naked capitalism

leftcoast says:

And Goldman management hired them….

Everything is fine as long as you don’t look behind the curtain!

dis says:

They are also wrong in their assessment of how unlikely the events have been

This one of today’s Le columns at the FT

Market downturns
Published: August 14 2007 09:58 | Last updated: August 14 2007 14:30
To judge by the reactions of some, financial markets have disappeared completely off the radar. Goldman Sachs says its quantitative funds experienced “things that were twenty-five standard deviation events”. Leveraged buy-out deals – from the auction of Cadbury’s drinks unit to the sale of TXU – are said to be endangered. KKR and Blackstone have lowered their expectations for the LBO market. Meanwhile banks have been hoarding cash, prompting the biggest open market intervention in the European Central Bank’s history.

Yet the uncomfortable fact is that, by any historical standard, nothing serious has actually happened. For example, in the last week of July, US junk debt yields did jump by 50 basis points using Lehman’s universal index. But since the end of 1986 a weekly rise or fall of at least 50 basis points has been seen no less than 37 times. The idea that equity volatility has been unprecedented is also dubious. The S&P500 index has fallen by 6 per cent in four weeks. An equivalent move in either direction has been seen 123 times since the end of 1986.

Some of the price moves in specialist areas, like mortgages, have been far more severe. But how could the business models of generalist equity vehicles, banks or buy-out funds be in jeopardy? The answer, of course, is leverage. Before Monday’s bailout, Goldman’s Equity Opportunities Fund had gearing of six times. This year, for European LBOs, gross debt hit 6 times earnings before interest, tax, depreciation and amortisation. Assuming typical capital expenditure levels, that implies cash flow interest cover of 1.3 times. Quoted companies run at 10 times.

This cult of debt has its origin in asymmetric pay structures which overcompensate risk. It has been compounded by the trend of allowing managers, whether of structured debt or private equity funds, to in effect value their own portfolios. The tremors in the financial superstructure show how fine the margins for error now are. It is hard not to wonder what would happen if something genuinely serious – like a downturn in US profits – occurred.

dis says:

Yves, over at the FT, Dizzard makes the case that these guys do not consider fat tails and non-normal distribution because of their compensation structure.

The normal distribution works well in the short term and they get paid on a short term basis, while nontypical events occur about once a decade, so they need not worry fat tails.

Steve Diamond says:

See the earlier exchange on normal distribution v. Levy distribution – the latter makes these triple digit moves look far common but for reason only gaussian curves seem to be used to describe the financial markets!