May 31, 2009

From the Age of Frankenstein to the Age of the Cockroach

I finished reading A Demon of Our Own Design. The last chapters venture into some profound and intriguing philosophical considerations. I don't quite agree with everything RB says, and I'll probably get back to that in future posts, but there are copious servings of food for thought there.

In conclusion, Doctor Bookstaber's prescription for curing or at least improving our current accident-prone financial system boils down to this: "Simpler financial instruments and less leverage". This will usher in a less finely-tuned system but it will be coarse and robust enough to survive unexpected adverse change.

Like the lowly cockroach, it won't be the most advanced and sophisticated (financial) organism out there but a least it won't be on the brink of annihilation each time a radical change in the (financial) environment comes along.

We lived in an era of wide-eyed innovation in a young industry (quantitative finance is around 20 years old) where the mantra was "let's try anything even it might blow up in our faces". The financial industry may now be entering a more mature phase, where tinkering away at the risk of producing potential financial Frankensteins is no longer deemed acceptable. 

The big question obviously is: is it even possible to set back the clock on innovation? And come to think of it, picking the cockroach as the ultimate basic, no-nonsense, master-of-survival creature might have been slightly misguided. It turns out there are 4,000 species of cockroach, some extremely advanced and, yes, complex.  

May 28, 2009

When Liquidity Vanishes

I've been traveling lately so I've had less idle time to come up with halfway interesting material to post. I'm still working my way through Bookstaber's demon of a book. He covers a lot of ground, not always in chronological order and it's a little all over the place but I'm finding many gems.

For example, he brings up one of the key assumptions underlying the perfect market model namely that markets are liquid enough so that buying and selling even in large quantities do not affect prices. Anybody with even a minuscule exposure to real life markets knows this assumption to be ludicrous. Liquidity, perversely, seems to be there when it's not needed and vanishes when it's most needed. When there is panic selling, liquidity dries up faster than a puddle of water in the Sahara desert.

Not only that but big orders do move prices even in liquid markets under normal market conditions. Why is that? Because of the adverse selection problem faced by market makers: if a big sell order, say, comes a market maker's way, he or she has no sure way of knowing if the seller is selling for benign reasons (portfolio rebalancing, for example) or if the seller knows something the market maker doesn't know (new negative fundamental news on the stock for instance). The market maker also doesn't know if the seller is done or if that sell order is only the first of a flood of sell orders. The MM is rightly scared of being tricked into catching the proverbial falling knife.

So what's a rational market maker to do? He or she drops the bid, substantially so if need be. So here you have a liquid market with no news out and yet a sell order can start a kind of psychological chain reaction resulting in a price dislocation. The 1987 crash is one extreme example of just such a phenomenon, taken to its grotesque caricature. On that fateful day, the more the NYSE specialists lowered their bids to attract potential buyers and bottom fishers (and to cover their asses), the more panic they created for the very simple reason that any rational market participant watching the price dislocations concluded that something really bad was going on and ran for cover. The lower bids actually scared away all the buyers. Very similar events took place in the Falls of 1997, 1998, 2001 and 2008.

May 20, 2009

Financial and Aviation Disasters: A Comparison

While reading Richard Bookstaber's memoir, the compulsively readable A Demon of Our Own Design, I started thinking about his point that engineering has improved safety in every field except in finance.

Before I go any further, I think there is a problem with this statement in that calling the invention of new trading vehicles and trading methodologies "engineering" is more a marketing ploy than anything else. Financial engineers are not really trying to design a machine, they're just trying to make money. If those products and strategies happen to bring a social good, great, but that's not really the goal.

However, for the sake of argument, let's pretend that a trading operation is comparable to an airplane, say. Then a quant trader would be the equivalent of a test pilot who would also be the engineer in charge of designing and improving airplanes. There no denying the fact that flying has become safer and safer whereas running a trading operation has become more and more accident prone with worse and worse consequences when accidents do happen. The aeronautic equivalent of what has been going on in the financial world would be a situation where ever bigger, faster and more complex planes crash more and more often and when they crash, they do so over more and more populated areas and therefore where fatalities per crash are ballooning. That's clearly not what is going on in the aviation industry. Why is that? What accounts for the drastic difference in the safety profile of flying and designing an aircraft on the one hand and managing a trading operation on the other?

I guess the first difference between the fields is that there is no such thing as a single individual responsible for designing an aircraft, testing it in flight, then improving on its design and finally flying it on a regular basis, with passengers . There might have been such individuals in the aviation industry's infancy (think the Wright brothers) but nowadays these are totally separate functions taking place in totally separate organizations. By contrast, in trading, the birth of quant traders in the 1980s has meant that the same person (or team) usually designs the product or strategy, tests it theoretically and in the markets, and then manages the trading book on a continuous basis. Not only is the trader in charge of the whole process involving a given financial product but he or she is usually one of very few individuals in the firm who really understand the product and its market. 

One could also say a big difference between the two fields is that the primary goal of aircraft engineering is to improve safety whereas the primary objective of trading is to improve returns. But that's not exactly true. In theory, aircraft engineering's primary goal is to produce better planes that fly faster, carry more people on the non-negotiable condition that it also improves (or at the very minimum does not decrease) safety.  Any plane that decreases safety even an iota, no matter how incredible its other attributes, will not make the cut (let's not mention corruption and forged tests, that's a whole other subject). In finance, theoretically, the main players try to maximize returns for a given risk. But in practice, what we often see are traders and organizations that repeatedly ignore, misprice and/or neglect the risk aspect. Why is that?

I guess one reason is that the built-in incentives for traders on the one hand and for pilots and aircraft engineers on the other differ wildly. Should the plane crash, its pilot usually dies, the engineer's reputation is shot forever and the aircraft maker most probably goes bankrupt. Should the trading book implode, the trader might have to leave his or her firm but will most likely be very much in demand at other firms (see Meriwether, John). His or her reputation will not really suffer. Even if the firm goes belly up, the trader won't. In fact, the trader doesn't even have to return his or her previous bonuses. Whatever he or she made during the fat years is his or hers for the keeping, even if it turns out the fat years were an illusion because the models were wrong and the risks severely underpriced. 

Bookstaber actually brings up the airline industry and more specifically the 1996 ValuJet crash in the Everglades as a case study to look, not for differences, but for similarities to financial disasters. He makes a crucial point when he observes that "flying an airplane is by nature fraught with tightly coupled processes. You can't pause the flight in midair to do some reengineering if something goes wrong." "Tight coupling means that components of a process are critically interdependent; they are linked with little room for error or time for recalibration or adjustment".

As in finance, when an accident occurs in the aviation industry (or, in Bookstaber's other example, in the nuclear power industry), it always seems, ex post facto, that the precise sequence of events that led to disaster had an infinitesimal probability of happening (100-year floods anyone?) and, if not for the worst luck, should not have happened. But the reality is that in such highly complex, tightly coupled environments, there is almost an infinite number of potential sequential failures. In other words, things can go wrong in a million different ways, each very unikely. As Bookstaber says, "the probability of any one event is small enough to be dismissed, but together, with so many possible permutations and with combinations beyond comprehension, the odds of one or the other happening are high". Moreover, perversely, these types of accidents are "borne of complexity, so adding safety checks to try to overcome these accidents can be counterproductive, because they add to this complexity"

Obviously I haven't even begun to cover the subject and I'm sure I overlooked a hundred pertinent points of comparison between financial and aviation disasters. Come to think of it, this kind of ties in with a point Nassim Taleb has been making incessantly, that the financial system, as it has evolved, inevitably leads to recurrent catastrophes because it is inherently vulnerable to black swans. 

May 15, 2009

Bookstaber

In his October 2008 introduction to the latest edition of A Demon of Our Own Design, Richard Bookstaber makes a couple of interesting points.

The first is that, during market crises, markets become correlated in unexpected and seemingly irrational ways. We've seen this happen often and dramatically enough last Fall that it's become common knowledge by now. But Bookstaber reminds us of a striking historical example of just that phenomenon: the silver collapse of 1980.

"The decline in the silver market brought the cattle market down with it. The improbable linkage between silver and cattle occurred because the Hunt brothers needed to raise capital to post margin as their silver positions declined. They happened to have sizeable positions in cattle, so they aggressively sold out of them. The end result was that silver and cattle, which have nothing to do with each other, dropped in unison. [...] what matters is who owns what, and who is under pressure to liquidate."

The second point he makes is that, while "in most fields, the evolution of engineering reduces risk, [...] this doesn't seem to be the case for engineering in the financial markets."

May 13, 2009

From an Existential Question to Another

What a difference a few days make! Only last week, the big question was still "Is this a bear market rally or is it something more, like a new bull market?". Now, the pressing question is "Is this a correction in the ongoing rally off the March lows or is this something more, like a resumption of the bear?"

The amount of anxiety,  joy, hope or fear with which the questions are asked usually tell you everything you need to know about the person's book. If hope was there in the first question, fear would be present in the second and vice versa. Although I'm sure there are those who, having waited until the S&P 500 broke out of that congestion zone around 880 to get long, have seen the index go up all the way up to almost 930 then reverse hard this week. As I'm writing this, we're back to the congestion zone (884). What the market does now should be very telling. Actually, how the market behaves here should go a long way toward answering both those vital questions.

May 9, 2009

Nothing but a Liquidity Tsunami?

Barron's Michael Santoli is wondering if the rally off the March lows, which he has doubted every step of the way, seeing behind each green shoot a new reason for a resumption of the bear, can be "as simple as government-created free money meeting a skeptical investment world and washing over all asset classes at once"

The very idea makes Mr. Santoli "very uncomfortable". That's funny because when we had a market-created sudden liquidity crunch last Fall, the very "simple" cause of a market collapse across all assets, he wasn't so quick to share his comfort level with his readers. Who cares where the liquidity comes from? The bottom line is that when liquidity is removed drastically and unexpectedly, markets tend to crash and when it's added drastically and unexpectedly, markets tend to rally strongly. To paraphrase Clint Eastwood in Unforgiven, uncomfortable's got nothing to do with it. 

When Effort Trumps Ability

I really enjoyed this New Yorker article by Malcolm Gladwell of The Tipping Point, Blink and Outliers fame. It's about David and Goliath, Laurence of Arabia and the full-court press in basketball. The main point is that effort can trump ability, if you're able to put in the required effort, that is. The money quote: "When underdogs choose not to play by Goliath's rules, they win."

May 7, 2009

The Market

The market has now obviously priced a little more than green shoots but probably a little less than a full-fledged V-shaped rebound in the economy. Depending on what kind of data we get going forward, we might very well stay in something like a 900-950 range on the S&P 500 for quite a while. 

There are a few clues that this rally (+38% for the S&P since the March lows) is getting a little tired. The most significant in my opinion is the relative underperformance of the NASDAQ yesterday, especially considering it had been a solid outperformer since March. The banks, as a group a stunning outperformer (it more than doubled) during this rally, might have a difficult time keeping this torrid pace after the stress test results are released. No matter what the results are, some banks will come out worse than others and we will see, as we started to these past few days, some divergences within the group. 

May 2, 2009

Green Shoots vs. Swine Flu: When Memes Collide

This has been an interesting week from a crowd psychology, behavioral economics point of view. The month-long hyping-up of the "green shoots", "glimmer of hope" meme, become quite formidable, at last came across a worthy opponent: the swine flu [that's apparently a politically incorrect way of naming it and so is Mexican flu: it should be called Influenza A (H1N1). Who said that? The WHO, that's who]. For a few days at least, the pesky upstart looked like it had a chance to unravel the rampant optimism that followed 6 months of utter despair in the financial markets. But the paucity of victims (so far) and depression-fatigue combined to defeat (so far) the pandemic meme in the news cycle as well as in the markets.  

Obviously, this is only the first round of a long fight. This flu virus will probably return later or become more lethal or both. The market is guaranteed not to keep going up at the torrid pace it has been since the 666 low in the S&P 500 (+30% in under two months) and the economy, if it indeed stopped worsening at a catastrophic pace, will not return to healthy growth any time soon. We can also be assured that more out-of-nowhere potential catastrophes will come and threaten any complacency that the worst is over and the only way from here is up. 

For a comparison of the swine flu and the "financial flu" and why we are much better prepared for the former than we ever were for the latter, read here. For a must-read interview of a head of state who aims, among other things, to be a "ruthless pragmatist" when it comes to the economy, read this. Speaking of which, I was very surprised to read an editorial by Thomas Donlan in today's Barron's that was kind of favorable to President O.'s policies in general and to the way the Chrysler situation was resolved in particular.  

Getting back to the Mexican swine A (H1N1) influenza virus, this great little NYT article will go a long way toward diffusing any sense of panic you may have.