Financial Crises, Contagion, and Complexity

The Challenges of an Interconnected World
CQF Extra July 19, 2010

The Lecture
• Part I: An Overview of Financial Crises - Manias, Panics, and Crashes through the ages • Part II: The Best of Times, The Worst of Times - select financial and economic timelines, trends, and case studies

• Part III: Complexity 1: The Globalization of Finance
• Part IV: Complexity 2: Technological Innovation in Finance

• Part V: The Garden of Forking Paths: Finance and Economics
• Part IV: The Fire Next Time: Where will the next crisis come from?
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A Note on Style and Format
The Disclaimer: • Attempting to cover a lot of ground – risk of going a mile wide and an inch thick • Wide range of readings selected from popular press and biographies to specialized finance, economics, market philosophy • Mix of stories, data, open questions, focus on diverse perspectives • Therefore, Conflicts of Opinion are encouraged • Embracing Logical Difficulties
– In philosophy, an aporia is a philosophical puzzle or a seemingly insoluble impasse in an inquiry, often arising as a result of equally plausible yet inconsistent premises.
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• There, in sum, in this place of aporia, there is no longer any problem. Not that, alas or fortunately, the solutions have been given, but because one could no longer even find a problem which would constitute itself and that one could keep in front of oneself, as a presentable object or project, as a protective representative or a prosthetic substitute, as some kind of border still to cross or behind which to protect oneself.
– Jacques Derrida, Aporias
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Part 1: An Overview of Financial Crises
• Anatomy of a Crisis • Varieties
– Manias and Bubbles – Panics – Crashes

• Regulatory Responses • US - Up to WWII • US - Post-War Boom

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Anatomy of a Crisis
• The Minsky Moment – In prosperous times, corporate cash flow rises beyond what is needed to pay off debt – A speculative euphoria develops – Soon, debts exceed what borrowers can pay from their revenues – This produces a financial crisis – Banks and lenders tighten credit, even to companies that can afford loans – The economy contracts The Financial Instability Hypothesis: “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.” - Hyman Minsky, 1974 Taxonomy – Hedge finance – Speculative finance – Ponzi finance

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Manias and Bubbles: Defined
• Mania, is a state of abnormally elevated or irritable mood, arousal, and/ or energy levels. The word derives from the Greek“ μανία" (mania), "madness, frenzy"and the presence of which is a criterion for certain psychiatric diagnoses. • An economic or financial bubble is characterized by “trade in high volumes at prices that are considerably at variance with intrinsic values.” • People are quite creative and also quite forgetful • You know what happens to those who forget history…

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Top Ten Bubbles
1. Dutch Tulip Mania, 1636 2. South Sea Bubble, 1720 3. Mississippi Bubble, 1720 4. Late 1920s – Stock Market Bubble, 1927-9 5. Bank Loans to Mexico & other devel. countries, 1970s 6. Real Estate and Stocks in Japan, 1985-9 7. Real Estate and Stocks in Scandinavia, 1985-9 8. Real Estate and Stocks in Thailand, Malaysia, Indonesia and other Asian Countries, 1992-7 9. Foreign Investment in Mexico, 1990-3 10. OTC Stocks , esp. Technology, in US, 1995 - 2000
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Tulip Mania, 1634 – early 1637
• 1593 – botany professor brings Turkish plants to Leyden • Mosaic virus produces “flames” and “bizarres” • Bulb merchants predicting demand for certain styles and stockpiling hot ones • Call options on bulbs • Upon crash, government sought to settle contracts at 10% of face value, dropped further
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South Sea Company, 1711-20
• 1711 – government offers SSC monopoly over all trade to region • Directors had no experience w/ S. American trade • Insider trading immediately • New issue in 1720, offered on payment plan • Gains rapid momentum; further issuance, plans • Bubble Cards, ridicule • Even Isaac Newton lost money. “Motions of the spheres, not the madness of crowds.”
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Panics: Defined
• A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy (or positive feedback); as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy. • A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession.
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Top Bank Panics
• • • • • • • • • • • • • • • • 18th century Panic of 1792 Panic of 1796–1797 19th century Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first boom-to-bust economic cycle Panic of 1825, a pervasive British recession in which many banks failed, nearly including the Bank of England Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression Panic of 1847 Panic of 1857, a U.S. recession with bank failures Panic of 1866 Panic of 1873, a U.S. recession with bank failures, followed by a 4-year depression Panic of 1884 Panic of 1890 Panic of 1893, a U.S. recession with bank failures 20th century Panic of 1907, a U.S. economic recession with bank failures

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Bank Panic, 1907
• Triggered by failed attempt to corner United Copper Company • Lenders include Knickerbocker Trust, which falls • Banks runs in NYC, then around the country • Speculative side bets in bucket shops • NYSE falls close to 50% from previous year • JP Morgan steps in (there is no Central Bank at this time) • Follow on – TC&I • JPM steps in again, via US Steel • Federal Reserve created in 1913

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Crashes: Defined
• A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative bubbles. • Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. • Generally speaking, crashes usually occur under the following conditions: a prolonged period of rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants. • There is no numerically specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of days. Crashes are distinguished by panic selling and abrupt, dramatic prices declines.

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Select Crashes
• Paris Bourse, January 19, 1882 • Wall Street 1929
– Black Thursday - October 24, 1929 – Black Monday - October 28, 1929 – Black Tuesday - October 29, 1929

• • • • • •

1973-4 UK stock market crash October 19, 1987 Friday the 13th Mini-Crash, October 13, 1989 Asian Contagion Mini-Crash, October 27, 1997 Dot-com Bubble and Crash, peak, March 10, 2000 Flash Crash – May 6, 2010
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Crash of 1929: Black Monday

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Crash of 1929: Black Monday
• Black Thursday - October 24, 1929 • Black Monday - October 28, 1929 • Black Tuesday - October 29, 1929 • Intense Duration: 4 years • Leverage already in use: The bursting of the speculative bubble in shares led to further selling as people who had borrowed money to buy shares had to cash them in, when their loans were called.

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Crash of 1929
600 500 400 300 200 100 0 3-Mar- 3-Sep- 13-Nov- Low 1928 1929 1929 1932
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AT&T Bethlehem Steel General Electric Montgomery Ward National Cash Register RCA


Regulatory Responses to 1929
• Public outcry and political will brings massive reform and legislation to the financial sector. • The Rise of Central Authority: The SEC was created to regulate the stock market and prevent corporate abuses relating to the offering and sale of securities and corporate reporting. • It was given the power to license and regulate stock exchanges, the companies whose securities traded on them, and the brokers and dealers who conducted the trading.

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Regulatory Responses
• The SEC was created by section 4 of the Securities Exchange Act of 1934 and was empowered to enforce the following : • The Securities Act of 1933 • The Trust Indenture Act of 1939 • The Investment Company Act of 1940 • The Investment Advisers Act of 1940 • And since that time: • The Sarbanes-Oxley Act of 2002 • The Credit Rating Agency Reform Act of 2006

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Up to World War II

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Post WWII: Boom

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Part II: Modern Events
• • • • • The Best of Times and the Worst of Times The Tools of the Trade: Modern Methods Investment Timelines and Trends Regulation to 1980 and beyond Case Studies:
– The Roaring ‘90s – The Credit Crisis – 2007 – 2009

• The Great Hangover • Seeking Solutions: An Engine not a Camera
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Top Banking Crises
• • • • • • • • • • • • • • • • • • • • • • • • • 18th Century Crisis of 1772–1773 in London and Amsterdam, begun by the collapse of the bankers Neal, James, Fordyce and Down. 19th Century Australian banking crisis of 1893 20th century Panic of 1907, a U.S. economic recession with bank failures Great Depression, the worst systemic banking crisis of the 20th century Secondary banking crisis of 1973–1975 in the UK Savings and loan crisis of the 1980s and 1990s in the U.S. Finnish banking crisis of 1990s Swedish banking crisis (1990s) 1997 Asian financial crisis 1998 Russian financial crisis Argentine economic crisis (1999–2002) 21st century 2002 Uruguay banking crisis Financial crisis of 2007–2010, including: Subprime mortgage crisis in the U.S. starting in 2007 2008 United Kingdom bank rescue package 2008–2009 Belgian financial crisis 2008–2009 Icelandic financial crisis 2008–2010 Irish banking crisis 2008–2009 Russian financial crisis 2008–2009 Spanish financial crisis 2008–2009 Ukrainian financial crisis

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The Tools of the Trade
• Modern Methods
– Fundamental Analysis – Technical Analysis – Quantitative Analysis

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Modern Methods: Fundamental Analysis
• • • • Graham and Dodd – Security Analysis The Intelligent Investor – Benjamin Graham The Sage of Omaha: Warren Buffett The top-down investor starts his analysis with global economics, including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. He narrows his search down to regional/industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then he narrows his search to the best business in that area. The bottom-up investor starts with specific businesses, regardless of their industry/region. Stock Valuation methods – focused on company, management, sector, Balance Sheet, Income Statement, Statement of Cash Flows
– Debt-to-equity – P/E ratio – Price Earnings Growth

• •

Drilling down deep on company’s position, its competitors, and future prospects

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Modern Methods: Technical Analysis
• Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns. Technical analysis ignores the nature of the company, market, currency or commodity and is based solely on "the charts,“: price and volume information and other indicators. Head and Shoulders Triangle Top/Bottom Resistance Support Breakout
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• • • • •

Beware, the Black Swan

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Modern Methods: Quantitative Analysis
• • • • • • • • • • • • • • • • • Financial Modeling;
– The Greek Paradise and many hot pricing models

Black–Scholes model Black model Binomial options model Monte Carlo option model Implied volatility, Volatility smile SABR Volatility Model Markov Switching Multifractal Finite difference methods for option pricing Optimal stopping (Pricing of American options) Interest rate derivatives Short rate model Hull–White model Cox–Ingersoll–Ross model Chen model LIBOR Market Model Heath–Jarrow–Morton framework

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Investment Timeline: 1950s - 1960s
So how does all that play out in the market? • November 23, 1954: the US stock market from the Great Crash • 1946: Launch of American Research and Development – first Venture Capital fund • 1957: ARD Invests in Digital Equipment Corporation ($70,000) • 1968: DEC goes public, valued at $355 million; 500x and 101% ARR • 1962: Launch of Fidelity’s Magellan Fund • 1969: Launch of the first Money Market Fund • Boom of new issues between 1959 – 1962 and through the decade
– Growth stocks – Concept stocks – Lure of technology, e.g. DEC, Control Data, IBM, TI, Varian Associates

• Generous p/e multiples
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Investment Trends: 1950s - 1960s
• Dawn of the Space Age • Optimism in US • Europe is rebuilding, with Marshall Plan • Popular Press • Social Revolution • International Travel – the Jet Set is expanding

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Investment Timeline: 1970s
• • • • • • 1971: End of the Gold Standard 1973-4: Oil Crisis, OPEC story 1975: First index fund launched 1979: Iranian Revolution – Oil Crisis revisited 1974-80: Speculation on Silver Period characterized by stagflation: high unemployment and high inflation • U/E peak of 9% in May 1975 and GDP fell by 3.2% • Recession from 1973-5 in UK as well
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Investment Trends: 1970s
• • • • Oil Silver Nifty Fifty Business Journals gaining readership
– Forbes – Fortune – Business Week

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Elites Weave Webs with Silver Threads

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Cornering the Silver Market

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Among the Gold Bugs

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Regulation to 1980 and Beyond
• Since actions of 1930s – sluggish economy in 1970s – new policies • Employee Retirement Income Security Act of 1974, created minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. • ERISA was enacted to protect the interests of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan; by establishing standards of conduct for plan fiduciaries; and by providing for appropriate remedies and access to the federal courts. • The institutionalization of investment
– For the Common Man: Diversification ~ Mutual Funds – Pension Funds now have a mandate

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Regulatory Recap
• • • • • • • • • • • • • • • • • • 1933 – Securities Act of 1933 1934 – Securities Exchange Act of 1934, governing the secondary trading of securities 1938 – Establishment of the Temporary National Economic Committee 52 Stat. 705 1939 – Trust Indenture Act 1940 – Investment Company Act 1940 – Investment Advisers Act 1964 – Securities Act Amendments PL 88-467 1968 – Williams Act (Securities Disclosure Act) PL 90-439 1975 – Securities and Exchange Act PL 94-29 1980 – Depository Institutions and Deregulation Money Control Act PL 96-221 1982 – Garn–St. Germain Depository Institutions Act PL 97-320 1984 – Insider Trading Sanctions Act PL 98-376 1988 – Insider Trading and Securities Fraud Enforcement Act PL 100-704 1989 – Financial Institutions Reform, Recovery, and Enforcement PL 101-73 1999 – Gramm-Leach-Bliley Act PL 106-102 2000 – Commodity Futures Modernization Act of 2000 2002 – Sarbanes-Oxley Act 2007 – Regulation NMS

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Investment Timeline: 1980s
• 1980 – Bayh-Dole Act stimulates innovation in universities and small companies by protecting IP and inventions developed through the course of government funded research
– Patents and startups, especially biotechs, begin boom

• 1982 – Launch of the first Emerging Markets Fund • 1984 – Reform of mortgage-backed bonds

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Investment Trends: 1980s
• New Issues • Biotech Stocks • Mid-1980s - High yield bonds aka Junk
– Drexel Burnham Lambert – Michael Milken and the fallen angels

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Crash of 1987: Black Monday
• Black Monday refers to Monday, 19 October, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average dropped by 508 points to 1738.74 (22.61%). By the end of October, stock markets in Hong Kong had fallen 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. New Zealand’s market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover.

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Crash of 1987

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Alternative Explanations

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Market Reactions: Modeling Wild Randomness
“In 1991, the Options Clearing Corporation decided to change the probability models employed to calculate margin requirements. This was a direct consequence of Black Monday. The OCC switched to the Levy distribution, which endows rare events with a much higher probability of existence than the Normal distribution. A Levy distribution allows for Wild randomness. The OCC liked the fact that under a Levy regime, a 99% confidence interval would cover five or six standard deviations, whereas under the Normal distribution only three standard deviations are so covered. This was desirable, not just on account of representative fairness, but also as a survival mechanism for the OCC and the individual exchanges that cleared with it.” - Pablo Triana, Lecturing Birds on Flying

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Investment Timeline: 1990s
• January 1990 – Crash of Japan leads to the yen carry trade • September 1992 – Sterling’s Black Monday spurs foreign exchange as an asset class • 1994-5 - Financial Crisis in Mexico • December 1996 – Alan Greenspan warns against “irrational exuberance” • 1997 – Asian crisis prompts Asian countries to build up reserves of dollars
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Investment Timeline: 1990s
• March 1998 – Citigroup and Bank of America mergers create banks that are “too big to fail” • August 1998 – Russia defaults on debt and Long-Term Capital Management melts down • 1999 – IPOs and existing tech stocks go up and up and up…

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Investment Trends: 1990s
• Black Box Trading • Real Estate • Internet Mania

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Case Study: The Roaring 1990s
Dotcom Bubble • Massive Inflows of Money to Alternative Investment • Everyone wants alpha • Early Warnings: Irrational Exuberance 1996 • The Results
– NASDAQ numbers
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Factors in the Tech Bubble
• • • • • • • WWW, Nov 1993 Mosaic, Feb 1994 Regulation & deregulation, Telecomms Act of 1996, Glass-Steagall Users reaching critical mass, 1997 End of Cold War, triumphalism, yet global instability, foreign crises Rep. Congress, cap gains tax cuts 28 – 20%, 1997 Growth of mutual funds and also rise of discount brokers, day traders; attitudes towards risk • Cultural change - business success touted and expansion of media reporting of business news • Analysts’ increasingly optimistic and visible forecasts: Blodgett, Meeker, Cramer; opinion leaders • Taleb: this period filled with narrative fallacy

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Dot Bomb

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Investment Timeline: 2000s
• • • • • 2000 – Dot-com bubble bursts 2001 – Emerging markets rebranded “BRICs” 2004 – Commodities become an asset class 2005 – Default risk becomes an asset class More International action – hot money

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Hot Money
• In economics, hot money refers to funds which flow into a country to take advantage of a favorable interest rate, and therefore obtain higher returns. They influence the balance of payments and strengthen the exchange rate of the recipient country while weakening the currency of the country losing the money. These funds are held in currency markets by speculators as opposed to national banks or domestic investors. As such, they are highly volatile and will be shifted to another foreign exchange market when relative interest rates make this more profitable. • Hot money is a major factor in capital flight, illicit financial flows, and the ability of developing nations to finance their debt. As large sums of money can move very quickly to take advantage of small fluctuations in interest rates and currency values, countries which have difficulty raising money through the sale of long-term bonds are particularly susceptible to short-term interest rate pressure, particularly during periods of rapid inflation.
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Investment Trends: 2000s
• Chasing Alpha • Venture Capital – Overhang/Hangover
– Life of the fund – GP v. LP – High Water Marks – Where are the exits?

• Private Equity – Credit Crunch • Rise of the Machines
– Patterns
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Case Study: Credit Crisis 2007-2009
• June 7, 2007 – Ten-year Treasury yields hit 5.05 percent • June 19, 2007 – Bear Sterns Hedge Fund appeals for help • August 3, 2007 – Jim Cramer declares “Armageddon” in the credit markets • August 7-9, 2007 – Big quant hedge funds suffer unprecedented losses • August 9, 2007 – European Central Bank intervenes after BNP Paribas money fund closes
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Credit Crisis 2007 – 2009
• August 17, 2007 – Federal Reserve cuts rates after Countrywide Financial funding crisis • September 13, 2007 – The run on Northern Rock • October 31, 2007 – World stock markets peak • November 1, 2007 – Fear of losses at Citigroup prompts a sell-off • March 16, 2008 – Bear Stearns rescued by JP Morgan • July 14, 2008 – Oil and the dollar rebound – the end of the “decoupling trade” • September 7, 2008 – Fannie Mae and Freddie Mac nationalized
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Credit Crisis 2007 – 2009
• September 15, 2008 – Lehman Brothers goes bankrupt • September 18, 2008 – AIG is rescued, Reserve Fund breaks the buck, money market panics • September 29, 2008 – Congress votes down the TARP bailout package • October 6-10, 2008 – Global correlated crash • October 24, 2008 – Emerging markets hit bottom as China rolls out stimulus package
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Credit Crisis 2007- 2009
• What Happened to Quants – August 2007? – Andrew Lo –

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The Big Short
• Quote by Michael Lewis • ~ All of Washington is reading this book, but I am not an Investment Banker…

• Credit Crisis beneficiaries
– The Publishing Industry thrives – Sampling of books, note S. Das reviews on – Rolling Stone and Vanity Fair emerge with high quality financial reporting
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The Big Short – Michael Lewis
• “It is unreal, because basically all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure. And I don’t know if that’s going to work. When you look at what Alan Greenspan did, or what Larry Summers did, or what Bob Rubin did, there are individual mistakes they made, like for example not regulating the credit default swap market, preventing that from happening. But the broader problem is just the air they breathe. The broader problem is just the sense they all seem to have that what’s good for Goldman Sachs is good for America.”
– Michael Lewis, Interview with Christopher Lydon

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The Great Hangover
• Joseph Stiglitz: Capitalist Fools: Five Key Mistakes that Led Us to the Collapse, Jan 2009, Vanity Fair • Systemic failure, not a single decision point, but a cascade
– Firing the Chairman – Volcker v Greenspan, 1987
• Ronald Reagan. Under Volcker inflation went from 11% to 4%, Greenspan bring liquidity and regulation-lite • Could have raised margin requirements during tech bubble • Could have combatted predatory lending during credit crisis • Innovation without oversight • Claims that no one knew – incorrect – the front lines knew
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Great Hangover
• Tearing Down the Walls
– November 1999 – Congress repeals the Glass Steagall Act, following a $300 million lobbying effort from the banking and financial service industries – Reason for Glass Steagall - enacted after the Great Depression had been to curb excesses; separate commercial banks from investment banks – This repeal drives a return to higher risk, more leverage – April 2004, SEC allows investment banks to increase debtto-capital ratio from 12:1 to 30:1 or higher, so they could buy more Mortgage Backed Securities – Self regulation; in 1998, Brooksley Born, head of CFTC, calls for derivatives legislation, Summers and Rubin against it.
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Great Hangover
• Applying the Leeches
– Bush Tax cuts, Economic Growth and Tax Relief Reconciliation Act of 2001, June 7, 2001 and – Jobs and Growth Tax Relief Reconciliation Act of 2003, May 28, 2003 – Fed floods with liquidity – Also implicit cultural attitude – with capital gains tax cuts, those who gamble and win are taxed more lightly than wage earners – So everybody, let’s borrow and roll the dice – Flip this house, HELOCs, max out credit cards
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Great Hangover
• Faking the Numbers
– After World Com and Enron collapse, Congress passes Sarbanes-Oxley Act in June 2002 – Stock options – top management incentivized to pump prices through distorted information – Incentives at rating agencies also perverse – paid by clients that they graded

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Great Hangover
• Letting it Bleed
– Bailout package produced October 3, 2008, debates, Paulson, counterproposals – Some bailed out, some not – Some shareholders get something back, some don’t – Bonuses return! – Moral outrage, but legislators powerless to reverse course – Stiglitz – very much opposed to the idea that the role of governments should be minimal, but look at their level of competence. Grandstanding, but substance?
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Home Value Index

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A Few Words on Glass-Steagall
• The Banking Act of 1933 was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. • The first Glass Steagall Act of 1932 was enacted in an effort to stop deflation, and expanded the Federal Reserve’s ability to offer rediscounts on more types of assets, such as government bonds as well as commercial paper. • The second Glass– Steagall Act (the Banking Act of 1933) was a reaction to the collapse of a large portion of the American commercial banking system in early 1933. It introduced the separation of bank types according to their business (commercial and investment banking), and it founded the Federal Deposit Insurance Corporation for insuring bank deposits.

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Glass- Steagall Reversed
• Some provisions of the Act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. • Provisions that prohibit a bank holding company from owning other financial companies were repealed by the Gramm-Leach-Bliley Act on November 12, 1999. • The repeal of Glass- Steagall effectively removed the separation that existed between Wall Street investment banks and depository banks and has been blamed, in part, for the collapse of the subprime mortgage market that led to the financial crisis of 2007-2010.
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The Subprime Solutions
• The Subprime Solution – Shiller

• Regulation: Dodd-Frank
– On June 25, 2010, conferees finished reconciling the House and Senate versions of the bills and filed a conference report. The new bill will be called the Dodd-Frank Wall Street Reform and Consumer Protection Act. – On June 30, 2010, the House passed the "Dodd-Frank" conference report of H.R. 4173 by a vote of 237-192. The Senate passed the bill on July 15 by a vote of 60-39, sending the legislation to President Obama's desk.
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The Performativity of Economics
“…What is less straightforward conceptually, and more complicated empirically, is to determine what effect, if any, the use of economics has on the economic process in question. The presence of such an effect is what is required for a stronger meaning of “performativity”…For the use of a theory, a model, a concept, a procedure, a data set…to count as effective performativity, the use must make a difference….Except in the simplest cases, one cannot expect observation alone to reveal the effect of the use of an aspect of economics… It might be that the use of economics is epiphenomenal – a empty gloss on a process that would have had essentially the same outcomes without it. ”
– Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets
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Computational Fluid Dynamics
• Finance: Theory and Practice • Behavior: Human Psychology
– Individual and Collective; Wisdom of Masses?

• Economics: Local, National, Global
– Ability to telescope

• Technology: Better, Faster, Stronger • Regulatory: Unintended Consequences • Quant
– Tries to sit above this mess, but is that possible?

• Start with Complexity of Global Finance
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Part III: Complexity I - Globalization
• Traders, Guns, and Money story • Crisis and Contagion • When Markets Collide • Capital Rules • Money on the Move • Case Study: Sterling 1992 • Case Studies: A Tale of Two Atolls • Bail Ins and Bail Outs • Fixing Global Finance
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No Risk
““OCM is a noodle maker, operates in Indonesia, and all its income is in rupiah?” I asked and Budi confirmed it. “In 1995, you decided to convert your borrowings into dollars?” “Yes.” “Why?” “Cheaper, much cheaper,” Budi said. “What about currency risk? You have borrowings in dollars but no dollar income. If the dollar rose against the rupiah, the you would show losses. Did you consider the currency risk?” “No risk, no risk,” Budi countered. “Why?” “Rupiah fixed against dollar, no risk….” “Bank advise us. They tell us no risk,” Adewiko interjected. “They advise that we have low cost, no currency risk.” Morrison, Albie and the junior accountant were making copious notes…” - Satyajit Das, Traders, Guns, and Money
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Crisis: Going Global
• • • • • Mexico - 1994-5 Argentina - 1995 Asia – 1997 Russia – 1998, particularly August 17, 1998 US Bear Market: October 11, 2007 – 2009
– The Dow Jones Industrial Average, Nasdaq Composite and S&P 500 all experienced declines of greater than 20% from their peaks in late 2007

• Dubai – 2009, November 27 debt deferment request • Iceland - 2009 • Greece – 2010 - April 27, 2010 Standard & Poor’s downgrades Greece’s sovereign credit rating to junk, four days after the country’s government requests the activation of a 45-billion euro EU-IMF bailout. European debt panic ensues • Euro Contagion – The PI(I)GS?
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Contagions: Not So New After All
• London Paris – 1700s
– First international crisis, 1720, speculation in Great Britain and France affected the Netherlands, Italy, and Hamburg – 1763 – Holland, Hamburg, Russia, Scandinavia

• Panics in 1800s
– 1825 – Great Britain and South America – Paris – 1847-8 – Failures chart – 1850 – London and Paris as world financial centers

• Panic of 1907 – New York, London, Paris • Post-WWI Crisis in 1920-1 – no international lender; highlights need for Bretton Woods post WWII
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When Markets Collide
• Signals and Noise - Structural Factors
– Fundamental realignment of global economic power – Pronounced accumulation of financial wealth by countries that had been debtors historically
• Sovereign Wealth Funds • Reinforced desire for diversification • Politicians in industrialized countries paying attention

– Proliferation of new financial instruments

• Aberrations, Conundrums and Puzzles
– – – – – Economic Data Interest Rates Conundrum Global Payment Imbalances – developing economies Most liquid market puzzle llide+El+Erian+June+2008.htm
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When Markets Collide
• “…investors face more than just the difficult challenge of understanding the new destination (or “steady state”), including what it implies for institutional and organizational set-ups. They also have to understand and navigate a journey that is inevitably turbulent and nonlinear. And with that comes the probability of market accidents and policy mistakes. • Due to the difficulties in being able to rapidly identify and adapt to multiple structural changes, it is inevitable that some investors (including previously successful investors) will trip, some firms will fail, some admired policy makers will be slow in reacting, and some international institutions will lose relevance. As long as the numbers remain contained, they will constitute only “flesh wounds” for a generally robust secular transformation. But if few become many, the world faces the prospect of a disorderly adjustment characterized by disappointing economic growth, higher unemployment, greater poverty, trade wars, capital controls, and financial market instability.”
– Mohammed El-Erian, When Markets Collide

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When Markets Collide
• Contagion - emerging markets prone through three distinct transmission channels:
– Economics – need to access industrialized countries through exports to generate cash to service their own debt obligations – Funding – reliance on sources to roll over maturing debt obligations – Technical – assessing tactical investors, beyond small pool of strategics

• Enormous correlation within these channels • And yet, EM no longer the most vulnerable to global shocks • IMF Reform Agenda
– Universal membership: 185 countries end of 2007 – Unmatched access to member countries; articles of agreement ”annual check-up” – Complements surveillance of national policies with multilateral responsibilities

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Capital Rules: The Construction of Global Finance
• End of the first wave - globalization, 1914-44
– Gold standard – Exchange rates

• Embedding liberalism, 1944-61
– IMF, Articles of Agreement, 1945 – European Community, Treaty of Rome, 1957 – OECD, Code of Liberalization of Capital Movements, 1961

• Ad Hoc Globalization, 1961-86 • Rewriting the Rules, 1986 - present
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Capital Rules
• Causes of Globalization
– American Hegemony and the French Period of Mondialisation Maitrisees – Neoliberalism and the European Left – Scientific Progress and Social Learning – End of Fixed Exchange Rates
• • • • Fixed Rates and Controlled Capital, 1945-71 Floating and Financial Flows, 1971-90 Age of Capital, 1990-97 Rise and Fall of Capital Account Amendment
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Capital Rules
• Paradoxes of Globalization
– – – – Managed Globalization Idiosyncrasies of Organization Building Liberalism and the Left Constitutive Norms and Market Expectations

• Nationally Recognized Statistical Rating Organization Status,
– SEC creation of NRSROS in 1975 – S&P – Moody’s

• BIS – Basel Accord, 1988 and Basel II, June 2004
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Money on the Move
• Revolution in Global Finance since 1980 • Debt crisis of developing countries • Political leadership:
– – – – Margaret Thatcher, 1979 Ronald Reagan, 1980, President in 1981 Helmut Kohl, 1982 Japan – LDP strong throughout 1970s and 80s

• In US Federal Reserve – the reign of Paul Volcker
– Practical Monetarism
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Money on the Move
• Second Oil shock
– Precipitated by Iranian Revolution, 1979

• Consumer Price Index for G7 countries
– 8% per year, 1976 – 1978 – Rises to 12.7% in 1980

• Balance of payments: Germany and Japan have surpluses
– US grew faster than EC from 1983-88 – And faster than Japan in 1983, ‘84 and ‘86

• Gold
– – – – – Approximately $225/ounce in 1979 Hits $850/ounce in January 1980 Down to ~ $400/ounce mid 1981 Fluctuates from $300-400/oz for rest of the decade Falls below $300/oz in late 1997
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Money on the Move
• Wide ranging dollar – 1980 to 1990
– Rising from 1981-85 – Declining from 1985-87

• Plaza Accord, 1985
– G5 intervention ~ $2.7 Billion – G10 sold $7.5 Billion to buy Euro currencies and Yen – US Share of activity - $2.8 Billion – Dollar declined gradually
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Money on the Move
• The Plaza Accord or Plaza Agreement was an agreement between the governments of France, West Germany, Japan, the United States and the United Kingdom, to depreciate the US Dollar in relation to the Japanese yen and the German Deutsche Mark by intervening in currency markets. The exchange rate value of the dollar versus the yen declined by 51% from 1985 to 1987. Most of this devaluation was due to the $10 billion spent by the participating central banks. Currency speculation caused the dollar to continue its fall after the end of coordinated interventions. However, in general, this devaluation was planned, done in an orderly, pre-announced manner and did not lead to financial panic in the world markets. The reason for the dollar's devaluation was twofold: to reduce the U.S. current account deficit, which had reached 3.5% of the GDP, and to help the US economy to emerge from a serious recession that began in the early 1980s. The Plaza Accord was successful in reducing the U.S. trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan because this deficit was due to structural rather than monetary conditions. However, the signing of the Plaza Accord reflected Japan's emergence as a real player in managing the international monetary system.

• •

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Money on the Move
• Louvre Accord, 1986-7
– The Louvre Accord was signed by the then G6 (France, West Germany, Japan, Canada, the United States and the United Kingdom) on February 22, 1987 in Paris. Italy had been an invited member, but declined to finalize the agreement. The goal of the Louvre Accord was to stabilize the international currency markets and halt the continued decline of the US Dollar caused by the Plaza Accord (of which a primary aim was depreciation of the US dollar in relation to the Japanese yen and German Deutsche Mark by the mutual agreement of the G7 Minister of Finance meeting that had been held in Louvre in Paris in 1987. Since the Plaza accord, the dollar rate had continued to slide, reaching an exchange rate of ¥150 per US$1 in 1987. The ministers of the G7 nations gathered at the Louvre in Paris to "put the brakes" on this decline.

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Money on the Move
• Foreign Exchange developments, 1988-90 • US Balance of Payments, 1987-90 • Exchange Rate Mechanism in Europe
– Delors Report – Prelude to EMS – Zone of Monetary Stability

• Single European Act, 1986 – “Europe 1992”
– Convergence – Britain and EMS – German Unification

• Maastricht turmoil in EMS
– Spain and Portugal join in 189 – 92 with wide margin of +/-6%

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European Monetary System
• • European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the EEC linked their currencies to prevent large fluctuations relative to one another. Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange fluctuations of more than 2.25% (the European "currency snake"). In March 1979, this system was replaced by the European Monetary System, and the ECU was defined. The basic elements of the arrangement were: The ECU: A basket of currencies, preventing movements above 2.25% (6% for Italy) around parity in bilateral exchange rates with other member countries. An Exchange Rate Mechanism An extension of European credit facilities. The European Monetary Cooperation Fund was created in October 1972 and allocated ECUs to members' central banks in exchange for gold and US dollar deposits. Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank were unquestionably the center of the EMS.

• • • • • •

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EMS - Stage I
• Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. • In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain. • 1992 Crisis:
– On 13 September 1992 Italy decided to devalue Italian Lira by 3.5%. – On 16 September 1992 UK withdrew from ERM. – On 17 September 1992 Italy withdrew from ERM.

• Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.

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EMS – Stage II and Stage III (EMU)
Stage II • The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the euro. Its successor however, the ERM-II, was launched on 1 January 1999. In ERM-II the ECU basket was discarded and the new single currency euro has become an anchor for the other currencies participating in the ERM 2. Participation in the ERM 2 is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark and Greece became new members. Stage III • The EMS-2 is sometimes described as "waiting room" for joining the Economic and Monetary Union of the EU. In the EMU (Stage III) the actual currencies in the participating member states are replaced by euro banknotes and coins, thus entering the Euro Zone.
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Money on the Move
• • • • From USSR to Commonwealth of Independent States Further increases Capital Mobility Currency Crisis: Mexico, Brazil, Argentina, 1982 British pound, Italian lira, other European currencies, 1992 • Mexico peso, 1994 – 5
– Tequila Effect

• • • •

Asia: Thai bhat, Malaysian ringgit, other Asian, 1997 Russia, ruble, 1998 Brazil, real, 1999 Argentina, peso, 2001
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Money on the Move
• The “Second World” – centrally planned economies under communist governments is transitioning to market economies and democracy • The Third World is changing rapidly and less dependent on First World countries • OPEC has become a less powerful force in the world economy • World trade in goods and services had grown much faster than output • New financial instruments have transformed the markets and influenced enormous capital mobility • Capital flows to developing countries have increased • Monetary policy and central banks more visible and important • Determinants of exchanges rates have changed; moderate current account imbalances less likely to move rates • Unemployment at high levels in continental Europe; a political problem • European economies have become much more integrated with each other, creation of the Euro, and further enlargement
CQF Lecture, Copyright PHE, 2010 91

Princes and Paupers: Speculation and Predation in 1990s
“High finance trembles in its boots whenever there is some political complication.”
– An aide to Bismarck, 19th century

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Case Study: The Pound Sterling, 1992
“In 1979, the Hunt family of Texas used silver futures contracts in a scheme to corner the silver market. This scandal made it unlikely that regulators would approve new ways of speculating in silver and gold. That left currencies.”

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The Vandal Has a Crown
• History of currency exchange
– Up to 1971, Foreign Exchange was done by banks only – In 1971, the International Monetary Market of CMEX was founded and began to trade currency futures

• Black Scholes 1973 – A Very Useful Tool • 1992 Attack on EMS – Soros’ Quantum Fund
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The Sting UK Style
• • On Black Wednesday (September 16, 1992), Soros's fund sold short more than $10 billion worth of the pound sterling, profiting from the Bank of England’s reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency. Finally, the Bank of England withdrew the currency from the European Exchange Rate Mechanism, devaluing the pound sterling, and Soros earned an estimated US$ 1.1 billion in the process. He was dubbed "the man who broke the Bank of England." In 1997, the UK Treasury estimated the cost of Black Wednesday at £3.4 billion. The Times of Monday, October 26, 1992, quoted Soros as saying: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell." Stanley Druckenmiller , who traded under Soros, originally saw the weakness in the pound. "Soros' contribution was pushing him to take a gigantic position."

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But The Emperor Has No Clothes

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Better to be Lucky and Smart! (clothing optional)

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A Tale of Two Atolls: East and West
• Japan – 1990s
– Balance Sheet Analysis

• Iceland – 2000s
– Wild Beasts of Finance

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Lessons from Japan’s Great Recession
• Structural problems and banking sector cannot explain Japan’s long recession • Points to supply side issues, Japan’s economy suffered from lack of demand • The bubble’s collapse destroyed 1,500 Trillion Yen in wealth and triggered a balance sheet recession
– Plunging asset prices triggered corporate balance sheet problems – Japanese companies moved collectively to repair balance sheets by paying down debt – Demand from Japan’s corporate sector fell by more than 20% of GDP and yet GDP did not fall after the bubble’s collapse
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Lessons from Japan’s Great Recession
• Fiscal expenditures bolstered Japan’s economy
– Delays on a cap for government deposit insurance also helped to avert a crisis

• Debt minimization and monetary policy
– Monetary policy is ineffective during a balance sheet recession, when there is no demand for funds – Government borrowing propped up the money supply – Fiscal policy determines the effectiveness of monetary policy

• Conventional economic theory does not allow for corporate debt minimization
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Lessons from Japan’s Great Recession
• Exploring Balance Sheet Recessions
– Germany has faced the same problem – The US took 30 years to recover from the Great Depression, to the level of the 1920s – Was that a Balance Sheet Recession?

• May agree or disagree with the analysis, but it is worthwhile to explore alternative viewpoints • Ask ten economists, obtain ten (different) opinions
CQF Lecture, Copyright PHE, 2010 101

Iceland 2008-10
• The 2008–2010 Icelandic financial crisis is a major ongoing economic crisis that involves the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt and a run on deposits in the United Kingdom. Relative to the size of its economy, Iceland’s banking collapse is the largest suffered by any country in economic history. • In late September 2008, it was announced that the Glitnir bank would be nationalized. The following week, control of Landsbanki and Glitnir was handed over to receivers appointed by the Financial Supervisory Authority (FME). Soon after that, the same organization placed Iceland's largest bank, Kaupthing, into receivership as well.
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Iceland 2008-2010 Banking Development
Stage 1. Pure financial intermediation
– Banks lend our from surplus savings to those in need of financing, no money multiplier

Stage 2. Fractional reserve banking – deposits used as money
– – – – – Longer term, larger and riskier loans Liquidity is distributed across the financial markets Lender with power of money printing offers insurance against systemic Liquidity shocks Lending and matching funds – deposit seeking, interbank lending or wholesale funding Banks turn existing loans into marketable securities; turn away form lending and favor derivatives products and off-balance-sheet profit opportunities
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Stage 3. Interbank lending

Stage 4. Lender of last resort facility
Stage 5. Liability management Stage 6. Securitization

Iceland 2008-10
• Commenting on the need for emergency measures, Prime Minister Geir Haarde said on 6 October, "There [was] a very real danger ... that the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could have been national bankruptcy.“ • The financial crisis has had serious consequences for the Icelandic economy. The national currency fell sharply in value, foreign currency transactions were suspended for weeks, and the market capitalizations of the Icelandic stock exchange dropped by more than 90%. • As a result of the crisis, Iceland entered into a severe economic recession; the nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009.
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Bail Ins and Bail Outs
• Sources of vulnerability within Balance Sheet framework
– Maturity mismatch – Currency mismatch – Capital structure mismatch

• Debt problems and their resolution
– Inability or unwillingness to pay – Crisis of creditor coordination – IMF as source of emergency liquidity
• Stand stills versus emergency loans • IMF lending may not lead to moral hazard

– Partial bailouts – IMF and bilateral first and second financings

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Bail Ins and Bail Outs
• Proposals for a more defined system of sovereign priorities
– Bolton- Skeel – First-in First-out lender – Soros – International Deposit Insurance Agency – Gelpern – Pick your own priority scheme

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Fixing Global Finance
• • • • • Risks in financial globalization Fiscal cost of financial crises Current account balances Private net capital flows Spreads of Emerging Market Loans

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International Financial System
What can individual countries do?
1) Devise a sensible strategy for liberalizing domestic financial markets and international capital flows 2) Strengthen Institutions, Information, and the Financial and Corporate sectors 3) Adopt sustainable Exchange Rate Agreements 4) Maintain Debt Discipline, sound macro economic policies, and market confidence 5) Open the economy to trade and FDI in a manner that results in growth-enhancing activities
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International Financial System
How can the International Financial System be reformed?
1) Strengthen the quality and impact of IMF surveillance 2) Induce changes in the composition of the international capital flows 3) Introduce contingent debt contracts or other mechanisms for hedging against macro economic risks 4) Address informational imperfections and distorted incentives on the supply side of int. capital flows 5) Revamp debt resolution procedures : SDRM Proposed 6) Strengthen frameworks for development aid and official non-concessional lending
CQF Lecture, Copyright PHE, 2010 109

The Two Horns of a Dilemma

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Part IV: Complexity II – Financial and Technological Innovation
• • • • • • • • • • Here Come the Quants Story: Emanuel Derman: My Life as a Quant Six Basic Functions of Finance Basic Steps in Financial Risk Management The People: Capital Ideas Evolving Case Study: When Genius Fails The Technology: Black Boxes and Big Pipes Pandora’s Box Rise of the Machines The Future of the Exchanges
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Engaging with Models
• “The right way to engage with a model is, like a fiction reader or a really great pretender, to temporarily suspend disbelief, and then push it as far as possible. The success of the theory of options valuation, the best model economics can offer, is the story of a Platonically simple theory, taken more seriously than it deserves and then used extravagantly, with hubris, as a crutch to human thinking. “If a fool would persist in his folly, he would become wise,” wrote Blake in The Marriage of Heaven and Hell. This is what quants have done with options theory.”
– Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance

CQF Lecture, Copyright PHE, 2010


Six Basic Functions of Finance
1) Making payments to facilitate the exchange of assets, goods, and services 2) Providing resources to fund large projects or enterprises 3) Transferring resources from savers to borrowers 4) Managing risk 5) Providing price information required for the coordination of decentralized decision making 6) Creating incentives to perform well – “the stakeholders’ interests”
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Basic Steps in Financial Risk Management
• First step:
– Diversification and collateralization

• Second step:
– Limited liability, bankruptcy laws, seniority rules, balance sheet structure

• Third step:
– Creating tradable instruments and liquidity in organized markets – Convertibles existed by the 1600s
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Basic Steps in Financial Risk Management
• Fourth and final step:
– Derivatives and financial engineering
• • • • Diagnosis of problem Analysis of solutions Production of instrument Pricing and customization

– On versus off-balance sheet activities

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Capital Ideas Evolving: The People
“Neoclassical theory is a theory of sharks.” • Behavioral: Kahneman and Tversky, Thaler • Shliefer and Vishny: The Limits of Arbitrage, p. 26 • The Theoreticians
– Samuelson

• The Institutionalists
– Merton, Lo, Shiller

• The Engineers:
– Sharpe, Markowitz, Scholes

• The Practitioners:
– Barclay’s Global Investors, Yale Endowment Fund (Swensen), Leibowitz, TIAA-CREF, Goldman Sachs Asset Management
• GSAM is a Black Box.

CQF Lecture, Copyright PHE, 2010


Myth of the Rational Market
• • • • • • • • • • • • • • • • Irving Fisher Fred Macauley Holbrook Working Harry Markowitz Paul Samuelson Modigliani and Miller Gene Fama Jack Bogle Fisher Black Michael Jensen Richard Thaler, Andrei Shleifer Robert Shiller Warren Buffett Ed Thorp Alan Greenspan
CQF Lecture, Copyright PHE, 2010 117

Case Study: When Genius Fails, LTCM
• The total losses were found to be $4.6 billion. Major losses: • $1.6 bn in swaps • $1.3 bn in equity volatility • $430 mn in Russia and other emerging markets • $371 mn in directional trades in developed countries • $286 mn in equity pairs (such as VW, Shell) • $215 mn in yield curve arbitrage • $203 mn in S&P 500 stocks • $100 mn in junk bond arbitrage • No substantial losses in merger arbitrage
CQF Lecture, Copyright PHE, 2010 118

That’s Not Supposed to Happen
“That Friday, Long-Term lost money wherever it looked. Credit spreads simply exploded. Mortgage spreads surged to 121 points, up from 107 only weeks before. High-yield bonds climbed from 269 to 276. Off-the-run Treasuries vaulted from 8 basis points to 13. Though these moves may seem small in absolute terms, the effect on Long-Term was magnified by the fund’s potent level of leverage and position size. Even in seemingly unrelated markets, Long-Term suffered a drubbing…In fact, nothing in any market went right that day.” - Roger Lowenstein, When Genius Failed: The Rise and Fall of LTCM

CQF Lecture, Copyright PHE, 2010


LTCM: The Higher They Fly…

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The Last Word
“Now is the time to encourage the Bank of International Settlements and other regulatory bodies to support studies on stress test and concentration methodologies. Planning for crises is more important than VaR analysis.”
- Myron Scholes, reflecting on LTCM aftermath, American Economic Review, May 2000
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Black Boxes and Big Pipes: The Technology
• For Crying Out Loud
– Globex Timeline – Equity Owners Association – “Rocket Fuel” – E-Mini: The spring board for the Merc’s Success

• Regulatory and Infrastructural activity
– – – – – – – – Securities Exchange Act of 1934 – Broker-Dealer Licensing NASDAQ – Small Order Execution System, 1988 1990s Market reforms lead to rise of ECNs Financial Information Exchange Protocol, 1993 Island – first ECN, 1996 SEC – Regulation of Alternative Trading Systems, 1997 This is a turning point in the uptake of ECNs by institutionals At same era, Interactive Brokers new offering Computer to Computer Interface using an API (Application Programming Interface) - direct connection – Next stop: Black Pools

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Pandora’s Box
• Chasing the Same Signals
– Black Box trend following
• • • • • • • • • • • Momentum Statistical arbitrage Market neutral Automated market making Algorithmic trading Balance Sheet metrics Market data indicators Macroeconomic data: u/e, interest rates, inflation Volatility spreads Volume Disturbances
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– What kinds of signals?

Pandora’s Box
• Science and Economic signals
– Econometrics – Microstructure Research - variables
• • • • • Mid point Bid and Offer Volumes Bid to offer ratio Effective spread Weighted bid price

– Operations Research: Optimization and Execution
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Pandora’s Box
• Risk Factor Models
– P/E ratio – Book to Market – Cash Flow to Price – Earnings Momentum – Dividend Yield – Senior Debt Ratio

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Black Box Brethren
• “Measure, manage, model” – engineering
– – – – – Renaissance Technologies/Simons D. E. Shaw Cliff Asness Monroe Trout Peter Muller

• High Frequency Trading
– “Pinging the box” - submit and cancel – Predatory algorithms – Rebate structure
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Smoke Signals
• • • • • Decay effect – contrarian Weather data Location data Search data – consumers, Googlenomics Adaptive Machine Theory

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The Elixir: Liquidity?
• Look back again to August 2007 • There were signals of imbalance – high vol, but the S&P unchanged – excessive dispersion
– Are quants creating volatility or stabilizing the markets? – Are large price swings and reversals more prevalent than ever? – What happened to buy and hold? – What about small retail investors?

• Competition for liquidity – when it is most needed, do these new liquidity providers stand back and watch?

CQF Lecture, Copyright PHE, 2010


Speed Freaks
• Top Ten Markets by Velocity (by volume of turnover)
– – – – – – – – – – NASDAQ – 811% China Shenzhen – 285% AMEX – 279% Germany – 236% NYSE – 205% Italy – 198% Korea - 189% Spain – 179% Taiwan – 155% London – 155%

• But also composition – LSE – $25B/day volume, with 70% of that taking place with London, Germany, Spain and Italy
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Rise of the Machines
• Minicrash: May 6, 2010 • The DJIA suffers its worst intraday loss, dropping nearly 1,000 points before partially recovering, all within less than half an hour.

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Case Study: Flash Crash
• The May 6, 2010 Flash Crash was a stock market crash on May 6, 2010 involving U.S. corporate stocks, followed by an almost immediate rebound. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Initial reports indicated that the event may have been triggered by a "fat-finger trade", an inadvertent large "sell order" for Proctor and Gamble stock, inciting massive algorithmic trading orders to dump the stock; however, this theory was quickly disproved after it was determined that Procter and Gamble's decline occurred after a significant decline in the Emini S&P Futures contracts. The "fat-finger trade" hypothesis was also disproved when it was determined that existing CME Group and ICE safeguards would have prevented such an error. Some analysts were skeptical of this hypothesis, suggesting that deliberate market manipulation could be to blame. Others have said it may have been tied to short positions, in the form of put options, taken on the S&P 500 just before the crash or a movement in the US Dollar to Japanese Yen exchange rate. Both the regulatory agencies and the US Congress announced investigations into the causes of the crash.

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Case Study: Flash Crash
• The cause of the drop remained unknown, but investigators focused on a number of possible causes, including a confluence of computer-automated trades, or possibly an error by human traders. By the weekend, regulators had discounted the possibility of trader error and focused on automated trades conducted on exchanges other than the NYSE. Others speculate that an intermarket sweep order may have played a role in triggering the crash. • On May 11, The Wall Street Journal suggested that a large purchase of put options by the hedge fund Universa Investments shortly before the crash may have been among the primary causes. • On May 14, reports appeared suggesting that the event may have been triggered by a single sale of 75,000 e-mini contracts valued at around $4 billion by the Overland Park, Kansas firm Waddell and Reed on the Chicago Mercantile Exchange.

CQF Lecture, Copyright PHE, 2010


The Future of the Financial Exchanges
• 1309 – commodity traders form Bruges Beurse
– Spreads to Ghent, Amsterdam, Italy (government securities); Holland allows the formation of joint stock companies

• 1602 – First stocks and bonds issued on the Amsterdam Stock Exchange –
– Dutch East Indian Company – Continuous trading – Speculative investments

• 1698 –Trading in coffee houses of London
– Jonathan’s issues a list of stock and commodity prices for traders after they were expelled from the Royal Exchange for rowdy behavior

• 1761 – 150 Brokers form a club, build the Stock Exchange in 1769 • 1801 – A modernized London Stock Exchange opens

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The Future of the Financial Exchanges
• Governance
– Demutualization, separation of ownership and membership, Stockholm in the early 1990s – Innovation in products and services

• Technical
• Small Order Management System • Stock Exchange Electronic Trading System

• Structural - Mergers
– NYSE-Euro Next – Eurex (Deutsche Bourse and SWX acquires ICE December ‘07 – TSE-NYSE Euro Next January ‘07 agreement, w/ LSE, Feb ’07

• Speed on the Outside
– Black Pools – Liquidnet vs. NYSE - 42,000 vs 400 sh. on average trade – Turquoise, Chi-X- Instinet; who will go faster than the speed of light?

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Part V: The Garden of Forking Paths
• • • • • • • • • • • • • Modern Economics in Brief Invoking the Animal Spirits Eight Big Questions Swensen’s Edges - Advanced Portfolio Theory Tip of the Iceberg Risk - Beyond Modern Portfolio Theory The Behemoth – RenTech Of Mice and Men: Are Central Banks Necessary? The Misbehavior of Markets in a World of Chance The Network Effect: X Degrees of Separation Systemic Risk Redux Origins of Wealth: The Production of Goods and Provision of Services Creation and Destruction Little Blue Planet

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Modern Economics in Brief
• The Modern Movement • Keynesian Revolution, 1935
– Macro glitches are dangerous – need regulation and active financial policy to smooth the road

• • • •

Samuelson – MIT, 1941 Economics goes high tech – Chicago Cowles Commission, 1954 Counter-Keynesians, Milton Friedman
– Condemns “fine tuning”, warns of perverse effects that would likely arise from attempts to interfere – extolls the magic of the market

• Greatest economist – Kenneth Arrow and the new math
– Infinite Dimensional Spreadsheet

• 1970s becomes and era of tool making
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Behavioral Economics
• Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns, and the resource allocation. The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. • Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest.
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Invoking the Animal Spirits
• Confidence – The Cornerstone
– Feedback mechanisms between it and economy that amplifies disturbances

• Fairness – Setting wage and price controls
– Opinion measurement, norms, expectations

• Corruption and Anti-social Behavior - Temptation
– Past three recessions each featured a major scandal:
• S&L Associations and the Recession of 1991 • Enron and the Nuclear Winter of 2001 • Subprime market and the Crisis of 2007-9
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Animal Spirits
• The Money Illusion – Public confused by inflation/deflation
– – – – – – – – Wage contracts, Cost of Living increases, expectations Debt contracts, bonds and repayment Accounting Failure to comprehend the consequences of a drop in consumer prices Human Mind Political and economic explanations Epidemic of stories Back to Taleb – The Narrative Fallacy
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• Stories: Our sense of reality intertwined with others

Eight Big Questions
• Why do economies fall into depressions?
– 1980s example – crash of confidence, stories of corruption and failure, sense of unfairness in economic policy

• Why do central bankers have power over the economy?
– Standard story – open market operations, rediscounting or lending at the discount window – Interest rate story – Managing quantity and price – supply and demand – Alternative view: The central banks will take action when confidence might be collapsing
CQF Lecture, Copyright PHE, 2010 140

Eight Big Questions
• Central Banks continued
– Shadow banking system experiences intense fear of failure late in the cycle; could lead to financial panic – So the central bank is the lender of last resort – counters the systemic risk in a liquidity crisis – However, in recent years, the magnitude of the crises has become so great that the central banks are more engaged in trying to save their own economies and, more generally, the world economy through coordination with peers
• Evidenced domestically by the US failing to relieve the pressure on Lehman – resulting in Chapter 11 filing in September 2008
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Animal Spirits or Lap Dogs
• Even so, the Fed also provided:
• Discount window lending through TALF, and • Direct injections of capital - $250 billion from TALF to:
– – – – – – – Bank of America Bank of New York Mellon Citigroup Goldman Sachs JP Morgan Chase Morgan Stanley Wells Fargo

• So for investors, what strategies and tactics to pursue on this quasi-level, interventionist playing field?
CQF Lecture, Copyright PHE, 2010 142

Swensen’s Edges – Advanced Portfolio Theory
• David Swensen, Chief Investment Officer, Yale Endowment Fund • Allocation to Alternative Investments
– Helps attain an 17.4% annualized return

• Data on VC and Hedge Fund Manager Performance • Access is the Golden Word • Global Investment – people on the ground
CQF Lecture, Copyright PHE, 2010 143

Venture Capital Contraction

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Hedge Fund Performance

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The Tip of the Iceberg – Risk Beyond MPT
• Addresses the abnormality of normality • Focus on rebalancing • Optimal mix with conditional Brownian Motion • Optimal mix with moderate Poisson risks • In Wilmott Mag: The Tracks of Tears and others • detail.cfm?articleID=310
CQF Lecture, Copyright PHE, 2010 146

Iceberg Risk
“Most people assume that portfolios are bound to suffer less than individual assets from high standard-deviation outliers. That’s not true. Granted, according to the Central Limit Theorem, portfolios of many independent, identically distributed assets have approximately normal distributions, even when those of individual assets are very fat-tailed. But even a small degree of dependence can render the CLT inapplicable.” - Kent Osband, Iceberg Risk: An Adventure in Portfolio Theory
CQF Lecture, Copyright PHE, 2010 147

The Behemoth - RenTech
• Jim Simons in Lecturing Birds on Flying – story
– December 2007, Jim Simons gave a lecture at NYU Stern, Pablo Triana relates some of the discussion in Lecturing Birds…(reading) And Triana concludes, “There can be no Einstein or Newton. Even the math genius raking in $1B a year and consistently generating 30 percent return wouldn’t qualify. The terrain, unlike the physical world, is just too untamable and lawless.”
CQF Lecture, Copyright PHE, 2010 148

Of Mice and Men: Are Central Banks Necessary?
• Can Central Banks Protect Us from Depression and Lead the Economy? • Argument 1: Yes. Without a central bank, there would be no way to control the dangerous excesses of the banking system and otherwise keep the economy on a steady course. • US Panic of 1907 leads to the Federal Reserve Act, 1913
– Loose or tight money, accelerators and brakes
CQF Lecture, Copyright PHE, 2010 149

Are Central Banks Necessary?
• Arguments 2 – 9 = No • 2. The record of the US Fed has been poor; the country did much better before its founding
“The severity of each of the major contractions, 1920-1, 1929-33, and 1937-8 is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.”
- Milton Friedman
CQF Lecture, Copyright PHE, 2010 150

Are Central Banks Necessary?
• 3. Price fixing is especially toxic for an economy and central banks are price fixers. • 4. Central banks are national economic planners and that planning does not work. • 5. Central banks rely on flimsy tools and rules. • 6. The Greenspan Fed – A case study in Unintended Consequences • 7. CBs represent moral, not only practical problems
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Are Central Banks Necessary?
• Central banks service the interests of politicians, primarily, rich people secondarily, and the poor not at all. • Central banks can and should be replaced
– Return to Gold – Private banking facilities
• Possible to have reserve requirements of 100%

• Disclaimer: for discussion only
CQF Lecture, Copyright PHE, 2010 152

Other Big Picture Debates
• • • • • • • • • Classical gold standard Gold exchange system Floating rates Managed floating rates Dollarization One World Money The World Bank International Monetary Fund And Market Mechanics – the Liquidity Story
CQF Lecture, Copyright PHE, 2010 153

The Quant World: Fractals, God (Higgs), and Dice

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A Game of Chance
“On the facing page you see four price charts of the kind you would find in a brokerage-house report, but with identifying dates and values removed. Two of the charts are real chronicles of the price of a real financial instrument – name also removed. Two are forgeries, entirely fictitious series of numbers, generated using different theoretical models of how markets work. Ignore whether they trend up or down. Focus on how they vary from one moment to the next. Which are real? Which fake? What rules were used to draw the fake?” - Benoit Mandelbrot, The (mis)Behavior of Markets
CQF Lecture, Copyright PHE, 2010 155

Fractals: Ten Heresies of Finance
1) 2) 3) Markets are turbulent Markets are risky, much more than standard theories admit Market timing matters greatly; big gains, losses concentrate into small packages of time 4) Prices often leap, not glide, adding to risk 5) Time is flexible 6) Markets in all places and ages work alike 7) Markets are inherently uncertain and bubbles are inevitable 8) Markets are deceptive 9) Forecasting prices is perilous, but you can estimate the odds of future volatility 10) In financial markets, the idea of Value has limited value.

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• Chance – Simple or complex • House of Modern Finance:
– Bachelier – Markowitz – What is Risk? MPT; Efficient portfolios – Sharpe – What is an Asset worth? CAPM – Black Scholes – What is Risk worth? BS

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• Shaky assumptions
– – – – People are rational and aim only to get rich All investors are alike Price change is practically continuous Price change follows Brownian Motion

• Anomalies that do not fit/contradict CAPM:
– The P/E effect, p. 101-2 – The small firm in January effect – The Market to Book effect

• Turbulent markets – fractals are studies in roughness
CQF Lecture, Copyright PHE, 2010 158

Fractals: A Primer
• • • • • • • • Initiator Generator Rule of recursion Scale up or down Self-similar Self-affine Multi-fractals Pictures – Sierpinski gasket, fractal skewed web, Cantor distribution, Koch curve • Cluster forms: clouds, cauliflower, human lung
CQF Lecture, Copyright PHE, 2010 159

Does God Play Dice?
• A World of Chance: Brenner and Brown
– Gambling stigma, prohibitions – Rise of entertainment and sports industries – From poker banks to clearing houses – Poker banks and junk bonds – Gambling on central banks

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Or it is just people in the kitchen, cooking with Gas: Enron & Amaranth

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The Network Effect: X Degrees of Separation
• The Company of Strangers • Fragility and strangeness in our everyday lives “Our evolved ability of abstract reasoning has allowed institutions like money markets, cities, and the banking system to provide the foundations of social trust.” • Even basic provisions of food and clothing now rely on a web of interaction that spans the globe • Civilization may act as a curb on our more violent instincts, but it is also highly dependent on their suppression
CQF Lecture, Copyright PHE, 2010 162

Systemic Risk Redux
• Lo, What Happened to the Quants, August 2007 • Dr. Mila Getmansky Sherman’s video – Finance Department at UMASS and affiliated with CISDM • Papers on SSRN

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All Ships Rise and Fall Together?

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Origins of Wealth
• • • • Production of Goods and Provision of Services Technological Innovation Productivity Supported by:
– Infrastructure – Legal System: Rule of Law – Intellectual Property Rights Regime – Robust and Liquid Capital Markets – Transparency – Higher Education System Work by Amsden, Saxenian, Bhide
CQF Lecture, Copyright PHE, 2010 165

Creation and Destruction
• The Trimurti (Three forms) is a concept in Hinduism in which the three cosmic functions are personified by the forms of Brahma, the Creator, Vishnu, the Maintainer or Preserver, and Shiva, the Destroyer or Transformer. The Hindu scriptures, the Puranas, explain that Absolute Satchinanda, or Absolute-Existence-Bliss once had a wish to be seer and player in the unreal world of Maya. So he created the Trimurtis, symbolizing the Universal Creator, Men, and Demons. They suggest that there are many perspectives conflicting with each other, but no one can say which one is right.

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Part VI: The Fire Next Time
• Where will the next crisis come from?

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Old World Crisis

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New World Crisis

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Those D@rn Swans
• Emanuel Derman from Alchemists on Wall Street: the models are not the problem, more the inputs – those are judgments. But his fear really centered on the prospect of the race going to the quickest • Alchemists came out before May 6

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Financial Modeler’s Manifesto
• I will remember that I didn’t make the world, and it doesn’t satisfy my equations. • Though I will use models boldly to estimate value, I will not be overly impressed by mathematics. • I will never sacrifice reality for elegance without explaining why I have done so. • Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights. • I understand that my work may have enormous impacts on society and the economy, many of them beyond my comprehension. •
CQF Lecture, Copyright PHE, 2010 171

Dungeons and Dragons
• • • • • • • Contagion: Macro Meltdown – Europe Regulation: Spillover Effects Speculation: Precious Metals, FX, Carbon Techno: Black Box Trading – Flash Crash II Techno-Human: Hackers and Terrorists Acts of God (or Higgs): Solar Storms Visible on the Horizon – The Power of Words
CQF Lecture, Copyright PHE, 2010 172

Contagion: Macro Meltdown – Europe

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Regulation: Spillover Effects
“Capital goes where it is appreciated.” • Domestic Regulation
– Actor Cooperation – Penalties for Anti-Social Behavior

• Global Regulation
– Sincerity and Deception – Oversight and Enforcement

• Again, Vandal’s Crown and Emperor’s Clothing • Cases of the Marshall Plan (grand scale), Plaza and Louvre Accords (moderate collaboration)
CQF Lecture, Copyright PHE, 2010 174

Speculation: Precious Metals, FX, Carbon
• Platinum chart
– 1972-2004

• EMU falls apart
– Who wins? – Who loses? – Imagine returning to the DMark, Drachma, Lira…

• Carbon Trading regime
– Government regulation – Emerging venues

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Techno: Black Box Trading – Flash Crash II
• Role of Black Pools • Data:
– Average trade on NYSE is 400 shares – Average trade on Liquidnet is 42,000 shares

• You apply circuit breakers and where is the flow going to go? • Race to the quickest – latency • Horse racing handicap – weight for age or for winning; maybe force some latency on GS
CQF Lecture, Copyright PHE, 2010 176

Techno-Human: Hackers and Terrorists
• Penetration of Networks
– Levels of Damage from Theft – How much is just exploring, for now?

• Growth in Dependence on Electronic Money • Haug – “Options Embedded in Physical Money”
– 1313665

• And not only Human Interlopers in our systems…
CQF Lecture, Copyright PHE, 2010 177

Acts of God or Higgs: Solar Storms
• Another recent paper by Haug: • “When Will God Destroy Our Money?” • NASA statements, data • Preparedness, very low • sol3/papers.cfm?abstra ct_id=1591768
CQF Lecture, Copyright PHE, 2010 178

Back to Barter?
“(If) a very large coronal mass ejection from the sun that could cause a super solar storm should hit the earth, it might wipe out the global money system within minutes from impact. Stock exchanges would not operate, banking systems would not function, and credit card and ATM machines would stop working. We could find ourselves without the use of our modern electronic forms of money for months and possibly years. And yet, even in a catastrophic scenario, where water pumps, power plants, public transportation, and other infrastructural assets that are essential to contemporary life had failed, some type of functioning money system would be required to keep the basic necessities, such as food and medical supplies, flowing without too much friction.” - Espen G. Haug, When Will God Destroy Our Money?
CQF Lecture, Copyright PHE, 2010 179

Visible on the Horizon
• The Power of the Word
– National Governments – International Organizations – Lobbyists – The Silent Majority

• Global Political Flows • Global Financial Flows • Global News Flows
CQF Lecture, Copyright PHE, 2010 180

Global Coordination and Cooperation
• Central Bank activity • Construction projects in US and UK – 30 years on infrastructure • US low rates – do not choke the recovery • Europe always a deathly fear of inflation • Emerging Markets: For Better and for Worse
CQF Lecture, Copyright PHE, 2010 181

Emerging Markets
• As emerging market economies become increasingly important in the global trading and financial systems, the world economy will depend even more on them to maintain strong domestic growth and economic and financial stability. Thus, the improvements in emerging market policies and policy frameworks I have discussed today have ramifications beyond the emerging market economies themselves. Emerging market nations also have a key role to play in the important efforts to reduce global imbalances in trade and capital flows. Again, the G-20 is in a position to lead.
– Chairman Ben. Bernanke at Bank of Korea’s International Conference, May 30 ,2010
CQF Lecture, Copyright PHE, 2010 182

Power of the News Media
• After dot com – introspection and some new rules of the game
– – – – Fairness Balance Accuracy Disclosure

• Then severely tested by Subprime Meltdowns • And even more so by Flash Crash
CQF Lecture, Copyright PHE, 2010 183

Interdisciplinarity, or CFD Revisited
• We joked before about Computational Fluid Dynamics, but the multivariate analysis angle is relevant: • Finance: Theory and Practice • Technology: Electrical Engineering, Computer Science, Math, Physics • Economics: Local, National, Global • Regulatory: Too Little, Too Much, Too Late , Unintended Consequences • Behavioral Psychology, including Mass Media
CQF Lecture, Copyright PHE, 2010 184

Loops and Influences
Financial Markets



Behavioral Psychology


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The Blank Swan
• In the midst of this cauldron, a new breed of analysis is brewing: “In a world that is only made of contingency, it is only natural that we should invent options or derivatives contracts…that we should circulate, today, things that we know will make a difference in the future. Thus we write those derivatives contracts and in their writing (the ‘If…then, else if…then formula) there is nothing even remotely related to possibility. It is the pure, material writing of contingency. It is pure difference. Writing is difference, as Derrida would say. However, writing, as we all know and as Roland Barthes suggests, is only the prelude to an exchange...”
– Elie Ayache, The Blank Swan: The End of Probability
CQF Lecture, Copyright PHE, 2010 186

• In philosophy and logic, contingency is the status of propositions that are neither true under every possible valuation (i.e. tautologies) nor false under every possible valuation (i.e. contradictions). A contingent proposition is neither necessarily true nor necessarily false. Propositions that are contingent may be so because they contain logical connectives which, along with the truth value of any of its atomic parts, determine the truth value of the proposition. This is to say that the truth value of the proposition is contingent upon the truth values of the sentences which comprise it. Contingent propositions depend on the facts, whereas analytical propositions are true without regard to any facts about which they speak.

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• Along with contingent propositions, there are at least three other classes of propositions, some of which overlap: • Tautological propositions, which must be true, no matter what the circumstances are or could be (example: "The sky is blue or the sky is not blue."). • Contradictions which must necessarily be untrue, no matter what the circumstances are or could be (example: "It's raining and it's not raining."). • Possible propositions, which are true or could have been true given certain circumstances (examples: x + y = 4; There are only three planets; There are more than three planets). All necessarily true propositions, and all contingent propositions, are also possible propositions.
CQF Lecture, Copyright PHE, 2010 188

Little Blue Planet
• Terrain • Human Inhabitants • Species: Flora and Fauna • GDP • Quality of Life Index • Perspective from successful software entrepreneur to Oyster Fisherman
CQF Lecture, Copyright PHE, 2010 189

Finding the Signal
• • • • Philosophy Art Music Hot Links
– Solar Flares – rsity-of-sheffield/sound-ofthe-sun – tch?v=ZbIffp40U8w&feature= player_embedded – Whale Songs – tch?v=WabT1L-nN-E

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Aporias Return
We share…a secret which cannot be shared, a secret which we know nothing about… To share a secret is not to know or to reveal the secret, it is to share we know not what: nothing that can be determined. What is a secret that is a secret about nothing and a sharing that doesn’t share anything?
– Jacques Derrida, The Gift of Death

CQF Lecture, Copyright PHE, 2010


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