As GS soap opera plays out, here is what I think.
Greg Smith's "Why I Am Leaving Goldman Sachs" parallels Mark Zuckerberg's blog post after Jessica Alona broke up with him. Mark called her "bitch" in his blog. Glaring lack of Grace.
The guy worked at GS for almost 12 years and took full monetary advantage of GS's culture. Since he doesn't return his bonuses, he is as obnoxious as the rest of GS managers he describes.
Now, what about Wall street at large?
Part of the financial crisis of 2007-2008 was due to the rating agencies rating risky bonds as AAA bonds pursuing profits and competing with each other for the clients-bond issuers. They, in effect, were taking advantage of the pension funds buying these bonds based on the AAA rating. I asked the head of the research of one of the rating agency about that. He answered that those who buy the bonds have to do their own research. Sounds similar to the Blankfein's response to why GS was selling to its clients the tools which were not appropriate for them. Blankfein said that the clients buy
instruments with the predefined risk profile to play certain role in their portfolio and that's, in the end, client's decision which instruments to buy.
The broader part of the financial landscape is institutional wealth management based on the model portfolios. The clients are duped to believe that there is scientific prove behind the models. They are not told that the investment theory cannot be proven experimentally, and, therefore, it's not a scientific theory. The wealth management is a huge industry swallowing one third of the client's money over the thirty-forty years of the client's portfolio management.
How exactly is GS different? The level of cynicism?
Showing posts with label Wall Street. Show all posts
Showing posts with label Wall Street. Show all posts
Sunday, March 18, 2012
Monday, March 5, 2012
S&P bull markets
Next week marks the third anniversary of the current bull market cycle in U.S. stocks. Back on March 9, 2009, a day not easily forgotten in the annals of wealth destruction, the S&P 500 sank to a 12-year low of 676, the bottom of the worst bear market since the Great Depression. Since then, the S&P has more than doubled. In fact, this bullish run in stock prices is in the top 10 in terms of duration (1088 days) and so far has delivered a bigger pop in share price appreciation (102 percent) than the 96 percent gain during the long upswing in stocks that lasted from July 23, 2002 to October 9, 2007—just before the economy and the U.S. financial system became a heaving mess.
Investors for the most part prefer to put their money in bonds and money market accounts rather than stocks. Investors have pulled more money out of U.S. domestic mutual funds than they’ve put in for five straight years. They withdrew $134 billion last year, according to the Washington-based Investment Company Institute. Trading volume in S&P component stocks, at near comatose levels this year, is down 20 percent through Feb. 21, year-on-year, according to Deutsche Bank.
Illustration Courtesy Bespoke Investment Group
Illustration Courtesy Bespoke Investment Group
You know things are bad when Wall Street firms such as Blackrock, the world’s biggest asset-management firm, start taking out multiple-page ads in the financial press urging investors to rethink the cost of cash. At a Feb. 29 speech in New York, Blackrock Chief Executive Officer Laurence Fink said: “I have said many times that I would personally be 100% in equities.” Really? Haven't you, Mr. Fink, already invested somewhere in private equity? Like Mitt Romney in Golden Gate Capital? (http://mittromney.abouttruth.net/2012/01/27/romney-tax-returns-detail-funds-not-included-in-ethics-forms/)
I have an advice for you: hire the best bond manager you can get and let him to run the total return fund which has been under-performing its benchmark (http://money.usnews.com/funds/mutual-funds/intermediate-term-bond/blackrock-total-return-fund/mjhqx)
The fund has returned 6.37 percent over the past year, 11.73 percent over the past three years, 4.53 percent over the past five years, and 4.10 percent over the past decade.
Monday, December 20, 2010
The great bank heist of 2010
By Brett Arends
Wall Street wins, Main Street pays — again. This was the year America finally took on the power and greed of the Wall Street banks. And the banks won.
They dodged the bullet of real reform, probably for all time. They bounced back to post huge profits, helped by legal theft from the middle class. They completed their takeover of both political parties — and bought themselves a new Congress even more pliable than the old one.
Middle-class America is flattened, devastated and broke. The bankers that caused it all have escaped punishment. They’re raking in huge profits. Oh, and the tax cuts just got extended for high earners, too!
Game over.
Of all the signs of Wall Street’s gloating and arrogance this year, which one stands out the most?
The image of the president of the republic, traveling to New York to reassure them that they wouldn’t suffer too much from new regulations?
Or maybe billionaire Steve Schwarzman, the private-equity oligarch at Blackstone Group, complaining that any attempt to make him pay actual income tax on his income was akin to “when Hitler invaded Poland.”
Not France. Not Belgium. Poland.
In the aftermath, he grudgingly issued a partial retraction.
In any civilized society he would now be pariah. He’d have to eat alone at unfashionable restaurants, and the waiters would spit in his soup.
Instead, as the year drew to a close, I saw him being interviewed on TV, the hosts hanging on his every word.
In 2010, Wall Street’s year, Schwarzman’s only real sin was getting caught flaunting his contempt for the nation.
Far worse went on behind closed doors.
Consider the Dodd-Frank reform act — all 2,300 pages of it. Sure, it fills in a few regulatory gaps, ends a couple of the more gratuitous abuses. You have to throw a few scraps to the masses.
But most of the reforms are meaningless. New rule books and committees. Bah. They’re like half-built fences. Anyone can just walk around them.
As for the new consumer finance watchdog? The agency that’s supposed to stand up to the banks will be housed… within the Federal Reserve. Literally, it will be a tenant of the banking system.
Champions of the “reforms” say this won’t really matter. But if that’s the case, why did Wall Street fight so hard to make sure it happened?
There are no coincidences in Washington.
Meanwhile, missing from this giant “reform” bill was any actual, serious reform like threatening crooked bankers with real jail time. Or ending the “other people’s money” racket of securitization, or smashing “too big to fail” megabanks into smaller firms that can never again threaten the republic.
Instead we’ve enshrined “too big to fail” as national policy. A standing taxpayer guarantee to the biggest banks. What a deal!
It’s amazing when you think about it.
Look at the chaos and catastrophe these guys have left in their wake. One middle-aged man in five is out of work. Tens of millions of families have been financially wiped out. The national debt has nearly doubled.
If inner-city gangs had done this to America, we’d have martial law. If Arabs had done it, we’d have launched another war.
Wall Street bankers? They’ve walked away scot free. And they’re actually being rewarded.
By keeping short-term interest rates near zero, the Fed is basically robbing your grandmother, and other hard-working savers, and giving to Wall Street. The banks borrow from us for free, and then lend us back our own money at interest by purchasing Treasury bonds.
And in a perfect circle of cynicism, the beneficiaries of bailouts are now spending some of their loot lobbying our Congress to overrule us on reform.
The commercial banks and investment firms spent a total of $118 million lobbying just in 2010, according to the Center for Responsive Politics.
That included $4 million spent directly by Citigroup Inc. (NYSE:C) , nearly $3 million by Bank of America Corp. (NYSE:BAC) , $3.5 million by Goldman Sachs Group Inc. (NYSE:GS) and $2.8 million by Schwarzman’s Blackstone.
This is in addition to the vast campaign contributions the top brass at these firms have lavished on pliable congressman, and indirect political lobbying through trade bodies like the American Bankers Association.
But it’s unfair to give the bankers all the credit for subverting democracy.
They couldn’t have done it without the Democrats.
Wall Street has spent years capturing the party establishment.
Think of the lavish campaign checks. The lucrative hedge fund “adviser” jobs. The pervasive influence of pinstriped “progressives” like Larry Summers and Bob Rubin.
This was the year the investment paid off. Big time.
Top Democrats were too terrified of alienating their sugar daddies to pass real reform.
But the joke was on them.
First, Wall Street’s campaign contributions aren’t that important — they only account for about 10% of the party’s money. The Democrats could have lost all of it (an unlikely scenario in any event) and still been in business.
Second, the Democrats would have got a lot more credit — and contributions — from the rest of America if they’d stood up to Wall Street.
And third: Sucking up to Wall Street didn’t help them anyway. Wall Street still turned Republican. The American Bankers Association, J.P. Morgan Chase & Co. (NYSE:JPM) , Citigroup, Bank of America, even Goldman Sachs: This time around, more than half their donations went to the GOP.
Most Americans don’t realize it, but this talk of a “grassroots” and “anti-establishment” election was a bunch of hooey. What really happened was that Wall Street has just bought itself a new, even more compliant
Congress.
The new Republicans are already fawning over the bankers. They’re promising to stop the restrictions on (ahem) “financial innovation.” Congressman Spencer Bachus — the next chairman of the House Financial Services Committee — actually said “Washington and the regulators are there to serve the banks.” Let the good times roll!
It was the greatest heist in history. The bankers pulled it off under everyone’s nose.
(Ref: MarketWatch, December 21, 2010)
Wall Street wins, Main Street pays — again. This was the year America finally took on the power and greed of the Wall Street banks. And the banks won.
They dodged the bullet of real reform, probably for all time. They bounced back to post huge profits, helped by legal theft from the middle class. They completed their takeover of both political parties — and bought themselves a new Congress even more pliable than the old one.
Middle-class America is flattened, devastated and broke. The bankers that caused it all have escaped punishment. They’re raking in huge profits. Oh, and the tax cuts just got extended for high earners, too!
Game over.
Of all the signs of Wall Street’s gloating and arrogance this year, which one stands out the most?
The image of the president of the republic, traveling to New York to reassure them that they wouldn’t suffer too much from new regulations?
Or maybe billionaire Steve Schwarzman, the private-equity oligarch at Blackstone Group, complaining that any attempt to make him pay actual income tax on his income was akin to “when Hitler invaded Poland.”
Not France. Not Belgium. Poland.
In the aftermath, he grudgingly issued a partial retraction.
In any civilized society he would now be pariah. He’d have to eat alone at unfashionable restaurants, and the waiters would spit in his soup.
Instead, as the year drew to a close, I saw him being interviewed on TV, the hosts hanging on his every word.
In 2010, Wall Street’s year, Schwarzman’s only real sin was getting caught flaunting his contempt for the nation.
Far worse went on behind closed doors.
Consider the Dodd-Frank reform act — all 2,300 pages of it. Sure, it fills in a few regulatory gaps, ends a couple of the more gratuitous abuses. You have to throw a few scraps to the masses.
But most of the reforms are meaningless. New rule books and committees. Bah. They’re like half-built fences. Anyone can just walk around them.
As for the new consumer finance watchdog? The agency that’s supposed to stand up to the banks will be housed… within the Federal Reserve. Literally, it will be a tenant of the banking system.
Champions of the “reforms” say this won’t really matter. But if that’s the case, why did Wall Street fight so hard to make sure it happened?
There are no coincidences in Washington.
Meanwhile, missing from this giant “reform” bill was any actual, serious reform like threatening crooked bankers with real jail time. Or ending the “other people’s money” racket of securitization, or smashing “too big to fail” megabanks into smaller firms that can never again threaten the republic.
Instead we’ve enshrined “too big to fail” as national policy. A standing taxpayer guarantee to the biggest banks. What a deal!
It’s amazing when you think about it.
Look at the chaos and catastrophe these guys have left in their wake. One middle-aged man in five is out of work. Tens of millions of families have been financially wiped out. The national debt has nearly doubled.
If inner-city gangs had done this to America, we’d have martial law. If Arabs had done it, we’d have launched another war.
Wall Street bankers? They’ve walked away scot free. And they’re actually being rewarded.
By keeping short-term interest rates near zero, the Fed is basically robbing your grandmother, and other hard-working savers, and giving to Wall Street. The banks borrow from us for free, and then lend us back our own money at interest by purchasing Treasury bonds.
And in a perfect circle of cynicism, the beneficiaries of bailouts are now spending some of their loot lobbying our Congress to overrule us on reform.
The commercial banks and investment firms spent a total of $118 million lobbying just in 2010, according to the Center for Responsive Politics.
That included $4 million spent directly by Citigroup Inc. (NYSE:C) , nearly $3 million by Bank of America Corp. (NYSE:BAC) , $3.5 million by Goldman Sachs Group Inc. (NYSE:GS) and $2.8 million by Schwarzman’s Blackstone.
This is in addition to the vast campaign contributions the top brass at these firms have lavished on pliable congressman, and indirect political lobbying through trade bodies like the American Bankers Association.
But it’s unfair to give the bankers all the credit for subverting democracy.
They couldn’t have done it without the Democrats.
Wall Street has spent years capturing the party establishment.
Think of the lavish campaign checks. The lucrative hedge fund “adviser” jobs. The pervasive influence of pinstriped “progressives” like Larry Summers and Bob Rubin.
This was the year the investment paid off. Big time.
Top Democrats were too terrified of alienating their sugar daddies to pass real reform.
But the joke was on them.
First, Wall Street’s campaign contributions aren’t that important — they only account for about 10% of the party’s money. The Democrats could have lost all of it (an unlikely scenario in any event) and still been in business.
Second, the Democrats would have got a lot more credit — and contributions — from the rest of America if they’d stood up to Wall Street.
And third: Sucking up to Wall Street didn’t help them anyway. Wall Street still turned Republican. The American Bankers Association, J.P. Morgan Chase & Co. (NYSE:JPM) , Citigroup, Bank of America, even Goldman Sachs: This time around, more than half their donations went to the GOP.
Most Americans don’t realize it, but this talk of a “grassroots” and “anti-establishment” election was a bunch of hooey. What really happened was that Wall Street has just bought itself a new, even more compliant
Congress.
The new Republicans are already fawning over the bankers. They’re promising to stop the restrictions on (ahem) “financial innovation.” Congressman Spencer Bachus — the next chairman of the House Financial Services Committee — actually said “Washington and the regulators are there to serve the banks.” Let the good times roll!
It was the greatest heist in history. The bankers pulled it off under everyone’s nose.
(Ref: MarketWatch, December 21, 2010)
Thursday, September 2, 2010
Jan Hatzius of Goldman Sachs and Richard Berner of Morgan Stanley Differ Sharply on Risk of Deflation
Michael Falco for The New York Times
Left, Jan Hatzius of Goldman Sachs; right, Richard Berner of Morgan Stanley.
By NELSON D. SCHWARTZ
When the latest unemployment figures are announced on Friday, all of Wall Street will be watching. But for Richard Berner of Morgan Stanley and Jan Hatzius of Goldman Sachs, the results will be more than just another marker in an avalanche of data.
The New York Times
Contrasting Forecasts
Instead, the numbers will be a clue as to which of the two economists is right about where the American economy is headed. Their sharp disagreement over that question adds yet another twist to the fierce rivalry between the firms, Wall Street’s version of the New York Yankees and the Boston Red Sox.
Mr. Hatzius is arguably Wall Street’s most prominent pessimist. He warns that the American economy is poised for a sharp slowdown in the second half of the year. That would send unemployment higher again and raise the risk of deflation. A rare occurrence, deflation can have a devastating effect on a struggling economy as prices and wages fall. He says he may be compelled to downgrade his already anemic growth predictions for the economy.
For months, Mr. Berner has been sticking to a more optimistic forecast, despite growing evidence in favor of Mr. Hatzius’s view. Last week, Mr. Berner was caught by surprise when the federal government reported that the economy grew at a 2..4 percent pace in the second quarter, well below the 3.8 percent he had forecast a month before. Mr. Hatzius came closer to hitting the mark, having projected a 2 percent growth rate.
Mr. Berner and his deputy, David Greenlaw, still expect a pickup in the second half of the year, which would help gradually bring down unemployment. They play down the danger posed by deflation, the malady that deepened the Great Depression and contributed to Japan’s lost decade of the 1990s.
“I’d say at this point the data and the sentiment in the marketplace have certainly gone more Jan’s way than mine,” Mr. Berner said. Some people, he added, “think I’m out of my mind. But I have a conviction in my beliefs that’s based on my analysis.”
Mr. Hatzius, a 41-year-old native of Germany who was 3 when Mr. Berner started out as an economist, is more restrained. He can afford to be, having snagged the top spot in a recent ranking of Wall Street economists as well as an award from Arizona State University honoring his “uncanny economic forecasting that anticipated the global financial crisis.”
On Wall Street, both men were among a very small group that accurately predicted the recent recession. Mr. Berner’s long résumé includes stints at the Federal Reserve in Washington and Mellon Bank in Pittsburgh. “I’ve seen plenty of ups and downs,” said Mr. Berner, 64, sitting in a corner office overlooking the Manhattan skyline at Morgan Stanley’s Midtown headquarters.
Showing not even a hint of doubt, Mr. Hatzius said, “The prospect of substantial inflation seems very remote, but the prospect for deflation is far from remote. A double dip is certainly possible but not likely.”
Mr. Berner does not expect substantial inflation, but he is predicting inflation will run 1 to 2 percent annually rather than the near-zero level Mr. Hatzius sees by the end of next year.
“There is still a one in 10 chance of deflation,” Mr. Berner calculates. “But we already have been much more aggressive and proactive in dealing with the problem than Japan was,” he said, referring to the Federal Reserve’s decision to quickly cut rates and aggressively buy government securities.
The split between the chief economists, whose work helps inform trading strategies recommended to investors by their firms, echoes a broader and sometimes fiercer debate among academic economists and commentators about the threat posed by deflation and what the government’s response should be.
According to the deflationistas, as they are nicknamed, a new round of stimulus spending by Washington is urgently required to stave off a Depression-like cycle of falling prices and wages that is difficult to reverse once it is set in motion.
Inflationistas, by contrast, worry more about the effect that additional government borrowing could have on the recovery. With the budget deficit expected to hover around $1 trillion a year for the next decade, they say, interest rates could eventually surge, making borrowing — and goods — more expensive. A double dip, they say, is highly unlikely.
Mr. Hatzius’s gloomy outlook is owed centrally to Americans’ slowdown in spending. Recent data suggest that consumers are using any extra cash they have to pay down debt or put into savings. That places a strain on an American economy that has become hugely dependent on consumer spending.
On Tuesday, the Commerce Department reported that Americans saved 6.4 percent of their after-tax income in June, in contrast to the years before the recession, when savings rates stood at 1 to 2 percent.
Last month, the Federal Reserve reported that consumer debt dropped by 4.5 percent in May, a $9 billion decline. It was the 20th consecutive month that figure has dropped. In 2007, consumer debt jumped by 5.7 percent, or nearly $40 billion.
“We had a housing and credit boom that was unsustainable, and now this boom has turned into a bust,” Mr. Hatzius said. “There was too much debt, and the deleveraging process has still got a ways to go. It’s going to keep private demand weak.”
Another big factor is the amount of slack in the economy. According to a recent report by Nomura, “The U.S. economy continues to operate with a staggering amount of spare capacity — unemployed workers, idle trucks and factories, etc.”
Mr. Hatzius agrees, adding that all this extra capacity will restrict the ability of companies to raise prices, thus raising the risk of deflation. “It’s plain to see there’s a ton of slack in the economy,” he said. “We’re not managing to generate enough demand to absorb all these productive resources in the economy.”
Mr. Berner is also studying the role that slack and deleveraging are playing, but he draws very different conclusions from Mr. Hatzius. Excess capacity is being reduced more quickly than Mr. Hatzius believes, Mr. Berner said. That will help businesses raise prices and improve profits, thus heading off the threat of deflation.
What is more, Mr. Berner argues that the deleveraging process is much further along than Mr. Hatzius contends, which will encourage consumers to start spending again. He expects economic growth in the second half of 2010 to run at more than 3 percent, roughly twice the 1.5 percent rate Mr. Hatzius projects.
If Mr. Hatzius is right, unemployment will still stand at 9.7 percent at the end of next year, slightly higher than it is now. Mr. Berner says he believes unemployment should sink to 8.7 percent by then. As for Friday’s numbers, Mr. Berner is calling for a private sector gain of 145,000 jobs versus Mr. Hatzius’s prediction of 75,000 new jobs.
Either way, both predict unemployment will remain at uncomfortably high levels for several years.
One answer, Mr. Hatzius says, is another round of stimulus spending by Washington to fend off the deflation risk he worries about.
Mr. Berner was skeptical of the stimulus bill passed in 2009, and he still “doubts that traditional fiscal stimulus is the right tool for the job.”
Instead, he and his colleague Mr. Greenlaw argue for new mortgage rules that would reduce foreclosures and steady the housing market, payroll tax credits to encourage hiring and a new job training corps for unemployed workers.
“Friday’s number is just one tile in a mosaic,” Mr. Berner said. “From time to time, it’ll be like I’m winning, from time to time Jan will be winning.”
“The truth is that it’s just a crummy moderate recovery,” Mr. Berner added, hedging his bets. “We’ll both testify to that.”
(source: NYT, August 5, 2010)
When the latest unemployment figures are announced on Friday, all of Wall Street will be watching. But for Richard Berner of Morgan Stanley and Jan Hatzius of Goldman Sachs, the results will be more than just another marker in an avalanche of data.
The New York Times
Contrasting Forecasts
Instead, the numbers will be a clue as to which of the two economists is right about where the American economy is headed. Their sharp disagreement over that question adds yet another twist to the fierce rivalry between the firms, Wall Street’s version of the New York Yankees and the Boston Red Sox.
Mr. Hatzius is arguably Wall Street’s most prominent pessimist. He warns that the American economy is poised for a sharp slowdown in the second half of the year. That would send unemployment higher again and raise the risk of deflation. A rare occurrence, deflation can have a devastating effect on a struggling economy as prices and wages fall. He says he may be compelled to downgrade his already anemic growth predictions for the economy.
For months, Mr. Berner has been sticking to a more optimistic forecast, despite growing evidence in favor of Mr. Hatzius’s view. Last week, Mr. Berner was caught by surprise when the federal government reported that the economy grew at a 2..4 percent pace in the second quarter, well below the 3.8 percent he had forecast a month before. Mr. Hatzius came closer to hitting the mark, having projected a 2 percent growth rate.
Mr. Berner and his deputy, David Greenlaw, still expect a pickup in the second half of the year, which would help gradually bring down unemployment. They play down the danger posed by deflation, the malady that deepened the Great Depression and contributed to Japan’s lost decade of the 1990s.
“I’d say at this point the data and the sentiment in the marketplace have certainly gone more Jan’s way than mine,” Mr. Berner said. Some people, he added, “think I’m out of my mind. But I have a conviction in my beliefs that’s based on my analysis.”
Mr. Hatzius, a 41-year-old native of Germany who was 3 when Mr. Berner started out as an economist, is more restrained. He can afford to be, having snagged the top spot in a recent ranking of Wall Street economists as well as an award from Arizona State University honoring his “uncanny economic forecasting that anticipated the global financial crisis.”
On Wall Street, both men were among a very small group that accurately predicted the recent recession. Mr. Berner’s long résumé includes stints at the Federal Reserve in Washington and Mellon Bank in Pittsburgh. “I’ve seen plenty of ups and downs,” said Mr. Berner, 64, sitting in a corner office overlooking the Manhattan skyline at Morgan Stanley’s Midtown headquarters.
Showing not even a hint of doubt, Mr. Hatzius said, “The prospect of substantial inflation seems very remote, but the prospect for deflation is far from remote. A double dip is certainly possible but not likely.”
Mr. Berner does not expect substantial inflation, but he is predicting inflation will run 1 to 2 percent annually rather than the near-zero level Mr. Hatzius sees by the end of next year.
“There is still a one in 10 chance of deflation,” Mr. Berner calculates. “But we already have been much more aggressive and proactive in dealing with the problem than Japan was,” he said, referring to the Federal Reserve’s decision to quickly cut rates and aggressively buy government securities.
The split between the chief economists, whose work helps inform trading strategies recommended to investors by their firms, echoes a broader and sometimes fiercer debate among academic economists and commentators about the threat posed by deflation and what the government’s response should be.
According to the deflationistas, as they are nicknamed, a new round of stimulus spending by Washington is urgently required to stave off a Depression-like cycle of falling prices and wages that is difficult to reverse once it is set in motion.
Inflationistas, by contrast, worry more about the effect that additional government borrowing could have on the recovery. With the budget deficit expected to hover around $1 trillion a year for the next decade, they say, interest rates could eventually surge, making borrowing — and goods — more expensive. A double dip, they say, is highly unlikely.
Mr. Hatzius’s gloomy outlook is owed centrally to Americans’ slowdown in spending. Recent data suggest that consumers are using any extra cash they have to pay down debt or put into savings. That places a strain on an American economy that has become hugely dependent on consumer spending.
On Tuesday, the Commerce Department reported that Americans saved 6.4 percent of their after-tax income in June, in contrast to the years before the recession, when savings rates stood at 1 to 2 percent.
Last month, the Federal Reserve reported that consumer debt dropped by 4.5 percent in May, a $9 billion decline. It was the 20th consecutive month that figure has dropped. In 2007, consumer debt jumped by 5.7 percent, or nearly $40 billion.
“We had a housing and credit boom that was unsustainable, and now this boom has turned into a bust,” Mr. Hatzius said. “There was too much debt, and the deleveraging process has still got a ways to go. It’s going to keep private demand weak.”
Another big factor is the amount of slack in the economy. According to a recent report by Nomura, “The U.S. economy continues to operate with a staggering amount of spare capacity — unemployed workers, idle trucks and factories, etc.”
Mr. Hatzius agrees, adding that all this extra capacity will restrict the ability of companies to raise prices, thus raising the risk of deflation. “It’s plain to see there’s a ton of slack in the economy,” he said. “We’re not managing to generate enough demand to absorb all these productive resources in the economy.”
Mr. Berner is also studying the role that slack and deleveraging are playing, but he draws very different conclusions from Mr. Hatzius. Excess capacity is being reduced more quickly than Mr. Hatzius believes, Mr. Berner said. That will help businesses raise prices and improve profits, thus heading off the threat of deflation.
What is more, Mr. Berner argues that the deleveraging process is much further along than Mr. Hatzius contends, which will encourage consumers to start spending again. He expects economic growth in the second half of 2010 to run at more than 3 percent, roughly twice the 1.5 percent rate Mr. Hatzius projects.
If Mr. Hatzius is right, unemployment will still stand at 9.7 percent at the end of next year, slightly higher than it is now. Mr. Berner says he believes unemployment should sink to 8.7 percent by then. As for Friday’s numbers, Mr. Berner is calling for a private sector gain of 145,000 jobs versus Mr. Hatzius’s prediction of 75,000 new jobs.
Either way, both predict unemployment will remain at uncomfortably high levels for several years.
One answer, Mr. Hatzius says, is another round of stimulus spending by Washington to fend off the deflation risk he worries about.
Mr. Berner was skeptical of the stimulus bill passed in 2009, and he still “doubts that traditional fiscal stimulus is the right tool for the job.”
Instead, he and his colleague Mr. Greenlaw argue for new mortgage rules that would reduce foreclosures and steady the housing market, payroll tax credits to encourage hiring and a new job training corps for unemployed workers.
“Friday’s number is just one tile in a mosaic,” Mr. Berner said. “From time to time, it’ll be like I’m winning, from time to time Jan will be winning.”
“The truth is that it’s just a crummy moderate recovery,” Mr. Berner added, hedging his bets. “We’ll both testify to that.”
(source: NYT, August 5, 2010)
Friday, August 27, 2010
Diane Garnick: The power of compounding
Diane Garnick, investment strategist with Invesco, discusses global trends and highlights her financial viewpoint in an interview with The Markit Magazine
Résumé
2007 - Present Invesco, investment strategist
2001 - 2003 State Street Global Advisors, chief investment strategist
1998 - 2001 Merrill Lynch, global derivatives strategist
1996 - 1998 Deloitte and Touche, certified public accountant
2001 - Present Ladies in Red, founder and board member
2007 - Present Christus Health, chair of Investment Committee
"It took 50 years for GM to achieve economies of scale, five years for Google to grow but only five months for Facebook to reach 4m households. The difference between companies that survive versus those that do not will be the speed and scope of their efficiency."
"The quality of the data that goes into these models is the single largest contributing factor to the quality of the data coming out. The more time and effort we can invest in the quality of the data, the better off we are as an investing community in understanding what has changed about the market and how valuable the models are."
"As scientists, we are just as excited to have a failure from an experiment as we are a success. There is a tremendous amount of information in failure. Sadly, as business professionals, we are not nearly as excited to have a failure, although the opportunity to learn is just as strong."
Q What broad-based investment opportunities do you currently see?
A There are two opportunities for investors that are consistent over time. The first is capturing the small cap premium. Fewer analysts cover small cap companies and these investments have the opportunity to change pretty quickly. They are also not under the same type of market pressure like large caps and can outperform large caps over the long run. Small caps are particularly compelling now. That is because of the unemployment situation. Our unemployed population currently has a sizeable element with three magical characteristics that did not exist in previous unemployed populations: it is highly educated; it has a wealth of experience; and it is used to being in positions of influence. These individuals will begin working with smaller companies in the near future on a formal or consulting basis. They are in a position to lead the next wave of innovation and change in the small cap space. Eventually this works its way into mid and large caps too, but small caps will benefit first. The second broad-based strategy that makes a tremendous amount of sense now is for investors to look at active investment managers that can go long and short. The last two market moves have been major ones. First, there was the decline from the credit crunch. Then we saw a strong recovery in asset prices in 2009. Macro investors on the right side of the market have had the opportunity to do very well. The next opportunity for investors will be to distinguish the better companies from their competitors. Forecasted earnings dispersion is so wide right now that proper investment selection is critical.
Q What is your outlook for the US economy, specifically in the area of Fed policy, unemployment and the housing market?
A We know that tightening is somewhere on the horizon. There has been unprecedented Fed activity and liquidity to support the markets to stop economic demise. It is equally important that we reflect on the fact that we have just as little experience in withdrawing these programmes as we have in implementing them. We run a really big risk of taking these programmes off too quickly or leaving them on too long. A measured pace of tightening is needed. It is going to be a very slow and delicate process. A measured pace probably means 25 basis points increases, on a more frequent basis than when liquidity was added, with significantly more signalling from the Fed. Ten per cent of the workforce is unemployed right now. We also have another 500,000 Americans who are underemployed as they wish to find additional work but cannot. We are in a new era of underemployment with people accepting jobs well below their skill and pay levels. This will hurt the economy in the long run as the underemployed will be hesitant to spend. One of the results of this could be an explosion of the number of part-time jobs. The new healthcare legislation essentially supports this. Full-time jobs used to provide healthcare and pensions. As companies stop making 401K contributions and there is guaranteed, portable healthcare, the benefit of a full-time job with one company becomes arguably less valuable. In housing, at long last we now see both residential and commercial prices flattening out or no longer dropping. However, we still have an overabundance of inventory. The truth is that not every family is ready to own a home; for whatever reason, some should be renters. Take, for example, baby boomers. As baby boomers retire they may not need or want homes. We are likely to see growth in community living.
Q The emerging markets have been leading the global economic recovery thus far. What trends do you see there?
A I think the biggest mistake people make with emerging markets is that they think it is one market. China dominates manufacturing by leading with cheap labour. India dominates services by leading with cheap labour. Russia and Brazil lead in commodities. Eventually the differences in labour costs between emerging markets and developed markets will have to narrow as expectations for standards of living go up in emerging markets. Developed markets will have to work harder in order to maintain their relative position in the world. The good news is that the opportunity to grow and improve your human capital still rests with intellect and work ethic. It is in our control. MIT puts some of its courses up for free on the web. The percentage of people in China and India downloading this content is disproportionate to those in developed markets. Those in developed markets need to reignite their passion for learning.
Q What is the outlook for exchange traded funds?
A There is a difference between a vehicle and a strategy. It is more important to focus on the strategy. One of the wonderful developments is that institutional quality products are now being offered in exchange traded funds (ETFs). Before, it was just basically indices and a lot of the ETFs only found their way into hedge funds or to institutional investors. Many great active managers now have ETFs and are willing to let households invest instead of just institutional investors. This is fuelling the popularity of these vehicles.
Q What opportunities do you see in high-yield and distressed investing?
A Now is a fantastic time to look at companies that are short of cash and could use some sort of turnround strategy. It took 50 years for GM to achieve economies of scale, five years for Google to grow but only five months for Facebook to reach 4m households. The difference between companies that survive versus those that do not will be the speed and scope of their efficiency.
Q We have undergone a fairly long period of volatility in the market. What are your volatility expectations?
A Right now there are a couple of mitigating factors that are shocking the market. The credit situation in Portugal, Italy, Ireland, Greece and Spain (Piigs) is an example. But right now, every government around the world has some type of fiscal challenge. According to a Boston University study, since the crisis began, stimulus packages around the world represent 3 per cent of total GDP. That is an unprecedented amount of stimulus. The second series of shocks that we will see is what happens as we remove this stimulus. There is also a potential concern with municipal securities. Opportunities here are good because yields will be higher but the probability of a default is low. The US government cannot politically bail out the banks and then abandon states should they get into trouble. The real question is how far can or will the US government go? I do not know if it would stop at the city or county level, for example. We are already seeing an increase in hidden taxes to compensate for the shortfall in receipts coupled with increase in payments. Road tolls are increasing. New York City even has an obesity tax. As unemployment payments are a direct obligation of the state, states have struggled with the unemployment problem.
Q How are you utilising derivatives to execute your investment strategies? Do you see that changing in any way? Do you have a view on pending regulatory changes in derivatives?
A At Invesco, we have PowerShares ETFs, some of which focus on option writing (i.e. selling covered calls on the S&P 500). Many households want to use this type of strategy but simply do not have the expertise. We also have ETFs that do this directly. Increasingly, customised risk/return profiles are becoming available to retail investors. Our Premia Plus product takes the primary asset classes (stocks, bonds and commodities) and allocates the portfolio based on risk rather than on dollars, trying to get an equal amount of risk across each asset class. Lastly, we also use futures for some of our macro and portfolio strategies. There are a whole host of politicians concerned about derivatives. There is a fear or a horrible misperception that the more instruments we give people, the faster they will lose their money. It seems odd that as a society we require people to buy car insurance, which is protection on rapidly depreciating assets. We also have this implicit requirement that people save for their own retirement but then limit the tools available to them to achieve their goals. Some of the regulatory reform may be overboard or not well thought out. I think most investors would welcome the reforms regarding more transparency.
Q What are the key differences in your approach to managing and hedging risks for a pension portfolio versus other types of portfolios? How have actuarial assumptions used in pension management changed in the last few years?
A The time horizon is key. Take longevity risk: if people live longer than expected, then the annuity needs to be able to pay out for longer. Inflation risk is also a concern. As for actuarial assumptions, as there is a tremendous gap between professors in universities teaching one thing in the classroom and practitioners applying the concepts correctly, this might be a five to 10-year gap; there is a similar gap between the actuaries and technology or medical professionals regarding life expectancy. Pensions rely on actuaries. Perhaps they should talk to the biomedical experts directly. It can take a significant amount of time to measure and detect trend shifts. Another point I want to make about pensions is that when you talk about pensions, you are really talking about a portfolio of people. Contrast this to the world of people saving for retirement on their own. They lose the diversification benefit. The life expectancy is now a single number as opposed to some average with a normal distribution around it. So as an individual you have to significantly outperform or more likely overfund.
Q With the increased application of technology, such as algorithmic trading, to the financial markets, how has this changed the role of investment strategists? Is there more focus on tactics now and less on strategy?
A I will give you an example. In the past, market strategists might have recognised that there was a dislocation or opportunity in the market. However, the due diligence process was so time consuming that the opportunity could not be realised. Today, pension plans are allocating roughly 3-5 per cent of their plan assets into a tactical allocations category as part of their strategy. Thus, they can take advantage of temporary opportunities more quickly. The pace of change in the market has altered the markets significantly and the strategy has had to adjust. If you think about the largest asset management firms in the world and divide the assets by the number of employees, each employee is responsible for a large sum of money. There is a need for investment intellect and strategists are used to identify investment management opportunity. It used to be very frustrating trying to identify a great investment but the window of opportunity would disappear before an investment committee could complete its due diligence. Now I can actually spend more time discussing the issues: appropriate size of the investment, strategic fit, exit strategy, etc. We now talk with the chief investment officers more frequently than at board meetings.
Q Some people have suggested that the requirements for mark to market (MTM) and fair value accounting for illiquid instruments may have accelerated or exacerbated the credit crisis. As you were actively involved with the Financial Accounting Standards Board (FASB) at one point in your career, would you share your perspective with us?
A I was invited to speak at an American Bankers Association conference right at the height of the argument. I am very pro-MTM accounting. I approached the podium and said: I am so pleased and honoured to be here to speak about MTM accounting on the day that happens to coincide with my 21st birthday. At that point, the whole room grew quiet and was a bit confused. I then said, If you are willing to suspend MTM accounting, then so should I. It is very unrealistic to believe that we can get valuable accounting data without MTM. There are so many financial instruments that trade so infrequently that there is a legitimate question of whether the valuation is accurate on some of these instruments.
Q That brings us to valuation and risk models. Many of these were criticised for not being able to predict the global credit crisis. Can these models be improved to be better forecasting tools? If so, how?
A There were two fundamental problems with models. People believed that our models were complete. They are not complete. They are very wonderful approximations of a complex world. We still have a lot of work left to do as financial engineers. Second, the quality of the data that goes into these models is the single largest contributing factor to the quality of the data coming out. The more time and effort we can invest in the quality of the data, the better off we are as an investing community in understanding what has changed about the market and how valuable the models are.
Q Wall Street’s reputation has suffered quite a bit in light of the recent economic challenges. Is a career in the financial markets still the noble pursuit it once was? If not, how can it be again?
A As for Wall Street’s reputation and attracting new people to a career there, we really had a problem of allocative inefficiency for the last five to 10 years before the crisis. This is what I mean. Let’s look at all the graduates and ask where they should go to work. Before the crisis, they all wanted to come to Wall Street. We really did not need all those smart people. While Wall Street is a noble pursuit, it is not the only noble pursuit. There are two benefits to all of this. If Wall Street does not attract people as much as it used to do, we have the opportunity to see this next generation of bright people pursue careers where they are needed, for example in medicine and the sciences. The ones left working on Wall Street will be those who are the most passionate about finance. They are where they should be. Allocation of labour resources is a self-correcting process, even though it takes time.
Q We understand that you are currently teaching a class at Massachusetts Institute of Technology on the topic of learning from one’s failures. What was your worst investment decision and what did you learn from it? How do you analyse your mistakes and apply the lessons?
A As scientists, we are just as excited to have a failure from an experiment as we are a success. There is a tremendous amount of information in failure. Sadly, as business professionals, we are not nearly as excited to have a failure, although the opportunity to learn is just as strong. We frequently do not reflect on these failures. I learned that you need a straightforward process that includes further examination of the investments that were rejected and understand why they were rejected. Without it, you have survivorship bias.
Q Your personal story is a tale of how one woman rose from rather humble beginnings on Main Street to pursue her dreams on Wall Street. Do you have any advice for our readers?
A I just have an excitement and eagerness to learn. There is no one grandiose thing that I have ever done. I just try to do one very small thing better each day and I counted on the power of compounding. Compounding is one of the things we are first taught in finance. The secret is actually very basic.
The Markit Magazine would like to thank Elise Rosenberg, director and head of account management North America and Otis Casey, vice-president of credit products for the interview with Diane
(from Markit, August 27, 2010)
Monday, June 7, 2010
BREAKING THE CYCLE - A Conversation with Emanuel Derman
Watching that interrogation of the bankers at the Senate hearings, I had the feeling that this is the way karma works in the universe. Everybody is going to do something not quite right as they act out their destiny mechanically, doing what they unthinkingly believe they have to do. The Wall Street people are going to reflexively overshoot and be too greedy. The Senate people are going to reflexively grandstand and be too uninformed and try to rein them in. There isn't going to be an elegant solution to any of this.
Introduction
When The Reality Club (the forerunner of Edge) was launched in 1980, one of it's founding members was the late Heinz Pagels, a particle physicist at Rockefeller University and president of The New York Academy of Sciences.
It was around that time that Pagels began to talk about themes that revolved around "the importance of biological organizing principles, the computational view of mathematics and physical processes, the emphasis on parallel networks, the importance of nonlinear dynamics and selective systems, the new understanding of chaos, experimental mathematics, the connectionist's ideas, neural networks, and parallel distributive processing. ..."
Pagels was having similar conversations at Rockefeller during this period with Emanuel Derman, one of his fellow particle physicists who soon after left academia for a position at Bell Labs, and from there went on to spend 17 years at Goldman Sachs where he became managing director and head of the Quantitative Strategies Group. It was Derman who brought the ideas floating around physics in the 70's and 80's to Wall Street, and in the process came to embody the word "quant."
Writing in the New York Times ("They Tried To Outsmart Wall Street" March 9, 2009) , Denis Overbye observed:
Dr. Derman, who spent 17 years at Goldman Sachs, and became managing director, was a forerunner of the many physicists and other scientists who have flooded Wall Street in recent years, moving from a world in which a discrepancy of a few percentage points in a measurement can mean a Nobel Prize or unending mockery to a world in which a few percent one way can land you in jail and a few percent the other way can win you your own private Caribbean island.
They are known as "quants" because they do quantitative finance. Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money.
Derman, Overbye noted, "fell in love with a corner of finance that dealt with stock options."
"Options theory is kind of deep in some way. It was very elegant; it had the quality of physics," Derman told him.
I recently sat down with Derman to ask about his thoughts on the financial crisis, the role played by Goldman and the other big banks, and what new questions we need to ask to get our heads around the big problems which, to some, seem intractable and unsolvable.
Concerning the last point, Pagels was on to something, when, in his 1988 book Dreams of Reason: The Rise of the Sciences of Complexity, he wrote:
Mathematicians and others are endeavoring to apply insights gleaned from the sciences of complexity to the seemingly intractable problem of understanding the world economy. I have a guess, however, that if this problem can be solved (and that is unlikely in the near future), then it will not be possible to use this knowledge to make money on financial markets. One can make money only if there is real risk based on actual uncertainty, and without uncertainty there is no risk.
EMANUEL DERMAN, a former managing director and head of the Quantitative Strategies Group at Goldman Sachs & Co, is a professor in Columbia University's Industrial Engineering and Operations Research Department, as well as a partner at Prisma Capital Partners. He is the author of My Life As A Quant.
Emanuel Derman's Edge Bio page
BREAKING THE CYCLE
[EMANUEL DERMAN:] One of the things I've been thinking about a lot, both in relation to the financial crisis and in relation to the way people understand the world in general, is the role of models in the world. There are a variety of different approaches to trying to understand the world, in all its facets, from the physical sciences to the social sciences and even one's personal life. I've categorized them in two ways: I like to distinguish what are called "theories" from "models". Theories, in my view, really try to capture the essence of the world, as in physics in one short equation, or in other fields, in one short schema.
It seems to me you can't really act in the world without having some kind of model or theory of how the world is going to behave in the future.
Models are simpler to describe in that they are similar to metaphors or analogies: you try to understand something that is difficult to comprehend in terms of something else you already comprehend. You try to understand the brain, for example, and you say, well, the brain is a lot like a computer. Or you try to understand a computer, and you assume people understand the brain and then say a computer is a lot like a brain.
In the same way in finance one says stock prices behave a lot like smoke diffusing off the tip of a cigarette . These are models or metaphorical ways of describing the world that add insight but you can't really rely on them very substantially in the long run. I'll give some examples in a little while.
The other extreme is to use theories, which are really ways of directly apprehending the way the world or the universe works: examples are Freud, Einstein and Newton. Of course, theories can be right or wrong, but theories are different from models.
Take the Dirac equation, for example, the most famous and most successful equation in physics. Dirac started out with a theory, produced a metaphor, and then turned it into a theory again, as I said, the most successful one. He began by trying to combine quantum mechanics, which was already a well established theory in late 1925, and relativity, special relativity, which had been around since 1905. The two theories weren't really compatible.
The Schrodinger equation which explains the hydrogen atom and all of chemistry is not relativistically invariant. Dirac, who was a big proponent of beauty, struggled very hard to elegantly unify the two and eventually wrote down one simple, literally one-inch-long equation. When he started to solve it, he discovered that it does miraculously explain the fact that the electron has spin, which was something that was only discovered experimentally after 1925 or 1926. The Dirac equation has four solutions. Two of the solutions described pretty well the electron and the hydrogen atom that everybody knew at that point. But there were two more solutions that have negative energy. Weird.
Nobody could make sense of this for several years after Dirac wrote it down in 1928. Nobody could quite understand what these negative energy electrons really meant. Dirac eventually came up with a pretty metaphorical explanation. He was reluctant to give up on the beauty of the equation and concluded after some struggles that the only way to understand it is to imagine that the entire universe and the whole world and what he calls the vacuum is actually filled up with negative energy electrons that you can't see and you don't sense. Sort of in the way when you're born you don't smell the air even though there is air around you, because it's the familiar background in which you live.
In the same way all the negative energy electrons that you are born into form part of the vacuum and nobody ever detects them under normal conditions. But then he realized that if you were to shoot photons or light into "empty "space, empty space isn't really empty. It's full of these negative energy electrons that you don't normally perceive. You can do a photoelectric effect on the vacuum, on empty space: shoot one photon in and hit an invisible negative energy electron, give it enough energy to make it positive and it becomes visible.
You will kick out what was formerly a negative energy electron and convert it into one with positive energy which everybody will observe as a normal electron, and what it will leave behind is a hole in the sea of negative energy electrons. This sea is called the Dirac sea. It is a metaphorical description of the way the vacuum works.
Dirac realized that a hole in this negative energy sea is an absence of negative charge and will behave like a positive charge and have exactly the mass of the electron but the opposite charge.
Except for Maxwell's completion of Maxwell's equations for electromagnetic fields, this is the first case where somebody literally plucked an equation out of their head and ended up predicting the existence of a new particle or a new phenomenon, which has been the style template for theoretical physics ever since.
Sure enough in 1931 or 1932, though nobody really believed Dirac, Andersen at UCLA or Caltech discovered the existence of positrons, which are positively charged electrons. All of this is described by Dirac's equation with incredible accuracy, nowadays to about ten significant figures. That to me is a good example of a theory.
Maxwell's equations, which describe electricity and magnetism are another example. What they illustrate about a theory is that nobody thinks light is "like" Maxwell's equations. There is an absolute identity between the way we think about light and the equations that describe it. Nobody says Maxwell's equations are a "model" for light. Maxwell's equations and light are the same thing. The same way with the electron: the Dirac equation and the electron are literally inseparable. That for me is a good example of a theory. I'll give some more soon when I talk about the social sciences.
Let me step aside and talk about the difference between theory and model. I was brought up reading the Torah and going to Hebrew school, and there is the story of Moses and the burning bush. God tells Moses to go to Pharaoh to Let My People Go. Moses doesn't like being sent to do this and he doesn't speak very well and so he runs away into the desert of Midian to evade his responsibility. Eventually he comes across a burning bush and a voice speaks to him from the burning bush and tells him to go to Pharaoh and tell him to free his people.
Moses tries to wriggle out of it and says, who shall I say sent me? The voice from the burning bush says, I am that which I am, which is a sort of pun on the Hebrew word Jehovah for God. I like to think of that as being the example of a theory: God in the story isn't saying "I'm a lot like this" or "I'm a lot like that." I'm absolutely exactly what I am and not like anything else, he says, and that is kind of true of the quality of theories. You're not comparing yourself to anything. You're saying this is the way I behave.
If I can give an example that I have been interested in from a different, more qualitative aspect: I have been reading Spinoza's "Ethics". It's a lot like Freud. He's trying to explain the behavior of human emotions and eventually derives a theory of ethics out of all of this. It's also very astoundingly similar to the theory of derivatives in finance in that he says there are three underliers, which are desire, pain and pleasure. Spinoza's avowedly trying to do a version of Euclid, who defines points and lines and then derive theorems about triangles. So analogously Spinoza defines the primitives, which are pleasure, pain and desire, plus a few others like wonder and contempt, which I'll mention later perhaps, but the three I mentioned are the ones that, even though he defines them, you don't really need him to. Everybody who has lived and who speaks English understands what points and lines are, and so do they understand what pleasure, pain and desire are.
Then he starts to define in a self consistent way all the emotions that people experience as derivatives of pleasure, pain and desire. I actually made a table of them which I could show. I drew a dependency chart. So, for example, he says love is pleasure associated with an external object. Hate is pain associated with an external object. Then he gets to more complex derivatives, which are like convertible bonds: envy is pain at somebody else's pleasure. He doesn't talk about Schadenfreude but clearly Schadenfreude is pleasure at somebody's pain and envy is the other way around. Cruelty, for example, is a triple derivative, a desire to inflict pain, on someone that you love.
In this way he builds up a categorical description of almost every single emotion you can name in the way they relate to the primitives, desire, pleasure and pain.
I like it because : A) it leads to a theory of ethics and B) there is no reference to anything outside of itself. He doesn't say the brain is like a computer. It's totally self contained. In a sense it's a theory of the way things are, not a model of saying this is a lot like something else.
To give the opposite example, let me distinguish everything I've just said about theories from models. Models really depend on analogies. So, for example, in physics, look at the liquid drop model of the nucleus for which Bohr and Mottelson got the Nobel Prize. Bohr is the son, Aage Bohr, of Niels Bohr. The nucleus which really consists of protons and neutrons, say, in uranium, all jammed together very tightly, you can instead approximately think of as a liquid drop, and if you think of all these things jammed tightly together as liquid drop, then the drop can oscillate and can vibrate and can rotate. If you know its mass and you figure out roughly what its elasticity is, you can figure out what the normal modes of vibration are when it oscillates. Bohr and Mottelson end up predicting other excited states of uranium or of heavy nuclei based on this analogy of the drop.
But it really is an analogy, and a limited one. It's not saying the nucleus is a liquid drop. It's saying, in a range of energies if it doesn't break apart, it's a convenient way to think about it. That's very different from something like the Dirac equation where you're writing down an equation and saying, this is the way the world is, this is not an approximate version of the way the world is.
I've been thinking about this a lot in relation to finance because it seems to me true of financial models. The ethics in Spinoza is a theory of psychology and maybe Freud is too, in a self consistent way, but most financial models are metaphors and are based on saying you can picture stock prices as smoke diffusing or as smoke diffusing and jumping. It's not a holistic description. It's just saying that I can understand this if I think about it as much like something else I already understand in another context.
I've become a bit of a Platonist. What I like about Spinoza is that he's unlike most people I know who are monists and like to explain the world mostly in terms of matter. So, they like to say the brain is a computer or love is equivalent to a set of neural currents in your brain.
Spinoza won't give primary power to mind or matter. He believes, even if I say it somewhat clumsily, that there is a mind side to everything and there is a physical side to everything. Neither the physical side causes the mental side nor the mental side causes the physical side but they live in parallel to each other. I like that approach; it seems to agree with my experience of the world.
It doesn't explain much about the things that matter to you as a human being to say they happen because of circuits in your brain. I'm not saying that circuits don't fire in your brain, but it doesn't give you a way of dealing with it other than a very mechanical and uninsightful sort of way.
What I like about Spinoza's theory of emotions is that he tries to deal with everything in human terms, in a self-contained sort of way. That's not to say that there isn't an electronic and chemical correlate to love or envy or that there isn't something pounding in your heart when you're anxious. But that's not the part that matters when you're trying to deal with it as a human being.
My background plays a role in my interest in these ideas. I'm originally from South Africa and when I was in high school I liked literature and writing as well as science. Then, as I was good at science and I liked it, I eventually gravitated into that and I gave up writing, but in my heart I liked philosophy and literature.
I started out in physics and graduated from Columbia in 1973. Then I was a post-doc and assistant professor doing theoretical particle physics for seven years. Then at some point the difficulty of getting jobs in cities I wanted to be in got to be too much for me and I took a job at Bell Labs, which in 1980 was the canonical way out of academic life for physicists. What Wall Street is to physicists today, Bell Labs and the Solar Energy Research Institute and places like that were for physicists - telecommunications or energy research as a result of the energy crisis of the late Seventies.
I took a job at Bell Labs not in basic research but in a Business Analysis Systems Center, which literally was a bunch of ex-rocket scientists who had worked for Bell Labs on some of the moon shots. They were running a business analysis center to try and retrain themselves. I spent five years there in the sort of middle ground between academic life and real industry. I didn't like it very much, to tell the truth, because it was never quite clear what your aim was. They wanted you to write papers but you couldn't publish them and they were always secret in some sense. Whether something was a success or failure often just depended on whether your boss said he liked it or he didn't. A lot of it didn't see the outside world. I spent five years there learning a lot, nevertheless.
What I really learned, which was most useful for me coming to Wall Street in 1985, was computer science, computer science from a point of view of doing symbolic programming and building programs that people could actually use, little languages to model their own needs. I built a language there which we called HEQS, which stood for hierarchical equation solver. This was before the days of spreadsheets and analysts had to solve big financial models, but the people who created the models couldn't actually do the math to solve them, and my language gave them a way of them describing the model and then letting the computer provide the solution. I spent five years doing this kind of stuff. I learned a little bit about option theory but not much. I didn't like the management culture. I still wanted to be a person who worked with his hands, and everybody there, except in the research area, was aspiring to get into management.
Eventually Wall Street came knocking at the door, as a result I believe of rising interest rates in the late '70s. Wall Street suddenly started having a lot more trouble managing their inventory when interest rates became a risky business. They were hiring more and more computer people and applied mathematicians, physicists. I took a job at Goldman Sachs in late 1985. I wasn't quite the first of the people who went from physics to finance or the first of the quants, but I was among the early group. It was very exciting because Goldman was small in those days, maybe 5,000 people. A few years earlier it had probably only been 2,000 people. So you got to know everybody and see them in the cafeteria and it was intimate in a good way.
There was a very close linkage between people who were doing technical work and people who were trading or doing sales. There weren't a lot of barriers to dealing with different people. It was a place that valued you if you had a skill, no matter what it was, if you were a good lawyer or if you were a good computer programmer. They might treat you as a geek if you were more of a scientist than a businessman or an MBA or a lawyer. Nevertheless they needed what you had and they respected it. So I really enjoyed working there. For me it was a shot in the arm after being at Bell Labs and having felt like I had quit physics. I suddenly got excited again about doing something new.
In terms of how physics figured into Wall Street at that point, I was among the first physicists there. I don't know if I was literally the first, but I was certainly among the first few, although there had been three of four engineering people in the group I was in who had been there a few years longer.
It was kind of a natural match for physicists because first of all options and interest rates were becoming big in terms of sales and marketing and hence valuation and hedging were necessary. Most of the models that had been developed in the financial world for treating the risk of bonds or the risk of options or valuing options were all essentially diffusion models, related to diffusion of heat in classical physics. Physicists spend their life doing this kind of stuff, so even if they didn't know much finance, it was very easy. In fact, when I came, the guy I worked for said to me, read this paper by Cox, Ross and Rubinstein over the weekend and then start trying to fix this program that I wrote for valuing options which seems to have some problem for bond options rather than stock options. I literally spent the week reading this paper and learned economics out of it.
Now Wall Street is much more sophisticated. The hurdle is higher. You really have to know something before you start. But in those days it was enough just to be a reasonably smart person who was willing to learn. So I leapt into it. There weren't a lot of textbooks. It was very exciting to be in a field where there wasn't much traditional stuff to learn and to study.
Although it was economics, the mathematics was very similar to that of physics, and physicists are kind of jack of all trades in that they can do modeling, they can do mathematics, they can do numerical analysis and they had to do their own programming pretty much. They were not like business people who needed somebody they could give the programming to.
To build a model of options — there are a lot of little things that can go wrong. If there is a gap between the person who understands the model and the person who does the implementation, then a lot of little things can go wrong which you have an incredibly hard time rooting out because the person who understands the theory can't implement it and the person who understands the implementation can't understand what might be wrong when you get some mistake.
So I liked being the person who spans both sides of their bridge. In the culture I worked in, everybody did their own programming. When I ran groups for the next 15 years at Goldman, it was pretty much like that too. The physicists or the computer scientists– it was mostly the physicists — knew enough programming to do their own dirty work. In my case I actually built interactive screen interfaces for traders. I had learned how to do this at Bell Labs. It was a good way to work. It was good for a physicist in that you got to span many different areas. If you were the person who actually built the model as well, it gave you a great deal of close contact with the traders. They used it and you were the guy who controlled their access to it. It was really a perfect job.
It was a very interesting non-management, non-managerial culture, unlike Bell Labs. It was in many ways much like a university research department where I worked, except it was a business. I would say the fixed income bond options group that I worked for when I started was more like a hedge fund in terms of culture. There were a few smart traders, some smart sales people, and then our group that supported them. We all spoke every day and worked pretty closely. You didn't need a lot of managerial permission to start some project. Everything was a little bit fly by the seat of your pants. You would talk to somebody and then go off and do something. That was what I liked about the culture, and what I didn't like towards the end of my time on Wall Street was that you could spend more time asking for permission to do something than it actually took to do it, when it became more managerially oriented.
In terms of what physicists brought to Wall Street — really good pragmatic modeling skills. The difference between being an economist and being a physicist is that most economists have never really seen a successful model. So they don't know what constitutes a good model and a bad model. They either denigrate models too much or they respect them too much and think they are much better than they are.
Physicists, going back to what I said earlier, know the difference between a really accurate theory and between a more or less pragmatic model and they understand where to make approximations and what not to take too seriously. It's that sort of understanding of how much theory is useful, but not too much, is one of the skills that physicists bring. The second is really a hands-on approach to doing things yourself.
Later on I helped run risk management. There are two levels of risk management in a trading firm. One level is desk by desk, where you're working, say, as I did, on an equity trading desk between 1990-2000. You have thousands of positions and they move around every minute as the market changes, and you want to understand how exposed you are to volatility to the S&P, to various market factors, to interest rates. You want to know that on a daily basis. You care what's going to happen to you every minute because you want to hedge your potential losses.
That's very engaging and very hands-on. What happened in the late '90s, maybe mid-'90s, is people started to tackle what is now called firm-wide risk, which is looking at the risk of the whole enterprise, where you want to understand not so much what will happen to you at any instant, but where the big market risks lie for the firm as a whole. It's a global approach. This is where the whole of the Value-at-Risk culture comes in. That's a much fuzzier business. The difference between "local" and "global" is one of the interesting things in life, in physics and in financial models.
It's interesting in this regard that the three biggest banks recently announced their quarterly results and not only day in the last quarter did they lose money. That is totally astonishing. It's really a reflection of what the administration has done. They've made interest rates very low so it's cheap for the banks to borrow money. They have eliminated a lot of the players, so there is much less competition for taking on risky trades and you can do them at a price that is much more preferable to the person who is in control. This is a risk profile that is a result of regulation and administrative policies rather than of genuine market conditions.
In terms of styles of regulation, I'm very disillusioned by what's happened in terms of the bailout. I don't know what is the right thing to do but one of the worst things for society's ethical sense is to see other people having the upside of risky positions and not suffering the downside. It makes me feel very uncomfortable.
What I also dislike is that firms that have made a lot of money out of this won't acknowledge that they made this money by being saved by the taxpayers and the administration.
There's a lot of talk about the role of algorithms and the change in markets. The financial world has changed a lot since I worked in it and the biggest change is more people are playing with more of other people's money. When most of the banks were partnerships, they had to be in it for the long run because people who were partners were playing with their own capital and taking risk with their own assets. Their money was tied up for 10 or 15 years. Even if somebody retired, they still couldn't take their money out of there. They just got paid interest while it was being used and drawn down. So there was a certain culture of not taking extreme risks because you didn't really have limited liability. Ultimately you could be broken completely by your company going bankrupt. With trading houses going public, they're playing with other people's money. They're immediately liquid in terms of stock and cash payment. The culture in all of these places has changed in that it's make money liquid and fast. The way this crisis has been treated exacerbates that attitude in that if you do badly, the government bails you out and if you do well, you keep the profits.
I used to hear 10 years ago at Goldman from colleagues that there was going to be doom one day at Fannie Mae and Freddie Mac because they were hedge funds in disguise. To some extent the government and regulators have encouraged this and they still haven't tackled the problems at Fannie Mae and Freddie Mac and are doing with them what they accuse Wall Street banks of doing, which is treating them as off-balance sheet and not counting the money they are spending on them as real money.
In terms of algorithmic trading, that's a big change too. I'm not against it — it's inevitable from a technology point of view. You trade airline tickets with computers. You buy things off the internet. There is no way people are going to trade stocks in vast amounts by making verbal or written orders. Stocks are going to be traded electronically and eventually bonds, currencies and everything else will be traded electronically too.
It's unfair, though, to allow high-frequency traders to get what essentially amounts to insider trading, to getting an early look at trades and deciding what to do because they are allowed to put powerful computers closer to the stock exchange. That doesn't make it a flat playing field.
Also, people who benefit from it tend to over-accentuate the need for efficiency. Everybody who makes money out of something to do with trading tends to say, oh, we're got to do this because it makes the market more efficient. But a lot of the people who provide this so-called liquidity and efficiency are not there when you really need it. It's only liquidity when the world is running smoothly. When the world is running roughly, they can withdraw their liquidity. There is no terrible need to be allowed to trade large amounts in fractions of a second. It's kind of a self-serving argument. Maybe a tax on trading to insert some friction isn't a bad idea, just as long term capital gains are taxed lower than short term gains.
Economics is a strange field. One of the things I noticed on Wall Street was that firms use the economists to talk to clients but their trading desks don't necessarily pay attention to what the economists are saying. Unexpected things happen unexpectedly and damage positions and net worths. I don't think there is a good quantitative solution to all of this. I sometimes get letters from mathematicians in Europe saying that they have come up with a better formula for capturing risk or for valuing risk or for trying to control or measure risk. You can do better than VaR but there isn't one formula, one number, that is going to save you in the end.
More important is incentives and disincentives and making sure that people understand they are going to pay the penalties for their own mistakes and somebody isn't going to bail them out. Jim Grant, who writes a newsletter called "Grant's Interest Rate Observer" that I like, had a column recently pointing out that in Brazil they haven't had a big banking crisis and that there, anybody who runs a trading firm is personally responsible for losses. It's not company risk. It comes down to their own assets. So they are much more cautious about this. Those kinds of incentives are going to make a much bigger difference than finding a better mathematical formula for handing risk.
And the scale at which people get paid has become quite astonishing. There is an increasing gap in America in general between what people make at the bottom and what people make at the top.
When I decided to work on Wall Street, I interviewed in '83. The guy who interviewed me said, this is one of the few jobs where you won't have to be an accountant or a lawyer and you can make $150,000 a year eventually. Now a trader might make $20 million. If they can't make it at an investment bank, they go to a hedge fund, if they have a really good track record.
I have less of a pay problem with hedge funds — I'm not sure if I'm right — from an ethical point of view than I do with very big, too-big-to-fail companies because hedge funds are by and large putting their own money or their clients' money at risk, and it's a clearly articulated compact between them. While there is a possibility of systemic contagion, it's a cleaner business in terms of potential conflicts. They are just doing proprietary trading for their own account or their clients' account.
Whereas, what is confusing about the big investment banks, if you watched the Senate hearings, is that there is a very unclear overlap between being a producer and being a market maker. So Goldman, for example, always used to be pretty much a service provider in the old days. Now they and all the other big banks want to be both a producer and the marketplace on which product trades. There are a many conflicts of interest. To make an analogy, I've read articles about how Amazon wants to be not just a place that sells books but one that also publishes books. That becomes dangerous — if you're a dominant player in both the conduit and the content. There is too much concentrated power. It used to be you were either a market maker or a producer.
In terms of crises: For the last few weeks we've seen the Euro drop, riots in Greece, and bailouts by the IMF and by the Central European Bank. As long as countries in Europe had separate currencies they could use currency devaluation to try to manage their own problems if they weren't being productive or were spending too much. But once you have the same currency but you don't have the same political identity and the same political and economic interest, there is a substantial danger of things breaking apart.
In terms of trends in automated trading and market microstructure: Last week a 1,000 point drop in 40 minutes. It's scary but it's more of a technical event than an economic one. In 1987 the market dropped by 22 percent in a day and it was okay in the end. It didn't have economic consequences. In contrast in the last three years the subprime crisis started out as a localized trading problem and has ended up influencing the whole economy. There is unemployment as a result of the interaction between housing prices and contagion from market to market. Last week markets got scared by Greece and some computers misbehaved, which interacted with what is now a fragmented equity trading market. But in the end it's like the 2007 quant crisis. The market dropped but it didn't really affect too much about the economy, which is shaky for its own good reasons.
But it can be difficult to distinguish sharply between economic events and technical events because if people get scared enough it has economic consequences.
What to do? Frankly, if I were asked to become the Treasury Secretary of this administration, I don't think I would take the job. I used to think I knew what the right thing to do was. I thought there was too much back and forth between government and Wall Street. I thought it was a mistake for people who had been so close to Wall Street be in charge of it. On the other hand, given some of the events of the last six months or eight months, I no longer know what the right thing to do is. There is too much back and forth, but then markets are a complicated business.
Watching the Senate hearings the other day and seeing Carl Levin and others interrogate the people from Goldman Sachs on the Abacus deal, I realized that most of the Senator questioners didn't seem to understand too well how markets work.
They didn't understand the difference between trading as principal and trading as agent. On the one hand, war is too important to be left to the generals. On the other, it's very hard to make sensible regulations without sufficient knowledge. And it should be noted that some of the Senate questioners, who were right to tackle Wall Street, are the same people who won't do anything about Fannie Mae and Freddie Mac and the same people who encouraged the mortgage deduction, easy access to housing for poor people. So I'm now a little bit more sympathetic to the idea that you have to have people who have been in the business do the regulation, or at least people who have spent enough time understanding it.
Watching that interrogation of the bankers at the Senate hearings, I had the feeling that this is the way karma works in the universe. Everybody is going to do something not quite right as they act out their destiny mechanically, doing what they unthinkingly believe they have to do. The Wall Street people are going to reflexively overshoot and be too greedy. The Senate people are going to reflexively grandstand and be too uninformed and try to rein them in. There isn't going to be an elegant solution to any of this. That's the way of human affairs, and in terms of leadership, perhaps the best we can hope for is that occasional, miraculous, moment when people who are in a position to make a difference cease to behave mechanically — to take some recent examples, Mandela and de Klerk, perhaps Gorbachev — and who, rather than fulfilling their preprogrammed destiny, break the cycle of karma.
(from Edge, Third Culture, May 27, 2010)
Wednesday, February 10, 2010
Controlled Emotions
In some situations, brain images of drug addicts are indistinguishable from those of traders, a researcher has found.
It is easy to dismiss Jérôme Kerviel, the rogue trader at Société Générale, as a fluke.
So here is a sobering thought for Wall Street: There may be a bit of Mr. Kerviel in all of us.
A small group of scientists, including some psychologists, say they are starting to discover what many Wall Street professionals have long suspected — that people are hard-wired for money. The human brain, these researchers say, responds to high-stakes trading just as it does to the lure of sex. And the riskier the trades get, the more the brain craves them.
French prosecutors have likened Mr. Kerviel’s trades to a drug habit. That is no surprise to Brian Knutson, a professor of psychology and neuroscience at Stanford University and a pioneer in neurofinance, an emerging field that combines psychology, neuroscience and economics, to examine how the brain makes decisions.
Mr. Knutson has sent volunteers through high-power imaging machines to map their brains as they trade. He concludes that sometimes, people get high on making money.
“The more you think you can gain from the risk, the more you take the risk and the more activation in the circuitry,” Mr. Knutson said.
Neuroeconomics has not won many converts on Wall Street. Researchers like Mr. Knutson have yet to show how their work can be applied effectively in the markets. And some academics question whether the field is of any use in economics.
“Economics is about equilibrium, and supply and demand, and forces that come to some stabilized system,” says Stephen A. Ross, the Franco Modigliani Professor of Finance and Economics at the Massachusetts Institute of Technology. “It’s not about atoms or how little people behave.”
Even so, the field seems to be gaining some traction. Last year Jason Zweig, who edited the 2003 edition of “The Intelligent Investor” by Benjamin Graham, wrote a 352-page book entitled “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make Your Rich.”
One of his findings was that brain images of drug addicts who are about to take another hit are indistinguishable from those of traders who are making money and about to place another trade. “That tells us pretty confidently that if you make money and make money again,” Mr. Zweig said, “it is very similar to a chemical addiction and it becomes very hard to let go.”
Mr. Kerviel, 31, told prosecutors that he was thrilled when his surreptitious trades in European stock index futures began to pay off. By late December, he had made a profit of about $2 billion. “That produced a desire to continue,” Mr. Kerviel said. “There was a snowball effect.”
But when the markets turned against him, Mr. Kerviel made an all-too-common mistake: He refused to cut his losses, which would balloon to more than $7 billion as the bank frantically unwound his positions on Jan. 21-22.
Daniel Kahneman, a Nobel Prize-winning psychologist, showed that individuals do not always act rationally when faced with uncertainty in decision making. When faced with losses, individuals may seek to take more risk rather than less, contrary to what traditional economic thought might suggest.
“When you are threatened with extinction, you act like nothing matters,” said Andrew Lo, a professor at M.I.T. who has studied the role of emotions in trading. Mr. Kerviel, he said, is a case study in loss aversion.
Mr. Lo and Dmitry V. Repin of Boston University have studied traders to determine how stress and emotions affect investment returns. They monitored traders’ vital signs like heart rate, body temperature and respiration as their subjects darted in and out of trades.
The findings, while preliminary, suggest — perhaps unsurprisingly — that traders who let their emotions get the best of them tend to fare poorly in the markets. But traders who rely on logic alone don’t do that well either. The most successful ones use their emotions to their advantage without letting the feelings overwhelm them.
“The best traders are the ones who have controlled emotional responses,” Mr. Lo said. “Professional athletes have the same reaction — they use emotion to psych them up, but they don’t let those emotions take them over.”
Or, as Warren E. Buffett once put it, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Of course most traders do not breach ethical boundaries like Mr. Kerviel, who doctored e-mail messages to hide his unauthorized trades. But unbridled ambition and the hit from the money high are a dangerous combination.
People like to think that logic prevails in the financial markets, that traders and investors always act rationally. “Clearly, institutional investors want to believe it’s all scientific,” said Mark W. Yusko, president of Morgan Creek Capital Management.
But Wall Street can get carried away. The Internet boom and bust were followed by an even bigger boom and bust in mortgage lending. Wall Street is now saddled with more than $100 billion in losses stemming from mortgage investments, and the economy may be sliding into recession.
Alpesh Patel, principal at the Praefinium Group, an asset management company, said that when traders get too emotional, they start making bigger, more frequent trades.
“You know you are damaging yourself, and there’s no gain in a financial sense, but the highs from the winning lead you to take bigger risks,” said Mr. Patel, who has written 11 books on trading psychology and risk management.
Legendary Wall Street traders like Steven A. Cohen and Julian H. Robertson Jr. are students of human emotion. Mr. Cohen, who runs a $15 billion hedge fund called SAC Capital Advisors, keeps Ari Kiev, a psychiatrist, on hand to work with his legions of traders, people from SAC say. (Dr. Kiev declined to say whether he worked for Mr. Cohen’s firm.)
Mr. Robertson, the founder of Tiger Management, which at its peak in 1998 managed $22 billion, turned to a psychoanalyst, Dr. Aaron Stern, to test and evaluate Tiger’s traders.
Dr. Kiev, author of the forthcoming “Mastering Trading Stress: Strategies for Maximizing Performance,” said many traders, professionals and everyday investors alike, fail to manage their risks.
“It is more common for people to hold onto losers and see their investment go to zero, or shorts go to the sky, than it is for them to practice good risk management and get out,” Dr. Kiev said.
(from nytimes.com, February 7, 2010)
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