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Archive for September 2008

Human capital

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The Role of Education Quality for Economic Growth
Eric A. Hanushek and Ludger Woessmann (http://ssrn.com/abstract=960379)

The figure shows, by country, the share of students that scored very low (< 400 rough PISA equivalent, “scientifically and mathematically illiterate”) or very high (> 600) on cognitive tests administered over the last 40 years. The results give a good indication of the quality of human capital in the country’s workforce. Click for larger version.

From the paper:

…To create our measure of quality of education employed in this study, we use a simple average of the transformed mathematics and science scores over all the available international tests in which a country participated, combining data from up to nine international testing occasions and thirty individual test point observations. This procedure of averaging performance over a forty year period is meant to proxy the educational performance of the whole labor force, because the basic objective is not to measure the quality of students but to obtain an index of the quality of the workers in a country.

If the quality of schools and skills of graduates are constant over time, this averaging is appropriate and uses the available information to obtain the most reliable estimate of quality. If on the other hand there is changing performance, this averaging will introduce measurement error of varying degrees. [i.e., younger workers in developing countries probably have better skills than indicated in the data.]

More PISA fun.

Written by infoproc

September 30, 2008 at 7:52 pm

Why no bailout?

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Representatives in Congress received thousands of phone calls and emails from constituents against the bailout, which some wags have characterized as “no banker left behind” 🙂

We can trace this popular reaction against CEOs and Wall St. to growing income and wealth inequality. Ordinary people no longer feel they have a stake in the system. Their reaction may be irrational (even the poorest American has a big stake in the continued functioning of the economy), but it was certainly predictable.

Next spring, unlike last year, less than half of the Harvard graduating class will take jobs in finance. I guess that signals a top in the market 8-/

Related posts:

financier pay

all about the benjamins

a reallocation of human capital

a new class war

non-residential net worth

working class millionaires

Written by infoproc

September 30, 2008 at 2:48 pm

Complexity illustrated: Lehman WAS too connected to fail

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This WSJ article illustrates what I discussed more abstractly in this earlier post Notional vs net: complexity is our enemy. The story claims that by allowing Lehman to fail, Treasury and the Fed triggered the final stage of the crisis that got us to where we are today. I’ve included my figures from the earlier post here.

…in an age where markets, banks and investors are linked through a web of complex and opaque financial relationships, the pain of letting a large institution go has proved almost overwhelming.

In hindsight, some critics say the systemic crisis that has emerged since the Lehman collapse could have been avoided if the government had stepped in.

The Fed had been pushing Wall Street firms for months to set up a new clearinghouse for credit-default swaps. The idea was to provide a more orderly settlement of trades in this opaque, diffuse market with a staggering $55 trillion in notional value, and, among other things, make the market less vulnerable if a major dealer failed. But that hadn’t gotten off the ground. As a result, nobody knew exactly which firms had made trades with Lehman and for what amounts. On Monday, those trades would be stuck in limbo. In a last-ditch effort to ease the problem, New York Fed staff worked with Lehman officials and the firm’s major trading partners to figure out which firms were on opposite sides of trades with Lehman and cancel them out. If, for example, two of Lehman’s trading partners had made opposite bets on the debt of General Motors Corp., they could cancel their trades with Lehman and face each other directly instead.

This figure shows three trades which almost cancel. Remove one of the counterparties and you have chaos instead of hedges. In a last ditch effort, after letting Lehman fail, Treasury tried to cancel these trades out manually — good luck! Why did we not have a central exchange in place earlier?


Oops, there goes AIG! (Big issuer of CDS insurance.)

The reaction was most evident in the massive credit-default-swap market, where the cost of insurance against bond defaults shot up Monday in its largest one-day rise ever. In the U.S., the average cost of five-year insurance on $10 million in debt rose to $194,000 from $152,000 Friday, according to the Markit CDX index.

When the cost of default insurance rises, that generates losses for sellers of insurance, such as banks, hedge funds and insurance companies. At the same time, those sellers must put up extra cash as collateral to guarantee they will be able to make good on their obligations. On Monday alone, sellers of insurance had to find some $140 billion to make such margin calls, estimates asset-management firm Bridgewater Associates. As investors scrambled to get the cash, they were forced to sell whatever they could — a liquidation that hit financial markets around the world. …AIG was one of the biggest sellers in the default insurance market, with contracts outstanding on more than $400 billion in bonds.

To make matters worse, actual trading in the CDS market declined to a trickle as players tried to assess how much of their money was tied up in Lehman. The bankruptcy meant that many hedge funds and banks that were on the profitable side of a trade with Lehman were now out of luck because they couldn’t collect their money.

…At around 7 a.m. Tuesday in New York, the market got its first jolt of how bad the day was going to be: In London, the British Bankers’ Association reported a huge rise in the London interbank offered rate, a benchmark that is supposed to reflect banks’ borrowing costs. In its sharpest spike ever, overnight dollar Libor had risen to 6.44% from 3.11%. But even at those rates, banks were balking at lending to one another.

Who was next after AIG? Time for a bailout!

…Goldman, Paulson’s former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Written by infoproc

September 29, 2008 at 3:17 pm

Clawbacks, fake alpha and tail risk

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Earlier this year I wrote a post Fake alpha, compensation and tail risk in finance:

…current banking and money management compensation schemes create incentives for taking on tail risk… and disguising it as alpha. The proposed solution: holdbacks or clawbacks of bonus money… When will shareholders smarten up and enforce this kind of compensation scheme on management at public firms?

The classic example is writing naked (unhedged) insurance policies covering rare events and pocketing the fees as alpha. You trade tail risk for cash, and hope things don’t blow up until you are out the door. It’s agency risk on steroids.

This NYTimes article describes, in detail, a perfect example of this phenomenon in the case of AIG. AIG, a global insurance company with over 100k employees, was brought down by a tiny unit in London that traded credit default swaps (CDS).

Once it became clear that AIG was in trouble, Treasury and the Fed had to step in because AIG was too connected to fail. In fact, the article states that Goldman, Paulson’s former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Joseph Cassano, the former head of AIG’s London credit derivatives unit, is perhaps the first (although probably not the last) poster boy for clawbacks in the credit crisis. Total compensation for his unit of 377 employees averaged over $1 million per employee in recent years. I would guess that means Cassano took home easily in the tens and perhaps over 100 million dollars in the last few years. Will taxpayers get back any of that compensation?

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

NYTimes …Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

…The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

…These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

Update: from the Pelosi bailout legislation summary — good luck implementing this!

New restrictions on CEO and executive compensation for participating companies:

* No multi-million dollar golden parachutes
* Limits CEO compensation that encourages unnecessary risk-taking
* Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate

Written by infoproc

September 27, 2008 at 7:57 pm

CDOs, auctions and price discovery

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How is Treasury going to buy up CDOs and other mortgage backed securities? What is the price discovery mechanism? I’ve heard discussion of a reverse auction process, in which the government offers a price and owners of the assets decide whether to accept the bid.

But this makes the problem sound much easier than it is. There are no simple or uniform categories for these securities — no two are exactly alike. I imagine Treasury is going to have to do a lot of homework before each auction, perhaps aided by some sophisticated professionals (Bill Gross of PIMCO recently offered his team’s services). Data on each security is available from ratings agencies like S&P and Moody’s but presumably one would supplement this with additional information. After some initial analysis Treasury could set a conservative bound (i.e., using pessimistic estimates of future default rates and home prices) on the value of each security in units of the original face value (this one is worth at least 25 cents on the dollar, this is one, 45 cents, etc.). Then, they can publish a list of securities in a particular value category (without, of course, giving out the actual value estimate) and conduct a reverse auction covering all the assets on the list.

If they can get the assets below the value estimate, great for taxpayers like you and me. If banks (hedge funds? pension funds? foreign banks? who is really holding all this stuff?) won’t sell at prices below the bound, and the auction heads above that price, Treasury should start demanding warrants or equity stakes on some sliding scale. In other words, the bid keeps getting higher, but at some point Treasury starts asking for not only the particular CDO but some additional warrants or stock. (This could also be done on a sliding scale from the beginning of the auction — Treasury gets an additional x percent of the bid in warrants, where x increases with price.) The equity stake is compensation for the government for having to having to overpay for the security. At this price there is an (expected) flow of funds from taxpayers to recapitalize the seller, but at least we are getting equity in return. It is claimed that there is a range of values (roughly 20 percent of current market prices) over which the seller would be getting more at auction than the market is currently offering, but the government is still getting a good deal on the asset (expects to make money even under conservative assumptions).

Will it work? Who knows, but at least it may restore some confidence to credit markets.

Here are some old posts that really get into the nitty gritty of what is inside a typical CDO. You’ll see that I’ve been covering credit securities since 2005 🙂

anatomy of a cdo

deep inside the subprime crisis

mackenzie on the credit crisis

gaussian copula and credit derivatives

Here’s a recent NYTimes article that gives a peek into the complexity of structured finance.

NYTimes: …Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here’s how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers’ incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6 percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it’s a toxic portfolio. Of the 2,093 loans that remain, 23 percent are delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most senior of the securities were downgraded to near junk bond status last week. Valuing mortgage bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear Stearns securities are almost certain to lose value as long as home prices keep falling.

“Under the current circumstances it’s likely that you are going to take a loss on these loans,” said Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear Stearns and bundled and rebundled them into even trickier investments known as collateralized debt obligations, or C.D.O.’s

“No two pieces of paper are the same,” said Mr. Feltus of Pioneer Investments.

On Wall Street, many of these C.D.O.’s have been selling for pennies on the dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31 billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar. Citigroup says its C.D.O.’s are relatively high quality because they were created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.

Written by infoproc

September 27, 2008 at 12:06 pm

Mortgage securities oversold by 15-25 percent

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Below are some quotes which support the view that mortgage assets are currently undervalued by the market. Yes, the market is inefficient — it overpriced the assets at the peak of the bubble (greed), and is currently underpricing them (fear). Both Buffet and ex-Merrill banker Ricciardi below think the mispricing is about 15-25 percent. That is, the “fear premium” currently demanded by the market is 15-25 percent below a conservative guess as to what the assets are really worth. This is the margin that can be used to recapitalize banks, perhaps without costing the taxpayer any money, simply by providing a rational buyer of last resort and injecting some confidence into the market. Note to traders: yes, this is obvious. Note to academic economists: this is yet another market failure — but of an unprecedented scale and complexity.

(Actually, 15-25 percent is not bad, and just shows that credit markets are generally more rational and data driven than equities. During the Internet bubble and collapse you had mispricings of hundreds of percent, even an order of magnitude.)

Warren Buffet interview from CNBC:

Government intervention necessary to restore confidence in the market.

If I didn’t think the government was going to act, I would not be doing anything this week. I might be trying to undo things this week. I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Mispricing is about 15-20 percent:

…all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government. And what they’re talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that’s going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won’t do it perfectly right, I think they’ll make a lot of money. Because if they don’t — they shouldn’t buy these debt instruments at what the institutions paid. They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.

Christopher Ricciardi, former head of Merrill’s structured credit business, in an open letter to Paulson. Note his comments illustrate the role that psychology, or animal spirits (Keynes), plays in the market.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis.

Government purchases of illiquid mortgage assets from the system will cost taxpayers significant sums and expose them to downside risk, without addressing this fundamental issue. Billions of dollars held by all the major institutional bond managers, hedge funds and distressed funds are already available to purchase mortgage assets.

However, in the absence of a way to finance the purchase of these assets, such funds must bid at prices which represent an attractive absolute return acceptable to their investors (15% to 25% typically), resulting in typical transaction terms that have significantly impeded the sale of mortgage securities to these funds. If these funds could finance their purchases, especially under efficient financing terms, they would still require similar returns, but would be able to buy many more assets, and bid higher prices for the assets.

Our financial system needs the capital markets and the natural power of securitization to get a jumpstart from the government. I propose using the powers granted to Treasury to create “vehicles that are authorized…to purchase troubled assets and issue obligations” under currently contemplated legislation to more efficiently address the crisis and establish a program which we might call the Federal Bond Insurance Corporation (”FBIC”), as an alternative to simply having the government directly purchase assets.

Comment re: behavioral economics. The preceding housing bubble and the current crisis are very good examples of why economics is, at a fundamental level, the study of ape psychology. On the planet Vulcan, Mr. Spock and other rational, super-smart traders and investors would have cleared this market already. But we don’t live on Vulcan. Anyone who wants to model the economy based on rational agents who can process infinite amounts of information without being subject to fear, bounded cognition, herd mentality, etc. is crazy.

When the conventional wisdom is that house prices never go down (people believed this just a couple years ago), you risk little of your reputation or self-image by investing in housing. When the conventional wisdom is that all mortgage backed securities are toxic, you must be extremely independent and strong willed to risk buying in, even if metrics suggest the market is oversold. This is simple psychology. Very few people can resist conventional wisdom, even when it’s wrong.

Written by infoproc

September 26, 2008 at 5:11 pm

Survivor: theoretical physics

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Some very interesting data here on jobs in particle theory, cosmology, string theory and gravity over the last 15 years in the US (1994 — present).

Based on these numbers and the quality of the talent pool I would guess theoretical physics is the most competitive field in academia, by a large margin. (Your luck will be much, much better in computer science, engineering, biology, …)

The average number of years between completing the PhD and first faculty job is between 5-6. That would make the typical new assistant professor about 33, and almost 40 by the time they receive tenure.

Here are the top schools for producing professors in these fields:

1. Princeton 23 (string theory rules! or ruled… or something)
2. Harvard 18
3. Berkeley 16

This is over 15 years, so that means even at the top three schools only 1 or at most 2 PhDs from a given year typically gets a job in the US. The US is by far the most competitive market. If you follow the link you will see that the list of PhD institutions of US faculty members is truly international, including Tokyo, Berlin, Moscow, etc. (Note I think the jobs data also includes positions at Canadian research universities.)

The field is very much dominated by the top departments; the next most successful include MIT, Stanford, Caltech, Chicago, etc.

Here are some well-known schools that only produced 1 professor of theoretical physics over 15 years: UCLA, UC Davis, U Illinois, U Virginia, U Arizona, Boston University, U Penn, Northwestern, Moscow State University (top university in USSR), Insitute for Nuclear Research (INR) Moscow

Here are some well-known schools that only produced 2 professors over 15 years: Ohio State, U Minnesota, Michigan State, U Colorado, Brown

Here are some well-known schools that only produced 3 professors over 15 years: Columbia, CERN, Johns Hopkins, U Maryland, Yale, Pisa SNS (Scoula Normale Superiore; the most elite university in Italy), Novisibirsk (giant physics lab in USSR)

You can see that by the time we reach 3 professors produced over 15 years we are talking about very, very good physics departments. Even many of the schools in the 1 and 2 category are extremely good. These schools have all hired multiple professors over 15 years, but the people hired tend to have been produced by the very top departments. The flow is from the top down.

This dataset describes a very big talent pool — I would guess that a top 50 department (in the world) produces 3-5 PhDs a year in theoretical physics. If most of them only place a student every 5 years or so, that means the majority of their students end up doing something else!

How many professors do you think are / were straight with their PhD students about the odds of survival?

I only knew one professor at Berkeley who had kept records and knew the odds. One day in the theory lounge at LBNL Mahiko Suzuki (PhD, University of Tokyo) told me and some other shocked grad students and postdocs that about 1 in 4 theory PhDs from Berkeley would get permanent positions. His estimate was remarkably accurate.

How many professors do you think had / have a serious discussion with their students about alternative career paths?

How many have even a vague understanding of what the vast majority of their former students do in finance, silicon valley, …?

Related posts: A tale of two geeks , Out on the tail

Written by infoproc

September 24, 2008 at 4:17 pm