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The Formula That Killed Wall Street
We recently discussed the perspective that the harrowing of Wall Street was caused by over-reliance on computer models that produced a single number to characterize risk. Wired has a piece profiling David X. Li, the quant behind the formula that enabled the creation of such simple risk models. "For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. ... [T]he real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust."
G+R+E+E+D
I want peace on earth and goodwill toward man.
We are the United States Government! We don't do that sort of thing.
you mean to say that everyone doing the same thing is bad? 1st post?
insert inflammatory comment here!
Enter Li, a star mathematician who grew up in rural China in the 1960s. He excelled in school and eventually got a master's degree in economics from Nankai University before leaving the country to get an MBA from Laval University in Quebec. That was followed by two more degrees: a master's in actuarial science and a PhD in statistics, both from Ontario's University of Waterloo.
He has more degrees than a thermometer!
In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.
Citation? Booms and busts are caused by, respectively, expansion and contraction of the money supply (usually in the form of bank credit), often accompanied by manipulated interest rates. The formulas used by lots of investing firms could cause clusters of errors, but the extent of types of companies (and governments) affected points to a more Austrian-style, systemic boom/bust rather than a single-(important-)sector miscalculation.
There is nothing wrong with using a model. Models are good. They help us simplify the world so that we can understand it. For example, we have hundreds of competing climate change models that explain what is going on and predict what we should expect. We model the weather for forecasts. And so on.
But. And it is a big but. You must know the limitations of your model. By definition, a model is a simplification of a complex phenomenon. That does not make it flawed: that makes it a model. Overreliance on the model is your fault, not the fault of the model.
This game will waste your life. Don't clicky!
Diversity.
Life is not for the lazy.
Ponzi? http://en.wikipedia.org/wiki/File:Gaussian_copula.png
- Don't spend the money you don't have
- Don't do credit unless you absolutely have to
I know I know, Wall Street are these big finance hotshots who do complicated things that have nothing to do with personal finances, but what is it they do apart from speculating and playing with money they don't have, or other people's money? They just hide that simple fact under abconce financial constructs, but that's all they do in the end.
Bring back some morals sanity in the credit business and there won't be anymore crisis of this magnitude. No need for math here...
"A door is what a dog is perpetually on the wrong side of" - Ogden Nash
It isn't killing Wall Street. Those jokers are getting $billions$ in free money.
It's killing us, the people who work for a living and have to provide all those $billions$ or suffer the inflationary consequences when the Feds just print it.
if you look really close you will see that
it all started with the swiss banks moving to
the USA, namly UBS and credit suisse.
they bought american "investment banks" in the
94-96 and have probably engineered this
gaussian curve with the beginning around 96, high
2006 and end around 2016.
this whole "recession" is hedged with options.
That Gaussian curves are a poor model for unlikely events has been known for quite some time. This is best explained by Nassim Taleb in the following books:
His main thesis is that the markets are essentially random and are basically impossible to predict in any meaningful way. Further there are unlikely unknown unknowns can cannot be predicted until the they occur, usually with disastrous consequences.
---- It won't be as bad as you fear or as good as you hope, but it will take twice as long as you plan.
One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.
There you have it. The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.
In a way ironic that a guy from rural china comes to play, lives the american dream of wealth and glory, and (partly) causes the most massive failure of free market economics in the history.
An interesting article, for sure. The issue with the Gaussian Copula model for pools of mortgages in CDOs is how sensitive they are to the assumptions of the model. If, for example, the annual growth rate of home prices is 2% instead of 10%, things look tremendously different. If correlations between housing prices in different cities is 50% instead of 10% -- disaster. The lack of stress testing of these models (checking what the results are for different inputs into the model) was a huge issue. Even if a model is decent (which in principle, copula models are), if they are too sensitive to inputs, then the prices it produces are not trustworthy. If the proper uncertainty was taken into consideration, then perhaps everyone would have been a little less gung-ho about CDOs.
Like the (worthless) Value-at-Risk figure, the (also pretty worthless in the end) Gaussian Copula was "easy" to understand. Given that the dynamics of financial markets are not simple and easy to understand, reliance on simple models that are easy to explain to the MBAs is probably not the best idea.
This story reminds me of "Long-Term Capital Management" story back in the late 1990's.
http://en.wikipedia.org/wiki/Long-Term_Capital_Management
These guys did the EXACT same thing using computer models to predict what funds they should be investing in so that they never have a loss ...
Unfortunately, they were bailed out, but folded in 2000.
http://www.geocities.com/eureka/concourse/8751/jurus/hf100203.htm
There was a PBS special about these guys and the computer models they used.
http://www.pbs.org/wgbh/nova/transcripts/2704stockmarket.html
If everybody's a winner in a win/lose game then everybody's a loser too.
A BIG part of the problem is Washington's tendency to reward economic losers at the expense of the people who know what they're doing, and I'm NOT just talking about the poor. There are plenty of the high-salary types who have some sort of governmental loophole or backing that saves them when they screw a big company up.
It's one reason we don't need to be bailing out bad companies, and instead rewarding or backing up the good ones with incentives and tax cuts so that they can really succeed and push forward.
The author of TFA Felix Salmon is a good read. If you're into finance or economic happenings check out his blog Market Movers at portfolio.com
I've had him on my feed list for a few years through various sites he's been at.
--Q
Wall Street is supposed to provide the money that Main Street needs to grow and develop. Investors will get returns on their money. Instead, it has become a form of legalized gambling. I think it would be good to bring back capital gains taxes on profits that are made on short term investments. That would dampen the desire to buy and sell so much, and encourage people to make investments in sound companies. That and raise the interest rate. If you do not desire to do research on what is a sound company, you should put your money in the bank and earn interest. With interest rates so low, you would be called stupid for putting your money in the bank and earning interest.
My grandfather woulda thought this guy was a Red infiltrator. Good job if he was.
The cost of that cleanup, of course, will be borne by taxpayers, not industry.
This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.
It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.
Hayek. Nobel Prize Lecture, 1974.
Gaius Baltar.
This seems to be a popular story for the past few weeks, but it is a mistake to blame the statistical method used. The problem wasn't that they were all using the equaton, it is that they were all mis-using the equation. All statistical tools can fail to be sensitive to certain aspects which may be critical to an application.
People in finance applied these statistical tools believing that they would be able to master risk with them. Unfortunately, they made assumptions that certain things would continue to be the same in the future, plugged the information into the equation, and now science was telling them that everything would be alright. If everybody on Wall Street was making decisions based on the Magic 8 Ball would we blame the ball or the foolishness of those misapplying it?
FTA: "The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time."
The problem wasn't that the Triple A accounts were defaulting rather Moody's and other companies were stamping these ratings while they were combined with Triple B and other more riskier loans. All it took is several loans to fail while rotting the entire bushel and therefore the Investor is stuck with securities that have no value.
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The problem started when wall street (and the rest of the financial system) stopped being a facilitator for investors and entrepreneurs to meet and became an incestuous self-perpetuating system.
If you are using bad data.
Complete BS. The Wall Street knew all along the bubble would burst, and cashed in all the time while knowing it. In essence, they kept milking while perfectly well knowing it would come to a disaster.
There's a crisis every 10-15 years. Huge crisis in every 30 years. How can some one be that gullible as to believe the economics would NOT see this coming? Of course they did, but saying and doing something about it would be bad business. It would scare off the suckers... who end up paying the bill.
1.) Encourage Joe the delivery man to re-mortgage up to %125 of his property value
2.) Transfer the mortgage to the in-house hedge fund.
3.) Encourgae Joe the delivery man to use his funds (from the re-mortgage) to purchase shares in the hedge fund
4.) ???
5.) Profit
Sorry, I'm new to this meme.
The love of money is the square root of all evil.
This formula may have and probably did help crash the world's stock markets (yesterday's Dow Jones was HALF of its worth at its high last June), but the reality is that high energy prices drained everyone's wallets.
When Bush took office, gasoiline here in Springfield was $1 per gallon. At Wall Street's high last summer it was nearly $4.50, over four times as high. We talk about elders living on a "fixed income" but the fact is almost all wage earners' incomes are fixed. We can't demand raises or overtime and have to live within our means. But when that $20 per week gasoline budget quadruples to $80 per week, with heating and electric costs going up as well, that takes money out of other aspects of the economy. Sooner or later people are over their heads and behind on bills, and things spiral out of control.
The result of that and other factors is what you see now.
Happy square root day, everyone.
Free Martian Whores!
Mandelbrot and Nassim Taleb have been writing for the last few years about the misapplication of models in financial markers... things were understood but people like Chuck Prince preferred to keep dancing... what makes some sense as it was the fun that shareholders were paying for and that politicians were in need of, right?
Most people ARE Wall Street whether they know it or not. At least, anyone with a 401K, pension, or other retirement fund. The fat cats at the top are getting bailed out but THEY are not Wall Street. America is Wall Street these days.
Any sufficiently complex system should be heterogeneous, so that not all parts of the system can fail due to the same flaw.
Any homogeneous system will inevitably be at greater risk of failure due to a flaw in the common "gene pool" so to speak.
Biology, computers, economics, politics... I could go on.
.: Max Romantschuk
"produced a single number to characterize risk" isn't this what Equifax, TransUnion, Experian and others have been doing for decades?
In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?
The cost of that cleanup, of course, will be borne by taxpayers, not industry.
As if it weren't bad enough to be using skewed or insufficient inputs, we also had everybody doing the exact same thing -- seeking a talisman to exorcise danger and legitimize universal greed.
And then it came. Correlation's revenge!
A massive shell game foisted on the public by the traders to disguise the fact that these financial 'instruments' were worthless. A glorified ponzi scheme + some magic numbers .. :)
In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?
Not the millions of migrant chinese workers who have lost their jobs, which will probably also cause civil unrest. Also, the Chinese holding trillions of dollars in U.S. treasuries will also be slightly annoyed when the U.S. government inflates away their debts.
Finally, the vast majority of China's stimulus package was already announced before this major recession. You have the order backwards.
My old friend Dr. Godel would like to have a word with you about the recklessness of going about smugly thinking your little model has captured every possibility.
If Slashdot were chemistry it would look like this:Cadaverine
When I think of Wall Street, one of the first things that springs to mind is a photo I saw sometime late last year. In it, a protester is holding a home-made sign with the text, "Jump you bastards".
They didn't jump, and I have only seen one or two articles mentioning trader or banker suicides.
I can only conclude that those working on Wall Street are so utterly detached from the riskier-than-roulette gambling they were engaged in, that the losses are meaningless to them. It wasn't their money, they had no real stake in any investment being viable in the long-term, and - what's worse - is I see zero effort to move away from the "must profit in the next quarter" philosophy.
I really don't care about any 'magic formula', and I doubt you can squarely lay the blame for the current problems at the foot of any. The issue is the drive to profit right now.
What is perhaps more worrying for the average person is that governments have been sucked into this mindset too - but perhaps not surprising when the only people who can get elected are those who have made the money to campaign from their own short-term investments, or by accepting backing from others who did so in exchange for perpetuating the system.
Where's the Kaboom?
There's supposed to be an Earth-shattering Kaboom.
So if the Street were all one way (hypothetically) then the
counterparts are the otherway.
The genesis of this debacle lies as much with the buy side
- pension funds, mutual funds, etc who were willing to buy
anything so long as they got a pickup of 15-25bp over the
comparable treasuries. In effect, they asked for this
stuff and they got it.
As to VaR - its a great way to model relatively stable
markets and to quantify short term risks of a large move
based on recent historical returns, volatility and asset
correlations. It's not meant to predict trends nor to
quantify 'what if the market for X tanks every day for Y
months'. Thats what managers and traders are for - to
realize there has been some change, perhaps fundamental,
which will have a long term negative effect on their
positions and to take what action is necessary to reduce
that risk. Instead, they froze.
There are a quite a few factual problems with this article, which massively overstates the importance of the Gaussian copula formula with respect to the failure of the cash CDO and securitization markets.
That is not to say that there were not modeling issues (mostly wrong assumptions about the ability and willingness of people to pay their mortgages and the value of the houses backing them) but these were not Gaussian Copula models.
The Gaussian Copula formula and its variants are a foundation used to price and risk manage primarily synthetic CDOs backed by corporate CDS. Corporate synthetic CDOs were a much smaller part of the market then mortgage CDOs (RMBS, CMBS, ABS CDOs), consumer CDOs (Credit card receivables, retail auto loans, dealer floor plan loans, student loans) and high yield corporate loan CLOs.
Full capital structure cash flow CDOs backed by the assets mentioned above are not structured, priced or rated using the Gaussian copula approach.
In fact, most "non corporate synthetic CDO" trading desks did not start looking at "correlation" until 2006, a full 15+ years after these types of CDOs were created. And thinking about these CDOs in a "correlation" framework did not change how they were created, valued, rated or traded.
The rating agencies, although aware of CDS levels (i.e. market implied default probabilities) and the Gaussian copula approach, did not use these frameworks to assign ratings to mortgage and loan cdos, or even corporate synhtetic CDOs. Instead the rating agencies took an historical default probability approach.
Now, that's not to say that corporate synthetic CDOs have not blow up (they have), and the framework does have significant limitations (as demonstrated by these blow ups). But the impact the Gaussian formula has had on the mortgage and loan CDOs is minimal.
In fact most would disagree that the Gaussian Copula framework has had any impact at all, as it just was not used in these markets. Mortgage and loan CDOs blew up for other entirely other reasons.
I haven't gotten a chance to read the article but it seems to me that if he did simple gausian interpretation, you only plan for one eventuality. If you look at Kalman filters it's the simplest kind, and when it fails in Robotic localization, it fails hard because it never finds it's way back to what it should be. But this is all guess work on my part as I have to run to work. Like a bunny.
Money is the root of all evil?
yes, instead of blaming the greedy fucks who decided to gamble dangerously with other peoples' money, let's blame the math.
The math isn't wrong. The guy who made the math isn't wrong. The people who decided to ignore glaring risk factors are wrong.
They're using their grammar skills there.
"Re:Best models in the world are useless... If you are using bad data"
..
How do you quantify human behavior and peoples confidence in the opinions of supposed experts. And in the case of the sub-prime crises, the brokers diced-and-sliced the mortgages so as the buyers wouldn't be able to tell they were worthless.
"The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans"
So, if a broker makes an offer and an expert says to buy, and people believe him, then they buy and the stock goes up. Else they don't buy or sell and the stock goes down and the expert is replaced. Simple isn't it. I should patent the formula
The real root of this problem is and has been the federal government all along, and I'm not just talking about between the years 2000 and 2008. This goes back all the way to the 1970s, the Carter Administration. A very good article to read: http://www.cnn.com/2008/POLITICS/09/29/miron.bailout/index.html?iref=mpstoryview
An equilibrium price doesn't mean that everyone agrees what the price should be, just that there is a balance between those who think the price too high and those who think it too low. If you restrict the supply of a given financial instrument, you chase out people at the margin who think the price is reasonable and are left with just the irrationally exuberant. Conversely, as you flood the market with new supply you are chasing progressively more bearish investors in the quest to find a buyer. Both of these effects are liable to dynamic positive feedback: as a price rises, the exuberant feel justified in their optimism and become ever more irrational. Likewise, as a price falls, bearish investors assume that the market is in possession of some negative information hidden from them and become ever more bearish - who wants to catch a falling knife?
The "types" of companies (and governments) directly affected by this bubble are in this case extremely narrow: banks (and none) respectively. In short, it is a classic financial bubble. Naturally, trouble for the banks spells trouble for everyone else, just as a cardiac arrest spells trouble for your little pinkie. Yes, it is always possible to view such a bubble as a "monetary" effect if money is defined sufficiently broadly - securitization is money creation, of a sort. But it is not money creation in the form of bank credit or manipulated interest rates and the Austrians and their Chicago students are of no use to you here.
"The good reader is a rarer swan than the good writer."
Yeah, "complex mathematical model". Tell it to the judge.
They did indeed use this model, and the work of many other PhD mathematicians, physicists, and other geniuses. But any of the bankers could have looked at this whole class of derivatives from mortgages and seen the basics that make the model a joke. They sold millions of mortgages and other loans to people using artificially low initial interest, to get people to take the loans, but which ballooned to rates they couldn't afford, so they'd have to default. Inevitably, a large percentage would certainly default. A losing bet overall for banks holding those loans. Meanwhile, each bad loan was "good" because the banks could sell many times the number of derivatives on it. Which was "good" because they got paid for the derivatives they sold, but was much more "bad" because the derivatives would cost the issuing bank many times more when it came due. The derivatives came due when the mortgages defaulted. Which was inevitable.
So whatever "gaussian copula" model they use to convince each other it was good, basic business sense would have insisted that the business was bad, horribly bad. These bankers don't get paid for discovering new math, they get paid for their years of experience and business sense. So they should have laughed this model out of the boardroom, even if they didn't understand why it was wrong. They should have known it was wrong, as the past few years proved beyond any doubt. But they embraced it instead, and centuries old banks like Lehman Brothers have gone down, taking us with them (and no end in sight).
Because ultimately, the model was a way to delay the costs of a business that paid some fat revenue up front. Since bankers are paid in huge bonuses for the initial year of revenue, and then leave before the bills come due , they got paid to make those bad deals, because they paid off up front, before costing many times more their benefit a few years later. By which time the bankers are gone with their early bonuses. Which have a lot more buying power when the economy collapses, and everyone else is holding merely the debt they created.
Nice work, if you can get it. Since they ruined the banking system and everything else, no one can get any work at all.
These people are holding the money. Their bonuses often equal the losses that destroy their bank. The government should take back that money to pay for fixing and repairing some of the mess they made. "Fiduciary responsibility" is a requirement of bank execs, and these violated that by the $TRILLIONS. Make them pay for what they did. That's a simple model anyone can understand. Not just a complex conjob to hide behind.
--
make install -not war
An interesting article, for sure. The issue with the Gaussian Copula model for pools of mortgages in CDOs is how sensitive they are to the assumptions of the model. If, for example, the annual growth rate of home prices is 2% instead of 10%, things look tremendously different. If correlations between housing prices in different cities is 50% instead of 10% -- disaster.
Wait... what you've just told me is that the Gaussian Copula model is very *good* at predicting what will happen. Or: the problem wasn't the model, it was the assumptions. Clearly, the assumption that house price correlation is only 10% is terribly, terribly wrong. Similarly, the assumption that houses will have a constant YoY appreciation of 10% is simply ridiculous in the long run. Sounds like the model isn't to blame at all: it was the idiots who fed those models bad data.
There's nothing advanced or innovative about a gaussian copula. It's a very simple mathematical trick, it doesn't say anything about finance in itself. It's a programming trick to go from a uniform distribution on a cube (easy to generate, run rnd() for each coordinate) to a multivariate gaussian with a specific covariance matrix. The way to do it is cholesky decomposition. This is OLD stuff.
Li's paper is a clever way to measure default correlation using correlation matrixes from asset returns. It's quite clever, and yes it's a pretty good model (more on that later)
This is not journalism, this is a bit of shit where the author decided having an "evil formula" would be cool. Look there's an "equal" sign, how can they be so sure... pffffffffffffffff.
I said it was a good model, yet it's been proven wrong hasn't it? Well, first of all, what has been shown to be wrong is the guesstimate of correlation that was input into the model. G.I.G.O
Plus, if you price a fixed income product and it produces higher than market return, you will borrow short term funds to invest them in it. In a free market that quickly drains the pool of saving and raises short term interest rate. Sure you end up losing money but no catastrophe. In a federal reserve system, well the short term rate stays what the fed says it should be and everyone piles on the arbitrage, creating sky high leveraged position.
Yeah the formula can be misleading, but for a true catastrophe, you need a federal reserve.
\u262D = \u5350
amidst all this chatter about economics and models that what we're really talking about here is gambling. The wealthy made bets on red and black and then they bought insurance on their bets and the bets of others. Ultimately, they gambled that the Casino (America) and it's croupiers (AIG, Morgan Stanley, Citi, etc.) had assets sufficient to pay off the bets. They were wrong and they lost but refuse to hand over their chips. The real problem is that we don't have a couple of guys with baseball bats to do the collections.
The Turing test cuts both ways
Blaming greed for a financial crisis is like blaming gravity in a plane crash.
\u262D = \u5350
Predicting (in scientific/math terms, at least) how people will behave dont work if all the people is aware of those predictions. Is like those paradoxes where you mix metalanguage with language, you can't be both the one that do the predictions and the one that behave as if not knowing them... the alternative is not Doc Brown's end of the universe, but the loop must be broken somewhat and bad things happens.
In Foundation the problem was solved creating a Second Foundation, separating the "predictors" from the rest.
But in markets, having something that predicts what will happen is like having a weapon, and everyone will want to have it. And in that arms race, when enough people have it, all lose.
Hari Seldon could've warned them about this.
What do you get if you multiply six by nine?
People want a simple answer. We hate having to think, and it's easy to be distracted and make a mistake solving a complex problem, particularly when we're in a hurry. Most of the time, these simple answers are good enough, but sometimes we're bitten by them.
"Who controls the past controls the future. Who controls the present controls the past." -- George Orwell
Only the very Naive would think that Li's formula was the fault of this massive bubble.
sell vast quantities of new securities
will affect the investor value of ANY stock. Hedge Funds, and Mutual Funds do this every day. This oligopoly is currently trying to influence the Oval Office by controlling the stock market price. When this handful of people don't like what they see from government, a massive sell off sends a clear message to the government. President Jr. couldn't work things out, I hope the new kid can. The new kid will have to start with ignoring "Wall Street", and focusing on "Main Street". Jr. didn't do this, for what ever reason, and because so many people equate Wall Street with Main Street, well, you've seen the rest on CNN.com; this is wrong. But when enough people believe, reality gets ignored. I think it has something to do with, "Greed".
Preposterous! Human gullibility is one of the few things that has no limits.
Support Right To Repair Legislation.
The market movement is integrally random. It's true that, like most random systems, if you have all the inputs you can probably predict it, but no one has all the inputs.
A model of this random system helps people to improve thier predictions and they invest in the market based on these predictions.
Unlike say a climate model, where if everyone is totally wrong, the weather still does what it wants anyway. With the markets, investors acting based on the results of whatever model they are using are actually changing the reality of the market.
When everyone uses the same model, when the model says "Stock A is a good investment" everyone sees the model and decides it's a good investment, demand increases, price goes up. This information is then fed back into the model. The model now looks at the increased demand and says "A is an even better investment". Everyone looks at this result, demand increases even more and price goes up faster. This information is fed into the model again which now says "Wow! look at the action on that stock it's an absolutely GREAT investment!" Demand goes through the roof and prices soar.
the problem with this is that the people pushing up the prices are the speculators. And all speculators rely on the fact that at the end of all the rigmarole, there will be an actual consumer willing to pay the price they are quoting for the item. According to thier model lots of people are willing to pay the price. But in the real world all the consumers got prices out of the market ages ago. When the speculators now try to sell, prices crash!
when everyone is using a different model, this activity is spread across diffent stocks becuase the initial recommendations vary and so the feedback is watered down. But as more people rely on the same model, the more likely it is that that model will actually begin to become the cause of market movements, rather than a predictor, and the more acute the boom/bust cycles will be.
The same thing could be seen in the housing market (in the UK at least). Long after house prices were way to expensive for the average family (even with a hundred percent mortgage) to buy. Thousands of people were still desperately trying to borrow money to buy a house they couldn't afford. Afterall all the experts were predicting that house prices would rise and they would soon be able to sell it pay off thier loan and make a tidy profit.
The question they all forgot to ask was "Who's gonna buy it?"
Quantum Physics a.k.a. sub-molecular statistics
The contribution of mathematical models to the present crisis has been vastly overblown. The breast-beating and mea culpas from the likes of Derman and Wilmott are self-flattering: after all, if you caused the problem, you must be important! In reality, the quant is at the bottom of the pecking order on most trading floors. The people who trafficked in securitized garbage did so not because they were fooled by their models, but because they were paid to. You can't tell me that the guy who lent $750,000 to a strawberry picker with $14,000 income would have thought it a good idea if he was lending his own money.
Contrast this to LCTM, which really is an example of quants gone wrong: those guys had so much faith in their models that they not only put their own money in the game, they borrowed money to invest in themselves! They were doing the same things they had done at Salomon but they failed to appreciate the importance of being able to lean on Solly's balance sheet in times of trouble.
As for Taleb ... puh-lease. The guy is a self-promoting windbag and his two most recent books are a waste of time. That's a shame, because he has written at least one interesting book I am aware of: Dynamic Hedging. Unfortuntely, the flaws that were present in embryo in that book - exaggerated self-regard, exaggerated criticism of others, deliberately cryptic statements meant to make the author seem clever - have grown like a tumour to consume 100% of his writing. All of Taleb's points have been made more clearly and more intelligently by other, better people. A recent example is Rebonato's Plight of the Fortune Tellers, but there are many others.
"The good reader is a rarer swan than the good writer."
Why is it people who have never lived in a "workers' paradise" love them so?
> [T]he real danger was created not because any given trader adopted it but because every trader did.
Is this the financial markets equivalent to everyone marrying ones sibling?
Before you design for reuse, make sure to design it for use.
"China's stimulus package was already announced before this major recession." Sorry, I've been fooled by propaganda from Xinhua, I should know better, what are your sources?. You seem to be thinking that this is NOT a winning position for the Chinese. I disagree. Don't underestimate the nationalist pride of the Chinese people, or the ruthlessness of their (and our) Fearless Leaders. Time will tell. Conserve topsoil.
The cost of that cleanup, of course, will be borne by taxpayers, not industry.
Right below this article is the article on the death of the video game ... "This has lead to a generation of cliff-hangers at worst, and endings that hedge their bets at best. ... As all the game's characters die, as the servers are shut down, as the data is erased or backed up and then boxed or whatever happens to MMO data once the game is done, it's hard not to be a little sad."... etc is the main point. And that is what the bulk of these created wall street "paper financial products" were and are, nothing more than legalized high stakes videogame "wealth". It was and still is completely bonkers *nuts* to allow that to be the basis for a real economy.
The models used by the latest generation of business thinkers have been used to justify an unwarranted certainty. Market behavior is above all a psychological phenomenon. Of course there are material constraints, such as supply limitations. But in the end the consumer buys most products for psychological reasons. Investors invest their money for psychological reasons. And psychology is inherently uncertain.
The certainty of business and right wing government leaders led them to make rash decisions. Because their models told them that the economy was going nowhere but up, thanks to Republican "Supply Side" economics, businesses borrowed heavily. Banks became increasingly leveraged, but that was OK, because their models told them that everything would be fine. Never mind that the "boom" was largely an illusion, a result of the excessive borrowing.
I would argue that certainty is often an extremely negative thing. It cuts off debate. It ends thought. When humans have too much certainty, they tend to do very stupid things. In the words of Voltaire, "Doubt is uncomfortable, but certainty is absurd".
This and no other is the root from which a tyrant springs; when first he appears as a protector - Plato (423 to 327 BC)
Mandelbrot some years ago already warned that current financial annalitical methods failed to capture the fractal nature of market oscilations, and that they simplified in excess the model. According to Mandelbrot, not only the amplitude of oscilations behaves as a fractal, but also his time distribution.
What's in a sig?
I am sure that the Federal Reserve keeping interest rates so low for so long had nothing to do with the bubble. /sarcasm
Gaussian Copula Model
Well there's your problem. Live is not Gaussian, and assuming it is can lead to cataclysmic failure.
Could they have not used a more robust distrubution, such as Student's t with 4 degrees of freedom (a distribution that seems to serve well in the real world), or perhaps even Cauchy?
Of course, these distributions would lead to more conservative trading practises, not good for one's career during an extended bull run.
are one and the same thing. Except that in gambling, you don't always wager your house.
What was lacking here (perfectly visible with hindsight) is critical oversight of what the formula and theory results were really stating. And importantly we have all learned that trying to contain randomness of massively diverse circumstances is probably impossible. I recall a seldom used saying about this - Don't put all of your eggs in one basket - it works for investors still whether people run hedge funds or their own personal finances. Torontoman.
In fact the true formula was:
e^x
and the inability of everyone to understand it.
May the Maths Be with you!
Lies, damned lies, and statistics.
This issue is a bit more complicated than you think.
All of this carping about a formula with dubious utility is ultimately irrelevant. These securities had inherent poison pills in them. Where did they come from? Risky mortgages. Period. And you can't lay all blame at the feet of so-called predatory lenders. The lenders were often blackmailed into taking the risk of lending to unqualified borrowers lest they be publicly flogged for discriminating against them. Sure, the initial lenders passed the buck/poison to the next group up in the food chain. But the poison only came from one source, a delinquent mortgage. There is no other source. That is patient zero.
Equations don't kill economies, people kill economies!
It has been broken since 1694.
Credit is an exponential function. Go check the national debt (in any country) for the last couple of centuries. It's an exponential growth curve. Credit has an exponential function built in to to it. When credit is created, it is created with an equivalent amount of debt attached, which pays interest.
So you have : credit on one side | debt + interest on the other.
So in order to work AT ALL, the supply of credit must grow exponentially every year to pay the interest on the previous year's debt. If it doesn't, there is a monetary collapse as the debt consumes the credit.
Li's function simply allowed the process to continue until they ran out of people to lend money to. The problem has been there as long as money lenders.
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i can't get into my /. account :(
but at any rate, is it just me, or am I sick and tired of getting recycled wired stories on slashdot every freakin' month. I get the magazine mailed to my house, why do I have to see the cover story on slashdot two weeks later...?
Just because he's from China, don't call him a 'quant'. This is the 21st century.
I want to delete my account but Slashdot doesn't allow it.
"I have nothing against economists: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them risk-management responsibilities."
Well, I have nothing against medical doctors: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them medical responsibilities.
I also have nothing against IT professionals: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them technology-management responsibilities.
Need I continue?
The problem with your example isn't that it doesn't work, it's that it doesn't average out known periodicities because the length of time is too short.
Far too many people are falling for this argument. The truth is, the top 1% alone owns over 30% of the wealth in America!. The bottom 80% of Americans, meanwhile, own only 16% of the wealth. So, sure, most Americans have a few stock holdings. But when people push for policies that rob workers to prop up speculators and sell it to the masses using this argument, it's a case of "100 for me, 1 for you."
Poor Economics, so wants to be a hard science. Mathematical models of human behaviour can get you prizes and money, but every now and then the fact that it's really a social science comes back to bite you in the ass, Big Time. Let loose mathematicians without insight into social behaviour and that is what you get.
One word: reflexivity
If your theory cannot explain itself, you lose.
Major tangent: Economics, capitalism, libertarianism - Adam Smith, the rational economic man, the invisible hand, the free market, the virtue of self-interest - all promise the greater benefit. So why the fuck have we not seen these jokers apologize publicly when it's obvious that the self-interested, rational actions of homeowners and lenders in the US have led to a global bloody recession where people from Stockholm to Brisbane are being laid off? There should be much hat-eating, but I haven't seen any.
I'm sorry if I haven't offended anyone
People have gotten better at saying which kind of average now whether arithmetic or median. But it isnt really descriptive of the distribution of statistics. You hear abuse from the price of houses to income tax policy.
Much like psychology or history. Economics is much more focused on convincing people than on developing scientific hypotheses. Ideology trumps results. Economists are not often judged on their work or their qualifications, they are judged based on how closely what they suggest fits with what their bosses want to do.
Remember the guy the fund companies brought out to say (base on his geology degree) that Amazon should be at $400? The fund companies made a killing after publicizing his lack of knowledge.
You got me into this! You were the ideologue! I'm only a poor assassin! - Twenty evocations, Bruce Sterling
You know I've been hearing this for years, so I actually looked it up. As far as I can see China "only" has about $700 billion of US government debt. A huge amount certainly, but really enough to cause the kind of financial armageddon that people talk about?
This sig all sigs devours
David Li's formula is not the root cause of the problem.
Actually, it is the Democrat's philosophy of "Welfare housing" which is the key reason for the mess we are in.
Under the Democrats, housing for the poor (in the form of "the projects") was not good enough; they wanted to provide actual houses for the poor -- which is a noble ideal in an ideal world, but a disaster in practice. If Democrat President Lyndon Johnson began the welfare generation with his "Great Society" vision, Democrat President Jimmy Carter escalated it with the "Community Reinvestment Act", and thereafter Democrat President Bill Clinton amended Carter's act to enable subprime mortgages, such as those facilitated by Fannie Mae and Freddie Mac, to be sold as securities on Wall Street. Indeed, in the press conference for Clinton's amendments, Clinton's economic policy assistant stated the following:
Securitization of subprime mortgages is the root of the current problem.
What is a subprime mortgage? It is a loan to a "subprime" borrower, who has a bad credit rating and is in danger of being unable to repay the debt.
The subprime mortgage crises of 2008 is fully explained in the CBS program "60 Minutes", as reported in the segment "House of Cards" by Steve Croft , which was broadcast on January 27, 2008 (and updated May 23, 2008). It is available for free viewing at http://www.cbsnews.com/video/watch/?id=4126094n, and the transcript is available at http://www.cbsnews.com/stories/2008/01/25/60minutes/main3752515.shtml?source=search_story (which also contains the video embedded in the picture) . For those of you who cannot access the video, here is an excerpt of the transcript by CBS:
Without an associated error bar.
"I have nothing against economists: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them risk-management responsibilities."
Well, I have nothing against medical doctors: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them medical responsibilities.
I also have nothing against IT professionals: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them technology-management responsibilities.
Need I continue?
No please don't. Your wrong but I feel stupid arguing with you.
Try the Chinese news sources, there were a few good pieces on Sohu and Xinlang when it was announced.
Though, what he should say is most of the stimulus package was already planned spending- they are simply rushing the schedule. Indeed, most of our own stimulus package (and many others) are mostly made up of already-planned packages, moving future spending to now rather than upping spending too much.
I'll dig through my history to get you citations, but much of the Chinese plan is provincial governments announcing they are breaking ground sooner rather than later, moving up a few billion in planned investments to today to absorb the newly-freed labor force from the export factories.
I borrow 1 dollar from you and promise to repay 2 dollars.
I buy food and energy from you for 1 dollar.
I cook a meal in my restaurant.
You eat at my restaurant and pay me 2 dollars.
I eat the leftovers.
I return 2 dollars to you.
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No model exists that make every wins through speculation.
We blame the system, the oversight, the laws, the formulas... where's the article that blames the people? Where is the banker who says "mea culpa"?
When a large group pays into an insurance pool, and there is the small number of payouts to the insured recipient (accident or health victim, etc.); THAT is spreading the risk.
But when a thousand or more insurance policies are taken out on one person, or entity, or bond, or corporation, without their knowledge of said transactions, then the most profit is realized by knocking off, or destroying, or devaluing said object of those policies.
THAT is compounding the risk to infinity. [Thanks to the economicpopulist.com for that most genius of phrases.]
The book Black Swan, which should be read by anyone interested in this topic, says that the hideous lie is that people claim that "they're better than nothing", when, in fact, they're worse than not having any model at all.
Say it with me: "All models are wrong. Some models are useful". A bad model CAN be worse than no model but it doesn't follow that all models are worse than no model. In fact it would be impossible to do anything without creating models of the world around you. You do it all the time without even being conscious of what your are doing. Newtonian physics is technically a less accurate model than Einstein's general relativity but it remains very useful for a wide variety of applications IF you understand its limitations. In the economic realm Modigliani-Miller and Black-Scholes are very useful models so long as you understand their limitations - and they do have limitations like every model.
The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model to quantify risk.
They didn't blow up because they had a model. They blew up because they had an inappropriately applied model. LTCM applied their models which apparently worked well for the narrow field of fixed income arbitrage to other areas like equity and currency arbitrage where the models assumptions combined with their excessive appetite for risk caused a catastrophe.
You correctly note that they failed to account adequately for extremely rare events but had they stayed within their original model parameters (fixed income arbitrage) and more reasonable levels of leverage it likely would not have been a big issue. Instead they applied their models to inappropriate financial instruments and levered up heavily which greatly compounded the problem. Worse, the financial institutions which lent them the cash failed because, like in the current financial crisis, they did not adequately consider the risks they were taking.
Jesus Christ, people keep throwing this around. It bloody IS exponential, why are all the bloody graphs exponential if the function isn't exponential?
Debt pays interest as a percentage per unit time. That is an exponential function.
In your model. WHERE DOES THE MONEY COME FROM? Not the food. Not the energy, not the leftovers. Where does the MONEY come from? Where does the 2 dollars come from which you promise to repay? It is BORROWED INTO EXISTENCE WITH DEBT ATTACHED.
Deleted
Who modded this insightful?
Lenders set the interest rate to be higher than monetary expansion. If they didn't do this, they'd lose real value.
Money is credit. If the parent was correct, the money supply would be expanding at around a typical debt interest rate (say 5%). Yet there are many stable economies where this has not been the case for a long while--every economy that ever used gold, for instance. Moneylenders didn't conjure gold into existence by setting interest rates.
The answer is even simpler than that. Amazingly enough, you can pay off debt without increasing the supply in credit. Do Slashdot mods really think you have to magic a dollar bill (or, pre fiat money, a gold coin) out of thin air to pay interest? That interest may not be paid from existing credit or debt? And once it gets paid, the token of exchange disappears forever? Stupid!
.
Models and simulations are here for a purpose (a tool) and can be useful, to prove a theory, but not explain the truth--that's Physics (/ducks under table).
.
Greed + using profit/growth as entropic was already a recipe for disaster.
The article keeps going on about a single correlation number. That's only true if there are 2 mortgages, and the copula is a bivariate normal distribution (see page 14 of the paper )
Real CDO's have more than 2 assets, so the correlation matrix used is key. This is a reason why prices can't be agreed for CDO's. Everyone uses different correlation matrices. Option pricing has a market because Black Scholes only has a volatility parameter to trade around.
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Yeah, and by "made to make loans to anyone based on skin color", you of course meant "made to stop discriminating in loans based on skin color". They were never required to make loans to unqualified lenders. They were never required to lower their standards with regards to minorities. They were required to stop "red-lining" entire neighborhoods and refusing to loan to anyone in them, regardless of how qualified.
You can blame this on the Democrats and poor people all you want. Fact is, responsible banks obeyed the law and made loans to qualified people in formerly red-lined areas, and made money off this. My bank was subject to the law. They're doing just fine. Because they were never required to loan to just anyone.
Irresponsible lenders, taking advantage of deregulation, decided to start loaning to anybody -- poor, middle class, or whatever -- without even bothering to check if the information given was true, because they were just going to roll the loan up into a security and re-sell it. So they didn't care. That's what caused the problem. Not an anti-discrimination law.
P.S. Coal sucks. It generates most of our energy, and we should change this. When we succeed, coal will go bankrupt. This is a good thing. Until then it's just a necessary evil.
The enemies of Democracy are
If bad mortgages had collapsed, banks would have taken the hit and we all would have moved on.
Enter synthetic financial instruments, that do all this financial nonsense using the bad mortgages as the core of the investments.
Then enter even more whiz kids that provided insurance against defaults of those mortgage based investments.
Then mix and sell all of the above in the expectation that previous performance predicts future performance.
Your assessment is very simplistic and parochial, you are just using the crisis to justify your political biases instead of analyse the whole situation dispassionately.
IANAL but write like a drunk one.
Classical economics cannot explain what is happening right now. It's without precedent. There is a little graph I would like to show [msn.com] you...
Try looking at that chart in log base 10 format which will provide an apples to apples comparison. The dip in 1929 was MUCH bigger percentage wise than the one we are experiencing presently. Furthermore despite tremendous volatility we basically find ourselves in a decade of more or less flat growth. The DJIA is at roughly the same levels it was 10 years ago. This HAS happened before from the late 1960s to the early 1980s where the stock market remained flat for nearly 20 years.
Just so we're on the same page, the reason "wall street" got hurt was artificially easy access to capital (centrally planned low interest rates) and indiscriminate buying and lending standards (lack of due diligence in the private sector). Simplifying it more than this is not meaningful.
-- I was raised on the command line, bitch
Sure, the bottom 80% only owns 16% of the wealth, but that does not necessarily indicate how much of that 16% is effectively in wall street.
If all of that 16% is effectively linked to Wall Street, then maybe you do want to prop it up.
If it's only a tenth of that 16%, then maybe not.
Even so, there's probably not a good solution - just a matter of picking lesser evils.
Much more was killed than Wall Street. Even Wired Magazine might soon be a victim: the issue covering the story is alarmingly thin and light, with very visible decrease in ads. I hope the bastards on Wall Street have not killed Wired, too.
Capitalism is a like a pyramid scheme, and like a pyramid scheme it requires contant growth.
An that is the basic problem of the industrialized world, it's model is based on constant growth.
The problem is that the real world doesn't have constant growth, at least not at the at expected rate.
That and the greed of the so called "masters of universe" ... more likely of "fucking up the universe", if that is not greed, i don't know what is.
So... we also need a good way to define "good company" and "succeed". Which we don't have. We thought we had it, but it turns out we didn't.
If making money isn't success, what is?
I think it is slightly unfair to call it "Monday Morning quaterbacking" as he predicted this before the game, as it were. In fact this was more like calling the scores over a Friday night beer with your mates.
Anyone ever wonder why it is that we have millions of people dedicating their lives to moving around numbers, taking a procentage of the value they represent for doing pretty much nothing of value to sociaty as a whole? We'd all be better off if they where in the fields picking beads.
The difference is that IT and doctors are based in hard sciences. Economists don't have any facts to base their theories on. They sound nice... but can never be proven.
Its not clear what the people here are debating about ? People who are attacking the models, Are you saying that all the models that exist today are WRONG? Are you talking about some particular model being wrong? People who are defending the models, Are you saying that every model that exists today to predict risks/gains is accurate? From a scientific point of view, It is possible to have models that predict risk/gains to a degree of accuracy which can be well defined. Just because things have gone wrong, it does not mean that models can never be right!! There could be hundred reason, people could have misused the models, some of the models might have been wrong (or not applicable) for certain scenarios.
When a thief sees a saint, all he sees are his pockets!
Sure, he may have messed things up, but there's no need for that kind of language.
This is exactly the sort of shenanigans that Marx and other historical socialists were trying to prevent. The reason this "bubble" emerged in the first place, AND the reason it burst, is precisely because we value everything subjectively rather than objectively.
Call me a socialist if you think it will break my bones, but had we taken the principles of socialism a bit more seriously in the last century it's unlikely the Great Depression would have happened at all.
The only way to stop these "bubbles" and recessions and depressions is to stop valuing everything subjectively. Yes, I realize that's a ridiculously tall order, but I'm just sayin'.
How do you pronounce quant in your part of the world?
Yes, I probably should not have used that term. I will point out that he has been betting (and not just his own money) on this downturn for quite a long time, to the degree that many people think he is actually a lifetime loser on this bet. It's sort of like a pro poker player bragging about his gross lifetime tournament winnings without telling you how many tournaments he's entered (and lost). Of course no pro would ever do that, would they? :-/
The article seems an over simplification and missunderstanding of risk analysis. I've been working in banking as a programmer in banking for a few years now. More recently I've been programming the risk analysis systems they talk about in the article. I can tell you there is no one forumula used by everyone. the modelers I work with try endless combination after combination to figure out what the banks portfolio risk is. They then test and retest the formulas constantly with various statistical analysis tools.
Other companies, paticularly in the energy futures business, are constantly tweeking and searching for better forumlas. They spend millions a year on systems to calculate risk. To say there is one formula that everyone used flies in the face of any one in the risk analysis business.
It is the shareholders decision. If they are so dumb as to give bonuses on a "one year model". They deserve to get screwed. A bank in Sweden puts all bonuses in a big "401k" for all employees. Bankers don't get paid before they retire. And if the fund goes belly up a few years after they retire they are still screwed, because they won't get any more benefits.
Of couse, the rest of us would be even more thoroughly raped when the crash finally did come -- but what would those new millionaires and billionaires care?
Should be:
It is difficult to get a man to understand something, when his salary depends upon his not understanding it!
-- Upton Sinclair.
Why doesn't the gene pool have a life guard?
The actual problem comes to the input data to these models. As TFA says, they measured the correlation value that would predict the observed market prices of CDS's.
This is kind of common in the financial business; you assume that "the market" is already taking into account all facts when deciding those prices, so that you can calibrate a single parameter (the correlation in this case) that will make up for all that assumed knowledge. If your model doesn't explain all data, you simply add more parameters.
I see two problems with this.
The first one is that many times "the market" actually doesn't know about the future, making your calibrated parameters reflect a collective subjective opinion instead of a tangible reality.
The second one is that, as markets mature, many players end up using the same models. This not only leads to a single failure mode for the whole market, but may end up producing a free-floating (unstable) fed back system if no tangible (real world) inputs are at hand; you price things with model M given parameters that were deduced from prices via the same model M. When everyone is doing the same without looking at their surrounding reality at all, there's no more of that "collective market knowledge" left, but a bunch of lemmings running towards the cliff edge.
You will be enlightened.
Whether the model works or not is not the real problem. The problem is that the big banks have the capability to lend ten to hundred times the amount of money they actually have on hand. In effect they can create as much money as they need to lend out AND earn interest on money they don't have! To see how this is possible watch the video 'Money as Debt' (Google it) and then watch the video 'The Crisis of Credit Visualized' (http://www.crisisofcredit.com/) and you will be shocked - I guarantee it - unless you are one of 'them'.
The hidden problem with this risk formula is that is does not account for other traders using this risk formula.
Blaming the current economic problems on this bit of math is a subtle lie. The financial sectors are doing everything they can to avoid any blame for their bad decisions.
- During the 80s the US had inflation problems. I remember seeing prices go up and wages remain flat all thru my childhood.
- Alan Greenspan tried to solve the inflation problem by restricting interest rates to absurdly low levels. This cost many retirees and investors their passive income. If you had $200,000 in a bank at 10% interest that's $20,000/year in income just doing nothing. With Greenspan's policies, that dropped to 4% or $8,000/year then 2% or $4,000/year. You can't retire on that unless you live with your children and like eating refried beans.
- The Clinton administration endorsed a tax-break when you sell your primary residence, $200,000 in capital gains tax free if you lived their over 2 years. This provided an antidote to low interest rates/low passive income. People began to flip houses for the capital gains, as you could make $100K/year tax free. Also, rental property provided realistic passive income.
- Housing prices started to rise about $100K/year. Hmm. What could possibly have caused this?
- When housing prices outpaced median wages, mortgage lenders started offering increasing ludicrous loan terms to allow people to be able to afford $600,000 1-bedroom homes. Banks followed suit to keep pace. Many of these home loans were ARMs to trick home buyers into signing while interest rates were still low.
- Interests rates went up. People with ARM loans were totally fucked and foreclosed. Banks began auctioning foreclosed houses _at_market_prices_ (when in the past they might go for a little less or a fire sale price).
- Because houses prices went up (from flipping) and the supply was low (from people renting houses to make money) rent in the US went through the roof. A craptacular 1-bedroom would rent for easily $800-1,100/month even in small towns and bad neighborhoods. I mean, where were you going to go? Rent was high all over, and any landlord knows offering below market rent attracts bad tenants with a history of problems and sob stories (sadly, it's true), there was ZERO incentive for anyone to lower rents or ask for even reasonable rents. I know a 2-bedroom that rents for $3,400/month!!! That's larceny. But everyone is doing it so that makes it somehow OK.
- Banks notice they are making money hand over fist on morgages (and with low-interest rates and free checking, they need to make money somehow...) and mortgages offer seemingly risk-free income: if they foreclose, you hire a bank contractor, fix it up, and sell it for market price (now $700,000) and make money on the forclosure. There is now no incentive NOT to loan to ANYONE, so they do: they loan to anyone with a pulse whatever they're dumb enough to agree to.
- Bank use the above formula to resell these mortgages in batches and as collateral for other investments. More mortgages = more collateral.
Then it finally happens. When housing prices hit the apex of absurdity, no one will buy them when they foreclose. Or buy them, period. So the houses sit on the market and rot.
Now as each as each foreclosure happens it make things only worse: no one will buy the foreclosed house for anything close to what the bank paid. Real-estate agents have to get regular jobs. Mortgage companies close down because no one will pay $850,000 for that hovel.
Housing prices have slowly been returning to normal, but still no one is buying. Rent is still outrageous. That may change with rising unemployment, but usually landlords price rent 10-12% above their cost to own to property, so rent may not really go down for 10-30 years.
Even this screed of mine is a gross over-simplification filled with inaccuracies, but to blame current economic meltdown on a piece of math take real gall.
All this
and I thought these guys did it. :-)
Fiat money (printed out of thin air) and cheap credit started the boom. If we liquor up the punch bowl at a high school prom, the kids are going to get drunk.
Without rules, the only thing between me and the solving of the garden slave problem would be a proper application of iron, which I, being extremely fit and intelligent, would not hesitate to do. In case of no rules, there would be no punishment by law. There would be locally applicated punishment by force, by lackeys of said fat cat, which can be easily overcome tho. Everybody sleeps once in a while.
Applied en masse, I would imagine the world wouold become something akin to the internet, with many power centers with locally enforced rules, by benevolent, or malevolent dictators (ala forums).
I have nothing to lose but my bindings.
Wired is such a shit magazine.
Or just a moron?
You have failed to show how Obama's spending is irresponsible. The amount spent does not enter into it.
I believe that there is more money going out of the US than money coming in. How much can you take out before a shortage? Imports vs exports.
I believe that some companies prefer to go out of business before decreasing the revenues they are used to or accepting a tax increase. Isn't it a reality that markets fluctuate and that sometimes you can't win 100% or the time. Some executives and corporations choose to ignore reality but it's still there. Part of the revenues should be considered to offset the fluctuations but some people don't care about that. Some of the top level executives decided to make short term money by dishonest practices and retire than to care about the consequences, maybe too many. Companies are interested in revenue more than in the consumer or anything else, all for the top. They do things that are dishonest but also expect the people to stay with them. Some don't even mind bad customer service. How can you expect consumer confidence in spending?
Over inflation: If you need two jobs to barely make it, how can you contribute to the economy if you do not have a quality of life nor the time or money to do so? What about people that work 6 days a week mandatory for 40 hours or less? Some people are so abused by some companies that are not even sure of their working schedules. There is a lot of people in that situation. And if you happen to fall under a situation like that, those types of systems are designed to keep you trapped there. How can it not implode?
A lot of the biggest revenue corporations are being run by highly unethical and uneducated individuals. (people into politics rather than qualification)
If you have a lot of money, a deep market crash can make you richer, just hold your money until the market reaches the deepest fall, invest, then pull it out again when it goes up. Maybe one or more days. Just invest when the market deeps so sharp that is hard to believe. Nasty.
Stock Market is a Poker Game played by these big companies.
I'd like to buy homeland for our 10 million people. http://twitter.com/mahadiga
That has absolutely NOTHING to do with it. The fact remains that many ordinary citizens are seeing 50% of their retirement funds go POOF overnight. What % of the total pie that is is meaningless to those people.
I am one of them. But the idea that everybody could get wealthy on capital gains was always a mirage. People are down 50% from the market high, that doesn't mean they've lost half of what they put in. As for "nothing to do with it," I don't see how you can miss it. Using public funds in a way that benefits people so disproportionately is obviously wrong.
Bull! The REAL reasons for the meltdown are much simpler: Lack of oversight by the responsible agencies, conspiracy by Congress, and a banking system that created JUNK bonds.
For example, it was well known starting in the late 1990's that Bank A would bundle up some securities, mix them with good A or AA bonds to hike the rating, then sell them to banks B, C, and so. Bank C would then take some of the securities it had bought from A, package them up with lesser rated securities, add in some A or AA securities, then sell them to A, C, D, etc. THIS HAS BEEN GOING ON FOR YEARS. It is also why you hear that the situation is "so complex."
Two major things transpired that caused a lot of the meltdown: the banks wanted guarantees, which AIG wrote insurance for, and the FED let this one company write insurance for debts it was not required to hold enough cash to cover.
Of course, Congress used the 1990's downturn and dot com bust to gut, then eradicate protections such as Glass-Steagall. You could say that the Fed helped grease the skids for the depression we now find ourselves in -- but there are too few men of virtue in positions of power to reverse the course.
IMHO, America will not only default on its debt, but it will go thru a hyperinflation much like the ones that have hit other economies: Germany in the 1920 is a great example, but not the only one. There was the French assignat in the 1790s, and essentially every major South American country in the '70s thru '90s: Peru, Brazil, Chile and Argentina to name a few.
The ONLY fix to this kind of situation is a precious metal based currency and proper oversight by government. It would also help if the governments did not have the EXCLUSIVE power to print money! The could regulate and test the money that was not printed by them, but governments do not obey their own laws, so that may be of dubious value.
A gold-/silver-based currency removes the ability of a government to get involved in social programs, illegal wars and deficit spending in general. Unfortunately for us all, the Monetarists are in control in every country.
The world will have to learn the hard way again...
The way at least one guy was able to bet against the housing investment stupidity was buying insurance on the investments. He paid a fee to keep the policies going, and then got the huge payout when the investments got destroyed.
The most hilarious thing was that before he did it, he went to the companies making the mortgage-backed securities and TOLD THEM what they were doing was ridiculous and he was going to bet against it. He gave them a nice presentation that explained it all - then when it all happened he made 500% on his money or something like that.
This was all in a recent CNBC documentary "House of Cards". You can watch it on Hulu (no link because I am at work).
Why, yes I have been touched by His noodly appendage. And I plan to sue.
They are all just Monkeys Pushing Buttons.
Not in the world of economic models that do forecasting.
So you advocate going back to a barter based system? Seriously, any investment requires some sort of a model. It might be a very simple model but you need a model. You have to accept that your model will not be perfect and that you are taking a risk. Every investment has a risk/return ratio and the risk is NEVER zero.
Physics models have their limits too. We have no model that integrates gravity with quantum mechanics. The models we have are good but they are limited and there is still much we don't understand.
large price movements (like what killed them)
They were killed by large price movements in equities and currency exchange with WAY too much leverage and far too little liquidity. When you are leveraged by 30X your investment even little mistakes can be punished severely. This is common sense and something one would expect Nobel laureates to understand. There is no such thing as a perfectly safe investment but theirs were HIGHLY risky in part because they either didn't understand and/or ignored the risks. Greed does that even to smart people.
Models that claim they can predict the future or quantify risk are dangerous.
Say it with me: "past results are no guarantee of future performance". It's the first thing they teach you in finance 101. I'm a certified accountant and have masters degrees in both finance and engineering. I do modeling for a living. Of COURSE they are dangerous, especially if you ignore or don't understand the model's limitations - like LTCM did. Forward looking financial models are models of probability based on particular (and usually over-simplified) assumptions, not models of fact.
Good financial models don't make predictions, they calculate probabilities of specific outcomes. Real financial analysis usually involves sensitivity analysis - the probability and rewards of various possible outcomes. Any net present value calculation is a guess and probably wrong. Clearly you understand the math but LTCMs failure wasn't really a math failure. It was greed overcoming good sense.
They *did* consider the risks they were taking.
Badly - which is proved by their results. Either they ignored the risks they were taking out of greed or they didn't understand them fully. My personal take is that it was a combination of greed and hubris. Hardly unique on wall street as we can see by the current economic crisis.
That's the point - the founders of LTCM had Nobel Laureates on this very subject!
Yes, Robert Merton and Myron Scholes. They won their Nobel for work in valuing options. Their work has incredibly important applications but a Nobel prize doesn't mean they are experts in every area of finance. Do you have any concept of how limited the parameters of the Black-Scholes equation are? Among the assumptions in the equation are (from wikipedia):
None of these assumptions normally holds in the real world and that's all assuming you can even accurately quantify volatility which I can tell you from personal experience can be very difficult or even outright impossible. It is especially difficult for many equities and illiquid assets and LTCM was burned by this fact. They took positions so large that liquidating their positions was essentially impossible.
Every financial model out there has a similar list of assumptions. Any real world use of these models is necessarily going to result in incorrect results. The only question is how wrong will it be? Yes they are smart guys but their models didn't predict everything and they damn well should have known that.
Here's an Economist article from back in November. There have probably be more details released recently, but I haven't done that much research into it.
Much remains unclear about the implementation of the stimulus plan-even its size. According to Sherman Chan, a Sydney-based economist with Moody's, the real size of the package may not be as large as the government has described. "Some of the measures announced in the stimulus package appear to have been already introduced or even implemented earlier. Hence, the size of this stimulus package-which is expected to be in the form of additional spending- may have been overstated," Chan wrote in a research note.
Economist
I think that table you linked is only for short-term treasuries. Check out this table: http://www.treas.gov/tic/shlptab1.html. My link shows that China holds some 1.2 trillion dollars in total debt and equity. Who knows how accurate this is though, since China may have entrusted a third-party country such as Switzerland to hold some of the instruments.
I admit that my "trillions" comment was a bit overstated, but the actual amount is still almost 10% of the total outstanding U.S. government debt. $1.2 trillion is also approximately 32% of China's GDP. That's hardly insignificant.