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IT DOESN'T ADD UP By Mike Gasior This year will mark the third anniversary of the beginning of the current financial “crisis”. Like any event of magnitude, the more time that passes after it occurs, the better the perspective as to its cause and its meaning. Already we have listened to every imaginable pundit opine as to what got us into this mess. Who is to blame? What can, should, and has been done to prevent anything like this from happening again? I’ve heard from politicians, economists, market prognosticators, academics and many others, and they have dozens of targets for fault. Too much credit. Too little regulation. Too low interest rates. Too much speculation. Too many derivatives. Too much of everything it appears. One thing that has ultimately become apparent to me at this point, having been in this professional life for basically thirty years, is that often the answer to complex problems are very commonly immensely simple and elegant. This current situation is one of those and I am confident that I am correct even more than is typical for me. My intellectual sorts of friends have for years suggested that I over simplify things. My usual retort to them is that many of life’s problems (economic, personal, mechanical and otherwise) are the result of making something too complicated. If you wonder already where I am going with this train of thought, consider a couple of conversations I was involved in very recently. The first one was in November at a conference in Boston at which I was the closing keynote speaker. My audience was a hard-core group of securities industry professionals who were attending a securities lending event. The world’s largest financial institutions were all represented in the audience. My speech was typical for me of late, meaning I was honest about my fairly worried outlook for the economy’s future. At the cocktail reception afterward, I was heavily engaged in conversation with an old friend who had hired me as a consultant a couple of years before. A gentleman (who I’d met briefly earlier) from one of the world’s most respected, oldest and largest, private financial institutions walked over and the conversation went exactly like this: Gentleman: “Mike…I’m sorry to interrupt, but I just wanted to make sure I understood what your message was. You think we’re all f***ed, don’t you? Mike: “Yeah. That’s what I think.” Gentleman: “Yeah, that’s what I thought. I think so too. Okay. Thanks.” At that point, I went back to enjoying my conversation, and my nice Samuel Adams Winter Lager, but then my new friend appeared again. Gentleman: “Sorry Mike. One other thing. You must think real estate is going further down too then, yes?” Mike: “Yes.” Gentleman: “A lot?” Mike: “Yes. Probably a lot.” Gentleman: “F***. Okay. Thanks.” What was striking about that conversation was that this was a VERY senior person at one of the most wonderful institutions you could ever imagine; and the guy didn’t want to even debate a single word that I had said. Commonly, I am bracing at these events for people looking to take my head off and try to argue how I couldn’t possibly be right. Yet here was a guy, who has lived his life in the financial universe as long as I have and I only seemed to be confirming what he was feeling himself. That was a very telling moment. A couple of weeks later I became engaged in a far reaching conversation with a very seasoned group for whom I was doing a presentation for in Bermuda. Many of these people can measure their careers in the financial industry in decades and we traveled through all sorts of topics during this discussion. At one point someone pointed out a couple of economic statistics that had been released in December that seemed to show promise that the economy might be improving. Then came a question that engendered an answer from me that perfectly summarizes my current opinion about the economy. Question: “Do you think that this is the beginning of the end of all this?” Mike: “Actually, I don’t think we’ve seen the end of the beginning yet.” Which leads me full circle to my point in this January newsletter. While there are other factors, which feed and amplify the underlying circumstances that led to this (and the upcoming larger) meltdown, the issue that brought us all to this point in the road can be summed up in one word: Mathematics. The case that I will be seeking to make for you this month, is that which happened to the global economy over the past three years was a mathematician, “quant” (quantitative analyst) driven meltdown of the world’s financial system. Plain and simple. Certainly, there were enabling contributors, most notably the rise of technological power and the continuous movement toward deregulation. But at the end of the day, the driver of all this badness was mathematics and the increased reliance upon them in the financial markets. Perhaps most worrisome to me is that the stage is still set for a future meltdown (maybe sooner than later) that will make what has happened so far seem like “Pee Wee’s Big Adventure” by comparison. Except that the next time, all the King’s horses and all the King’s men, won’t be able to put the economy back together again. As usual, I digress. Let me take care of a wee bit of business and then I’ll make my case to you. OUR SCHEDULE IS COMPLETE FOR 2011 I have been offering training to the institutional investor community for 22 years, but this education may never have been as important as it has been during the past three. With the turmoil we have just endured and the confusion surrounding many of the assets held by investors; staffs need appropriate knowledge to operate in these conditions. With many organizations reducing headcounts in various departments, cutting back on education for the remaining personnel in this environment could be potentially catastrophic. One thing I am always reminding my friends in the financial industry is that the most dangerous thing for an institution is "not knowing what you don't know". That will always be the thing that blows you up. We will be offering 18 of our most timely programs in New York City during 2011 and you can view the entire schedule at the following link: http://www.afs-seminars.com/schedule.html We also have four, brand-new and exciting seminars for this year. Their names and links to the complete descriptions are as follows: "Alternative Investments" "Corporate Actions" "Distressed Securities" "Treasury Management & Operations" We still have a variety of convenient dates available if your organization is interested in holding an in-house session for your staff or having me speak at your function. You can view our course catalog, which details all of our "standard" sessions at the link below. Please remember that we are also happy to create a custom program of topics that is perfectly tailored to your audience's needs at no extra cost. To inquire about either in-house seminars or my speaking availability, please call my offices at (860)347-6568 or write me at mike@afs-seminars.com CATCH ME ON THE RADIO ON MONDAY, JANUARY 17TH I have been a regular on a wonderful radio show out of London on 104.4 FM for my friends in the UK, but luckily you can also listen in via the Internet at: The show is titled “The Naked Short Club” and it is always a very lively hour with some of the most brilliant guests from the hedge fund and financial community. Monday’s show should be particularly energetic (I’m on it after all) and my topic is planned to be the same as this newsletter. Basically, how the “quants” drove us to the edge of the abyss, where we are basically idling until they jam the accelerator to the floor again and drive us right in. It should be fun kids, so block off the hour and tune in. Put the earphones in at work and no one will be the wiser. The show will be on Monday, January 17th at 4:00 p.m. New York time or 9:00 p.m. London time. See you there! IT DOESN’T ADD UP The movement towards looking at markets more mathematically isn’t a brand new phenomenon. Economists and mathematicians have been trying for over 100 years to figure out techniques to try and skew the odds in their favor by analyzing investment opportunities dispassionately rather than emotionally. Using probability and statistics to make decisions. We can begin to trace the origin of this quest back to Louis Bachelier, who published his Doctoral thesis title “The Theory of Speculation” in 1900. He was the first academic who tried to show that, although markets seemed to move at random, perhaps some of the mathematical techniques used in science might also be applied to the markets to identify patterns that would otherwise not be easily observed. Before I send some of you scurrying to find a gun you can put in your mouth thanks to the direction I seem to be going, here is a visual for you to better understand what Mr. Bachelier was trying to accomplish. His premise was to compare the movements of the markets to particles suspended in fluid. When you shake up a snow-globe and watch the snowflakes drifting aimlessly about, you would figure the path of each flake is completely random and unpredictable. However, since the amount of space, fluid and snowflakes are all measurable, Louis figured that using complex formulas you could, at the very least, make better predictions and get better results than you would get through random luck. This was the beginning of the mess we are now in. In the 1970’s a trio of academics unveiled the “Black–Scholes model” to the world and things would never be the same again. This was the birth of the modern derivatives market that we now have. This mathematical technique finally gave the markets a way to attempt to value what an option on a given stock (or anything else) should be. The markets wasted no time in responding to this discovery, with the Chicago Board of Trade opening a brand new business in response to it, the Chicago Board Options Exchange. The 1980’s gave way to the biggest enabler of all when IBM introduced the “personal computer” and technology and the power that it possessed began to mesh with the desire of the mathematicians and economists to process MASSIVE amounts of data at the speed of light. With this sort of horsepower, investment firms could now hire “quantitative analysts” and, using those brains and the computer’s brawn, begin to trade in ways that had never been seen before. There were now techniques to arbitrage the difference between the value of the actual S&P 500 index and the S&P futures contract, and “program trading” was born. Now there was also “portfolio insurance” techniques that could allow computers to issue buy and sell orders to protect your portfolio if the markets were to begin to move against you. One of the first powerful people to embrace the power of math and technology was John Meriwether at Salomon Brothers. Salomon was already the most powerful bond house on Wall Street but Meriwether took the playing field to a whole new level when his fixed income arbitrage group began using models and technology to make staggering sums of money. The first whiff of trouble was the crash of 1987 that saw the Dow Industrials fall 22.6% in a single day of trading on massive amounts of volume. To put that in current terms, that same percentage decline would be 2,263 Dow Jones points. Very impressive indeed. While there has been many different reasons given as far as to what contributed to the crash, one item that is on every person’s list; program trading. What is funny about that to me is that the amount of technology that drove that crash no doubt pales in comparison to the computing power contained in the iPhone 4G in my pocket this at very moment. Small measures were taken by regulators and markets afterward to prevent another event like that, such as “circuit breakers” and other nonsense, but none really limited the influx of mathematics and technology as an increasingly dominant factor in trading. In my own opinion, the real wake-up call was in the summer of 1998, when the hedge fund “Long Term Capital Management” came close to blowing up the global financial system. The fund was started by no other than John Meriwether, and when they went to the Federal Reserve for help in August of that year they were carrying over $100 billion in actual securities in the portfolio as well as a $1.25 trillion dollar position in derivatives. The risk came from the fact that the fund had gotten down to about $3.6 billion in actual equity, and had they lost that we might have seen many of Wall Street’s largest firms implode along with the fund. When they got into that trouble, LTCM had on their staff two Nobel Prize winners (Myron Shoales and Bob Merton of “Black-Shoales” fame), a former vice chairman of the Federal Reserve and 34 other PhD’s. Not to mention technology, that NASA wished that they could have afforded, to compute the many models and algorithms that were the basis for their trading decisions. Luckily the Federal Reserve was able to arrange a bailout at that time (led heavily by Timothy Geithner who was a rising force at the New York Fed) and the world was saved from the mathematicians yet again. Hopefully the world had learned its lesson about the use of massive leverage and complex derivatives would prevent any future cataclysm, especially when one of the witnesses was a future president of the New York Fed and U.S. Treasury Secretary. Politicians also took notice of how close we’d come to the abyss. Senator Bernie Sanders of Vermont, who was, and still is, a member of the Senate Finance Committee stated, “Americans should be concerned about the gambling practices of the Wall Street elite.” One might have expected that the government, regulators, markets and investors would have all begun to cast a suspicious eye toward this movement toward modeling and computers as large players in the system. Unfortunately, you would have been wrong. The concept of a Credit Default Swap would have been illegal in the United States for the vast majority of the 20th century. I’ll do you the favor of not explaining the market crash of 1907 and the passage of “Bucket Shop” laws that followed, but trust me when I tell you that if parties had tried to engage in such a transaction up until the year 2000, the participants could have been prosecuted for a felony. I would have expected an Attorney General such as Elliot Spitzer would have taken great joy in having the executives of AIG doing the “perp walk” for participating in the CDS transactions done by the Financial Products group. For more background on bucket shops, here is a link for you: http://en.wikipedia.org/wiki/Bucket_shop_(stock_market) Unfortunately for Americans, and the rest of the world for that matter, Wall Street had been lobbying Congress for years to pass the “Commodity Futures Modernization Act”, which did several things. First of all, it exempted participants in CDS from prosecution under any existing “Bucket Shop” laws in local jurisdictions. Secondly, it exempted CDS from regulation by either the SEC or insurance regulators at the state level. This legislation was passed unanimously in the Senate (imagine that if you will in this day and age) and was immediately signed into law by President Clinton. Thus creating a whole new playground for the mathematicians and technology kids to play on. The final, most recent straw was the influx of modeling into the U.S. mortgage market. I was among the absolute first people to be involved in the creation of the CMO market in the early 1980’s and they were a wonderful product. They helped make mortgages easier for Americans to attain and the resulting securities were a good and solid investment for the people who bought them. Not to mention the brokers who created them were able to make a few bucks too. Everyone was happy. What happened in the early part of the new century was to use the technique of repackaging assets into new securities and relying on modeling to predict the risk of a homeowner defaulting. A host of new types of mortgages were created for any type of borrower. Bad credit, no down payment, negative amortizing and more styles were created. The math wizards continued to devise clever ways of packaging them into CDO’s, CLO’s and other structures to make them appear safe and secure to investors. Even the rating agencies were baffled as to how these new investments should be rated and initially were reluctant to even try. But with the prospect of all sorts of new revenue, and the “training” they would receive from both Goldman Sachs and Morgan Stanley on how to rate them, the rating agencies now had mathematical techniques to properly rate the risk that these products presented. Or so they (and we) thought. The math was wrong, and now here we are. Nothing has changed in our direction. The latest stomping ground for the mathematicians is “High Frequency Trading”, which uses algorithms to analyze everything from price movements, Google searches, news stories and more, to make trading decisions at the speed of light with the computers issuing buy and sell orders based on the math. It is estimated that 70% of all trading volume in the United States is now attributable to High Frequency Trading. But even this new strategy is meeting its limits thanks to the speed of light and has now created a race for who has the shortest distance from their “black box” to the market’s computers. Even at 671 million miles per hour, if MY order arrives at the marketplace one electron ahead of YOUR order, than I’m going to make more money than you. To capitalize on this race, none other than the New York Stock Exchange has built a new data center in New Jersey and is renting server space to high frequency traders directly across the aisle from the NYSE’s own servers. Of course, this sort of co-location costs plenty of money and only the biggest players can afford such things. Yet none of this seems to be concerning the government or regulators at all. Which brings me to my conclusion. A conclusion based on my training in economics and 30 years in the financial industry (basically, my entire adult life). While math is wonderful and sometimes nearly miraculous, when applied to markets it will almost inevitably fail you in the end. I documented several catastrophes above that I will assume occurred during the lifetime of nearly anyone reading this newsletter. It’s an inevitable lead pipe lock and it’s going to blow the system up but good the next time. And it is no longer a question or debate IF there will be a next time, because there is going to be. The only remaining question is WHEN the next time is going to be. The simple truth is that these mathematicians try to treat economics and finance as though it were an actual science. But it isn’t. There are no “laws” in economics. There are interesting ideas. Wonderful theories. Temporarily effective strategies. But no laws. The law of gravity is a law. Every time you lift your arm and drop your pencil while on the planet earth, it’s going to fall to the ground. If you boil water at sea level it’s going to boil at 212 degrees Fahrenheit. Always. Period. Paragraph. No such dependability exists in finance and economics and it is folly to think otherwise. If not, how did 34 PhD’s, two Nobel Prize winners and a former vice chairman of the Federal Reserve go straight down the toilet a scant 12 years ago? Perhaps me mentioning “non-linear mathematics” will send you scrambling for that gun once again, but give me a quick chance here to explain why this is important and why we are doomed to another “quant-led” disaster. As I write this, more than 99% of all models being used in financial markets do math in a linear way, which is truly about the only choice they have. What that means in plain English can be illustrated by considering the following problem: “If a bottle of beer is $1.00, then how much will 100 bottles cost?” The answer seems as though it couldn’t be more simple: $100.00 But you arrive at that answer by taking a linear path. $1.00 X 100 = $100.00 The problem is, however, that markets and economies don’t work that way. For example, when buying that many bottles of beer you might expect a discount and a shopkeeper might give you a discount and sell you 100 bottles for $.80 each. So the 100 bottles only ends up costing you $80.00. On the other hand, you might have shown up in the shop right before closing and not wanting you to clean out his inventory (and also sensing you’re in hard place), so he tells you he’ll sell you the 100 bottles for $2.00 per bottle. Now the 100 bottles is going to cost you $200.00. That is the “non-linear” nature of how math actually works in the real world of business and finance and how approaching math in the linear way that is used in science will always fail you. The 100 bottles might cost $80 or $200 but it’s almost guaranteed to not be the $100 predicted by the simple approach. And modern modeling of markets has no real capacity to cope with this non-linearity. So the models will work wonderfully for a period of time until something inevitably happens that it didn’t expect and we’re all screwed the next time. Luckily for the “quants” however, is that they will likely be hired to try and explain to everyone else how we ended up in this mess, since they’ll have been the ones who got us into it. Just like they have during every disaster for the past 25 years. THE COMPLEXITY ISN’T LIMITED TO JUST THE INVESTMENTS EITHER The complexity also makes it difficult for investors who hold portfolios of these types of securities to properly accountant for, price and report them in their financial statements. Let me tell you a story, as briefly as I can, that struck fear deep into my heart recently. I was doing some research last year that caused me to go through the regulatory filings of a group of large insurance companies (their statutory annual and quarterly filings). When going through thousands of pages of these statements, I found a few companies who had errors that I found to be worrisome enough for me to send a letter to senior management, alerting them to what I had found and offering to help if they wanted any help. The first troubling thing was how many of the companies straight out ignored my contact and I never heard back from them. Then there were other companies who contacted me in a panic and I either provided some assistance or I provided specifics and then they disappeared again. I will tell you a quick story of the latter. I got a voicemail from the vice chairman of one of the world’s largest insurance companies. The company is a household name, publicly traded and their stock a component of some of the most popular stock indexes. After a couple of phone calls between him and I, it seemed they were very concerned about the letter I had sent and wanted me to itemize some specific problematic things so they could believe there was reason for concern. Fair enough I figured, and I grabbed the annual statement from their largest company (they have many in many different lines of business and states) and made a short list. Here are a few things I included in my response to the vice chairman. I will be delving into some arcane accounting issues now, so the following is only appropriate for mature audiences. I quote from my letter verbatim: “I found dozens and dozens of examples of
securities, which while bought at discount prices, the company was
reporting amortization versus accretion. While the dollar amounts
were fortunately small on the ones I observed, it is worrisome because
some systemic flaw allowed it to occur in the first place and went
unnoticed by assorted humans. Such flaws can result in more substantial
errors and I have only observed this phenomenon on a couple of occasions
in 21 years. It was also interesting because I found examples of
it in various bond categories (municipal, corporate and MBS) and
it didn't appear “There is an assortment of entries that are difficult to understand based on the information contained within the schedules. Page XXXXXXX offers several. XXXXXXXXX XXXXX CO has the following entries related
to it: “I have never seen a company do this before
and it also created tremendously confusing reconciliation problems.
In a quick scan of your schedules I saw one security CUSIP listed
seven separate times in the schedules (this is a CMO "Z"
tranche and it would appear XXXXX was treating each accrual as a
"lot") Page EXXXX - XXXXXXXXXXXXXXXX Your schedules have dozens and perhaps hundreds of examples of single holdings broken out and being reported as though they were individual holdings.” “Per the annual statement instructions, companies are required to identify bonds that have optional characteristics. With a simple scan of Schedule D Part 1, I identified
well in excess of 500 examples where XXXXX did not identify bonds
that clearly have optional characteristics associated with them.
If more time was spent researching the holdings I would also find
many more because I randomly checked several that Ultimately I would receive a phone call followed by a registered, return-receipt “thank you” note from the vice chairman (which I still consider framing) assuring me that they’d discussed my findings with the people who prepared them and the people have assured them that all is well. Now I’m not going to try to teach accounting to any of my readers who are non-accountants, but trust me when I tell you that if any of my friends who prepare these annual statements got the above “memo” from me about their own work, they would become immediately nauseous. Truthfully, the un-named company above was fairly mild compared to some of the others who got letters from me. A few of the largest insurance companies in the United States had monumental errors in their financials compared to the jaywalking kind of stuff inventoried above. My summary point of all this is that the senior management who sign off on the veracity and accuracy of their financial statements don’t honestly have any true idea what is contained within them. And the people below them who are stuck with doing the preparation are so understaffed, overworked and outgunned compared to the investment managers who make all these investments, they’re lucky to even get them out on time. In the past 22 years of doing this training and consulting I have watched the combination of more and more technology and fewer and fewer humans being involved in the reporting process that I sense this is another recipe for disaster. It has gotten to the point that very few human eyes at these large institutions have any clue what risks might be lurking in those statements. And when a dope like me can sit there with the paper statements on my desk and using a highlighter and PostIt Notes identify hundreds of errors an hour, the world should be scared. Probably because I’m only performing a superficial scan, but with more access and effort Lord knows what I might find since I know where every department buries their bodies. We can all be very sure of one thing now. And that is that the senior management of AIG didn’t honestly have the foggiest notion of what the mathematicians in their Financial Products division even did. All they knew was that the division was making tons and tons of money. Until it wasn’t any more. And then they were gone. The scariest thing in this industry is not knowing what you don’t know. YOUR JANUARY BRAINTEASER I haven’t given you guys a brainteaser in a bit, so I don’t want anyone to pull a brain muscle. So I would only rate the difficulty of this one as “medium”. I like the fact that it also includes my love of music of all kinds. Here it is: "A man is sitting in a pub feeling rather
poor. He sees the man next to him pull a wad of $100 bills out of
his wallet. What song did he sing?” Give it a good effort before caving in and peeking early, but when you want to view the answer you can do so at the following link: http://www.afs-seminars.com/brainteaser_Jan2011.html Copyright 2011, Michael Gasior. All Rights Reserved AFS Seminars LLC |
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January 2011 Newsletter
