Wednesday, November 26, 2008

Don't Blame The Quants

by Steven Shreve, PhD (founder of the computational finance program at Carnegie Mellon)

The investment banks created mortgage-backed securities with payoffs that depend on the performance of hundreds or even thousands of mortgages. Many of these securities received investment-grade ratings, and their returns were significantly greater than investing in a comparably rated bond. The law that higher expected return means higher risk seemed to have been repealed. The practice of "ratings arbitrage," getting a better-than-merited rating and selling securities based on that rating, was born.

It is easy under these circumstances to point an accusing finger at the "quants" on Wall Street, that cadre of mathematics and physics Ph.D.s who crunch numbers in esoteric models. Without the quants, the complicated mortgage-backed securities that fueled the housing bubble and led to the freezing of credit might not have been created. The models used by the quants determine the prices of those securities and steer the traders who make markets in them. Without this guidance, the banks might not have touched them in the first place. To prevent a recurrence of financial crises, some call for a return to a simpler time, before derivative securities and the quants who analyze them--a time when investors bought stocks and bonds and little else.

Such complaints miss the point. When a bridge collapses, no one demands the abolition of civil engineering. One first determines if faulty engineering or shoddy construction caused the collapse. If engineering is to blame, the solution is better--not less--engineering. Furthermore, it would be preposterous to replace the bridge with a slower, less efficient ferry rather than to rebuild the bridge and overcome the obstacle.

Before the collapse, Carnegie Mellon's alumni in the industry were telling me that the level of complexity in the mortgage-backed securities market had exceeded the limitations of their models. The bridge was cantilevered out way too far, and the quants knew it. But in most banks, the quants are not the decision-makers. When they issue warnings that stand in the way of profits, they are quickly brushed aside. Furthermore, in addition to better engineering, the bridge must not be built this time with the shoddy construction material of no-documentation mortgage applications and a network of unscrupulous mortgage originators.

The quants did not create derivative securities. The quants help us understand them, price them, trade them and manage the risk associated with them. The quants know better than anyone how their models can fail. For banks, the only way to avoid a repetition of the current crisis is to measure and control all their risks, including the risk that their models give incorrect results. On the other hand, the surest way to repeat this disaster is to trust the models blindly while taking large-scale advantage of situations where they seem to provide trading strategies that would yield results too good to be true. Because this bridge will be rebuilt, the way out of our present dilemma is not to blame the quants. We must instead hire good ones--and listen to them.

Source: Forbes [Thanks to DL for the link]

Blame the Quants

(Scientific American editorial)

If Hollywood makes a movie about the worst financial crisis since the Great De­­pres­­sion, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Ex­­change Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number-savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

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Existing home prices hit 40-year low

No, not really.

Not at all, actually. But that's how the press keep reporting it. Even the Financial Times, which usually is very good about accuracy.

What they really mean is that the price of previously owned homes in the US fell in October by the biggest amount in 40 years, which although alarming news is completely different.

Borders trading under $1

Shares of Borders Group headed south, losing more than 40% after the bookseller reported massive losses and dwindling sales, said it was no longer contemplating a sale of the company, and learned it would soon be booted out of the S&P MidCap 400. Borders said that its third-quarter loss ballooned to $172.2 million, or $2.85 a share, from a loss of $40 million, or 68 cents a share, in the same period of last year. The loss includes non-cash, non-operating charges totaling $133.2 million in the quarter, consisting primarily of deferred tax and fixed asset impairments.

Sunday, November 23, 2008

Citi is dead too

The federal government was nearing an agreement to rescue Citigroup by helping to remove billions of dollars in toxic assets from its balance sheet. The agreement, which was still under discussion and could fall apart, would mark a new phase in government efforts to stabilize U.S. banks and securities firms. After injecting nearly $300 billion of capital into financial institutions, federal officials now appear to be willing to absorb bad assets, on a targeted basis, from specific institutions. The talks centered on the creation of what is sometimes called a "bad bank" - an outside entity designed to hold some of a financial firm's worst assets. That structure would help Citigroup cleanse itself of billions of dollars in potentially toxic assets. Under the terms being discussed with top Treasury Department and Federal Reserve officials, Citigroup would agree to absorb losses on assets covered by the agreement up to a certain threshold. The U.S. government would then absorb any additional losses. One person said the new entity is expected to hold about $50 billion of assets. That would mean taxpayers could be on the hook if Citigroup's massive portfolios of mortgage, credit cards, commercial real-estate and big corporate loans continue to sour. It was unclear Sunday night whether the government would take an equity stake in Citigroup in return for the support. Also uncertain was whether Citigroup would get a government loan to finance the facility. [...] It wasn't known if Citigroup will have to make changes to its executive ranks, board or elsewhere inside the company in return for government assistance. After weekend discussions, the parties were hoping to unveil an agreement Sunday evening.

Thursday, November 20, 2008

Citi's fate?

As Citigroup's share price sinks, investors are wondering if the US government will have to help the bank. Some ideas thrown out in a recent Fox Business article.

  • More preferred shares - rinse and repeat until the federal government owns all of Citi
  • A loan with ownership stake as was done with AIG - Would wipe out most of the earlier $25 billion investment in preferred shares, plus it would hurt investors in Citigroup's bonds as well as bank bonds in general which would make it harder for some banks to fund themselves
  • Guarantee all of Citigroup's debt and derivative obligations
  • Buy Citigroup's worst assets perhaps at a discount and allow an asset manager such as BlackRock to manage them for taxpayers - isn't that what TARP was supposed to do in the first place?
  • Instituting a new short-selling ban, loosening mark-to-market accounting rules for bank assets, or halting trading in credit default swaps - too brilliant for words
  • FDIC liquidation - This is a little like saving the patient from cancer by shooting him in the head with a bazooka, but may be the best option at this point. Too big too fail, my butt.

Wednesday, November 19, 2008

Can someone please educate the financial media

...to quit saying "inflation is down 1%." That would mean that inflation went from 4% to 3%. What actually happened is that we had deflation, PRICES are down 1%.

Tuesday, November 18, 2008

Yahoo CEO Yang is out!

Good riddance. Moron. Refusing a $45 billion offer because it was "too little." Company is worth less than 1/3 of that now.

Monday, November 17, 2008

Citigroup Laying Off 50,000+ Employees

Over 1/7th of their remaining workforce, above and beyond all previously announced layoffs. So many different thoughts:

1) Last week some Citi bigwigs made a big deal about buying large chunks of Citi stock for their personal accounts, presumably to shore up confidence in the stock. They must have known this layoff was in the works. How is this not insider trading?

2) These 50,000 (52? 53? I keep seeing different numbers in the press) people were doing some sort of work yesterday. Apparently that work does not need to be done tomorrow? Why not? It's not like Citi's revenues have gone down by 1/7th. Did it not need to be done yesterday? Then why were these folks warming a desk? It doesn't make any sense.

3) The bottom line, as I've said before, is that it appears fairly certain that Citi is not going to make it. I guess that will prompt the MOAB (mother of all bailouts).

Saturday, November 15, 2008

Market News

Teasury may have to pump more than the planned $200 billion into Fannie Mae and Freddie Mac to keep the mortgage giants afloat. Deterioration of the housing market and the broader economy have put the corporations into deeper trouble than they were in when Treasury announced their takeovers. (Source: The Washington Post)
Follow-up: Freddie Mac has a net worth of NEGATIVE $13.7 billion; FNMA still has a positive net worth but said it may be negative by year-end.

Delinquency on subprime mortgages set an all-time record in October as unemployment soared and interest rates reset, driving monthly payments higher. The increase is spreading to the entire mortgage market, as well as auto loans and credit cards. (Source: CNBC)

A further $103 billion of synthetic CDOs are vulnerable to catastrophic losses based on defaults involving underlying derivatives. Defaults by Lehman Brothers and other institutions have already touched off $24 billion in synthetic CDO losses. There is about $750 billion of synthetic CDOs outstanding that are tied solely to corporate-debt derivatives. (Source: Financial Times)

Monday, November 10, 2008

Amex becomes bank

American Express is the latest US firm granted approval to become a bank holding company, which allows it access to the Federal Reserve’s discount window as well as the opportunity to apply for Treasury assistance if needed. Citing the “unusual and exigent circumstances” weighing on the financial markets, the Federal Reserve Board waived the standard 30-day waiting period.

Circuit City Files for Bankruptcy

Not much to add to that, other than it's about time.

Friday, November 07, 2008

LTCM II in BIG trouble

No, not Meriwether's hedge fund, although it's still in trouble too. I'm talking about Scholes' hedge fund. When will these guys learn that having a Nobel Prize does NOT exempt you from the basic economic fact that greater returns are ONLY possible with greater risk. Highly leveraged bets are great when the market is up, but they will trash you on the way down.

Platinum Grove Asset Management, the hedge-fund firm co-founded by Nobel laureate Myron Scholes, temporarily stopped investor withdrawals from its biggest fund after it lost 29% in the first half of October. The decline left Platinum Grove Contingent Master fund with a 38% loss this year through October 15. Funds employing a similar approach of exploiting differences in the value of related securities fell 14% last month and 30% this year, according to data compiled by Chicago-based Hedge Fund Research. Scholes, winner of the 1997 Nobel Prize in economics, was a founding partner in Long-Term Capital Management. He started Platinum Grove in 1999 with Chi-fu Huang, Ayman Hindy, Tong-sheng Sun, and Lawrence Ng, who had all worked at LTCM.

Jobs Data

The US labor market has shed 651,000 jobs and driven the unemployment rate to 6.5%, its highest point in more than 14 years. Nonfarm payrolls fell by 240,000 in October, worse than expected. Payrolls losses in September were revised down sharply to 284,000, the largest job loss in seven years. Unemployment surged by 603,000 in October to 10.1 million, the highest level in 25 years. In the past six months, unemployment has leaped by 2.45 million, the largest increase since 1975. So far in 2008, a total of 1.18 million jobs have been lost, according to the survey of work sites. Payrolls have fallen for 10 straight months.

Thursday, November 06, 2008

More Bad News at Blackstone

Shares of Blackstone Group fell sharply (-9.88% as of the time of this post) after the large private equity fund reported heavy third-quarter losses as the value of its holdings were battered by the ongoing financial crisis. The company said its quarterly loss jumped to $340.3 million from $113.2 million during the same three-month period in 2007. Blackstone is now trading at $7.75.

Source: FoxBusiness

Credit Card Backed ABSs are next

Faced with rising consumer credit-card delinquencies, buyers are not interested in bonds backed by credit-card payments. Top-rated card-backed securities maturing in three years traded at a spread of 475 basis points more than Libor during the week ending October 30, compared with 50 basis points higher in January. Sales of credit-card bonds hit zero in October, the first time since 1993.

Source: Bloomberg