Wednesday, October 31, 2007

Excellent growth and let's cut rates again!

GDP growth galloped along today at 3.9%, and yet YOUR Fed cut rates. Interesting.

Our all-knowing eye in the sky Fed calculates GDP by obtaining "nominal" GDP then subtracting a price deflator (in other words, they subtract some inflation amount from nominal GDP) Nominal GDP growth was 4.7%, the deflator is .8%, and so we get that 3.9% number...which was mid/late 90s type of growth.

I will not get into details, but, suffice to say, I don't believe that the GDP Deflator was a 40yr. low .8%. This is important because the deflator is subtracted from current nominal GDP growth (4.7%) to obtain "real" GDP growth: 3.9%.

I simply do not take such a sanguine view of inflation, in light of obvious indicators of increased inflation expectations (gold, dollar index, commodities, etc., etc.) no matter what data the Fed is providing at the moment. I will take market reaction over a central government's data processing unit any day of the week.

Wave of Litigation

As if an 8 Billion write-off was not enough, Merrill is being hit with a shareholder lawsuit. They will not be the only ones, and sooner or later all the large investment banks that had subprime exposure will be embroiled in litigation.

It will be interesting to see the Plaintiff's try to circumvent the business judgement rule in law as applied to "reasonable" securities will also be a good test to determine the facility of our legal system to conceptualize complicated securities.

Article below:

NEW YORK (Reuters) -

An investor lawsuit has been filed against Merrill Lynch & Co Inc
(MER.N: Quote, Profile, Research), contending that the company issued
false and misleading statements about its exposure to risky mortgage
investments, the plaintiffs' lawyers said on Tuesday.

The lawsuit, which the lawyers said was filed in U.S. District Court
for the Southern District of New York, seeks class-action status. It
was brought by law firm Coughlin Stoia Geller Rudman & Robbins LLP on
behalf of an institutional investor, Life Enrichment Foundation.

The complaint accused Merrill of issuing materially false and
misleading statements about its financial exposure to collateralized
debt obligations (CDOS) containing subprime mortgage securities.

The company's statements "were materially false due to their failure
to inform the market of the ticking time bomb in the company's CDO
portfolio due to the deteriorating subprime mortgage market," the
complaint said.

Also named as defendants are Stanley O'Neal, who was ousted as Merrill
chairman and chief executive on Tuesday, firm Co-Presidents Ahmass
Fakahany and Gregory Fleming and Chief Financial Officer Jeffrey

The complaint was brought on behalf of purchasers of Merrill stock
between February 26 and October 23.

A Merrill representative was not immediately available for comment

Wednesday, October 24, 2007

Stress Testing

A popular online encyclopedia defines a "stress test" as the following:

"Stress testing is a form of testing that is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. Stress testing may have a more specific meaning in certain industries."

Most people in the quantitative financial community (yours truly included) have performed "stress tests" on portfolios of financial assets - sometime one has to "sum up possible futures and average to the present" (or simply ask "what is the worst thing that can happen?) to get a good idea of what your portfolio might look like when "Black Swans" arise.

It goes without saying that there is an initial decision of magnitude with regards to the stress test - how stressful do you want the test to be?

Today, the CEO of a very large investment bank that was forced to write-off over 8 Billion in financial assets stated (paraphrasing) that his "risk managers" never thought to provide a harsh stress test and that events caused asset prices to go below the "most punitive" stress event scenarios.

Quantitative aptitude (the ability to run models) is a different skill set from creativity (the ability to imagine events that might be more stressful than one has seen in the past).

More on the Paper Dragon

Warren Buffet has weighed in on the China question.

An economy based on defacto central planning and cronyism cannot enjoy double digit GDP growth forever.

It would better serve an investor to think about the ramifications to global asset prices WHEN China's stock markets "correct" than to think about investing in Chinese companies.

Tuesday, October 09, 2007

The convergence of "risk".

"Convergence" has long been talked about in terms of ReInsurance and capital insurance contract is just a binary put option, for example. A collection of these options will likely converge (Central Limit Theorem) into stable normal distributions. But notice in the article how local (micro) knowledge regarding specific ("idiosyncratic" in the finance lexicon) risks can obviate the need for assessing risk as a truly random variable in a population.

Here is a pretty good (albeit general) discussion of how Reinsurers think about risk, it is not exhaustive by any means, but it does illustrate the fact that "risk" is not "beta" or sigma/SDEV or any single measure. "Risk" has many origins. We just choose to distill its antecedents into something more tractable.


interesting section:

"So I think volatility and liquidity concepts are concepts applicable to low-risk, relatively low-return risk classes. Casualties, reinsurance and Cat reinsurance are high-return, high-risk classes. And they demand a different set of technical tools and methodologies to accurately assess the risk and actually -- accurately price the risk.

So when I look at investment banks and I look at VAR, value at risk, which is a daily measure, and I look at [reinsurers], which is capital at risk, which is an annual measure, one measures daily volatility. One measures downside risk. I think, again, for those risks which are long term in nature, which are difficult, which are severe, you're much better off with the CAR concept than you are with the VAR concept.

We have within the organizations, all the reinsurers represented today, we have great quantitative skills. Our actuaries are as smart as the quants in many cases, in all cases. At a number of our capital markets competitors, when a math major leaves college, it can go two ways. They can either go become a quant on Wall Street, or they can become an actuary for the insurance or reinsurance industry. I haven't been able to see any kind of difference in terms of the capabilities of the people who take either one of the two paths. They tend to be very similar.

I think the difference is, is that while the math is generally the same between capital markets and reinsurers, I think the atmosphere within which they work is distinctly different. There is a long culture within insurance and reinsurance companies of asking the actuary to come up and give you the long -- the bad answer, the answer you don't want. The worst thing as a CEO is when the actuary walks into your office and says can I talk to you.

I'm not sure that that always happens sometimes on the capital markets side, where in fact it is difficult to see how the actuary or the quant has the ability to withstand the blandishments sometimes perhaps of the trader. In our shop and in most reinsurance shops, the actuary and the underwriter are coequal in terms of their analysis and coequal in terms of their authority to put the Company at risk."

Sunday, October 07, 2007


I debated for some time whether or not to post the following article from the New Yorker:

Why? Because in a world where conformity and timidity guarantees a certain amount of safety, there will always be iconoclasts who see the world not as risk, but as opportunity. We should celebrate the "failure" of these individuals, not villify them for not playing it safe.

The tragic/flawed hero subject of the article is someone I have alluded to several times on this blog. I would agree with the article that Victor is someone who has an almost preternatural ability to shoulder risk (in all forms of his life). He just cannot seem to tolerate a day without the presence of thought-concentrating levels of risk. This perspective towards life and investments should serve as more inspiration than cuationary tale.

(Of course, I have to disclaim part of the above with the caveat that investors should always be aware of what the strategy and risks a fund is employing. In this case, it was clear: To generate high returns, one must take high amounts of risk. There are no free lunches, and the current malaise effecting several prominent hedge funds serves to illustrate that funds advertising high returns and low risk might suffer from the "past performance is no guarantee of future success" mantra)

What the article does not say is how generous a man he is and will continue to be. I never had Abalone (a shell-fish delicacy) in my life prior to meeting Vic Niederhoffer, and his teachings and way of analyzing the world has caused me and hundreds of others immense benefit. He will do more than merely "survive".

Friday, October 05, 2007

No surprise...

About criminal investigations at Bear following the closure of a couple of its fixed income hedge funds (which had drifted considerably from the strategies their prospectus and disclosures said they would follow) due to large (70-80%) losses. This headline risk is something most financial institutions discount...but one can see how quickly it can cause massive damage to a firm.

Federal Prosecutors Launch Probe of Bear Stearns Funds
October 4, 2007 7:01 p.m.

Federal prosecutors have launched a criminal investigation into two
Bear Stearns Cos. mortgage-related hedge funds that collapsed during
the summer, according to people familiar with the matter.

The U.S. attorney in Brooklyn has made a request to Bear Stearns for
information related to the hedge funds, whose failure cost investors
$1.6 billion, said these people. The probe is in the early stages, the
people added, and has not generated subpoenas.

The specter of a criminal investigation is clearly bad news for the
embattled Wall Street firm, which is already under the microscope by
the U.S. Securities and Exchange Commission. Thursday, two weeks after
reporting an abysmal third quarter marred by broad declines in their
asset-management and fixed-income operations, Bear officials tried to
put a positive spin on the firm's future during an investor gathering
at its New York City headquarters.

Wednesday, October 03, 2007

The Paper Dragon redux...

Markets are, as evidenced by the recent peformance of the Hang Seng, finally waking up to the Macro prospects for China in light of a depreciating dollar against a Yuan that the PRC will not allow to
appreciate. Something has to give, and it will. As I have said many times, China (which I have pejoratively called "The Paper Dragon") is in deep trouble. If it allows the Yuan to appreciate, its export industry will be "adversely effected". If it does not, rampant money creation (read: inflation) is the result.

Now, academics (in China, no less) are waking up to the facts of life as well. China will now face an immense challenge to its legal rule set as the temptation to keep politically connected (yet functionally bankrupt) businesses afloat...which is the "objective necessity" (to borrow from the incomprehensible Marxist lexicon) of central planning. Ruling with an Iron Hand on a sliding scale indeed.



Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans. They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.

The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks. Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility. China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.

This has happened in many countries undergoing reform besides China. For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings.