Thursday, May 21, 2009

Gillian Tett at LSE

Highly recommended: FT journalist Gillian Tett, a PhD in social anthropology, discusses her book on the financial crisis: Fool's Gold, at an LSE public lecture.

I haven't read the book yet, but it's on my list :-) Here are two nice excerpts that appeared in the FT. She does a great job of covering the birth and development of credit derivatives, CDOs, etc.

Genesis of the debt crisis

How panic gripped the world's biggest banks

Below is a discussion of correlation from the first excerpt.

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.


anon said...

"and working out how they might develop among any basket of companies is fiendishly complex"

A better description would be "impossible to model", but there is a tacit assumption among quants that there is always a model.

Still ignored is what Soros calls "reflexivity". That is, the performance of loans/bonds depends on future lending/underwriting.

Don said...

"The number of defaults required to set off such a chain reaction was a vexing unknown. "

Here's where I disagree with Tett and a lot of others. It is not that the CDSs actually defaulted. What happened was that the rise in the foreclosure rate led to uncertainty about the solvency about CDSs, and this led to credit downgrades and calls for more capital.

What then followed is what I call a Calling Run, following the ideas of Irving Fisher on Debt-Deflation. Many people decided to Flee to Quality, cash or its equivalents, all at once. This included investors not even directly hit by the CDSs or foreclosure problems. A perfect example is China moving from Agencies into Treasuries. Why did they do that?

At this point, in a Calling Run, assets are revalued according to safety and liquidity. On that basis, CDSs and CDOs, etc., lost value precipitously because they are very low on the Flight to Safety Chart, where low isn't good.

For two good papers on this:

Read Irving Fisher's "The Debt-Deflation Theory Of Great Depressions" here:


Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007+
Gary Gorton

Having said that, I'm going to read her book and listen to her lectures, as I read everything that she writes in the FT. Big Felix Salmon also interviewed her for Reuters about this book.

Don the libertarian Democrat

PS I'm going to eventually do a series of posts on whether a robot can discover that it's a robot. But ponder this: The Many-Worlds View proves that there is free will, since any action that can occur, does.

ziel said...

From the first excerpt: But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.
There's a very prosaic term to describe all this: "fraud". More profitable investments carry a higher risk - this is called "spread." These derivatives allowed banks to earn the higher returns while wishing away the risks - i.e. paying a token premium. Of course it eventually bankrupted AIG - but Joe Cassano is still a free and wealthy man.

The only safe investment is a safe investment - you can't "insure" a security - the underlying risk is built into the price - there's nothing to insure.

anon said...

A CDS is a put option with strike price the face value.

How is a put not insurance?

STS said...

Obviously CDS are insurance policies. The problem isn't the idea of "insuring" credit defaults. The problem is that in writing a lot of that kind of insurance the insurer can't seek safety in diversification. Property insurers can write policies on the Gulf coast and then diversify away risk by writing policies on ranches in Montana. Hurricanes just don't hit both places the same year (if indeed at all).

Credit markets are inherently connected. Default correlations increase whenever there's a serious crisis.

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