Oct. 18th, 2008

peterbirks: (Default)
Some interesting stuff in, of all places, the Financial Times magazine. Sam Jones has ostensibly written a piece about Moody's, but tucked away inside it is the story of ABN Amro and its quants' invention of the Constant Proportion Debt Obligation (CPDO). A CPDO is, effectively a bet on the creditworthiness of hundreds of US and European corporations. What was interesting about CPDOs were that they seemed to achieve triple A rating safety while returning single A levels of annual interest.

Of course, it wasn't like that. It was smoke and mirrors. But that isn't the point. Mikey mentioned a couple of days ago how it wasn't really the Quants' job to understand risk; it was just to be able to create products that seemed to give a higher rate of return for a lower apparent risk. And the CPDO appeared to fulfil this, in spades.

I suspect that these Quant product designers are all boardgamers in their spare time. Because what the designers of the CPDOs did wasn't to try to produce a product that generated a better rate of return for a lower chance of loss. What they were trying to do was create a product that achieved a better rate of return relative to the average for the agency rating it was supplied. The trick, therefore, wasn't to produce a better product, but to produce a product that beat the rating agencies' stress-testing simulators.

The real world had nothing to do with it.

Now, you and I have common sense. If a product can offer me a 50% rate of return (I exaggerate here -- in reality we were talking of small fractions of a per cent "extra") and a stress test that I run tells me that its chance of failure is on a par with products typically offering a 5% rate of return, my first thought is not that this is a great offer, but that there is something wrong with my stress-testing simulator.

Did the investment guys "know" that the CDPOs that they were buying weren't really a holy grail of investment, but they didn't care? Or did they genuinely believe that they were a better product? I don't know, but I guess it matters. Because in the first case it would mean that the system is broken, while in the second case, it just means, get better people.

Andrew Lahde of Lahde Capital clearly thinks it's mainly a matter of these people being stupid. He's closing down his hedge fund, having made his "fuck you" money, and in a parting note has basically referred to counterparties at the larger banking institutions as a collection of corporate fish. In effect, Lahde claims that the insitutional culture of larger firms ensures that the people who are good at office politics rather than the people who are good at their job rise to the top. Inevitably they will be ripped apart by outsiders who are actually good at what they do.

In investing (and in poker), it takes a lot of mental strength to "keep the faith" of your own beliefs when all around you are saying something different. Although I disagree vehemently with Merryn Somerset Webb's view on how the next five years is going to pan out, I fully admire her ability to think things through from first principles. One thing that she noted was that lots of asset classes appear to be uncorrelated when times are good, but cease to be uncorrelated when times are bad (which is when you want them to be uncorrelated). Merryn remains convinced that cash is the place to be at the moment and that real interest rates will remain good for a long time. So, that's another voice making me feel like the lone gunman in a conspiracy thriller who is only a lone gunman because he's turned up in the wrong town at the wrong time. Fortunately that nice Mr Buffett said that he was investing in equities.

Merryn also, I think, made the mistake of assuming an inverse correlation between bonds and equities. In fact, for a last sentence, she is surprisingly weak.

"In general, except for in times of inflationary recession, bonds and equities seem uncorrelated: when equities fall, bonds rise. And vice versa. Now that's what I call diversification".


Well, clearly, if one thing falls when the other rises, it isn't uncorrelated. It's inversely correlated. I had an economics lecturer who made a similar kind of error once, which led him to a conclusion that a certain policy would cause decreasing inflation, whereas his maths showed that the result would be increasing deflation -- not the same thing at all.

But the other problem with Merryn's point here is that her recommendation is based on her original assumption -- that we are not heading for inflationary recession but for deflationary recession. In other words, her line is the logical equivalent of "if I'm right, I'm right".

Since I assume that we are heading for inflationary recession, then bonds and equities could indeed stop moving in an inversely correlated fashion.

The counter-argument here, of course, is that equities have not performed well historically in times of inflation, even though, logically, they should outperform most asset classes, simply because they are based in the real world (profits in the long run match the value of "real" wealth, and so should be resistant to inflationary erosion). I suspect that part of the reason for the apparent poor performance is a failure to allow for a three-year lag or so. Equities performed badly in the UK from 1968 to 1975 (when inflation was going up), but they performed very well from 1974 to 1979 (during which time inflation was gradually brought under some sort of control).



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