Of Models and Short Regulators

Yet another tip of the hat to Gillian Tett for her article on "Metaphors, Models and Theories" by Emanuel Derman, author of My Life as a Quant, currently a professor at Columbia University and the head of risk at a fund manager. He also blogs here.

Derman's paper helps one get to grips with the financial crisis by succinctly explaining the shortcomings of financial models. Importantly, he points out that:

"Models are analogies, and always describe something relative to something else. Theories, in contrast are the real thing. They don't compare; they describe the essence, without reference."

While Derman gives examples of various theories that can be expressed in mathematical equations, he shows that finance is not capable of such expression. "There are no genuine theories in finance... Only imperfect models remain."

Derman suggests that we "use models as little as possible, and to replicate making as little (sic) assumptions as [we] can," and that we adhere to five rules:

1. While every financial axiom is wrong, the question is "how wrong, and can you still make use of it?"
2. "Build vulgar models in a sophisticated way", "using variables the crowd uses... to describe the phenomena they observe."
3. "A user should know what has been assumed when he uses the model, and... exactly what has been swept out of view."
4. Models can't be truly right. "You are always trying to shoe-horn the real world into one of the models to see how useful an approximation that is."
5. "To confuse the model with a theory is to embrace a future disaster driven by the belief that humans obey mathematical rules."

Of course, such limitations could also be said to extend to non-financial models deployed in and around the financial markets, demonstrating the enormous challenge inherent in the regulation of markets for complex products.

Financial models don't operate in a vacuum. The debt markets comprise at least as many models with inherent assumptions about how various aspects of those markets should operate as there are roles, functions, systems and controls, whether they be related to accounting, regulation, underwriting, collections, rating, marketing or audit. Everyone is operating on models - rating models, asset pricing and valuation models, accounting models that assume a company's health is reflected in its financial statements, regulatory models that may be either 'light touch' or heavily prescriptive. And everyone is operating on his or her own model of how these models work together.

The shortcomings of financial models apply equally to all of them.

However, all these models only ultimately 'bite' when a transaction occurs. And since transactions only occur between buyers and sellers (or their agents), only their beliefs about how models 'work' affect each transaction - capitalism keeps the authorities and everyone else on the sidelines. So the 'protective' models deployed by support functions and external actors can only be effective if they are properly deployed and fully understood by market participants. This seems impracticable, given that the likes of lawyers, accountants, ratings agency managers and bond traders have very different views of the same market, and differing attitudes to their employers, clients and so on.

So it's no real surprise that the narrative of the current financial crisis (e.g. "The Big Short") demonstrates the deficiencies in all these models and the manner in which they were deployed, as well as the (sometimes willful) lack of understanding of them amongst virtually all sub-prime debt market participants, regulators, intermediaries and advisers.

This poses an enormous challenge for the future development of markets for complex products. Better financial models, and better use of those models, won't avoid future financial crises. More rules and regulations cannot really be the answer, at least while they remain external to market participants and their transactions - and weakly enforced. Ultimately, we must either improve the knowledge of market participants relative to the complexity of products (through better education and training and/or by reducing the complexity of the products) or give regulators, or some independent creature - a more active role in transactions, if not as outright participants or potential participants.

Regulatory participation in transactions - or the threat of it - could be achieved partly through real-time transaction reporting from all significant financial markets, as is currently proposed in various initiatives around the globe. But that begs the question what the regulators will actually do with the transaction data.

As suggested in my previous post, perhaps adding short-selling to the regulatory repertoire would not only improve transparency and timeliness in dealing with market misconduct, but also provide regulators with a better feel for the limits in the models deployed in and around the financial markets.

Should Regulators Be Short?

As the ebbing economic tide exposes more and more fraud, it's striking to see how long the authorities have been aware of some problems before attempting to correct or publicise them. How are investors protected in the meantime? Shouldn't they be given a chance to cut their losses and switch to better investments as soon as problems are detected? Should new investors be compensated for transactions they would not have entered into had they been aware of the misconduct and/or a firm's diminished reputation?

A review of various accounting, debt and pension scandals suggests that, rather than banning short-selling "to protect the integrity and quality of the securities market and strengthen investor confidence", regulators would be more effective if they were to publicise their own short selling as a tool to identify and punish errant firms and companies and to promote market confidence.

Lack of timely regulatory response to financial problems is perhaps best illustrated in books like "Fooling Some of the People All of the Time" about the six years of foot-dragging over Allied Capital's creative accounting and The Big Short, about the few players who got ahead of the sub-prime debt crisis. It's also emerged what a poorly kept secret Madoff's fraud was, yet nothing was done officially until it was too late. Meanwhile, Ernst and Young are being taken to task over Lehman's use of so-called "Repo 105" transactions to take certain assets of its balance sheet at each quarter-end. Other specific examples have been given in defence of short-selling before.

Some recent, comparatively trifling, examples closer to home are also instructive. In May 2009, Aegon (then known as Scottish Equitable) informed the FSA of 300 "issues" amounting to £60 million of consumer detriment. Yet this was only presented to the marketplace on 16 December 2010, with a 30% reduction in Aegon's fine, from £4 million to £2.8million. In April 2010 various trading firms were fined £4.2 million, for failing to "provide accurate and timely transaction reports to the FSA." Yet only now are we told that:

"Each firm could have prevented the breaches by carrying out regular reviews of its data. Despite repeated reminders from the FSA during the course of 2007 and 2008, none of the firms did this."

While civil enforcement authorities tip toe around the edges of market problems, things are no better on the criminal enforcement side. UK judges are understandably reluctant to approve US-style 'plea bargains' that result in smaller fines and no admission of illicit conduct. A recent case in point was Mr Justice Bean's reaction to the tiny 'settlement' to emerge from the notorious BAE Systems saga.

Why all this regulatory timidity?

One justification for restraint, co-operation behind the scenes and discounted fines is that it encourages firms to report their own misdeeds rather than hide them - yet the misconduct does remain hidden from customers by the regulators. And informal regulatory discussions can be problematic. Witness the concern around the FT's report that UK banks' auditors may have factored assurances of government support into their opinions as to whether the banks were going concerns in 2008. Worryingly, the FT notes that "auditors are likely to be encouraged to have more private chats with regulators to help prevent another crisis."

In cases of corporate fraud, the justification for restraint is similarly misplaced, as David Einhorn explains in "Fooling Some of the People All of the Time":

"The authorities really don't know what do do about fraud when they discover it in progress... It seems the regulatory thinking... is that shareholders should not be punished for corporate fraud, because... they are the victims in the first place... This thinking may be politically expedient in the short term, but creates a classic moral hazard - a free fraud zone. If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies... If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said [and] allocate their capital more carefully. This sensitivity and other consequences will, in turn, deter dishonesty."

On the flip-side, as Sy Jacobs has observed (quoted in The Big Short) "Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people..." .

Regulators also often cite their own statutory boundaries as the basis for ignoring firms' extra curricular activities. This may be a good technical defence, but feeble given that the financial markets are inter-connected globally, can dwarf the regulated sphere and are populated by subsidiaries of regulated holding companies, as the New York Fed recently admitted in its report on 'shadow banking'.

Finally, unlike a typical approach to risk assessment, the authorities are not able to extrapolate from problems found in a sample of cases to reach a view on a portfolio basis in enforcement actions (see Financial Services and Markets Tribunal decision concerning Legal and General's Flexible Mortgage Plans. But if the material facts were in the market, at least investors would be able to decide for themselves.

What distinguishes the short sellers' approach?

The literature suggests that, firstly, short sellers think more deeply and critically than the financial authorities about the limits of the various models used in and around the financial markets. Perhaps this is because the short sellers' first instinct is to question the status quo, whereas the regulators first instinct is to support it. Secondly, once short sellers detect a potential anomaly, they investigate it with a view to trading - and so putting themselves at real risk - potentially over a long period of time. Whereas the authorities merely commence an investigation with the vague intention of possibly activating a more formal, lengthy investigation, which might eventually end in a fine or settlement without any admission of wrongdoing. So the short sellers' are driven by a strong sense of anxiety about being wrong, while the authorities are not really 'driven' at all.

Adding short-selling as a regulatory tool may be controversial. But it would enable regulators to learn the same disciplines as the most critical market participants, and remove the time lag and lack of transparency associated with civil and criminal actions. Publishing their short positions would also serve as an instant early warning of the underlying issues - and maybe pay for the ensuing enforcement activity.

Image from Mises Daily.

Christmas Special

Here's a little thought to distract you from the frustration of seemingly insufferable transport delays over the holiday season: might all this grief be a signal to either buy transport companies' shares or short them?

If it's true (as you may bitterly begin to suspect) that transport companies are ultimately profiting from captive UK customers (and the government) by raising fares despite ongoing public subsidy, under-investing in service improvement or snow-clearing and/or saving money by reducing services during difficult weather conditions, then might it not be worthwhile to buy their shares? I mean, if they're engaging in all theses tactics to be more profitable, then why not climb aboard?

Or perhaps you would prefer to bet that, if transport companies are unfairly taking advantage, then sooner or later they'll get rumbled and their stock prices will fall. In which case it may be worth shorting their shares.

In either case, any gains you might make would at least off-set fare increases and other costs. And the consolation that you are personally profiting from disruption might ease your personal discomfort.

Of course, your suspicions may prove to be unfounded or, even if true, may not be material to corporate results or otherwise sound in the market. In which case your investment won't pay off and you're misery may increase. But, hey, at least you'll be able to console yourself that you didn't just sit there simmering helplessly ;-).

Anyhow, safe travels and have a happy Christmas and New Year.


Image from ImpactLab.

German 'Fraudclosure' Issues

Hat-tip to Glen Davis, insolvency and financial services barrister par excellence, for pointing out Dr Philiipp Esser's piece on "Mortgage Foreclosure Turbulence" in Germany.

It seems the US securitisation market is not the only one in which the purchasers of mortgage debt have enforcement problems. German portfolios are similarly vulnerable.

According to Philipp, the Federal Court of Justice of Germany (Bundesgerichtshof, BGH) has ruled (in XI ZR 200/09) that the Risk Limitation Act 2008 requires the loan purchaser to become a party to the original security agreement between the borrower and the original lender before it can lawfully exercise any immediate right of foreclosure in that security agreement. Merely taking an assignment of the agreement from the original lender is not enough. Unlawfully foreclosing will also render the loan purchaser directly liable for any damage suffered by the borrower.

Philipp suggests that "in most transfers of real estate loans for purposes of refinancing the acquirer has not joined the [original] security agreement."

Robo-signers beware!

Policy Fail? Simple Products And The UK Treasury

The UK's regulated financial services providers have failed to co-operate with various government initiatives to encourage the offering of simple financial products, according to a recent report by Professor James Devlin for the UK Treasury. He found that:

"The combination of a relatively low fee cap [1 to 1.5%], free movement in and out of products without penalty and the relatively low level of funds invested by many users together represented a formidable barrier to enthusiasm from the industry for previous “simple products” (Devlin, p.4)

The lack of simple regulated financial products affects virtually the entire UK population. The primary target may be those people earning low to medium incomes, and those with little financial services experience/expertise/interest and/or limited savings (Devlin, p.10). But people earning higher incomes (over £30k) include themselves in the target market because they would most welcome "standards which show when a financial service offers customers a reasonable deal" (Devlin, p.14). The Treasury also notes in the accompanying consultation on simple financial products, that 48% of UK households have less than a month's salary in savings, and 27% have none at all (para 2.13).

When launching the Retail Distribution Review of financial advice in 2006, the FSA claimed that "insufficient consumer trust and confidence in the products and services supplied by the market lie at the root of what we are seeking to address." And while Professor Devlin cites recent research to the effect that trust in financial service providers is "not significantly below" supermarkets, mobile phone providers and the NHS (Devlin, p.16), that's not saying very much. Investments, pensions and securities are the least trusted consumer services across the EU. Only 34% of consumers think they deliver what's promised, 26% of us are as likely to trust investment providers as used car salesmen, yet 76% of us don't bother to switch providers. What would be the point?

Faced with regulated financial services providers' continuing refusal to supply suitable investment, pension and savings products at reasonable prices, you'd think the government would directly question the structure of all the providers and their products. After all, similar proposals for 'vanilla products' are afoot in the US (and meeting strong resistance from providers, of course (Devlin, p.31)). Instead, however, the UK government has meekly decided to avoid simple investments altogether and focus solely on simplifying "deposit savings accounts" and income protection insurance:

"Although the Government believes that the principles of simple products are widely applicable, it also believes that, initially, simple products should focus on products that do not carry risk to capital, i.e. that are not investment products. Risk would add an extra level of complexity to the product design, as the design would have to weigh up how much risk individuals are willing to bear, both in terms of capital risk and risk to gains."

Hello?

This astonishingly narrow focus fails on at least four counts. First, and most obviously, it shies away from the key challenge facing the consumer: the lack of simple investment products. Second, it means the government won't enable us to diversify at a reasonable cost. Third, it encourages us all to put our money in the banks for little or no interest, leaving us exposed to inflation that continues to hover well above base rates. Fourth, given the banks' reluctance to lend their deposits due to capital constraints, these proposals inhibit the efficient allocation of our surplus cash to creditworthy people and businesses.

While initiatives to improve financial advice are helpful, good advice does not equate to simple products. The glacial Retail Distribution Review, launched in 2006, will only alter compensation for financial advisers from the end of 2012. Full advice will be fee-based and beyond most people. While advisers are "considering" developing a simplified advice model that might provide a "limited sales route", they're worried that if the investments do not perform customers may claim they thought they were given full advice which proved to be wrong (Devlin, p.26). I wonder why?!

In response to the sound of dragging feet, the government recently commissioned the Consumer Financial Education Body to develop a "free and impartial national advice service":

"It will not give regulated advice, but it will provide people with information and advice on all major areas of money and personal finance. A key component of the national financial advice service will be a financial healthcheck, that will provide people with a holistic review of their finances, highlight areas to prioritise, and give people a personalised action plan to take forward. The service will move as close to the regulatory boundary as possible to ensure that people have a seamless journey between the national financial advice service and regulated advice, should they need it. To this end, CFEB is exploring the possibility of providing generic product recommendations, for example 'you should consider purchasing home contents insurance'." (HMT, para 4.3; see also Devlin, p.29))

You mean home contents insurance is an investment? In what, burglaries?

That little gem aside, the "Moneymadeclear" web site may help improve the knowledge of someone who already has a basic understanding of the various types of financial service. But it won't help anyone to actually decide on a suitable product, or render products 'simple'. Which is surely the point.

A little sunlight may penetrate via the "key investor information document" introduced at EU level to enable easier comparison of the key terms of multiple products. Professor Devlin also suggests that strong warnings on products that do not meet "simple product" criteria (Devlin, p.5) and a traffic light system to declare the risk associated with products (Devlin, p.27) would help people choose suitable products. He has urged the government to retain rule RU64 that obliges a financial advisor to explain why any alternative product being recommended is at least as suitable as a simple product. He found that this rule led product providers to reduce fees for more complex products to make them at least as suitable (Devlin, p.22).

For now, however, we're stuck with expensive, complex regulated financial products.

Like... the Kickout bond! ;-)