Dragon Kings, Black Swans and Bubbles

"Dragon Kings" is a new term to me, and the subject on Monday evening of a presentation by Prof. Didier Sornette at an event given by PRMIA. Didier has been working on the diagnosis on financial markets bubbles, something that has been of interest to a lot of people over the past few years (see earlier post on bubble indices from RiskMinds and a follow up here).

Didier started his presentation by talking about extreme events and how many have defined different epochs in human history. He placed a worrying question mark over the European Sovereign Debt Crisis as to its place in history, and showed a pair of particularly alarming graphs of the "Perpetual Money Machine" of financial markets. One chart was a plot of savings and rate of profit for US, EU and Japan with profit rising, savings falling from about 1980 onwards, and a similar diverging one of consumption rising and wages falling in the US since 1980. Didier puts this down to finance allowing this increasing debt to occur and to perpetuate the "virtual" growth of wealth.

Corn, Obesity and Antibiotics - He put up one fascinating slide relating to positive feedback in complex systems and effectively the law of unintended consequencies. After World War II, the US Government wanted to ensure the US food supply and subsidized the production of corn. This resulted in over supply over for humans -> so the excess corn was fed to cattle -> who can't digest starch easily -> who developed e-coli infections -> which prompted the use of antibiotics in cattle -> which prompted antibiotics as growth promoters for food animals -> which resulted in cheap meat -> leading to non-sustainable meat protein consumption and under-consumption of vegetable protein. Whilst that is a lot of things to pull together, ultimately Didier suggested that the simple decision to subsidise corn had led to the current epidemic in obesity and the losing battle against bacterial infections.

Power Laws - He then touched briefly upon Power Law Distributions, which are observed in many natural phenomena (city size, earthquakes etc) and seem to explain the peaked mean and long-tails of distributions of finance far better than the traditional Lognormal distribution of traditional economic theory. (I need to catch up on some Mandelbrot I think). He explained that whilst many observations (city size for instance) fitted a power law, that the where observations that did not fit this distribution at all (in the cities example, many capital cities are much, much larger than a power law predicts). Didier then moved on to describe Black Swans, characterised as unknown unknowable events, occurring exogenously ("wrath of god" type events) and with one unique investment strategy in going long put options.

Didier said that Dragon-Kings were not Black Swans, but the major crises we have observed are "endogenous" (i.e. come from inside the system), do not conform to a power law distribution and:

• can be diagnosed in advanced
• can be quantified
• have (some) predictability

Diagnosing Bubbles - In terms of diagnosing Dragon Kings, Didier listed the following criteria that we should be aware of (later confirmed as a very useful and practical list by one of the risk managers in the panel):

• Slower recovery from perturbations
• Increasing (or decreasing) autocorrelation
• Increasing (or decreasing) cross-correlation with external driving
• Increasing variance
• Flickering and stochastic resonance
• Increased spatial coherence
• Degree of endogeneity/reflexivity
• Finite-time singularities

Didier finished his talk by describing the current work that he and ETH are doing with real and ever-larger datasets to test whether bubbles can be detected before they end, and whether the prediction of the timing of their end can be improved. So in summary, Didier's work on Dragon Kings involves the behaviour of complex systems, how the major events in these systems come from inside (e.g. the flash crash), how positive feedback and system self-configuration/organisation can produce statistical behaviour well beyond that predicted by power law distributions and certainly beyond that predicted by traditional equilibrium-based economic theory. Didier mentioned how the search for returns was producing more leverage and an ever more connected economy and financial markets system, and how this interconnectedness was unhealthy from a systemic risk point of view, particularly if overlayed by homogenous regulation forcing everyone towards the same investment and risk management approaches (see Riskminds post for some early concerns on this and more recent ideas from Baruch College)

Panel-Debate - The panel debate following was interesting. As mentioned, one of the risk managers confirmed the above statistical behaviours as useful in predicting that the markets were unstable, and that to detect such behaviours across many markets and asset classes was an early warning sign of potential crisis that could be acted upon. I thought a good point was made about the market post crash, in that the market's behaviour has changed now that many big risk takers were eliminated in the recent crash (backtesters beware!). It seems Bloomberg are also looking at some regime switching models in this area, so worth looking out for what they are up to. Another panelist was talking about the need to link the investigations across asset class and markets, and emphasised the role of leverage in crisis events. One of the quants on the panel put forward a good analogy for "endogenous" vs. "exogenous" impacts on systems (comparing Dragon King events to Black Swans), and I paraphrase this somewhat to add some drama to the end of this post, but here goes: "when a man is pushed off a cliff then how far he falls is not determined by the size of the push, it is determined by the size of the cliff he is standing on". 

 

 

The financial crisis and Andrew Lo's reading list

I spotted this in the FT recently - for those of you diligent enough to want to read more about the possible causes and possible solutions to the (ongoing) financial crisis, then Andrew Lo may have saved us all a lot of time in his 21-book review of the financial crisis. Andrew reviews 10 books by academics, 10 by journalists and one by former Treasury Secretary Henry Paulson.

Andrew finds a wide range of opinions on the causes and solutions to the crisis, which I guess in part reflects that regardless of the economic/technical causes, human nature is both at the heart of the crisis and evidently also at the heart of its analysis. He regards the differences in opinion quite healthy in that they will be a catalyst for more research and investigation. I also like the way Andrew starts his review with a description of how people's view of the same events they have lived through can be entirely different, something that I have always found interesting (and difficult!).

A quote from Napolean (that I am in danger of over-using) seems appropriate to Andrew's review: "History is the version of past events that people have decided to agree upon" but maybe Churchill wins in this context with: "History will be kind to me for I intend to write it.". Maybe we should all get writing now before it is too late...

Taleb and Model Fragility - NYU-Poly

I went along to spend a day in Brooklyn yesterday at NYU-Poly, now the engineering school of NYU containing the Department of Finance and Risk Engineering. The event was called the "The Post Crisis World of Finance" was sponsored by Capco.

First up was Nassim Taleb (he of Black Swan fame). His presentation was entitled "A Simple Heuristic to Assess Tail Exposure and Model Error". First time I had seen Nassim talk and like many of us he was an interesting mix of seeming nervousness and confidence whilst presenting. He started by saying that given the success and apparent accessibility to the public of his Black Swan book, he had a deficit to make up in unreadability in this presentation and his future books.

Nassim recommenced his on-going battle with proponents of Value at Risk (see earlier posts on VaR) and economists in general. He said that economics continues to be marred by the lack of any stochastic component within the models that most economists use and develop. He restated his view that economists change the world to fit their choice of model, rather than the other way round. He mentioned "The Bed of Procrustes" from Greek mythology in which a man who made his visitors fit his bed to perfection by either stretching them or cutting their limbs (good analogy but also good plug for his latest book too I guess)

He categorized the most common errors in economic models as follows:

1. Linear risks/errors - these were rare but show themselves early in testing
2. Missing variables - rare and usually gave rise to small effects (as an aside he mentioned that good models should not have too many variables)
3. Missing 2nd order effects - very common, harder to detect and potentially very harmful

He gave a few real-life examples of 3 above such as a 10% increase in traffic on the roads could result in doubling journey times whilst a 10% reduction would deliver very little benefit. He targeted Heathrow airport in London, saying that landing there was an exercise in understanding a convex function in which you never arrive 2 hours early, but arriving 2 hours later than scheduled was relatively common.

He described the effects of convexity firstly in "English" (his words):

"Don't try to cross a river that is on average 4ft deep"

and secondly in "French" (again his words - maybe a dig at Anglo-Saxon mathematical comprehension or in praise of French mathematics/mathematicians? Probably both?):

"A convex function of an average is not the average of a convex function"

Nassim then progressed to show the fragility of VaR models and their sensitivity to estimates of volatility. He showed that a 10% estimate error in volatility could produce a massive error in VaR level calculated. His arguments here on model fragility reflected a lot of what he had proposed a while back on the conversion of debt to equity in order to reduce the fragility of the world's economy (see post).

His heuristic measure mentioned in the title was then described which is to peturb some input variable such as volatility by say 15%, 20% and 25%. If the 20% result is much worse than the average of the 15 and 25 ones then you have a fragile system and should be very wary of the results and conclusions you draw from your model. He acknowledged that this was only a heuristic but said that with complex systems/models a simple heuristic like this was both pragmatic and insightful. Overall he gave a very entertaining talk with something of practical value at the end.

Investment risk not rewarded

Interesting article from the FT, Reward for risk seems to be a chimera, effectively saying that more risky (volatile) equities do not necessarily provide higher returns than less risky equities. I like the suggestion that the reason for this is that "hope springs eternal" and investors buy more volatile stocks (pushing up price) in the hope of higher returns. However, as yet another illustration of the law of unintended consequences, the article goes on to suggest that choosing a benchmark index to outperform and limitations on borrowing imposed by investment mandates may both be driving this effect, are interesting and challenging ideas for investment managers.

 

2010 Risk in Review NY

I went along to a a Prmia event last night "2010 - Risk Year in Review". The event started with a somewhat overwhelming brain dump of economic and credit statistics from John Lonski, Chief Capital Markets Economist at Moody's Analytics. In summary he seems very bullish about corporate credit spreads tightening given the way in which corporate profit growth is surging ahead of debt growth. His main concern for the economy was maybe unsurprisingly the US housing market and whether this will bottom out and start to rise in 2011. Given fiscal imbalances and competition from emerging markets he did not think that inflation was a big risk despite activity such as QE2.

Robert Iommazzo of search firm Seba International did a fairly dry presentation on industry compensation for risk managers. Seba seem to getting around having had a big presence at Riskminds in Geneva last week. This section only livened up when the questions started after the presentation, and is probably worth noting that the UK FSA is being perceived as a "Big Brother" with its involvement in setting compensation policies in financial markets. Obviously the FSA is not heading back to the heady days of the 1970's where central government set industry pay rises (journalists please note this meant you back then!), but it is also obvious that such control over an individual's remuneration is something that goes totally contrary to an American way of thinking. UK Government needs to be mindful of this perception particularly if it leaves itself open to arbitrage on compensation policy from other financial centres.

Panel debate followed, involving Ashish Das of Moody's, Yury Dubrovsky of Lazard Asset Management, Jan H. Voigts of the NY Fed and Christopher Whalen of Institutional Risk Analytics. Main points:

• Chris said that he was one who was predicting a further fall in the housing market next year, and he asked the audience that when they looked at economic statistics, credit spreads,the Vix, bond spreads, did anyone getting the feeling the things are "normal" yet? Using these numbers and plugging them into a model does any believe the results are stable and can be relied upon? The audience fundamentally seemed to agree with these "warning" questions.
• Jan asked the audience to consider how believable is your data and to try to understand what data is critical for your business and that is imperative to create tools to manage this data appropriately. Jan said that the biggest challenge for financial institutions going forward is how to calibrate what rate/volume/type of business you can transact safely and that this needed a lot more consideration.  
• Yury said that he finds that the risks present in 2008 are still around in 2010, but now with the addition of European sovereign credit problems and the raft of regulation heading towards the industry. To add to this pessimistic note, he also said that some of the interest in "hot" emerging markets such as the BRICs was resulting in investments in lower quality IPOs relative to previous years.
• Ashish thought that systemic risk was going to become more important for the industry. With the setting up of the Office of Financial Research (OFR) next year, he suggested that the industry needed to take much more of a lead in sorting out its own house in advance of letting the regulators do so. On the subject of models, he said that models should supplement human judgement but not replace it, and mentioned the quote by George E. P. Box that "all models are wrong, but some are useful".
• Chris suggested that the role of risk managers will become more like that of a credit collector, with more involvement in actually seeing what can be recovered once a default has occurred. He also suggested that the industry should create its own consensus-based ratings (supplemented by the existing CRAs) to get a more reliable view of credit.
• Ashish echoed some of the speakers last week at Riskminds in saying that regulatory compliance is not risk management, and that practitioners should do more to guide the regulators.
• On the subject of risk culture, Yury asked how many risk managers knew data, quant, markets and how to deal with the egos of traders and senior management. This last point seemed to be conceded by the audience as a major weakness of the risk management profession and goes back to whether a risk manager is willing to put his career on the line to go against accepted business strategy.
• Chris added that having worked at several investment banks he had not yet experienced a risk manager attending a senior committee, let alone a risk manager speaking up against a senior trader. He talked of two business models "Paranoid and Nimble" and "Well Documented and Pedantic" with the second one being the only one possible in his view once a business gets to a certain size.
• On the subject of Government Sponsored Enterprises (GSEs like Fannie Mae and Freddie Mac) Chris said that the role of these will be up for review by the end of 2011. He thinks that the banks will head back towards actually holding mortgages and loans and the GSEs will become more conduits rather than direct sources of finance. This was news to me, given that so far the GSEs have been notably left out of recent reviews of what went wrong with the recent crisis.

Panel was very good, all speakers very knowledgeable. "Regulation is not risk", "models are not perfect", "risk governance" and "take control of your data" were all themes that echoed last week's RiskMinds event, allbeit with more of an American rather than international viewpoint on the economy, regulation and markets.

The current bad luck of the Irish

If like me you are puzzled as to:

• Why the Irish need a financing package now when they don't need to borrow for at least another 6 months?
• Why adding more debt on top of bad debt makes things better?
• Why bondholders of failed banks don't get forceably converted to holding equity and original equity holders get nothing?

Then take a read of the this article from the FT. We live in interesting economic times.

Dodd Frank Regulation - being seen to be doing something?

I went along to a Six Telekurs event "Securities Valuations: Is the Price Right?" last week - good event with some interesting speakers, most notably Paul Atkins of Patomak Partners to talk about the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. Paul is based out of Washington and was not very complimentary about what has been going on.

He started by saying that the Act was very large in size, with over 2319 pages (compared to SarbOx with only 60) and given this size he suggested that you could guess how many in Congress had actually read it. Background to the Act were:

• "Political Tailwinds" such as:
  • New Democrat Government with tenuous majority
  • Ambitious legislative plans
  • Bleak economic back-drop
• An angry populace:
  • TARP bailouts/Wall St bonuses
  • Recession and high unemployment
  • Perception that Govt. contributed to crisis
• Aggressive case for new regulation based on:
  • Lack of confidence in current systems and regulation
  • "Too big to fail" demonstrating that regulators lack the toolsets necessary to deal with such events
  • High leverage across the financial system and the economy
  • Poor risk management by existing participants
  • Opaque shadow banking system and opaque derivatives markets

He summarised that Housing and the Credit Rating Agencies were the key fundamentals behind the financial crisis.

Paul said that with the new regulation had the following features:

• The Act is a sweeping revision of financial regulation in the US
  • few dodged the regulatory changes (notably insurance managed to do this)
• The Federal Reserve has emerged pre-eminent amongst all regulatory bodies in the US.
• Significant discretion has been yielded to regulators to work out specifics
• Sheer size and ambiguous wording of the Act exacerbates the uncertainty in the market and economy and will require further fixes over coming years
• The Act does not reform Government Sponsored Enterprises (Fannie Mae, Freddie Mac)
• Far from reducing/simplifying the number of agencies involved in regulation the Act eliminated 1 agency and created 13 more
• Paul asked the question whether spreads and volatility will rise in the market due to new regulation (such as the Volcker rule) and whether ultimately this will trickle down to hinder or benefit SMEs.
• The Act will likely result in regulatory arbitrage opportunities and Paul said this was not a good thing for the United States

Paul said that in his view Congress learned the wrong lessons from the crisis:

• No reform of Fannie Mae and Freddie Mac
• Government Housing Policy left unaddressed
• Transparency still lacking despite efforts from FASB on fair value
• International Policy Co-ordination is still an open question as to its extent
• No reform of existing regulator structures
• The crisis has resulted in payoffs to favoured groups (Unions, Trial Lawyers etc)

Paul talked about how hedge funds and private equity funds were going to experienced increased regulation with them having to register if they have over $100M assets under management and future implications for systemic risk provisions. He mentioned that Venture Capital investments had escaped being required to register if the lock-up period was over 2 years.

He briefly discussed the coming changes in OTC derivatives on centralised clearing, post trade reporting and new liability provisions. Paul was also concerned about certain SEC related issues such as "Whistleblower" provisions which contain a bounty programme of about 10-30% of any fine subsequently awarded against a financial institution. He re-iterated that it was not yet clear what all of the bodies involved in regulation would be doing, and at the same time as this was the case the very same bodies were also being given very strong powers such as that of legal subpoena.

Paul was a very knowledgeable speaker and had some good points to make. Listening to him speak it would seem from my perspective that the Act is a prime example of "being seen to be doing something" to address the crisis rather than something better structured, with all of "law of unintended consequencies" risks that such an initiative entails.

 

 

 

Of Grasshoppers and Ants...

...not sure what Martin Wolf of the FT has been drinking or smoking recently, but he has certainly put together a very different way of explaining some of the economic inbalances faced by the world at the moment in his latest article.