Ex-Goldman Quant Arrested

Bloomberg reports a computer programmer, Sergey Aleynikov, was arrested July 3 on arriving at the Newark, New Jersey, airport and charged with theft of trade secrets. As someone involved in intellectual property litigation, it brings back nightmares, though I am happy to say I've never been arrested.

From Bloomberg, they note that:

the proprietary code lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said. The trades generate “many millions of dollars” each year, they said.

This highlights the problem with IP law. These statements sound like sufficient probable cause to a judge, but they could be a program that buys stocks based on the simplest of pairs trading algorithms. The problem is that intellectual property law in most states allows an ex-employer a very broad scope to level charges, so if someone wants to accuse you of something very vague based on the flimsiest arguments(eg, 'he planned to do mean-variance optimization as he did at our firm') they have the right. As an instrument of harassment this is much scarier than any anti-terrorist legislation, because no one cares when it is abused. The fact that while they engage in discovery (which can last years) and send and receive interogatories, searching your hard drives and emails, you cannot work for anyone because without a precise definition as to what information, code, algorithms, etc., are at issue, anyone doing business with you is taking on infinite liability. Plus, good IP lawyers cost a lot of money, and as litigation takes several years, a large firm can easily bankrupt a target. With such a prospect, a rich litigator can make the ex-employee an offer he can't refuse.

Firms who engage in such over broad litigation are invariably alpha-less because only those so insecure about how outsiders view their alpha, and how important non-principals are to their alpha, use this tactic gratuitiously. In the end, it does not work, mainly because 1) they demonstrate they believe they have little endogenous alpha, which is usually true and 2) no new alpha comes in, because those with a choice prefer to avoid such people.

In this case, I think Goldman is probably on the right side. This is because Goldman has a habit of letting ex-employees leave and prosper, as they have learned to use their ex-employee success to their advantage. They have no insecurity that people will think Goldman's alpha is from the current crop leaving to start new companies, as this has been going on for decades. Further, the person at issue is a computer programmer, not a trader or portfolio manager, and such code is often very specific (not broad concepts like 'variance' or 'cash flow'). Lastly, programmers are usually given algorithms to code; it is implausible that such workers already knew about parochial trading rules based on previous work automating account statements for Blue Cross.

Blurber Quid Pro Quos

After the dot-com bubble, people were shocked to find that Investment Banks often promoted stocks to their clients while simultaneously seeking business from these companies, often in a quid-pro-quo. Analysts such as Henry Blodget of Merrill Lynch, Jack Grubman of Citi, Mary Meeker of Morgan Stanley, and Frank Quattrone of Credit Suisse First Boston were considered perspicacious gurus of the 'new economy' back in 2000 (Meeker still works as an analyst!). In fact, they were in indiscriminate shills for their corporate bankers, who would reap big fees on new equity or debt issues. Their signal-to-noise ratio was actually negative. But they wrote in a way readers appreciated, so like giving whiskey to Indians, they could merely say they were filling a need.

The SEC has adopted new rules and now full disclosure is required, along with a separation between research and investment banking, and a prohibition against analyst compensation based on investment banking business.

But most of business, if not life, is about doing people favors. Very few major business transactions are one-off, but rather, part of a relationship.

I recently wrote a book, and remember that the first question my editor had was whether I knew someone famous to blurb my book. Unfortunately, I didn't. My eventual blurbers were not nobodies (Todd Houge, Kevin Blakely, Don van Deventer), but their q-scores are not off the charts. There isn't much of a quid pro quo if only because I am not in a position to help these guys very much, though the fact they knew me was probably essential in their willingness to read my book (surely an imposition one simply cannot grant to anyone, having finite time).

Anyway, knowing how important blurbing is to selling books, I now often read the blurbs, and find them often transparently compromised. That is, 90% of the time the blurbers are close colleagues, mentioned positively in the book, or otherwise interested in the positive fortunes of the author and the book. For example, Tyler Cowen has a new book coming out, and he referenced two rather glowing reviews, one by Tim Hartford, the other by Ben Casnocha. For Hartford's 2008 book The Logic of Life, Tyler blurbed:

This witty, intelligent book will help you see the entire world in a new light.

In the New York Times, Tyler wrote a glowing review of Ben Casnocha's 2007 book, My Start-Up Life.

Payback? I'm sure they will say their unqualified, over-the-top admiration for each other is sincere, after all praise to those who have done, or may do, a great favor for you comes naturally. But back in the 1990's every stock analyst would regularly insist that their recommendations came from bottom-up due diligence and an uncompromising evalution of the big picture. It is what economists call 'cheap talk', because it costs nothing in reputation, money, or cognitive dissonance, to insincerely say one is sincere, making the declaration meaningless.

Considering the fact that most books are bad (Sturgeon's Law), you should only put credence in a venue where their average review is negative. If you have never read at least two negative reviews from someone, you should dismiss their positive reviews. Richard Posner and Bob Solow are good reviewers, in my opinion.

But what about the shady, crooked business of quid-pro-quos? I don't know, but it's endemic. I once mentioned to a prominent risk website I have a free default model online, and whether I could mention it in a discussion post on his site. He mentioned that his other advertisers who actually sell such services would not appreciate this, so I could either buy space, or post on various topics for free for a couple weeks and ask him again later.

Clearly this kind of thinking implies that his advertisers are probably not subject to the same whithering criticism given to, say, bureaucrats, various academics, or those not advertising on his site. This same well-known quant is outraged that ratings agencies have a conflict of interest with those they rate, and probably thinks his situation is different. As they say, it's good to be reasonable, because then you can come up with a reason for everything you do.

It's hard to get too worked up about these situations. People shade their public opinions based on how it relates to their bigger picture. I don't begrudge those giving tendentious support for those doing them favors. It's my responsibility to evaluate everything, including evaluations of third party evaluators.

The Idiocy of Financial Journalism

As a rule, any article that tries to make a profound point, while also having the following sentence—"Derivatives are financial contracts derived from an underlying asset, such as a stock, a financial index or even a mortgage"—has entered the journalism hack zone. If you presume your audience may not understand what a derivative is, it's safe to say your article's claim that some old or obscure insight has some really important implications for the future of economic science, is probably considered via the noob criterion: if I were reasonably intelligent but had no clue about finance, would this sound cool? This vetting process leads to countless redundant articles on behavioral finance, efficient markets, and hubris that people may read and enjoy, but does not increase anyone's understanding of finance.

I was reading Scientific American on the plane, and usually can't stand their smarmy, PC take on everything. In July's issue, they didn't fail me. Their article Science of Economic Bubbles and Busts seemed to uncover "the promise of changing forever our fundamental assumptions about the way entire economies function", using "a high tech fusing of neuroimaging with behavioral psychology." The result would show an "economics [that] has begun to proved clues to how individuals, and, aggregated on a larger scale, whole economies may run off track." OK, do tell!

Great, what are these insights?

• how could markets be 'efficient' if prices can fall so precipitously?
• people buy based on gut feelings (animal spirits)
• people dislike losses more than they appreciate gains
• people use rules of thumb, heuristics such as anchoring on a set of base information (that may be arbitrary), or the whatever is easiest to remember (which may not be more important)
• markets may work like ecosystems, where the most profitable survive

There are several more in this vein. These ideas are true, but they have all been around for at least 30 years. Sure, now we can model fMRI that shows what part of the brain lights up when we lose money, but that has not shown anything other than that there is a biological substrate to human thought, which I don't think anyone ever doubted. It isn't obvious how these facts are related to some better model of finance, because it's not like thousands of smart people haven't been working with them for decades. Of course economists are predicting the effects of individuals interacting, and these people have emotions and are not perfect. The problem is most of these 'biases' tend to cancel out or are ambiguous. For example, there are biases of over and under-extrapolation that will explain both mean reversion and momentum.

Some revolution.

How to Derive the CAPM

The following 3 minute video goes over the mathematical proof of the CAPM, taken from my lecture on Asset Pricing Theory (where you can also download the Powerpoints I'm going over, and see a much larger screen size). It is so simple you can see why 4 people independently figured it out about the same time (Mossin, Sharpe, Lintner, Treynor). Given the insights of Markowitz (the efficient frontier) and Tobin (two-fund separation theorem), it is rather trivial. You can see more videos here, related to my book Finding Alpha.

Porn Up, Rape Down

There's a neat paper arguing that in contrast to initial expectations, pornography is why rape is down 85% over the past 25 years. Both Nixon and Reagan had tried to regulate porn more using the argument that watching porn increases sexual assaults or criminal behavior. The author finds that those states with the least internet access had actual increases in rape, while those with the most internet access and the biggest decreases. Correlation is not causation, but I don't have any other theories. Is there anything porn can't do?

Feminist organizations don't even mention this great progress. We should note the areas where society makes improvements, because we should not take this for granted. Note that in South Africa, a 1999 survey of 4000 women reported 1 in 3 were raped the prior year! Things may be bad, but they can be a lot worse.

Life is full of misfortune, and sometimes we make progress. Never perfection, but that's an unhelpful standard.

Where Smart People are Stupid

George Orwell famously stated that 'There are some things so stupid that only an intellectual can believe them', and this create biases peculiar to our intellectual elites. John Jost does research about how many oppressed people rationalize their oppression, becoming 'Uncle Toms', aiding and abetting the unjust status quo via their agreeablenesss. For example, he finds that when threatened, people tend to grasp comforting stereotypes, such as that rich people are more intelligent than poor people, and that fat people are lazier than skinny people. Crazy talk.



Less intelligent people tend to confuse 'tend' with 'always' more often, so if you say men are stronger than women, they would be more prone think this implies this is true for every possible pair of men and women. That is clearly a logical error in inference. The twentieth century's most singular intellectual insight is that discrimination—the idea that certain groups like women or blacks are all different than, say, white men—is morally wrong and inefficient. Thus, every New York Times article noting some difference between groups of people has a perfunctory paragraph stating, for example, that "this does not imply all women are not as strong as all men", just in case anyone made such an inference.

Modern intellectuals are so afraid of stereotyping they can no longer generalize about people as intelligently as the great unwashed. The thought that obese people are lazier than average seems not merely mean, but illogical, to many intellectuals. Thinking that there are many poor persons much smarter than many rich persons, yet on average rich people are smarter than poor people, does not imply we should sterilize the poor, or never listen, hire, or marry a less intelligent person. Yet to assume the wealthy are just as intelligent as the poor would imply a conspiracy so vast and efficient at working to offset the natural advantages implied by the nature of 'intelligence', defies credulity. Almost all stereotypes are true as generalizations, a useful fact plebians believe more than intellectuals. This guy seems to think the only way to believe pathetic people are not as virtuous or admirable as rich people rationalizes our current, arbitrary hierarchy.

A Risk Management Serenity Prayer

God grant me the serenity
to accept the things I cannot change;
courage to change the things I can;
and wisdom to know the difference.

There is profound wisdom in this statement, because it highlights the importance prioritization. A mathematician can tell you what is true, false, or undecidable using irrefutable logic, but that's generally not very helpful, and why mathematicians are generally considered smart in that idiot-savant way.

I thought of this when I read Paul Wilmott blog about why quants should address more of the outside-the-box questions. He gives the example of, basically, what is the probability a magician will pull a card out of a deck, given you get to 'randomly' pick the card (eg, ace of clubs). With a fair deck the odds are 1/52, but given the card picker is a magician this is probably not a 'fair' deck. So an obvious potential answer is 100%, especially if you are being asked in front of a large audience.

All well and fine, but Wilmott draws from this story that this is what quants should focus upon, the outside-the-box things that seem to bedevil real life. Look for the magicians, not the simple odds in a fair deck.

Consider high profile fiascoes as Metallgesellschaft, Orange County, Enron, AIG. These were not properly calculated risks that went awry, nor were they outright fraud where an unauthorized intraday position blew up. They were the result of investors or management not fully understanding the risks that were being taken (the CEO off AIG was telling employees they had no, zero, exposure to mortgages throughout most of 2008). These risks—breakdowns in incentives, communication, assumptions, etc.—are called operating risks, and represent a residual of all things that are not cleanly within credit or market risks. If operating risk are the primary reason why financial firms fail, emphasis on refining models where the assumptions are presumed true seemingly misses the point.

Operating risk is neglected by risk management for good reason. It is impossible to quantify existing operating risks, which in turn makes it near impossible to evaluate methods of monitoring and reducing these risks. One can endlessly discuss assumptions, but invariably there comes a time to make an assumption and then work on those assumptions. To merely assume anything can happen in a particular instrument invariably will imply you should not be investing in that instrument, because if it makes money under the 'anything can happen' assumption it is obvious arbitrage.

If the primary risks facing financial companies are from things 'outside the box', shouldn't one focus outside the box? That is, if what brings down most companies are flawed assumptions or poor controls rather than poor luck, then most of the true risk for a trading operation is not in stress tests or Value-at-Risk, but the risks that exist outside a firm’s precisely calculated risk metrics.

Consider an analogy from American football. The biggest single metric determining wins and losses is turnovers: you get a turnover you gain a huge amount of field, and vice versa if you lose. While you should tell your players to hold onto the ball, and not throw interceptions, this can't be the focus of your game preparation. There is a lot of luck involved in turnovers, and generally, a team fighting to catch up, or afraid of getting the snot smacked out of them, fumbles more. Focus on what you can improve.


Most high-profile risks appear in retrospect to be the result of avoidable vices such as overconfidence, laziness, fraud, and gross incompetence. Yet complicating this picture is the fact that traders are notorious for continually expanding the scope of products they offer, especially because these cutting-edge products tend to have higher profit margins. This is a risk a profitable trading floor cannot avoid; by the time a product is fully understood by independent risk managers, the large margins will be gone. As opposed to academia where one can spend a long time on a single issue that one defines, in the private sector quants have to come up with solutions for many problems they do not fully understand, and do not have the luxury of saying 'it may lose 100% of its value' as if that's helpful.

One sign of good judgment is the ability to make wise decisions when information is incomplete. Knowing how to prioritize one's focus is a big part of that. There's nothing more pointless than a bunch of high IQ quants—whose comparative advantage is not the 'bigger picture'—focused on that bigger picture. Have them calculate the implications to standard assumptions. This is yeoman's work, essential but insufficient

Everything is an Empirical Matter

In Boldrin and Levine's book Against Intellectual Property, they note that their are no a priori grounds for their argument. That is, there are offsetting costs and benefits to intellectual property, and so it is a matter of empirically estimating these costs and benefits. In the book's case, this is mainly focused on patents, as opposed to confidentiality agreements, non-compete agreements, or trade secrets.

I think this is really true for almost any economic debate. Theoretically, there's a case for quotas: assume sufficiently high increasing returns to scale, some spill-over effects, and you have the case for quotas (this kind of pretty reasoning led to Krugman's fall to the Dark Side). The issue is whether empirically, giving a legislature the ability to grant quotas, to what degree will they be used in this area, as opposed to a pure rent generation via government fiat.

Thus, theory is nice merely because it tell us what variables to look at when doing an empirical analysis. In practice, with enough data, the variables speak for themselves, and it will be obvious what they are saying. The problem is merely that there are infinite number of potential effects, and potential interesting variables to control for. For example, looking at stocks, we may be interested in their annualized returns and volatility. If stock returns are lognormally distributed, this completely defines their distribution. If they have fat tails, we need futher data, higher moments, or extremum statitics. If markets are not efficient, perhaps it helps to look at auto-correlation in returns over various horizons (daily, weekly), or various technical patterns (head-and-shoulders). The state space is infinite, you need a theory to constrain it.

Similarly, when looking at what affects the effects, you need to control for other things. You might look first at how the 'market' affects returns contemporaneously, or industry effects. You might look at size, or value factors. Again, the state space is infinite, and you need a theory, a story.

So, theory is very useful, but usually theory merely suggests something to look at. The data then say how the functional form fits. If theory says variance, but it turns out that the result is really a function of the square root of variance (volatility), you can be sure that in 10 years no one will remember the theories that proposed variance, and it will all appear an unbroken advance in science.

So, I don't get too excited by proofs, or the precise nature of the functional forms. Just identify what is important as an input and output, and then roll up one's sleeves and see what the data say.

For people who hate models, I think the key to remember is they provide a useful scaffold to fit real data. That is, if you fit data without theory, you need a lot of it so it is not really bumpy, and without focusing on a small set of data, the combinations of potentially interesting data is simply too big.

Barry Ritholtz's Offer

I don't read Barry Ritholtz's blog, so I don't know much about how he thinks. I did skim his book, which I found very confused about what it means to explain something. He pridefully notes on his blog 30 people or groups to blame for the financial crisis (one factor being Congress, so perhaps all in there are 100 groups at fault). That's not an explanation. A useful way of looking at the data compresses it, so you can understand more with less. Merely cataloging everyone important who did not anticipate an event that by definition was not anticipated(a decline in asset values), is pointless.

He takes his epistemelogical confusion to the next level by offering to take one side of a $10-100k wager, on the proposition 'Is the CRA significantly to blame for the credit crisis?" This would be decided by "a fair jury." He is arguing for the negative. Anyone who thinks 'a debate' has ever settled a contentious issue is rather naive. I suppose most of this debate would fall under the 'what do you mean by significant' umbrella, where he would retreat to the meaning 'necessary and sufficient', which no one asserts.

You can read about how the CRA morphed into a monster in this piece by Stanley Kurz:

Banks merger or expansion plans were rarely held up under CRA until the late 1980s, when ACORN perfected its technique of filing CRA complaints in tandem with the sort of intimidation tactics perfected by that original “community organizer” (and Obama idol), Saul Alinsky

So the CRA was a tactic by nonprofits looking to redistribute wealth to their constituents. Classic politics. But then the CRA was used to gather pledges for lending targets, and aid to non-profits, which were then used to pay the measely down payments needed, and then the bank lenders (like Golden West) and homebuilders would profit. They in turn, would give grants to nonprofits, and legislators encouraging these activities. The naked self-interest in this game, all under the pretext of helping the little guy, is pretty obvious.

Now, CRA commitments were in the Trillions of dollars. You don't spend a trillion dollars without creating a lot of vested interests, and the same logic that underlay the CRA underlay the arguments by the Congressional Black Caucus in keeping Fannie and Freddie from greater oversight. The same Boston Fed study used to rationalize greater CRA lending, was used to rationalize lower, even absent down payments. The one exogenous mover in this whole mess was the thought that increasing home ownership was good business, in that it lead to happier, wealthier communities. This derived from the fact that when people don't lend purely out of discrimination, you can rectify a moral wrong costlessly the way breaking the color barrier in baseball both made the game better, made the first movers better, and was the right thing to do.

Unfortunately, they made an error in assuming bankers leave money on the table because of their irrational fear/hatred of minorities. This insidious assumption, and how it played into the zeitgeist, are discussed admirably in Stan Liebowitz's piece, Anatomy of a Train Wreck.

The CRA was insignificant in the following sense. I'm sure that without the CRA, another vehicle for promoting a political patronage system, focused on race and masked as justice, would have been found. That home buyers, investors, rating agencies, academics, legislators (Rep and Dem), and regulators, all agreed that this initiative was a good idea highlights how the real common factor was the idea that pure, inefficient discrimination was prevalent. That's the only way you can change an equilibrium level of homeownership without causing a mess.

Youth Not Liking Catcher in the Rye

The classic (1951) book of teenage angst, Catcher in the Rye, is about a young man, Holden Caulfield, who finds the world filled with phonies. Adults are shallow, hypocritical, insignificant. He seems to have Tourrette's syndrome, as every other word is 'goddam'. The New York Times reports current teens find the protagonist whiny, as opposed to 'deep'. Perhaps reality television and more complex TV shows are paying off.

Steve Johnson's Everything Bad is Good for You argues that TV and video games are getting more complex, more engaging, and just better. Shows in the 60s and 70s were linear, with a minor comic subplot (think Starsky and Hutch, Dragnet). Today, shows like The Sapranos and Desparate Housewives have a multithreaded approach, where characters are much less black and white. The net effect is that your average TV watcher is more sophisticated that a generation ago, in the same way that New Yorkers were more sophisticated than country bumpkins in the 1920s (the term 'corny' relates to the observation in the 1920s that rural--corn fed--audiences tended to like trite or overly sentimental jokes or scenes, presumably because of their ignorance).

The whole navel gazing as in, Bartelby the Scrivener, where one is supposed to feel bad for someone who can't handle reality, I always found annoying. This is the beatnick idea, that self discovery is the number one priority of people, and that people who are part of an organization (eg, the military, a corporation) with their external values, are either deluded or empty and pathetic. This idea has been very damaging, as it invites a pointless narcissism, elevating a lack of focus, and instant gratification. I believe self discovery is important, as I describe in Finding Alpha, mainly at finding your competitive advantage, what you are best at. This is both related to the self, and the market, because if you are good at what others do not value, it is not good for you. The fact is, happiness and prosperity comes from focusing on others, not oneself. Loving a child, a god, serving a customer, are all other-directed, and generate a lot of happiness.

I was reminded of Holden Caulfield when I read Michael Lewis's book Liar's Poker, a book about Wall Street written by a young man who worked for exactly 3 years in the business. Lewis was appalled by the hypocrisy and shallowness of his rich superiors, who he thought were all phonies. It was a bunch of funny anecdotes about the rich and famous that purported to give one an understanding of finance. It didn't. If you're over 30, think about how clueless those 25 year old Ivy league kids are in your company.

Hopefully, our youth's rejection of adolescent whining is a permanent evolution in the zeitgeist, like when we learned that zero is a number. In the future, perhaps people will become sufficiently sophisticated to learn that knowing about the major personalities in debates or big organizations--their sexual proclivities, drug usage, their family history--is not the same thing as knowing about the ideas or organizations.

Conspicuous Missing Legislation

A lot of top-down financial legislation is in arrears, but there is nothing relating to actual home buyers. That is, the quaint 20% down on a home purchase? The Income-to-debt levels? In crazy times those things weren't verified, and there were non-profits organizations receiving money from the Federal Government that paid for down payments so that everyone was happy. To blame this on 'derivatives' is absurd.

That's the front end of the mortgage meltdown, the prime mover. David Reilly of Bloomberg asks why not require 'borrowers have some of their own money on the line?' Or as a Saturday Night Live parody notes, a profound but counterintuitive bankruptcy advice is merely Don't buy things you can't afford. Indeed, the government still (ie, today!) has a prominent 3% down homebuyer initiative. Given home volatility, a 3% down no-recourse mortgage is a giveaway given the option value (keep upside, lose 3% if wrong). But that's related to hard-working people as opposed to abstract caricatures like 'bankers' and such.

The obvious answer is this would have disproportionate impact on the poor, which does not play well when grandstanding new legislative initiatives. By logical extension, this would disproportionately affect NonAsian-Minorities (NAMs). Better to blame this on the greed of rich people, mathematical mistakes by quants, anyone but actual people instigating the necessary instruments for this boondoggle, or their 'well intentioned' legislators. This urge to blame the wealthy for anything that goes wrong clearly plays well to the median voter. Perhaps I should pitch a book for a new 'grass-roots' movement against the plutocracy: 'My Struggle: How Smart, but Greedy and Rich, Bankers Screwed Us.' I just have to find a comp to convince my publisher this kind of work has a natural audience...

This is why Plato hated democracy. Popular means crap, as in public golf course, school, bathroom, recreation center. It means placating the mob unrelated to the weight of their opinions. Our founding fathers fought to establish a republican democracy, but now all we see are democracy fetishes, indeed, legislators go out of their way to emphasize their low origins and how their legislation helps the lowest levels of society (ignoring illegal immigrants, of course). So current rectifications conveniently exclude actual home buyers who got us into this mess, because, they aren't empathetic to the median voter.

Bloggers Address Gary Gorton's Paper

One reason I think Gary Gorton's work is so useful is because it reflects his appreciation of how subtle this financial crisis was. If you were totally outside it, or just calling for some unspecified disaster, it is tempting to see the crisis as something really obvious (eg, outlaw greed, hubris, and poorly targeted regulation).

Recently Fed Chief Ben Bernanke recommended people read Gary Gorton's latest paper, probably after reading my blog post praising it (heh).

So, you can watch Gorton's trenchant analysis get transformed into tripe in real time. James Kwak, Ezra Klein, Mike Rorty, Mark Thoma, and Felix Salmon, and Dr. Manhattan jumped in. I'm not saying they are all generating tripe, merely it basically demands a reader have correct prejudices to draw the correct inferences from the union of all these writings.

The debate is generating the focus of any decentralized collective, where everyone distills a different key point. Part of this group dynamic is simply specialization, where people focus on their unique insights because they want to say something new (interesting ideas are important, true and new). But it is very confusing when everyone agrees with the basics of what everyone else says (eg, there were regulatory failures) excepting the priority of the concerns.

First, I would agree with Dr. Manhattan that regulation has a poor batting average in the financial sector, and merely saying our new regulators should be smart, disinterested, and hardworking is like saying our political leaders should be so to. They aren't, and never have been. Highlight a specific regulatory idea, because merely calling for 'more' only ensures that it will be more of the same.

Secondly, Kwak and Klein get it backward when they first describe a repo secured by an 'informationally insensitive' derivative, then talk about a bank run caused by investors afraid that the bank will default. In the repo problem described by Gorton, the repo collateral-- mortgage securities rated AAA -- is what became risky or 'informationally sensitive'. This was the basis of the contraction, the prime mover, which lead to Bear and AIG's collapse, not Bear and AIG leading to mortgage problems. The causation arrow's direction is very important for both diagnosis and potential cures.

Felix Salmon notes that we shouldn't guarantee informationally insenstive assets, as it encourages the belief that investing is riskless. I agree, but I don't think it is possible to think investors will not create some new 'riskless' time bomb in the future. The situation is, like Minsky's financial instability hypothesis, endogenous. Currently investment grade securities are viewed like junk bonds circa 2006. For example, at the 5 year point, A-rated bonds trade at 170 basis points over Treasuries, the same spread BB-rated bonds traded at in June 2006. Historically, A-rated bonds have about a 0.1% annualized default rate, BB a 1.15% annualized default rate, so currently people don't think anything is riskless.

After another 50 years of no defaults, the new AAA asset securities will be of two types. An asset class with an even longer period of no default, like US Treasury debt, or the next generation of mortgage backed securities, which will have explicitly addressed the issues relevant to this current crisis. In the latter case, a reasonable argument can be made that such securities should not include the 2007-8 scenario in their future default rate expectations because there has been a structural change specifically rectifying the mistakes so that the 2007-8 scenario is no longer relevant (eg, all mortgage ABS now includes a 50% collateral value collapse as having a 3% probability, unlike previously).

As a practical matter, worrying about securities with 0.01% annualized default rates is a waste of time, like worrying about World Wars. Sure, they happen, but they are always different, you probably will have no control, and for most people they won't experience such a crisis here their entire working life. So the asset becomes, through no mandate or official diktat, money, and through the money multiplier, a keystone in any future financial collapse. If people generally believe an asset is AAA, it will be treated like money endogenously through the process Gorton outlines. Such assets do not acquire this characteristic merely by a rating agency, people actually believe it is true using all of their insight. They are usually write, but not always.

I think it is much better to focus on the regulations we know work, such as stable property rights, and accept that growing economies will have recessions. Robert Lucas has written about how "the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management". The current crisis is short term demand management. The mistakes, with hindsight, are obvious and should be addressed. But the general take-away should not be how to prevent anything like this from happening again, because it is going to happen again in spite or because of anything we do now. Remember, crashes are endogenous, but so are recoveries.

Samuelson Examplifies my Hypothesis

In an interview with Conor Clarke, Paul Samuelson states

You know that happiness is: 'Having a little more money than your colleagues.'

This preference is for relative status, and it is a zero-sum game. The standard utility function is ignorant of what others have, utility is solely a function of wealth. The increasing, concave utility function is a necessary and sufficient condition for risk aversion, why economists believe that risk must generate a return premium to the risk free asset. Yet in practice no one is indifferent to other's performance, and risk premiums are the exception, not the rule empirically.

Consider the following ideas by the CAPM gurus, whose model is predicated on ignoring what other's do:

“I want a product to be defined relative to a benchmark."
~Bill Sharpe

"Most investors are probably sensitive to the risk of being different from the market, even if overall variability is no higher. Value stocks do not outperform market portfolios regularly or predictably—if they did, they would not be riskier ."
~ Eugene Fama

Given this reality, people define risk relatively.

Consider a choice between two hypothetical worlds, one in which you earn $100,000 a year in perpetuity while others earned $90,000, and another world in which you would earn $110,000 while others earn $200,000. In surveys, almost everyone prefers the world which is in aggregate poorer because they would be relatively richer. Eugene Fama and many others noted that 'small stocks were in a depression' in the 1980s, even though they rose about the same as in the 1970s, its just that in the 1970s they were relative outperformers, in the 1980s, relative underperformers. For someone with sufficient food and shelter, relative wealth is the priority.

The implication of this kind of thinking is that risk becomes a deviation from a consensus, or market portfolio. If you are totally out of the market with your savings, you are taking a risk, because if the market goes on a bull run and you allocated none of your wealth to the market portfolio, you are relatively impoverished. People are not indifferent to this, which is why benchmark asset allocations are so perennially popular: people want to know what their neighbors are doing so they know how to define their risk.

Payoffs to Assets X and Y in States 1 and 2

	Total Return			Relative Return
	X	Y	Avg	X	Y
state 1	0	-20	-10	+10	-10
state 2	20	40	30	-10	+10

As shown in the table above, Y is usually considered riskier, with a 60 point range in payoffs versus a 20 point range for X. Yet on a relative basis, each asset generates identical risk. In State 1, X is a +10 out performer; in State 2, X is a -10 underperformer, and vice versa for asset Y. In relative return space, the higher absolute volatility asset is not riskier; the reader can check this for any example in which the two assets have the same mean absolute payout over the states (i.e., the average for asset X and asset Y is the same) The risk in low volatility assets is its losing ground during good times. If X and Y are the only two assets in the economy, equivalent relative risk can be achieved by taking on an undiversified bet on X or Y, which is identical to taking a position on not-Y and not-X. The positions, from a relative standpoint, are mirror images. Buying the market, in this case allocating half of each, meanwhile, generates zero risk.

The proof of this is rather straightforward, and I outline several models in this SSRN paper here.

Levitt's Abortion Result

Steve Levitt's most famous empirical finding in his best-selling Freakonomics is that abortion cuts crime. The basic idea is that abortions cut unwanted births, and because unwanted kids would have less nurturing, they would be more prone to crime. Hence, abortion lowers crime. Looking at the data between states with interaction terms, using 1973 as the cut-off date for legal abortion in the US, Levitt and Donohue argue their analysis supports this hypothesis. Many have found data contrary to this, and note that those who abort appear have socio-economic characteristics suggesting they would be better than average parents.

In a new NBER paper, Theodore Joyce notes:

Economists, on the other hand, have corrected mistakes in the original analyses, added new data, offered alternative tests and tried to replicate the association in other countries. Donohue and Levitt have responded to each challenge with more data and additional regressions. Making sense of the dueling econometrics has proven difficult for even the most seasoned empiricists.

Empirical debates can be very tricky. But the bottom line is that a positive, true result becomes more clear the more data and people look at it. If the issue becomes less clear, this favors the null that there is no effect. With GMM, instrumental variables, and interaction terms, you can torture the data to confess to anything, but when others try to replicate your results without the same bias such confessions are rarely observed.

True? No. But Strongly Felt!

In a review of Michael Harrington's The Other America, the wonkish book that motivated, or rationalized, so many 1960s anti-poverty programs:

In 1999, Time magazine named “The Other America” one of the 10 most influential nonfiction books of the 20th century. But how relevant does it remain today? As social theory, it is deeply flawed. Harrington’s culture-of-poverty thesis was at best ambiguous, at worst an impediment to making the case for what he regarded as the real solution. (In later books, he made no use of the term.)

But what remains fresh and vital in “The Other America” is its moral clarity.

'Moral clarity' is a euphemism for a strongly held belief in right and wrong, usually used by those who agree with the dichotomy. 'Manichean', 'platonic', 'naive', 'simplistic', 'absolutist', are common criticisms of these views, and usually by the left towards the right.

'Moral clarity' is one of those virtues that is ambiguous by itself, because allied with a misguide notion it is the basis for a great amount of evil. Strong moral feelings without a good discrimination mechanism, is like having a powerful gun with no aim (Mr. Evil himself, Adolf Hitler, had large amounts of it). As Oscar Wilde has noted, many people die for sincere beliefs that are rather absurd. When the most singular compliment one can say about a former intellectual pertains to their 'moral clarity', you can be sure they are irrelevant to current debates, relevant only to biographers and historians.

Risk Factors and Sex Appeal

Both relate to human preferences. Our perception of risk is primordial the way sex appeal is. People react to risky assets the way the respond to sexy women, the response is pervasive and predictable (though there are many individual exceptions). You can mathematize it and show how white sclera and smooth skin can be measured mathematically, and how these attributes relate to evolutionarily successful mating strategies, which is why we find them attractive, but this all backs up intuition. The key is, human preferences that exist can be modeled, analyzed at deeper levels. If you mathematize a human preference that generates absurd intuition (e.g., you should find fat, old women attractive), then you can be sure that thinking is on the wrong track.



See more here.

Larry Page's Commencement Address

Just a beautiful tribute to his father. I think I have something in my eye...

Modern Risk Factors

In Justin Fox's book Myth of the Rational Market, he has a little mention of Eugene Fama and Ken French's three factor model:

The Fama-French 'three-factor model' as it came to be known, and the subsequent four-factor model that included momentum, weren't really economic theories. They were exercises in data mining, with dubious explanations tacked on after the fact. What's more, they were exercises in data mining that revealed several time-honored Wall Street strategies--dismissed by finance scholars since the 1960s as folklore or worse--to be consistent money makers.

I delve deeper into the whence and why of the factors. It isn't obvious these are data mined because they are prominently used by academics and practitioners for benchmarking, so either everyone's an idiot, or we have some explaining to do. I go over the anomalie soup that gave rise to size and value. How the size effect was initially >15%, now <1%. What did they initially represent? Financial distress. That didn't work. Measure distress independently and you get a very strong, and anomalous negative relationship. Hmmm. Fama and French's factors--the market, size, and value--are the most dominant risk factors applied outside the Capital Asset pricing Model's singular 'beta' model. They are ubiquitous in the academic literature and also in fund style guides.

See this brief (2:37 second) discussion of how size was essential in uncovering that CAPM betas does not work.



see my longer videos for more, or buy the book.

More New Regulation!

The problem with Washington oversight is they haven't a clue what is important, only what is popular. The pitchfork and torches crowd is against 'rich guys in suits' and derivatives, and want to appear pro-active. So now we have:

Firms may have to put "warning labels" on their alternative products or require applicants to fill out financial-experience questionnaires, according to the administration.

"This is a game changer," said Ed Mierzwinski of U.S. Public Interest Research Group,

Warning labels? Has anyone seen a mortgage in the past 5 years? There are tens of pages, and you have to initial it in 17 places, so many none are read by your average borrower. So now we will have to initial in 34 places. If the warning light is always flashing, people ignore it. But to prioritize implies understanding the relative magnitudes of risk, and that is outside their scope. This doesn't change anything.

Getting rid of the OTS, and moving them into the Fed? Yawn. Everyone gets new business cards. The new Consumer Financial Protection Agency can now "enforce rules across a slew of financial products", and chances are these will involve a lot of busy work, mercilessly slamming anyone trying to sell a derivative that no longer has a market. They will probably also prevent financial institutions from diversifying their product base, making friend with industry lobbyists eager to prevent competition, all in the name of preventing another systemic collapse. But they will also now micromanage Community Reinvestment Act requirements, which surely had absolutely nothing to do with this crisis.

But what about the prime mover in all this, mortgage underwriting. You know, the loans without which derivatives and banks would not have collapsed? The FHA actually encouraged a program that allowed home buyers to pay up to 6% of the down payment, which is nice because that means no money down in many cases! The positive feedback loop of nonprofits getting Federal grants, giving money to poor people to buy homes they could not afford, supported by homebuilders and lenders who would then donate to legislators, could not be more corrupt. Last year, they quietly shuttered that one, but the FHA still proudly notes "The most popular FHA home loan is the 203(b). This fixed-rate loan often works well for first time home buyers because it allows individuals to finance up to 97 percent of their home loan". And the CRA lending targets that could only be acheived via lowering lending standards? The Consumer Finance Protection Agency supposedly will only double down: "A critical part of the CFPA’s mission should be to promote access to financial services, especially for households and communities that traditionally have had limited access." With the government on the hook, this merely means higher taxes, though, not systemic financial panic. That's a relief.

Regulator shopping, agency rating shopping, are all a sideshow. Sure they are bad, but it didn't matter because no regulators or investors thought those mortgage innovations had any risk. It wasn't like evil guys in suits were manipulating the system, the system was lending too much because it was thought to be profitable, safe, and morally good. It's like blaming binge drinking on beer commercials. Sure some knew it was a train wreck, but they were lonely voices, and giving Washington more power would have done zero back in 2006 because there was no large support for rolling back the insane mortgage underwriting standards that were implicitly predicated on home prices not falling.

Regulators are making sure the market won't make the same mistakes again. Perhaps the UN should inform Germany not to start any more two-front wars in Europe this century (didn't work out so well in the 20th)?

Strategy Momentum?

A big hedge fund is known for hiring a lot of traders, giving them each a small amount of capital, and then firing them when they lose, say, 5% of their capital. With this rule, they are basically running a strategy momentum portfolio. I know the fund is very successful, with about 140 traders at any time and getting rid of 25% or more each year. They have several billion dollars under management.

I'm not sure, however, this is all a smokescreen. They could make all their money doing some basic strategies, and the 100+ traders coming and going acts as camouflage. But any firm I have known implements a capital rule along similar lines: if you make money, you get more capital, if you lose, you get less. For most traders just starting out, this basically means you will be at 10x next year, or out. This make perfect sense if you think their profits are a function of their alpha plus the specific strategy return, which is often difficult for outsiders to see. Nevertheless, the result is pretty straightforward. It is conceivable that momentum in strategies is strong, and only a hedge fund, with its unlimited, discretionary, and secretive scope, can avail itself to it.

Actual strategies usually are not nearly as homogeneous as those reflected by standard hedge fund indices (converts, distressed, long/short), but much more heterogeneous. Think of them as factor bets within asset classes. Further the factors are not simply macro factors like the market, or size, but also correlations, dispersion, credit spreads, mean reversion. The asset class/factor combinations are many. Thus, this 'strategy momentum' strategy would be difficult to test academically. But if it does work, it gives large, multistrat hedge funds a big advantage. Their only disadvantage is that there is a large amount of operational risk with such comings and goings, and from a PR perspective, it sounds horrible. Rarely does a multistrat ever admit to actually doing this, they merely say they are doing individual analysis all the time. That many (most) asset managers basically allocate capital using the rule, 'did you make money last year?', is perhaps why hedge funds seem to generate positive alpha in contrast to long-only mutual funds (such funds don't have access to near the same scope of strategies).