naked capitalism

bg says:

Long dated options are proportional to the square root of time.

The black swan types believe that equities are overpriced (too little fear) and options are underpriced (too little fear).

The other missing piece from Black-shoales that Warren is onto is that investing in a diversified portfolio over the long term does have positive alpha (1.5% ?), and so the formulas will overvalue puts and undervalue calls. Over the very long term this can be significant.

I would not dismiss Warren lightly.

Steve says:

It doesn’t matter if Buffett is right about long-term valuation, if the trade is bad enough short-term to endanger his AAA.
The marks have gotten a lot worse since 12/31/08, and he’s unhedged. An equity derivatives trader said the put premia were `about right’, implying 20%-25% volatility, and certainly not `mispriced at inception’ as Buffett claims in his letter. Some of his CDS deals aren’t looking so hot either.

artichoke says:

Buffett appears to be arguing for mean reversion of prices, saying that Black Scholes overstates the probability that the underlier price drops very low. On the contrary, Black Scholes assumes that returns on the underlier follow a memory-less process: that falling 20% today does not affect the probability of falling (a further) 20% tomorrow.

It’s not clear whether he is assuming that option implied volatility is independent of option strike, that is, the at-the-money volatility will apply for options with other strikes as well. This assumption is commonly observed to be incorrect, and each market violates it in characteristic ways, having a particular “skew” or “kurtosis”. For equity options, there is “put skew” meaning put options are valued even higher than the flat assumption would have them. Volatility increases as the underlier price drops, reflecting typical increase in panic by the investing public. If this is overstated one can generally make money by writing far out-of-the-money put options, taking on the panic risk and being generally well paid for it. But again that bet was often a loser in the past year.

Effectively he’s saying that things cannot get that much worse. He may be right and his historical performance as an investor lends much weight to his judgment. He’s usually right.

And over a long historical perspective one may find that his statement is right. But surely his statement is not right as applied to banking stocks in the past year, and he didn’t predict that correctly a year ago.

Thomas says:

Took a look at his letter to shareholders. In there, he states quite clearly that he considers a drop in stock prices to be good, even if he owns shares that have dropped in value, because it allows him to buy more stocks on the cheap.

So in essence, he argues that the stock market crash overestimates the drop in underlying fundamental value. The market exaggerates. And WB knows better.

In other words: Mean reversion.

It’s not a fact. It’s his opinion and investment philosophy.

He may be right, or he may be wrong. Time will tell.

Anonymous says:

Michael Hudson video

Anonymous says:

From: Guess What Got Lost in the Loan Pool?

“If notes underlying even some of these mortgages were improperly assigned or lost, that will surely complicate pending legislation intended to allow bankruptcy judges to modify mortgage terms for troubled borrowers. A so-called cram-down provision in the law would let judges reduce the size of a loan, forcing whoever holds the security interest in it to take a loss.

But if the holder of the note is in doubt, how can these loans be modified?”

I can easily imagine boxes of these notes getting lost in the shuffle, either be accident or deliberately. The Financial Engineers would not have given paper much priority after slicing and dicing. The storage of these notes may have been assigned to some underling or office geek who muffed it. Or these boxes may have just floated around after the Securitization and ended up who knows where? And, with the cost of storage, just get rid of them. Then some person offended by the Crime around them might have even deep sixed these boxes deliberately. Even now some of these boxes may be floating around who knows where? Maybe even some of the storage companies have thrown the stuff out when the bills weren’t paid by the distressed Banksters.

First and foremost to any Bankster: SHOW ME THE DOCUMENTS!!!! You may end up in a free house due to some geek Good Samaritan who worked for the Banksters.

I really love how all this so called sophisticated Math comes down to “Where the hell are those boxes???”
So much for AUTOMATION.

russell1200 says:

WB is talking his book. As an insurer he is often (in effect) short on puts of varying length.

There is not a long enough period of market data to even know if what he is saying is correct. Based on the US market only he may be correct, but how many 20 year time periods have their been since the market first started. A number less than 100 is not a great statical basis for risking bankrupting your company.

It is also not true that if the stock market collapses that there will be no need for money because the system has been destroyed. The Russian émigré situation post 1917 would argue that position.

Terry Maynard says:

The Dahlem Report on the failure of academic economics is the best–OK, only–serious examination of why economists missed the current downturn that I’ve seen.

Every academic economist in the world should read and heed its message.

Still, they generally remain at least a step ahead of their policy and market wonk counterparts who have been selling boom, boom, boom for the better part of three decades. Apparently, it’s time for a bust.

Anonymous says:

Min says …

"It's a common, silent understanding among TPTB & experts that after letting Lehman to collapse on Sept 15 '09 what happened 3 days latter on Sept 18 2009 made sure no gorverment can let that to be repeated again."

——–

The credit crunch caused by the failure of Lehman will not be repeated because the Fed has backstopped money market funds and money market accounts. Panic by those funds is the only thing that caused the system to seize up, and they have no reason to panic if the Feds backstop them.

Eric L says:

Buffett’s comments are puzzling in at least two ways.

First, one common complaint with Black-Scholes is that it underprices black-tails, not that it over-prices them. In fact, exchange-traded option prices tend not to follow Black-Sholes closely, for this and other reasons such as the volatility skew that artichoke mentions.

http://tinyurl.com/2np4tz

Second, Buffett’s in a strange rhetorical position here. He says in his letter that in his opinion “the valuations that the Black-
Scholes formula now place on our long-term put options overstate our liability”. So what about when Berkshire wrote the options? Hopefully, the options were overpriced then too (in Buffett’s opinion), which is good for Berkshire investors, since it means they collected a premium for a larger move in the underlying than will occur. So why does Buffett seem to be complaining about B-S?

In fact, I bet Berkshire did not sell those puts using pure Black-Scholes. I certainly hope for their investors’ sake that they used a pricing model that better took into account fat tails and skewness.

So rhetorically, instead of writing a letter to his investors complaining about B-S, he should have told them how brilliant he was to sell equity puts using a model that wildly over-prices them.

Final comment: if you’ve sold naked puts and are confident of direction, as Buffett claims to be, you yawn when you see the premium explode higher on the puts, since you (think you) know you’ll get it all back. Likewise if you’ve sold puts and, being less confident of direction than Buffett, covered the sale with an offsetting short position. It’s only when someone has sold puts naked and is losing confidence about direction that I would expect them to start whining about “inappropriate” pricing formulas.

Just saying.

Swedish Lex says:

On Black-Scholes.
I spent 24 months lobbying the EU 4-5 years ago for clients, arguing taht BS was wholly inappropriate to value long-term employee stock options beause of volatility etc. We had extensive research undertaken by senior experts in finance to demonstrate our case. However, the mark to market fundamentalists in the IASB refused to listen. Now it seems that what we said then, laregly in vain, is confirmed. The Larosière Report that came out last week is testimony of that too. It thus seems that the EU will turn away from blindly accepting what the IASB ayatollahs dictate.
I just had to get that off my chest. It has been brewing for several years………

Keenan says:

RE: Antidote

I am of two minds concerning the photos: One one hand it evokes the old testament scripture concerning a time of hope – the lamb lying down with the lion etc.

On the other, it is further evidence of the ecological imbalance driven by real estate development. The creation of edge habitat via suburbanization and the absence of predators, which is dulling their genetic fright/flight response even to domestic canines, have fostered proliferation of this invasive and adaptable species.

Deer ambling through the streets of residential neighborhoods in my city of Pittsburgh is not an uncommon sight.

dearieme says:

The failure of academic economics should have been predictable from the economists’ hubris in awarding themselves their pretendy wee Nobel Prize, as a correction of the indignity they suffered when Nobel himself unaccountably omitted to award them one.

Dave Raithel says:

I posted a related comment re Hudson on Yves Smith’s post “Reader Sanity Check …” and won’t repeat those points here. Instead I’ll just ask the Hudson critics if I read the same essay they did? Consider these points I pull from the essay:

“The 19th-century program to nationalize the land (it was the first plank of the Communist Manifesto) did not mean anything remotely like the government taking over estates, paying off their mortgages at public expense and then giving it back to the former landlords free and clear of encumbrances and taxes. It meant taking the land and its rental income into the public domain, and leasing it out at a user fee ranging from actual operating cost to a subsidized rate or even freely as in the case of streets and roads.

Nationalizing the banks along these lines would mean that the government would supply the nation’s credit needs. The Treasury would become the source of new money, replacing commercial bank credit. Presumably this credit would be lent out for economically and socially productive purposes, not merely to inflate asset prices while loading down households and business with debt as has occurred under today’s commercial bank lending policies.”

And: “… the classical political economists down through John Stuart Mill, Karl Marx and the Progressive Era … sought to create markets free of extractive rentier claims by special interests…”

And: “The argument between Progressive Era reformers, socialists, anarchists and individualists thus turned on the political strategy of how best to free markets from debt and rent. Where they differed was on the best political means to achieve it, above all the role of the state. There was broad agreement that the state was controlled by vested interests inherited from feudal Europe’s military conquests and the world that was colonized by European military force. The political question at the turn of the 20th century was whether peaceful democratic reform could overcome the political and even military resistance wielded by the Old Regime using violence to retain its “rights.” The ensuing political revolutions were grounded in the Enlightenment, in the legal philosophy of men such as John Locke, political economists such as Adam Smith, John Stuart Mill and Marx. Power was to be used to free markets from the predatory property and financial systems inherited from feudalism. Markets were to be free of privilege and free lunches, so that people would obtain income and wealth only by their own labor and enterprise. This was the essence of the labor theory of value and its complement, the concept of economic rent as the excess of market price over socially necessary cost-value.”

And: “The common aim [of Individualists and Socialists] was to maximize economic efficiency so as to pass on the fruits of the Industrial and Agricultural Revolutions to the population at large. This required blocking the rentier class of interlopers from grabbing the public domain and controlling the allocation of resources. Socialists did not believe this could be done without taking the state’s political and legal power into their own hands. Marxists believed that a revolution was necessary to reclaim property rent for the public domain, and to enable governments to create their own credit rather than borrow at interest from commercial bankers and wealthy bondholders. The aim was not to create a bureaucracy but to free society from the surviving absentee ownership power of the vested property and financial interest.

All this history of economic thought has been as thoroughly expunged from today’s academic curriculum as it has from popular discussion. Few people remember the great debate at the turn of the 20th century: Would the world progress fairly quickly from Progressive Era reforms to outright socialism – public ownership of basic economic infrastructure, natural monopolies (including the banking system) and the land itself (and to Marxists, of industrial capital as well)? Or, could the liberal reformers of the day – individualists, land taxers, classical economists in the tradition of Mill, and American institutionalists such as Simon Patten – retain capitalism’s basic structure and private property ownership? If they could do so, they recognized that it would have to be in the context of regulating markets and introducing progressive taxation of wealth and income. This was the alternative to outright “state” ownership. Today’s extreme “free market” idea is a dumbed-down caricature of this position.”

Perhaps I should understand the Hudson critics to mean only this: That one can read Hudson to “sterilize” or “sanitize” words like “nationalization” so that we could either just drop it entirely or use it guilt-free. I read the Hudson piece as one of necessary intellectual history: We cannot even talk about options because we don’t (collectively) know how we got to here.

With RueTheDay, I hope to see more of Hudson’s contributions in the larger MSM. I only learned of him in the last 18 months or so. But I am not really surprised that Missouri’s political and media elite would give so little acknowledgement to him. If he’s ever been cited in the St. Louis Post-Dispatch, the Kansas City Star, or the Columbia Daily Tribune, I cannot find it, and I did some googling before writing this. But we gets by mostly on common sense, ya know, don’t wants to be neither too dumb nor too bookish. Pearls before swine, mutes screaming at the deaf in a vacuum, oh, the futility, the futility ….

Anonymous says:

Steve,

“`L’enfer, c’est les autres’”

Ah, Sartre is the source of this wisdom, not Neitzsche, eh? Sartre’s progeny need to raise a stink, for I am hardly the first to be led down the garden path on this one. As eminent an intellect as Walter Kaspar has suggested Neitzsche as the author.

As to Bush’s speeches, please know that neither I nor my cats expected any more from his enthusiasts in their day that we do now of the claque currently worshiping Abraham Delano Obama. When it comes to politicians, my contempt for the credulous onlooker is simply boundless. Why even kitty winces when our dear savior declares war on lobbyists.

doc holiday says:

Buffett is just Madoff with power steering and supercharged PR … so pleaze get real with your romance of financial illusions. The next shoe to drop (or set of panties) is the sweet old innocent crook image that is nothing but a Ponzi scheme by the richest crook in Bedford Falls …..yah don’t get to the top of the shit pile by giving away ice cream cones, now do yah punk, huh, huh?

Anonymous says:

Buffett is either stupid or playing at stupid (or both). His argument reduces to several components one of which is that he “gets the use” of the premium until expiration (which he seems to assume is always European).

Of course he does. Duh.

However, if he only earns the risk free rate used in the BS model itself, he neither wins nor loses.

If he earns above the risk free rate, then he wins.

But by definition he takes risk to do that.

So he’s really saying that there is a “free lunch,” at least statistically, that for example investing short option premium over time at a spread has a positive expectation.

It probably does.

But that’s not a defect in the model, it’s a defect in its use, as anyone buying that option should be putting in the same factors and so willing to pay less.

The same is true for all the other components including volatility (inflation is just a component of the risk free drift rate, or rather can be accounted for thus).

Buffett has “invented” something that boils down to, “Why invest in an index fund when you can buy the SPUs (futures) and put your cash in spread product and generate alpha relative to the market,” which is hardly a novel concept, it’s called cash enhanced replication.

********** HOWEVER THERE IS AN ASYMMETRY IF YOU TAKE TAXES INTO ACCOUNT ************

Normally, and I’m no insurance company tax accountant, but I am a tax laywer in financial transactions, selling an option is an open transaction and the received premium is not taxed until expiration when (assuming no exercise) you get to keep it.

So from the standpoint of differential taxation, indeed selling a deep in the money put instead of investing in the market may well make sense.

But then he didnt discuss that did he, so you tell me if that’s cause he has to maintain his “apple pie I’m jes’ folks” concept of not taking advantage of “loopholes.”

Anonymous says:

“The September bailout of AIG led to $18.7 billion of money going to GS, Soc Gen, DB, ML, and other big banks.”

Cuomo should prosecute management at all those firms for extortion and racketeering.

Anonymous says:

Tim is saying similar to what I did. The BS assumption that anyone can engage in infinite replication by borrowing at the risk-free rate would have to be modified to reflect that such is not possible over long terms or things degenerate. Whether you deal with this by padding the drift rate or the variance is unimportant.

But more generally, all the BS model is doing is two things: (1) saying the present value of a call option is the net present value of the conditional expected value, ie the net present value of the amount by which the terminal underlying is expected to exceed the strike; and (2) one can calculate all this by assuming log normality and risk-free replication.

(2) breaks down in less-than perfectly liquid, complete markets (ie it breaks down in reality and the longer term of reality the more it breaks down).

(1) must always be true as its definitional.

Anonymous says:

“Normally, and I’m no insurance company tax accountant, but I am a tax laywer in financial transactions, selling an option is an open transaction and the received premium is not taxed until expiration when (assuming no exercise) you get to keep it.”

A premium received under a CDS is not taxed like receipt of a premium under an option. It is taxed like any other swap payment, and so results in income over the term of the swap. A couple banks have asked the IRS about deferring payments received under a CDS as option premiums, and every time the IRS said no.

Anonymous says:

Reuters is repeating the lie that letting AIG fail would cause systematic risk. Burn them, and burn their counterparties (GS, MS, JPM, SG, DB, Rabo, Calyon, UBS, Barclays, CS, etc). http://www.reuters.com/article/americasDealsNews/idUSTRE5202MT20090301

Greenspan/Rubin defanged banking/brokerage regulation on the theory that the threat of bankruptcy would regulate them just fine. It is time for Rubin/Greenspan and their proteges Summers/Geithner to stop being hypocrites and the FDIC follow its legal mandate to restructure or dissolve zombie banks.

If Summers/Geithner don’t like regulating banks with the iron law of bankruptcy / receivership, then they should regulate the banks as tightly as a public utility or a baby food manufacturer. It is bad economics and morality to let the banks gamble with the public’s money.

Anonymous says:

Please.

We’re talking about long-date put options on market indexes not on 5-year CDS swaps, OK?

And the contingent payment swap method is not law it’s a long-ago proposed but never formally executed regulation.

CDS aren’t calculated on BS anyway.

Anonymous says:

I dont care what they think. Or what you think. But give me their fone numbers and you bet I’ll call them and tell them you quoted them indirectly in here … I’m sure you have their permission.

I DARE YOU.

Now go home and repeat “I will read the topic before I open my mouth and make myself look dopey that I don’t know the difference between a swap and an option and when substance over form governs and behave myself”

Juan says:

Power was to be used to free markets from the predatory property and financial systems inherited from feudalism. Markets were to be free of privilege and free lunches, so that people would obtain income and wealth only by their own labor and enterprise. This was the essence of the labor theory of value…

I always enjoy Hudson’s writings but, unless referring to parts of Latin America, he is flatly wrong to believe that early 20th c legal-political systems hence property relations remained dominated by feudal ‘inheritances’.
Additionally, labor theories of value should not be lumped together as, over a few hundred years, they evolved, became increasingly developed. The idea that ‘people would obtain income and wealth only by their own labor’ seems to neglect that the developed theory is one of social relations between people.