Michael
Feb 8th 2009, 11:41 AM
Here's a link to a series of articles in the Economist - a multipart analysis on "The future of finance" - which is essentially a good summary of just about everything that went wrong in the financial industry over the last dozen years. I've read through the whole thing and can't recommend it highly enough.
Here's the link to the whole Article (http://www.economist.com/surveys/displaystory.cfm?story_id=12957709)
And here's just a few highlight paragraphs, taken out of context from the series of articles and presented here like bullet points, but I think that taken together, these disparate quotes tell a rather coherent story. I added the numbering to the quotations to make reference to them easier. :)
1. Finance is increasingly fragile. Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University identify 139 financial crises between 1973 and 1997 (of which 44 took place in high-income countries), compared with a total of only 38 between 1945 and 1971. Crises are twice as common as they were before 1914, the authors conclude.
2. In 2007 Dick Fuld, the former head of Lehman Brothers, observed that whereas credit grows arithmetically, it shrinks geometrically. Much to his cost, he was later proved right.
3. In the booming American housing market mortgage originators were happy to accept no security at all, lending 100% of the value of the house—partly because they thought house prices would continue to rise, and partly because they assumed the market would be liquid enough for them to palm the mortgages off on other investors. As it happened, the mortgage originators were wrong and the loans that were stuck on their books helped destroy their businesses.
4. If it is hard to stop booms once they are in full swing, it is no easier to prevent them from starting in the first place. Hyman Minksy, an unconventional economist who made it his life’s work to study crises, was convinced that they arose spontaneously. Financial stability itself creates confidence and risk-taking, eventually leading to recklessness and instability. After the bust, stability will return and the cycle will begin again. Similarly, David Roche and Bob McKee, of Independent Strategy, an investment consultancy, among others, think credit started flowing more easily in the 1980s because the rich economies conquered inflation and the large emerging markets embraced globalisation.
5. Powerful new computers also created a platform for a new sort of mathematical finance. In the hands of “quants”—the mathematicians and physicists expert in the arcana of quantitative analysis—this proved immensely versatile. Unfortunately, it also led financial services astray.
6. The idea behind quantitative finance is to manage risk. You make money by taking known risks and hedging the rest. And in this crash foreign-exchange, interest-rate and equity derivatives models have so far behaved roughly as they should.
Yet the idea behind modelling got garbled when pools of mortgages were bundled up into collateralised-debt obligations (CDOs). The principle is simple enough. Imagine a waterfall of mortgage payments: the AAA investors at the top catch their share, the next in line take their share from what remains, and so on. At the bottom are the “equity investors” who get nothing if people default on their mortgage payments and the money runs out.
7. Each source of a CDO had interminable pages of its own documentation and conditions, and a typical CDO might receive income from several hundred sources. It was a lawyer’s paradise.
8. This was modelling at its most feeble. Derivatives model an unknown price from today’s known market prices. By contrast, modelling from history is dangerous. There was no guarantee that the future would be like the past, if only because the American housing market had never before been buoyed up by a frenzy of CDOs. In any case, there are not enough past housing data to form a rich statistical picture of the market—especially if you decide not to include the 1930s nationwide fall in house prices in your sample.
9. The issuers of CDOs asked rating agencies to assess their quality. Although the agencies insist that they did a thorough job, a senior quant at a large bank says that the agencies’ models were even less sophisticated than the issuers’. For instance, a BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet, because both shared the same BBB rating, they would be modelled in the same way.
10. Issuers like to have an edge over the rating agencies. By paying one for rating the CDOs, some may have laid themselves open to a conflict of interest. With help from companies like Codefarm, an outfit from Brighton in Britain that knew the agencies’ models for corporate CDOs, issuers could build securities with any risk profile they chose, including those made up from lower-quality ingredients that would nevertheless win AAA ratings.
11. Almost as damaging is the hash that banks have made of “value-at-risk” (VAR) calculations, a measure of the potential losses of a portfolio. This is supposed to show whether banks and other financial outfits are being safely run. Regulators use VAR calculations to work out how much capital banks need to put aside for a rainy day. But the calculations are flawed. The mistake was to turn a blind eye to what is known as “tail risk”.
12. However, although the normal distribution closely matches the real world in the middle of the curve, where most of the gains or losses lie, it does not work well at the extreme edges, or “tails”. In markets extreme events are surprisingly common—their tails are “fat”. Benoît Mandelbrot, the mathematician who invented fractal theory, calculated that if the Dow Jones Industrial Average followed a normal distribution, it should have moved by more than 3.4% on 58 days between 1916 and 2003; in fact it did so 1,001 times. It should have moved by more than 4.5% on six days; it did so on 366. It should have moved by more than 7% only once in every 300,000 years; in the 20th century it did so 48 times.
In Mr Mandelbrot’s terms the market should have been “mildly” unstable. Instead it was “wildly” unstable. Financial markets are plagued not by “black swans”—seemingly inconceivable events that come up very occasionally—but by vicious snow-white swans that come along a lot more often than expected.
13. Modern finance may well be making the tails fatter, says Daron Acemoglu, an economist at MIT. When you trade away all sorts of specific risk, in foreign exchange, interest rates and so forth, you make your portfolio seem safer. But you are in fact swapping everyday risk for the exceptional risk that the worst will happen and your insurer will fail—as AIG did.
14. Edmund Phelps, who won the Nobel prize for economics in 2006, is highly critical of today’s financial services. “Risk-assessment and risk-management models were never well founded,” he says. “There was a mystique to the idea that market participants knew the price to put on this or that risk. But it is impossible to imagine that such a complex system could be understood in such detail and with such amazing correctness…the requirements for information…have gone beyond our abilities to gather it.”
15. Rather than being victims, shareholders may well have driven managers on. Hans-Werner Sinn, the head of Ifo, an economic research institute in Munich, argues that limited liability gives them a reason to flirt with disaster. The creditors of a failed firm have no claim on the personal assets of its shareholders. So if the bank takes big risks that promise big profits, its shareholders stand to enjoy the full gains but to bear only part of the losses. By contrast the shareholders of low-risk, low-return banks that never collapse have to bear all the losses.
16. George Gilbert Williams, long-time head of Chemical Bank in New York in the 19th century, once explained that his success was founded on “the fear of God”. But as a boom takes its course, fear is supplanted in what a senior quant at an American bank calls the “Cassandra effect”. The more you warn your colleagues about the tail risks—the rare but devastating events that can bring the bank down—the more they roll their eyes, give a yawn and change the subject. This eventually leads to self-censorship. “The system”, he says, “filters out the thoughtful and replaces them with the faithful.”
I think that last line sums it up nicely!
And as a bonus, here's a little graph showing the growth of financial securitizations (i.e. derivatives) over the last dozen years - I'm sure no one could have seen it coming... :rolleyes:
Here's the link to the whole Article (http://www.economist.com/surveys/displaystory.cfm?story_id=12957709)
And here's just a few highlight paragraphs, taken out of context from the series of articles and presented here like bullet points, but I think that taken together, these disparate quotes tell a rather coherent story. I added the numbering to the quotations to make reference to them easier. :)
1. Finance is increasingly fragile. Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University identify 139 financial crises between 1973 and 1997 (of which 44 took place in high-income countries), compared with a total of only 38 between 1945 and 1971. Crises are twice as common as they were before 1914, the authors conclude.
2. In 2007 Dick Fuld, the former head of Lehman Brothers, observed that whereas credit grows arithmetically, it shrinks geometrically. Much to his cost, he was later proved right.
3. In the booming American housing market mortgage originators were happy to accept no security at all, lending 100% of the value of the house—partly because they thought house prices would continue to rise, and partly because they assumed the market would be liquid enough for them to palm the mortgages off on other investors. As it happened, the mortgage originators were wrong and the loans that were stuck on their books helped destroy their businesses.
4. If it is hard to stop booms once they are in full swing, it is no easier to prevent them from starting in the first place. Hyman Minksy, an unconventional economist who made it his life’s work to study crises, was convinced that they arose spontaneously. Financial stability itself creates confidence and risk-taking, eventually leading to recklessness and instability. After the bust, stability will return and the cycle will begin again. Similarly, David Roche and Bob McKee, of Independent Strategy, an investment consultancy, among others, think credit started flowing more easily in the 1980s because the rich economies conquered inflation and the large emerging markets embraced globalisation.
5. Powerful new computers also created a platform for a new sort of mathematical finance. In the hands of “quants”—the mathematicians and physicists expert in the arcana of quantitative analysis—this proved immensely versatile. Unfortunately, it also led financial services astray.
6. The idea behind quantitative finance is to manage risk. You make money by taking known risks and hedging the rest. And in this crash foreign-exchange, interest-rate and equity derivatives models have so far behaved roughly as they should.
Yet the idea behind modelling got garbled when pools of mortgages were bundled up into collateralised-debt obligations (CDOs). The principle is simple enough. Imagine a waterfall of mortgage payments: the AAA investors at the top catch their share, the next in line take their share from what remains, and so on. At the bottom are the “equity investors” who get nothing if people default on their mortgage payments and the money runs out.
7. Each source of a CDO had interminable pages of its own documentation and conditions, and a typical CDO might receive income from several hundred sources. It was a lawyer’s paradise.
8. This was modelling at its most feeble. Derivatives model an unknown price from today’s known market prices. By contrast, modelling from history is dangerous. There was no guarantee that the future would be like the past, if only because the American housing market had never before been buoyed up by a frenzy of CDOs. In any case, there are not enough past housing data to form a rich statistical picture of the market—especially if you decide not to include the 1930s nationwide fall in house prices in your sample.
9. The issuers of CDOs asked rating agencies to assess their quality. Although the agencies insist that they did a thorough job, a senior quant at a large bank says that the agencies’ models were even less sophisticated than the issuers’. For instance, a BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet, because both shared the same BBB rating, they would be modelled in the same way.
10. Issuers like to have an edge over the rating agencies. By paying one for rating the CDOs, some may have laid themselves open to a conflict of interest. With help from companies like Codefarm, an outfit from Brighton in Britain that knew the agencies’ models for corporate CDOs, issuers could build securities with any risk profile they chose, including those made up from lower-quality ingredients that would nevertheless win AAA ratings.
11. Almost as damaging is the hash that banks have made of “value-at-risk” (VAR) calculations, a measure of the potential losses of a portfolio. This is supposed to show whether banks and other financial outfits are being safely run. Regulators use VAR calculations to work out how much capital banks need to put aside for a rainy day. But the calculations are flawed. The mistake was to turn a blind eye to what is known as “tail risk”.
12. However, although the normal distribution closely matches the real world in the middle of the curve, where most of the gains or losses lie, it does not work well at the extreme edges, or “tails”. In markets extreme events are surprisingly common—their tails are “fat”. Benoît Mandelbrot, the mathematician who invented fractal theory, calculated that if the Dow Jones Industrial Average followed a normal distribution, it should have moved by more than 3.4% on 58 days between 1916 and 2003; in fact it did so 1,001 times. It should have moved by more than 4.5% on six days; it did so on 366. It should have moved by more than 7% only once in every 300,000 years; in the 20th century it did so 48 times.
In Mr Mandelbrot’s terms the market should have been “mildly” unstable. Instead it was “wildly” unstable. Financial markets are plagued not by “black swans”—seemingly inconceivable events that come up very occasionally—but by vicious snow-white swans that come along a lot more often than expected.
13. Modern finance may well be making the tails fatter, says Daron Acemoglu, an economist at MIT. When you trade away all sorts of specific risk, in foreign exchange, interest rates and so forth, you make your portfolio seem safer. But you are in fact swapping everyday risk for the exceptional risk that the worst will happen and your insurer will fail—as AIG did.
14. Edmund Phelps, who won the Nobel prize for economics in 2006, is highly critical of today’s financial services. “Risk-assessment and risk-management models were never well founded,” he says. “There was a mystique to the idea that market participants knew the price to put on this or that risk. But it is impossible to imagine that such a complex system could be understood in such detail and with such amazing correctness…the requirements for information…have gone beyond our abilities to gather it.”
15. Rather than being victims, shareholders may well have driven managers on. Hans-Werner Sinn, the head of Ifo, an economic research institute in Munich, argues that limited liability gives them a reason to flirt with disaster. The creditors of a failed firm have no claim on the personal assets of its shareholders. So if the bank takes big risks that promise big profits, its shareholders stand to enjoy the full gains but to bear only part of the losses. By contrast the shareholders of low-risk, low-return banks that never collapse have to bear all the losses.
16. George Gilbert Williams, long-time head of Chemical Bank in New York in the 19th century, once explained that his success was founded on “the fear of God”. But as a boom takes its course, fear is supplanted in what a senior quant at an American bank calls the “Cassandra effect”. The more you warn your colleagues about the tail risks—the rare but devastating events that can bring the bank down—the more they roll their eyes, give a yawn and change the subject. This eventually leads to self-censorship. “The system”, he says, “filters out the thoughtful and replaces them with the faithful.”
I think that last line sums it up nicely!
And as a bonus, here's a little graph showing the growth of financial securitizations (i.e. derivatives) over the last dozen years - I'm sure no one could have seen it coming... :rolleyes: