Intreresting article on The Quants

[Steve O]

Man this stuff outta be illegal

The Quants: Formula for a Financial Crisis - WSJ.com

[donheff]

Sounds like a good read. If the author did a good job it will be like a fiction thriller.

[TooFrugal]

I'd buy that book. It sounds pretty interesting. It read a lot like "When Genius Failed", which was a really good book. Too bad history had to repeat itself, on an even larger scale, from one book to the next.

I've really been focused on investing in my business more since last year since I can control that, but who controls the stock market is, to borrow a quote from the past, "a riddle wrapped in a mystery inside an enigma."

[Independent]

Quote:

Originally Posted by Steve O Man this stuff outta be illegal The Quants: Formula for a Financial Crisis - WSJ.com

I assume everyone involved in these funds had heard about LTCM and could explain why the new models were vastly superior to anything that LTCM had. You know, It's different this time.

Regarding the "illegal" comment, this is the impetus for a transactions tax. It doesn't make this activity illegal, but it does make it harder to justify very round trips for very small gains.

[TooFrugal]

Quote:

I assume everyone involved in these funds had heard about LTCM and could explain why the new models were vastly superior to anything that LTCM had. You know, It's different this time.

"When Genius Failed" was about LTCM but the difference is they only almost brought down Wall Street.

The scary part was that even after LTCM failed miserably the people in charge set up shop again and investors still turned their money over to them to invest/gamble away.

[audreyh1]

Quote:

Originally Posted by TooFrugal "When Genius Failed" was about LTCM but the difference is they only almost brought down Wall Street. The scary part was that even after LTCM failed miserably the people in charge set up shop again and investors still turned their money over to them to invest/gamble away.

And in spite of a pretty good scare, we (US congress and administration) rolled back even more regulation, quit enforcing several existing regs, and let investment banks triple their leverage.

Such a big, big surprise when things blew up way worse than LTCM.

Audrey

[Maurice]

As someone who was pretty close to this I can say that the quants (or more precisely, the traders and risk managers who used their models) made the same mistake most of the country did. They simply didn't account for the possibility of a non-localized housing downturn. (in quant speak, they assumed a very low correlation on defaults as long as the underlying mortgages were sufficiently dispersed geographically).

That same erroneous assumption was broadly shared by much of the Government, Greenspan and his Fed, John Q. Public using his house like an ATM, and of course John Q. Speculator taking out the exploding ARM to be able to flip the latest Vegas condo.

But we find it psychologically necessary to find a group to blame for bubbles. Its decidedly unsatisfying to spread the blame throughout the broader society. Bubbles therefore are something that a particular group perpetrates on society, not a consequence of the mass psychology of society itself.


Enter the quants...

[Independent]

I see the great contraction as composed of two parts. The first was the housing bubble. The second is the morphing of the housing pop into a crisis that would have led to the next Great Depression except for billions of tax dollars (and actually did lead to the Great Recession).

Step One has many parents. Ordinary buyers who believed that prices could never go down; the Chinese gov't that manipulated the RMB and generated too many investment dollars looking for a home; a US gov't that thought any increase in home ownership was always a Good Thing; lenders that cynically loaned to people who were likely to default (because they assumed they could always foreclose and sell at a profit); CMO developers who misled investors; investors who bought things they didn't understand...

But Step Two was exclusively in the financial sector and their apologists in the gov't. Too much risk sitting on too little capital.

The tech stock bubble never moved to step two because tech stocks were generally owned by people investing their own money. When they went down, people lost their money and that was the end. We had a modest recession. Houses are bought with borrowed money that came from another tier of borrowing and sometimes still another tier of borrowing. It's all the borrowing (and too little capital to buffer losses) that brought the financial system down.

OTOH, LTCM was viewed as a near disaster for the system. IIRC, LTCM was also all levered up with lots of borrowing on a modest capital base. That's a great way for the owners to maximize profits, but bad for everbody if it crashes too hard.

[Maurice]

I agree with your step two - there was (is?) way too much leverage in the banking system.

[audreyh1]

Yep - it was the step two (the excessive leverage and inappropriate (excessively risky) use of exotic financial instruments) that caused the crisis - not step one.

And step one (the housing bubble) was exacerbated/prolonged by use of financial instruments that "buried" the inherent risks of mortgage lending causing a lot more investors to take excessive risks. Of course the fact that the ratings agencies treated these as super-low risk investments (AAA ratings) was another spin on the "fancy financial instruments".

My take away from this is beware of fancy financial instruments/innovations. Supposedly reducing risk they instead create a disaster situation when things inevitably go wrong. And they are also a great way for the financial sector to increase their profits while other people end up holding the bag.

Audrey

[Maurice]

Quote:

Originally Posted by Independent I see the great contraction as composed of two parts. The first was the housing bubble. The second is the morphing of the housing pop into a crisis that would have led to the next Great Depression except for billions of tax dollars (and actually did lead to the Great Recession).

Quote:

Originally Posted by Independent But Step Two was exclusively in the financial sector ...

Actually, those two descriptions of step 2 are not the same. A deflating housing bubble would have been highly recessionary whether the banking crisis occurred or not. Consumers were (are) over-leveraged as well, remember.

[unclemick]

I seem to remember ?? back in the 1980's a run on Oceanographers cause they had the the math skills to design trading and market beating equations.

Other than Buffett and Bogle cautioning - dat's a no no - over many years - what else is new?

'God Looks After Drunkards, Fools and The United States of America.'

'The number is not the thing.' One of my favorite misquotes.

heh heh heh - Psst - a certain famous person's son is a quant. My lips are sealed.

[Independent]

Quote:

Originally Posted by Maurice Actually, those two descriptions of step 2 are not the same. A deflating housing bubble would have been highly recessionary whether the banking crisis occurred or not. Consumers were (are) over-leveraged as well, remember.

I'll agree that some sort of recession was baked into the bubble popping. But, I think that the dramatic steps to "save the system" with tax dollars were driven by too much risk on too little capital. I also think that the recession is twice as bad (I'm making up the number, but think it's in that range) because of the risk/capital issue.