First, as someone who puts a great deal of emphasis on the difference between Political Economy and Economics, a great quote:
"Political economy is not a science, it's a clinical art, like medicine."
Eliot Janeway"
I'm going to go through this interview. However, I have one main point of divergence. People can be fooled by models, iff, they are predisposed to do so. As well, the point in these investments was to decrease capital requirements. That's risky. Period. It defines risk. You can use math to help you lessen that risk, but you are starting with inherently more risk. You know that. That's why you were looking to get around regulations, and lessen your capital requirements. You wanted to make more with less. That's inherently risky. Period. Finally, this view of math being held here is one that a little philosophy would show to be highly flawed. It's almost faith based, as Janeway will mention.
So, I agree that the math helped justify these decisions, but not that they caused them. That's simply an excuse for behavior that was, in many cases, not all, but many cases, fraudulent, negligent, and fiduciary mismanagement, which needs to be investigated. Also, if we're going to be able to prevent or lessen the chances of this happening again, we will have to focus on explanations that are based on Human Agency, not Mechanistic thinking. Contrary to Janeway, this idea that the models made me do is Mechanistic, not based on Human Agency. What were the predispositions? And why did people have them?
"The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable. So consequently, you could construct ways to hedge any position by means of a "replicating portfolio" whose statistics would offset the securities you started with."
I guess I'll be generous here and accept that, even though, from my point of view, it's a preposterous view, a lot like Logical Positivism.
"How it came to be, for example, that financial institutions largely owned by their employees could leverage themselves 35:1 and then go bust, destroying the jobs and destroying the wealth of the very same people! It is very easy unfortunately, as both Republican candidates said, to blame this mess on the greed and corruption of Wall Street, it is very easy to look at this crisis as another lesson in agent-principal conflict… "
That's part of it, but it's all based on Human Agency, not on mathematical models.
"Yes, but here the agents were principals!"
That simply says that they thought these investments might work. It doesn't explain why.
"Many people believed, by no means only the folks at Bear and Lehman, that the emergence of Basel II and the transfer to the banks themselves of responsibility for determining the amount of required regulatory capital based upon internal ratings actually reduced risk and allowed higher leverage. The move by the SEC in 2004 to give regulatory discretion to the dealers regarding leverage was the same thing again. "
It's a play on words. I'm reducing risk on higher risk. That's more truthful.
"That's my point. It was a kind of religious movement, a willed suspension of disbelief. If we say that the assumptions necessary to produce the mathematical models hold in the real world, namely that markets are efficient and complete, that agents are rational, that agents have access to all of the available data, and that they all share the same model for transforming that data into actionable information, and finally that this entire model is true, then at the end of the day, leverage should be infinite. Market efficiency should rise to the point where there isn't any spread left to be captured. The fact that a half a percent unhedged swing in your balance sheet can render you insolvent, well it doesn't fit with this entire constructed intellectual universe that goes back 50 years. "
I'd say that religion is more rational than this belief, given its context.
"Yes, but here is the problem. Real scientists tend to be much more skeptical about their data and their models, and thus tend to be critical empiricists. We can blame the crisis on failed physicists; they had all of the math but none of the instincts of good scientists that would enable them to be good physicists."
Weren't there any Real Investors?
"On the one hand, what you have driving all of this an intellectual movement that was enormously appealing and that for a variety of reasons fit within a larger frame of what was happening within economics. Paul Samuelson wrote his original work on the foundations of economic analysis in 1939, which took the principles of economics and translated them into math. This allowed researchers to run data against the math, to go from writing words to describe economics to writing equations, and to use math to empirically test the results."
That's why there's a difference between Economics and Political Economy.
"Samuelson laid down a fundamental philosophical principle, namely that we have to apply to economics what is known as the ergodic principle from the natural sciences, which is the notion that the underlying processes are stationary, the results, the observables they generate arrive stochastically, seemingly randomly, but the distribution is stable over time. Without that principle, we cannot do "positive economics."
Fine. That's Economics.
"I don't see quantitative methods leaving economics. They will be much more carefully bounded and limited, and the math will be far more difficult. Remember that a large part of what we today refer to as modern economics was defined before the advent of the computer. Most recently, one of the really sick jokes about what brought down the edifice of modern finance was the fact that, if you are actually trying to construct and price a CDO, it is far simpler to use a Gaussian copula to define the correlation between the different elements of the security - even though everybody knows that using a Gaussian copula implicitly guarantees that you are modeling a normal distribution. Everybody knows that this data is not normal, that the tails are much too fat, that there is skew built in. But it is computationally convenient. So, computational convenience had a lot to do with how we arrived at the present mess. '
A lot of science uses math that is simply computationally convenient. It doesn't exactly fit the world, but it works well enough to employ it. That's basic.
"No, but those who followed their work clearly took it too far in terms of practical applications. We will see mathematical models applied to cases where we have inefficient markets, where we posit that people are reasonably rational, that they try to make good decision with inadequate data or incomplete models. I think that most people are rational or try to be, and that accordingly we should treat them as generally rational because they are doing the best that they can. And therefore, they will actually behave in ways that are described by people like John Maynard Keynes and Ben Graham. "
You mean Real Investors?
"There are a couple of steps along the way here that got us to the present circumstance, such as the issue of regulatory capture. When you talk about regulatory capture and risk, the capture here of the regulators by the financial industry was not the usual situation of corrupt capture. The critical moment came in the early 1980s, which is very well documented in MacKenzie's book, when the Chicago Board appealed to academia because it was then the case that in numerous states, cash settlement futures were considered gambling and were banned by law. "
But there's a basic difference between Gambling and Investing. That's one point of divergence between me and Derivative Dribble.
"And a good digression, but back to Chicago, the stock index future was the holy grail of the financial industry. You had to get them qualified as non-gambles, like the physical world of commodities, bushels of wheat and corn, pork bellies, where you had speculators who were facilitating true hedging of real commodities."
All sports are physical. I'm missing the point here.
"The point here is that Milton Friedman was prevailed upon to write a letter to Secretary of the Treasury Nicholas Brady, Reagan's Secretary of the Treasury, as a result of which the Chicago Board was cleared to trade stock index futures, all cash settlement. There is another story in which Alan Blinder on the Democratic side played a similar role, by providing the academic legitimacy for the markets and for the integration into the fabric of finance of the derivatives that instrumented modern financial theory. That enabling role - McKenzie has a nice way of putting it - played by modern finance theory can be broken into three separate pieces. Technically, it created a tool through which you could price things that did not heretofore trade. Puts and calls did not trade. The spreads were enormous. So it played a technical role and but it also played a linguistic role. Anytime somebody talks about "implied vol" or implied correlation, they are talking finance theory, they are using the theory as a way of communicating across domains, between quants and traders, between Buy Side and Sell Side. And then finally finance theory played this legitimatory role in that what you are telling people is that you are making the markets more efficient! That's an unequivocally good thing, right? "
I'm fine with enabling.
"The point here is that the regulators were captured intellectually, not monetarily. And the last to be converted, to have the religious conversion experience, were the accountants, leading to fair value accounting rules. I happen to be the beneficiary of a friendship with a wonderful man, Geoff Whittington, who is a professor emeritus of accounting at Cambridge, who was chief accountant of the British Accounting Standards Board and was a founder of the International Accounting Standards Board. He is from the inside an appropriately knowledgeable, balanced skeptic, who has done a wonderful job of parsing out what is involved in this discussion in a paper called "Two World Views." Basically, he says that if you really do believe that we live in a world of complete and efficient markets, then you have no choice but to be an advocate of fair value, mark-to-market accounting. If, on the other hand, you see us living in a world of incomplete, but reasonably efficient markets, in which the utility of the numbers you are trying to generate have to do with stewardship of a business through real, historical time rather than a snapshot of "truth," then you are in a different world. And that is a world where the concept of fair value is necessarily contingent. "
That's fine, but you still need to understand the Predispositions involved.
"What the accountants did do, what the fair value rule did do, was something really fundamental. It started getting into the core of what's going on now. There were some $730 billion in subprime mortgages outstanding, according to some data I've pulled from a very interesting paper by Gary Gorton at Yale (See Gorton, Gary, "The Panic of 2007", NBER Working Paper 14358, p.76). The first version, which came out in 2008, was called the "Panic of 2007." In the most recent version, he just calls it the "Subprime Panic" with no date. Let's say that of that subprime mortgage debt, half will default over the life of the mortgages and after recoveries we'll be writing off a couple of hundred billion dollars. How did that equate into a ten trillion dollar reduction in global wealth in 12 months? There is a scale factor at work here and something that I have been trying to get straight in my own head, thus the Gorton paper is very useful. One piece is understanding what was involved in the construction of a CDO that was built off of some RMBS that was based upon subprime mortgages. There were two steps there. First step was that subprime was distinctive. Gordon makes the point that in order for subprime mortgages to be confirmed, to make any sense from a credit perspective, then home prices had to continue rising indefinitely. Not just stay the same and not fall. So that meant that they were going to go bust sooner or later. Second, by the time you get to the CDO let alone to a CDO-squared - and this gets back to a point you made before about the banks - the buyer of whichever tranche could not even in principle, much less in practice, see through the layers of securitization and deals to observe the underlying cash flows. "
Panic is a useful concept, and a Human Agency based one.
"But even Goldman Sachs (NYSE:GS) and everybody else could not value this stuff. The way it was sliced and diced makes it practically impossible. Now, when that happens in this one segment, what segment of the derivative world am I going to trust as representing underlying cash flow? This is where our friends at the rating agencies come in. They built their businesses going back to John Moody on cash flow analysis. One of the great gifts I have from my father is an original 1900 edition of Moody's book called The Truth About the Trusts. He took apart two hundred of the trusts that had been created in the 1890s and which represented the most brilliant exercise in financial engineering. This is not irrelevant to our point or to where we are today. What Moody demonstrated was what a revolution in finance the trust represented. Historically, the market valued an equity security based upon its actual cash generation to the investor, the dividend yield. In putting together a trust, Morgan and the others represented a pro forma financial of what the cash flows would be and therefore what the debt carrying capacity would be once the trust was implemented. And that was the moment at which future earning power and not historical cash dividends was invented. "
See, if you can't value it, that's a Warning Signal. The Ratings Agencies are a real problem of conflict of interest.
"The IRA: The rating agency monopoly up to this crisis could certainly be viewed as a form of legalized extortion. There was no choice for a global issuer but to go to Moody's or S&P.
Janeway: Yes, but even so the job of the rating agencies until as little as a decade ago was to evaluate cash flows. Then came the CDO.
The IRA: Yes but Moody's and S&P were not explicitly paid to notch CDOs each month. They were paid in the primary market effectively acting as an adviser - and sharing in commissions. But there was no "issuer pay" model explicit in the CDO budget for following these deals in the secondary market.
Janeway: On the other hand, the model of what they were doing, namely correlation models - there's a great quote in the latest issue of Risk Magazine by a very smart guy named William Perraudin of Imperial College in London. It goes side by side with chapter 12 of Keynes' General Theory and Ben Graham's Columbia lectures from 1948, which are up on the web and are great reading. Perraudin says: "Of course, if you are constructing and selling and retaining a piece of a CDO, you have to use the same correlation model as the market because you are going to be hedging in the same market you are selling." Just as Keynes says it is so much easier to stay with the mob as opposed to being a long term investors. And Keynes says in this regard that you have to be rich to be a long term investor, not just in capital but in terms of your funding base."
Bingo! Hedging in the same market you are selling. The Ratings Agency Monoploy I've talked about elsewhere, especially the post by Robert Waldmann on Angry Bear.
"The IRA: You see people referencing CDS spreads in bank loan documentation. It's amazing the degree to which market participants and the media are willing - indeed, eager - to treat CDS spreads as the gospel truth on a subject's likelihood of default. Personally I see CDS as more of an equity volatility tool, but that is another story.
Janeway: In bank loans now you are being priced not on LIBOR but on CDS.
The IRA: But isn't that ridiculous? The pricing in the CDS market is like you and I walking down Bishopsgate in London and peering in the windows of Lloyds of London to see if any risk is being written on FL hurricanes and at what price. There is no significant secondary market in these contracts that thus no price quality in terms of projecting probaility of default. CDS is a primary market much like Lloyds of London, where issuers write cover on demand and lay off risk via offsetting treaties. Is that fair? The public pricing in CDS is a function of a survey of sales assistants late in the afternoon."
A point I've made as well. If you can't predict a hurricane, you can't write insurance on it. The secondary investing is weird, but, assuming you understood it, not implausible. Again, to me it's crazy.
The IRA: Now that is a radical concept."
I think that's sarcasm.
"The first mode is the "hedge mode" of banking lending, where you are fully hedged for the underlying cash flows of the loan including principal, but in the second you are covered by the cash flows for interest payments, but you are basically relying on refinancing for principal repayment. So you are not talking about a fully amortizing mortgage, for example. That is the what Minsky called the "speculative" mode of lending. As this type of lending becomes accepted, over time as the principal does get refinanced and the interest payments are not missed, lenders loosen terms even further. Then you move inevitably into the third and final phase, the "Ponzi" phase, where people are borrowing the interest.'
The Speculative Mode I call Gambling, as opposed to Investing. The Ponzi idea is foolish.
"The IRA: As you are describing the three phases of the lending cycle, the comparison with the different levels of the insurance markets comes to mind, from low-beta, relatively uncorrelated transactions involving weather or op-risk events, vs. the high-beta world of CDS. The progression and evolution of risk taking in lending follows the same pattern. And now in CDS we have $50 trillion or so in contingent barrier options, written against CDOs, corporate bonds and anything else the derivatives community could dream up, that our financial system must fund as default rates rise. And these claims are largely speculative and have no connection to the real economy.
Janeway: Right. These are basically leveraged bets. Minisky illustrates the cycle, the kind of excess that evolves over time.
The IRA: What do you think Minsky would say about CDS? A fourth level of risk?
Janeway: Yes."But the 4th level of risk is less risky because of models. Please.
"Sibley was the public face of Jardine Fleming. He once said that giving liquidity to bankers is like giving a barrel of beer to a drunk. You know exactly what is going to happen. You just don't know which wall he is going to choose. "
Since we knew what Investing really was, I guess we could have avoided this. I guess the quants and managers are drunks in this example, and known drunks at that. Don't give them models, for God's sake.
"Janeway: There are two indictments of modern finance theory that define the hole we are in now. The first is the distinction between illiquidity and insolvency. When I was a kid growing up in this business in the 1970s, we thought of illiquidity and insolvency as two fundamentally different conditions. You were illiquid if the expected net present value of the cash inflows that I am entitled to by contract exceed the expected present value of the net outflows. All I have is a timing problem. You can tide me over. You are insolvent if the reverse applies. I'm bust. In this world, when you mark to market, liquidity drives insolvency.
The IRA: Correct. This is the point we try gently to get our friends in the accounting world to accept, namely that the snapshot of price at a point in time is not value. It reminds us of Heisenberg's Principle in physics. We kind of sort of understand the rate of movement and approximate positions of objects in space, but we have no idea of the precise location at any point in time. At least the great men of science admit when they don't know.
Janeway: Yes. So when we hear Secretary Paulson's explanation of why he refused to protect the creditors of Lehman Brothers, they made that theoretical statement about fair value real. That decision shifted the systemic process of deleveraging that we've been going through for 15 months into panic, the first real panic we've seen in this country since the Depression."
I've been waiting patiently for Heisenberg. Can Godel be far behind?"they made that theoretical statement about fair value real."
I knew philosophy was behind this.
"Janeway: The Lehman decision is one indictment. The other is really the flip side of modern finance theory. It's the notion that money is a veil, the financial system is a circus, and somewhere out there is a real economy whose behavior and performance is driven entirely by "real" factors, above all growth in the labor force and productivity, TFP, total factor productivity. And that you can model how this economy will work without taking note of anything financial except the interest rate, which in fact is determined by the central bank. So all of this money stuff is excluded. What I am saying is so silly that it is useful. A professor from the University of Chicago, Casey Mulligan, wrote a piece in the New York Times ("An Economy You Can Bank On," New York Times, October 9, 2008") in which he basically said: if you are not one of the six percent of the work force that is not employed in finance, don't worry, be happy. If a bank fails, another bank will emerge to fill its role. There will be some transitional effects, but the real economy is basically isolated from the financial economy. The real economy will continue on its course, essentially proving Say's Law, that supply creates demand. Keynes never lived and supply creates its own demand in real terms and we can ignore the fundamental fact of a monetary economy. Which is, that the non-financial sector lives on the provision of working capital and fixed investment, to be able to spend money before money is received. For being able to pay workers and vendors before receivables are collected. And to increase capacity before the revenues from higher sales are received.
The IRA: And I would say Mulligan is dead wrong. Middle America is doing better than the coasts, but you cannot help but be impressed with the widening range of negative GDP estimates for the 2009-2010 forecasting horizon, for the entire global economy.
Janeway: We are talking here of the most fundamental economics. It took real genius to break down this relationship between the real and financial sectors. All of the assets and liabilities of the financial sector, at the end of the day, come down to whether or not, back to Minsky, the cash flows from the non-financial sector validate them. The integration of the financial and non-financial sectors of the economy is complete. The interdependence is complete. And that's why I call the period from the collapse of the Bear Stearns hedge funds got into trouble, then Northern Rock, from about September 2007 to today the wasted year."
Not good for Casey, but I still think that he has some useful points about the differences in today's economy that could help us weather this crisis.
"The IRA: Roger Kubarych starts the reckoning from the collapse of New Century Financial.
Janeway: The authorities again and again pumped liquidity into the financial system, adding liquidity to banks but without addressing the insolvency issue. They didn't see the issue clearly until almost a year later and then Washington missed the issue of fiscal stimulus to bolster the cash flows of the non-financial sector. "Now, this relates to me with Moral Hazard, not the amount of money. The interventions led to a belief in implicit government guarantees to intervene in a financial crisis.
"The IRA: Yes, but the age of modern finance your have so skillfully described has allowed us to make the speculative economy much larger.
Janeway: This is precisely my point. This is the role of theory in modern finance. What we were doing is making the markets complete. One of the great thinkers and great men of the last half of the 20th Century who, like Samuelson, is still alive, is Ken Arrow. The Arrow-Debreu general equilibrium mathematical construction was one of the precursors to the current mess. If only we had hung it up on the wall and contemplated it as an aesthetic object, and never led people down this terrible path towards trying to make it operational. This notion that "if" markets were complete and efficient; "if" we had the infinite array of contingent securities so that we could at one point in time hedge every possible event, we'd have complete closure, everything would close.
The IRA: It's called absolute zero in physics, the end of molecular motion. It implies the end of days and, thus, is hopefully only a theoretical possibility. That's why my partner Dennis Santiago and I prefer Minsky and scientific notions like entropy to describe market behavior.
Janeway: Exactly. Reaching general equilibrium implies that we have extracted ourselves from historical time and that we are frozen in stasis. We had done one trade that was good forever. And remember that the math is beautiful. The practical effect is catastrophic. And that is the catastrophe you are talking about. Because as we build layer upon layer of derivatives, what we were doing was pursuing Ken Arrow's challenge. These are not bad people, they have simply been chasing the impossible dream of completing the market and, going back to MacKenzie, chasing the legitimatory goal of making the world a more efficient place.
The IRA: The road to hell is paved with good intentions. Thanks Bill."
At least it's paved. Too many "if"s is too many variables, and too much risk. We've come a long way from blaming models when the South Sea Bubble is mentioned. Doesn't entropy also lead to the end of days? Doesn't everything?
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