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Old 01-23-2010, 09:29 PM
 
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Sounds interesting.

The Minds Behind the Meltdown - How a swashbuckling breed of mathematicians and computer scientists nearly destroyed Wall Street

Quote:
...what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets. Nearly every single quantitative strategy, thought to be the most sophisticated investing ideas in the world, was shredded to pieces, leading to billions in losses. It was deleveraging gone supernova.
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Old 01-23-2010, 09:52 PM
 
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yeah - I just read about this in WSJ - I will have to read the book. Pretty fascinating, albeit disturbing....
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Old 01-24-2010, 10:58 AM
 
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Quote:
Nearly every single quantitative strategy, thought to be the most sophisticated investing ideas in the world, was shredded to pieces, leading to billions in losses.
...At the time, few quants realized what was happening, but over the next few days a theory would emerge: The U.S. housing market was unraveling, leading to big losses in the mortgage portfolios of banks and hedge funds. One or more of those hedge funds needed to raise cash quickly to make up for the losses, and needed to sell assets quickly to do so. And the easiest-to-sell assets of all were stocks, those held in portfolios highly similar to quant funds across Wall Street.
Why the quants' models didn't work:

The U.S. housing market was unraveling...

"BEN BERNANKE: Oh, the worst moments were back in September. The financial crisis began with Fannie Mae and Freddie Mac, the large housing companies that were taken over by the government, and subsequent to that a number of very large financial firms came under enormous pressure. One of them, Lehman Brothers, an investment bank, failed. Others came close to failure, needed government support, not just in the United States, but around the world. And those were some very long nights I spent on the sofa in my office as we worked to try to keep the financial system running."
At Forum, Bernanke Defends Fed's Aggressive Moves | Online NewsHour | July 27, 2009 | PBS

Massive fraud at Fannie and Freddie:
"...Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A.
In general, a subprime mortgage refers to the credit of the borrower. A FICO score of less than 660 is the dividing line between prime and subprime, but Fannie and Freddie were reporting these mortgages as prime, according to Mr. Pinto. Fannie has admitted this in a third-quarter 10-Q report in 2008.
...It is easy to see how this misrepresentation was a principal cause of the financial crisis.
...because of Fannie and Freddie's mislabeling, there were millions more high-risk loans outstanding. That meant default rates as well as the actual losses after foreclosure were going to be outside all prior experience."
Peter J. Wallison: The Price for Fannie and Freddie Keeps Going Up - WSJ.com

Stats on the GSE's loans:
RealClearMarkets - How Did Paul Krugman Get It So Wrong?

More of Pinto's analysis: The FHA is in trouble, too...
http://www.house.gov/apps/list/hearing/financialsvcs_dem/ed_pinto_testimony_and_attachments.pdf (broken link)
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Old 01-24-2010, 11:36 AM
 
Location: Portland, Oregon
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The problem is that you can't predict the future, but you can extrapolate past movements and attempt to see where things are going *based on that current fundamentals hold true* (or at least expected). The problem is that when big market shifts happen, you can see it coming but what exactly will happen is unknowable. Not like many analyst didn't see it coming, I did and I took action, but their warnings were never headed by the general public. In fact, many people who were saying things were going to have problems were screamed at till they just walked away while people cheered those saying housing was going to double every few years forever.

The models do nothing if people don't like what they see, and find another telling a story they like and decide to do it. The models that got airplay were the ones that people liked to look at, not the ones where people could defend it or explain the movements. I see the same thing giving people financial advice (which is why I stopped), people just want some one to agree with what they want to do and make it sound happy...not to tell them what would be the best to to.

People only want things that agree with their views, not something that is accurate. People can whine and moan all they want after the fact, but it's just better to ignore it any more because it will never change.
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Old 01-24-2010, 12:02 PM
 
74,446 posts, read 34,676,874 times
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Quote:
Originally Posted by subsound View Post
The problem is that you can't predict the future
That's why risk is factored into the quants' models. The problem in this case was that everyone was unknowingly working with the massively fraudulent loan classifications provided by the GSE's, which owned or had sold nearly $5 Trillion worth of loans/MBS's which touched nearly every corner of the global financial system.

Who can forget Sherman's disclosure?


http://www.youtube.com/watch?v=h9gtf6nT3zg
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Old 01-24-2010, 05:58 PM
 
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The real problem seems to be the layers and layers of exotic derivatives and derivatives of derivatives that were flying around these companies and their trading desks. It was a clear violation of the principle "don't put all your eggs in one basket," except that things got so complex, no one knew the contents of the basket in the first place.
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Old 01-24-2010, 06:56 PM
 
74,446 posts, read 34,676,874 times
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Quote:
Originally Posted by tablemtn View Post
The real problem seems to be the layers and layers of exotic derivatives and derivatives of derivatives that were flying around these companies and their trading desks. It was a clear violation of the principle "don't put all your eggs in one basket," except that things got so complex, no one knew the contents of the basket in the first place.
No one knew the contents of the basket because the GSE's intentionally misrepresented the classifications of millions of loans included in their $5 Trillion worth of owned/guaranteed loans/MBS's. All it took was that one very large fraudulent domino to topple the interconnected financial system. Read Bernanke's statement on PBS:

"BEN BERNANKE: Oh, the worst moments were back in September. The financial crisis began with Fannie Mae and Freddie Mac, the large housing companies that were taken over by the government, and subsequent to that a number of very large financial firms came under enormous pressure. One of them, Lehman Brothers, an investment bank, failed. Others came close to failure, needed government support, not just in the United States, but around the world. And those were some very long nights I spent on the sofa in my office as we worked to try to keep the financial system running."
At Forum, Bernanke Defends Fed's Aggressive Moves | Online NewsHour | July 27, 2009 | PBS

And the passage from the book review...
Quote:
...At the time, few quants realized what was happening, but over the next few days a theory would emerge: The U.S. housing market was unraveling, leading to big losses in the mortgage portfolios of banks and hedge funds. One or more of those hedge funds needed to raise cash quickly to make up for the losses, and needed to sell assets quickly to do so. And the easiest-to-sell assets of all were stocks, those held in portfolios highly similar to quant funds across Wall Street.
Why blame the quants and the derivatives when it was the fraudulent loan classifications that ran the mathematical models off the rails?
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Old 01-24-2010, 07:25 PM
 
5,765 posts, read 10,734,794 times
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I think you are looking past the fundamental issue here - imagine the exact same Fannie/Freddie situation, but without any exotic derivatives trading at all. It would have been a typical bubble and slump of the sort we've seen before many times. It would not have almost brought down some of the biggest banks in the world.

Also, think back to the period before the crash, when prices in various commodities were spiking and declining with very little rational reason. As it turned out, a lot of that had to do with extremely convoluted derivatives contracts between investment banks distorting the "real" economy.

As the article notes, the management at firms like JP Morgan did not even know what the financial products divisions were doing.

Here; read through this 2005 Guide to Exotic Credit Derivatives produced by Lehman Brothers:

The Lehman Brothers Guide to Exotic Credit Derivatives - PDF file

See if you can make heads or tails of the models and strategies described in that document. See if you can describe in simple terms why a Cholesky decomposition would help provide an apt basis for the risk modeling of these types of securities.

Many of these derivatives got piled into housing, but even without that market, the models used to determine the "risk" of those derivatives were applicable to basically anything. If not housing, it was commodities. If not that, it would have been something else.

The structure itself created the certainty of an inevitable collapse.
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Old 01-24-2010, 07:49 PM
 
74,446 posts, read 34,676,874 times
Reputation: 10474
Quote:
Originally Posted by tablemtn View Post
I think you are looking past the fundamental issue here - imagine the exact same Fannie/Freddie situation, but without any exotic derivatives trading at all. It would have been a typical bubble and slump of the sort we've seen before many times. It would not have almost brought down some of the biggest banks in the world.

Also, think back to the period before the crash, when prices in various commodities were spiking and declining with very little rational reason. As it turned out, a lot of that had to do with extremely convoluted derivatives contracts between investment banks distorting the "real" economy.

As the article notes, the management at firms like JP Morgan did not even know what the financial products divisions were doing.

Here; read through this 2005 Guide to Exotic Credit Derivatives produced by Lehman Brothers:

The Lehman Brothers Guide to Exotic Credit Derivatives - PDF file

See if you can make heads or tails of the models and strategies described in that document. See if you can describe in simple terms why a Cholesky decomposition would help provide an apt basis for the risk modeling of these types of securities.

Many of these derivatives got piled into housing, but even without that market, the models used to determine the "risk" of those derivatives were applicable to basically anything. If not housing, it was commodities. If not that, it would have been something else.

The structure itself created the certainty of an inevitable collapse.
Theoretically, maybe. There's no indication whatsoever that a failure other than the grossly misrepresented risk on $5 Trillion worth of financial products sold worldwide would have had the same effect.
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Old 01-26-2010, 09:53 AM
 
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In any case, it looks like exotic securities are starting to thrive again on Wall Street:

Banks Reviving Synthetic Bets as Volcker Blasts Default Swaps

Quote:
Bets using credit-default swap indexes that speculate on bonds without buying them have jumped 13 percent in the past three months to $1.2 trillion, DTCC data show...

As Wall Street recommends more complex trades, investors are also augmenting bets with borrowed money. Some banks are offering as much as 10-to-1 leverage on securities backed by prime-jumbo home loans
Hmmm... we should probably get the next round of bailouts ready...
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