Wall Street and the Wages of Estimation

Last week, the New York Times blog Bits had a piece about Wall Street analysts "lying" to their computers. Written by a journalist who has covered both the Internet and trading and finance, it indicates how little many reporters know about the mathematical processes they write about -- otherwise there might have been much earlier warnings of the problems now facing the world's economy.

Yes, the current meltdown is supposed to be a "once in a hundred years" event, as the president of a consulting firm told the reporter. However, these black swan events, when considered together, happen far more frequently than every hundred years. That's because when you have potential events that are independent of each other, but still capable of creating financial cataclysm, the cchance of at least one of them happening is the sum of the separate chances of a given one happening.

So already experience and math suggest that the surprise at an unusual event should have the same tone as Captain Renault being "shocked, shocked" at the gambling at Rick's in Casablanca. The concept of adding probabilities for independent events has literally become math in grade school, or at least high school.

Now for the other revelation:

The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

I'm sure there's something to this, but let us get at a more fundamental issue: many complex problems in math and engineering and science are too tough to easily solve. What people do, then, is simplify. You put the world into models and approximations that you have a prayer of solving. You drop factors that seem tiny in comparison with the rest of the problem in an attempt to simplify the equations even more. You employ numeric methods to get closer and closer to the "real" answer ... as close as you need.

Unfortunately, your answer is simply an approximation, nothing more. It may be acceptible for your uses if the real world conditions are forgiving enough. But when things get hairy -- you're trying to predict the behavior of materials in the face of quantum mechanics effects or trying to understand how an incredibly complex system, such as the weather or global finance, will behave -- then approximate may not be good enough. If a chip fails, well, you head back to the drafting board. When an economy fails, then you end up with huge banks and investment companies going out of business, oil prices swinging by $25 in a single day as short-sellers have to cover their positions, and governments begging for the right to spend $700 billion of taxpayer money to get their croneys out of the frying pan.

JP Morgan to Sweeten Bear Honeypot

It sounds as though JP Morgan may have to up its offer for Bear to $10 a share, and the entire situation is creating an interesting dilemma. ON one hand, the Fed is looking to ensure that commerce continues. It's not that Bear Stearns itself is so important to the economy so much as its position as a middleman in so many transactions. The problem is that if Bear had gone into bankruptcy, then the court would have had no choice under the law but to freeze all transactions in which it took part, no matter what it was actually doing. That could be a big enough hiccough to derail enough commerce that suddenly everything would come tumbling down.

So the Fed wanted to keep this from happening, and I can understand that. But Bear Stearns is a publicly-traded company, and the public that trades the company was pretty upset about the price being only $2 a share when it had gone for as much as $30 on Friday - and that was a loss of two-thirds of its value. According to a New York Times story, shareholders were ready to head to court.

On one hand, I don't have a lot of sympathy for the shareholders. They wanted the high return and were happy to overlook the questionable nature of the business that the bank was doing. Hey, it's capitalism, and there's risk. Why is it that so often so many people who have money to invest suddenly want welfare for the rich? But the intriguing issue is which governmental (quasi or not) agency has precedence when it comes to the conflict of interests? Can the Fed encourage a fire sale, or does the SEC have to come in on the side of investors, who want as much money per share as they can get?

The new offer must be approved by the Fed, which had initially balked at the new price.

If the Fed balks, does the deal come apart? This seems like a deal that is so important to the economy that the Fed is effectively powerless to say no, which means it has little leverage in a negotiation.

A new deal could raise even more questions about the Fed’s involvement in the negotiations. As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets. The central bank had also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, people involved in the negotiations said Sunday night.

Might not the SEC say, "Sorry, folks, but the directors can't legally agree to such a deal?" I don't know that different branches of business regulation have ever clashed in such a way.

Did the Feds Topple Bear?

New Jersey Institute of Technology management professor Michael Ehrlich has an interesting premise. A former government arbitrage trader himself, his research and background suggest to him that by announcing that it would make $200 billion available to finance securities from investment banks, the Fed may have unintentionally set off the panic that claimed Bear Stearns.
"I think it's a bad thing for Bear Stearns shareholders, but a brilliant thing for public policy," Ehrlich says. We've established a precedent that they're prepared to bail out firms to protect the little guys ... but that the people responsible bear the costs."

As he says, that means management and the shareholders. I think some of those shareholders often may be little guys, but, realistically, this is capitalism and they continued were holding stock in a company making ever riskier trades because they liked the returns.

The minute the Federal Reserve made the announcement, everyone in the markets started asking whether the Fed knew something that they didn't, which may well have triggered speculation about Bear Stearns - smallest of the investment banks - that turned into "a classic run on the bank," according to Ehrlich.

I keep asking myself the question of whether the Fed's new willingness to lend to investment banks might be handing more money to the very organizations that have proven themselves so tremendously reckless. Ehrlich thinks I'm looking at it the wrong way, and that the effect is to keep the financial system propped up while the shareholders take the brunt of the heat.

But I still feel unconvinced, because I think businesspeople are likely to take this as a tacit guarantee that no matter how stupidly they act, someone will pull their chestnuts out of the fire. All they need to do is keep diversified enough that their estates don't get clobbered like those of the Bear employees.

In any case, Ehrlich also thinks that this is by no view charity on the part of JP Morgan. As he deemed the Fed's move for public policy, so he called the acquisition a "brilliant" move that will probably give the new owner a profit of several billion dollars. Guess I don't see that as something to dissuade behavior in the future - because all the high-powered type A's will assume that they will be the ones coming out on top. We've seen the same behavior in virtually every man-made financial calamity in history, and there's no reason to think that people will act much differently. The only question is how much time it will take them to get back to the usual business.

A Sudden Realization About the Sub-Prime Crisis

I've written a fair amount about this topic, so this will be short. (Having impending deadlines, like other forms of death, concentrates the mind wonderfully.) But when I started thinking about how this debacle came to being, I wrote the following:

By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.

That was the explanation I had read, but something bothered me about it. It didn't quite make sense that some juggling could improve the credit rating that much. After all, to really cover the potential default rates, you'd probably need to add a significant number of "good" mortgages that would be unlikely to default so the return on the investment had a reasonable chance of occurring. But then the default rates shouldn't have had that kind of impact. And yet, it seemed that the derivative securities were largely based on poor credit lending. How did bundling them get better ratings than the individual loans would have?

After paying attention to more reporting on the subject, I think I now understand. The rating agencies abdicated any ethical or moral responsibility to give an honest opinion on the derivatives because they are paid by the very financial institutions that were issuing them. Unfortunately, investors pay significant heed to these ratings and often pass on doing further due diligence. I could understand that from individuals who are intimidated by understanding financial matters. But these derivatives could never have taken off without significant institutional investor participation. What happened here? Don't these large organizations that hire lots of brainy people actually do their own thinking? Actually, many rely on the opinions of others far more than you might thing, certainly in proxy voting issues, as I learned in writing an article for Corporate Secretary.

So many individual investors, putting their money into money markets, pension funds, and other aggregations of cash might be taking a larger risk than they realize, because they don't always know who's really making the decisions. Where has the financial media been through all this? This story has an Enron-like cast, with lots of people writing in awe of the clever financing and no one pointing out that the Emperor ruled in the buff.