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Tuesday, November 27, 2007

Jim Simons is my hero

This is long, but worth the read! I just quoted the first part below. The whole thing can be found here.

Simons at Renaissance Cracks Code, Doubling Hedge Fund Assets 2007-11-27 00:13 (New York)

By Richard Teitelbaum
Nov. 27 (Bloomberg) -- On a hot afternoon in September, Renaissance Technologies LLC founder Jim Simons is too busy to take a phone call. It is, he says, from Cumrun Vafa, a preeminent Harvard University professor and expert on string theory, which describes the building blocks of the universe as extended one-dimensional filaments.

``Get another time when I can talk to him,'' Simons tells his assistant.

Then he mentions that the next day, he'll be meeting with Thomas Insel, director of the National Institute of Mental Health, to discuss autism research. And he's slated that Saturday to host a gala honoring Math for America, or MFA, a four-year-old nonprofit he started that provides stipends to New York City math teachers.

``I'm undoubtedly involved in too many things at the same time,'' Simons says in his 35th-floor office in midtown Manhattan. ``But you make your life interesting.''

String theory, autism, math education: It's fair to ask how Simons, 69, manages his day job overseeing the world's biggest hedge fund firm. The answer, judging from the numbers, is very well.

Renaissance is on fire: Its Medallion Fund -- which uses computers and trading algorithms to invest in world markets -- returned more than 50 percent in the first three quarters of 2007. It had about $6 billion in assets as of July 1.

Simons registered that performance as subprime and related markets were collapsing, sending two mortgage-related hedge funds run by Bear Stearns Cos. into bankruptcy. The turmoil pummeled the Goldman Sachs Global Alpha Fund, a rival to Renaissance's funds, which fell more than 25 percent during the same time. Morgan Stanley's computer jockeys lost $390 million in a single day in early August.

Life Story

Medallion's returns are no anomaly. The fund, which trades everything from soybean futures to French government bonds in rapid fire, hasn't had a negative quarter since early 1999. From the end of 1989 through 2006, it returned 38.5 percent annualized, net of fees.

More surprising than those returns is Simons's life story. At an age when hedge fund pioneers such as Michael Steinhardt have long since stopped managing other people's money, Simons is building on Medallion's success. He's adding funds and strategies and accumulating assets, which totaled $35.4 billion as of Sept. 28.

In August 2005, Simons started Renaissance Institutional Equities Fund, or RIEF, which invests in U.S. stocks. Through Sept. 30, it has returned 12.8 percent annualized. Unlike Medallion, which turns over its holdings dozens of times each year, RIEF keeps its positions for months or longer. Simons said at the time of the fund's inception RIEF could theoretically manage as much as $100 billion.

'New Possibilities'

In December 2006, he limited new investments in the fund to $1.5 billion a month. As of Sept. 30, 2007, it had $25.6 billion in assets.

In October, Simons started Renaissance Institutional Futures Fund, or RIFF, to invest in commodities. It's up 5.2 percent for the month. He says Renaissance's research shows the new fund can manage as much as $50 billion. Along with RIEF, it will promote cross-fertilization of ideas inside Renaissance, Simons says.

``Challenge is good,'' he says. ``It opens one's eyes to new possibilities.''

When not in Manhattan, Simons runs his empire from a 15-foot (4.6-meter) by 20-foot office in Renaissance's gated and guarded campus off Route 25A in East Setauket on New York's Long Island, some 50 miles (80 kilometers) east of the Empire State Building. With most of the trading automated, there's little of the hurly-burly of a typical hedge fund firm.

Doubling Assets

Along with routine personnel and marketing tasks, Simons makes time for the researchers and programmers who stop by his office to discuss mathematical and statistical issues they've encountered as they work on new trading strategies.

More than 200 employees, of whom about a third have Ph.D.s, work in East Setauket. Another 100 are based in Manhattan, San Francisco, London and Milan. ``He creates an environment where it's easy to be creative and works hard to keep the bullshit level to a minimum,'' says former managing director Robert Frey, who worked at Renaissance from 1992 to 2004.

Even without the new commodities fund, Renaissance's assets have more than doubled in a year from about $16 billion on Sept. 30, 2006. That growth has catapulted Renaissance past such titans as Daniel Och's Och-Ziff Capital Management Group LLC, Ray Dalio's Bridgewater Associates Inc. and David Shaw's D.E. Shaw & Co. to become the world's largest hedge fund manager, according to data compiled by Hedge Fund Research Inc. and Bloomberg.

Code Cracker

Medallion's 3.9 percent return during August, though that fund too was whipsawed by volatility, bolstered Simons's reputation as the silver-bearded wizard of quantitative investing.

In quant funds, mathematicians and computer scientists mine enormous amounts of data from financial markets looking for correlations among stocks, bonds, derivatives and other instruments. They search for predictive signals that will foretell whether, say, a palladium futures contract is likely to rise or fall.

``There are just a few individuals who have truly changed how we view the markets,'' says Theodore Aronson, principal of Aronson + Johnson + Ortiz LP, a quantitative money management firm in Philadelphia with $29.3 billion in assets. ``John Maynard Keynes is one of the few. Warren Buffett is one of the few. So is Jim Simons.''

Aronson credits Renaissance with validating the entire field of quantitative investing and proving that the freedom accorded to hedge fund managers to short stocks, borrow money and invest in myriad instruments can produce results that far outstrip typical market returns.

`Role Model'

Simons, standing just under 5 feet 10 inches tall and weighing 185 pounds (84 kilograms), has trod an unlikely path. A former code cracker for the U.S. National Security Agency, in 1968 he became chairman of the mathematics department at Stony Brook University, part of the New York state university system. He built the department into what David Eisenbud, former director of the Mathematical Sciences Research Institute in Berkeley, California, calls one of the world's top centers for geometry.

In 1977, frustrated with a math problem and eager for change, he abandoned academia to start what would become Renaissance, hiring professors, code breakers and statistically minded scientists and engineers who'd worked in astrophysics, language recognition theory and computer programming.

``All the quants in the world are trying to follow in Jim's footsteps because what he's built at Renaissance is truly extraordinary,'' says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for Financial Engineering and chief scientific officer of quant hedge fund firm AlphaSimplex Group LLC. ``I and many others look up to him as a tremendous role model.'' ...

Singularity summit

Someone once said that the Singularity is like the Rapture for geeks :-)

Nevertheless, some of the talks from the recent Singularity Summit are interesting.

So far I've enjoyed Omohundro, Jurvetson and Thiel. (Respectively, a physicist turned computer scientist, an engineer turned venture capitalist, and a derivatives trader turned PayPal CEO turned hedge fund manager.) Omohundro argues that AI beings will be much more rational than we are, using game-theoretic ideas of Von Neumann. Jurvetson thinks that we'll use evolutionary algorithms to create AI. But the resulting beings will be so complex that, while we understand the process of their creation, we won't understand how they really work -- any more than we understand evolved biological beings. Thiel's talk about investing for the singularity is goofy, but the comments near the end about Buffet's positions are quite interesting. The talk by robotics pioneer Rodney Brooks is surprisingly lame. There are quite a few talks I haven't yet had time to listen to...

Wednesday, November 21, 2007

Monster minds

There's a story in Surely You're Joking, Mr. Feynman, about the first seminar Feynman gives at Princeton. He's just a graduate student, working on a formulation of electromagnetism in terms of advanced and retarded potentials with his advisor Wheeler:

...So it was to be my first technical talk, and Wheeler made arrangements with Eugene Wigner to put it on the regular seminar schedule.

A day or two before the talk I saw Wigner in the hall. "Feynman," he said, "I think that work you're doing with Wheeler is very interesting, so I've invited Russell to the seminar." Henry Norris Russell, the famous, great astronomer of the day, was coming to the lecture!

Wigner went on. "I think Professor von Neumann would also be interested." Johnny von Neumann was the greatest mathematician around. "And Professor Pauli is visiting from Switzerland, it so happens, so I've invited Professor Pauli to come" - Pauli was a very famous physicist- and by that time, I'm turning yellow. Finally, Wigner said, "Professor Einstein only rarely comes to our weekly seminars, but your work is so interesting that I've invited him specially, so he's coming too."

By this time I must have turned green... Then came the time for the talk and here are these monster minds in front of me waiting!

Last Friday Sean Carroll emailed me to ask if I'd give a short blackboard talk at an informal cosmology meeting they have on Monday morning at Caltech. My real talk was in the afternoon, so I said, sure, no problem. I thought I'd mainly be talking to grad students and postdocs, so I didn't prepare anything. My plan was to give some background on entropy, information, black holes, etc. so that they could better follow the afternoon talk.

To my surprise, rather than a bunch of grad students I found monster minds arrayed around the big oak table in 469 Lauritsen: Carroll, Kamionkowski, Wise, Preskill, Politzer (Nobel laureate), Ooguri and Stanley Deser! No need for elementary background. I was kind of nervous at first, but we ended up having a lively discussion that lasted over 90 minutes -- I pretty much covered my whole talk using the blackboard, and ended up giving it again using slides later in the day. We had a funny moment when I first started discussing the ADM energy of the monsters. I looked over at Deser (the "D" in ADM) and smiled; he smiled back and nodded slightly :-) Having Stanley in the audience helped a lot because the entropy packing I described depends on using negative gravitational binding energy to nearly cancel the energy of the constituent matter. He was quite familiar with these constructions and helped convince the audience that I wasn't nuts.

Ten years ago I wrote a paper (unpublished) showing how to obtain a zero energy configuration in GR out of massive constituents. Particle theorists I discussed it with all thought I was crazy, but the referee was a very erudite relativist, who pointed out that a similar result (using different constructions) had been obtained by ADM, Novikov and Zeldovich, and others long ago. (So my result wasn't really new, but at least it wasn't wrong...) I had suspected Deser of being the referee but he said it wasn't him. He thought it might have been Wald... :-)

I had a wonderful visit, clouded only by the news (received by email on my cellphone while chatting with Sean) that Sidney Coleman had passed away on Sunday.

Sunday, November 18, 2007

Goldman OK?

According to the Times, Goldman unloaded their subprime exposure:

NYTimes: ... Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

With its mix of swagger and contrary thinking, it was just the kind of bet that has long defined Goldman’s hard-nosed, go-it-alone style.

Most of the firm’s competitors, meanwhile, with the exception of the more specialized Lehman Brothers, appeared to barrel headlong into the mortgage markets. They kept packaging and trading complex securities for high fees without protecting themselves against the positions they were buying.

Even Goldman, which saw the problems coming, continued to package risky mortgages to sell to investors. Some of those investors took losses on those securities, while Goldman’s hedges were profitable.

When the credit markets seized up in late July, Goldman was in the enviable position of having offloaded the toxic products that Merrill Lynch, Citigroup, UBS, Bear Stearns and Morgan Stanley, among others, had kept buying.

“If you look at their profitability through a period of intense credit and mortgage market turmoil,” said Guy Moszkowski, an analyst at Merrill Lynch who covers the investment banks, “you’d have to give them an A-plus.”

This contrast in performance has been hard for competitors to swallow. The bank that seems to have a hand in so many deals and products and regions made more money in the boom and, at least so far, has managed to keep making money through the bust.

In turn, Goldman’s stock has significantly outperformed its peers. At the end of last week it was up about 13 percent for the year, compared with a drop of almost 14 percent for the XBD, the broker-dealer index that includes the leading Wall Street banks. Merrill Lynch, Bear Stearns and Citigroup are down almost 40 percent this year.

...At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

“The risk controllers are taken very seriously,” Mr. Moszkowski said. “They have a level of authority and power that is, on balance, equivalent to the people running the cash registers. It’s not as clear that that happens everywhere.” ...

A Caltech wedding

I'm at Caltech this weekend, for the wedding of one of my college roommates and to give a seminar (Monday) on monsters and black hole entropy.

I'm glad one of us had the good taste to get married at the Athenaeum, the beautiful faculty club. Wonderful to be back on campus with old friends on a mild Pasadena evening. 20 years ago seemed like yesterday!

As the reception was winding down, we took a stroll down the olive walk to peek in on Interhouse, the annual 7 house bash that takes place in the fall term. During my time in Page house we engineered ambitious rides each year for the party, including a roller coaster, a sky tram over a lagoon in our courtyard, and a jungle raft ride along a flooded main corridor. I didn't see anything quite as impressive last night, but the kids seemed to be having a great time. Someone told me the male to female ratio is nearly equal in the freshman class -- quite a change from the old days :-)

Earlier yesterday, coming out of the gym, I overheard the following conversation:

Undergrad 1: Yeah, they emailed me the test. I guess it's honor code.

Undergrad 2: But it's a hedge fund, right? Is there an honor code?

Undergrad 1: Hmmm.... good point.

Wednesday, November 14, 2007

CDOh no!

This Economist article summarizes the current situation nicely. Notice the doomsday scenario in which bond insurers suffer a ratings reduction, which has spillover effects in the muni and state bond markets. This was mentioned previously in a comment here but I hadn't appreciated the seriousness of it before.

I suppose there is some muni-treasury spread index I should be betting on?

Over the years I've noticed a lot of my super-rich friends in fixed income keep a disproportionate (at least according to naive portfolio theory) fraction of their net worth in munis -- probably because of the tax benefit and because fixed income people always think equities are airy fairy overpriced and can never bear to place a big bet there. I'm going to see if any of them are worried about spillover into their personal portfolios if the bond insurers take a downgrade.

CDOh no!

Nov 8th 2007 | From The Economist print edition

With trades scarce and losses mounting, it is going to be a harsh winter.

IT WAS not a good omen. This week Lewis Ranieri, a pioneer of mortgage securitisation in his “Liar's Poker” days at Salomon Brothers, sold his property-financing firm because the subprime crisis had cut it off from fresh debt. If the industry's godfather can't navigate the storm-tossed markets, what hope its greedy children?

Banks that a few months ago were falling over each other to underwrite mortgage-backed securities and the labyrinthine pooling structures, known as collateralised-debt obligations (CDOs), that sit atop them, have admitted to more than $30 billion in losses. That figure is set to rise sharply as mortgage defaults in America climb. Citigroup estimates that big banks may be facing $64 billion in write-downs, excluding its own figures—and it was one of the top two underwriters of CDOs. Banks will be dealing with the pain for a lot longer than anyone imagined only a couple of months ago.

Most CDOs were engineered to provide both yield and safety, with a thick band of each rated AAA or even better, “super-senior”. Lower-rated tranches have been in trouble for months. But the prospect of a collapse in the value of the supposedly safe portions terrifies the banks—not surprisingly, since there is at least $350 billion-worth of such CDOs outstanding.

This looks all too possible now that rating agencies have started to downgrade AAA-rated CDOs, some of them by several notches (14 in the case of one notorious tranche). The agencies have given warning in the past month that they might downgrade another $50 billion-worth of top-rated CDOs, and that looks like the tip of the iceberg. One fear is that this leads to a wave of hurried sales, because many institutional investors are allowed to hold only AAA-rated paper. In addition, default notices have been issued on more than $5 billion-worth of CDOs, as senior investors try to grab what they can.

The uncertainty is compounded by the difficulty of finding a “fair value” for these complex instruments. The fall-back method recommended in a recent paper by the Centre for Audit Quality, an industry research body, is to employ “assumptions that market participants would use”, a technique known as “Level 3”, which becomes subject to strict accounting regulations in America on November 15th. But “Level 3 is not that useful,” confesses a risk controller at a big European bank. Banks have tended to use it as a bucket into which they throw any securities they find hard to value and then make an educated guess at the price. Among Wall Street firms, the soaring amounts of Level 3 securities now exceed their shareholder equity.

Finding a better indicator of market prices is no easy task, however. One measure, though an imperfect one, especially for CDOs, is the ABX family of indices. These relate to derivatives linked to subprime, which are traded even when the underlying bonds are not. The ABX indices are near record lows, having fallen precipitously in October. Even the top tranches are well below par value (see chart). According to Citi, some AAA-rated CDO tranches are faring even worse—at a mere 10 cents on the dollar.

Most banks are probably reluctant to mark down their assets that far. Citi and Merrill Lynch lead the list of shame, with combined write-downs of more than $22 billion. But others may just be slower in coming clean—even the teflon traders at Goldman Sachs. CreditSights, a research firm, estimates Goldman's potential CDO-related charges at $5.1 billion, for instance. On November 7th Morgan Stanley said it would write down its assets linked to subprime by $3.7 billion. For the first time, there is serious talk of banking giants running short of capital.

European banks can expect more grief, too. UBS, a Swiss bank, has reportedly been criticised for booking its mid-quality paper at twice the level implied by the ABX index. Marcel Ospel, its chairman, faces mounting pressure to resign after the bank reported big losses on fixed-income securities in the third quarter.

Banks are not the only ones who need to worry. Hedge funds hold more than 45% of all CDO assets, according to the IMF. Insurers are exposed, too; American International Group, the world's largest insurer, this week fell far short of earnings targets because of mortgage-related problems. In addition, one obscure but important corner of the industry faces a fight for survival over its subprime exposure: the specialist bond insurers.

In return for a premium, bond insurers guarantee repayment of interest on a variety of debt securities in case of default. Their mainstay used to be municipal bonds, but over the past decade they moved aggressively into structured finance. Before October, it was thought that the two biggest, MBIA and Ambac, would get away with losses in the low hundreds of millions. But the rating agencies' assault on high-grade CDOs, the bread and butter of the insurers' structured business, raises the prospect that they could run low on capital. Analysts at Morgan Stanley forecast combined losses for the two firms of up to $18.7 billion. Even the minimum expected loss, a much lower $3.3 billion, would be a huge blow for companies with combined equity capital of just $12 billion.

Some think the rating agencies will eventually have to strip the bond insurers of their cherished AAA ratings. They are loth to do this because it would “wreak havoc”, not only in structured products but across financial markets, says Andre Cappon, a consultant. New issues of municipal bonds could slow dramatically, since many borrowers rely on the insurers' top rating to enhance their own creditworthiness. Over $1 trillion of debt issued by American cities and states—much of it held by retired people through funds—might have to be downgraded. Public-private partnerships in Britain, which are also customers, would also be affected.

For those holding CDOs, things could get worse before they get better. Tim Bond of Barclays Capital points out that defaults on subprime loans are still accelerating in America, particularly on mortgages made since 2006. This will take time to feed through to CDOs, via mortgage-backed bonds, but feed through it will. A consumer-credit slump, which looks increasingly likely, would clobber securities backed by credit-card and car loans, which are also pooled in CDOs. That would be all the beleaguered banks need.

Thursday, November 08, 2007

Gender differences in "extreme" mathematical ability

Since the Larry Summers debacle I've kept my eye out for relevant data on gender differences in mathematical ability. Finally I've found some analysis of results from a nationally representative study of elementary school children (K-5). Interestingly, the larger variance in male math performance is already observed at the beginning of kindergarten -- yes, before formal schooling has begun. By 3rd grade males are outperforming throughout the distribution, but the advantage at the high end is roughly unchanged. Note the authors consider 95 percentile to be "extreme" ability, which is kind of funny. You have to go quite a bit further out on the tail to find the talent pool from which professors of math, computer science, physical science and engineering are drawn.

Taking a quick look at their numbers, it appears that at the beginning of kindergarten the male distribution has standard deviation about 8 percent greater than the female distribution (larger variance -- both tails are overpopulated by males), although means and medians are pretty much the same. This implies that, already at age 5, at the 1 in 1000 talent level there will be roughly 2.5 times as many boys as girls. This ratio becomes larger and larger as one looks at more elite groups -- for 1 in 10k talents the ratio is something like 4 to 1 male to female. (I am extrapolating the normal distribution here, which might be a source of error.)

If subsequent societal effects were exactly gender neutral after age 5, one still might expect to find a strong asymmetry in gender representation in certain fields. Therefore, gender asymmetry in outcomes is not by itself evidence of discrimination at higher levels of the selection process. Removing gender bias at all levels, starting from kindergarten and continuing through grade school, high school, undergraduate, graduate and postdoctoral training, and, finally, faculty hiring, will not correct for the effect which is already present at age 5!

Note, I'm not claiming that the male advantage at age 5 is necessarily biological in origin -- it might be due to environmental causes. If one believes the causes are entirely environmental, and if one wants to equalize the numbers of male and female math geniuses, then intervention had better begin quite early -- extending to how mommies and daddies raise their infants.

In some other research by the same authors (I don't have a web link), international scores on the TIMSS examinations show that at the 90th percentile in math ability among seniors in high school, the ratio of males to females varies between roughly 2-3. This is a much larger discrepancy than the kindergarten numbers (strongly apparent already at only the 90th percentile), although it would be hard to know whether it is due to biological causes such as hormones and differences in male/female development, or to societal causes. The fact that there is some variation between countries does suggest at least a significant societal component.

If you read this post carefully, you will see that I have done little more than interpret the results of the nationwide testing examined in the paper below. Nevertheless, I anticipate I might get into trouble for having the temerity to perform this simple analysis. Let me therefore state, for the record, that I do believe that societal effects tend to discourage women from achievement in math and science, and that we can do much better than we currently are in promoting female representation in math-heavy fields. However, I do not think that there is any data supporting a complete absence of gender differences in the distribution of cognitive ability.

Gender Differences in Kindergartners Mathematics Achievement! Evidence from a Nationally Representative Sample

Paper presented at the annual meeting of the American Sociological Association (to appear in Social Science Research)

Paret, M. and Penner, A., Dept. of Sociology, UC Berkeley (2006, Aug)

Abstract: Gender differences in mathematics achievement are typically thought to emerge at the end of middle school and beginning of high school, yet some studies have found differences among younger children. Until recently the data available to examine gender differences among young children consisted of small non-nationally representative samples. This study utilizes data from the Early Childhood Longitudinal Study, Kindergarten Class of 1998-99 to analyze differences in a nationally representative sample of kindergarteners as they progress from kindergarten to third grade. Using quantile regression techniques to examine gender differences across the distribution, differences are found among students as early as kindergarten. Initially boys are found to do better at the top of the distribution and worse at the bottom, but by third grade boys do as well or better throughout the distribution.

Wednesday, November 07, 2007


From the comments on the previous post More mark to model:

It’s worse than you think. Even the top brass at the big C (our nations largest) don’t know how much toxic waste sub prime CDOs they’ve got on book, and off book in siv s. C is not nearly alone. Your idea about’s is very unlikely to be a safe haven and the list goes on and on and on. The problem takes on new proportions of fugly when you realize that the monolines (bond insurers) are way in over their heads. Counter party trust is in bad shape. This mess cascades into a true shit avalanche by summer 09 during the next round of mortgage re-sets. The Dollar is being deserted like lifeboats leaving the Titanic. (Look what the dollar did at 9pm on the forex market this evening... a brief period of free fall during a long down trend.) Make no mistake about it this doesn't end pretty. The fed has a grim the dollar and plunge the country into depression or support the it appears to be doing with lower interest rates... and generate hyperinflation and a dollar crash. Suggested reading, Nouriel Roubini blog and Calculated Risk.

Funny story: my brother was at an event in Minneapolis about 10 days ago where Rob Rubin was the keynote speaker. During Q&A my brother asked him about subprime, SIVs, etc. and Rubin replied rather categorically that they weren't a problem for Citi. The local paper covered the story but not the national media.

StarTribune: Citigroup and other giant U.S. banks are not imperiled by subprime debt, despite the fact that they own tens of billions of dollars in debt linked to the deteriorating mortgage markets, former U.S. Treasury Secretary Robert Rubin said in Minneapolis on Wednesday.

Rubin, who was a Goldman Sachs executive before serving as President Bill Clinton's Treasury secretary, said the U.S. economy has bigger worries than subprime debt, ranging from the fear of consumer spending hitting a wall to the sagging international value of the dollar.

At a conference sponsored by the Dorsey & Whitney law firm, Rubin found himself answering questions about the growing troubles of the U.S. financial system stemming from the lax lending standards that prevailed during the housing boom.

The Bush administration has pushed the money-center banks to create a fund to avert a panic sell-off of subprime mortgages -- and the securities backed by those loans, often referred to as structured investment vehicles, or SIVs.

The efforts to create that $100 billion fund should not be seen as an effort by Citigroup and other major banks to protect themselves by propping up the subprime market, said Rubin, who is now a Citigroup director and chairman of its executive committee.

More than 95 percent of Citigroup's investments in SIVs are fully financed through the rest of 2007 and the bank has the money to cover losses if the value of subprime loans continues to fall next year, he said.

"I think the problem with this SIV issue is that it's been substantially misunderstood in the press," said Rubin, who has a considerable personal stake in the fate of Citigroup. The banking firm paid him $17.3 million last year.

"The banks appear to be in fine shape," he said. "That's not a problem."

The SIV issue isn't critical for the economy, he insisted.

"It's massively less important that it's been presented," Rubin said. "It's been presented as a sort of centerpiece of what's going on. I just don't think that's right."

Monday, November 05, 2007

More mark to model

Exactly what will certified accountants say about the balance sheets of Citi, Merrill, et al. at the end of the year? We may need a modification of financial accounting rules that allows for error ranges and Monte Carlo simulation in the reported results :-)

Can anyone guess when financials as a group will be oversold and I can go bargain shopping? Anyone recommend a good ETF for this purpose? (IYF, IYG, VFH, ...)

Earlier I had heard about foreign banks (e.g., in Germany) as big buyers of toxic CDO tranches, but now I learn that our sophisticated investment banks are also on the hook! (Goldman, perhaps, excepted?)

WSJ: Citigroup Acknowledges
It Can Only Estimate Write-Offs

November 6, 2007

How much more will Citigroup Inc. and other banks end up having to write off? It's still anyone's guess. In a Citigroup conference call Monday, a day after the bank said it expects it might have to record losses of $8 billion to $11 billion this quarter, likely wiping out net profit, Chief Financial Officer Gary Crittenden acknowledged that these numbers are an estimate of the write-downs the bank may need to take on $55 billion in subprime securities and collateralized debt obligations. It "can't give any assurance" that the loss won't grow worse, or perhaps shrink, as the quarter progresses, he said.

Our reporters write that investors were especially unnerved by the fact that the big U.S. bank announced the additional write-downs just weeks after saying third-quarter losses due to the bank's subprime exposure would be $1.56 billion. The new, vastly bigger losses calls into question Citigroup's ability to measure its holdings, while sparking wider fears that the credit crunch is continuing unabated. Citigroup officials said it will take the bank until the middle of next year to iron out the mess created by the recent credit-market turmoil.

Investors voted with their pocket books, sending Citigroup shares down 6.2% in New York Monday after the bank said it will need much longer to dig itself out of a hole that has deepened dramatically in recent weeks. The steep share drop showed that any relief among investors' over Chief Executive Charles Prince's departure was quickly eclipsed by concerns about continuing losses the bank may face due to securities underpinned by subprime mortgages.

The crows come home to roost? Recall that financial firms have posted record profits in recent years, accounting for a larger and larger fraction of all S&P 500 earnings.

Will super senior tranches suffer losses, or are they merely suffering from contagion?

WSJ: Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be

November 5, 2007; Page C1

When the market for mortgage securities entered a meltdown over the summer, financial firms holding billions of dollars of hard-to-trade assets used mathematical pricing models that were heavily dependent on credit ratings. When the credit-rating firms began a massive downgrade campaign last month, firms such as Citigroup Inc. and Merrill Lynch & Co. saw the value of their holdings plummet.

Citigroup's struggles to put an exact number on its losses demonstrate just how fallible the models can be, and how serious the consequences. Last night, Citigroup said that the downgrades will result in a reduction of fourth-quarter net income of $5 billion to $7 billion. That follows a third quarter when Citigroup recorded mortgage-related write-downs of $2.2 billion, including losses on subprime securities and fixed-income trading.

The latest update, much of it involving securities linked to subprime mortgages, follows a revision made late last month by Merrill Lynch that increased third-quarter write-downs to $7.9 billion from an earlier estimate of about $4.5 billion for exposure to debt pools and subprime loans. As a result, analysts are beginning to see Merrill's big hit as less of an anomaly than originally thought.

"We estimate that there's over $10 billion of write-downs in the fourth quarter for the industry for banks and brokers," said analyst Mike Mayo, who covers financial firms for Deutsche Bank. Mr. Mayo said his estimate is based on exposure to debt pools and mortgage securities and includes Citigroup, Bear Stearns Cos., Morgan Stanley and Bank of America Corp. Citi's updated write-downs could be included in its coming quarterly filing with U.S. securities regulators.

The source of Citigroup's write-down is at least as significant as its size. The bank's estimate of its losses has changed so rapidly in large part because the models it used to value hard-to-trade securities relied heavily on credit ratings, according to people familiar with the models.

That made the bank highly vulnerable when, in October, ratings firms Moody's Investors Service and Standard & Poor's slashed, or put on watch for downgrade, the ratings on tens of billions of dollars in securities.

It is unlikely that Citigroup is alone. Ratings play a big role in valuation models used by many banks, investment funds and insurance companies. Meanwhile, the market for securities linked to subprime loans has deteriorated in recent weeks as defaults have confirmed some of analysts' most dire forecasts, increasing the likelihood of further ratings downgrades.

Citigroup's subprime exposure -- and source of its problems -- is found in two big buckets that together total $55 billion in its securities and banking unit, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

These highly rated super-senior securities are portions of collateralized debt obligations, or CDOs. CDOs are repackaged pools of lower-rated securities backed by subprime loans into pieces with different levels of risk and return. Analysts estimate that $60 billion in such super-senior tranches are sitting on the books of banks, insurers and investment funds.

The troubles stem back to the heyday of the U.S. housing boom, when Citi became one of the biggest players in the lucrative world of CDOs backed by subprime-linked bonds. Overall, Citi was the second-largest underwriter of CDOs in 2006, doing $34 billion in deals, according to data provider Dealogic. ...

Sunday, November 04, 2007

The plight of the serial entrepreneur

Below are profiles of two serial entrepreneurs, Avi Rubin and Max Levchin. These are guys who have succeeded before but are still at it, still tooling, still cranking, to the benefit of society. Avi Rubin, the older of the two at 44, seems to have had his share of successes and failures, coming close to bankruptcy with his latest startup before a serendipitous Google acquisition. It's a long and difficult road.

Why do it? Why risk failure every few years when you could take a cushy, secure job at a big company? I don't really know, but it is people like this who are disproportionately responsible for innovation in society.

When I was in college, a few of my friends were devotees of Ayn Rand. I dismissed this interest as sophomoric and her ideas as simplistic, but the more time I spend around startups and in technology the more I come around to her point of view...

Rand on Objectivism: "My philosophy, in essence, is the concept of man as a heroic being, with his own happiness as the moral purpose of his life, with productive achievement as his noblest activity, and reason as his only absolute."

Avi Rubin and the Google phone:
NYTimes: ...Mr. Rubin then became an entrepreneur in residence at a Silicon Valley venture firm and retreated for a few months to the Cayman Islands, where he began writing software and tried developing a digital camera. But he could not find a backer for the camera, so he returned to his original idea of creating a next-generation smart cellphone. Using a domain name that he had owned for several years,, he started a new business and assembled a small team of engineers and product planners. Their goal was to design a mobile hand-set platform open to any and all software designers.

Mr. Rubin spent all his savings on that project. He called his friend Mr. Perlman and told him he was broke.

“How soon do you need the money?” Mr. Perlman asked.

“Now!” was the answer.

Mr. Perlman went to the bank and withdrew $10,000 in $100 bills, brought them to Mr. Rubin’s office and set them in a stack on Mr. Rubin’s desk. Ultimately, he lent him a total of $100,000, which helped Android complete its business plan.

This time, venture capitalists loved the idea. So did Craig McCaw, the early cellular telecommunications pioneer who is now chairman of Clearwire, a wireless network operator. As Mr. Rubin was negotiating terms with Mr. McCaw, he sent an e-mail message to Mr. Page informing him of the potential partnership. Within weeks, Google acquired Android for an undisclosed sum. Mr. McCaw declined to comment on the sale. ...

Max Levchin, formerly of PayPal:

NYTimes: ...A few years ago, Mr. Levchin, one of the young princes of Silicon Valley, bought his first home, a 12-room Edwardian high atop a hill here, for $3.4 million. But Mr. Levchin, who made a fortune at age 27 selling PayPal, the online payment service he helped start in 1998, never moved in. He sold it two years later without having slept there for even one night.

Since then, Mr. Levchin has moved into his second home, a more expensive one found for him by Nellie Minkova, his girlfriend of eight years who has become his fiancĂ©e. But so consumed is he by work on his second company, an Internet start-up focused on sharing photos and videos, that the cartons that contain what Mr. Levchin described as “85 percent of my worldly possessions” are still stacked in his living room, five months after moving day.

Mr. Levchin, who is now 32, is typical of a new generation of junior titans in Silicon Valley who might be called the prematurely rich — techies worth tens of millions of dollars, sometimes more, at an age when many others are just starting to figure out what to do with their lives.

The Internet, a low-overhead medium with a global reach, has greatly accelerated the wealth creation phenomenon, producing a larger breed of multimillionaires even younger and richer than in the past.

They are happy to be wealthy, of course, but many of these baby-faced technology tycoons often seem indifferent to the buying power of their money, at least at this stage of their lives. Instead, nearly all of them have chosen to throw themselves back into a start-up, not so much because they want a spectacular new home or a personal jet — though many of them do — but because they are in a competition with themselves and one another.

“For most of us, doing it again means surpassing what we’ve done previously,” said Peter A. Thiel, Mr. Levchin’s partner at PayPal, who also has started a new business, a hedge fund called Clarium Capital. “And that can be a really high bar.”

Even among this jittery group of overachievers, Mr. Levchin stands out. In part that is because outdoing PayPal may be an all-but-impossible goal. Mr. Levchin acknowledges that he has already earned more money than he could ever spend. But he said he would not consider, the photo and video sharing site he founded in 2005 that is still in its start-up phase, a success unless it is ultimately worth, in real dollars, “at least $1.54 billion”— the price eBay paid for PayPal.

“Otherwise,” he asked rhetorically, “what have I learned?”

During his PayPal days, Mr. Levchin was so committed to seeing the company succeed that he often sacked out at the office in a sleeping bag he kept under his desk. Considering that he described his apartment during some of this time as “scary,” that had a certain logic. Cardboard boxes served as his living room furniture; a discarded computer desk was his dining room table.

These days, despite the phenomenal success of PayPal, which gave him the bulk of a fortune worth around $100 million, Mr. Levchin continues to work an average of 15 to 18 hours a day.

“We occasionally go out to eat, he sleeps a few hours, he works out,” Ms. Minkova said. “But other than that, Max works.”

Ms. Minkova half-joked that she might appreciate her occasional evenings out with Mr. Levchin more, if only he were not on his BlackBerry, answering e-mail messages and checking his Web site.

One friend, Dennis Fong, who sold a company to MTV Networks last year for $102 million (and is already at work on a new start-up), talks about the “weird growling sound” that Mr. Levchin tends to make when someone even mentions the name of his chief rival, RockYou.

And so committed is Mr. Levchin to seeing succeed that he keeps a blood-pressure monitor on his desk. “I don’t know what I would do if I couldn’t start companies,” he said. “I’d probably think about slitting my wrists.”

Wealthy at a Young Age

Maximillian Rafael Levchin was born and raised in Kiev, Ukraine, a Jew living under Soviet rule for 16 years. As the Soviet Union was crumbling, the family moved to the United States and settled in Chicago. But the worst year of his life, he said, was not when he was growing up but after eBay bought PayPal.

He thought he would spend the time after the sale “exploring my inner self.” Instead, he spent the better part of 12 months “feeling worthless and stupid” and baffled by what he might do with the remainder of his life. He felt too young to retire or downshift a gear or two — and too restless to become a philanthropist.

“I enjoy sitting on nice beaches and hanging out with my girlfriend and playing with my dog, but that’s three hours a day,” Mr. Levchin said. “What about the remaining 18 hours I’m awake?”

At first, free time was not much of a problem. Coming into a lot of money at a very young age, Mr. Levchin found himself forced to ponder things like irrevocable trusts and secondary beneficiaries. Several times a week, he would listen to the gentle hectoring of older, well-dressed men and women whom he playfully mimicked, employing a basso profondo, game-show announcer’s voice.

“Think of the kids you don’t have,” Mr. Levchin quoted them as saying. “Think of your unborn grandkids.”

As those obligations of his new wealth subsided, Mr. Levchin contemplated what he might do next. For a time, Mr. Levchin, a graduate of the University of Illinois at Urbana-Champaign, thought about returning to school and earning a doctorate. That is what his mother, a physicist, had always wanted him to do, and it seemed to suit his temperament.

But discussions with a friend who teaches computer science at Stanford convinced him that academia was not the life for him. “This friend said, ‘Don’t kid yourself, you’re going to start another company,’” Mr. Levchin said. “It was one of those things where as soon as he said it, I knew it was true.”

He thought, too, about becoming a venture capitalist or an angel investor, a well-paved path for generations of entrepreneurs before him. Sequoia Capital, one of Silicon Valley’s top venture firms, gave him a desk to use while he figured out his next step. The partners at Sequoia would regularly invite him to join pitch meetings, but that experience taught him that he was hardly suited to the more nurturing side of the profession.

“I took this perverse pleasure in seeing if I could make someone cry,” he said.

At Sequoia, Mr. Levchin met James Hong, another successful entrepreneur who today is one of his closest friends.

“We’d go out drinking, and Max’d talk about how miserable he was, and I’d talk about how miserable I was,” said Mr. Hong, who was 27 when he and a friend started HotOrNot, a Web site popular with the under-30 crowd.

Mr. Levchin added, “We were both pretty pathetic.”

While not nearly as rich as Mr. Levchin, Mr. Hong describes himself as well off enough so that work is optional. He was collecting more than $1 million a year from HotOrNot, a project he and his partner had created in seven days and which demanded little of his time.

“All of a sudden, you have the luxury — or the curse — of being able to ponder the meaning of life,” Mr. Hong said. “You ask yourself, ‘Why am I not happier given how lucky I’ve been?’”

Only later did Mr. Hong diagnose the real source of his angst: he was not doing much of anything. So like most of his peers, Mr. Hong decided to throw himself back into work, in his case refocusing on HotOrNot in the hopes of transforming the Web site into a larger business.

In Silicon Valley, said Robert I. Sutton, a professor of management science and engineering at Stanford and co-founder of the Stanford Technology Ventures Program, remaining relevant, if not also admired and respected, requires that an entrepreneur continue to speed along in the fast lane.

“In other parts of the country, things like a great estate are the symbols people most respect,” Mr. Sutton said. “But here, the greatest status symbol is a person’s ability,” he added, to “still bring out hot new companies” and show that you are “working on the hot new technologies.”

Thursday, November 01, 2007

The quants of August

Why the rough markets in August? Why the big losses for certain quant funds? This paper claims the following:

1) many funds are pursuing the same strategies, using significant leverage

2) problems in the credit markets forced some multi-strategy funds to sell liquid equity positions in order to meet margin calls

3) positions commonly held by quant funds deteriorated in a correlated manner

Conclusion: systemic risk galore!

More discussion in the Economist.

What Happened to the Quants in August 2007?

Massachusetts Institute of Technology

September 20, 2007


During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere - apparently in a completely unrelated set of markets and instruments - suggests that systemic risk in the hedge-fund industry may have increased in recent years.

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