Pessimism of the Intellect, Optimism of the Will     Archive   Favorite posts   Twitter: @steve_hsu

Thursday, September 29, 2005

Hedgehogs, foxes and Feynman

Freeman Dyson reviews the recently published collection of Feynman's letters, collected by his daughter Michelle. The essay is long, but worth reading in full. I feel Dyson underrates Feynman a bit, and his classification of thinkers as hedgehogs (Einstein) or foxes (Feynman) is too black and white. Our scientific activities are shaped by the questions of our day. Einstein had the opportunity to solve foundational puzzles (the problems and data were at hand) -- did Feynman? (Also true of Dirac, who Dyson rates as a "greater genius" than Feynman.) Certainly, Feynman had broad interests, but it is also clear that he kept returning to deeper issues like turbulence (strangely not classified as a deep issue at the time), interpretation of quantum mechanics (EPR, probability, etc.) and quantum gravity. I might add that 100 years from now his early interest in quantum computing could be remembered as particularly significant. Although he didn't develop any key algorithms (or even, if I recall correctly, explore the notion of universal quantum computers built from simple gates), he was the first to note the exponential power of quantum computers and the qualitative difference between quantum and classical computing.

Why should we care about Feynman? What was so special about him? Why did he become a public icon, standing with Albert Einstein and Stephen Hawking as the Holy Trinity of twentieth-century physics? The public has demonstrated remarkably good taste in choosing its icons. All three of them are genuinely great scientists, with flashes of true genius as well as solid accomplishments to their credit. But to become an icon, it is not enough to be a great scientist. There are many other scientists, not so great as Einstein but greater than Hawking and Feynman, who did not become icons. Paul Dirac is a good example of a scientist greater than Feynman. Feynman always said, whenever the opportunity arose, that the "space-time approach" that led him to his new way of doing particle physics was directly borrowed from a paper of Dirac's.[6] That was true. Dirac had the original idea and Feynman made it into a useful practical tool. Dirac was the greater genius. But Dirac did not become an icon because he had no wish to be an icon and no talent for entertaining the public.

Scientists who become icons must not only be geniuses but also performers, playing to the crowd and enjoying public acclaim. Einstein and Feynman both grumbled about the newspaper and radio reporters who invaded their privacy, but both gave the reporters what the public wanted, sharp and witty remarks that would make good headlines. Hawking in his unique way also enjoys the public adulation that his triumph over physical obstacles has earned for him. I will never forget the joyful morning in Tokyo when Hawking went on a tour of the streets in his wheelchair and the Japanese crowds streamed after him, stretching out their hands to touch his chair. Einstein, Hawking, and Feynman shared an ability to break through the barriers that separated them from ordinary people. The public responded to them because they were regular guys, jokers as well as geniuses.

The third quality that is needed for a scientist to become a public icon is wisdom. Besides being a famous joker and a famous genius, Feynman was also a wise human being whose answers to serious questions made sense. To me and to hundreds of other students who came to him for advice, he spoke truth. Like Einstein and Hawking, he had come through times of great suffering, nursing Arline through her illness and watching her die, and emerged stronger. Behind his enormous zest and enjoyment of life was an awareness of tragedy, a knowledge that our time on earth is short and precarious. The public made him into an icon because he was not only a great scientist and a great clown but also a great human being and a guide in time of trouble. Other Feynman books have portrayed him as a scientific wizard and as a storyteller. This collection of letters shows us for the first time the son caring for his father and mother, the father caring for his wife and children, the teacher caring for his students, the writer replying to people throughout the world who wrote to him about their problems and received his full and undivided attention.

Tuesday, September 27, 2005

Globalization and high fashion

Predictably, even the high fashion industry has started producing in low-cost countries.

I notice in Eugene that the $3k Natuzzi Italian leather sofa set is competing against a $1.2k Italian leather, but made in China, sofa set made by some company called Shanghai Living. Both have nice modern lines and would look at home in Dwell magazine. Last time I was in Shanghai a few years ago I was amazed at the huge furniture showrooms there, packed with buyers representing furniture distributors from all over the world. The Shanghai Living stuff was brought to Eugene by an enterprising store owner who liked what he saw and "bought an entire container".

According to the WSJ article (excerpt below), hourly fashion manufacturing wages are about $20 in Italy and France, and under a dollar in China. The guy who says it will take 15 years for full delocalization of production is dreaming. There are already armies of good designers (not just armies of workers) in Asia who are ready to take business from these guys.

See here for how design and manufacturing are done today.

WSJ: The move out of France and Italy is only just beginning. Fashion executives say some production won't ever move to low-cost countries because Italian craftsmanship is still unparalleled. Sophisticated items made in low volumes -- such as hand-woven leather handbags -- may always be "Made in Italy," for example. For the rest, the industry thinks it's only a matter of time.

"It will take another 15 years until luxury brands' main lines are completely delocalized, but it will happen," said Tonino Perna, chief executive of IT Holding SpA, which manufactures relatively affordable collections for labels such as Versace and Dolce & Gabbana. IT Holding makes about 30% of its clothes and accessories abroad. Executives say privately that more fashion brands are producing outside of Europe than the number who care to admit it.

This shift underscores how the developing world's manufacturing talent is improving to the point where even quintessential luxury products are starting to move offshore. It's also a sign of the extent to which high-end products are under pressure from low-cost alternatives.

Companies from sneaker makers to automotive giants have long outsourced to China and Mexico, but luxury-goods brands have always touted Italian and French production as essential to the luxury experience. The "Made in Italy" label, with its centuries-old history of artisanship, has justified exorbitant prices. If their clothes are stitched at low-cost factories, how will consumers react? Will luxury brands eventually have to bow to pressure and lower prices at the expense of their margins?

Many Italian fashion houses fear a backlash if they're seen hastening the decline of Italy's textile industry. For more than a century, that sector helped power the Italian economy, the fourth-largest in Europe. As companies outsourced production, sales of Italian textiles have fallen more than 10% in the past three years, with 24,000 textile manufacturing jobs lost last year, according to Italy's textile association. How to stop the trend, which is contributing to Italy's current economic malaise, is a hotly debated political issue.

"Our 'Made in Italy' has to be defended with force," Claudio Scajola, Italian Minister for Productive Activities, said at the Milan fashion shows, which started this week.

Monday, September 26, 2005

No direction home

"When I got back from India I went to a party thrown by a poet friend in Bolinas. He put on an album by this new folk singer Bob Dylan. I think we heard Hard Rain's Gonna Fall -- and I wept. I wept because I felt the torch had been passed to a new generation."

-- Allen Ginsberg

Interviewed in No Direction Home, Martin Scorsese's documentary on Bob Dylan. Catch it on PBS!

Saturday, September 24, 2005

Philip K. Dick

Are these the thoughts of a pulp SF writer, or a serious and underappreciated thinker?

"I am a fictionalizing philosopher, not a novelist; my novel & story-writing ability is employed as a means to formulate my perception. The core of my writing is not art but truth. Thus what I tell is the truth, yet I can do nothing to alleviate it, either by deed or explanation. Yet this seems somehow to help a certain kind of sensitive troubled person, for whom I speak. I think I understand the common ingredient in those whom my writing helps: they cannot or will not blunt their own intimations about the irrational, mysterious nature of reality, &, for them, my corpus is one long ratiocination regarding this inexplicable reality, an integration & presentation, analysis & response & personal history."

Tannhauser gate

Philip K. Dick was a creative genius -- full of tremendous and deep ideas. Do Androids Dream of Electric Sheep (which became the movie Blade Runner) is a meditation on identity, free will and artificial intelligence. (The main character can't be sure whether he himself is android or human, and, ultimately, whether there is any difference. Director Ridley Scott was true to this idea, making it clear that Deckard (Harrison Ford) is, without knowing it, indeed a replicant!) The Man in the High Castle is one of the best alternate history stories I've read--it takes place in an America which has been partitioned in half at the Rockies by the victorious Japanese and Germans. Some of the characters are dimly aware that things might have been otherwise... Dick's life was almost as interesting as his fiction. A serious intellectual, he dropped out of Berkeley, struggling financially and with psychological problems his entire life. He did not live to enjoy his fame.

Dick was an unappreciated genius of his time.

From the final soliloquy of the android Baty (Rutger Hauer), after he spares Deckard's life:

I've seen things you people wouldn't believe. Attack ships on fire off the shoulder of Orion. I've watched C beams glitter in the dark near the Tannhauser gate. All those moments will be lost in time like tears in rain.

That quote popped into my head a few years ago while I was at dinner with some other theorists at a conference in Seoul. We were discussing my recent return from running a startup in silicon valley. Someone leaned over and asked, somewhat dubiously (suggesting that anything but theoretical physics was a waste of time), "But would you do it again?"

Wednesday, September 21, 2005

Exporting mortgage risk

Oh goody, foreigners are stepping up to take on the default risk from our housing bubble! Better them than us when the market pops :-) I'm glad Fannie and Freddie have been reigned in -- too bad Franklin Raines seems to have gotten off scott free, thanks to friends in high places.

WSJ: When the American housing boom winds down, some of the first howls of pain are likely to be heard in Europe and Asia.

That is because investment banks have been moving more of the risk of defaults on home mortgages to foreign investors, leaving less with U.S. lenders and investors.

This change comes amid concern among U.S. bank regulators about frothy house prices and about lenders' heavy promotion of loans that allow borrowers to afford pricier homes by delaying repayments of principal. The offshoring of such risk also comes as Fannie Mae and Freddie Mac -- formerly the main holders of credit risk in the U.S. mortgage market -- are playing a smaller role in that area.

Lenders wrap home loans into securities known as mortgage bonds, and foreign investors are gobbling up some of the riskiest ones, says Daniel Ivascyn, a portfolio manager at Pacific Investment Management Co., or Pimco, even as "many sophisticated investors at home" shy away from the riskier types of these bonds.

The vehicle for this shift of risk is the fast-expanding market for collateralized debt obligations, or CDOs, pools of debt instruments that are a rich source of fees for investment banks and money managers. CDOs are investment vehicles created by investment banks and others that sell equity and debt to investors. The proceeds are used to buy an array of bonds and other fixed-income assets. More and more CDOs are being created to buy U.S. mortgage-backed securities and other types of asset-backed securities.

Issuance of this type of CDO in this year's first seven months totaled about $35 billion, compared with $49.7 billion for all of 2004 and $23.1 billion in 2003, according to Bear, Stearns & Co.

Gyan Sinha, a senior managing director at Bear Stearns, says CDOs are an easy way for foreign insurers, pension funds and others to put money into the vast U.S. mortgage market. CDOs wrap a variety of mortgage securities into one package, sparing the investor from having to research each individual security.

CDOs, in turn, are the biggest buyers of the riskier types of mortgage securities, Pimco's Mr. Ivascyn says. If defaults reduce the amount of cash available to pay holders of a mortgage-bond issue, the holders of the lower-rated, higher-risk portions absorb losses before holders of the investment-grade portions suffer.

Complete New Yorker

OK, I'm not sure what kind of geek this makes me, but I just received my Complete New Yorker DVD set. 80 years of fiction, cartoons and essays on eight DVDs. Now, if I only had time to look at them...

The New Yorker was my first exposure to serious magazine writing (as opposed to Time magazine or US News, which my parents subscribed to). I discovered the odd copy at friends' houses or in waiting rooms. Later when I was at Harvard the eccentric composer who lived down the hall used to leave piles of old New Yorkers out for anyone who wanted them. Despite the timeless quality of some of the writing there is no way to store all of that paper. Now I have my own portable collection! I can't wait to see (e.g.) what was written during WWII or about the Kennedy assassination or civil rights... Will there be interesting profiles of von Neumann or Claude Shannon?

Entanglement

Apologies for lack of posts. I'm deeply entangled in entanglement entropy, patents, and beginning of school year stuff.

Saturday, September 17, 2005

Don't become a scientist! II

Despite the lip service paid to the importance of basic science to US competitiveness, you can see that not only are natural scientists underpaid here, but their rate of income growth has lagged that of other professions in the last decade. A careful study would show that US scientists, as a class of workers, are the first victims (in an economic sense) of globalization and its consequent reduction of returns to labor. Science was the first field of human endeavor to become globalized, with a truly international market for talent. US cold war policies were meant to produce as many scientists as possible, providing generous graduate fellowships for talented foreigners (like my father). After the cold war, the lion's share of the most talented Soviet scientists ended up here, along with the cream of the university crop from countries like China, India, Korea, Taiwan, etc. Beneficiary: the US economy in general, losers: US-born scientists.

If you love science, by all means go for it, but please be advised that it is hardly an optimal choice from an economic standpoint! See here and here for previous discussion.

Data below from WSJ. Note that among professionals, scientists had the worst wage-growth performance (essentially zero when inflation adjusted) in the period under study. Does that sound strange in our era of nanotech, biotech and infotech? You might argue that, according to this data, natural scientists are better paid than programmers (a group that is starting to feel the effects of globalization), but the vast majority of scientists have PhDs and should be compared with workers in categories like lawyers, physicians or "teachers of economics" (econ profs).

Thursday, September 15, 2005

PC censorship

I used to be an admirer of Berkeley economics professor Brad DeLong. I've been a regular reader of his blog for several years. Indeed, he, more than any other individual, inspired me to start blogging. This recent post on the US dollar conundrum shows him at his analytical and expository best.

I was shocked to discover that Professor DeLong actively and surreptitiously censors comments on his blog. You can read about it here. I can't explain his actions without assuming his goal is obfuscation, rather than truth seeking.

I've copied three of my comments below, originally posted to this discussion of human evolution. The third was removed without explanation.

Posted by: steve | Sep 12, 2005 7:55:47 PM

As mentioned, Brad's calculation neglects the possibility that mutations which might be adaptive in one environment are not necessarily adaptive in another.

According to the recent Lahn research (linked to by Anne, above), certain alleles of genes with direct effects on brain function have been subject to strong selection over the last tens of thousands of years. In certain populations (e.g., in Eurasia), the new alleles have rapidly replaced their predecessors, so they were clearly adaptive in those environments. In other populations (sub-Saharan Africa), the new alleles are rare, so they were probably less adaptive.

I don't know what will happen in the future, but current research shows that geographically isolated populations can have very different distributions of certain alleles, and not just those related to superficial features like skin or hair color.

Most fascinating is the possibility that relatively recent mutations had something to do with the rapid advancement of human civilization over the last 5000 years. (The ASPM variant may have emerged about that long ago.)

Posted by: steve | Sep 13, 2005 10:07:14 AM

Janet,

As already noted, it will take hundreds of years (at minimum) for mixing to eliminate the correlations between genes and "race" (or ancestral geographic lineage) that we currently have. That is a very long time from the perspective of social policy, although not in evolutionary terms.

I am by no means a fan of Sullivan, but I think he is correct to say that most liberals (I am one myself) have, due to wishful thinking, gratefully accepted the "there is no scientific basis for race" line. Anne's post of the NYTimes op-ed by LeRoi gives the history of this facile, but now doomed, position. (Cochran's explanation above is very clear - better than LeRoi's.) I don't think most people appreciate that we are now on a Moore's Law growth curve for genomic information. Google "hapmap" and have a look for yourself at the state of the art.

Rather than rely on the scientifically unsupported claim that "we are all equal," it would be better to teach our students that we all have inalienable human rights regardless of our abilities or genetic make up. Continuing to rely on the false equality premise only undermines the liberal position on race issues.

Posted by: steve | Sep 13, 2005 11:17:21 PM

gcochran wrote:

"Do principal component analysis on the covariance matrix for many loci (or cluster analysis) and !presto! - Bob's your uncle."

This gets right to the point (see an earlier post by gcochran for a less terse explanation). Too bad that very few readers here will understand (or even try to understand) what it means. Bambi vs Godzilla had the insight to ask the question properly. Will he or she make the effort to understand the answer?

Imagine each individual's genetic code as a point in a space of *very high* dimension. Then look at clusters of points. (Define a cluster as a group of points whose distance from each other is less than some radius; distinct clusters are separated by distances larger than this radius.) These clusters map directly onto traditional groupings of ethnicity. In fact, a recent study by Neil Risch at UCSF showed that self-reported "race" correlates very well with the clustering results. (Mixed race people are obviously an exception, but as discussed they are a small fraction of the total population, and will continue to be for some time.)

People (especially professors of social science) who confidently state to their students that "there is no genetic basis for race" should think through the analysis described above and look at the data carefully if they want to retain their credentials as scientists.

From the conclusions of the Risch paper (Am. J. Hum. Genet. 76:268–275, 2005):

Attention has recently focused on genetic structure in the human population. Some have argued that the amount of genetic variation within populations dwarfs the variation between populations, suggesting that discrete genetic categories are not useful (Lewontin 1972; Cooper et al. 2003; Haga and Venter 2003). On the other hand, several studies have shown that individuals tend to cluster genetically with others of the same ancestral geographic origins (Mountain and Cavalli-Sforza 1997; Stephens et al. 2001; Bamshad et al. 2003). Prior studies have generally been performed on a relatively small number of individuals and/or markers. A recent study (Rosenberg et al. 2002) examined 377 autosomal micro-satellite markers in 1,056 individuals from a global sample of 52 populations and found significant evidence of genetic clustering, largely along geographic (continental) lines. Consistent with prior studies, the major genetic clusters consisted of Europeans/West Asians (whites), sub-Saharan Africans, East Asians, Pacific Islanders, and Native Americans. ethnic groups living in the United States, with a discrepancy rate of only 0.14%.

Wednesday, September 14, 2005

Quantum chemist to lead Germany?

Angela Merkel, the Christian Democratic Union candidate favored to lead Germany after the upcoming elections, is a former physicist. Why can't we have scientists in high office in this country?

WSJ: Ms. Merkel, who excelled at math and science, eventually obtained a post at the Academy of Sciences in East Berlin. It was the communist state's top scientific institution, but Ms. Merkel was relegated to a converted workers barracks tucked behind overgrown shrubbery. Her work in quantum chemistry was considered marginal because it had no industrial relevance.

Fellow physicist Michael Schindhelm recalls that doing worthwhile research was difficult. Because neither he nor Ms. Merkel was a member of the communist party, they weren't permitted to travel to the West or even read most Western science publications. The laboratory's computers and equipment were obsolete. "We tried to focus on research you could do with a pencil and paper," Mr. Schindhelm says.

The experience helped sharpen Ms. Merkel's political views. Mr. Schindhelm says he and Ms. Merkel both became convinced that the overbearing East German state had caused a decay of society by undermining individual responsibility. "In a different form, we're experiencing something similar now in unified Germany," he says.

Monday, September 12, 2005

Gaussian copula and credit derivatives

This WSJ article describes a mathematical innovation that helped create the now huge market for credit derivatives. Credit derivatives let banks, hedge funds and other investors trade the risk associated with credit defaults (i.e. bankruptcy of bond issuers). Just as in previous derivatives markets, things didn't take off until a simple model for pricing became widely accepted. The model itself is almost certainly too simple, but is (hopefully) improved in proprietary ways by sophisticated traders and researchers. On the plus side, credit derivatives make bond markets more liquid and efficient, allowing risk to be transferred to those most willing to bear it. On the downside, we have yet another ill-understood casino running, with trillions of dollars in play. A few years ago I looked at the Vasicek model for default probabilities (which forms the basis of the KMV methodology), and boy did it look rough. This all looks a lot like the CMO market, where traders blow up with regularity.

The banker, David Li, came up with a computerized financial model to weigh the likelihood that a given set of corporations would default on their bond debt in quick succession. Think of it as a produce scale that not only weighs a bag of apples but estimates the chance that they'll all be rotten in a week.

The model fueled explosive growth in a market for what are known as credit derivatives: investment vehicles that are based on corporate bonds and give their owners protection against a default. This is a market that barely existed in the mid-1990s. Now it is both so gigantic -- measured in the trillions of dollars -- and so murky that it has drawn expressions of concern from several market watchers. The Federal Reserve Bank of New York has asked 14 big banks to meet with it this week about practices in the surging market.

The model Mr. Li devised helped estimate what return investors in certain credit derivatives should demand, how much they have at risk and what strategies they should employ to minimize that risk. Big investors started using the model to make trades that entailed giant bets with little or none of their money tied up. Now, hundreds of billions of dollars ride on variations of the model every day.

"David Li deserves recognition," says Darrell Duffie, a Stanford University professor who consults for banks. He "brought that innovation into the markets [and] it has facilitated dramatic growth of the credit-derivatives markets."

The problem: The scale's calibration isn't foolproof. "The most dangerous part," Mr. Li himself says of the model, "is when people believe everything coming out of it." Investors who put too much trust in it or don't understand all its subtleties may think they've eliminated their risks when they haven't.

The story of Mr. Li and the model illustrates both the promise and peril of today's increasingly sophisticated investment world. That world extends far beyond its visible tip of stocks and bonds and their reactions to earnings or economic news. In the largely invisible realm of derivatives -- investment contracts structured so their value depends on the behavior of some other thing or event -- credit derivatives play a significant and growing role. Endless trading in them makes markets more efficient and eases the flow of money into companies that can use it to grow, create jobs and perhaps spread prosperity.

But investors who use credit derivatives without fully appreciating the risks can cause much trouble for themselves and potentially also for others, by triggering a cascade of losses. The GM episode proved relatively minor, but some experts say it could have been worse. "I think this is a baby financial mania," says David Hinman, a portfolio manager at Los Angeles investment firm Ares Management LLC, referring to credit derivatives. "Like a lot of financial manias, it tends to end with some casualties."

Mr. Li, 42 years old, began his journey to this frontier of capitalist innovation three decades ago in rural China. His father, a police official, had moved the family to the countryside to escape the purges of Mao's Cultural Revolution. Most children at the young Mr. Li's school didn't go past the 10th grade, but he made it into China's university system and then on to Canada, where he collected two master's degrees and a doctorate in statistics.

In 1997 he landed on the New York trading floor of Canadian Imperial Bank of Commerce, a pioneer in the then-small market for credit derivatives. Investment banks were toying with the concept of pooling corporate bonds and selling off pieces of the pool, just as they had done with mortgages. Banks called these bond pools collateralized debt obligations.

They made bond investing less risky through diversification. Invest in one company's bonds and you could lose all. But invest in the bonds of 100 to 300 companies and one loss won't hurt so much.

The pools, however, didn't just offer diversification. They also enabled sophisticated investors to boost their potential returns by taking on a large portion of the pool's risk. Banks cut the pools into several slices, called tranches, including one that bore the bulk of the risk and several more that were progressively less risky.

Say a pool holds 100 bonds. An investor can buy the riskiest tranche. It offers by far the highest return, but also bears the first 3% of any losses the pool suffers from any defaults among its 100 bonds. The investor who buys this is betting there won't be any such losses, in return for a shot at double-digit returns.

Alternatively, an investor could buy a conservative slice, which wouldn't pay as high a return but also wouldn't face any losses unless many more of the pool's bonds default.

Investment banks, in order to figure out the rates of return at which to offer each slice of the pool, first had to estimate the likelihood that all the companies in it would go bust at once. Their fates might be tightly intertwined. For instance, if the companies were all in closely related industries, such as auto-parts suppliers, they might fall like dominoes after a catastrophic event. In that case, the riskiest slice of the pool wouldn't offer a return much different from the conservative slices, since anything that would sink two or three companies would probably sink many of them. Such a pool would have a "high default correlation."

But if a pool had a low default correlation -- a low chance of all its companies stumbling at once -- then the price gap between the riskiest slice and the less-risky slices would be wide.

This is where Mr. Li made his crucial contribution. In 1997, nobody knew how to calculate default correlations with any precision. Mr. Li's solution drew inspiration from a concept in actuarial science known as the "broken heart": People tend to die faster after the death of a beloved spouse. Some of his colleagues from academia were working on a way to predict this death correlation, something quite useful to companies that sell life insurance and joint annuities.

"Suddenly I thought that the problem I was trying to solve was exactly like the problem these guys were trying to solve," says Mr. Li. "Default is like the death of a company, so we should model this the same way we model human life."

His colleagues' work gave him the idea of using copulas: mathematical functions the colleagues had begun applying to actuarial science. Copulas help predict the likelihood of various events occurring when those events depend to some extent on one another. Among the best copulas for bond pools turned out to be one named after Carl Friedrich Gauss, a 19th-century German statistician.

Mr. Li, who had moved over to a J.P. Morgan Chase & Co. unit (he has since joined Barclays Capital PLC), published his idea in March 2000 in the Journal of Fixed Income. The model, known by traders as the Gaussian copula, was born.

"David Li's paper was kind of a watershed in this area," says Greg Gupton, senior director of research at Moody's KMV, a subsidiary of the credit-ratings firm. "It garnered a lot of attention. People saw copulas as the new thing that might illuminate a lot of the questions people had at the time."

To figure out the likelihood of defaults in a bond pool, the model uses information about the way investors are treating each bond -- how risky they're perceiving its issuer to be. The market's assessment of the default likelihood for each company, for each of the next 10 years, is encapsulated in what's called a credit curve. Banks and traders take the credit curves of all 100 companies in a pool and plug them into the model.

The model runs the data through the copula function and spits out a default correlation for the pool -- the likelihood of all of its companies defaulting on their debt at once. The correlation would be high if all the credit curves looked the same, lower if they didn't. By knowing the pool's default correlation, banks and traders can agree with one another on how much more the riskiest slice of the bond pool ought to yield than the most conservative slice.

"That's the beauty of it," says Lisa Watkinson, who manages structured credit products at Morgan Stanley in New York. "It's the simplicity."

It's also the risk, because the model, by making it easier to create and trade collateralized debt obligations, or CDOs, has helped bring forth a slew of new products whose behavior it can predict only somewhat, not with precision. (The model is readily available to investors from investment banks.)

The biggest of these new products is something known as a synthetic CDO. It supercharges both the returns and the risks of a regular CDO. It does so by replacing the pool's bonds with credit derivatives -- specifically, with a type called credit-default swaps.


The swaps are like insurance policies. They insure against a bond default. Owners of bonds can buy credit-default swaps on their bonds to protect themselves. If the bond defaults, whoever sold the credit-default swap is in the same position as an insurer -- he has to pay up.

The price of this protection naturally varies, costing more as the perceived likelihood of default grows.

Some people buy credit-default swaps even though they don't own any bonds. They buy just because they think the swaps may rise in value. Their value will rise if the issuer of the underlying bonds starts to look shakier.

Say somebody wants default protection on $10 million of GM bonds. That investor might pay $500,000 a year to someone else for a promise to repay the bonds' face value if GM defaults. If GM later starts to look more likely to default than before, that first investor might be able to resell that one-year protection for $600,000, pocketing a $100,000 profit.

Just as investment banks pool bonds into CDOs and sell off riskier and less-risky slices, banks pool batches of credit-default swaps into synthetic CDOs and sell slices of those. Because the synthetic CDOs don't contain any actual bonds, banks can create them without going to the trouble of purchasing bonds. And the more synthetic CDOs they create, the more money the banks can earn by selling and trading them.

Synthetic CDOs have made the world of corporate credit very sexy -- a place of high risk but of high potential return with little money tied up.

Someone who invests in a synthetic CDO's riskiest slice -- agreeing to protect the pool against its first $10 million in default losses -- might receive an immediate payment of $5 million up front, plus $500,000 a year, for taking on this risk. He would get this $5 million without investing a dime, just for his pledge to pay in case of a default, much like what an insurance company does. Some investors, to prove they can pay if there is a default, might have to put up some collateral, but even then it would be only 15% or so of the amount they're on the hook for, or $1.5 million in this example.

This setup makes such an investment very tempting for many hedge-fund managers. "If you're a new hedge fund starting out, selling protection on the [riskiest] tranche and getting a huge payment up front is certainly something that's going to attract your attention," says Mr. Hinman of Ares Management. It's especially tempting given that a hedge fund's manager typically gets to keep 20% of the fund's winnings each year.

Synthetic CDOs are booming, and largely displacing the old-fashioned kind. Whereas four years ago, synthetic CDOs insured less than the equivalent of $400 billion face amount of U.S. corporate bonds, they will cover $2 trillion by the end of this year, J.P. Morgan Chase estimates. The whole U.S. corporate-bond market is $4.9 trillion.

Some banks are deeply involved. J.P. Morgan Chase, as of March 31, had bought or sold protection on the equivalent of $1.3 trillion of bonds, including both synthetic CDOs and individual credit-default swaps. Bank of America Corp. had bought or sold about $850 billion worth and Citigroup Inc. more than $700 billion, according to the Office of the Comptroller of the Currency. Deutsche Bank AG, whose activity the comptroller doesn't track, is another big player.

Much of that money is riding on Mr. Li's idea, which he freely concedes has important flaws. For one, it merely relies on a snapshot of current credit curves, rather than taking into account the way they move. The result: Actual prices in the market often differ from what the model indicates they should be.

Investment banks try to compensate for the shortcomings of the model by cobbling copula models together with other, proprietary methods. At J.P. Morgan, "We're not stupid enough to believe [the model] is omniscient," said Andrew Threadgold, head of market risk management. "All risk metrics are flawed in some way, so the trick is to use a lot of different metrics." Bank of America and Citigroup representatives said they use various models to assess risk and are constantly working to improve them. Deutsche Bank had no comment.

As with any model, forecasts investors make by using the model are only as good as the inputs. Someone asking the model to indicate how CDO prices will act in the future, for example, must first offer a guess about what will happen to the underlying credit curves -- that is, to the market's perception of the riskiness of individual bonds over several years. Trouble awaits those who blindly trust the model's output instead of recognizing that they are making a bet based partly on what they told the model they think will happen. Mr. Li worries that "very few people understand the essence of the model."

Consider the trade that tripped up some hedge funds during May's turmoil in GM securities. It involved selling insurance on the riskiest slice of a synthetic CDO and then looking to the model for a way to hedge the danger that the default risk would increase. Using the model, investors calculated that they could offset that danger by buying a double dose of insurance on a more conservative slice.

It looked like a great deal. For selling protection on the riskiest slice -- agreeing to pay as much as $10 million to cover the pool's first default losses -- an investor would collect a $3.5 million upfront payment and an additional $500,000 yearly. Hedging the risk would cost the investor a mere $415,000 annually, the price to buy protection on a $20 million conservative piece.

But the model's hedge assumed only one possible future: one in which the prices of all the credit-default swaps in the synthetic CDO moved in sync. They didn't. On May 5, while the outlook for most bond issuers stayed about the same, two got slammed: GM and Ford Motor Co., both of which Standard & Poor's downgraded to below investment grade. That event caused a jump in the price of protection on GM and Ford bonds. Within two weeks, the premium payment on the riskiest slice of the CDO, the one most exposed to defaults, leapt to about $6.5 million upfront.

Result: An investor who had sold protection on the riskiest slice for $3.5 million had a paper loss of nearly $3 million. That's because if the investor wanted to get out of the investment, he would have to buy a like amount of insurance from somebody else for $6.5 million, or $3 million more than he was getting.

The simultaneous investment in the conservative slice proved an inadequate hedge. Because only GM and Ford saw their default risk soar, not the rest of the bond world, the pricing of the more conservative slices of the pool didn't rise nearly as much as the riskiest slice. So there wasn't much of an offsetting profit to be made there by reselling that insurance.

This wasn't really the fault of the model, which was designed mainly to help price the tranches, not to make predictions. True, the model had assumed the various credit curves would move in sync. But it also allowed for investors to adjust this assumption -- an option that some, wittingly or not, ignored.

Because numerous hedge funds had made the same credit-derivatives bet, the turmoil they faced spilled over into stock and bond markets. Many investors worried that some hedge funds might have to dump assets to cover their losses, so they sold, too. (Some hedge funds also suffered from a separate bad bet, which relied on GM's bond and stock prices moving in tandem; it went wrong when GM shares rallied suddenly as investor Kirk Kerkorian said he would bid for GM shares.)

GLG Credit Fund told its investors it lost about 14.5% in the month of May, much of that on synthetic CDO bets. Writing to investors, fund manager Jean-Michel Hannoun called the market reaction to the GM and Ford credit downgrades too improbable an event for the hedge fund's risk model to capture. A GLG spokesman declines to comment.

The credit-derivatives market has since bounced back. Some say this shows that the proliferation of hedge funds and of complex derivatives has made markets more resilient, by spreading risk.

Others are less sanguine. "The events of spring 2005 might not be a true reflection of how these markets would function under stress," says the annual report of the Bank for International Settlements, an organization that coordinates central banks' efforts to ensure financial stability. To Stanford's Mr. Duffie, "The question is, has the market adopted the model wholesale in a way that has overreached its appropriate use? I think it has."

Mr. Li says that "it's not the perfect model." But, he adds: "There's not a better one yet."

Sunday, September 11, 2005

Economist on higher education

Nice survey here. Some interesting points excerpted below.

Universities are a mess across Europe. European countries spend only 1.1% of their GDP on higher education, compared with 2.7% in the United States. American universities have between two and five times as much to spend per student as European universities, which translates into smaller classes, better professors and higher-quality research. The European Commission estimates that 400,000 EU-born scientific researchers are now working in the United States. Most have no plans to return. Europe produces only a quarter of the American number of patents per million people. It needs to ask itself not whether it can overtake the United States as the world's top knowledge economy by 2010, but how it can avoid being overtaken by China and other Asian tigers.

... India has two valuable things going for it. One is its collection of elite institutions. For decades, India has been pouring resources into the All India Institute of Medical Sciences, the Indian Institute of Science in Bangalore and, above all, the Indian Institutes of Technology. These institutions take their pick from an army of candidates every year, with 180,000 hopefuls taking the screening test for around 3,500 places in the seven IITs. They provide a highly intensive education, with all students and often professors too living on campus. And they produce a stream of highly educated people who help to set professional standards. “They are a class apart, like Oxford and Cambridge,” says P.V. Indiresan, an expert on universities.

These elite institutions help to keep India plugged into the global knowledge economy. R.S. Sirohi, the former director of IIT Delhi, explains that he used to give his staff long sabbaticals in western universities, and that about a third of them spend time in America every summer. His institute receives sponsorship for research from multinationals such as Sun Microsystems, Cisco, Volvo and Ford. Granted, the elite institutions produce many people who get brain-drained away, but they also keep many bright people from emigrating, and may even attract émigrés back if India's economy keeps booming. It is accepted wisdom in India that the brightest students go to the IITs and the second-best to American universities.

...In higher education, as in so much else, China is visibly pulling ahead of India. The Chinese are engaged in the biggest university expansion in history. In the 1980s, only 2-3% of school-leavers went to university. In 2003, the figure was 17%. The watershed year was 1999, when the number of students enrolled jumped by almost half. The expansion at the doctoral level is even faster than for undergraduates: in 1999-2003, nearly 12 times as many doctorates were awarded as in 1982-89 (see chart 4). And there is more to come: the number of new doctoral students jumped from 14,500 in 1998 to 48,700 in 2003.

The Chinese are determined to create a super-league of universities to rival the best in the world. The central government is investing heavily in chosen universities, such as Peking, Tsinghua and Fudan, offering higher salaries and more research funding. The state governments are doing likewise. It is no accident that the most widely used annual ranking of the world's research universities, the Shanghai index, is produced by a Chinese university.

What lies behind all this is a gigantic exercise in technology transfer. The Chinese are trying to recreate the best western universities at home in order to compete in more sophisticated industries. They have stocked up with foreign PhDs: in some departments of the University of Peking, a third of the faculty members have American doctorates. They are using joint ventures with foreign universities in much the same way as Chinese companies use joint ventures with foreign companies.

The Chinese have no qualms about using market mechanisms to achieve this technology transfer. Tuition charges now make up 26% of the earnings of public universities, nearly twice the level in 1998; many professors are paid according to the number of students they attract; and China is creating a parallel system of private universities alongside the public ones. For example, the University of Peking has more applicants than places, so it has created a parallel university that charges higher fees and accepts slightly less able students. Links between universities and industry are commonplace. The majority of doctorates earned in China between 1992 and 2003 were in practical subjects, which attract the brightest students: engineering (38% of the total), natural sciences (22%) and medicine (15%).

But will China achieve its academic ambitions? The trouble is that investment will not do the trick without broader cultural changes. Rui Yang, a professor at Australia's Monash University, points out that academic corruption is rife. The powerful academies that distribute much of the research funding are prey to both political favouritism and lobbying. Plagiarism is commonplace. Many academics use a good part of their research funding for personal rather than academic ends.

...The spectacle of so many bright people from poor countries upping sticks for the rich world raises questions of social justice, in part because they contribute both money and brainpower to their host country while they are studying and in part because so many of them end up staying permanently. Some people see the development as a kind of neo-colonialism of the mind. But there is no guarantee that all these bright people would have prospered if they had stayed at home. The combined net worth of Indian IIT graduates in America is reportedly $30 billion. But would all those brilliant Indians have become so rich if they had stayed in India? “Better brain drain than brain in the drain,” was the much-quoted verdict of the late Rajiv Gandhi, an Indian prime minister.

Perhaps what is going on is not so much a “brain drain” as “brain circulation”. The governments of many developing countries encourage bright students to go abroad, often using scholarships as inducements, as part of a general policy of “capacity-building” so they can plug themselves into the latest thinking in the West.

Few highly skilled migrants cut their links with their home countries completely. Most keep in touch, sending remittances (and, if they are successful, venture capital), circulating ideas and connections, and even returning home as successful entrepreneurs. A growing number of Indian and Chinese students go home after a spell abroad to take advantage of the hot labour markets in Shanghai or Mumbai. And a growing number of expatriate businessmen invest back home.

...World-class universities can also produce outsize economic benefits. The best-known example of this is Stanford, which helped to incubate Google, Yahoo!, Cisco, Sun Microsystems and many other world-changing firms. But there are plenty of others. The University of Texas at Austin has helped to create a high-technology cluster that employs around 100,000 people in some 1,700 companies. In 2000, the eight research universities in Boston provided a $7.4 billion boost to the region's economy, generated 264 new patents and granted 280 licences to private enterprises.

Top universities are a valuable asset in the global war for talent too. America's great research universities enable it to recruit more foreign PhD students than the rest of the OECD put together. And a striking number of these people stay put: in 1998-2001, about two-thirds of foreigners who earned American doctorates in science and engineering said they had “firm plans” to stay, up from 57% in 1994-97.

The benefits of having global universities are now so clear that governments around the world are obsessed with producing “Ivy Leagues”. The British are introducing fees in part because they want their best universities to be able to compete with the best American ones. The German Social Democratic Party—traditionally a bastion of egalitarianism—has produced a plan to create German equivalents of Harvard, Princeton and Stanford. And the Chinese are hard at work trying to build world-class universities. Today “excellence” is taking over from “expansion” as the mantra of higher education.

Thursday, September 08, 2005

ASPM and MCPH1: big trouble from two little alleles

Two variants of genes suspected to be related to brain function show very different distributions in different ethnic groups, and show signs of having been subject to strong selection fairly recently in human history. Of course, one cannot directly conclude anything about effects on intelligence, but the implication is pretty strong that there are correlations between distributions of genes with phenotypical consequences beyond superficial traits like skin or hair color, and traditional conceptions of ethnicity. This was already known for genes related to certain diseases like Tay-Sachs or sickle cell anemia. For related posts, see here and here.

NYTimes: Two genes involved in determining the size of the human brain have undergone substantial evolution in the last 60,000 years, researchers say, suggesting that the brain is still undergoing rapid evolution.

The discovery adds further weight to the view that human evolution is still a work in progress, since previous instances of recent genetic change have come to light in genes that defend against disease and confer the ability to digest milk in adulthood.

The new finding, reported by Bruce T. Lahn of the University of Chicago and colleagues in the journal Science, could raise controversy because of the genes' role in determining brain size. New versions of the genes, or alleles, as geneticists call them, appear to have spread because they enhanced the brain's function in some way, the report suggests, and they are more common in some populations than others.

...They report that with microcephalin, a new allele arose about 37,000 years ago, although it could have appeared as early as 60,000 or as late as 14,000 years ago. Some 70 percent or more of people in most European and East Asian populations carry this allele of the gene, as do 100 percent of those in three South American Indian populations, but the allele is much rarer in most sub-Saharan Africans.

With the other gene, ASPM, a new allele emerged some time between 14,100 and 500 years ago, the researchers favoring a mid-way date of 5,800 years. The allele has attained a frequency of about 50 percent in populations of the Middle East and Europe, is less common in East Asia, and found at low frequency in some sub-Saharan Africa peoples.

More coverage here, including comments like the following:

What I love about this article is that we're starting to get to the bottom of the seemingly infinite regress of lies and obfuscations.

Note that

1) they can't call Lahn a racist (he's a Chinese ancestry HHMI investigator publishing in Science, for god's sake)
2) they can't say the genes weren't selected
3) They can't say all populations have equal frequencies of these alleles
4) ...and they can't even say that there is even significant overlap between all populations on this locus (a la lewontin's 85/15 fallacy)

So those are four biggies gone at the outset. As Lahn has (wisely) separated the psychometric arguments -- for now -- they also can't demagogue IQ. So that's another one down.

Goldstein threw up drift, but it was already demolished -- unlike baseless mumbling about spandrels, it is actually a testable hypothesis and makes quantitative predictions (e.g. linkage disequilibrium varies for things boosted by drift vs. by selection). So it was tested and rejected, as it was in the Ashkenazi Cochran/Harpending paper. Next?

Next up they say that maybe *this* ASPM variant had some anomalous non-brain related function, or that different populations might not all have the same frequency of this allele, but that they have different complements of alleles that all lead to exactly the same distribution of ability.

Wednesday, September 07, 2005

Outsourced tutoring

I was wondering how long this would take... online collaboration tools plus broadband make it easy to outsource individualized tutoring. From today's Times. I don't think this type of tutoring is limited to English. As mentioned in the article, one can also find math or science tutors in India at bargain prices. Why not have college-level tutoring in subjects like calculus, Java programming or organic chemistry? The potential is limitless as long as the labor cost disparity is so high. Growing Stars' margins are huge -- once this becomes commonplace I imagine companies could be profitable charging $10 per hour on the US end and still paying twice a college professor's salary in India.

Note that this could eventually work both ways. A lot of Americans (and Canadians, Australians, etc.) make a good living teaching English in Japan, Korea, Taiwan, etc. Eventually, we might have tutors based here teaching kids in those countries (after the inevitable currency revaluation sends the dollar down against Asian currencies :-) I'm told that Skype is already overrun with people from China and other countries wanting to practice their English with native speakers.

Twice a week for a month now, Ms. Salin, who grew up speaking the Indian language Malayalam at home, has been tutoring Daniela in English grammar, comprehension and writing.

Using a simulated whiteboard on their computers, connected by the Internet, and a copy of Daniela's textbook in front of her, she guides the teenager through the intricacies of nouns, adjectives and verbs.

Daniela, an eighth grader at Malibu Middle School, said, "I get C's in English and I want to score A's," and added that she had given no thought to her tutor being 20,000 miles away, other than the situation feeling "a bit strange in the beginning."

She and her sister, Serena, 10, a fourth grader at Malibu Elementary, are just 2 of the 350 Americans enrolled in Growing Stars, an online tutoring service that is based in Fremont, Calif., but whose 38 teachers are all in Cochin. They offer tutoring in mathematics and science, and recently in English, to students in grades 3 to 12.

Five days each week, at 4:30 a.m. in Cochin, the teachers log on to their computers just as students in the United States settle down to their books and homework in the early evening.

Growing Stars is one of at least a half-dozen companies across India that are helping American children complete their homework and prepare for tests.

As in other types of outsourcing, the driving factor in "homework outsourcing," as the practice is known, is the cost. Companies like Growing Stars and Career Launcher India in New Delhi charge American students $20 an hour for personal tutoring, compared with $50 or more charged by their American counterparts.

Growing Stars pays its teachers a monthly salary of 10,000 rupees ($230), twice what they would earn in entry-level jobs at local schools.

Tuesday, September 06, 2005

Hedge fund risks high

Andrew Lo is a finance professor at MIT/Sloan, and runs the hedge fund AlphaSimplex. In a recent paper (also discussed in the Times) he argues that risks for a hedge fund meltdown are high.

Lo et al. posit that the smoothness of returns is a proxy of illiquidity. That is, if positions are marked to market using theoretical models (rather than actual trading values), the resulting valuations will be unnaturally smooth. Based on this notion, they propose the serial auto-correlation of hedge fund returns as a proxy for illiquidity and find that this is at a 20 year high. I find this analysis convincing as a method of tracking illiquidity. It is also plausible that illiquidity is an important contributor to systemic risk - under adverse market conditions we may see a lot of funds scrambling to get out of their positions.

Monday, September 05, 2005

Virtual worlds and outsourcing

The Times reports on World of Warcraft, an online multiplayer role-playing game with over 1 million US subscribers, and 1.5 million Chinese subscribers (in the US, players pay $30-50 for the software and $15 per month in subscription fees). Games like this have spawned their own real-world economies, with markets in magic items, gold, powerful characters, etc. Impatient players pay real money to buy these things from entrepreneurs employing bot-watching "farmers" in countries like India and China.

With this level of interest, it's not surprising that online gaming is driving interesting technology development. The new game from Sims creator Will Wright, called Spore, looks like a pretty good take on artificial life and virtual evolution.

The real money is made by the people with the resources and the right programs. Rich Thurman earned $100,000 by farming 9 billion gold in Ultima Online. A longtime user of the macro easyUO, Thurman says he had "up to 30 PCs running at once, automatically collecting gold for me."

That is the first step. It isn't too difficult from there to make the leap into creating your own sweatshop. All you need is the ability to write game macros or the money to purchase them. That's right, if you know where to look, they are on the open market. A macro that uses a teleportation exploit in WOW is currently going for $3,000. Then just hire cheap labor to monitor the bots.

Weeks go by as I chase ghosts and rumors of Chinese workers clicking 12 hours a day. Word has it that 300 farmers are working at computers lined up in airport hangars somewhere in Asia. After all, Lineage II banned certain Chinese IPs for a reason. Finally, I get in contact with a man in his 30s who goes by the name Smooth Criminal. He's a partner in one of the largest sellers of MMORPG gold, and he isn't apologetic. His rap sheet: banned from Ultima Online, Asheron's Call, Shadowbane, Star Wars Galaxies, and Ultima Online again. He says once someone even traded him a wedding ring worth $2,000 for WOW gold.

Smooth Criminal's game cartel made $1.5 million from Star Wars Galaxies alone last year, and individually, he's made as much as $700,000 in a single year. "[SWG] built my new house, which I paid for in cash," he says. "So when you ring my doorbell, it plays the Star Wars music." Smooth Criminal is in charge of writing programs, finding exploits, and locating in-game "dupes" (bugs for duplicating gold or items). "I have a real job, but when there's a dupe, I call in sick," he says. It costs him more money to actually go to his "real job." "When I dupe," Smooth Criminal adds, "I farm billions on every game server and spread out my activities." He then uses three accounts to launder the gold: a duper account, a filter account, and a delivery account—each created using different IPs, credit cards, and computers. This way, it's hard to trace the source, and the gold comes back clean.

Sunday, September 04, 2005

Oppenheimer books

Thomas Powers (author of Heisenberg's War) reviews recent biographies of Oppenheimer in the New York Review of Books.

What Oppenheimer left us at the end of the day was not the bomb— somebody would have built it—but his life. I mean the whole of it—the brilliance, the rich and complex personality, the example of his greatest achievement, pushed through in the furious, triumphant American way; and then the long harrowing aftermath so apparent in his late photographs—a man distressed by what the world insisted on doing with what he had built, and convinced there would be a price to pay. Foreboding of this kind was banished at a very early date from the Pentagon, the White House, and the bomb laboratories. There the ruling faith is that professionals can manage the dangers, and for a decade after the collapse of the Soviet Union and the end of the cold war, it was possible to think they were right. But now things have changed again, and we find we are living once more with the old suspense, threatened by the weapons we were the first to build and use, and waiting for nothing to happen forever.

Thursday, September 01, 2005

The face of battle

Michael Yon is a blogger embedded with the 25th Infantry Division in Mosul. His posts provide a vivid look at "boots on the ground" in Iraq, including amazing photos of a close quarters firefight.

Shots were fired behind us but around a corner to the left.

Both the young 2nd lieutenant and the young specialist were inside a shop when a close-quarters firefight broke out, and they ran outside. Not knowing how many men they were fighting, they wanted backup. LTC Kurilla began running in the direction of the shooting. He passed by me and I chased, Kurilla leading the way.

There was a quick and heavy volume of fire. And then LTC Kurilla was shot.

Kurilla was running when he was shot, but he didn't seem to miss a stride; he did a crazy judo roll and came up shooting.

BamBamBamBam! Bullets were hitting all around Kurilla. The young 2nd lieutenant and specialist were the only two soldiers near. Neither had real combat experience. AH had no weapon. I had a camera.

Blog Archive

Labels

Web Statistics