The risk management function of the banks should ensure that such trades are not done

TO BE NOTED: From A Credit Trader:

"Inside the MUNI Trading Funhouse

Lawsuits… here we come

Trades are going sour and the municipalities are rebelling…

• Milan Police Seize UBS, JPMorgan, Deutsche Bank Funds
• JPMorgan, 11 others sued over Jefferson county crisis
• Derivatives Hit Austrian Railroad With Record Loss

… and market spreads are responding

implying default rates that illustrate to what extent the market is dislocated.

Find the one that doesn’t fit
Municipal CDS market spreads (via the MCDX index) imply a 5y cumulative default probability of 34% versus a historical default rate of 0.02% (Moody’s) - a figure 1500x higher!

Purists in the room will claim that we cannot rely on a rating agency for historical default rates, as statistics come only from rated issues. Additionally, the default numbers do not take into account conduits where the default rate can run 10x higher – in fact, 2008 alone saw over $6bn of muni defaults – 19x higher than the previous year, though this has been in non-GO and unrated issues all of which recovered at 100% (anyone involved in the CDO market would laugh at a “default” that recovered at 100%, having been inured to the trusty old 0%).

The high market implied default rate is also skewed by the high expected (marked) recovery for muni bonds of 80% versus 40% in high grade (a higher recovery implies a higher default rate for a given CDS spread level) as well as potential uncertainty over deliverable obligations into muni CDS.

Each down cycle in markets exposes those unsophisticated investors who are “swimming naked”. Municipalities tend to be perfect examples as the Lack of Sophistication / Assets Under Management quotient is strikingly high. Though the current crisis is presenting muni’s with more than badly gone trades, it is these trades that offer the biggest lessons to investors.

Below I walk through what has gone wrong and what lessons have been learned (or relearned). In particular, I suggest the following guidelines to both the municipalities that have gone off the trading deep end as well as the banks that have assisted in the process.

Suggested Guidelines (fleshed out below)

Investment guidelines for municipalities:

1. Take no basis risk
2. Use no leverage
3. Make no punts

Risk management guidelines for banks:

1. Do not offer double-down trades
2. Pay attention to “willingness to pay”
3. Use credit mitigants like collateral and mark-to-market trigger agreements

Munis under stress
Though Muni spreads are clearly too high, it is as equally true that many municipalities are under economic stress. In April Moody’s assigned a blanket negative outlook to the entire U.S Local Government sector, citing fiscal challenges as a result of the housing market collapse, dislocations in financial markets, and a deep recession.

• Total fiscal 2009 budget deficits stood at $72bn, or 12% of general fund assets, according to the Center on Budget and Policy Priorities
• Decline in state revenues is accelerating due to a decline in sales and tax receipts
• Tight capital markets are constraining raising funds, though issuance has recovered since the Lehman default
• States are facing challenges with their pension obligations just as falling equity and corporate bond prices have eaten into investment pools

With Jefferson county teetering on the edge of Chapter 9, Vallejo, Calif recently entered Chapter 9 protection. Other California cities, including Rio Vista and Iselton have also said that budget gaps may force them into insolvency.

Outside of the difficult economic environment, munis have also been embroiled in their own financial mess, involving VRDO’s, TOBs as well as the monoline insurance disaster all of which are putting additional pressure on finances. In fact, trading decisions made by municipalities now figure in municipal investor analysis just as strongly as fundamental indicators like unemployment, interest expense and general revenue.

The Brave New World of Muni Trading
Below I list the trades executed by municipalities that have been particularly prominent in the news.

VRDNs
The most interesting trade to come out of the muni crisis has been the debacle seen in the variable rate market. The two types of variable rate muni securities are VRDOs and ARS. They are broadly similar but vary in puttability (VRDO’s are puttable, ARS’s are not), denominations, monoline coverage, investor types etc.

The most important thing, which is common to both types of securities, is that the interest rate resets periodically according to some basic rules( NB DON ) (auction-failure for ARS or a result of the remarketing process/changes in specified index for VRDO). The interest rate resets either to whatever rate clears the market or in the case of auction failure, steps up to a very high level so as to compensate those investors who were not able to sell their securities. These securities were very popular with muni issuers simply because, even after all the structuring fees (bank letter-of-credits and monoline insurance), the variable short-term rates paid by issuers were less than if they had issued long-term fixed rate debt.

The rates paid on the VRDO’s have tended to track the front-end cash/Libor levels. For this reason, the municipalities, bowing to the wisdom of risk management, hedged( 1 ) their interest rate exposure by paying fixed on interest rate swaps (or buying interest-rate caps). The floating index on the swaps was typically 67% of Libor. So, in the ideal case, the muni is paying a floating rate while receiving pretty much the same rate on its swap hedge on which it pays fixed.

When the market grew suspicious of monolines, paricipants rushed to put the bonds back to the market just as the bids retreated from auctions. Clearing rate levels shot up and ARS’s hit their maximum rates – most well-known in the case of Port Authority which started paying 20% vs. an earlier 4%.

So, the net result was that the floating rates the muni’s were paying on their VRDN’s shot up (owing to general illiquidity as well as the concern around monolines), while the floating rates they were receiving on the swaps collapsed (as interest rates fell) – meaning the muni’s managed to lose money both on their bonds as well as the hedges.( NB DON )

In retrospect, the municipalities made a number of key mistakes:

• Liquidity risk – the most fundamental mistake was similar to the one that befell the Structured Investment Vehicles: the reliance on short-term debt( NB DON ). Once cracks appeared in the monoline wraps and investors withdrew into cash, the muni’s were not able to roll over their debt. The municipalities were effectively subsidizing the rate on their debt by writing a massive liquidity option. They compounded the problem by backstopping their own short-term debt with impossibly high rates, knowing full well that paying such rates on their debt was not sustainable. The realization by the market of lack of demand for variable-rate securities and the unstainably high rates paid on the debt only added to the lack of confidence in muni debt
• Monolines – anything having to do with monoline wraps tends to be procyclical meaning it will exaggerate the pain on the wrapped products. The basic point is that the nature of the monoline business suggested that the time when an investor will seek to benefit from the wrap, is exactly time when that wrap will be worthless. Apparently, some municipalities have also agreed to post collateral( NB DON ) in the case of ratings downgrades, something which would tend to happen when the monolines are gone, the economy is in recession and cash is at a premium and difficult to raise and swaps are negative-MTM to the muni’s.
• Rates – municipalities may be forgiven for failing to foresee the silly price action in 30y swap rates which are still trading below 30y treasury yields. This was due to hedging of structured rate notes by dealers issued mostly to individual investors. The massive rally in rates has led banks to receive fixed in size in the long end of the swap curve in a largely illiquid market. This has led to large losses to the swap hedges done by municipalities. Most of these have tended to be in the long end of the curve, just where the rally has been most brutal.

Selling swaptions
Second on the list of poorly-thought-out trades has been the selling of interest rate swaptions. On the face of it, the motivation for selling swaptions looks quite reasonable. The muni issuer sells a payer swaption (on exercise the muni will pay the fixed strike). If the swaption is exercised, the muni pays fixed, receives floating and at the same time issues floating-rate bonds and uses the proceeds to refund the outstanding issue of bonds. Net result( 2 ) is a locked in synthetic rate for the issuer with some savings from the swaption premium.

This all sounds well and good except for the fact that the banks end up dictating if and when the municipalities issue debt. This decision to issue debt is not based on any fundamental funding need, but rather on the performance of a single trade done with the bank.

A cursory look through the news shows that Erie School District, Philadephia National Airport and Alabama Schools have all sold swaptions. This suggests that if rates were to fall they, and many other counties and districts who have also sold swaptions would need to come to the market and issue debt, leading to potential supply dislocations.

Structured Notes
This round of municipal crises has been (yet?) notably clear of structured note exposure, unlike the Orange County episode. Recall that Robert Citron put a large part of the portfolio into structured notes, particularly, inverse floaters. In fact, the county bought more inverse floaters (in notional terms) than there was equity in the fund. In the end, it was the leverage (about 2.6 at the highs), financed via reverse repos, that largely led to the $2bn of losses for the fund.

The particular danger in inverse floaters has to do with their duration profile. As inverse floaters are floating-rate products (the rate is linked to the level of interest rates), one would be forgiven in thinking they have short duration. In fact, the duration is higher than for a similar-tenor fixed-rate bond and increases as the trade goes against the investor (i.e. it starts behaving more like a zero-coupon bond).

What blew up Citron was the fact that he took on two kinds of leverage (you could say, he tripled-down): 1) the particular investment that he chose to express his views – the inverse floater was already dollar-for-dollar a leveraged investment as the duration of the product increased precisely when it went against Citron and 2) Citron put more money into inverse floaters than there was equity in the fund.

In addition to leverage and unappealing duration risk, the county had credit exposure to the dealers which was less of a concern then but is clearly much more significant now. In fact, given the current experience, real money investors are much more likely to structure trades with SPV’s rather than dealers directly in the future.

FX KIKOs
FX KIKO trades are the latest in the long series of toxic trades executed by unwitting investors during the latest market cycle. In fact, they have been so popular that they’ve been described in Bloomberg magazine, where they were called “I-kill-you-laters”, rather than “Accumulators” – their traditional pre-crisis name.

Though rumours of potential pain by European municipalities is only beginning, recent victims include corporates like Gruma – the world’s leading tortilla manufacturer with $700mm losses on the Mexican peso, Citic - with losses of $2.7bn on the Aussie dollar as well as countless other companies and investment houses. Although they come in different variations, these are essentially carry trades with some additional bells and whistles (or, if you like, smoke and mirrors).

Without going into detail, the basic structure of the trade can be summarized by the following chart.

Salient points of this trade are the following:

• If the market goes in the client’s favor, they make a little money and the trade matures in short order
• If the market goes against the client, the notional amount on the trade increases and the maturity extends.

Exporters who did the trades claimed they were being done for hedging purposes( 3 ). For example, a Mexican company exporting tortillas to the US market received dollars and needed a product that effectively made them short USD/MXN (ie whereby they sold dollars and bought pesos in the market). It is true that these trades positioned these companies the right way, unfortunately the trades were done in much larger size than the hedging operations required and the timing (knock-out components) plus leverage on the trades (which typically flipped from 1 to 2x the size when it went against the client) had no fundamental bearing on the actual financial flows.

It’s not clear how popular this trade was with municipalities though history of municipal involvement with FX stretches all the way back to 1995 when the State of Wisconsin Investment Board lost $95mm from MXN peso trades. Add to this the fact that municipalities pile in, along with companies and retail investors, into popular trades at the top of the market suggests that should see losses on such trades may be disclosed soon enough.

Categories
The classification of the trades described above can be summarized as follows:

1. Basis Risk – these are trades done for fundamental reasons, like obtaining cheaper funding, but go sour occasionally because they expose the investor to some tail risk. VDRN’s was one such trade that exposed muni’s to tail funding/liquidity risk as described above. The key here is to understand that the only reason muni’s were cheapening their funding was by selling a liquidity option to the market. So long that these tail options are viewed as risk free, municipalities will continue making the same mistakes. In reality, nothing is free in the market, and issuance decisions will be made on a more sound basis in the future if all risks are properly taken into account rather than swept under the rug.
2. Leverage – these are the typical “investment” trades based on a particular view of the market. The danger lies in the execution of the view (e.g. structured notes), as well as the leverage taken separately by the investors (via reverse repo’s).
3. Punts – these are trades done for apparently “investment” or “hedging” reasons. What differentiates punts from normal investment trades is the fact that the punt is done in a market where the investor can have no competitive advantage or insight relative to other players in the market. In other words, the answer to Ken Fisher’s question “What do I know that others don’t?” cannot be answered satisfactorily. These trades often figure in FX markets and often executed long after the popular press begins writing about their virtues. The FX KIKO, which is based on the carry trade, is an example of such a trade.

Conclusion
In order for the market to move beyond the news cycle of losses by municipalities and other unsophisticated real money investors, there need to be some fundamental changes. These changes have to come from both sides of the equation: municipality investment mandates and bank risk management policies.

Recent news has made it painfully clear that municipalities need to abstain from certain kinds of risks. These risks include the 3 categories mentioned above because each one has the potential to bury them, if left unchecked. In general, municipalities do not have the resources to run a full-fledged asset management organization, suggesting that their investment mandates need to shrink significantly. Although, generally speaking, the allocation of more power and decision-making ability to the local levels is not a bad thing, what we cannot have is a situation where part-time town board members without strong and dedicated risk management support staff make decisions that put at risk pensions of thousands of other people, while guided by biased investment advisors.

Investment mandates for municipalities need to be made on a state, if not the federal level and there has to exist a framework for escalating problems higher up before they explode. For example, a county finding itself in financial difficulties should not think that the only way out of trouble is to finance its budget by selling a ton of swaptions to the next friendly dealer that comes along.

On the bank side, dealers need to adapt consistent trading and “know-your-client” standards with municipal counterparties. These should not only include a relatively conservative set of products, but also collateral calls so that “punts” and leveraged trades, to the extent they are allowed to happen at all, are unwound/collateralized early and are treated with more care and tracked closely.

The traditional treatment of counterparty risk does not hold for unsophisticated investors like municipalities who can easily claim in court (often with good reason) that they did not understand the risks in the trades they were doing. Clearly, this will happen only when trades go bad adding its own particular wrong-way risk to these trades for banks.

There needs to be greater emphasis placed on the motivation behind client decisions to do certain trades. For example, an interest rate position done for genuine hedging of risk (preferrably without any basis risk) is very different from a short swaption position done to raise cash. The latter is a clear red flag and suggests that the client is essentially doubling down to get out of a financial jam. The risk management function of the banks should ensure that such trades are not done."

Me:

Don the libertarian Democrat says:

May 10, 2009 at 1:30 am

This terrific post just came up on my feeder. I counted three hedged investments that blew up. It would be great if you could refer me to a paper or post that goes into hedging strategies that have blown up in this crisis.

Obviously, by telling their clients that their investments are hedged, they led their clients into the mistaken notion that their asses were covered no matter what happened. I can’t imagine what it’s like to find out that, in some cases, it compounded their losses.

an unprecedented transformation exemplified by increased regulation and a heightened risk aversion

TO BE NOTED: From AllAboutAlpha:

"The Ascendancy of Risk Management

Posted By Alpha Male On April 30, 2009 @ 8:36 pm In Today's Post | No Comments

We conclude a week covering hedge fund operations issues with a guest contribution from Abdul Sheikh, CAIA, a Vice President at State Street’s fund administration group. Sheikh makes the case that many attendees of GAIM Ops also made: that independent fund administration may be the only way to fully address investor concerns in the post-Madoff world.

Alternative Viewpoints: The Ascendancy of Risk Management

Special to AllAboutAlpha.com by: Abdul Sheikh, State Street Fund Administration

In the past years, investors used to select fund managers based on three criteria: performance, philosophy and pedigree. But in Deutsche Bank’s annual Alternative Investment Survey released last month (see [1] related post) , “risk management” entered the ranks of the top three selection criteria for the first time, and “pedigree” fell to fifth.

[2]

It’s clear that we are witnessing a paradigm shift in manager selection and asset allocation criteria. Gone are the days of just looking at attributes like track records, top down vs. bottom up approaches, low correlations to markets, and manager size. Recent events have shown that investors need transparency, independent risk analysis, and independent asset servicing.

A State Street study conducted late last year in conjunction with the 2008 Global Absolute Return Congress (see [3] related post) reinforces this - indicating that five out of six institutions (84 percent) expect more disclosure of hedge fund positions and nearly half (49 percent) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19 percent) currently receive some level of consistent transparency across hedge fund holdings. (See chart below from report)

[4]

Institutional investors may believe their portfolios are well diversified. However, do they really know what their concentrations are and what these concentrations mean to them? Depending on the strategy, the managers may be allowed to take on leverage, but only a thorough analysis can determine whether that leverage is accidental or deliberate (and thus beneficial to the overall portfolio). However, this kind of thorough analysis usually requires position-level transparency.

Heightened concerns over transparency and risk management are increasing demand for independent asset servicing. Functions such as securities processing, fund accounting, reconciliations, security settlement and safekeeping are no longer viewed as value-added but necessary. Many industry experts think that the Darwinian processes occurring for the past year will separate the “premier league” of funds from the others. Based on the result of the surveys above, these premier league funds will likely be distinguished by their ability to employ independent asset servicing, provide transparency and use better risk management systems.

Some of these basic asset-servicing functions have traditionally been provided by investment banks and prime brokers. But some are now calling for third party custodians who hold customer assets “off the books” in custodial accounts. Since prime brokers have much more extensive rights in client’s assets - including their ability to rehypothecate their client’s assets - some argue that they expose investors to additional risks.

Without a doubt, we are witnessing an unprecedented transformation exemplified by increased regulation and a heightened risk aversion. As cases like Madoff and Stanford have proven, regulatory oversight sometimes provides a false sense of protection. And that is why investors seem to be saying that fund-level risk management has become more important than ever.

- A. Sheikh, April 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or State Street Corporation.

Editor’s Addendum: Sheikh’s State Street colleagues seem to agree with his assessment as evidenced by [5] this FT piece earlier in the week:

“‘The old system seemed to work pretty well as long as assets grew,’ says Jack Klinck, head of global investment product services at State Street. ‘But now investors are really nervous. There’s a tremendous focus on ‘who’s your counterparty?’”

“Mr Klinck expects to see a number of large US hedge funds, which have until now done all their administration in-house, outsource this function in order to reassure their clients. ‘Self-administered hedge funds are looking like outliers now. They’re having to break their operating model.’”

Finally, before the AllAboutAlpha.com corporate jet departs the Cayman Islands, we thought you might find [6] this recent Hedge Funds Review Cayman supplement to be kind of interesting:

“There is no doubt the global financial crisis and the push for tighter and more onshore regulation of hedge funds will change the industry forever. Cayman’s role in this is unclear but the government, regulator and industry are confident they have the skills and will to keep the jurisdiction as the number one domicile.”

---

Article printed from AllAboutAlpha.com: http://allaboutalpha.com/blog

The wrong models are partly responsible for the current mess, and many of them are too mathematical

TO BE NOTED: From Paul Wilmott:

"Good Risk Management Techniques Do Already Exist

Posted At : March 26, 2009 10:29 AM | Posted By : Paul Wilmott
Related Categories: General

In the popular press I keep reading about how quant models need to be improved. It's not as simple as that, but nor is it so subtle for the journalists to have to dumb down.

There was an article in the Financial Times last week that said we need more maths, yes, more, lots of it, until we are stuffed to the very brim. No mention of what sort of maths, no mention of the relevance of the maths or the robustness of the resulting models. Just "we need more maths." I have to disagree that it is just a case of more is better. The wrong models are partly responsible for the current mess, and many of them are too mathematical. Well, I've said that many times over the years.

There's also the perception that there are no good models out there. Again, I have to disagree strongly. There are plenty of models that are better than the established models. Some of them are better by virtue of being more accurate in a scientific sense, some are better by virtue of their simplicity. Given that financial models are never going to be perfect it surely makes sense to have models that are transparent and easy to understand (and mend when they go wrong) rather than complex and impenetrable.

One error that keeps being repeated is that there are no models for crashes, when all instruments move together in sync. Well, the much-maligned-and-rightly-so copulas are meant to do that. Clearly they didn't do a great job. There is also the model that Philip Hua and I designed in the mid to late '90s, CrashMetrics.

CrashMetrics ticks all the important boxes: a) accuracy, b) correct level of mathematics, c) understandability, d) robustness, e) flexibility, f) ease of use. We came up with the idea because it was clear that Value at Risk would only work during rather dull markets, that is, perversely at times when it almost wasn't important to measure risk! So something had to be done about the bank-destroying events, the crashes for example. Extreme Value Theory was supposed to do that, but that's just "rearranging the deck chairs on the Titanic." CrashMetrics is a worst-case scenario model, designed to tell you how bad the crash would be for your portfolio, with no reliance on probabilities. Once you know what the worst could be you then decide whether you want to protect yourself against it, and then, thanks to "Platinum Hedging," the methodology also tells you how to do this in the optimal, most cost-effective manner.

Sadly CrashMetrics fails to tick the most important box of all, the so-complicated-that-only-a-handful-of-people-with-17-PhDs-each-can-understand-it box. Silly us!"

"Unfortunately the training that most quants get seems to actively discourage creativity. "

Paul Wilmott with another interesting post:

"Quantitative finance and risk management are not just about the numbers. Numbers play a part, but so does the human side of the business. When analyzing risk it is important to be able to think creatively about scenarios. Unfortunately the training that most quants get seems to actively discourage creativity."

The human side is what I call the Human Agency side. To be honest, philosophical education can also discourage creativity. Thinking about scenarios is what I call Narrative Thinking. Behind all this is a misunderstanding of the nature of math models and their tenuous, but useful, relationship to the world. By the way, if you want an example of Narrative Thinking, I would recommend Kierkegaard.

"Some of the following appeared on the BBC website in December 2008.

We've learned the hard way how important it is to measure and manage risk. Despite the thousands of mathematics and science PhDs working in risk management nowadays we seem to be at greater financial and economic risk than ever before. To show you one important side of banking I'd like you to follow me in an exercise with parallels in risk management"

It's interesting how this mirrors Skepticism. I believe that as science and rationality have advanced, the argument of the Skeptic has gotten stronger. I call this Paradoxical, and believe that human existence, and Human Agency, and Narrative Thinking, are inherently Paradoxical. The concept of Risk is no exception. The more you can understand and capture risk, the riskier life will seem.

"You are in the audience at a small, intimate theatre, watching a magic show. The magician hands a pack of cards to a random member of the audience, asks him to check that it's an ordinary pack, and would he please give it a shuffle. The magician turns to another member of the audience and asks her to name a card at random. "Ace of Hearts," she says. The magician covers his eyes, reaches out to the pack of cards, and after some fumbling around he pulls out a card. The question to you is what is the probability of the card being the Ace of Hearts?"

It's rigged. That's his job. The Magician, a good one, will always pull out the correct card.

"Think about this question while I talk a bit about risk management. Feel free to interrupt me as soon as you have an answer. Oh, you already have an answer? What is that, one in fifty two, you say? On the grounds that there are 52 cards in an ordinary pack. It certainly is one answer. But aren't you missing something, possibly crucial, in the question? Ponder a bit more.

One aspect of risk management is that of 'scenario analysis.' Risk managers in banks have to consider possible future scenarios and the effects they will have on their bank's portfolio. Assign probabilities to each event and you can estimate the distribution of future profit and loss. Not unlike our exercise with the cards. Of course, this is only as useful as the number of scenarios you can think of.

You have another answer for me already? You'd forgotten that it was a magician pulling out the card. Well, yes, I can see that might make a difference. So your answer is now that it will be almost 100% that the card will be the Ace of Hearts, the magician is hardly going to get this trick wrong. Are you right? Well, think just a while longer while I tell you more about risk and its management. "

The Magician can get it wrong. I call "scenario analysis" understanding the context, presuppositions, and beliefs underlying the situation.

"Sometimes the impact of a scenario is quite easy to estimate. For example, if interest rates rise by 1% then the bank's portfolio will fall in value by so many hundreds of millions. But estimating the probability of that interest rate rise in the first case might be quite tricky. And more complex scenarios might not even be considered. What about the effects of combining rising interest rates, rising mortgage defaults and falling house prices in America? Hmm, it's rather looking like that scenario didn't get the appreciation it deserved."

I'd say that it didn't get the fear and prudence it deserved.

"Back to our magician friend. Are those the only two possible answers? Either one in 52 or 100%? Suppose that you had billions of dollars of hedge fund money riding on the outcome of this magic trick would you feel so confident in your answers? When I ask this question of finance people I usually get either the one in 52 answer or the 100%. Some will completely ignore the word 'magician,' hence the first answer. Some will say "I'm supposed to give the maths answer, aren't I? But because he's a magician he will certainly pick the Ace of Hearts." This is usually accompanied by an aren't-I-clever smile! Rather frighteningly, some people trained in the higher mathematics of risk management still don't see the second answer even after being told."

I'm sorry, but I'm traumatized by the billions of dollars scenario. It's like a joke that can't be understood by some people, especially people with no sense of humor.

"This is really a question about whether modern risk managers are capable of thinking beyond maths and formulas. Do they appreciate the human side of finance, the herding behaviour of people, the unintended consequences, what I think of as all the fun stuff. And this is a nice question because it very quickly sorts out different types of thinkers."

Between people who have a good sense of humor and the humorless?

"There is no correct answer to our magician problem. The exercise is to think of as many possibilities as you can. For example when I first heard this question an obvious answer to me was zero. There is no chance that the card is the Ace of Hearts. This trick is too simple for any professional magician. Maybe the trick is a small part of a larger effect, getting this part 'wrong' is designed to make a later feat more impressive...the Ace of Hearts is later found inside someone's pocket. Or maybe on the card are written the winning lottery numbers that are drawn randomly 15 minutes later on live TV. Or maybe the magician was Tommy Cooper. Or it was all the magician's performance-anxiety dream the night before. When I ask non mathematicians this is the sort of answer I get."

In order for magic to work, you have to work with people's expectations. I think this limits the possible plays the magician has. One of them has to be that he picks the correct card.You see, the human mind will supply a context, so I disagree with him here.

"The answer one in 52 is almost the answer least likely to be correct! Magicians only rarely rely on probability. Clue: How many times did Houdini die during his Water Tiorture trick? (Unless the magician was using an ordinary deck of cards, was aiming to pull out a different card but accidentally pulled out the Ace of Hearts instead! Accidentally not making the intended 'mistake.')"

He can make a mistake. He's not a real "Magician".

"A member of wilmott.com didn't believe me when I said how many people get stuck on the one in 52 answer, and can't see the 100% answer, never mind the more interesting answers. He wrote "I can't believe anyone (who has a masters/phd anyway) would actually say 1/52, and not consider that this is not...a random pick?" So he asked some of his colleagues the question, and his experience was the same as mine. He wrote "Ok I tried this question in the office (a maths postgraduate dept), the first guy took a fair bit of convincing that it wasn't 1/52 !, then the next person (a hardcore pure mathematician) declared it an un-interesting problem, once he realised that there was essentially a human element to the problem! Maybe you have a point!" Does that not send shivers down your spine, it does mine."

The Human Element is uninteresting. What can that mean?

"Once you start thinking outside the box of mathematical theories the possibilities are endless. And although a knowledge of advanced mathematics is important in modern finance I do rather miss the days when banking was populated by managers with degrees in History and who'd been leaders of the school debating team. A lot of mathematics is no substitute for a little bit of commonsense and an open mind."

Throw in Philosophy as well old boy, and we'll call a wrap.

"How can we get quants and risk managers to think beyond the mathematics? I'm afraid I don't think we can, the way the majority of them are currently educated."

One never ceases being educated.

"as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.

Yesterday, Eric S .Rosengren of the Boston Fed gave a talk focusing on some principles for future regulatory reform, which I found out about on the WSJ:

"I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions. I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.[Footnote 1] As you know, many banks around the world have, of late, found themselves needing equity infusions from governments, or expanded guarantees for their liabilities."

Actually, a more appropriate time for a conference on risk management and modeling is when things are seemingly going very well, but this is now a step in the right direction.

Banks have needed:
1) Money from government
2) Implicit guarantees made explicit

"A widespread need for banks’ recapitalization has occurred at least twice in the past century, and in many countries has occurred much more frequently than that. Many banks’ risk models were supposed to be calibrated for “once-in-a-thousand-years” events; however, these models seriously underestimated risk."

They not only underestimated risk, but, in doing so, were magnifying risk. That's the reason a " Once-in-a-thousand-year" event occurred in about five years.

"Certainly there is much still to study and understand about the recent financial turmoil that emerged in the summer of 2007. But it seems abundantly clear, and not all that surprising, that risks calibrated from a few years of data from good times can dramatically under-estimate risk exposure for a particular asset, as well as the high correlation of risks across asset classes during periods of significant stress. "

When you read how little data they had to base their predictions on, there's no way but to consider that ridiculous and negligent behavior. You have to ask what incentives or goals predisposed people to accept such preposterous presumptions.

"Furthermore, while capital models were intended to suggest minimum capital requirements that would keep institutions sound during risky times, the models were frequently used to justify expansion of dividends and stock buybacks, because they suggested that banks were overcapitalized during boom times. So this conference occurs at a good time, as we all try to re-evaluate how best to model and manage risk."

Lowering capital requirements is inherently risky. Period. This was a conscious and obvious attempt to find investments with lower capital requirements. Period.

"And it is not only our risk models that need to be reevaluated. Our regulatory framework clearly needs to be reconsidered, in light of recent events. Both in the U.S. and globally, we had in place a complex set of regulations and supervisory structures intended, in part, to increase the likelihood that financial intermediaries would remain well capitalized without government assistance. Like the risk models, bank regulators did not foresee the dramatic illiquidity that could emerge during a period of acute financial turmoil – nor the changes in the value of assets on balance sheets, or the degree of correlation of those asset values."

We've had a system, at least since the S & L Crisis, of implicit and explicit government guarantees to intervene in a financial crisis. We've had a pretty well established set of precedents from the S & L Crisis and Tech Bubble that fraud, negligence, fiduciary mismanagement, and collusion, are rarely and arbitrarily prosecuted. We've had a regulatory structure that did not do much regulating, and which was easily influenced by lobbying. Put those in your risk pipe and smoke it.

"While regulatory reform proposals are already beginning to surface, I see value in first evaluating the principles that should frame the discussion. Before we begin to work on regulatory details we need to evaluate whether the problem was poor execution of a well-considered regulatory framework, or that important principles were absent from the framework. While in my view the recent experience shows elements of both, I want to focus today on regulatory principles rather than their implementation."

It's more like the pool is being drained down to the level where regulatory reform proposals are being taken seriously. Was the problem:
1) Poor enforcement of good rules
2) Poor rules
3) A combination of both ( Yes. And he agrees )

He will focus on 2. Better to focus on rules than people. They might be offended.

"But before discussing regulatory principles, I would like to briefly discuss our current economic situation, in order to put the recent crises in context.

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Recent Economic Conditions

Many countries have already experienced two consecutive quarters of negative GDP growth and the NBER has recently declared that the U.S. entered the recession at the end of last year. In the U.S., GDP in the second quarter was positive, helped in part by a fiscal stimulus package. In the third quarter, GDP declined by 0.5 percent, and it looks like in the fourth quarter it will decline somewhat more significantly – since consumer and investment spending appear to be dropping quite precipitously. This is due, in part, to the interplay of developments in asset markets and the real economy. U.S. consumers – and, increasingly, consumers across Europe – have been buffeted by declining housing prices and falling stock prices. The resulting loss of consumer wealth, coupled with a rapidly rising unemployment rate, suggests the holiday buying season will not be robust as was hoped earlier this year."

What's with the constant use of "robust"? We're in a recession.

"The likelihood of further weakening of labor markets, and a reluctance of consumers or businesses to increase spending until economic conditions are more certain, together imply a continued difficult environment for banks. There are several conditions necessary for financial markets to resume a more normal state, and I would like to briefly discuss each."

Fire away.

"First, we need short-term credit markets to return to normalcy. Conditions in short-term credit markets have improved significantly since the end of September. As shown in Figure 1, rates in the market for high-grade financial commercial paper have resumed a more normal relationship to the Federal Funds rate target, compared to the mid September to mid October timeframe. This improvement in what was a very large spread has been greatly aided by the various short-term credit facilities established by the Federal Reserve to help reduce the stress in short-term credit markets. These facilities have also enhanced the ability of financial firms and issuers of commercial paper to extend the maturities on commercial paper issues (see Figure 2), which at the end of September had become dependent on overnight financing. The facilities have also reduced the risk that financing would not be available over the year end, as many commercial-paper issuers have now financed themselves beyond that point. But despite these improvements, short-term credit markets remain strained. Figure 3 shows that the spread between Libor[Footnote 2] and the Overnight Index Swap rate has fallen from its late-September peak but remains well above the level that prevailed prior to the outbreak of financial turmoil in summer of 2007."

This makes sense.

"Second, we need to see some improvement in the housing market before financial markets will resume a more normal state. In the U.S., residential investment began declining in the first quarter of 2006 and has declined in each quarter since. And as Figure 4 shows, house prices have declined nationally, and in some markets the declines have already exceeded 25 percent. A number of proposals have been floated to help stem foreclosures, but to date there has been relatively modest progress – faced, as we are, by the dual problems of falling housing prices and rising unemployment. Stabilization in house prices and a drop in foreclosures would help the overall economy as well as the banking sector that is exposed to construction loans, residential mortgage loans, and mortgage-backed securities."

This makes sense. How to do this is where we disagree.

"Third, officials must take into account – and develop policies and actions that reflect – the degree to which monetary policy tools are currently deployed. The stance of U.S. monetary policy reflects our rate reductions, with the Federal Funds rate target currently at 100 basis points. Given that interest rates cannot be negative, further monetary-policy actions are limited by the zero lower bound for interest rates. While other monetary policy tools can be employed, increasingly many observers and commentators are suggesting that fiscal stimulus will be an important element of economic recovery."

The word"deployed" again. Strange. We need a stimulus. Yes.

"Principles to Guide the Design of Regulatory Structure

With actions already taken to stabilize short-term credit conditions, and the widely-reported likelihood of further fiscal measures, I would hope that over the next year there can be a broader discussion of lessons learned from our recent problems, and what measures can be taken to reduce the risk of a recurrence. There can sometimes be a tendency to move to proposals for regulatory design before building a consensus on the underlying principles that should guide the debate. To that end, I would like to use my remaining time to discuss a few key principles that I hope will inform the many proposals that are likely to emerge."

I agree that principles should be developed first.

"Principle 1:
Financial regulation must be more clearly focused on the key goal of macroeconomic stability as well as the safety and soundness of individual institutions.

I lead with this principle, because I believe it has not necessarily received sufficient attention in our current regulatory structures. There is a clear link between the financial regulation of institutions and the stability of markets and the macroeconomy. Some countries have had frequent and severe banking crises, while other countries have been much more successful at weathering periods of international financial turmoil.

On the one hand, too conservative a regime of financial regulation can stymie innovation and creativity, thus preventing borrowers and lenders from interacting in the most efficient ways. On the other hand, inadequate oversight can cause periods of financial turmoil that are quite destructive to the financial infrastructure and the real economy. Future regulatory design must allow for innovation without increasing risks to the financial infrastructure and the real economy."

This is what I believe. The main objective should be to examine financial innovations as they occur as to whether they:

1) Transfer Risk

2) Magnify Risk

Whether regulation or supervision is needed is secondary to a clear and thorough examination of the new financial products or arrangements.

"Principle 2:
Because it is a key determinant of macroeconomic stability, systemic financial stability must receive greater focus, with roles and responsibilities during a financial crisis more clearly articulated.

Regulatory structures should be designed to minimize the probability of systemic disruption or instability. In the future, the definition of a “systemically important” firm must be clear in advance, and the regulatory structure should be designed to minimize the chance that such firms will take actions that would put systemic stability at risk. In addition, should a crisis arise despite the best efforts of regulators, the conditions and processes to “save” such firms must be well understood in advance."

I agree with this and have said so over and over. All government guarantees must be made explicit and agreed upon beforehand, as well as there being a minimal but clear and effective mode of regulation, involving rationalization and oversight of the regulators themselves as to their effectiveness and competence.

"Importantly, care must be given to the design of rescue options to minimize the incidence of moral hazard, or additional risk-taking by a party that is insured, “saved,” or otherwise insulated from the consequences of its activities. Of course, the best way to avoid moral hazard is to avoid crisis situations in which organizations need “saving.” The next best way is to have well-defined processes in place in advance, which minimize the effects of moral hazard.[Footnote 3]"

This is the most important point for me. We need to clearly differentiate between businesses that have government guarantees and those that don't, and regulate risk accordingly. What I've called Bagehot's Principles need to be applied, including killing off insolvent businesses quickly and effectively to enforce moral hazard as an ongoing regime. If you let it slide, your actions will overcome your words, and moral hazard will be significantly increased.

One addition to Bagehot's Principles might be:

We might save your bank, but you and and the people responsible for the bank's problems will not be saved, and might even suffer personal losses.

"Essential to determining which institutions are systemically important is a comprehensive view of what you might call the “financial entanglements” – interdependencies – among financial instruments and institutions.[Footnote 4] In an ideal situation, financial institutions could fail or have their assets transferred to other organizations with little disruption to counterparties or markets. Recent experience indicates that the uncertainty around counterparty risk in non-exchange-traded transactions is significant during periods of market stress. And it is difficult to ascertain the true extent of counterparty risk and whether a failure will result in significant disruptions in markets where the financial institution serves as a key player."

This is key, if for no other reason that, and this seems silly saying this, a financial institution can actually know what it has in assets and liabilities from day to day.

"In the U.S., the central bank can provide liquidity to the marketplace, but decisions to take on credit risk that pose substantial risks to taxpayers should ideally be in the hands of the Treasury Department, with oversight by Congress. However, during this period of financial turmoil the Treasury Department did not have the pre-existing authority to intervene expeditiously in such a crisis situation. The result was that the central bank became directly involved in urgent, time-sensitive issues that involved significant credit risk."

We need one agency to be in charge.

"To be better prepared for systemic problems, “standing” fiscal and monetary facilities are needed, to provide the ability to react more quickly than was possible of late. Until the passage of the Troubled Assets Relief Program (TARP), the U.S. Treasury Department did not have the ability to react to emerging problems as quickly as it would have liked. Similarly, many of the Federal Reserve facilities required significant accounting, legal, and back-office infrastructure that took some time to put in place."

We should plan for crisis management situations.

"In addition, as you all know, liquidity has been provided to institutions and markets where previously the central bank had little direct regulatory involvement. For example, facilities that were needed to provide liquidity to investment banks and money-market funds were established despite the absence of direct regulatory oversight by the Federal Reserve at the time the facility was initiated. Also, markets such as those for asset-backed commercial paper and unsecured commercial paper were not markets in which the Federal Reserve was actively engaged prior to the crisis. In the future, it would be ideal to clarify in advance which institutions and markets could require liquidity, and make sure the central bank has sufficient information about these institutions and markets to better serve in its role as lender of last resort."

This is also key, and follows from making everything explicit and agreed to beforehand.

"Principle 3:

Liquidity risk must receive greater policy focus in determining regulatory structures.

At the outset of the recent financial turmoil, many observers assumed that liquidity risk was well contained. In the case of investment banks, many of their assets were financed by repurchase agreements – short-term loans that were fully collateralized. Because the repurchase agreements were collateralized, most parties assumed there was a relatively low risk of a “run” because the collateral could always be sold in the event of a default. However, concerns with valuations of assets used for repurchase agreements resulted in many investors refusing to continue to lend even overnight once the counterparty was feared to be at risk of failure."

You have to be able to sell assets in order to get the money you need back.

"In addition, money market mutual funds were assumed to have relatively little liquidity risk, because they were constrained by regulations that compel them to hold only investment-grade securities of short duration. However, after one well-known money market mutual fund announced that its investors would not be able to redeem their entire principal (“breaking the buck”), many funds faced a wave of redemption requests they had great difficulty meeting – until action was taken to put in place temporary U.S. Treasury insurance as well as a new Federal Reserve liquidity facility."

People have to believe that they can get their money back when they need it.

"The financial turmoil has highlighted the reality that our regulatory structure had not fully anticipated the types of liquidity shocks that have occurred. Going forward, more attention should be focused on ensuring that the causes of liquidity disruptions are better understood, and that we are better equipped to avoid liquidity problems.[Footnote 5]"

Financial institutions need to be able to sell assets in order to meet capital requirements.

"Also, we must be cognizant of an issue that has compounded these liquidity problems – the interaction with accounting rules. Regulatory and accounting frameworks need to consider how best to address periods of sustained illiquidity."

Mark-to-market, Etc.?

"In order to prevent bank runs, many countries have not only insured bank deposits but have also guaranteed other liabilities. We need to better understand how best to structure liabilities to avoid the need for such debt guarantees in the future. In the recent turmoil, for many institutions it was the unexpected lack of a stable and fluid market for short-term debt to finance their balance sheets that created liquidity problems.[Footnote 6]"

We'd rather not have the government get involved.

"Principle 4:

Careful thought must be given to coordinating the work of the various domestic and international regulators in the design of the regulatory structure.

In the United States there exists a patchwork of overlapping regulators. Much of our regulatory design results from reactions to the Great Depression. Given all the changes that have occurred since then, it is probably appropriate to take a fresh look at our regulatory structure – not just the bank-regulatory agencies but also the inter-relationship of their work with that of the Securities and Exchange Commission and the Financial Accounting Standards Board."

This is what I've already called Rationalization.

"Ideally, a new structure would minimize the adverse effects of competing regulatory goals. It will also need to consider how different regulatory bodies can be better coordinated so that information moves more freely between them. Also, international coordination is becoming much more important, as firms have become more global. And as with monetary policy, I believe that to the extent possible, creating independent regulatory agencies with clear mandates is critical to success."

Same point, including ones I've already made about how regulations should be framed.

"Principle 5:

Responsibility for strengthening market infrastructure should receive more attention in regulatory design.

The current crisis has highlighted the need for better transparency. If every transaction is unique, it becomes difficult to determine valuations during periods of illiquidity. To the extent possible, contracts governing securitization should be standardized, with clearly defined steps to resolve competing interests when the underlying assets lose value."

I don't mind this, but frankly doubt its usefulness. Better, it should happen, but room should be left for some innovation.

"Similarly, contracts between institutions provide less transparency than transactions through exchanges. Exchange-traded assets provide a price that is widely observable – on contracts for assets that are clearly defined. To the extent that more assets move to be exchange-traded, counterparty risk is reduced, and transparency is increased."

This I agree with.

"I also believe that payment and settlement activities need greater oversight. The back-office difficulties involved in unwinding complex trades that were not exchange-traded highlight the need for more attention to settlement activities."

It might also deter graft.

"Conclusion Of course, these five principles are not the only ones of import. Others may stress other very worthy points taken from the lessons of the recent episode. For example that financial regulation must be grounded in an understanding of institutional relationships – “real world” details, which clearly do matter. "

You know you're in a strange situation when someone feels it necessary to remind everybody that we need to deal with the "real world".

"Or, as I mentioned when discussing moral hazard, that financial regulation needs to do a better job of recognizing the role of incentives. For example, compensation structures affect actions – as is evident in situations where short-term risk-taking is rewarded very lucratively and losses are not borne by the originators of the risk."

That's addressed by my addition to Bagehot's Principles.

"The current crisis provides the opportunity and impetus to reexamine a regulatory framework that originated in the Great Depression. While I believe there is a clear need to redesign the current regulatory structure, it is important that we not lose important features of the current market. It is critical that any regulatory design not stifle the industry’s innovation and creativity. However, the regulatory structure needs to be more adaptable to innovations – in order to ensure that new safety and soundness, and systemic, concerns are not ignored. And it needs to be aware of the details of the evolving financial-market structure."

That's why we need to focus on principles, and on our ability to discern what investment products are doing.

"Additional regulations do run the risk of moral hazard where the presence of a safety net creates an incentive to take additional risk. While any countercyclical monetary, fiscal, or regulatory policy runs this risk, it should be minimized. Ideally, situations requiring public support should occur only after losses have been borne by equity holders, and existing management and directors have been held responsible for the losses."

This is the main cause of the crisis for me. It stemmed from the self deception involved in the implicit guarantees, that everyone in the financial world believed were explicit. Everyone was pretending that these guarantees weren't there, while everyone was acting as if they were. This allowed a fairy tale view of what risk there was in the system, which led to an unnaturally childish view of risk by the individuals involved, since, if everything got scary, the investors had a fairy godmother called the government to bail them out. The fairy tale world turned out to be the one with no government guarantees, not the one that people were pretending wasn't real. We need a very onerous and specific set of principles for the government to be involved, and enforce moral hazard religiously from the outset. No more self deception and fairy tales, please.

"To the extent a new regulatory structure reduces counterparty risk, or requires offsets in capital for transactions involving significant counterparty risk, the likelihood of spillover effects from one firm’s failure should be significantly reduced. Ideally a new structure will reduce the likelihood of future financial turmoil of the length and severity of current financial problems."

We should raise capital requirements, and have a system in which capital can easily be raised if needed. An interesting talk.

"Thank you for having me join you today, and thank you for the opportunity to share my views on principles to guide the redesign of U.S. financial regulation."

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Complete speech, with exhibits

X Footnote 1

Of course, the views I express today are my own, not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee (the FOMC).

X Footnote 2

The London Interbank Offered Rate.

X Footnote 3

In a recent speech Chairman Bernanke, while stressing the importance of market discipline and the problem of moral hazard, said that "the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are 'too big to fail' must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and address the problem of 'too big to fail' should be a top priority for lawmakers and regulators." The Chairman’s speech, Federal Reserve Policies in the Financial Crisis, is available at http://www.federalreserve.gov/newsevents/speech/bernanke20081201a.htm.

X Footnote 4

I discussed the benefits that central bank policymakers gain from having supervisory roles and relationships in a speech in Seoul in March. “Bank Supervision and Central Banking: Understanding Credit During a Time of Financial Turmoil” is available on the Boston Fed’s website at http://www.bos.frb.org/news/speeches/rosengren/2008/032708.htm

X Footnote 5

For more on issues of liquidity, liquidity-risk concerns, and systemic risk, see speeches entitled “Liquidity and Systemic Risk” and “The Impact of Financial Institutions and Financial Markets on the Real Economy: Implications of a Liquidity Lock.’”

X Footnote 6

Some observe that another lesson of the recent turmoil involves possible over-reliance on short-term debt throughout the financial system.

X Figure 1:
Asset-Backed Commercial Paper Rate and the Federal Funds Target Rate

July 1, 2008 - November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 2:
Commercial Paper Issuance

July 2, 2007 – November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 3:
Spread: One-Month London Interbank Offered Rate (LIBOR) to Overnight Index Swap (OIS) Rate

January 1, 2007 - November 28, 2008

Source: Financial Times, Bloomberg / Haver Analytics

X Figure 4:
S&P/Case-Shiller Home Price Indices: Composite and Selected Metropolitan Areas

January 2001 - September 2008

Source: S&P/Case-Shiller / Haver Analytics

"So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. "

Taleb again, in the FT with Pablo Triana:

"On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese’s wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese’s rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the “bystander effect”. This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods)."

I'm with him completely. Remember Fraud, Negligence, Fiduciary Mismanagement, and Collusion? But who are the bystanders? Let's catch the actual culprits first.

"Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes."

Okay. I agree.

"Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible."

If they took part, then they're culprits, not bystanders.

"So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen."

Okay. Fine. But does anyone ever do time for these crimes, beyond a few token high profile cases?

"Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide be-hind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

If they're not going to listen to you, I doubt that they'll listen to me. I'll give it a try anyway.

"Why didn’t policymakers think to look at these, instead of relearning everything again? "

Interesting post by Felix Salmon. He interviews Citibank chairman Bill Rhodes:

"A Citibanker since 1957, few bankers have racked up more air miles than Bill Rhodes over the course of their careers, and probably none have done so in the cause of resolving so many crises, from Jamaica to Nicaragua to Korea to Uruguay, with many in between. His name is especially associated with the resolution of massive Third World debt problems in the early Eighties.

But Rhodes freely admits that he’s never seen a crisis as big or as dangerous as the one we’re in now.

FS How did we get to this place?
WR Confidence disappeared and was replaced by fear, all of which was exacerbated by the policymakers’ incremental approach to problem resolution – we’re letting one company go, but not letting the next one. The decrease in market confidence was seen in the interbank lending market. When liquidity started to become scarce, the lack of confidence grew worse. Liquidity, capital, and then deposits have become king, all in that order. First you need to have liquidity. Then you need capital. Investment banks suddenly realised that they needed to have a deposit base and that they couldn’t go to the markets easily and cost-efficiently to raise funds.

FS You say that policymakers exacerbated the problems. Were they too complacent?
WR We’ve had two false dawns here. The first one was the period around November, because the initial hit to the system in August was assuaged by the tremendous amount of liquidity that the Fed, the European Central Bank and others put in the system. But in spite of those actions, we never got the confidence back in the interbank market and among counterparties. We got into December and January, and the problems started to become more apparent. The cost of LIBOR and the monoline insurance company problems were indicators that the problems in the markets hadn’t been resolved.

Then we suddenly had Bear Stearns in March. People thought once that bail-out was complete, the worst was over. I remember attending meetings where some of the seniors of major investment banks were saying, ‘The worst is over in the credit markets because the investment banks and brokerage houses were given access to the Fed window.’ And that’s what you also heard in Washington. I was hearing all sorts of comments of reaching the ninth inning of a nine-inning baseball game. And all this was being said in spite of the credit markets still being unsettled and the housing markets continuing their decline into what amounts to the worst housing crisis since the Great Depression."

Read the whole interview. Here's my comment:

Posted: Nov 04 2008 01:51am ET

First of all, thanks for the Rhodes interview. That's just what I was looking for when asking for asking people involved.
Second, here:
"Confidence disappeared and was replaced by fear, all of which was exacerbated by the policymakers’ incremental approach to problem resolution – we’re letting one company go, but not letting the next one.'
This is what I believe was the main cause of the crisis. The uncertainty over the implicit and explicit assumptions about government involvement, and the belief that it would intervene.
Third,here:
"Financial institutions need to do a much better job of risk management and corporate governance. The regulators have to do a better job on the regulatory oversight. You’ve got to look at both the buy-side and the sell-side of the market. In many cases the sell-side was pushing paper that they probably shouldn’t have, but at the same time, the buy-side wasn’t properly analysing the investments being taken on to their balance sheet. So it cuts both ways.

On the regulatory side, what we don’t need is a lot of over-regulation which is what we may be headed for – what we need is smart regulation that is properly enforced.

Where the ratings agencies are going to come out of all of this is not clear. I think there was an over-reliance by individual institutions on rating agencies. I also think in some cases there was an over-reliance by the regulators on ratings agencies."
I believe that some investments were fraud or negligence,and this was the second big cause,but there was some lack of knowledge by investors.
Third, I agree about regulation.
Fourth, I've already said that I thought that ratings agencies were another real problem,but you reminded me that these banks, etc., had done some of their own rating.
Great article from my point of view.

By DonthelibertarianDemocrat