So I'm at this NBER conference in Chicago, and today there were papers on the recent financial tumult. As with all conferences, there was a combination of interesting and uninteresting material presented.
One neat set of papers was when Andy Lo presented his paper on a specific, mean-reverting strategy common to hedge funds, and noted it experienced 8 standard deviation losses back-to-back-to-back in August (8/7/07-8/9/07), and got it all back the final day (Friday, 8/10). It appears someone puked up the strategy pretty bad. Then, Kent Daniel noted that several standard long/short quant factors (eg, long/short book-to-market) also lost a lot on those days. So it seems that some big fund, or some big group of funds, all exited these strategies simultaneously, and got clobbered. Lo also documented that really short mean-reversion, say over a 1 hour period, lost a lot only in that period--generally a market maker makes money on mean reversion. It appears someone big was exiting and the standard liquidity providers were getting run over, so they just disappeared.
Atif Mian and Amir Sufi, besides having very symmetric names, presented an interesting paper on the degree to which the mortgage problem was supply vs. demand based. They note that several standard risk metrics of borrowers--debt to income, rose dramatically from 2000 to 2005. So did the proportion of mortgage debt sold to third parties, which are rife for moral hazard (idiots buying loans originated by guys with no skin in the game, and thus have an incentive to be lax in underwriting). When house prices rise, the obligor's risk doesn't matter, because you merely repossess the collateral. But when prices flattened, the chicken came home to roost, and here we are. But they looked at thing by county, and it was suggested they look at those areas targeted by CRA and other government programs. It will be interesting if they find that the Fed's initiative, the Community Reinvestment Act, was a big reason for this problem. We will know soon.
There was also a neat note by Markus Bunnermeier. He estimates this calamaty is a $500B loss in market value. But that's about a 2% downtick in the S&P500. So, it's not the magnitude of this mess that is the problem, but the concentration, and how it reverberates through the system.
There were some people talking about VAR performance, looking at the number of times big firms hit their 99% or 95% limits. I thought this was very strange, as I'm unsure what purpose a top-down VAR measure performs. At that level of aggregation, its pretty meaningless. I imagine it's just done for regulators, and generally considered meaningless by insiders.