The Great Confidence Trick

When Bobby "Dazzler" Diamond said the time for bankers' remorse is over, I thought for a moment he was suggesting something more profound.

But of course he was merely attempting to inspire enough confidence to justify a quick bonus before reality bites harder.

A recent tour of the contrarian financial blogs did not make for pleasant reading.

US bank "earnings — like those from 2009 — will be skewed by falling loan loss provisions set aside to cover bad debt." Meanwhile, toxic assets remain on public books as delinquencies soar and the rules are bent to allow the banks to magically produce profits. Which may explain why at least one of the ratings agencies may finally be taking steps to curb the ratings of investment banks.

Even the US Commerce Department seems to be engaging in jiggery-pokery to avoid a 'double-dip'.

And while FT Alphaville speculated that the impact of the decline in the pace of US mortgage foreclosures might be good for the economy because:

- Fewer houses come to market, thereby propping up prices (or slowing their decline)

- Therefore fewer people go underwater on their mortgages

- Foreclosures have a devastating impact on the prices in the surrounding neighborhood

- Households preserve more wealth and are therefore more likely to spend rather than save

- Consumer confidence in housing increases

- More loan modifications (though how many successful ones is unclear)

- Time is bought for the rest of the economy to recover

On the other hand, [they said] this might not be good for the economy because:

- The problems in the housing market have simply been put on hold, not solved

- The excess inventory in the market won’t clear unless prices fall to a more natural level, and the sooner the inventory is cleared, the sooner the housing sector recovers and builders can get started again

- It’s unlikely that loan modifications will ever work on a large enough scale to make a difference

- Foreclosure delays are a distorting incentive on mortgage borrowers, who will be more likely to strategically default

[But] we have a nagging feeling that there are unintended consequences (or even straightforward expected consequences) that we simply haven’t thought of..."

Of course, the authorities remain timid in their approach to corporate and securities fraud, perpetuating collusion in the mortgage markets and prolonging the economic crisis.

Which encourages the aforesaid aggressive provisioning and selling practices:

"In its offer for the $1.5bn stock sale of privately held social-networking company Facebook, Goldman Sachs disclosed that it might sell or hedge its own $375m investment without warning clients. Under the deal, private wealth-management clients would be subject to “significant restrictions” limiting their ability to sell stakes while Goldman Sachs own holding can be sold or hedged at any time, and without warning."

Amazingly, today Goldmans pulled the offering, but only in the US. We gullible foreigners can always be relied upon...

As can pension funds, life insurers and other asset managers. So don't expect to retire.

Now, Bob. About that bonus...

Image from Sulekha.

Alternative Power For Geeks

It's fascinating how much data is publicly available. Here, for instance, is a summary of key data that describe the UK electricity market, including demand and generation by fuel type.

So what?

Well, apart from putting various fuel types into perspective, and maybe settling a few arguments, it's worth reflecting that the Hawthorne Effect was named after the electricity plant in which it was first documented. Henry Landsberger found that workers' productivity improved when he measured it to study the impact of light levels on their work, but declined again when his experiments ended. That suggests that when people know you're measuring their activity, it improves.

Alternative energy-generation measurement widget, anyone?

Water Quality/Filter Filter?

A tale of two teas

I confess to having taken drinking water pretty much for granted, until my brother-in-law joined a leading water softener and filter supplier. Now I'm a little obsessed.

Amazingly, UK water companies actually produce a report that shows the water quality in your area. Just plug in your post code and tick the content you want to see. This is designed to tell you what 'contaminants' the water companies have been able to filter out, and allow you to decide what you might need or want to filter out yourself for whatever reason.

Unfortunately, there seems to be no mash-up that enables you to directly compare the remaining contaminants in your area with the capabilities of all the available water filters on the market - a "water quality/filter filter".

Something for the Open Data community, using API's and data from the various utilities and filter providers?

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.