The Rise of the (Financial) Machines

BartlebyScrivener writes "A New York Times Op-Ed quoting Freeman and George Dyson wonders if Wall Street geeks and 'quants' outsmarted themselves with computer algorithms to create the current financial debacle: 'Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth. It's not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers.'" The quoted essay from George Dyson is available at Edge.

Re:VaR anybody?

[dnwq]

An interesting article from Newsweek, The Monster That Ate Wall Street [newsweek.com]:

But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?

What the bankers hit on [in the 1990s] was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices... [JPMorgan] built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return.

...

Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool.

...

AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.

The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG.

Ever wonder where 'money' comes from?

[mrbill1234]

Check out this 47 minute video for a very easy to understand and clear explanation.

http://video.google.com/videoplay?docid=-9050474362583451279 [google.com]

Unless you've been through university on some Economics degree - you were probably unaware of this.

Re:TFA perpetuates voodoo explanations

[drooling-dog]

Don't be so touchy. The point is not that the crisis is the fault of "the nerds", but that the risk was effectively masked by the conversion of mortgages into ill-understood derivatives. Everyone along the chain could ignore it because it would always be the next guy's problem. The models that evaluated the risk of default were based on historical data, and failed to take into account that both the quality of the mortgages and the nature of the housing market were changing rapidly.

Re:VaR anybody?

[Anonymous Coward]

I work with this as well, and I can tell you that the way VaR is run is somewhat flawed. What they basically do is to run various scenarios, changing different factors and calculate what the impact on the investor's position is.

Now, there are several ways you can do this. One is to run a massive monte-carlo simulation on all the input data, something that all financial software supports. There is a problem with this though, and that is that it requires some massive CPU power. Even a smaller bank would require many hundreds if not thousands of CPU's chugging away for 12 hours or more to come up with the proper numbers.

The solution they've come up with is called "historical VaR". What they do is to use the historical market data for the last year instead of random data which would be used otherwise.

The obvious problem with historical VaR is of course that it doesn't take unexpected market movements into account. If a drop such as the ones that we have seen recently haven't happened in the last year, VaR won't take such a scenario into account.

So, in short, VaR only really works in "normal" market conditions. It doesn't take extreme movements into account.

More Leverage....

[mosch]

As painful as this is, I do take some comfort in the crisis happening now rather than a year or two from now when even more leverage would have been injected into the system.

I'm confused, and wondering what you're talking about.

The original leverage ratios were set by Basel, which pegged them at 8% (or 12.5:1). In 2004, this was updated. It's still 8%, but now assets are risk-weighted.

Claims on depository banks were were given the following risk weights:
AA- 0%
A- 20%
BBB- 50%
B- 100%
(worse) 150%
Unrated 100%

And to make matters worse, claims on securities firms were defined to be the same as claims on banks.

And the kicker, claims secured by residential mortgages were weighted at 35%.

As such, though the leverage ratio was officially 12.5, somebody who held nothing but mortgages could be levered up 35:1. And if you owned some bank issues, you could get nearly infinite.

But I'm wondering... what makes you think that these limits were going to be further increased?

Re:Yes, let's blame the geeks

[Anonymous Coward]

Riiiiight, the large banks are such big pushovers that they would rather face bankruptcy than be publicly derided.

No, jackass.

The banks faced lawsuits.

From folks like ACORN.

Like this one [mediacircus.com]:

Case Name
Buycks-Roberson v. Citibank Fed. Sav. Bank Fair Housing/Lending/Insurance
Docket / Court 94 C 4094 ( N.D. Ill. ) FH-IL-0011
State/Territory Illinois
Case Summary
Plaintiffs filed their class action lawsuit on July 6, 1994, alleging that Citibank had engaged in redlining practices in the Chicago metropolitan area in violation of the Equal Credit Opportunity Act (ECOA), 15 U.S.C. 1691; the Fair Housing Act, 42 U.S.C. 3601-3619; the Thirteenth Amendment to the U.S. Constitution; and 42 U.S.C. 1981, 1982. Plaintiffs alleged that the Defendant-bank rejected loan applications of minority applicants while approving loan applications filed by white applicants with similar financial characteristics and credit histories. Plaintiffs sought injunctive relief, actual damages, and punitive damages.

U.S. District Court Judge Ruben Castillo certified the Plaintiffs suit as a class action on June 30, 1995. Buycks-Roberson v. Citibank Fed. Sav. Bank, 162 F.R.D. 322 (N.D. Ill. 1995). Also on June 30, Judge Castillo granted Plaintiffs motion to compel discovery of a sample of Defendant-banks loan application files. Buycks-Roberson v. Citibank Fed. Sav. Bank, 162 F.R.D. 338 (N.D. Ill. 1995).

The parties voluntarily dismissed the case on May 12, 1998, pursuant to a settlement agreement.
Plaintiffs Lawyers Alexis, Hilary I. (Illinois)
FH-IL-0011-7500 | FH-IL-0011-7501 | FH-IL-0011-9000
Childers, Michael Allen (Illinois)
FH-IL-0011-7500 | FH-IL-0011-7501 | FH-IL-0011-9000
Clayton, Fay (Illinois)
FH-IL-0011-7500 | FH-IL-0011-7501 | FH-IL-0011-9000
Cummings, Jeffrey Irvine (Illinois)
FH-IL-0011-7500 | FH-IL-0011-7501 | FH-IL-0011-9000
Love, Sara Norris (Virginia)
FH-IL-0011-9000
Miner, Judson Hirsch (Illinois)
FH-IL-0011-7500 | FH-IL-0011-9000
Obama, Barack H. (Illinois)
FH-IL-0011-7500 | FH-IL-0011-7501 | FH-IL-0011-9000
Wickert, John Henry (Illinois)
FH-IL-0011-9000

Yeah, THAT fucking Barack Obama.

I guess we now know what "community organizers" do, eh?

Re:The million dollar question is...

[nomadic]

Only most of the loans that were rolled into the mortgage-backed securities were made by institutions that were not governed by the CRA.

Nice try though.

Re:Risk of property lending = Pyramid Scheme?

[Anonymous Coward]

I've done some more digging on this imaginary wealth ... Here's a news report from 2005, which says just how huge the bubble has got (even just up to 2005).

Jun 16th 2005
From The Economist print edition
"NEVER before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?

According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries' combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America's stockmarket bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history."

So it "rose by more than $30 trillion over the past five years" ... oh wow, that's way more than 2%!

Here's the link...
http://www.economist.com/opinion/displaystory.cfm?story_id=4079027 [economist.com]

Re:Yes, let's blame the geeks

[moortak]

Plaintiffs filed their class action lawsuit on July 6, 1994, alleging that Citibank had engaged in redlining practices in the Chicago metropolitan area in violation of the Equal Credit Opportunity Act (ECOA), 15 U.S.C. 1691; the Fair Housing Act, 42 U.S.C. 3601-3619; the Thirteenth Amendment to the U.S. Constitution; and 42 U.S.C. 1981, 1982. Plaintiffs alleged that the Defendant-bank rejected loan applications of minority applicants while approving loan applications filed by white applicants with similar financial characteristics and credit histories.

Did you read the allegations you posted? This is not a case of oh no you don't give poor people enough loans. This is an accusation of hey you give one group loans while not doing so for other races with the same credit background. Redling is a terrible practice.

Re:More Leverage....

[martyb]

As such, though the leverage ratio was officially 12.5, somebody who held nothing but mortgages could be levered up 35:1. And if you owned some bank issues, you could get nearly infinite.

But I'm wondering... what makes you think that these limits were going to be further increased?

You obviously know more about these details than I. What I was working from was what I heard in the second program: Another Frightening Show About the Economy [thislife.org]. You can download it for free at the moment from: here [thisamericanlife.org].

Here's the summary for part 2:

Act Two. Out of the Hedges and Into the Woods.

One more confusing financial product that's bringing down the global economy. And one of way to think about this product is this: If bad mortgages got the financial system sick, this next thing you're about to hear about, helped spread the sickness into an epidemic. These are "credit default swaps." Alex explains. (19 minutes)

The segment was so well done, it's hard to summarize, but I'll do my best. In essence, "Credit Default Swaps" (CDS) were presented as a form of insurance that a lender could by so as to minimize the risk that a loan would default. So far, so good. Then, somebody realized they could by a CDS for a loan they did not even own. So what? It got out of hand when someone realized they could make money by buying a CDS for something that was questionable. How so? Like buying life insurance. Like buying life insurance on somebody ELSE. Who is old and feeble. I have an opportunity to buy a policy for, say, $1M on this person. And YOU have an opportunity to buy the same kind of policy from your agent. The sicker the person, the more of an incentive there is to buy in.

Now, replace "old and feeble person" with "Lehman Brothers". And for "insurance company", try "AIG". And multiply just You and Me with hundreds or thousands of CDSs in play. With many, many other companies. As I understand it, there was no regulatory limit on how many CDSs could be purchased on the exact same debt issue. And, because there was no mandatory reporting or the like on what CDSs were out there, we really don't know just how many of these are out there. With all the repackaging of these as securities, sliced and diced and sold as yet more instruments, we don't know just how bad the situation is.

Again, I cannot do the show justice. Listen to the podcast. I'd love to hear your take on it once you have done so.

Re:Yes, let's blame the geeks

[Anonymous Coward]

Can't see the forest because of the trees, or because you're too fucking STUPID? The CRA built the framework for the entire Fannie Mae/Freddie Mac debacle and resultant credit crunch that's killing the world economy right now. Just because the Obama the Messiah (to quote Louis Farrakhan) decided to extort Citibank using other portions of that framework doesn't excuse him from the effects of his shakedown.

And because Freddie and Fannie were all too willing to buy up those affirmative-action mortgages, banks soon learned to play ball:

From Confrontation to Collaboration? Banks, Community Groups, and the Implementation of Community Reinvestment Agreements [harvard.edu]

Banks and other depository institutions have signed more than 300 community reinvestment agreements valued at $350 billion in the two decades since the passage of the Community Reinvestment Act (CRA). This article examines the effectiveness of negotiating CRA agreements in Chicago, Cleveland, Pittsburgh, and New Jersey. After describing the agreements and the procedures by which they are enforced, the article looks at their impact and discusses several factors that could limit implementation of CRA agreements in the future. The findings suggest that CRA agreements are more effective in some areas than others. They seem most consistently successful in meeting their goals for mortgages, investments in low-income housing tax credits, grant giving to community-based organizations, and in opening (and keeping open) inner-city bank branches. The future of CRA agreements is clouded by several factors, most notably the restructuring and consolidation of the financial service sector.

And one of those factors is finding out that it's not such a great idea to hand out trillions of dollars of mortgages based on social engineering and wishful thinking.

Re:This American Life

[Anonymous Coward]

From credit default swaps to the paper market drying up to NINA loans, these two episodes gave me more information in two hours than I could gather watching every single major TV news show for weeks.

Which is why NPR, as a whole, currently has THE best journalism and reporting in the entire country. The major networks (Fox, CNN, ABC, MSNBC, etc.), frankly, look pathetic when you hold them up to the quality and depth of coverage you get from NPR.

Personally, I love their vast library of podcasts [npr.org].

Re:Ah, liberals are at fault.

[jbengt]

To emphasize your point, from

Prepared Testimony of Michael S. Barr Professor of Law, University of Michigan Law School Before the Committee on Financial Services U.S. House of Representatives Hearing On âoeThe Community Reinvestment Act: Thirty Years of Accomplishments, But Challenges Remainâ February 13, 2008

see this:

In a Federal Reserve Board survey of CRA-covered institutions, most responded that CRA lending was profitable or marginally profitable, and not overly risky.

this:

Despite the fact that CRA appears to have increased bank and thrift lending in low- and moderate-income communities, such institutions are not the only ones operating in these areas. In fact, with new and lower-cost sources of funding available from the secondary market through securitization, and with advances in financial technology, subprime lending exploded in the late 1990s, reaching over $600 billion and 20% of all originations by 2005. More than half of subprime loans were made by independent mortgage companies not subject to comprehensive federal supervision; another 30 percent of such originations were made by affiliates of banks or thrifts, which are not subject to routine examination or supervision, and the remaining 20 percent were made by banks and thrifts.

and this:

As has become all too evident, the subprime market has been plagued by serious problems. Some subprime borrowers who could have qualified for loans from prime lenders end up in the subprime market, paying higher rates: Preliminary research suggests up to 35% of subprime borrowers could qualify for prime mortgage loans.

(emphasis mine)

Re:The creation and transfer of funny money

[the eric conspiracy]

The main problem with the gold standard is that it ties the amount of money available to the economy to the amount of gold available to governments. Well guess what this has nothing to do with the size of the economy. Especially in an economy that is very service oriented. Gold is a natural resource that is becoming increasingly difficult to dig out of the ground. People tend to hoard gold (see Roosevelt's gold confiscation in 1933) taking it out of circulation. Gold has other uses - jewelry, inert plating in electronics, etc. that assure competition with its use as an asset backing currency.

All of this means that use of a gold standard will place a deflationary bias on money supply. This is very dangerous; it causes a positive feedback loop during recessions intensifying them and making recovery difficult. This is not an acceptable way to operate, and been shown to be so by some really severe depressions in the US over the past 200 years, many triggered by a mismatch between the money supply constrained by the gold standard and the actual size of the economy and rate of economic growth.

I know you Ayn Rand fanboys like the idea of a gold standard, but sorry it is just a really bad idea.

And if you are going to complain about fractional reserve banking have you considered just where a bank is going to actually generate any income if this business model is outlawed? What is exactly the purpose of a bank in the first play if there is no business model? Better count on stuffing your money in a mattress because there won't be any banks.

Now there is a problem of governments getting carried away putting too much money into circulation etc. but the solution to that is verty simple. Make the damn government run a balanced budget. Of course NeoCons don't like that because they are tied to the insane idea of reducing taxation increases tac revenues (NOT!!!).. too bad.

Re:Anti-math/science witch hunt

[anaesthetica]

HOW did the model not include some check

That's just the point. They didn't do the sociology of the people taking the NINA variable rate mortgages. A lot of them were speculators who were buying properties with no money down and then flipping them. This had two effects: driving the price up because they could; and, making it looks like NINA variable rate mortgages were getting paid off with only slightly higher risk than normal loans. Once the house-flippers got out and interest rates went up, the people with no assets and no income left holding the variable rate mortgages couldn't pay and the house of cards collapsed. The model was based on speculators flipping houses, not on real owners.

If the quant people had done the sociology instead of just running the numbers, they would know who was buying and why the data appeared the way it did.

Appraisals were not necessarily accurate

[IvyKing]

A huge point is completely missing: all of the houses were appraised at the values the mortgages were offered. These appraisals were done at market value and were accurate - if you can sell your house for $500,000 today, then it should be appraised at $500,000 today.

Uh no. The fact that a house sold for $500,000 does not mean it is worth $500,000 to another buyer. The whole point of appraising for loan qualification was to assure the lender had a good chance of getting their money back in case of a loan default. What happened was that appraisers were generally pressured into approving sale prices if they wanted business from the real-estate agents.

My take is that there were too many people involved in the process that were making money without any long term responsibility. Things might have been different if say 50% of the mortgage brokers commisions were based on loan payments.

The other big problem was that there was too much leverage in a speculative market - which is exactly what led to the 1929 stock market crash - and that speculation was driven by the Fed maintaining low interest rates.

Re:Anti-math/science witch hunt

[Znork]

When all else can be held equal, formal modeling can give you very powerful insights into causal mechanism and prediction.

Of course, as the very foundation upon which all the formal modeling is built is flawed, it's no surprise that it falls down. It's not math, it's not science, it's the very axiom of the banking system that's at fault.

Essentially every single thing that has gone wrong can be traced to, and derived from, fractional reserve banking and the central banks. Everything above that is built on the theory that credit is always expanding. People will always borrow more, allowing the central banks to hold rates below the free market cost of money, enforcing 'investment' (speculation) and spending as the appropriate ways to divest money. Credit expansion is what creates asset inflation, it is what leaves the banks insolvent, heck, it's even what creates demand for oversized extra expensive cars, and it is what leaves the models fundamentally flawed as they never consider the end game.

The end game comes when the last debtor cannot carry his debt any more. The models figure that, but they miss the fact that as the last debtor loses his ability to carry debt, the assets everyone else has purchased suddenly lose his added bid. Asset prices start falling. Then we lose those who could only carry their debt as their assets were appreciating. And asset prices start falling even more. Then we get credit destruction as debt defaults, assets are written down and credit gets constrained by balance sheet requirements (the banks that thought they were solvent suddenly realize they're sitting on a pile of assets that's not worth anywhere near what they were when the last sucker paid his price). When they go over their books they realize that they, and probably everyone else, has nowhere near the money they need to repay their debts.

Suddenly credit isn't expanding anymore. And the central banks lose control over their ability to control interest rates; when credit isn't infinite you pay the market price or you don't get the money. And the whole house of cards comes crashing down.

Of course, it's entirely possible to build a rational model of a fractional reserve system too, but as that would require debt ratings that go down as economic leverage goes up it'd essentially negate the exact thing the FRB system and central banks try to accomplish. It would basically mean that risk rating and cost of money would go up as the central banks tried to lower interest rates and inflate. We would have had the whole economy on a B rating in 1999, and on C last year.

It'd be saner just to move to full reserve banking. I wish. I'm not holding my breath.

Re:Ever wonder where 'money' comes from?

[anaesthetica]

The secondary money market (known as derivatives) in the US, is $500 trillion.

It's worse than that:

The main categories of the USD 1.144 Quadrillion derivatives market were the following:

1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
   1. Interest Rate Derivatives at about USD 393+ trillion;
   2. Credit Default Swaps at about USD 58+ trillion;
   3. Foreign Exchange Derivatives at about USD 56+ trillion;
   4. Commodity Derivatives at about USD 9 trillion;
   5. Equity Linked Derivatives at about USD 8.5 trillion; and
   6. Unallocated Derivatives at about USD 71+ trillion.

Re:Slaves to Debt

[johanatan]

That's just not true. One big advantage to gold is the quite unique trait of resistance to corrosion. Yes, it is quite soft and so can't be used in heavy-duty applications, but it does have a great many uses (electrical for one; as part of an alloy for another).

Here's [wikipedia.org] a more complete list:

Re:This American Life

[plasmacutter]

the CRA did not compel lending to bad credit risks.

what it did do was compel banks to actually assess people based on credit rather than arbitrary geographic area.

Re:Reagan's tax cut DID increase revenue

[Anonymous Coward]

That graph really should be on a log scale, and take into account inflation and population growth in order to begin to argue about causation. By your low standard of evidence, the Clinton tax hikes also increased revenue. I haven't looked over it in detail, but this analysis [cbpp.org] seems more comprehensive and appears to discount "Voodoo economics".