared to be a modest glitch in the mortgage market, the damage to the world of financial modeling is ever-extending, and has now come to be surprisingly widespread, involving huge swathes of modern financial theory:

Subprime mortgages turned out to be correlated with each other, so that securities apparently rated AAA were in reality dangerously concentrated in a particular sector of the market that could and did collapse.
That also blew out the theory surrounding monoline insurance, that a well capitalized insurance vehicle could insure debt representing a large multiple of its capital base, without its bond rating or profitability coming into question.
Then there was asset backed commercial paper, under which commercial paper of short term maturity was issued by a shell company against the backing of financial assets of a long term maturity, and through this means removed from a bank's balance sheet - it turned out that in a financial crisis the funding for these vehicles dried up.
Finally, credit default swaps are showing signs of strain, and may have turned out to have concentrated risk in unsuitable hands rather than spreading it as had been promised for them. In particular the counterparty problem in the CDS market becomes acute when defaults rise to a substantial level and declared debt ratings turn out to be unreliable.
As well as the instruments themselves, their risk management turns out to have been flawed. Value at Risk, the paradigm of risk management systems, recognized by the Basel II system of bank regulation and incorporated into it, has proved to be almost entirely useless - like rain-proofing that works well in a light shower, but falls apart completely in a heavy storm.


Looked at in this way, the subprime mortgage is simply a scam, and the market a giant Ponzi scheme that could survive only as long as more people entered into subprime mortgage contracts, keeping house prices high and mortgage brokers active. Once interest rates began to rise, the demise of the market became inevitable, and it also became clear that the market was not simply entering a downturn but would disappear altogether. In 10 years' time, only Fannie Mae and Freddie Mac will be making subprime mortgages, and they will exist only because they have been bailed out by the taxpayer through the generosity of their friends in Congress, possibly several times.


Needless to say, the opportunities for chicanery and malfeasance in such a business are legion, and made more manifold by bonus systems which reward bank officers and brokers for the business done in a particular year, without regard to the losses that business may produce in later years. Risk assessment in this business is a joke; the VAR models that fail in assessing the risk of a broad based portfolio fail even more spectacularly in assessing a narrow based portfolio of credit risks, in which correlations between different assets are not properly explored and for which the experience is at most a few years. In spite of their convenience to loan originating banks, it is thus likely that the market for credit default swaps will in future be very limited indeed.

When all these products are taken into account, it becomes obvious that the financial system of the future will look very different from that of the recent past. Shareholders will pay much more attention to the conflicts of interest between traders', brokers' and bank officers' bonus schemes and their own returns. Opportunities to make large amounts of money by pure salesmanship, without regard as to the quality of the underlying assets, will disappear. Risk management will become much more conservative, and will treat exotic and little-understood assets with the utmost suspicion; that in itself will greatly limit the market for profitable "financial engineering" creativity.

The percentage of finance's value added in the US and world economy will shrink once again, close to the levels of the 1970s and 1980s, around half those of today, and remuneration for bankers, traders and salesmen will be correspondingly more restricted. Since new career opportunities on "Wall Street" will be few and far between, there will be an aging in place of existing staff, which will itself increase those institutions' conservatism, probably replacing it with gerontocracy.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Feb 13th, 2008 at 02:52:25 PM EST
I'm tempted to supplement my Lazy Quote Diary: This Should Never Have Happened with a couple of quotations on "Value at Risk" from Taleb's Dynamic Hedging (1997). His basic thrust is that VaR is a rule of thumb used by traders to quickly estimate the proper size of a hedge for a single instrument, and that it should not be taken as a measure of risk for whole portfolios, which is precisely what has happened (Basel II has made VaR the cornerstone of risk management in banking). In fact, there are good mathematical reasons not to use VaR for portfolios.
The Value-at-Risk

Below is a presentation of a risk management method that, like portfolio insurance, can only work if a small number of people are using it. It is a paradox ... that states that it can only work (and succeed) if it is unsuccessful

"Porfolio insurance" was a financial product which caused a liquidity hole in 1987. Essentially, the way this insurance was constructed it caused larger positions to be taken in stocks than would otherwise have been, when  people tried to get out of the positions as prices started going the wrong way it snowballed out of control.
The VaR can present some useful short-term hedging tools for traders... However, it led to seriously disputed applications by risk management firms that led (perhaps innocently) their customers to believe they possessed tools to summarize the overall market risks for a position, a unit, a department, or an entire firm, in one simplified numerical exposure, without standard error.
So VaR was already "seriously disputed" as a risk measure before 1997.
The idea of disclosing the overall exposure as one simple quantity appeals to most corporate board members and regulators, many of whom are uninitiated into the nuances and complexities of financial market risks. They can easily be impressed by the "scientific" tools used.

... Critics of VaR (including the author) argue that simplification could result in such distortions as to nullify the value of the measurement. Furthermore, it can lead to charlatanism. Lulling an innocent investor or business manager into a false sense of securitycould be a serious breach of faith. ...

In brief, it cannot be used to say "Within 99.7% (or within 90% or something of the sort), you are not expected to lose in the next month more than 1 million dollars". The innocent treasurer or company official would believe himself to be listening to a scientific statistic similar to statistics on airplane crashes. It could, however, be used to say: "You are expected to lose no more than 100,000 dollars within the next two hours with a 66% accuracy, provided that you do not try to liquidate your position and the other similar firms do not have the same portfolio."

After discussing various shortcomings of VaR when large deviations are involved, he concludes
The VaR provides an admirable short-term hedging tool but is by no means a risk management device
Under "dangers of generalized use" he discusses how
the fact that such a system became a benchmark would cause a snowball effect.

... In a schematic world of a small numner of homogeneous leveraged players, everyone would end up with close to the same portfolio constitution and weights owing to the diversification scheme (optimal portfolio) ... They would all ivest more lulled with the knowledge of being comfortably diversified asthey were properly taught by the risk management consultant.


Assume that the price of A went down. Assume that the volatility of A increased. To maintain a constant VaR ... the operator would have to sell some stocks of B and C. The quantities, though small, would be enough to push prices lower and make operators race each other to the state of near-bankruptcy. ... An interesting parameter in hedges is that they only work when they are not identified as hedges by the multitude. If most other similar institutions needed to act in a similar manner in similar circumstances, there would be a dynamical system traders would need to account for.

And then the punchline
The market will follow the path that will thwart the higher number of possible hedgers.

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Feb 13th, 2008 at 05:23:18 PM EST
[ Parent ]
So what you're essentially saying (or quoting Taleb as saying) is that the stock market can only be modelled as long as most players on it - as measured by their dollars, not their noses - are ignorant of the models used.

Somehow, this strikes me as a fact that should not be surprising. After all, if the market works, and everyone has access to the same information, future value should already be incorporated into share price - so in order to do better than betting on horses, you need to be better at predicting the future value than the other players.

So, are these people betting on horses, or do they think everyone else are suckers, or have I missed something in my analysis?

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Feb 13th, 2008 at 05:54:04 PM EST
[ Parent ]
<physics>Think of it as a condensed-matter phase transition between a weakly-coupled regime and a strongly-coupled regime (or one with long-range correlations - probably strongly coupled via duality). Linear (mean-field) techniques to describe the environment of a single component of the sytem are appropriate when the back-reaction of a single element on the hole system is negligible. But in the strongly-coupled/long-range-correlated regime different kinds of techniques are needed even to describe the local environment, because of backreaction.</physics>

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Feb 13th, 2008 at 06:51:33 PM EST
[ Parent ]
I'm sure that description would be very helpful if I'd had condensed-matter physics. Unfortunately, I've dabbled in x-rays and quantum computing more than condensed matter.

What I hear you saying is that they assume that stuff happening on the other side of the market is only weakly correlated with the stuff that happens to their portfolio. And that assumption turned out to be Very Wrong.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Feb 14th, 2008 at 09:07:11 AM EST
[ Parent ]
Checking that there's a small door out of a theatre that allows you to get out at any time won't help you much when fire has started and everybody is trying to get out through that single small door...

Un roi sans divertissement est un homme plein de misères
by linca (antonin POINT lucas AROBASE gmail.com) on Thu Feb 14th, 2008 at 10:39:44 AM EST
[ Parent ]
You watch the show from that doorway so you can make them all pay to get out.

Signed: Bill Gates

by afew (afew(a in a circle)eurotrib_dot_com) on Thu Feb 14th, 2008 at 10:53:39 AM EST
[ Parent ]
After one year of working closely with a large var system and the underlying portfolio, I conclude that it is a rather good risk management tool.

That is, when it is properly implemented (full MC) and with a sensible model. We only got a few backtesting exceptions above the norm (when major US banks had dozens since the beginning of the crisis).

VaR (and CVaR ideally) does tell you that you are at risk, and how much risk, it does not tell you how to cut that risk without materializing the loss if your market isn't deep enough - VaR analyzes market risk, not credit risk or liquidity risk. Confusions on the aim of the indicator are due to over-hyping and marketing by gurus and software vendors.

And lastly, VaR applies to trading portfolios, not to investment portfolios. And all the significant losses in this crisis happened in banking portfolios, except for the Kerviel case. VaR isn't even computed on banking portfolios (buy and hold, whether direct or indirect through SIV, of crappy assets like CDO's and RMBS, which are meant to take direct exposure and are not hedged because they are not supposed to default, hedge not being available on the required notionals anyway, or if "available", it's bogus, see monolines).


by Pierre on Thu Feb 14th, 2008 at 01:19:54 PM EST
[ Parent ]
I understand what you're saying and that's the way it's supposed to work in theory, but then how do you explain all these 50-year events and 11- or 23-sigma moves, and so on?

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Thu Feb 21st, 2008 at 04:25:47 AM EST
[ Parent ]
I don't explain these. The market is not log-normal. It may even follow a diffusion law where no moment exist and sigma is moot or infinite. That does not undermine the VaR concept. It does mean that the common MC VaR computed with a set of normally distributed shocks is an optimistic approximation of the market risk. It does not preclude the use of MC VaR with a set of Levy-distributed or fractal shocks (although practical calibration issues have so far precluded real-life adoption, banks R&D are still working on it, guys next door to me).

It does degrade the accuracy of VaR through prices and/or greeks used in VaR and derived by means of log-normal resolution of stochastic equations, or MC diffusions. For equities, volatility smiles etc are some sort of built-in-pricer fixes, though ugly. Younger derivatives markets (CDS anyone ?) may have a bigger accuracy problem. Although nothing impossible to overcome.

My feeling is, these present short-comings are (quite) well understood in (some) (french) risk management. The US do seem to have a huge problem with it. Presently writing an article on this, but it will be company-copyrighted material ("you address the shortcomings faster if you buy my consulting", no shit).


by Pierre on Thu Feb 21st, 2008 at 11:51:51 AM EST
[ Parent ]

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