International Law

Forty Years Ago Today, The Band Began to Play

Cover via Amazon

Almost forty years ago, George Soros wrote a memo about mortgage trusts, reprinted on pages 61-63 of his book the Alchemy of Finance.  You should get a copy of it and read the entire 3 pages, do your own calculations to demonstrate his point.

Soros argued that "If a [mortgage] trust with a book value of $10 and 12% return on equity doubles its equity by [somehow!] additional shares at $20.00, the book value jumpst to $13.33 and per share earnings go from $1.20 to $1.60."

This seems, to me, like magic - who is going to buy these new shares at $20.00. This is why Soros is a financial genuis and I am not.  Soros tracked the cycle of the mortgage industry, and showed rather convincingly, that once the per share earnings becomes the single measure of value for a mortgage trust, you have all the necessary conditions for a bubble.

It makes sense when you think about it, if you can sell a $10 asset for $20 to someone who is following the trend in per share earnings increases, and hopes to benefit from that trend, under the right circumstances most people will start to use the single valuation measure, just because most other people are using it.

I was reminded of Soro's insight, when I read Felix Salmon's article in Wired entitled "Recipe for Disaster: The Formula that Killed Wall Street."

In brief, Salmon makes that a single formula used to evaluate relative risks in bond portfolios briefly dominated the world of pricing bonds.

"The heart of it all was Li's formula. When you talk to market participants, they use words likebeautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.

"The corporate CDO world relied almost exclusively on this copula-based correlation model," saysDarrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee.

The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations.

"Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus," wrote derivatives guru Janet Tavakoli in 2006.

Janet Tavakoli, in her 2007 submission to the SEC, was even more scathing about the assumptions which allowed correlation trading:

"Correlation traders have adopted the language of the conventional options markets. This is a false analogy. For conventional option pricing the volatility of the underlying is a function of the price of the underlying, the strike price of the option, the time to option expiration, interest rates, and the price of the option. If we consider an interest rate option, the price of the underlying instruments can be calculated with certainty for various interest rate environments.

Market implied default correlation is much more nebulous. Market implied default correlation is a function of the tranche being considered (the hard-to-pinpoint-price and the attachment points), the loss given default assumptions (as usually estimated from flawed averages of CDS premiums and historical loss given default), and asset default correlation assumptions (equal pairwise default correlations and a form of copula model - Gaussian, Student's t, or Archimedean).

All of this effort is a waste of time and resources. In the first place, the market is estimating asset correlations instead of the necessary default correlations. The overwhelming flaw in the methodology, however, is that the only reason default correlation exists at all is if we pretend that default probability does not vary, but of course, it does.

This suggests that hedging should focus on default probability and recovery rates. Instead of hiring quantitative analysts to write inaccurate models that solve the wrong problem, a fundamental corporate balance sheet analysis that reveals better information about the probability of default and loss given default is a more sensible approach. That requires a different skill set and a different focus than is currently in use on the majority of trading desks today.

A major improvement in the financial markets would be to spend zero time, money, and resources on correlation and spend all of one's time, money, and resources on better estimates of default probabilities and recovery rates."

Paul Wilmott predictably has some observations about the dangers of allowing a single model of valuation to dominate pricing decisions:

"In the late 1970s I had the dubious pleasure of attending a Billy Graham evangelical event for the followers of the christian cult, as a guest of some born-again nutters.

Over the last decade I have had the equally dubious pleasure of attending many conferences on credit, listening to various academics, let's say "Professor X," for example, preaching about the copula cult.

I use the word 'cult' in this context because of the similarities between the unthinking adoration I witnessed at both types of event.

I found the Billy Graham event hilarious, I found the credit events disturbing.

In both cases the audiences were intelligent people, in both cases there was only one non-sheep among them: me."

The persuasion techniques remain in the same, only the names of the con men change.

Full post as published by Misleading Advertising Law on February 24, 2009 (boomark / email).