WordPlay - Language, Culture, Media, and Meaning

A Country Lawyer Looks at Derivative Trading

    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.

What Would President Palin Have Done?

The rather genial Democrats on the discussion site on which I normally post are having a lot of fun sneering at Sarah Palin. She can't name the newspapers she reads, she can't cite more than one Supreme Court case. (For what it's worth, I can't name a newspaper I read, either, since the Internet began to flourish - I check various sites.) But it seems to me this is the wrong time for various credentialed types to be jibing in this way, what with the nation and world in a furor over the threat to the financial system brought on by the Best and Brightest, following five years of uproar over a war based on the reasoning and values of a different set of Best and Brightest. Condescension just doesn't feel right.

This suspicion of credentialism leads me to a thought experiment. What would the last eight years of the Presidency have looked like if Sarah Palin had been in office? Let's take the financial crisis first.

(1) Wall Street. I am not going to suggest that Sarah Palin would have brought some magical insight into the coming storm. But it is the fact that storm warnings were issued constantly. The problem was not that Congress or the White House was not aware of potential problems in the home morgage industry. The difficulty was point of emphasis. Moreover, it is difficult for anyone, no matter what the bacjground, to stand up against the sheer weight of supposedly informed opinion when so much money is at stake.

But how could she have done worse? Sarah Palin has a good record of resisting intimidation, whether from pipeline consortiums or the Republican establishment. It is more than a little possible that a mother of four, with her varied, middle class experience, and no stake at all in the Establishment might just have brought Trumanesque insight to the situation. She might have looked at the towering pyramid of debt, and the bewildering array of debt instruments, and thought, something is wrong here. I don't know what it is, but something is wrong. She might have given some thought to the people at the base of the pyramid, the nurses, firefighters/policemen, grocery clerks, paramedics, and so on, who want nothing more than to buy a home. She might have been more interested in their ambitions than those of hedge fund managers.

Just as a reminder, these issues were before the three other candidates on the ticket. Let's throw in Hillary Clinton for good measure. McCain at least cosponsored a reform bill in 2005, though it was not a major item. The others did nothing. It is not unreasonable to wonder if President Palin wouldn't have done a little better. Obama from Harvard, Clinton from Yale, Biden a member of the bar amd four-term Senator - it is not like any of them burned up the track here.

(2) Iraq. This one is a little 'iffier'. Anyone who reads this blog knows I have a lot more sympathy for this decision than most. However,  I am not debating the rights and wrongs of the Iraq War here. I do think it is safe to assume that, in the immediate aftermath of 9/11 any President - and I am including Clinton and Carter - would have considered some use of American force to alter the status quo in the Middle East. Other terrorist acts were considered inevitable. If you think about the position of the Chief Executive, he or she would be haunted by that possibility - of having to face the American people after another atrocity, when something could have been done, and nothing had been. So it is a fair bet that President Palin would have done something - just what I don't know.

Maybe it would not have been Iraq. Maybe President Palin would have been just dumb enough, unlike the Yalie in the White House,  to wonder about the collective wisdom of all that intelligence that showed weapons of mass destruction. Perhaps she would not have been as impressed with the thinking of all those Ph D's from Chicago, who definitely read a lot of newspapers and know Supreme Court cases. Perhaps she would have made her own down-and-dirty calculation of risks and rewards, and demanded a different calculation of options. Or, if she did decide on Iraq, she might have assigned reasons that were a little more far reaching than simply the search for weapons.

This last is the main point. Whatever her decisions,  I am next to certain that President Palin would have done an infinitely better job of explaining them to the American people and the world than the present, Andover-and-Yale educated incumbent. Almost for sure, she would articulate the reasons for whatever action she chose, in terms that the public could understand, if not completely accept. I doubt very much she would retreat into the White House and leave the public debate to go on without her. The presidency of George Bush is going to take a long time to assess - but one conclusion I think can be fairly reached right now, is that his inability and/or unwillingness to explain himself has resulted in a truly, dismal, one-sided public dialog. It is a failing that might even rise to the level of a tragic fault.
 

So the disdain of the Best and Brightest seems to me completely misplaced, given the issues that face the nation. (By the way, one of my constant readers took me to task for the Kleptocrats piece, claiming I was exhibiting class prejudice. Well, I did not mean that in a moral sense. I intended to make the same point that David Halberstam did when he entitled his classic book on the Vietnam War 'The Best and the Brightest', meaning that this calamity has been visited on us BY the Establishment, the most privileged and credentialed persons in our society - who have also been hugely enriched as a result.)

I don't know whether President Palin would have done better. But it is doubtful she would have done much worse. This is hardly the appropriate moment to be contemptuous of what is clearly a lively and active intelligence.