I looked over a number of books on this topic before deciding on 'Inventing Money', by Nicholas Dunbar. The book is not about the present crisis, but the collapse of LTCM in 1998. What it offered in addition to that is a history of derivative trading, reasonably easy to follow, but not dumbed down either. The Economist recommended the book highly. The gist and some comments follow.(There are also a couple of references to Nassem Taleeb's career makingbooks, 'Fooled by Randomness' and 'The Black Swan').
Derivatives and hedging mechanisms in general have been around for millennia. There is a reference to options of a sort in the Code of Hammurabi. But actual trading in financial derivatives (commodity futures is far simpler conceptually) was a practical impossibility in an open market until the second half of the last century, due principally to the difficulty of pricing options over time. Pioneer mathematicians such as Bachelier had suggested as early as the first decade of the century that 'random walk' statistical methods, the same that apply to the Brownian motion of dust particles and other natural phenomena, were equally applicable to movements in the price of stocks and the market in general. In 1968, Fischer Black and Myron Scholes came up with the Black-Scholes equation as a method of pricing options, for which they ultimately won the Nobel Prize in economics- or, as Nassem Taleeb is quick to remind anyone who needs reminding, the prize awarded by the Swedish Central Bank in honor of Alfred Nobel. Nobel himself did not endow a prize for economics.
Dunbar goes on to describe the increasing sophistication and complexity of these models developed throughout the 70's and 80's. It is not necessary to describe these in detail. The mechanics are fairly easy to understand, the actual implementation, extremely difficult. (One method borrows heavily from Richard Feynman's Quantum Electric Dynamics [QED] theory.) Without exception, all of these methods are based on data quantifications of varying and increasing subtlety. Traditional investment analysis - this company is well managed, that one is not - have little or nothing to say here. It is an arena in which theoretical physicists and Ph.D's in math are quite at home.
Durint the 80's, when I lived a lot closer to this stuff, I was fond of saying, as a joke, that modern market trading would not be possible without the personal computer. I didn't know how right I was. Texas Instruments programmed the Scholes-Black formula into some of the earliest models of its hand calculator, because otherwise traders would not be able to make use of it. Mitch Kapor developed the earliest models of Lotus for a friend at MIT who was working on derivative pricing models. Both men did extremely well, both from the product and from the trading strategies it made possible.The subtlety of the various computations of data done on these instruments is such that trading in fact would not be possible without personal computers.
The trading techniques do work well, extemely well, in normal market conditions. However, they have also lead to catacysmic market disasters - Black Monday, on October 19th, 1987, the fall of LTCM in 1998, and the catastrophe that has overtaken the present market. I would not have the temerity to give detailed explanations for why this should be - I lack the training. But three obvious observations do come to mind.
(1) First, and obviously, the regulatory framework that governs securities trading in the United States antedates the creation and explosive growth of these markets. The Securities Act of 1933 and the Exchange Act of 1934 were aimed at controlling bad practice in the traditional markets for stocks and bonds - not overseeing the effect of mathematically quantified derivatives on this scale. Requirements of full disclosure, prohibitions against misrepresentation, and all the others, are all but meaningless here. The SEC and the CFTC have done their best with this stuff - but the basic regulatory clothes don't fit.
(2) The second observation is even more obvious. Human beings are not Brownian particles. Although market behavior may be described in normal circumstances by statisical methods, what is reflected in the market isn't unconscious particle movement, but the thoughts, desires, aspirations, hopes, fears, and cunning of literally hundreds and millions (if not billions) of living, breathing rational beings. The traders who rely on these quantifications of data never considered that fact.
This blindness showed up in 1987 and 1998, when the major traders involved in the meltdowns attempted to justify themselves by reference to the statistical improbability of the events. These were ten sigma occurrences (they said), market movements so rare that they could not occur again in the history of the universe. Talk about missing the point - the explanations would be absolutely valid, if what was involved was a simple data array. But of course it was not, which is the simple, elemental crux of the matter.
There are times when that mass of people all come to share the same general perception of where their welfare lies, and move in exactly the same direction, and all hell breaks loose with those whose theories are predicated on a random walk. This is precisely what Nassem Taleeb, cited above, means by his reference to a Black Swan - an event off the charts of the statistical curve, infrequent to the point of impossibility in nature, but all too common in the far more complex world of human affairs. Statistics in the world of human affairs do not define. They only describe.
(3) The final obvious point has to do with leverage. It may not be immediately apparent, but the trading models decribed above are engines of awesome refinement. A bond trader using these methods is not looking for the benefit of a warrant attached to a share of common stock. Anyone can compute the value of that, in whole dollars, and act accordingly. What the trader seeks to identify is some subtle semi=option somewhere in the mix of contract features in a particular bond instrument - something that gives it a trading value not immediately recognized on the market.
Obviously, we are not talking whole dollars here, or tenths of dollars, or hundredths of dollars, or even thousandths of dollars (tenths of a cent). Economic benefits of this substance and visibility are already factored into efficient markets. The targets are advantages that too small to be factors in trading consciousness - thousandths of a cent, ten thousandths of a cent, hundred-thousands of a cent. (I don't know if the scale of these numbers is accurate, but the concept certainly is.)
From which perception the reason for the extreme leverage of these trading instruments is apparent. If you are after an advantage in a trade on a particular mortgage bond that is worth a thousandth of a cent on a dollar, you are not going to settle for simply trading the face amount of the bond. Exploiting a bond with a million dollar face amount nets you only $100 - less than the price you paid for the program. To make any real money, the sort of money that leads to seven and eight figure salaries after expenses have been paid and clients satisfied, you are going to have to leverage the bejeezus out of your position - more capital than even well-endowed institutions usually have. You can only do that if you hedge your position, or insure it in various ways, with still other derivatives, credit swaps, reverses, and so on.
All of this is just great when the markets are stable and well-organized. But suppose they are not? Suppose the insurer you used becomes bankrupt because its own co-insurer has gone under.? Suppose the entire insurance and hedging structure collapses like so many dominoes? You probably reply this could only happen once in the history of the galaxy - except that it has happened three ttimes now in 30 years, and on increasing scale of catastrophe.
Nassem Taleeb, whose eloquence is going to be quoted by many in years to come, referred to the LTCM trading strategy, as 'picking up pennies in front of a steamroller'. Safe enough in ordinary circumstances, because you are fast and the steam roller very slow - but think Kevin Kline in the marvellously funny scene in 'Fish Called Wanda'. What is happening now is that we are all stuck in the cement and a much larger steam roller is bearing down on us - fast.
What to make of all this? A few final points, though I am no financial guru.
First, this is hardly the death of capitalism. Despite its monumental effects, the trading markets that has brought forth these horrors are only about forty years old. They literally didn't exist in 1970. They are a sideshow in terms of the regular process of capital formation. I have my own doubts whether they have any raison d'etre at all in the scale on which they exists, except to generate trading profits for a small group of the ultra-elite for astronomical trading profits - kleptocrats, as I said elsewhere. Surely the legitimate needs of financial institutions can be met without engaging in these hair raising dangers.
Second, it is also true that the regulation that is inevitable in these markets does not portend the death of capitalism. Regular equity markets have been coping, and even thriving, with much more burdensome regulation for three generations now. It is true that opportunities for trading profit are going to diminish considerably. But we would all have been better off if some of these financial types had had REAL jobs all this time.
Third, and finally, the leverage that is the most striking feature of these markets must be curbed and limited.
My own naive thought is quite direct. I think trading in financial derivatives should be abolished, except by licensed traders trading on behalf of a few major institutions. At the very least, it has to be monitored trade by trade.
But I am, as said, no financial guru. I hope these thoughts and insights will be of some value to others who, like me, have been wondering what the hell happened.
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Posted by: hypotheek grafiek | March 06, 2009 at 06:52 PM