23 September 2012

Listen to the Bald Headed Guy

As regular reader must have figured out by now, while I dearly love stats/quant, I've been skeptical of mathy staty economics/business ever since grad school when I was subjected to a bunch of flunked out math and physics Ph.D. re-purposed into assistant professors of economics. This was the mid-1970s, ancient history to most alive today. The Great Recession's seeds were sown that long ago.

In the movie "Taras Bulba", Yul Brynner in the title role tells his son that he must go live with the Poles to understand how they think so that the Cossacks can win back what they've lost. I feel much the same about "financial engineering", an oxymoron ranking with "happily married" as the apotheosis of irony. So, in a desultory way, I've been reading David Ruppert's "Statistics and Data Analysis for Financial Engineering". Today was the chapter on copulas (which, if one uses them, must be termed copulation, yes?). Wait for it: we sure got copulated by Wall Street.

Each chapter has a Bibliographic Notes, which is usually a bunch of reference to papers in the professional literature. However, here is a reference to a piece in Wired, by Felix Salmon. Boy Howdy! It was written in the early days of the Great Recession, Spring 2009, just before or after this endeavor went public. I was unaware of it until now. It is eerie, reading it now. I do disagree that the quant invasion happened in the 80s; it was a decade earlier.

To reiterate: my issue with Wall Street quants is that many (most? all?) have little understanding of either macro or micro economics. The micro folks believe that each actor is independent while the macro folks understand that such a view is naive' at best.

One of my favorite aphorisms (attributed to any Good Mother, and presented a few times already): "what would the world be like if everybody behaved like you?". This was said to misbehaving kids.
...the 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.

Conspiracy nuts would, perhaps did at the time, have fun with the fact that the inventor of this particular copula (there are a host of specific ones; copula is a general definition, so there are many variations) is a Chinese named Li. Was he sent here to crash the American economy? Only the time will tell. As of the date of the piece he had returned to China and was working in banking.

What Salmon doesn't get into is the specifics of why CDOs and CDSs came to be so loved by the Wall Street folks. Here, the answer is Greenspan and Dubya: they had crashed interest rates on Treasuries, leaving all that Chinese money and American pension money and what have you looking for greater "risk free" returns. As I've said more than once here, returns (real world variety) can only come from better production of and sufficient demand for the increased production of goods; there really isn't much point in making physical investment just to produce what you already do (modulo firing most of your employees, see Mother's Advice above). Home mortgages provide no such. Some within the economics profession have talked, for decades, about "psychic utility" and its measure in housing. Here's a piece which skewers it well and truly. If it sounds familiar, just delve into the early musings here and you'll find his arguments and more.

Returning to Salmon's piece.
...because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.
In other words, while, in my opinion Wall Street investing is really just gambling twixt buyers and sellers of stocks and bonds, this was very much a step further into wagering.

What Li, and any of the quants who bought his story, relied on was the truth of The Efficient Market Hypothesis. That is, those pricing both CDOs and CDSs were always the Smartest Guys in The Room. The problem here is simple: the financial engineering folks rely wholly and explicitly on some amount of historical data, and almost all of that data is some single time series. Imagine your local weather person saying that the day was dry and sunny, because her forecasting model said so, but never bothered to look out at the downpour in the parking lot. Such was the simplicity of the error made by the Wall Street quants. They wanted to, vampire squid style, suck ever more moolah from the saver-to-borrower stream, and there was all that Chinese money just itching for some place to sit. It was not in their individual best interest (see Mother's Advice above) to question the wisdom of the plan. One need look, as early as 2002, no further than the (median house price / median income) metric to know that someone was lying. House prices were soaring, but median income was flat. No amount of utility shifting could account for the divergence.
And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool.

It isn't as if all these mortgage based CDSs and CDOs were built on new and better production. They weren't. All that held them up was the incomes of the home buyers. Nothing else. Said home buyers might derive a whole lot of psychic utility from a McMansion they'd never dreamed they'd ever be living in. Psychic utility doesn't pay the mortgage. Some academic economists, going back at least to when I was in school, have questioned American's perverse "investment" in housing. Europe doesn't waste capital that way. We shouldn't, either.

The numbers are staggering:
The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.
God may not play dice with the world, but Wall Street is more than happy to play dice with other people's money. "Abandon hope all ye who enter here."

So there you have it. Just as I've described, but with some contemporary reportage. The results of TARP and the QEs? A soaring stock market in the face of economic stagnation. How can that be? Now that all that Chinese money and American pension money doesn't have AAA rated bonds (and their derivatives) to buy, where else to go? Yup, the squid. It's deja vu all over again.

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