Adoboli convicted...food for thought...

Kweku Adoboli, the UBS 'rogue trader' in London, was convicted of fraud yesterday...fair enough, looks like he was guilty, yet why is it you never see a headline: "Rogue trader earns bank $2bn"? Not once...ever! A sceptical person might conclude that whenever unauthorised trading makes money it is simply bundled under 'profits' and no more is said...yet loses from such activities are called 'rogue trading' and treated VERY seriously...criminal conduct, no less! It's pretty clear that someone was at least willfully ignorant and possibly criminally negligent, and UBSs internal systems and controls were woefully inadequate (I have this on good authority). It seems possible, perhaps likely that at a lot of banks a 'heads I win, tails you lose' mentality prevails regarding breaches of trading limits: bank management will look the other way as long as the bets are profitable, but woe betide traders who lose money in this fashion... they may double down, but are always at risk of having the rug pulled from under their feet when the problem becomes too big to ignore and management or risk "realises" what is going on...management then claims that this 'unforseeable' loss was due to criminal conduct by a rogue individual and hence should have no bearing on their own compensation...and woe betide the shareholders... The most interesting question for me is this: How much of the profits of the investment banking sector over the past 10 or so years were due to so-called 'rogue' trades (i.e. trades in breach of stated risk limits)...

A Tale of Two Marios, Part Deux

I believe that one critical problem at the moment is that financial markets and the political class are still talking past one another. Given the levels at which they are trading, we can assume that financial markets, conditioned, like Pavlov's dog, by 30 years of the Greenspan put, fully expect the ECB to come out with these kind of tough-talking statements, but are convinced that, one policymakers see the gravity of the situation, they will open the spigots and begin financing the Italian state. However, I see the prospect of a much darker scenario emerging - I think there is a very strong possibility that the ECB will refuse to step beyond its mandate to finance Italy (or at least, will refuse to do so until it's too late, which amounts to the same thing). The main reason for this is that the ECB has been trying to tell us, in as plain a way as central bankers can manage, for some time, "our mandate is price stability; we cannot finance government borrowing - it would require treaty change". In short, the ECB, genuinely or not, is arguing that such action would be illegal - it is deliberately painting itself into a corner. Why would it tie itself to the mast like this if it were not serious - it is one thing to say "We won't do this", but quite another to say that "We can't do this, it's illegal". I think the ECB is trying to tie its hands to provide a credible signal to the market, and the politicians, that they had better sort this mess out, because they will see no help from the central bank. The market, however, knowing that the ECB is the Bundesbank in drag, has discounted this, as I said above. The irony of this, of course, is that we are currently in a state where a simple statement by the ECB that they are prepared to spend say, €2 or 3 trillion euros buying peripheral bonds as neccessary would solve the problem, combined with the anticipated supply-side reforms in Italy, and (hopefully) Spain. Italian bond yields would go to 400 bps instantly. Every day that passes, however, brings us closer to that time when the market will simply take borrowing costs out of Italy's reach entirely (and it will happen very quickly, probably sooner than we think). By that time, we may then reach a situation whereby the entire eurozone banking system will be effectively insolvent (already some French banks have difficulty borrowing in dollars). Italy may well be Europe's Lehman - the spark that lights the powder keg to spread contagion across the continent and the world. The problem, then, is that by the time that the ECB realises it is the only institution that can act, and the euro itself is collapsing before its eyes, it may be too late.

A Tale of Two Marios

It seems pretty clear over the past week or so that the fiscal bailout plan for Italy I described in my previous post is dead in the water. Germany and the more fiscally stable northern eurozone members (a shrinking number) will not countenance essentially unlimited aid, even if they could afford it without damaging their own credit rating, which, considering Gavyn Davies estimates Italy will need €750bn in financing over the next 3 years, they likely couldn't anyway. Short of full fiscal union (and with an 85% Eurozone debt/GDP ratio, would even that solve the problem?), there will need to be a monetary solution. Worryingly, however, new Bundesbank President Jens Weidmann re-emphasised in a (rather shocking) interview over the weekend that the ECB could not intervene since monetary financing of governments is prohibited by Article 123 of the Lisbon treaty. The interview betrays a quite spectacular lack of appreciation from the monetary authorities regarding the scope of the crisis. Mr Weidmann appears to believe it is a little local difficulty. He opens the interview by saying that "For me, the eurozone as a whole is not at stake" and that "the seriousness of the (sovereign debt) crisis is apparent, but it is not a crisis of the euro", which is nice - I'm sure we all feel much more reassured now. He goes on to explain that "We need a debate now over the future architecture of the monetary union", which indeed we do, but can I suggest that perhaps the bigger issue, Jens, is that the eurozone economy is trundling toward a catastrophe with our eyes closed because the central bankers and politicians are still being either small-minded or willfully ignorant. But Herr Weidmann goes on to say that , the Greek problem is one of simply implementing the 'adjustment path' (the austerity measures), that have been agreed, and "market turmoil comes from the fact that this implementation has been questioned - and not because the plan is not credible". He is apparently oblivious to the fact that maybe, just maybe, the lack of credibility comes from the fact that no-one with eyes and a brain seriously thinks Greece is going to put up with a decade of vicious austerity measures in order to put themselves in the situation that Italy is now in, with debts that are merely very large rather than totally overwhelming. I think Mr. Weidmann is employing the 'see no evil, hear no evil, speak no evil' model of economics, which involves closing your eyes, sticking your fingers in your ears and repeating ad infinitum "If I don't acknowledge it, it doesn't exist". To address his point about Article 123, however - why, if it is the legality of the situation rather than the fear of inflation that is tying the ECB's hands, is the ECB not being more proactive in looking for ways in which it can help the situation, rather than aggravate it by continually declaring "nuffin' doin', guv". To those who say that the ECB will be preparing, behind the scenes, to do whatever they can if a crisis blows up, but doesn't want to make the situation worse or let spendthrift governments off the hook, I will say this: The crisis is already here - the ECB needs to show it actually has a grip on the situation or the crisis will become a self-fulfilling prophecy - and they are already making the situation worse by acting as if nothing is wrong. There are times to say "don't frighten the horses" and others to say "damn the horses, all hands to the pumps". Everyone apart from the central bank has realised that we are now in the latter situation. Monday's idea from the FT was for the ECB to lend to the IMF, which would then assume the credit risk of lending to European sovereigns, but not a peep has been heard from Brussels, Frankfurt, Paris or Berlin or the matter. Reading Mr. Weidmann's interview, one increasingly appreciates how Alice must have felt when she stepped into Wonderland. I can only think that Mr. Weidmann is the mad hatter...

Soros strikes again...

George Soros, speculator and philanthropist par excellence (and, for my money, probably the most genuinely brilliant philosopher-financier in history), was on Stephanomics with Stephanie Flanders last night. Insightful as ever, and in addition to emphasizing the reflexive relationship between credit and collateral (dealt with in Alchemy of Finance, but far more important than most people recognise), he expressed a couple of opinions that I found interesting: the first was that the UK economy was actually in a significantly worse position than Italy and Spain, but that, while they were effectively issuing bonds in a foreign currency (i.e one over which they had no unilateral authority), the UK's ability to print sterling at will has immunised it from the turmoil (though presumably not to an unlimited extent if we really muck it up). Secondly, he emphasised the inbuilt deflation bias to the ECB, in that it has a mandate to maintain price stability, but not, unlike most of its peers around the world (including the BoE and the Fed), to maintain a healthy economy or full employment. This was not a point I had really thought about since 2008, when the ECB was particularly reticient about intervening with expansionary monetary measures (though to their credit they overcame their reluctance on that occasion at least). It is worth remembering now... this is of course a legacy of the Bundesbank and the hawkish German focus on low inflation. I appreciate that the monetary history of Germany has been traumatic, particularly in 1923, but they and the ECB are letting this long shadow dictate to and destroy their present. The Germans have over-learned their lesson. Little annoyances like the now obviously mistaken rate hikes earlier this year are embarrassing for the ECB, but German/ECB intransigence about providing backstops and liquidity to weaker Eurozone members is now threatening to imperil the whole system. The German body politic needs to take a long, hard look at what is really important to them, and what the consequences of their actions are likely to be...

Thoughts on the Eurozone situation...

Some excellent analysis in the FT of the basic problem with the Eurozone's 'rescue' deal announced in the early hours of yesterday morning from Wolfgang Munchau and Gavyn Davies. Basically, this deal won't decisively resolve matters because it doesn't involve either of two options to stabilise/backstop the funding requirements of Club Med: (a) the possibility of essentially unlimited fiscal transfer from north to south in the shape of 'joint and several' liability Eurobonds or (b) the ECB committing to buy as many peripheral bonds as necessary and run money supply growth at above-normal levels for several years to ensure reflation. This would essentially mean the ECB assuming a 'lender of last resort' function which it has thus far been very chary of taking on. Option (a) would stop speculative attacks on eurozone sovereign debt and buy significant time (by which I mean up to 10 years) for the eurozone to work through its problems and get it's debt and deficits under control by undertaking gradual supply-side structural reforms to pensions, benefits, and labour markets. Option (b) would essentially monetise the debts to a limited extent, reflating Club Med and allowing real wages in the periphery to fall, partially restoring competitiveness. But Germany and its brethren at the ECB are unwilling to allow inflation of say, 5% for 2 or 3 years to 'jump start' the peripheral European economies by inflating away part of the debt burden.

Instead of this, the Europeans have put their faith in the EFSF issuing partial guarantees (i.e. basically writing CDS) on Italian and Spanish bonds, and asking the BRICs and other Sovereign Wealth Funds (SWFs) to cough up on their behalf....one can only wonder what kind of person thinks this is a clever idea!! To deal with the second point first, the BRICs and any SWFs won't be interested in backing the EFSF if Germany is swearing off any further commitments....the Russians, Indians and Brazilians have actually said they won't be participating in any case. The Chinese may try to be helpful but they won't interested in bailing out Europe if Germany and the stronger European states aren't going to guarantee to take all the losses...and then we're back to Germany not wanting to increase its risk. As to the first point, re. guarantees, the idea is to have the EFSF guarantee by some means the first 20-35% of loses on Italian or Spanish debt. Straight away, the problem that stands out is that Italy's debt is 120% of GDP and it is the third largest debtor in the world - if Italy were to default, it would likely want to write off 40-50% of debt at a minimum to make the immense economic turmoil worthwhile and bring the number down to a manageable level (remember that, back in the mists of time, 60% was supposed to be the Eurozone ceiling!). If the EFSF were to guarantee 35% of the debt issued by Italy it could leverage itself just under three times (on the approx. €250bn remaining in the fund), yet Italy has gross public debt approaching €1.9trn, with an average maturity of 7 years... the problem should be clear... Italy will need to roll over €950bn of debt in the next seven years, yet EFSF capacity is at most €750bn when leveraged three times. Of course, you could leverage it four or five times, just as Angela Merkel has said, but then you run into the problem described above - will the market think that a 20-25% guarantee sufficient to protect buyers from losses in the event of default. And, don't forget, this is just Italy!...Spain's deficit and unemployment is so high that they will be trouble within a few years if this crisis isn't decisively put to bed...

So, my reason for drawing the rather somber conclusion that only Eurobonds or QE will do as a resolution to the crisis is as follows: Markets only respect money - i.e. trades, buying and selling power, but the good thing is, they do consistently respect money. If you're willing to anti-up, you will usually get your way, but the moment your money runs out (or heaven forbid, you're found to be bluffing), the markets will fall upon you with fury...as everyone discovered in the past five years. Hank Paulson's 'bazooka' and Fed QE worked in 2008-09, co-ordinated action by the G5 to weaken the USD worked in 1985, but you have to be willing to put up the readies. Note, you don't have to actually spend the money, but you have to show that you are more than willing to spend the money - then markets will move for you. That is why the Eurozone hasn't found a solution to its crisis...Germany (and France to a lesser extent) has been consistently applying the brakes - the speculative attacks on European sovereign debt won't stop until the market is convinced that a really big beast (read: Germany or the ECB, preferably both) is standing behind the weaker credits, ready to deploy their considerable firepower (estimates vary, but €2-3 trillion would likely be enough) to defend the system. Until that happens, we're just kicking the can further down the road...and closer to the day of reckoning, where international bond markets will finally ask the Europeans to put up or shut up...as to what form this will take - if European growth remains turgid, a speculative attack on OATs (French govt. bonds) would be my presumption. I very much hope that European leaders have the courage and foresight to do what is necessary to stop that day from arriving.

The Traders' Training Programme

Recently I've been giving some thought to how I would design a training programme for front office professionals in financial markets (portfolio managers, traders, analysts, salespeople and the like). I thought back over my own mostly self-taught education in finance, and about what I considered to be the important concepts around which one can structure one's experience. This (below) is what I came up with. The major difference from the curriculum of a typical business school is the significant weighting given to philosophy, together with economic history and psychology (through behavioural economics). This is because, as a philosopher myself, I see awareness of philosophy as critical to success in any area where human psychology determines the rules, and where the actions of participants change the game through feedback effects. Some of the most important 'philosophers of finance', in my view, include Nassim Taleb, Benoit Mandelbrot, and George Soros (with his theory of reflexivity). Others whose views are extremely important from a wider, 'background' context include John von Neumann and Karl Popper. In fact, I would argue that without a proper philosophical understanding of financial markets, we cannot properly understand which economic and statistical interpretations can be applied to them (and for the dangers of relying upon incorrect statistical assumptions, look no further than the Nobel prize-winners at LTCM). In other words, our philosophy of markets is the foundation upon which the rest of our knowledge of finance rests. While the word 'philosophy' makes many people think of tedious debates over unsolvable problems, what I am really advocating can be expressed very simply, but it must be consciously expressed. For example, my own philosophy might be summarised as: "I believe that financial markets are theoretically intended to be an information discounting mechanism for future economic events. However, because financial markets are purely psychological constructs (i.e. there are no hard-and-fast 'laws', as in science), the relationship between economic reality and the market becomes distorted, and each influences the other in non-linear ways. The fact that markets are manifestations of mass psychology also means that they are areas in which we can expect large deviations from 'expected' values (Nassim Taleb's 'extremistan'), due to the presence of power laws rather than a normal or log-normal distributions, as in natural science."

The Programme:

Philosophy

- Epistemology

- Philosophy of Science

- Philosophy of Mathematics

- Logic and critical thinking - philosophical logic, mathematical logic/foundations of mathematics

Statistics

- Computational statistics

- Experiment design

- Statistical modelling

- Mathematical statistics, statistical theory, decision theory and probability

- Sampling and surveying

Economics

- Macroeconomics

- Microeconomics

- Financial economics

- Econometrics

- Neuroeconomics/behavioural economics/finance (incorporating psychology)

- Economic & financial history

- Game theory

Business

- Finance – investment analysis – technical and economic analysis

- Accounting – financial reporting

- Risk management

- Business ethics

Computer Science

- Excel etc

- CS logic - programming language semantics, trading system design – fuzzy logic, genetic algorithms, artificial neural networks

The nonsense of VaR

Value at Risk - Just a few short years ago it was all the rage. The question on the trading floor was not 'how big is your position', but 'What's your VaR?'. Over the past couple of years, VaR has taken a battering from many who have pointed out that VaR is all very well for dealing with day-to-day volatility, it is truly useless for understanding worst-case scenarios because it is reported to a confidence level, usually 95 or 99%, and thus deliberately excludes the 'fat tail' or abnormal deviations that are the really important and interesting part of risk management. Being told that your portfolio has a daily VaR of $10 million, with 99% confidence is all very well, but what does it actually mean, in real terms? Risk management shouldn't primarily be about fluctuations in value (i.e. volatility), but about permanent impairment of wealth - i.e. rare, cataclysmic events that wreck portfolios terminally, not the daily back-and-forth. VaR is just another volatility-based definition of 'risk' - relevant perhaps, but not the kind of risk that a portfolio manager or trader should focus on. However, I want to focus on another serious flaw in the VaR measurement, one that has been overlooked. This is that it measures volatility using past data as its input. More specifically, through there are differences in calculation, VaR typically uses the past x days of a market as typical of the volatility in that market, and uses this figure to derive its confidence levels. This in turn means that VaR is always behind the curve as market volatility changes. Think this is a theoretical argument? Well, allow me to make it a very real one. Using figures culled from Bear Stearns annual reports over the past decade, we can see what this really means. Over the nine and a half years between Q1 1998 and the end of Q2 2007, Bear's traders experienced just 5 days of loses above the 95% daily VaR limit. In Q3 2007, however, BSC succumbed to 10 such days. In Q4 they had 16, and in Q1 2008 (just before BSC went the way of the dodo), they experienced a further 8. That's 34 days where the day's trading loss exceeded the firm's 95% confidence level in a mere 9 months. Assuming a 21 trading day month, that implies that loses exceeded the VaR limit 18% of the time in a 9 month period. Equally worryingly, it came after just 5 such days in nearly the entire previous decade. Figures from Goldman Sachs, Morgan Stanley and Lehman Brothers show similar rapid increases in the number of days where VaR limits were exceeded. The problem then is that not only does VaR fail to account for the really crucial 'fat tail' risk, but, as conventionally configured, it isn't even that good at quantifying volatility due to an over-reliance on the near past. Bad, VeRy bad!