Is the finance boom over?

At least for a while. Note the dip after the great depression -- is that where we are headed?




This data comes from papers by Thomas Phillippon (MA in physics, Ecole Polytechnique, PhD in economics, MIT -- vive Les Grandes Ecoles!). See here and here; via Zubin Jelveh.

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and its wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward [deregulation!], another shift occurred. The financial sector became a high-skill high-wage industry again.

The figure below (click for larger version) shows the relative incomes of engineers and financiers over time. The data on the right is for those with postgraduate degrees. Perhaps the collapse of the finance bubble will reallocate human capital back into more "productive" activities?

The Laskers and the Go master

My father played Chess, Go and Bridge. I don't know much about the last two, but I recently came across this vignette from Edward Lasker (International Master and US Chess champion) about his and Emanuel Lasker's encounter with a Go master. Emanuel Lasker was world Chess champion for 27 years -- rated among the strongest players of all time -- and a mathematician as well.

Mr. Kitabatake one day told us that a Japanese mathematician was going to pass through Berlin on his way to London, and if we wanted to we could play a game with him at the Japanese Club. Dr. Lasker asked him whether he and I could perhaps play a game with him in consultation, and was wondering whether the master – he was a shodan – would give us a handicap.

“Well, of course,” said Mr. Kitabatake.
“How many stones do you think he would give us?" asked Lasker.
“Nine stones, naturally,” replied Mr. Kitabatake.
“Impossible!” said Lasker. “There isn’t a man in the world who can give me nine stones. I have studied the game for a year, and I know I understood what they were doing.”
Mr. Kitabatake only smiled.
“You will see,” he said.

The great day came when we were invited to the Japanese Club and met the master – I remember to this day how impressed I was by his technique – he actually spotted us nine stones, and we consulted on every move, playing very carefully. We were a little disconcerted by the speed with which the master responded to our deepest combinations. He never took more than a fraction of second. We were beaten so badly at the end, that Emanuel Lasker was quite heartbroken. On the way home he told me we must go to Japan and play with the masters there, then we would quickly improve and be able to play them on even terms. I doubted that very strongly, but I agreed that I was going to try to find a way to make the trip.

Edward Lasker:

While the baroque rules of Chess could only have been created by humans, the rules of Go are so elegant, organic, and rigorously logical that if intelligent life forms exist elsewhere in the universe, they almost certainly play Go.

I'm sympathetic to this point of view. The rules of Go seem to be a natural embodiment of two dimensional notions of encirclement and control of space. They are much simpler and less arbitrary than those of Chess. I can't say anything about the strategic and tactical subtlety of the game, since I don't play, but experts seem to think it is quite deep (certainly it is more challenging for AI than Chess, if only for combinatorial reasons). One problem with Lasker's contention is that Go doesn't seem to have been invented independently by any human civilizations other than ancient China (supposedly 4000 years ago)!

Housing bubble: one third to go

Via Calculated Risk, Case-Shiller indices (10 and 20 city composites) show that, adjusted for inflation, we have given back two thirds of the peak relative to 2000.

Here is the last 100 years:





International comparisons (not inflation adjusted):

Greenspan now agrees with Soros; Galbraith interview and a calculation

Bill Moyers' Journal is usually pretty boring, but of late he's been quite good. Two weeks ago he interviewed George Soros, who said the following:

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

Yesterday he interviewed (thanks to Mark Thoma for the link) heterodox economist James Galbraith (UT Austin; son of John Kenneth Galbraith). Moyers led into the Galbraith interview by first quoting from Alan Greenspan's recent congressional testimony.

ALAN GREENSPAN: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.

CHAIRMAN WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working.

ALAN GREENSPAN: Absolutely, precisely. You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.

Now on to the heterodoxy:

BILL MOYERS: With his ideological blinders stripped away by reality, Alan Greenspan might well do penance by curling up this weekend not with THE FOUNTAINHEAD and ATLAS SHRUGGED but with James K. Galbraith's new book THE PREDATOR STATE: HOW CONSERVATIVES ABANDONED THE FREE MARKET AND WHY LIBERALS SHOULD TOO. In it, the author asks: "Why not build a new economic policy based on what is really happening?" ...

BILL MOYERS: What scares you most right now?

JAMES GALBRAITH: Well, a week ago or two weeks ago I would have said the possibility that [McCain economic advisor] Phil Gramm might become Secretary of the Treasury. ...Gramm himself was the architect, a deep architect of the speculative markets that have just collapsed. ...

BILL MOYERS: You call your book THE PREDATOR STATE, what do you mean predator?

JAMES GALBRAITH: What I mean is the people who took over the government were not interested in reducing the government and having a small government, the conservative principle. They were interested in using these great institutions for private benefit, to place them in the control of their friends and to put them to the use of their clients. They wanted to privatize Social Security. They created a Medicare drug benefit in such a way as to create the maximum profit for pharmaceutical companies.

They used trade agreements to extend patent protections for various interests or to promote the expansion of the corporate agriculture's markets in the third world. A whole range of things that were basically political and clientelistic. That's the predator state.

BILL MOYERS: You call it a corporate republic.

JAMES GALBRAITH: It is a corporate republic.

BILL MOYERS: Which means that the purpose of government is to divert funds from the public sector to the private sector?

JAMES GALBRAITH: I think it's very clear. They also turned over the regulatory apparatus to the regulated industries. They turned over the henhouse to the foxes in every single case. And that is the source of the decline in, the abandonment of environmental responsibility, the source of the collapse of consumer protection, and the source of the collapse of the financial system, all trace back to a common root, which is the failure to maintain a public sector that works in the public interest, that provides discipline and standards, a framework within which the private sector can operate and compete. That's been abandoned.

BILL MOYERS: We saw what Alan Greenspan said yesterday. But did you see what the chairman of the Securities and Exchange Commission, Christopher Cox, said? I mean, it was one of the great recantings in modern American history. Quote, "The last six months have made it abundantly clear that voluntary regulation does not work."

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years.

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional 0.1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was 0.1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than 0.1 percent, then the intellectually honest answer to the policy question is: I don't know. No shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

Intellectual honesty: how much do we know?

As I have emphasized many times on this blog, when it comes to complex systems like society or economy (and perhaps even climate), experts have demonstrably little predictive power. In rigorous studies, expert performance is often no better than random. This is not surprising to anyone who has studied nonlinear dynamics and is free from ideological or professional bias (see below).

What is worse, experts are usually wildly overconfident about their capabilities. I'm often quite critical here of work done in fields like economics and social science, not because the results are unimpressive -- I acknowledge that the problems are hard and the systems under study intractable -- but because the researchers themselves often have beliefs whose strength is entirely unsupported by available data. They are usually unaware that biases (strong priors) shape their thinking, not scientific hypothesis testing. These biases come in many forms -- market fundamentalism, extreme belief in nature over nurture or vice versa, unrealistic faith in the powers of government, unrealistic faith in simple models, etc. (More from Robin Hanson and company here.)

It's refreshing to hear experts openly proclaim their lack of knowledge. Below are some comments from economist Arnold Kling, which would have gotten a physicist like me into hot water had I made them:

Economists pretending to have knowledge: ...I am shocked at the behavior of my fellow economists during this crisis. They are claiming to know much more than they do about causes and solutions. Rather than trying to understand and explain what is going on, they are engaged in a fierce battle over narrative.

...My main beef with economists is that standard macroeconomics does such a poor job of describing what is going on. The textbooks models are pretty much useless. Where in the textbooks is "liquidity preference" a demand for Treasury securities? Where in the textbooks does it say that injecting capital into banks is a policy tool?

Graduate macro is even worse. Have the courses that use representative-agent models solving Euler equations been abolished? Have the professors teaching those courses been fired? Why not?

I have always thought that the issue of the relationship between financial markets and the "real economy" was really deep. I thought that it was a critical part of macroeconomic theory that was poorly developed. But the economics profession for the past thirty years instead focused on producing stochastic calculus porn to satisfy young men's urge for mathematical masturbation.

More from Paul Romer of Stanford:

In the current crisis, the astonishing and unexpected consequences of the Lehman Brothers bankruptcy should serve as a similarly decisive data point. On the Thursday and Friday before Lehman filed for protection, I was at a conference on the financial crisis. Everyone there expected them to file on Monday. We repeated for each other all the fundamentalist arguments: "Everyone had been given time to prepare." "The courts handle bankruptcies all the time." None of us expected that putting Lehman through a court managed bankruptcy would be much different from arranging a forced sale of Bear Stearns.

We were all wrong. Within days, AIG was insolvent. Runs were developing on Goldman Sachs, Morgan Stanley, and the entire money market fund industry. Banks had stopped lending to each other in the Fed Fund market. Rates on Treasuries approached zero.

Here is one of the best academic papers I have seen on the credit crisis and the growth of the shadow banking system ("New Financial Architecture"). But note that the author James Crotty of U Mass Amherst is not considered a mainstream researcher in the field -- he's "heterodox"! It is amusing that in economics Crotty is considered a quasi-Marxist, whereas his views correspond quite strongly with those of actual financiers (at least when privately expressed).

This PERI Working Paper argues that the ultimate cause of the current global financial crisis is to be found in the deeply flawed institutions and practices of what is often referred to as the New Financial Architecture (NFA) – a globally integrated system of giant bank conglomerates and the so-called ‘shadow banking system’ of investment banks, hedge funds and bank-created Special Investment Vehicles. These institutions are either lightly and badly regulated or not regulated at all, an arrangement defended by and celebrated in the dominant financial economics theoretical paradigm – the theory of efficient capital markets. The NFA has generated a series of ever-bigger financial crises that have been met by larger and larger government bailouts.

After a brief review of the historical evolution of the NFA, this paper analyses its structural flaws: 1) the theoretical foundation of the NFA – the theory of efficient capital markets – is very weak and the celebratory narrative of the NFA accepted by regulators is seriously misleading; 2) widespread perverse incentives embedded in the NFA generated excessive risk-taking throughout financial markets; 3) mortgage-backed securities central to the boom were so complex and nontransparent that they could not possibly be priced correctly; their prices were bound to collapse once the excessive optimism of the boom faded; 4) contrary to the narrative, excessive risk built up in giant banks during the boom; and 5) the NFA generated high leverage and high systemic risk, with channels of contagion that transmitted problems in the US subprime mortgage market around the world.

Finally, as any trader knows, talk is cheap. Your opinion counts nothing unless you have skin in the game. By that accounting, it's George Soros and John Paulson who emerge as the real experts here -- they are each up billions of dollars after making smart bets on the crisis :-)


Obligatory disclaimer concerning string theory and speculative theoretical physics:

There is an old saying in finance: in the short run, the market is a voting machine, but in the long run it's a weighing machine. ...

You might think science is a weighing machine, with experiments determining which theories survive and which ones perish. Healthy sciences certainly are weighing machines, and the imminence of weighing forces honesty in the voting. However, in particle physics the timescale over which voting is superseded by weighing has become decades -- the length of a person's entire scientific career. We will very likely (barring something amazing at the LHC, like the discovery of mini-black holes) have the first generation of string theorists retiring soon with absolutely no experimental tests of their *lifetime* of work. Nevertheless, some have been lavishly rewarded by the academic market for their contributions.

Everett on Nova

Nova has aired a version of the BBC documentary on Hugh Everett III, the discoverer of many worlds quantum mechanics. The story is told from the perspective of his rock musician son Mark Everett. I liked it very much, although the casual viewer might easily have the wrong impression that the Everett interpretation is a crackpot theory. A brief introduction to many worlds here (or, click the label below). The photo above shows Niels Bohr meeting a young Everett (to Bohr's left).

PBS provides a pdf version of Everett's thesis here.

In the letter that appears here, Hugh Everett deemed this paradoxical "collapse" postulate "a philosophic monstrosity." Casting it aside, he decided to take the Schrödinger Equation at face value and work out what happens if there is no physical collapse. Everett considered the collection of all objects in the universe, including large or macroscopic systems (what we can see with the naked eye) to be fundamentally composed of atoms and molecules (microscopic quantum systems that we can't see). He suggested that these objects existed in ever-evolving superpositions without ever collapsing into a single reality, even though our reality suggests otherwise.

From a discussion with Everett's biographer Peter Byrne.

He was 27 in 1957 when his thesis was published in Reviews of Modern Physics, and the editor of that issue was a cosmologist named Bryce DeWitt. Initially, DeWitt was put off by Everett's theory. He wrote to Wheeler and Everett that, if the universe is splitting, then why don't I feel myself split? Everett wrote back to him, Well, Copernicus made the analysis that the Earth was moving around the sun, undoing thousands of years of belief that the sun was going around the Earth, and people asked him, If the Earth is moving around the sun, then why don't I feel the Earth move? And DeWitt, who was well aware of the Newtonian reasons why they wouldn't, said "Touché" and then forgot about the theory for a while. [See Everett's original letter in response to DeWitt's concerns.]

In the late '60s, when he was working seriously in quantum cosmology, DeWitt was attracted to the universal wave function as an interpretive method of dealing with what was going on, and he started writing about it. In 1970, he published an article in Physics Today that set off a fairly intense series of letters back and forth in that publication, debating the theory. Then, in 1973, he went to Everett and said, "I know that there's a longer version of your thesis than the one that I printed in 1957. I'd like to publish it." It was 137 pages, whereas the thesis that was published in 1957 was about nine pages.

Incentives and bubble logic

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.


Some of the best journalistic coverage I have found of the mortgage bubble is from Ira Glass and This American Life (audio, pdf transcript). They get the "local color" right from top to bottom: self-interested individual borrowers, local mortgage brokers rushing to assemble as many loans as possible, to be sold to Wall Street banks and repackaged as CDOs, rated by agencies like Moody's and S&P that were making record profits from fees, and sold to investors chasing yield in the midst of a liquidity glut caused by low interest rates. From their coverage you can see the incentives were messed up from top to bottom, and that many individuals anticipated trouble ahead, but couldn't put up a fight without risking their careers or bonuses. Some excerpts below.

borrower: ...I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. ...Nobody came and told me a lie: just close your eyes and the problem will go away. That's wasn’t the situation. I needed the money. I'm not trying to absolve myself of anything. I thought I could do this and get out of it within 6 to 9 months. The 6 to 9 month plan didn’t work so I’m stuck.


mortgage broker ...it was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive.

...my boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.” He fought the owners and sales force tooth and neck about these guidelines. He got same answer. Nope, other people are offering it. We're going to offer them too. We’re going to get more market share this way. House prices are booming, everything’s gonna be good. And ... the company was just rolling in the cash. The owners and the production staff were just raking it in.


Wall St. banker ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

...All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.


CDO packager: ... In 2005, we had an internal debate here because there were two banks coming to us, why don’t you do a deal with us, BBB securities, you get paid a million bucks in management fees per year. Very clear, just like that, in 2005. And we declined those deals. We just don't believe those BBB RMBS assets are money-good. And we thought if we do a CDO of those, that's gonna blow up completely. We were early in '05 by not wanting to do those deals. People were laughing at us. Saying you're crazy. You’re hurting your business. Why don’t you want to make ... Per deal, you could make a million dollars a year.

The joy of Turkheimer

I've been a fan of psychologist Eric Turkheimer's work for some time.

In a previous post I discussed the following article, which shows that in the case of extreme poverty (by US standards) the genetic heritability of intelligence is drastically reduced. It is the first study I had heard of which really showed a clear case of nonlinear response to environment (excluding cases of severe malnutrition). See related discussion of heritability and regression here.

Turkheimer, E., Haley, A., D'Onofrio, B., Waldron, M & Gottesman, I. (2003). Socioeconomic status modifies heritability of IQ in young children. Psychological Science, 14, 623-628.

In this paper he discusses interactions between genes and environment, and why they make social science hard:

Turkheimer, E. (2004). Spinach and Ice Cream: Why Social Science Is So Difficult. In. L. DiLalla (Ed). Behavior genetics principles: Perspectives in development, personality, and psychopathology. (pp. 161-189). Washington, DC, US: American Psychological Association.

Recently, he gave the following talk at Stanford, emphasizing how the problems faced by state of the art genomic science (e.g., genome wide association or gwa studies) mirror those of social science. That is, outcomes depend nonlinearly on a large number of (possibly correlated) causes. This is the "Gloomy Prospect" first referred to by psychologist Robert Plomin. I highly recommend the audio version -- Turkheimer is a good speaker and the discussion at the end is interesting.

Gloomy Prospect Wins

slides (ppt) , iTunes audio

The contemporary era has seen a convergence of genomic technology and traditional social scientific concerns with complex human individual differences. Rather than finally turning social science into a replicable hard-scientific enterprise, genomics has gotten bogged down in the long-standing frustrations of social science. A recent report of an extensive genome wide association study of human height demonstrates the profound difficulties of explaining uncontrolled human variation at a genomic level. The statistical technologies that have been brought to bear on the problem of genomic association are simply modifications of similar methods that have been used by social scientists for decades, with little success. The motivation for the statistical methods in genomics is the same as it is in traditional social science: An attempt to discern linear causation in complex systems when experimental control is not possible.

In the talk Turkheimer gives the following definition of social science, which emphasizes why it is hard:

Social science is the attempt to explain the causes of complex human behavior when:

There are a large number of potential causes.

The potential causes are non-independent.

Randomized experimentation is not possible.

He proposes that genomics will also be hard for similar reasons. Final slide:

The question is not whether there are correlations to be found between individual genes and complex behavior— of course there are—but instead whether there are domains of genetic causation in which the gloomy prospect does not prevail, allowing the little bits of correlational evidence to cohere into replicable and cumulative genetic models of development. My own prediction is that such domains will prove rare indeed, and that the likelihood of discovering them will be inversely related to the complexity of the behavior under study.

Modigliani-Miller, RIP

Even a casual observer knows that the current financial crisis was partially caused by high leverage ratios. But did you know that a Nobel Prize in Economics [sic] was awarded for a theorem that "proved" that leverage ratios don't matter? Yes, it is called the Modigliani-Miller theorem:

Leverage doesn't matter!

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.

See if you can spot the completely unrealistic efficient market "no-arbitrage" assumption used to prove the theorem:

Proposition: VU = VL, where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. [Ha ha ha ha!] Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

If U and L are banks investing in risky mortgage assets, which do you think is going to collapse due to a run when those assets are marked down? (See here for more problems.)

Believe it or not, Nobelist Myron Scholes invokes Modigliani-Miller in this debate over stronger financial regulation at the Economist web site. ***

Here is what I wrote in a post back in March 2008 (Privatizing gains, socializing losses).

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on.

My corollary to the Modigliani-Miller theorem: A Nobel in Economics ain't no Nobel in Physics. (Sorry, Krugman.)


*** Footnote: I do agree with Scholes' point that any argument for regulation needs to take into account the benefits from innovation that we might be giving up.

CDO, CDO-squared and CDS in pictures

If you already know what a CDO is, this is too elementary, but it might be helpful for explaining to your friends...


Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.


Here's one for CDS (thanks to MFA for the pointer):


Untangling credit default swaps from Marketplace on Vimeo.

Complexity in the ruins of Lehman

Lehman was too connected to be allowed to fail. Now a bankruptcy court is trying to sort through 1.5 million derivatives trades with 8000 counterparties...

WSJ: Lehman Brothers Holdings Inc.'s legal and financial advisers said Thursday they plan to hire about 200 professionals to help settle the more than 1 million derivatives trades the investment bank entered into before it collapsed last month.

Lehman attorney Harvey Miller said at a court hearing that advisers are working around the clock to understand Lehman's transactions in the wake of the "chaos" that resulted from its Sept. 15 bankruptcy filing, the largest ever in U.S. history.

Much of their work will focus on wading through about 1.5 million derivatives trades involving 8,000 counterparties. Lehman's chief restructuring officer Bryan Marsal of turnaround firm Alvarez & Marsal said about 210 financial professionals will be hired to unwind those trades.

Mr. Miller credited Mr. Marsal for his work so far, saying he has "brought order to this chaos." Alvarez & Marsal has 144 employees working on the Lehman matter along with 165 Lehman employees still working at the bank.

...Mr. Miller told Judge Peck he expects it will take 45 to 60 days before Lehman can answer numerous inquiries from creditors.

Factory girls

Leslie T. Chang was WSJ's correspondent in southern China for many years. She's written a book called Factory Girls about the role of migrant workers in the manufacturing boom. Here is a 30 minute interview in which she discusses the book.

Stories of industrialization and urbanization have always been Dickensian, whether set in Manchester or Manchuria. Conditions are tough in factories in the developing world, but conditions are even tougher on the farm -- if you doubt me, just ask any migrant. That is why hundreds of millions of Chinese (not to mention Europeans and Japanese and North Americans in earlier times) have opted for city life.

Related posts on the great migration from the countryside to cities here, here and here.

Regression to the mean

Consider a trait like height or intelligence that is at least partially heritable. For simplicity, suppose the adult value of the trait X is equally affected by genes G and environment E, so

X = G + E

where G and E are, again for simplicity, independent Gaussian random variables (normally distributed) with similar standard deviations (SDs).

Suppose that you meet someone with, say X = +4 SD (i.e., someone with an IQ of 160 or a (male) height of roughly 6 ft 9). What are the likely values of G and E? It's more likely that the +4 SD is obtained from two +2 SD draws from the G and E distributions than, say, a +3 SD and +1 SD draw. That is, someone who was lucky(?) enough to grow to seven feet tall probably benefited both from good genes and a good environment (e.g., access to good nutrition, plenty of sleep, exercise, low stress).

Now consider a population of +4 SD men married to +4 SD women. (More generally, we can consider a parental midpoint value of X which is simply the parental average in units of SD.) Suppose they have a large number of children. What will the average X be for those children?

If we treat the environment E as a truly independent variable (i.e., it is allowed to fluctuate randomly for each child or family), then the children will form a normal distribution peaked at only +2 SD even though the parental midpoint was +4 SD. In other words, given the random E assumption the kids are not guaranteed to get the environmental boost that the parents likely had. Most of the parents benefited from above average E as well as G. This is called regression to the mean, a well documented phenomenon in population genetics that was originally discovered by Galton.

Regression to the mean implies that even if two giants or two geniuses were to marry, the children would not, on average, be giants or geniuses. On the positive side, it means that below average parents typically produce offspring that are closer to average.

How reasonable is this model for the real world? I already mentioned that regression is confirmed by data. (In fact, one uses this kind of data to deduce the heritability of a trait - the relative contributions of G and E need not be equal.) An interesting possibility in the context of intelligence is that, perhaps due to the modern phenomena of assortative mating and obsession with elite education, E and G can no longer be treated within the population as indpendent variables. In this case we should see a reduction in the level of regression to the mean among the intellectual elite, and further separation in cognitive abilities within the population.

Another possibility is that the original model is too simplistic, and that there are intricate and important interactions between G and E. It may not be very easy for a parent to ensure a positive environment tailored to their particular child's G. That is, buying lots of books and sending the child to good schools may not be enough. It may be that development is nonlinear and chaotic -- not determined by coarse average characteristics of environment. For example, the parent may have benefited from a special interaction with a mentor that cannot be reproduced for the child. Or perhaps different children respond very differently to peer competition. Although I find this picture plausible at the individual level, it seems likely that, averaged over a population, obvious enrichment strategies have a positive effect.

Soros speaks the truth

The bottom line from George Soros, from this interview with Bill Moyers (via Barry Ritholtz). Read the whole transcript, or watch the interview -- there's much more about the credit crisis, modern finance, etc.

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

It would be much easier for Soros to wax eloquent about how greed is good, greed works, markets are efficient optimizers, etc. He is, after all, a huge winner in the capitalist system. But he's seen too much to buy everything that Ayn Rand and market fundamentalists are selling.

Longer NYBooks article on Soros by John Cassidy, who covers business and finance for the New Yorker.

In 2007, after the subprime crisis erupted, he returned, at the age of seventy-seven, to directing Quantum's investments, with results suggesting he hadn't lost his touch. Alpha magazine, a glossy publication that covers hedge funds, estimates that he made $2.9 billion in 2007, placing him second on its list of mega-speculators, behind only John Paulson, of Paulson & Co., who raked in an even more astonishing $3.7 billion.

Earlier post on investor John Paulson, who made $15B for his fund betting against the credit bubble.

Godel's theorems and Oliver Stone

Two audio suggestions to take your mind off the financial crisis -- at least until Asian markets open on Sunday :-)

An excellent 40 minute discussion of Godel's incompleteness theorems with two mathematicians (one a logician) and a theoretical physicist. If you know a bit about the subject the first 15 minutes or so are quite slow, but the last 20 minutes are well worth listening to. One of the discussants notes that the axioms of Euclidean geometry are not rich enough to be self-referential (unlike those of arithmetic), hence do not suffer from incompleteness. (Geometry is axiomatizable but not adequate to encode the syntax of proofs.)

Leonard Lopate interview (30 min) with Oliver Stone. Stone directed Wall Street, one of my favorite movies. (Too bad he's not doing the sequel Money Never Sleeps.) Few people know he was a classmate of George W. Bush's at Yale. The contrast could not be greater: Stone volunteered for combat duty in Vietnam, was wounded twice and won the Bronze heart and Purple Star. He also wrote the screenplays for Midnight Express (for which he won an Oscar) and Scarface ("say hello to my little friend!" :-). Stone's biopic of Bush, W, was done in collaboration with Stanley Weiser, his co-writer from Wall Street, and will open next week. At one point in the interview Stone comments that he doubts Greenspan, Paulson or any of the other leaders really understands what is happening in this crisis, due to the complexities of derivatives.

Lehman CDS auction

Starts in a few minutes. Previous posts here, here and here.

The 350 participants in the auction -- meaning each of them are party to at least one CDS contract referencing (insuring) Lehman debt -- are a rogues gallery of big financial firms. Guess who has been trying to raise cash in anticipation of today, when hundreds of billions could change hands? The net payments will be much less than this notional amount, but each player has to have their cash ready -- the cancellations may be "non-local" (between multiple parties; see figure at bottom).

Bloomberg: ...Lehman's $128 billion of bonds were trading yesterday at an average of 13 cents on the dollar, indicating credit swap sellers may have to pay 87 cents.

...More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.

The list of participants includes Newport Beach, California- based Pimco, manager of the world's largest bond fund, Chicago- based hedge fund manager Citadel Investment Group LLC, and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

...Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company's ability to pay its debt.

Settlement of Lehman contracts may lead to protection sellers paying out as much as $220 billion, assuming a 20 percent recovery on the U.S. bank's senior debt, according to Andrea Cicione, a London-based credit strategist at BNP Paribas SA. [Others estimate as high as $400B.]

``Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning'' to meet protection payments, said Cicione. ``But fund managers or hedge funds, once they've used their cash, have only one option, to sell assets.''

Web of three contracts with net value of $.1B and notional value of $3.1B. Even though, ultimately, only $.1B changes hands, each party may have had to bring $1B or more to the table. (Even if they have canceling positions, like B in the figure, there is always counterparty risk -- what if A can't pay up?)


Update: Priced out at 8.625 cents on the dollar (Bloomberg). Here's an example of the type of fund that has been selling into the markets to meet obligations.

A unit of Primus Guaranty Ltd., a Bermuda-based company that has sold more than $24 billion in credit-default swaps, said last month it guaranteed $80 million of Lehman debt. The firm sold protection on $215 million of Fannie and Freddie debt and $16.1 million on WaMu. Yesterday, it said it also had made bets of $68.2 million on Kaupthing Bank hf, which the Icelandic government seized. Primus said last week it had $820 million in cash and liquid investments to meet claims on the contracts.

Felix Salmon notes that today was just the auction and parties don't settle until October 21. A commenter there claims the contracts are collateralized daily. I don't know if that is true, but if it is then the auction doesn't do much except set the price, which we sort of knew beforehand from earlier trades.

Second update: I was told again that most CDS contracts require the party offering protection to post collateral, which adjusts according to the market value of the debt. That means that the auction itself is more an accounting event than an economic event. When the default occurs the insurers already have a rough idea of what they will owe and presumably start selling assets to cover their obligations. In this case (LEH) the auction price came out below but not that far from where the market was pricing the debt beforehand. Whether any CDS issuers won't be able to cover their obligations won't be known until October 21.

Lessons from Japan

It took the Japanese two decades to recover from their 80's-90's bubble. This Times article discusses the similarities and differences between their crisis and ours. (Our current crisis is also affecting them -- the Nikkei is down 11 percent as I type this.)

I first posted the graph above in 2005.

NYTimes: ...The similarities with Japan are striking. Like the United States today, Japan in the early 1990s faced a banking and real estate crisis that undermined the entire economy and required large government intervention. Some of Japan’s most venerated financial institutions collapsed as snowballing losses from failed business and property loans plunged the nation’s financial system into paralysis.

But the differences are also pointed and revealing. The United States reacted far more quickly than Japan, committing taxpayer funds just over a year after the subprime mortgage problems surfaced in summer of 2007. Japan took nearly eight years to pass a sweeping bailout, a delay that contributed to a long economic slump that Japanese call their “lost decade.”

“Japanese government and financial institutions realized there was a problem, but they tried to cover it up,” said Junichi Ujiie, chairman of Nomura Holdings, Japan’s largest investment bank. “The United States has done in months what Japan took years to do.”

...Most of the government officials, business leaders and economists interviewed praised America’s plan to spend $700 billion buying troubled mortgage-related assets from banks. But they also said they expected that Washington would soon have to put together another huge bailout package, this time to recapitalize American banks, especially with the International Monetary Fund now estimating total bank losses from the subprime mortgage crisis to reach $1.4 trillion.

On the other hand, another lesson from Japan is that the American bailout may end up costing taxpayers far less than $700 billion or whatever the final figure may be. Japanese regulators were eventually able to recover all but $100 billion of the $450 billion spent by selling off the troubled loans and bank stocks later, after the economy had rebounded.

More on Lehman CDS auction

There's very little information on the web about this. Elizabeth McDonald at Fox Business:

...A key driver behind the market plunge has been the tremendous demand for cash from counterparties related to the CDS (credit default swap) payouts on these recent major credit events.

It’s all happening now.

This past Monday: An estimated $200 bn to more than $1 tn in CDS written on Fannie and Freddie’s debt, the two companies’ senior and subordinated debt, were auctioned on Monday.

Reports indicate that protection sellers on the mortgage giants’ subordinated debt won big time here, with contracts on Fannie Mae’s subordinated debt recovering 99.9% of the sum insured, and swaps on Freddie Mac’s subordinated debt recovering 98%, reports auction administrators Creditex and Markit.

However, CDSs on the senior debt got less, with Fannie Mae’s senior swaps recovering 91.5% the sum insured and Freddie Mac’s senior swaps recovering 94%. CDS sellers’ losses less than expected being felt here, because Fannie and Freddie debt have rallied since the two were placed under conservatorship;

This Friday, October 10th: When the Lehman deals get unwound. Potentially $400 bn in payouts. Lehman debt now trading between 15 cents and 19 cents on the dollar, with imputed losses of 81 cents and 85 cents on the dollar.

Felix Salmon has a nice discussion, and a news search brings up this schedule for the auction. My CDS posts here.

Salmon: ...Now there are people who made money betting against Lehman Brothers by buying default protection. And since the CDS market is a zero-sum game, there must therefore be people who lost money by selling that protection. The $400 billion question is whether they have the wherewithal to make good on their obligation. (And remember that $400 billion is a gross number: the net exposure -- the total amount that some people made and others lost -- is much smaller.)

I'm optimistic on that front: I think the answer is yes, although it might well involve selling collateral and other securities in order to come up with the cash. So there could be some nasty liquidation events on or around October 10. But I suspect that a lot of the exposure to Lehman came from synthetic bonds, CDOs of CDSs, and that kind of thing -- in other words, it resides on the buy-side, not on the sell-side.

It's always possible that some hedge fund somewhere will find itself going bust as a result of writing protection on Lehman -- but so far the big hedge-fund returns on CDS have been positive (Paulson, Lahde) and not negative. I'm holding out hope that the same will hold true on October 10.

This just up from Barry Ritholtz. Today (Thursday) looks like a very bad day for equities... suspicious. Tomorrow could be worse?

I've heard concerns from various traders and hedge fund managers over the past few weeks that the Lehamn Brothers (LEH) derivatives unwind has been what's roiling markets.

Early October, Citi (C) credit analyst Michael Hampden-Turner estimated there is $400bn of Lehman credit derivatives that will be settled on Friday.

This picture may tell all, once the dust settles. Either I am overly focused on the role of CDS, or the financial press and academic economists are totally missing one of the biggest drivers of systemic risk and current volatility. Here is a post I wrote in 2005 linking CDS strategies to equity vol. At the time, over half of all CDS volume involved hedge funds. In the end I think we're going to see some big hedge funds wiped out from selling naked or poorly hedged CDS insurance.

The subprime primer

In case you haven't seen this, it's pretty funny (strong language warning).

Special bonus: The Making of Goldman Sachs. Leonard Lopate interviews Charles Ellis, the author of The Partnership.

Double plus good: the Times goes after Greenspan and those weapons of mass destruction, derivatives.

CDS central exchange?

The Lehman auction on October 10 is fast approaching. Previous posts on credit default swaps. In every case I've seen discussed the notional value of CDS contracts exceeds the amount of outstanding debt being insured!

WSJ: The Federal Reserve Bank of New York has summoned participants in the credit-default-swap market to another meeting Friday amid jostling by dealers, exchanges and regulators for a bigger role in this $55 trillion market, according to people familiar with the matter.

The meeting would be the second this week as regulators wrestle with rival solutions to streamline the market and reduce counterparty risk through the creation of one or more central clearinghouses.

... the fallout from unraveling billions of dollars in CDS trades following the problems of Lehman Brothers and American International Group has intensified the urgency among regulators to see major improvements in the infrastructure of this market.

CME and Citadel Investment Group this week unveiled plans to launch a CDS trading platform that would be tied to a clearinghouse, inviting banks and other users to take equity in a project slated to start in early November.

The timetable would give them first-mover advantage over another planned CDS clearinghouse being developed by Chicago-based Clearing Corp., which is owned by banks and brokers.

Nobel Prize in physics 2008

I've found the awarding of physics Nobel prizes in the last decade or two to be, well, erratic. Probably it was always erratic, but this was not apparent to me as a student, and the particulars of prizes even further past are lost to the mists of time.

Once again, I'm not sure I understand today's selection of Nambu together with Kobayashi and Maskawa. All are deserving theoreticians. K-M generalized the flavor mixing matrix of Cabibbo to 3 flavors and thereby introduced the likely origin of (thus far observed) CP violation.

But what is the justification of the Nambu prize? If it is for spontaneous symmetry breaking shouldn't people like Goldstone, Higgs, Englert, Brout, etc. also share the prize? The citation says

...for the discovery of the mechanism of spontaneous broken symmetry in subatomic physics.

If by mechanism they mean the general phenomena of spontaneous symmetry breaking then surely others deserve credit as well. If by mechanism they mean the actual dynamics, then I can only conclude they are giving the prize for the Nambu-Jona-Lasinio model? (Which is clearly not deserving of the prize!)

I think a more appropriate choice would have been Cabibbo-Kobayashi-Maskawa (Cabbibo is still alive) and Nambu-Goldstone + other.

Note added: I take back my comment about Cabibbo. The prize citation for KM is really for CP violation, and Cabibbo played no role in that. Regarding Nambu, the citation focuses on his being the first to discuss spontaneous symmetry breaking in a field theoretic context (not exactly Nobel worthy, in my view), and being the first to guess that the strong interactions exhibit spontaneous symmetry breaking, making an analogy with a conventional superconductor. This analogy is fleshed out in a talk given at Purdue in 1960, one year before Goldstone's scalar model which explicitly realizes what has now become known as a Nambu-Goldstone boson. Probably Nambu was the first person to deeply understand that the strong interaction (QCD) ground state spontaneously breaks axial symmetries -- I suppose that is by itself worthy of the prize.

See this Nobel committee scientific report for more details. Thanks to reader MFA for the pointer!

October CDS auctions and helicopter Ben

How do CDS contracts get settled after a credit event? We've had several recently, which means upcoming auctions (see also here). Fannie Mae and Freddie Mac auctions were October 6 (yesterday), Lehman is October 10, and Washington Mutual is scheduled for October 23.

Since Treasury is guaranteeing the GSE debt, October 6 was probably not as much of a problem as the Lehman auction will be in a few days. Many firms are scrambling for or hoarding cash and probably don't know the size of their obligation. At the auction, one has to determine the value of the bonds before deciding the value of each CDS contract. That means first an auction of Lehman debt, presumably worth only a fraction of its face value (but exactly how much?), and then a settlement of contracts. If most of the contracts are offsetting they can be canceled then and there, but the suspicion is that many CDS counterparties (perhaps, especially, hedge funds?) were writing naked contracts, which means they would have to come up with the money on the spot. For detailed discussion see here. Related post at naked capitalism.

If Treasury wants to stabilize markets and perhaps avoid more collapses, it could start on 10/10 by buying up some of Lehman's debt with its $700B war chest. Will they make an appearance? It's estimated that Lehman was involved in hundreds of billions in CDS contracts (notional). This is a very delicate moment since no one is going to want Lehman debt and therefore the market value will be very low. I can imagine a lot of smart guys who wrote CDS contracts hedged their Lehman exposure against some other (imperfectly but highly) correlated index or debt. Since those entities used in the hedge will not be simultaneously marked to market on 10/10, what was, at the time, a reasonable hedge will turn into a disaster. Note, I think the auction only covers contracts that reference Lehman -- that is, which protect one of the counterparties from a Lehman default on its debt. The auction won't resolve the problem that arises in other contracts if Lehman was actually one of the counterparties. To the extent that these exposures are canceled they would be "glued" together at the appropriate reference auction, but it's possible Lehman had some naked exposure as well.


Thinking about this more broadly, freezing of credit markets means that the effective money supply is shrinking even as central banks cut interest rates. Helicopter Ben Bernanke has always said that in an emergency the Fed had numerous tools available to inject liquidity into the markets, and today it was announced they would enter the paralyzed short term commercial paper market which is crucial to the functioning of ordinary businesses.

Helicopter speech: ...The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.5

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. ...

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

New blog layout

Love it? Hate it? Vote here -- I can roll back if I'm the only one who likes the new design...

Note links to older posts (archive, categories by label) are at the bottom of the page -- just hit the "Archive" link above to go there, or scroll all the way down.

Fear beats greed

I think I've seen it all before, thanks to the tech bubble collapse in 2001, but the systemic risk then was much smaller than it is now.




The Europeans seem to have woken up to the fact that their banks have

1. plenty of bad US mortgage securities on the books
2. worse accounting and transparency than US banks
3. their own housing bubbles to deal with in the UK, Spain, ...

and that their governments are even further behind the curve than ours.

Markets are down everywhere and people close to the action are ranting about the apocalypse.

To make us all feel better, here's a graph of long run US economic growth (via Tyler Cowen).

Mortgage finance in pictures

This graphic is from TheDeal.com (via Paul Kedrosky). Note they give the notional to net ratio for CDS as $62 to $2 trillion, or 30 to 1. That ratio is a good proxy for the complexity of the network of contracts and how difficult it will be to disentangle.

Don't blame the quants: Fannie edition

This article in the Times gives some details about the collapse of Fannie Mae. It's pretty clear that the quants at Fannie knew they were undercharging for risky loans, and that senior management knowingly pushed the firm into dangerous territory.

Fannie's business: repackaging mortgages into collateralized securities. But it operated under political pressure to help low-income buyers achieve home ownership and under financial pressure to compete with investment banks getting aggressively into the mortgage securitization business.

NYTimes: ...When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.

...So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie’s stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.

Take aggressive risks, or "get out of the company":

...But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.”

In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.

Employees, however, say they got a different message.

“Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little,” said a former senior Fannie executive. “But our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”

I complained about Frankin Raines, who embroiled Fannie in a derivatives accounting scandal, back in 2004-5.

Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.

Dinner with the Econ

Late this afternoon (Friday), the picture below appeared on my Google Reader screen with the caption Six kinds of recycling at the University of Oregon,



compliments of the feed from Brad DeLong's blog. I immediately thought, is Brad DeLong (with iPhone camera) on campus? and checked the seminar page in the economics department. Yes, he was scheduled for a 3:30 pm seminar, with Economist's View blogger Mark Thoma as host!

Given current events, I thought this would have to be an especially interesting talk, so I walked across campus for the chance to be a fly on the wall during a meeting of the Econ tribe. I was treated to a wonderful 90 minute talk which started from the general question of whether central banks should fight asset bubbles, but soon dove into the intricate details of the credit crisis. Mark recognized me and was kind enough to invite me to dinner, along with the speaker and professors Tim Duy and Nick Magud. It was quite an interesting discussion as we had among us a former member of Treasury (Brad), of the Fed (Tim) and an expert on Latin American financial crises (Nick). At one point Brad asked me about spontaneous symmetry breaking and the Higgs. I noted that physics is much easier than figuring out how Treasury is going to handle the bailout!

Quant trivia: at one point in the talk Brad mentions all the physicists modeling mortgage backed securities. The economists laugh, but Brad protests that his Harvard roommate Paul Mende (who did a string theory PhD under David Gross at Princeton) is now working for a hedge fund modeling volatility!

Buffet on the credit crisis

Charlie Rose interview

Skeptics will claim he is talking his own book, with the recent GS and GE investments. But I agree with most of it. Buffet says that if he could take a 1 percent stake in the bailout (investing $7 billion), he would. He thinks the bailout will make money investing in distressed mortgage securities at current market prices.

"I love to buy distressed assets... I just don't have $700B to do it with." (At about 13-14 minutes into the hour long interview.)

Bubble logic: "Innovators, Imitators and then the Idiots" (20 minutes)

"Confidence in markets and institutions is like oxygen... when you have it you don't think about it... but you can't go 5 minutes without it." (24 minutes)

"Beware of geeks bearing formulas!" (takes a shot at quants at 27 minutes)

Upper income people should pay more taxes (basically endorses Obama's tax plan) (42 minutes)

"It is terrible that income from investments (capital gains) should be taxed less than income from labor." (against regressive taxes) (44 minutes)

"If AIG had to unwind their derivatives book, it would have hit every institution in the world." (50 minutes)

"The Fed structured the AIG deal very well. They are very likely to get their money back or more." (51 minutes)

Are you a Biller or a Player?

Excellent article by Arnold Kling and Nick Schulz. "Winner take most" markets, the upper-upper and upper-lower income gaps, and more.

Inequality and the Sergey Brin effect

...A final trend that promotes income inequality is that more Americans may be engaging in a kind of gambling behavior in their choice of occupation. They are increasingly choosing to play in winners-take-most tournaments, such as the contest to build the leading Internet search engine. For every Sergey Brin, there were thousands of software engineers who played in the search-engine contest and lost.

As best-selling writer and investor Nassim Nicholas Taleb points out in The Black Swan, safe occupations are those where the worker is paid a fixed amount per unit of time. An accountant or a nurse is not going to become extremely rich or extremely poor; they could be called “billers,” because they bill for their time. On the other hand, a professional singer or a software entrepreneur is playing in a winners-take-most tournament. The difference in talent between an international pop star and an unknown lounge singer may actually be quite small. However, the nature of these fields is that the difference in rewards can be enormous. People who choose these sorts of occupations could be called “players.”

Sign problem in QCD

The revised version of our paper 0808.2987 is up on arXiv now. Special thanks to Kim Splittorff, Mark Alford, Bob Sugar, Phillippe de Forcrand and many others for comments. See earlier discussion.

On the sign problem in dense QCD

http://arXiv.org/abs/0808.2987

S. Hsu and D. Reeb

We investigate the Euclidean path integral formulation of QCD at finite baryon density. We show that the partition function Z can be written as the difference between two sums Z+ and Z-, each of which defines a partition function with positive weights. If the ratio Z-/Z+ is nonzero in the infinite volume limit the sign problem is said to be severe. This occurs only if, and generically always if, the associated free energy densities F+ and F- are equal in this limit. In an earlier version of this paper we conjectured that F- is bigger than F+ in some regions of the QCD phase diagram, leading to domination by Z+. However, we present evidence here that the sign problem may be severe at almost all points in the phase diagram, except in special cases like exactly zero chemical potential (ordinary QCD), which requires a particular order of limits, or at exactly zero temperature and small chemical potential. Finally, we describe a Monte Carlo technique to simulate finite-density QCD in regions where Z-/Z+ is small.

Simple question, complex answer

A former physicist (but non-financier) writes:

I have a question, and who better to ask than you. ...something isn't adding up.

I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn't this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.

Is this reasoning correct? If so, I don't understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.

Your calculations are reasonably correct (see comments for more detail). So why the crisis?

1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It's like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor...

2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed -- no muni bond issuance, no short term loans to businesses, no car loans, etc.

The efficient functioning of our economy is built on trust -- I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.

We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.

Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing -- our most valuable asset.)

Historical vol

Worried now? Graph from maoxian. Check these out.




Too bad I don't have my vol trade on any more... I bought some vol back in 2004 or so (long-dated VIX options), which looks to have been near the bottom :-)

Meltdown links

1) Leonard Lopate interview with Economist editor Greg Ip, formerly of the WSJ. (Scroll down the page to Financial Crisis: What Happens Next?). This is the best 12 minute summary of the current situation I have yet heard. Ip is consistently good at explaining this complicated subject in an accessible manner. If you have a friend who is confused about the credit crisis, have them listen to this interview. (Avoid Terri Gross and pals on this one... ;-)

I have been listening to Leonard Lopate's show for some time and I can tell his grasp of finance has increased dramatically in the last year or so (his strength is interviewing artists, writers, etc.). It's yet another example of high-g at work. He knew almost nothing a year ago but now asks occasional perceptive questions. (But of course it doesn't matter how smart our next President is!)

2) Mark Thoma discusses the pros and cons of mark to market accounting. To me it's rather obvious that M2M accounting is exacerbating this crisis. It has introduced a very significant nonlinearity, both on the upside (bubble), and now in the collapse. If the market for mortgage assets has failed it is crazy to use it as a barometer for value. More discussion at WSJ.

3) This NYTimes Op-Ed written by a former theoretical physicist discusses agent-based simulation, behavioral economics and phase transitions -- yes, in an Op-Ed! (Thanks again to reader STS for the pointer.)

Trends in social science

More interesting graphs from GNXP, based on searches of JSTOR in the following journal categories: anthropology, economics, education, political science, psychology and sociology. Progress!