IAFE 2010 Annual Conference - Keynote Speech: The Possible Misdiagnosis of a Crisis

A few words on some of the talks at the 2010 International Association of Financial Engineers meeting.
Let's start with the Keynote Speech: "The Possible Misdiagnosis of a Crisis" by Richard Roll,Japan Chair of Finance, UCLA & 2009 IAFE/SunGard Financial Engineer of the Year Winner
* The recent global financial crisis has been blamed on several factors
* Elementary principles of finance suggest that none of these explanations are likely
* There is an alternative diagnosis consistent with financial principles
* The current treatment may be exacerbating the symptoms

In his talk he used 3 hypotheses to conclude that the current crisis is due to the government's increased share of national wealth in the US economy at the expense of the private sector:
H1. The some of all assets equals the sum of liabilities on a balance sheet.
H2. Merkets are forward looking
H3. Total wealth in an economy decreases as the share of government ownership increases. As a way of benchmark he put forward the statistic that a 20% increase in total wealth by the government results in a 50% decrease in aggregate wealth.


H1 is axiomatic; H2 is reasonable. H3??? Well...

From these hypotheses he reasoned that the total loss of wealth in the US Economy caused by the real estate bust was due to an increase ownership of the government in the US economy.He stated that this was a fact that had been observed in many other countries including China India, Brazil. The more government retreated from the economy the more aggregate wealth increased.

First of all I have to tip my hat to him for sticking his neck out there and saying something that stirred strong emotions.

However, I was really surprised that such an eminent and seasoned scholar would make such an extraordinary dubious claim as in H3 and back it with such little evidence in a keynote speech.

The most compelling evidence to disprove this argument is a comparison of loss of wealth in the US during the dot com bust and the real estate bust. The dot com bust occurred in an environment where more laiseez faire, welfare reform arguments were the dominant philosophy with the repeal of the Glass–Steagall Act, the incoming republican administration and all that.The real estate bust in 2007 triggered a more aggressive government interventionist posture in the real economy. For a comparison, I turn to Jeffrey D. Benson of the blog American MacroEconomic Dynamism:

"How much wealth has actually been destroyed in the current housing decline versus the 2001 tech burst? According to the Case Shiller Indices (the most accurate housing guage available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion. So is this decline in value a direct hit to the Net Worth of the United States. Absolutely. If the value of liabilities declined proportionally to asset price then the answer would be no, but they clearly do not. The United States has significantly overstated it's wealth. Sound familiar?

In 2001 the Dot.com bubble was another significant overstatement of wealth. The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. Comprising all Nasdaq-listed common stocks, it is the most commonly used index for tracking the Nasdaq. The Dow Jones Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. No other index comes close to offering its comprehensiveness. For comparison, the NASDAQ listed securities compose 19% of the 5000 Total Market Index. The Market Capitalization of the Dow Jones Wilshire 5000 Full Cap was $16.7 Trillion as of April 30, 2008. Comparatively, the market cap at the end of Q1 in 2000 was approximately $16 trillion (only slightly smaller). However, between 2000 Q1 and Q1 2003 the index lost a stunning 43% of its valuation. In other words, $7.1 Trillion of wealth was lost."

In order to make a statement on China, the proxy by which a comparison would be made is India. Here again In China, we have state capitalism and a government controlled economy. India has a more liberal democratic tradition. So far China has outperformed India year after year for the past 3 decades.

In Russia, the failure of liberalization policies of the early 1990s led to the strong state reassertion and state capitalism under Putin with popular support.

In Africa in the late 80s and 1990s, the IMF liberal orthodoxy led to the crumbling of national welfare in so many economies...

And on and on and on....

How could such a respected scholar and from all appearances a nice and sound minded person make such a claim, I am still scratching my head...


As I have made the case many times before in my BICs book and Knol collection and blogs, the role of government is bound to increase as population density increase, and this is due to what I have called the holistic theorem.



References:
The 2010 IAFE Annual Conference

Housing Bubble vs. Tech Bubble Loss of Wealth in Dollars denominated terms by Jeffrey D. Benson of the blog American MacroEconomic Dynamism

High Frequency Traders and Liquidity

See: Speedy New Traders Make Waves Far From Wall St.


I was reading this article in the times and it just illustrated the fallacy of the argument that high frequency traders provide indispensable liquidity in the markets. Like all other normal or continuous trading assumptions about markets we question here this is one more. These assumptions work in normal times, but when they are most needed, they don't. And it makes dynamic or continuous time derivatives hedging potentially disastrous.

And this is where BICs, with there pre-determined contractual agreements provide economically valuable edge.

On Financial Reform :Regulation Vs. Size of Banks, A false dichotomy?

The debated on financial reform as summarized by Krugman in his latest piece in the NYT seems to have boiled down to the Volker position of limiting the size of financial institutions so that they do not reach a too big to fail size or the position of Krugman of tight and generalized regulation of Banks and shadow banks.

It seems to me that both analysis miss the simple but central ingredient needed to secure the financial system while not impending economic growth and that is a centralized clearing of all trades. Centralized clearing by nature remove a lot of the incentives in the buildup of too big to fail financial entities, it brings a level of transparency that all times gives regulator a clear picture of the dangers in the positions taken by financial/ economic actors.

A simple example to illustrate the power of centralized counterparty on trades. When you go online to buy an item or at the to a store and you use a credit card, that transaction is facilitated and secured by the existence of a centralized counterparty who keeps track of your assets and liabilities and authorize the transaction only when you have enough credit. No party to the transaction takes credit risk on the other and the system is robust. If the same worked among financial trading institutions the same efficiency and security would be gained, eliminating much of the systemic risks that are the source of current concerns.

See:

http://www.nytimes.com/2010/04/02/opinion/02krugman.html?src=me&ref=general


The Holistic Theorem

Too Big to Fail

See more presentations by kongtcheu | Upload your own PowerPoint presentations

Unity of Purpose

See more presentations by kongtcheu | Upload your own PowerPoint presentations

Greek Derivatives, Derivatives' Greeks, BICs and the Risk Management Illusions that lead to recent financial disasters

This Knol article points to a strange coincidence of words and circumstances surrounding the Greek debacle and the dangers associated with the use of Greeks in financial derivatives risk management...
Check it out!

http://knol.google.com/k/phil-kongtcheu/greek-derivatives-derivatives-greeks/24v2kgtuvzk2v/23#

Citi Plans Crisis Derivatives

This CLX plan appears to be a pickup from my article in the investment professional where I lambasted Krugman's analysis of the Treasury's PPIP and the fallacy of expectations based risk management he perpetuated in his analysis. In particular I pointed out the rise in funding cost at times of crisis not priced into such analysis to show how the computation of the so-called free lunch to PPIP investors was misguided.
The prescription in the article was to find replication contracts such as BICs that replicate the risks taken on as early as possible and keep uncertainty to a minimum.

However this contract, interesting as it may be only marginally addresses the range of risks. Anyway was it not Citi who would have needed such a contract last time? How could it safely be the underwriter?

Power-Reverse Dual Currency (PRDC) business & BICs

On January, 28th, 2010, Risk.net reported that losses and increasing hedging costs have led many smaller firms to leave the Power-Reverse Dual Currency (PRDC) business, leaving a rump of major banks operating in the market. This represents yet another example where had a BICs market on the currencies and interest rates involved existed, there would have been no such issue. Not only hedging activity would have been contracted before hand, in addition the atomic structure of replicating BICs would have made nearly impossible for counterparties to identify what the contract held is in order to attempt a 'squeeze'; furthermore most of the individual BICs would be used for other hedging purposes unrelated to PRDCs, ensuring the liquidity of the market on those contracts.

Public-Private Investment Program Almost Ready to Begin - NYTimes.com

Public-Private Investment Program Almost Ready to Begin - NYTimes.com
This article has some important numbers to bear in mind:
"The International Monetary Fund estimated last week that financial institutions worldwide still held about $2.8 trillion in troubled mortgages and securities, and that they had booked losses on less than half that amount so far. A big share of those assets is in American banks.

The Public-Private Investment Program would acquire only a tiny fraction of those assets, amounting to $12 billion. All told, the Treasury said, the five firms have thus far raised $3.07 billion in private equity. The Treasury will match that amount, dollar for dollar, with its own equity investment. It will also provide up to $6.13 billion in financing guaranteed by the government.

In effect, the money-management firms will be able to buy about $12 billion in troubled assets. The firms will split any profits evenly with the Treasury, but taxpayers would ultimately be on the hook if the investments lost money."

Finally it looks like it is going to start at long last along the lines that we outlined in The Investment Professional
http://www.theinvestmentprofessional.com/vol_2_no_3/abstract-bics.html


See also my knol articles:
1. Fair Value Pricing, Government Market Making and PPIP
2. Estimating Costs for PPIP Assets in a Market Making Framework & BICs

How Did Economists Get It So Wrong? - NYTimes.com

How Did Economists Get It So Wrong? - NYTimes.com

This piece is well written and offers a plausible explanation within the framework of mainstream accepted knowledge. But it's explanations merely reflect what has emerged as conventional wisdom and the intellectual strengths and weaknesses of its author, namely strength in economic history understanding and relative weakness in mathematical fluency.

As a result the piece trashes mathematical skill and look to economic history in Keynesian analysis to seek prescriptions for the current predicament.

What Mr. Krugman may not be able to grasp is not that there are good maths and there are bad maths. The maths used in economic theory and neoclassical economic theory since the end of WWII is transposed from Physics and seems a priori impressive. But we seek to address economic issues. "It ain't Physics" . It is only suitable and built for a world with no constraints on resources, continuity of time and space, unrestricted trade i.e. no frictions, perfect rationality of operators, etc.

There have been recent attempts to correct those assumptions, but all withing the edifice of the traditional mathematical architecture.

Indeed behavioral economics and finance are descriptive theories and provide a well deserved criticism of rational agents theories, but these have not been translated in efficient prescriptive formulations.

BICs are built from the ground up to provide a more resilient framework for more effective formulations that reflect actual human economic reality and behavior. They provide the math to efficiently accommodate evolving economic realities

My biggest concern is with prescriptions that are derived from Mr. Krugman's analysis. They are backward looking and fail to integrate the economic transformations that have taken place since the 1930s, notably the advent of the Internet, the rise of the service and network economies, the relative decline of manufacturing as a source of economic wealth, globalization, the environment...


-------------
PS: The following section made me scratch my head:"The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims."

Although the original vanilla call option was originally priced by Fischer Black using a CAPM based argument, derivatives pricing theory in all subsequent textbooks more the arbitrage arguments along Merton's Rational Pricing Theory. It is true that Merton makes a CAPM style argument to value derivatives in incomplete settings such as underlyings driven by jumps, but a robust and replicative pricing argument can still be made without reference to the CAPM and its outrageous assumptions, as I do with BICss.

OK, here let's just say the proposition on CAPM as the modern tool used to value derivatives is debatable. As far as I know, the CAPM is more commonly used in corporate finance for corporate valuation purposes where one uses the CAPM to obtain the required rate of return that is used to discount expected future earnings to deduce present value.

But what's really is a bit startling to me is the characterization of derivatives as "claims on claims"... Derivatives are contracts whose payout is is derived from(i.e. is a function of )the value of other observables(stocks, credit indices, temperature,...) at payout payment time(i.e. maturity).

The Crisis of Credit Visualized

The Crisis of Credit Visualized

Just virally sharing this short & comprehensive clip about the Credit Crunch I just watched, courtesy Fabienne-Fariba Salimi, Process Safety Expert on the HEC Alumni page


The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

The wider scope of BICs

I released this knol on The wider scope of BICs that reaches out to strategic partners.

Op-Ed Columnist - Financial Policy Despair - NYTimes.com

Op-Ed Columnist - Financial Policy Despair - NYTimes.com

I could not agree more with Mr. Krugman on the sense of desperation over this plan.
I have cried a river over this, and over and over.
And I cry again...

However we arrive at the same conclusion from different analytic paths and our prescriptions differ. My analysis remains this

Op-Ed Columnist - Are We Home Alone? - NYTimes.com

Op-Ed Columnist - Are We Home Alone? - NYTimes.com: "And you will ensure that we’ll never get out of this banking crisis, because the solution depends on getting private money funds to team up with the government to buy up toxic assets — and fund managers are growing terrified of any collaboration with government."

Huh!...
My only quarrel with the article is the apparent assumption that the plan the government appears to be poised to announce is the obviously best and only game in town...

Once more, Mr. Friedman, would you read this?

A Medical Madoff: Anesthesiologist Faked Data in 21 Studies: Scientific American

A Medical Madoff: Anesthesiologist Faked Data in 21 Studies: Scientific American

As I was going through the French edition of this article in Le Monde, it hit me once again that the present crisis is also at a deeper level a crisis of defect in the structure of means of attribution of credit that is not limited to finance, but that extend to all learned fields of knowledge in the upper echelons of society.

I have refused to play the "gaming the system" strategy for I believe sooner or later things in such games fall apart.

This gives me hope that someday those who stood up to look for the truth and claim it no matter what the price may receive their due.

Someday, somewhere over the rainbow...

Toxic Asset Plan Foresees Big Subsidies for Investors - NYTimes.com

Toxic Asset Plan Foresees Big Subsidies for Investors - NYTimes.com
Moronic disgrace.
Design complexity here is no substitute for discernment.
I cry a river over this.
See: http://knol.google.com/k/phil-kongtcheu/fair-value-pricing-government-market/

Senators Debate Fed's Role in Overseeing Systemic Risk - WSJ.com

Senators Debate Fed's Role in Overseeing Systemic Risk - WSJ.com
Reasonable debate to have. In my book BICs 4 Derivatives Volume I : Theory
(Chapter VIII, pp 192-195), I argued for a central counterparty organization as counterparty of reference on all trades which guarantees the payment of contractual agreements on both sides of a transaction.

The systemic risk overseeing entity should act as central counterparty of reference on all trades whose default may pose a systemic risk or act as a regulator and guarantor of last resort to private entities (exchanges, clearing houses,...) who play such a role.

As a guarantor of last resort, this entity may be best within FDIC; As guarantor of credibility through the power to print money, this entity may be best within the Central Bank authority. What is most important in my view is that its function be articulated as proposed above.

TALF Is Reworked After Investors Balk - WSJ.com

TALF Is Reworked After Investors Balk - WSJ.com

This subsidized lending program just looks like major league subsidy to the securities industry with layers of transaction costs that incentivize people to trade in potentially irrational way with cheap money and are likely to contribute to TARP assets price inflation . Why not just do market making as I have repeatedly suggested?

The key mistake here is that policy makers seem to confuse
- incentivizing trade on securities with high economic impact which should be the mission of the government here and would lead to a more rational underwriting industry practices going forward
vs
- encouraging the potential reckless issuance of new securities which may in fact perpetuate the practices that led to this mess.

John Stewart Vs. Jim Cramer

The Daily Show with Jon Stewart | Stewart vs. Cramer:
A few thoughts:

1) "Is collective responsibility an alibi?"

This topic of my high school philosophy dissertation exam seems to me like something that out to be debated or revisited here. All the culprits in the present crisis seem to think collective responsibility is an alibi. I differ.

How at the very least about a journalistic or governmental effort to search and single out the heroes?


2) "It is much easier for a man to fail conventionally than to stand against the crowd and speak the truth" John Maynard Keynes

The usual expectation is that the one(s) who stood against the crowd and spoke the truth at great cost to themselves would reap the benefits when convention fails.

Painful as it was to watch for Mr. Cramer, I suspect he is still going to be having his show and make even more money "head he wins, tail you loose".


I have spent a decade on BICs, and BICs would have helped and can still help get out of this... And here am I, just as pitiful, out of the public sight and out of the public mind.

Where is the morality of all of this?

3) Is it time to debunk the Financial Investment Equity Risk Premium Fallacy
which says over the long term stocks outperform bonds?

(1976 Ibbotson Brinson) .See also:
http://www.dailyspeculations.com/scholarly/LongTermStockReturns.html
http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/IntnlRiskPremium.pdf
How about saying "Lies, damned lies, and statistics"

I bet that buying government I-Bond (inflation bonds) would yield a better return net of management fees and taxes than the large majority of index funds.
But saying that would destroy the entire financial advisory industry. So let's keep it quiet....

4) Finance and Economics is a complex and serious business that must be handled with nuance, intellectual sophistication that can sound very boring to simply minded persons; by attempting to be simplistic and entertaining to attract huge audiences, CNBC & Cramer dig for themselves huge holes in which they ultimately fall

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Pt. 1

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Pt. 2

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Pt. 3

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

The Stewart clip evidence against Cramer:


CARLY SIMON - YOU'RE SO VAIN referred to by stewart in the interview

Charlie Rose - A conversation with Timothy Geithner, U.S. Treasury Secretary

Charlie Rose - A conversation with Timothy Geithner, U.S. Treasury Secretary
In this interview he made a lot of sense. His enunciation of principles is coherent; however the actual tools to effect those principles, while not entirely unacceptable are not always the most effective I would think of.

"Ars sine scientia nihil est"

For example, when he is talking about doing the private public partnership to unclog tarp assets . They are going to lend money to private investors so that the can go and buy tarp assets. The contention I have repeatedly made is: why would this be better than setting up a market making operation on those assets traded at a refined level of granularity?

They Tried to Outsmart Wall Street - NYTimes.com

They Tried to Outsmart Wall Street - NYTimes.com
The newsy or useful point the article is trying to make kind of eludes me. From the front page snapshot, I thought there would be some statistic showing demand for quants has shot up with the crisis other than the discrete opinion of a quant professor who has a conflicted interest in selling his academic curriculum to prospective students. The reporter apparently just opened his quant rolodex and got a number of known quants say something that would make them look good and prop their books. Unlike what the title "They Tried to Outsmart Wall Street" would suggest, it does not try to hold any of those accountable.

How about BICs Sir, how about BICs, it actually would help...
I cry a river over this...

As I have described at length in other writings(See this or this ), and keep on saying, this crisis was a failure of the existing mathematical modeling framework at describing the real world dynamics of underlyings. Therefore the corresponding hedging and risk management strategies failed to represent reality and this fact becomes most obvious at times of crisis. One of the reasons for this development is the over-representation of former physicist at the highest levels of "quantdom" who have forced the adoption of a framework coming from another world. But "It ain't physics". It just ain't.
And I cry a river over this. I just cry a river over this....

LinkedIn: Answers: What are the best ways to enable grassroots stimulus, esp. with entrepreneurship?

LinkedIn: Answers: What are the best ways to enable grassroots stimulus, esp. with entrepreneurship?: "How about simply providing stimulative loans/ investments directly to all those educated professional in the financial services and media sectors that are being laid off in droves to start up anew?
Simple criteria: US Citizen or Permanent resident+college degree
Max amount 50K - No paperwork -Checks mailed by the IRS"